References: Financial Management by Khan Jain Financial Management by I. M. Pandey Financial Management by Prasanna Chandra Financial Management by Shashi Gupta and Neeti Gupta Financial Management by Rustogi

SIKKIM MANIPAL UNIVERSITY 238 Financial Management Subject code : MB0029

Contents

Unit 1 Financial Management 1

Unit 2 Financial Planning 15

Unit 3 Time Value of Money 34

Unit 4 Valuation of Bonds and shares 50 Unit 5 Cost of Capital 72

Unit 6 Leverage 88 Unit 7 Capital Structure 101 Unit 8 Capital Budgeting 113

Edition: Fall 2008 Contents

Unit 9 Risk Analysis in Capital Budgeting 147

Unit 10 Capital Rationing 167

Unit 11 Working Capital management 174

Unit 12 Cash Management 190 Unit 13 Inventory Management 204

Unit 14 Receivables Management 218 Unit 15 Dividend Decision 231

Edition: Fall 2008

BKID – B0671 Dr. K. Jayakumar

Vice Chancellor

Sikkim Manipal University of Health, Medical, and Technological studies

Prof. Nandagopal V. B.

Director and Dean

Sikkim Manipal University of Health, Medical, and Technological studies.

Board of Studies

Dr. T. V. Narasimha Rao Prof. K. V. Varambally

Professor. Manipal Universal Learning Director, Manipal Institute of Management, Manipal

Ms. Vimala Parthasarathy Mr. Shankar Jagannathan

Asst. Professor. Sikkim Manipal University of Health, Former Group Treasurer

Medical and Technological studies. Wipro Technologies Limited, Bangalore

Ms. Sadhana Dash Mr. Abraham Mathews

Senor Manager HR Chief Financial Officer

Microsoft India corporation ( Pvt) limited Infosys BPO, Bangalore

Mr. Pankaj Khanna

Director, HR, Fidelity Mutual Fund

Content Preparation Team Content Reviewed and Edited by

1. Prof V. Narayanan Dr. T. V. Narasimha Rao Dean, M.S. Ramaiah Institute of Management, Bangalore Professor. Manipal Universal Learning 2. Smt. Asha Nadig Adarsh Institute of Management, Bangalore

Edition: Fall 2008 This book is a distance education module comprising of collection of learning material for our students.

All rights reserved. No part of this work may be reproduced in any form by any means without permission in writing from Sikkim Manipal University of Health, Medical and Technological Sciences, Gangtok, Sikkim. Printed and Published on behalf of Sikkim Manipal University of Health, Medical and Technological Sciences, Gangtok, Sikkim by Mr. Rajkumar Mascreen, GM, Manipal Universal Learning Pvt. Ltd., Manipal – 576 104. Printed at Manipal Press Limited, Manipal. INTRODUCTION

Financial Management deals with the management of financial resource of a business firm. It discusses the goal of financial management and emphasizes on shareholder value maximization. Financial management mainly comprises of all managerial actions relating to the three major decision areas such as Investment, Financing and Dividends and working capital management. This courseware comprises 15 units: Unit 1: Financial Management

Explains the meaning and scope of financial management. It examines the goal of corporate financial management.

Unit 2: Financial Planning

Gives a brief account of the meaning and need for financial planning.

Unit 3: Time Value of Money This unit introduces the concepts of time value of money, compounding and Discounting of cashflows. Unit 4: Valuation of Bonds and Shares

Explains the principles behind the valuations of bonds and equality shares

Unit 5: Cost of Capital

This unit describes the concept of cost of capital and the computation of the weighted average cost of capital.

Unit 6: Leverage

Describes the concepts of operating, financial and combined leverage and gives the procedure for computing the different types of leverage.

Unit 7: Capital Structure

This unit introduces the concept of capital structure and the importance thereof. It also discusses the various theories of capital of structure. Unit 8: Capital Budgeting

Explains the meaning and significance of capital budgeting decisions. It gives a detailed account of various investment appraisal techniques.

Unit 9: Risk Analysis in Capital Budgeting

Gives the meaning of risk types and sources of risk in capital budgeting decisions. It also analysis the various approaches for handling the risk factor in investment decisions

Unit 10: Capital Rationing

This unit explains the meaning of capital rationing. It also examines the steps involved in capital rationing process.

Unit 11: Working Capital Management

Gives the meaning of various concepts of working capital. It gives a detailed account of the factors that influence the working capital requirements of a firm.

Unit 12: Cash Management

Cash is an important component of working capital. It needs to be managed efficiently so as to avoid either excess cash balances or cash shortages. This unit looks at different cash management tools.

Unit 13: Inventory Management

This unit describes briefly the various forms of inventory that a firm keeps. A brief description and pricing of inventory along with the determination of stock levels are also explained.

Unit 14: Receivables Management

Gives the meaning of receivables management. Costs of maintaining receivables, formulation of credit policy and determinations of an optimal credit period are discussed.

Unit 15: Dividend Decision

Dividends are payments made by firm to its shareholders. Dividends form a part of the returns expected by the shareholders. This unit explains the dividend policy matters of a business firm and the different types of dividends. Financial Management Unit 1

Unit 1 Financial Management

Structure

1.1 Introduction 1.2 Meaning And Definitions 1.3 Goals Of Financial Management 1.3.1 Profit Maximization 1.3.2 Wealth Maximization 1.4 Finance Functions 1.4.1 Investment Decisions: 1.4.2 Financing Decisions: 1.4.3 Dividend Decisions 1.4.4 Liquidity Decision 1.5 Organization Of Finance Function 1.5.1 Interface Between Finance And Other Business Functions 1.5.2 Finance And Accounting 1.5.3 Finance And Marketing 1.5.4 Finance And Production (Operations) 1.5.5 Finance And HR 1.6 Summary Terminal Questions Answers to SAQs and TQs

1.1 Introduction To establish any business, a person must find answers to the following questions: a) Capital investments are required to be made. Capital investments are made to acquire the real assets, required for establishing and running the business smoothly. Real assets are land and buildings, plant and equipments etc. b) Decision to be taken on the sources from which the funds required for the capital investments mentioned above could be obtained, to be taken. c) Therefore, there are two sources of funds viz. debt and equity. In what proportion the funds are to be obtained from these sources is to be decided for formulating the financing plan.

Sikkim Manipal University 1 Financial Management Unit 1 d) Decision on the routine aspects of day to day management of collecting money due from the firms’ customers and making payments to the suppliers of various resources to the firm. These are the core elements of financial management of a firm.

Financial Management of a firm is concerned with procurement and effective utilization of funds for the benefit of its stakeholders. The most admired Indian companies are Reliance, Infosys. They have been rated well by the financial analyst on many crucial aspects that enabled them to create value for its share holders. They employ the best technology, produce quality goods or render services at the least cost and continuously contribute to the share holders’ wealth. All corporate decisions have financial implications. Therefore, financial management embraces all those managerial activities that are required to procure funds at the least cost and their effective deployment. Finance is the life blood of all organizations. It occupies a pivotal role in corporate management. Any business which ignores the role of finance in its functioning cannot grow competitively in today’s complex business world. Value maximization is the cardinal rule of efficient financial managers today.

Learning Objectives:

After studying this unit, you should be able to understand the following. 1. The meaning of Business Finance. 2. The objectives of Financial Management. 3. The various interfaces between finance and other managerial functions of a firm.

1.2Meaning And Definitions The branch of knowledge that deals with the art and science of managing money is called financial management. With liberalization and globalization of Indian economy, regulatory and economic environments have undergone drastic changes. This has changed the profile of Indian finance managers today. Indian financial managers have transformed themselves from licensed raj managers to well informed dynamic proactive managers capable of taking decisions of complex nature in the present global scenario. Traditionally, financial management was considered a branch of knowledge with focus on the procurement of funds. Instruments of financing, formation, merger & restructuring of firms, legal and institutional frame work involved therein occupied the prime place in this traditional approach.

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The modern approach transformed the field of study from the traditional narrow approach to the most analytical nature. The core of modern approach evolved around, procurement of the least cost funds and its effective utilization for maximization of share holders’ wealth. Globalization of business and impact of information technology on financial management have added new dimensions to the scope of financial management.

Self Assessment Question 1 1. Financial Management deals with procurement of funds at the least cost and ______funds.

1.3Goals Of Financial Management Goals mean financial objective of a firm. Experts in financial management have endorsed the view that the goal of Financial Management of a firm is maximization of economic welfare of its shareholders. Maximization of economic welfare means maximization of wealth of its shareholders. Shareholders’ wealth maximization is reflected in the market value of the firms’ shares. A firm’s contribution to the society is maximized when it maximizes its value. There are two versions of the goals of financial management of the firm:

1.3.1 Profit Maximization: In a competitive economy, profit maximization has been considered as the legitimate objective of a firm because profit maximization is based on the cardinal rule of efficiency. Under perfect competition allocation of resources shall be based on the goal of profit maximization. A firm’s performance is evaluated in terms of profitability. Investor’s perception of company’s performance can be traced to the goal of profit maximization. But, the goal of profit maximization has been criticized on many accounts: 1. The concept of profit lacks clarity. What does the profit mean? a) Is it profit after tax or before tax? b) Is it operating profit or net profit available to share holders?

Differences in interpretation on the concept of profit expose the weakness of the goal of profit maximization 2. Profit maximization ignores time value of money because it does not differentiate between profits of current year with the profit to be earned in later years.

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3. The concept of profit maximization fails to consider the fluctuation in the profits earned from year to year. Fluctuations may be attributable to the business risk of the firm but the concept fails to throw light on this aspect. 4. Profit maximization does not make clear the concept of profit as to whether it is accounting profit or economic normal profit or economic supernormal profits. 5. Because of these deficiencies, profit maximization fails to meet the standards stipulated in an operationally feasible criterion for maximizing shareholders wealth.

1.3.2 Wealth Maximization Wealth Maximization has, been accepted by the finance managers, because it overcomes the limitations of profit maximisation. Wealth maximisation means maximizing the net wealth of the Company’s share holders. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. Following arguments are in support of the superiority of wealth maximisation over profit maximisation: 1. Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand there are many subjective elements in the concept of profit maximisation. 2. It considers time value of money. Time value of money translates cash flows occurring at different periods into a comparable value at zero period. In this process, the quality of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallizes into the rate of return that will motivate investors to part with their hard earned savings. It is called required rate of return or hurdle rate which is employed in evaluating all capital projects undertaken by the firm. Maximizing the wealth of shareholders means positive net present value of the decisions implemented. Positive net present value can be defined as the excess of present value of cash inflows of any decision implemented over the present value of cash out flows associated with the process of implementation of the decisions taken. To compute net present value we employ time value factor. Time value factor is known as time preference rate i.e. the sum of risk free rate and risk premium. Risk free rate is the rate that an investor can earn on any government security for the duration under consideration. Risk premium is the consideration for the risk perceived by the investor in investing in that asset or security. X Ltd is a listed company engaged in the business of FMCG (Fast Moving Consumer goods). Listed means the company’s shares are allowed to be traded officially on the portals of the stock

Sikkim Manipal University 4 Financial Management Unit 1 exchange. The Board of Directors of X Ltd took a decision in one of its Board meeting, to enter into the business of power generation. When the company informs the stock exchange at the conclusion of the meeting of the decision taken, the stock market reacts unfavourably with the result that the next days’ closing of quotation was 30 % less than that of the previous day. The question now is, why the market reacted in this manner. Investors in this FMCG Company might have thought that the risk profile of the new business (power) that the company wants to take up is higher compared to the risk profile of the existing FMCG business of the X Ltd. When they want a higher return, market value of company’s share declines. Therefore the risk profile of the company gets translated into a time value factor. The time value factor so translated becomes the required rate of return. Required rate of return is the return that the investors want for making investment in that sector. Any project which generates positive net present value creates wealth to the company. When a company creates wealth from a course of action it has initiated the share holders benefit because such a course of action will increase the market value of the company’s shares.

Superiority of Wealth Maximisation over Profit Maximisation

1. It is based on cash flow, not based on accounting profit. 2. Through the process of discounting it takes care of the quality of cash flows. Distant cash flows are uncertain. Converting distant uncertain cash flows into comparable values at base period facilitates better comparison of projects. There are various ways of dealing with risk associated with cash flows. These risks are adequately considered when present values of cash flows are taken to arrive at the net present value of any project. 3. In today’s competitive business scenario corporates play a key role. In company form of organization, shareholders own the company but the management of the company rests with the board of directors. Directors are elected by shareholders and hence agents of the shareholders. Company management procures funds for expansion and diversification from Capital Markets. In the liberalized set up, the society expects corporates to tap the capital markets effectively for their capital requirements. Therefore to keep the investors happy through the performance of value of shares in the market, management of the company must meet the wealth maximisation criterion. 4. When a firm follows wealth maximisation goal, it achieves maximization of market value of share. When a firm practices wealth maximisation goal, it is possible only when it produces quality goods at low cost. On this account society gains because of the societal welfare.

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5. Maximization of wealth demands on the part of corporates to develop new products or render new services in the most effective and efficient manner. This helps the consumers as it will bring to the market the products and services that consumers need. 6. Another notable features of the firms committed to the maximisation of wealth is that to achieve this goal they are forced to render efficient service to their customers with courtesy. This enhances consumer welfare and hence the benefit to the society. 7. From the point of evaluation of performance of listed firms, the most remarkable measure is that of performance of the company in the share market. Every corporate action finds its reflection on the market value of shares of the company. Therefore, shareholders wealth maximization could be considered a superior goal compared to profit maximisation. 8. Since listing ensures liquidity to the shares held by the investors, shareholders can reap the benefits arising from the performance of company only when they sell their shares. Therefore, it is clear that maximization of market value of shares will lead to maximisation of the net wealth of shareholders. Therefore, we can conclude that maximization of wealth is the appropriate of goal of financial management in today’s context.

Self Assessment Questions 2 1. Under perfect competition, allocation of resources shall be based on the goal of ______. 2. ______is based on cash flows. 3. ______consider time value of money.

1.4 Finance Functions Finance functions are closely related to financial decisions. The functions performed by a finance manager are known as finance functions. In the course of performing these functions finance manager takes the following decisions:­ 1. Financing decision 2. Investment Decision 3. Dividend decision 4. Liquidity decision.

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1.4.1 Investment Decisions: To survive and grow, all organizations must be innovative. Innovation demands managerial proactive actions. Proactive organization’s continuously search for innovative ways of performing the activities of the organization. Innovation is wider in nature. It could be expansion through entering into new markets, adding new products to its product mix, performing value added activities to enhance the customer satisfaction, or adopting new technology that would drastically reduce the cost of production or rendering services or mass production at low cost or restructuring the organization to improve productivity. All these will change the profile of an organization. These decisions are strategic because, they are risky but if executed successfully with a clear plan of action, they generate super normal growth to the organization. If the management errs in any phase of taking these decisions and executing them, the firm may become bankrupt. Therefore, such decisions will have to be taken after taking into account all facts affecting the decisions and their execution. Two critical issues to be considered in these decisions are:­ 1. Evaluation of expected profitability of the new investments. 2. Rate of return required on the project. The rate of return required by investor is normally known by hurdle rate or cut­off rate or opportunity cost of capital. After a firm takes a decision to enter into any business or expand it’s existing business, plans to invest in buildings, machineries etc. are conceived and executed. The process involved is called Capital Budgeting. Capital Budgeting decisions demand considerable time, attention and energy of the management. They are strategic in nature as the success or failure of an organization is directly attributable to the execution of capital budgeting decisions taken. Investment decisions are also known as Capital Budgeting Decisions. Capital Budgeting decisions lead to investment in real assets Dividends are pay­outs to shareholders. Dividends are paid to keep the shareholders happy. Dividend policy formulation requires the decision of the management as to how much of the profits earned will be paid as dividend. A growing firm may retain a large portion of profits as retained earnings to meet its needs of financing capital projects. Here, the finance manager has to strike a balance between the expectation of shareholders on dividend payment and the need to provide for funds out of the profits to meet the organization’s growth.

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1.4.2 Financing Decisions: Financing decisions relate to the acquisition of funds at the least cost. Here cost has two dimensions viz explicit cost and implicit cost. Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the securities etc. Implicit cost is not a visible cost but it may seriously affect the company’s operations especially when it is exposed to business and financial risk. For example, implicit cost is the failure of the organization to pay to its lenders or debenture holders loan installments on due date on account of fluctuations in cash flow attributable to the firms business risk. In India if the company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up. This risk is normally known as risk of insolvency. A company which employs debt as a means of financing normally faces this risk especially when its operations are exposed to high degree of business risk. In all financing decisions a firm has to determine the proportion of equity and debt. The composition of debt and equity is called the capital structure of the firm. Debt is cheap because interest payable on loan is allowed as deductions in computing taxable income on which the company is liable to pay income tax to the Government of India. For example, if the interest rate on loan taken is 12 %, tax rate applicable to the company is 50 %, then when the company pays Rs.12 as interest to the lender, taxable income of the company will be reduced by Rs.12. In other words when actual cost is 12% with the tax rate of 50 % the effective cost becomes 6% therefore, debt is cheap. But, every installment of debt brings along with it corresponding insolvency risk. Another thing notable in this connection is that the firm cannot avoid its obligation to pay interest and loan installments to its lenders and debentures. On the other hand, a company does not have any obligation to pay dividend to its shareholders. A company enjoys absolute freedom not to declare dividend even if its profitability and cash positions are comfortable. However, shareholders are one of the stakeholders of the company. They are in reality the owners of the company. Therefore well managed companies cannot ignore the claim of shareholders for dividend. Dividend yield is an important determinant for stock prices. Dividend yield refers to dividend paid with reference to the market price of the shares of the company. An investor in company’s shares has two objectives for investing: 1. Income from Capital appreciation (i.e. Capital gains on sale of shares at market price) 2. Income from dividends.

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It is the ability of the company to give both these incomes to its shareholders that determines the market price of the company’s shares. The most important goal of financial management is maximisation of net wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholders enjoy both dividend income and capital gains as per the expectation of the market. But, dividend is declared out of the profit earned by the company after paying income tax to the Govt of India. For example, let us assume the following facts: Dividend = 12 % on paid up value Tax rate applicable to the company = 30 % Dividend tax = 10 % When a Company pays Rs.12 on paid up Capital of Rs.100 as dividend, the profit that the company must earn before tax is: Since payment of dividend by an Indian Company attracts dividend tax, the company when it pays Rs.12 to shareholders, must pay to the Govt of India 10 % of Rs.12 = Rs.1.2 as dividend tax. Therefore dividend and dividend tax sum up to 12 + 1.2 = Rs.13.2 Since this is paid out of the post tax profit, in this question, the company must earn: Post – tax dividend paid 1 – Tax rate applicable to the company = pre tax profit required to declare and pay the dividend 13.2 13.2 = = 1 – 0.3 0.7 = Rs 19 approximate Therefore, to declare a dividend of 12 % Company has to earn a pre tax profit of 19 %. On the other hand, to pay an interest of 12 % Company has to earn only 8.4 %. This leads to the conclusion that for every Rs.100 procured through debt, it costs 8.4 % where as the same amount procured in the form of equity (share capital) costs 19 %. This confirms the established theory that equity is costly but debt is a cheap but risky source of funds to the corporates. The challenge before the finance manager is to arrive at a combination of debt and equity for financing decisions which would attain an optimal structure of capital. An optimal structure is one that arrives at the least cost structure, keeping in mind the financial risk involved and the ability of the company to manage the business risk. Besides, financing decision involves the consideration of managerial control, flexibility and legal aspects. As such it involves quite a lot of regulatory and managerial elements in financing decisions.

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1.4.3 Dividend Decisions Dividend yield is an important determinant of an investor’s attitude towards the security (stock) in his portfolio management decisions. But dividend yield is the result of dividend decision. Dividend decision is a major decision made by a finance manager. It is the decision on formulation of dividend policy. Since the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands the managerial attention on the impact of its policy on dividend on the market value of the shares. Optimum dividend policy requires decision on dividend payment rates so as to maximize the market value of shares. The payout ratio means what portion of earnings per share is given to the shareholders in the form of cash dividend. In the formulation of dividend policy, management of a company must consider the relevance of its policy on bonus shares. Dividend policy influences the dividend yield on shares. Since company’s ratings in the Capital market have a major impact on its ability to procure funds by issuing securities in the capital markets, dividend policy, a determinant of dividend yield has to be formulated having regard to all the crucial elements in building up the corporate image. The following need adequate consideration in deciding on dividend policy: 1. Preferences of share holders ­ Do they want cash dividend or Capital gains? 2. Current financial requirements of the company 3. Legal constraints on paying dividends. 4. Striking an optimum balance between desires of share holders and the company’s funds requirements.

1.4.4 Liquidity Decision Liquidity decisions are concerned with Working Capital Management. It is concerned with the day ­to –day financial operations that involve current assets and current liabilities. The important element of liquidity decisions are: 1) Formulation of inventory policy 2) Policies on receivable management. 3) Formulation of cash management strategies 4) Policies on utilization of spontaneous finance effectively.

1.4.5 Organization Of Finance Function Financial decisions are strategic in character and therefore, an efficient organizational structure is required to administer the same. Finance is like blood that flows through out the organization.

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In all organizations CFOs play an important role in ensuring proper reporting based on substance to the stake holders of the company. Because of the crucial role these functions play, finance functions are organized directly under the control of Board of Directors. For the survival of the firm, there is a need to ensure both long term and short term financial solvency. Failure to achieve this will have its impact on all other activities of the firm. Weak functional performance by financial department will weaken production, marketing and HR activities of the company. The result would be the organization becoming anemic. Once anemic, unless crucial and effective remedial measures are taken up it will pave way for corporate bankruptcy. CFO reports to the Board of Directors. Under CFO, normally two senior officers manage the treasurer and controller functions. A Treasurer performs the following function : 1. Obtaining finance. 2. Liasoning with term lending and other financial institutions. 3. Managing working capital. 4. Managing investment in real assets.

A Controller performs: 1. Accounting and Auditing 2. Management control systems 3. Taxation and insurance 4. Budgeting and performance evaluation 5. Maintaining assets intact to ensure higher productivity of operating capital employed in the organization. In India CFOs have a legal obligation under various regulatory provisions to certify the correctness of various financial statements information reported to the stake holders in the annual reports. Listing norms, regulations on corporate governance and other notifications of Govt of India have adequately recognized the role of finance function in the corporate set up in India.

Self Assessment Questions 3 1. ______lead to investment in real assets. 2. ______relate to the acquisition of funds at the least cost. 3. Formulation of inventory policy is an important element of ______. 4. Obtaining finance is an important function of ______.

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1.5 Interface Between Finance And Other Business Functions

1.5.1 Finance And Accounting Looking at the hierarchy of the finance function of an organization, the controller reports to CFO. Accounting is one of the functions that a controller discharges. Accounting and finance are closely related. For computation of Return on Investment, earnings per share and of various ratios for financial analysis the data base will be accounting information. Without a proper accounting system, an organization cannot administer effectively function of financial management. The purpose of accounting is to report the financial performance of the business for the period under consideration. It is historical in character. But financial management uses the historical accounting information for decision making. All the financial decisions are futuristic based on cash flow analysis. All the financial decisions consider quality of cash flows as an important element of decisions. Since financial decisions are futuristic, it is taken and put into effect under conditions of uncertainty. Assuming the degree of uncertainty and incorporating their effect on decision making involve use of various statistical models. In the selection of these models, element of subjectivity creeps in.

1.5.2 Finance And Marketing Many marketing decisions have financial implications. Selections of channels of distribution, deciding on advertisement policy, remunerating the salesmen etc have financial implications. In fact, the recent behaviour of rupee against us $ (appreciation of rupee against US dollar), affected the cash flow positions of export oriented textile units and BPO’s and other software companies. It is generally believed that the currency in which marketing manager invoices the exports decides the cash flow consequences of the organization if the company is mainly dependent on exports. Marketing cost analysis, a function of finance managers is the best example of application of principles of finance on the performance of marketing functions by a business unit. Formulation of policy on credit management cannot be done unless the integration of marketing with finance is achieved. Deciding on credit terms to achieve a particular level of sales has financial implication because sanctioning liberal credit may result in huge bad debt, on the other hand a conservative credit terms may depress the sales. Credit terms also affect the investment in receivable, an area of working capital management. There is a close relation between inventory and sales. Co ordination of stores administration with that of marketing management is required to ensure customer satisfaction and good will. But investment in inventory requires the financial clearance because funds are locked in and the funds so blocked have opportunity cost of capital.

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1.5.3 Finance And Productions (Operations) Finance and operations management are closely related. Decisions on plant layout, technology selection, productions / operations, process plant size, removing imbalance in the flow of input material in the production / operation process and batch size are all operations management decisions but their formulation and execution cannot be done unless evaluated from the financial angle. The capital budgeting decisions are closely related to production and operations management. These decisions make or mar a business unit. We have examples to substantiate this. Failure to understand the implications of the latest technological trend on capacity expansions has cost even blue chip companies. Many textile units in India became sick because they did not provide sufficient finance for modernization of plant and machinery. Inventory management is crucial to successful operation management. But management of inventory involves quite a lot of financial variables.

1.5.4 Finance And HR Attracting and retaining the best man power in the industry cannot be done unless they are paid salary at competitive rates. If an organization formulates & implements a policy for attracting the competent man power it has to pay the most competitive salary packages to them. But it improves organizational capital and productivity. Infosys does not have physical assets similar to that of Indian Railways. But if both were to come to capital market with a public issue of equity, Infosys would command better investor’s acceptance than the Indian Railways. This is because the value of human resources plays an important role in valuing a firm. The better the quality of man power in an organization, the higher the value of the human capital and consequently the higher the productivity of the organization. Indian Software and IT enabled services have been globally acclaimed only because of the man power they possess. But it has a cost factor i.e. the best remuneration to the staff.

1.6Summary Financial Management is concerned with the procurement of the least cost funds and its’ effective utilization for maximization of the net wealth of the firm. There exists a close relation between the maximization of net wealth of shareholders and the maximization of the net wealth of the company. The broad areas of decision are capital budgeting, financing, dividend and working capital. Dividend decision demands the managerial attention to strike a balance between the investor’s expectation and the organizations’ growth.

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Terminal Questions 1. What are the objectives of financial management? 2. How does a finance manager arrive at an optimal capital structure? 3. Examine the relationship of financial management with other functional areas of a firm.

Answers To Self Assessment Questions’s Self Assessment Questions 1: 1. Effective utilization

Self Assessment Questions 2

1. Profit maximisation. 2. Wealth maximisation 3. Wealth maximisation

Self Assessment Questions 3 1. Investment decisions. 2. Financing decisions 3. Liquidity 4. Treasures

Answer for Terminal Questions 1. Refer 1.3 2. Refer 1.4.1 3. Refer 1.5

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Unit 2 Financial Planning

Structure

2.1. Introduction 2.2. Steps in financial planning 2.3. Factors affecting financial plan 2.4. Estimation of financial requirements of a firm. 2.5. Capitalizations 2.1.1 Cost Theory 2.1.2 Earnings theory: 2.1.3 Overcapitalization 2.1.4 Undercapitalization 2.6 Summary Terminal Questions Answer to SAQs and TQs

2.1 Introduction Liberalization and globalization policies initiated by the Government have changed the dimension of business environment. It has changed the dimension of competition that a firm faces today. Therefore for survival and growth a firm has to execute planned strategy systematically. To execute any strategic plan, resources are required. Resources may be manpower, plant and machinery, building, technology or any intangible asset. To acquire all these assets financial resources are essentially required. Therefore, finance manager of a company must have both long­range and short­range financial plans. Integration of both these plans is required for the effective utilization of all the resources of the firm. The long­range plan must consider (1) Funds required to execute the planned course of action. (2) Funds available at the disposal of the company. (3) Determination of funds to be procured from outside sources.

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Learning Objectives:

After studying this unit you should 1. Explain the steps involved in financial planning. 2. Explain the factors affecting the financial planning. 3. List out the causes of over­ capitation 4. Explain the effects of under capitation.

Objectives of Financial Planning Financial Planning is a process by which funds required for each course of action is decided. It must consider expected business Scenario and develop appropriate courses of action. A financial plan has to consider Capital Structure, Capital expenditure and cash flow. In this connection decisions on the composition of debt and equity must be taken. Financial planning generates financial plan. Financial plan indicates: 1. The quantum of funds required to execute business plans. 2. Composition of debt and equity, keeping in view the risk profile of the existing business, new business to be taken up and the dynamics of capital market conditions. 3. Formulation of policies for giving effect to the financial plans under consideration. A financial plan is at the core of value creation process. A successful value creation process can effectively meet the bench marks of investor’s expectations.

Benefits that accrue to a firm out of the financial planning 1. Effective utilization of funds: Shortage is managed by a plan that ensures flow of cash at the least cost. Surplus is deployed through well planned treasury management. Ultimately the productivity of assets is enhanced. 2. Flexibility in capital structure is given adequate consideration. Here flexibility means the firms ability to change the composition of funds that constitute its capital structure in accordance with the changing conditions of capital market. Flexibility refers to the ability of a firm to obtain funds at the right time, in the right quantity and at the least cost as per requirements to finance emerging opportunities. 3. Formulation of policies and instituting procedures for elimination of all types of wastages in the process of execution of strategic plans. 4. Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for plant and machinery and other fixed assets. This will help the firm in reducing its

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operating capital. Operating capital refers to the ratio of capital employed to sales generated. A perusal of annual reports of Dell computers will throw light on how Dell strategically minimized the operating capital required to support sales. Such companies are admired by investing community. 5. Integration of long range plans with the shortage plans.

Guidelines for financial planning 1. Never ignore the coordinal principle that fixed asset requirements be met from the long term sources. 2. Make maximum use of spontaneous source of finance to achieve highest productivity of resources. 3. Maintain the operating capital intact by providing adequately out of the current periods earnings. Due attention to be given to physical capital maintenance or operating capability. 4. Never ignore the need for financial capital maintenance in units of constant purchasing power. 5. Employ current cost principle wherever required. 6. Give due weightage to cost and risk in using debt and equity. 7. Keeping the need for finance for expansion of business, formulate plough back policy of earnings. 8. Exercise thorough control over overheads. 9. Seasonal peak requirements to be met from short term borrowings from banks.

2.2 Steps In Financial Planning 1. Establish Corporate Objectives: Corporate objectives could be grouped into qualitative and quantitative. For example, a company’s mission statement may specify “create economic – value added.” But this qualitative statement has to be stated in quantitative terms such as a 25 % ROE or a 12 % earnings growth rates. Since business enterprises operate in a dynamic environment, there is a need to formulate both short run and long run objectives. 2. Next stage is formulation of strategies for attaining the objectives set. In this connection corporates develop operating plans. Operating plans are framed with a time horizon. It could be a five year plan or a ten year plan. 3. Once the plans are formulated, responsibility for achieving sales target, operating targets, cost management bench marks, profit targets etc is fixed on respective executives. 4. Forecast the various financial variables such as sales, assets required, flow of funds, cost to be incurred and then translate the same into financial statements. Such forecasts help the

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finance manager to monitor the deviations of actual from the forecasts and take effective remedial measures to ensure that targets set are achieved without any time overrun and cost overrun. 5. Develop a detailed plan for funds required for the plan period under various heads of expenditure. 6. From the funds required plan, develop a forecast of funds that can be obtained from internal as well as external sources during the time horizon for which plans are developed. In this connection legal constrains in obtaining funds on the basis of covenants of borrowings should be given due weightage. There is also a need to collaborate the firm’s business risk with risk implications of a particular source of funds. 7. Develop a control mechanism for allocation of funds and their effective use. 8. At the time of formulating the plans certain assumptions need to be made about the economic environment. But when plans are implemented economic environment may change. To manage such situations, there is a need to incorporate an inbuilt mechanism which would scale up or scale down the operations accordingly.

Forecast of Income Statement and Balance Sheet There are three methods of preparing income statement: 1. Percent of sales method or constant ratio method 2. Expense method 3. Combination of both these two

Percent of Sales method: This approach is based on the assumptions that each element of cost bears some constant relationship with the sales revenue. For example, Raw material cost is 40 % of sales revenue of the year ended 31.03.2007. But this method assumes that the ratio of raw material cost to sales will continue to be the same in 2008 also. Such an assumption may not hold good in most of the situations. For example, Raw material cost increases by 10 % in 2008 but selling price of finished goods increases only by 5 %. In this case raw material cost will be 44 / 105 of the sales revenue in 2008. This can be solved to some extent by taking average for same representative years. However, inflation, change in Govt policies, wage agreements, technological innovation totally invalidate this approach on a long run basis.

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2. Budgeted Expense Method: Expenses for the planning period are budgeted on the basis of anticipated behaviour of various items of cost and revenue. This demands effective data base for reasonable budgeting of expenses. 3. Combination of both these methods is used because some expenses can be budgeted by the management taking into account the expected business environment and some other expenses could be based on their relationship with the sales revenue expected to be earned.

Forecast of Balance Sheet 1. Items of certain assets and liabilities which have a close relationship with the sales revenue could be computed based on the forecast of sales and the historical data base of their relationship with the sales. 2. Determine the equity and debt mix on the basis of funds requirements and the company’s policy on Capital structure.

Example : The following details have been extracted from the books of X Ltd Income Statement (Rs. In millions) 2006 2007 Sales less returns 1000 1300 Gross Profit 300 520 Selling Expenses 100 120 Administration 40 45 Deprecation 60 75 Operating Profit 100 280 Non operating income 20 40 EBIT (Earnings before interest & Tax 120 320 Interest 15 18 Profit before tax 105 302 Tax 30 100 Profit after tax 75 202 Dividend 38 100 Retained earnings 37 102

Balance Sheet (Rs. In million)

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Liabilities 2006 2007 Assets 2006 2007 Share holders fund Fixed Assets 400 510 Share Capital Less: Depreciation 100 120 Equity 120 120 300 390 Preference 50 50 Investments 50 50 Reserves & Surplus 122 224 Current Assets, loans Secured Loans 100 120 & Advances Unsecured loans 50 60 Cash at Bank 10 12 Receivables 80 128 Current Liabilities Inventories 200 300 Trade Crs 210 250 Loans & Advances 50 80 Miscellaneous Provisions 10 24 expenditure Tax 10 60 Proposed Dividend 38 100

760 984 700 984

Forecast the income statement and balance sheet for the year 2008 based on the following assumptions. 1. Sales for the year 2008 will increase by 30% over the sales value for 2007. 2. Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2007. 3. Depreciation is to charged at 25 % of fixed assets. 4. Fixed assets will increase by Rs.100 million. 5. Investments will increase by Rs.100 million. 6. Current assets and Current liabilities are to be decided based on their relationship to sales in the year 2007. 7. Miscellaneous expenditure will increase by Rs.19 million. 8. Secured loans in 2008 will be based on its relationship to sales in the year 2007. 9. Additional funds required, if any, will be met by bank borrowings. 10. Tax rates will be 30 %.

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11. Dividends will be 50 % of profit after tax. 12. Non operating income will increase by 10%. 13. There will be no change in the total amount of administration expenses to be spent in the year 2008 14. There is no change in equity and preference capital in 2008. 15. Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007.

Income Statement for the Year 2008 (Rs. In million) (Forecast) Particulars Basis Working Amount (Rs.) a. Sales Increase by 30 % 1300 x 1.3 1690 b. Cost of Sales Increase by 30 % 780 x 1.3 1014 c. Gross profit Sales–Cost of sales 1690 ­ 1014 676 d. Selling expenses 30 % increase 120 x 1.3 156 e. Administration No change 45 f. Depreciation % given 390 + 100 123 (Rounded off) 4 g. Operating Profit C ­ (D + E + F) 352 h. Non operating Income Increase by 10 % 1.1 x 40 44 i. Earnings Before 396 Interest & Taxes (EBIT) j. Interest 18 of sales 18 x 1690 23 (Decimal ignored) 1300 1300 k. Profit before tax 373 l. Tax 112 m. Profit after tax 261 n. Dividends 130 o. Retained earnings 131

Balance Sheet for the year 2008 (Rs. In million) (Forecast)

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Particulars Basis Working Amount (Rs.) Assets Fixed Assets Given 510 Add: Addition 100 610 Depreciation 120 + 123 243 1. Net fixed assets 367 2. Investments 150 3. Current Assets & Loans & advances Cash at bank 12 12 x 1690 16 (Rounded off) 1300 1300 Receivables 128 128 x 1690 166 1300 1300 Inventories 300 300 x 1690 390 1300 1300 Loans & Advances 80 80 x 1690 104 1300 1300 4. Miscellaneous Given 24 + 19 43 Expenditure Total 1236

Liabilities 1. Share Capital Equity 120 Preference 50 2. Reserves & Surplus Increase by current year’s retained 355 earnings 3. Secured Loan 60 60 x 1690 78 1300 1300 Bank borrowings 40 (Difference – Balancing figure)

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4. Unsecured Loan 60 60 5. Current Liabilities & Provision Trade creditors 250 250 x 1690 325 1300 1300 Provision for tax 60 60 x 1690 78 1300 1300 Proposed Dividend Current year given 130 Total Liabilities 1236

Computerised Financial Planning Systems All corporate forecasts use Computerised forecasting models. Additional funds required to finance the increase in sales could be ascertained using a mathematical relationship based on the following:

Additional funds = Required increase ­­ Spontaneous ­­ Increase in Required in assets increase in retained liabilities earnings (This formula has been recommended by Engene.F.Brighaom and Michael C Ehrharte in their book financial management – Theory and Practice, 10 th edition.

Prof. Prasanna Chandra, in his book Financial Management, has given a comprehensive formula for ascertaining the external financing requirements: EFR = A (∆s) – L (∆s) – ms (1­d) – (∆1m + SR) S S Here A = Expected increase in assets, both fixed and current required for the X ∆s S expected increase in sales in the next year. L = Expected Spontaneous financing available for the expected increase in S X ∆ s sales

MS1 (1­d) = It is the product of Profit margin x Expected sales for the next year x Retention Ratio

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Here, retention ratio is 1 – payout ratio. Payout ratio refers to the ratio of dividend paid to earnings per share ∆1m = Expected change in the level of investments and miscellaneous expenditure SR = It is the firm’s repayment liability on term loans and debenture for the next year. This formula has certain features:­ 1. Ratios of assets and spontaneous liabilities to sales remain constant over the planning period. 2. Dividend payout and profit margin for the next year can be reasonably planned in advance. 3. Since external funds requirements involve borrowings from financial institution, the formula rightly incorporates the management’s liability on repayments. Example A Ltd has given the following forecasts: “Sales in 2008 will increase to Rs.2000 from Rs.1000 in 2007” The balance sheet of the company as on December 31, 2007 gives the following details: Liabilities Rs Assets Rs Share Capital Net Fixed Assets 500 Equity (Shares of Rs.10 each) 100 Inventories 200 Reserves & Surplus 250 Cash 100 Long term loan 400 Bills Receivable 200 Crs for expenses outstanding 50 Trade creditors 50 Bills Payable 150 1000 1000

Ascertain the external funds requirements for the year 2008, taking into account the following information: 1. The Company’s utilization of fixed assets in 2007 was 50 % of capacity but its current assets were at their proper levels. 2. Current assets increase at the same rate as sales. 3. Company’s after­tax profit margin is expected to be 5%, and its payout ratio will be 60 %. 4. Creditors for expenses are closely related to sales ( Adapted from IGNOU MBA)

Answers Preliminary workings A = Current assets = Cash + Bills Receivables + Inventories

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= 100 + 200 +200 = 500 A = 500 = Rs.500 S X ∆s 1000 X 1000 L = Trade creditors + Bills payable + Expenses outstanding = 50 + 150 + 50 = Rs.250 L = 250 = Rs.250 X 1000 S X ∆s 1000 M (Profit Margin)= 5 / 100 = 0.05

S1 = Rs.200 1­d = 1 – 0.6 = 0.4 or 40 % ∆1m = NIL SR = NIL Therefore: A ( ∆ s ) L EFR = − x ∆ S − mS (1 − d ) − ( ∆1 m + SR ) S S 1 = 500 – 250 – (0.05 x 200 x 0.4) – (0 + 0) = 500 – 250 – 40 ­ (0 + 0) = Rs.210 Therefore, external funds requirements (additional funds required) for 2008 will be Rs.210. This additional funds requirements will be procured by the firm based on its policy on capital structure.

Self Assessment Questions 1 1. Corporate objectives could be group into ______and ______. 2. Control mechanism is developed for ______and their effective use. 3. Seasonal peak requirements to be met from ______from banks. 4. Exercise through ______over overheads.

2.3 Factors Affecting Financial Plan

1. Nature of the industry: Here, we must consider whether it is a capital intensive or labour intensive industry. This will have a major impact on the total assets that the firm owns. 2. Size of the Company: The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long

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term sources at competitive terms. On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short term and long term at attractive rates. 3. Status of the company in the industry: A well established company enjoying a good market share, for its products normally commands investors’ confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment. 4. Sources of finance available: Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finance is closely linked to the firm’s capacity to manage the risk exposure. 5. The Capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders. 6. Matching the sources with utilization: The prudent policy of any good financial plan is to match the term of the source with the term of investment. To finance fluctuating working capital needs the firm resorts to short terms finance. All fixed assets financed investments are to be financial by long term sources. It is a cardinal principle of financial planning. 7. Flexibility: The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure when ever need arises. If the capital structure of a company is flexible, it will not face any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalization of capital market. 8. Government Policy: SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of corporate affairs (Govt of India) influence the financial plans of corporates today. Management of public issues of shares demands the compliances with many statues in India. They are to be complied with a time constraint.

Self Assessment Questions 2: 1. ______has a major impact on the total assets that the firm owns. 2. Sources of finance could be grouped into __ and ______.

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3. ______of any good financial plan is to match the term of the source with the term of the source with the term of the investment. 4. ______refers the ability to ______whenever need arises.

2.4 Estimation Of Financial Requirements Of a Firm. The estimation of capital requirements of a firm involves a complex process. Even with expertise, managements of successful firms could not arrive at the optimum capital composition in terms of the quantum and the sources. Capital requirements of a firm could be grouped into fixed capital and working capital. The long term requirements such as investment in fixed assets will have to be met out of funds obtained on long term basis. Variable working capital requirements which fluctuate from season to season will have to be financed only by short term sources. Any departure from this well accepted norm causes negative impacts on firm’s finances.

Self Assessment Question 3: 1. Capital requirement of a firm could be grouped into ______and ______. 2. Variable working capital will have to be financed only by ______.

2.5 Capitalizations Meaning: Capitalization of a firm refers the composition of its long­term funds. It refers to the capital structure of the firm. It has two components viz debt and equity. After estimating the financial requirements of a firm, then the next decision that the management has to take is to arrive at the value at which the company has to be capitalized. There are two theories of Capitalization for new companies: 1. Cost theory and 2. Earnings theory

2.5.1 Cost Theory: Under this approach, the total amount of capitalization for a new company is the sum of the following: 1. Cost of fixed assets. 2. Cost of establishing the business. 3. Amount of working capital required

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Merits of cost approach: 1. It helps promoters to estimate the amount of capital required for incorporation of company conducting market surveys, preparing detailed project report, procuring funds, procuring assets both fixed and current, trial production run and successfully producing, positioning and marketing of its products or rendering of services. 2. If done systematically it will lay foundation for successful initiation of the working of the firm. Demerits 1. If the firm establishes its production facilities at inflated prices, productivity of the firm will be less than that of the industry. 2. Net worth of a company is decided by the investors by the earnings of a company. Earnings capacity based net worth helps a firm to arrive at the total capital in terms of industry specified yardstick ( i,e, operating capital based on bench marks in that industry) cost theory fails in this respect.

2.5.2 Earnings Theory: Earnings are forecast and capitalized at a rate of return which is representative of the industry. It involves two steps. 1. Estimation of the average annual future earnings. 2. Normal earning rate of the industry to which the company belongs.

Merits 1. It is superior to cost theory because there are, the least chances of neither under not over capitalization. 2. Comparison of earnings approach with that of cost approach will make the management to be cautious in negotiating the technology and cost of procuring and establishing the new business.

Demerits 1. The major challenge that a new firm faces is in deciding on capitalization and its division thereof into various procurement sources. 2. Arriving at capitalization rate is equally a formidable task because the investors’ perception of established companies cannot be really representative of what investors perceive of the earning power of new company.

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Because of the problem, most of the new companies are forced to adopt the cost theory of capitalization. Ideally every company should have normal capitalization. But it is an utopian way of thinking. Changing business environment, role of international forces and dynamics of capital market conditions force us to think in terms of what is optimal today need not be so tomorrow. Even with these constraints, management of every firm should continuously monitor the firms capital structure to ensure to avoid the bad consequences of over and under capitalization.

2.5.3 Overcapitalization A company is said to be overcapitalized, when its total capital (both equity and debt) exceeds the true value of its assets. It is wrong to identify overcapitalization with excess of capital because most of the overcapitalized firms suffer from the problems of liquidity. The correct indicator of overcapitalization is the earnings capacity of the firm. If the earnings of the firm are less then that of the market expectation, it will not be in a position to pay dividends to its shareholders as per their expectations. It is a sign of overcapitalization. It is also possible that a company has more funds than its requirements based on current operation levels, and yet have low earnings. Overcapitalization may be on account of any of the following: 1. Acquiring assets at inflated rates 2. Acquiring unproductive assets. 3. High initial cost of establishing the firm 4. Companies which establish their new business during boom condition are forced to pay more for acquiring assets, causing a situation of overcapitalization once the boom conditions subside. 5. Total funds requirements have been over estimated. 6. Unpredictable circumstances (like change in import –export policy, change in market rates of interest, changes in international economic and political environment) reduce substantially the earning capacity of the firm. For example, rupee appreciation against U.S.dollar has affected earning capacity of firms engaged mainly in export business because they invoice their sales in US dollar. 7. Inadequate provision for depreciation adversely affects the earning capacity of a company , leading to overcapitalization of the firm. 8. Existence of idle funds.

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Effects of over capitalization 1. Decline in the earnings of the company. 2. Fall in dividend rates. 3. Market value of company’s share falls, and company loses investors confidence. 4. Company may collapse at any time because of anemic financial conditions – it will affect its employees, society, consumers and its shareholders. Employees will lose jobs. If the company is engaged in the production and marketing of certain essential goods and services to the society, the collapse of the company will cause social damage.

Remedies for Overcapitalization: Restructuring the firm is to be executed to avoid the situation of company becoming sick. It involves 1. Reduction of debt burden. 2. Negotiation with term lending institutions for reduction in interest obligation. 3. Redemption of preference shares through a scheme of capital reduction. 4. Reducing the face value and paid­up value of equity shares. 5. Initiating merger with well managed profit making companies interested in taking over ailing company.

2.5.4 Undercapitalization Under­capitalization is just the reverse of over­capitalization. A company is considered to be under­capitalized when its actual capitalization is lower than its proper capitalization as warranted by its earning capacity.

Symptoms of under­capitalization 1. Actual capitalization is less than that warranted by its earning capacity. 2. Its rate of earnings is exceptionally high in relation to the return enjoyed by similar situated companies in the same industry.

Causes of under­capitalization 1. Under estimation of future earnings at the time of promotion of the company. 2. Abnormal increase in earnings from new economic and business environment. 3. Under estimation of total funds requirements.

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4. Maintaining very high efficiency through improved means of production of goods or rendering of services. 5. Companies which are set up during recession start making higher earning capacity as soon as the recession is over. 6. Use of low capitalization rate. 7. Companies which follow conservative dividend policy will achieve a process of gradually rising profits. 8. Purchase of assets at exceptionally low prices during recession.

Effects of under­capitalization 1. Encouragement to competition: under­capitalization encourages competition by creating a feeling that the line of business is lucrative. 2. It encourages the management of the company to manipulate the company’s share prices. 3. High profits will attract higher amount of taxes. 4. High profits will make the workers demand higher wages. Such a feeling on the part of employees leads to labour unrest. 5. High margin of profit may create among consumers an impression that the company is charging high prices for its products. 6. High margin of profits and the consequent dissatisfaction among its employees and consumer, may invite governmental enquiry into the pricing mechanism of the company.

Remedies 1. Splitting up of the shares – This will reduce the dividend per share. 2. Issue of bonus shares: This will reduce both the dividend per share and earnings per share. Both over­capitalization and under­capitalization are detrimental to the interests of the society.

Self Assessment Question 4 1. ______of a firm refers to the composition of its long –term funds. 2. Two theories of capitalization for new companies are ______and earnings theory. 3. A company is said to be ______, when its total capital exceeds the true value of its assets. 4. A company is considered to be ______when its actual capitalization is lower than its proper capitalization as warranted by its earning capacity.

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2.6 Summary Financial planning deals with the planning, execution and monitoring of the procurement and utilization of funds. Financial planning process gives birth to financial plan. It could be thought of a blueprint explaining the proposed strategy and its execution. There are many financial planning models. All these models forecast the future operations and then translate them into income statements and balance sheets. It will also help the finance managers to ascertain the funds to be procured from outside sources. The essence of all these is to achieve a least cost capital structure which would match with the risk exposure of the company. Failure to follow the principle of financial planning may lead a new firm to over or under­capitalization when the economic environment undergoes a change. Ideally every firm should aim at optimum capitalization. Other wise it may face a situation of over or under­capitalization. Both are detrimental to the interests of the society. There are two theories of capitalization viz cost theory and earnings theory.

Terminal Questions 1. Explain the steps involved in Financial Planning. 2. Explain the factors affecting Financial Plan 3. List out the causes of Over – Capitalization. 4. Explain the effects of Under – Capitalization.

Answers To Self Assessment Questions Self Assessment Questions 1 1. Qualitative, Quantitative. 2. Allocation of funds 3. Short term borrowings

Self Assessment Question 2 1. Nature of the industry 2. Debt, Equity 3. The product policy 4. Flexibility in capital structure, effect changes in the composites of capital structure

Self Assessment Question 3

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1. Fixed capital, working capital. 2. Short term sources

Self Assessment Question 4 1. Capitalization 2. Cost theory 3. Over Capitalized 4. Under capitalized

Answer to Terminal Questions 1. Refer to unit 2.2 2. Refer to unit 2.3 3. Refer to unit 2.5.3 4. Refer to unit 2.5.4

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Unit 3 Time Value of Money

Structure

3.1 Introduction 3.2 Time Preference Rate and Required Rate of Return 3.2.1 Compounding Technique 3.2.2 Discounting Technique 3.2.3 Future Value of a Single Flow (Lump sum): 3.2.4 Future Value of Series of Cash Flows 3.2.5 Future Value of an Annuity 3.2.5.1 Sinking Fund 3.3 Present Value 3.3.1 Discounting or Present Value of a Single Flow 3.3.2 Present Value of a Series of Cash Flows 3.3.2.1 Present Value of Perpetuity 3.3.2.2 Capital Recovery Factor 3.4 Summary Solved Problems Terminal Questions Answer to SAQs and TQs

3.1 Introduction The main objective of this unit is to enable you to learn the time value of money. In the previous unit, we have learnt that wealth maximization is the primary objective of financial management and that is more important than profit maximization for its superiority in the sense that it is future­oriented. A decision taken today will have far­fetching implications. For example, a firm investing in fixed assets will reap the benefits of such investment for a number of years. If such assets are procured through bank borrowings or term loans from financial institutions, these involve an obligation to pay interest and return of principal. Decisions are made by comparing the cash inflows (benefits/returns) and cash outflows (outlays). Since these two components occur at different time periods, there should be

Sikkim Manipal University 34 Financial Management Unit 3 a comparison. In order to have a logical and meaningful comparison between cash flows that accrue over different intervals of time, it is necessary to convert the amounts to a common point of time. This unit is devoted for a discussion of the techniques of doing so.

Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Explain the time value of money. 2. Understand the valuation concepts. 3. Calculate the present and future values of lump sum and annuity flows.

Rationale: “Time Value of Money” is the value of a unit of money at different time intervals. The value of money received today is more than its value received at a later date. In other words, the value of money changes over a period of time. Since a rupee received today has more value, rational investors would prefer current receipts to future receipts. That is why this phenomenon is also referred to as “Time Preference of Money”. Some important factors contributing to this are:

Investment opportunities: Preference for consumption Risk These factors remind us of the famous English saying “A bird in hand is worth two in the bush”.

Why should money have time value?

Some of the reasons are:

Money can be employed productively to generate real returns. For example, if we spend Rs. 500 on materials and Rs. 300 on labour and Rs. 200 on other expenses and the finished product is sold for Rs. 1100, we can say that the investment of Rs. 1000 has fetched us a return of 10%.

Secondly, during periods of inflation, a rupee has a higher purchasing power than a rupee in future.

Thirdly, we all live under conditions of risk and uncertainty. As future is characterized by uncertainty, individuals prefer current consumption to future consumption. Most people have

Sikkim Manipal University 35 Financial Management Unit 3 subjective preference for present consumption either because of their current preferences or because of inflationary pressures.

3.2 Future Value: Time Preference Rate and Required Rate of Return The time preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It is called the risk­free rate. For example, if an individual’s time preference is 8%, it implies that he is willing to forego Rs. 100 today to receive Rs. 108 after a period of one year. Thus he considers Rs. 100 and Rs. 108 are equivalent in value. But in reality this is not the only factor he considers. There is an amount of risk involved in such investment. He therefore requires another rate for compensating him with this which is called the risk premium. Required rate of return=Risk free rate + Risk Premium There are two methods by which time value of money can be calculated – compounding and discounting.

3.2.1 Compounding Technique: Under this method of compounding, the future values of all cash inflows at the end of the time horizon at a particular rate of interest are found. Interest is compounded when the amount earned on an initial deposit becomes part of the principal at the end of the first compounding period. If Mr. A invests Rs. 1000 in a bank which offers him 5% interest compounded annually, he has Rs. 1050 in his account at the end of the first year. The total of the interest and principal Rs. 1050 constitutes the principal for the next year. He thus earns Rs. 1102.50 for the second year. This becomes the principal for the third year. This compounding procedure will continue for an indefinite number of years. The compounding of interest can be calculated by the following equation:

A=P (1+i ) n Where A = Amount at the end of the period P = Principal at the end of the period i =rate of interest n = number of years

The amount of money in the account at the end of various years is calculated as under, using the equation:

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Amount at the end of year 1=Rs. 1000 (1+0.05)==Rs. 1050 Amount at the end of year 2=Rs. 1050 (1+0.05)==Rs. 1102.50 Amount at the end of year 3=Rs. 1102.50 (1+0.05)==Rs. 1157.63 Year 1 2 3 Beginning amount Rs. 1000 Rs. 1050 Rs. 1102.50 Interest rate 5% 5% 5% Amount of interest 50 52.50 55.13 Beginning 1000 Rs. 1050 Rs. 1102.50 principal Ending principal Rs. 1050 Rs. 1102.50 Rs. 1157.63 The amount at the end of year 2 can be ascertained by substituting Rs. 1000 (1+0.05) for R. 1050, that is, Rs. 1000(1+0.05) (1+0.05)= Rs. 1102.50.

Similarly, the amount at the end of year 3 can be ascertained by substituting Rs. Rs. 1000(1+0.05) (1+0.05) (1+0.05) =Rs. 1157.63.

Thus by substituting the actual figures for the investment or Rs. 1000 in the formula A=P (1+i ) n, we arrive at the result shown above in Table.

3.2.2 Discounting Technique: Under the method of discounting, we find the time value of money now, that is, at time 0 on the time line. It is concerned with determining the present value of a future amount. This is in contrast to the compounding approach where we convert present amounts into future amounts; in discounting approach we convert the future value to present sums. For example, if Mr. A requires to have Rs. 1050 at the end of year 1, given the rate of interest as 5%, he would like to know how much he should invest today to earn this amount. If P is the unknown amount and using the equation we get P (1+0.5)=1050. Solving the equation, we get P=Rs. 1050/1.05=Rs. 1000.

Thus Rs. 1000 would be the required principal investment to have Rs. 1050 at the end of year 1 at 5% interest rate. In other words, the present value of Rs. 1050 received one year from now, rate of interest 5%, is Rs. 1000. The present value of money is the reciprocal of the compounding value. Mathematically, we have P=A {1/(1+i) n } in which P is the present value for the future sum to be received, A is the sum to be received in future, i is the interest rate and n is the number of years.

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3.2.3 Future Value of a Single Flow (lump sum): The process of calculating future value will become very cumbersome if they have to be calculated over long maturity periods of 10 or 20 years. A generalized procedure for calculating the future value of a single cash flow compounded annually is as follows: n FVn = PV(1+i)

Where FVn = Future value of the initial flow in n years hence PV = Initial cash flow I = Annual rate of interest N = Life of investment

The expression (1+i) n represents the future value of the initial investment of Re. 1 at the end of n number of years at the interest rate i, referred to as the Future Value Interest Factor (FVIF). To help ease in calculations, the various combinations of “I” and “n” can be referred to in the table. To calculate the future value of any investment, the corresponding value of (1+i) n from the table is multiplied with the initial investment.

Example: The fixed deposit scheme of a bank offers the following interest rates: Period of deposit Rate per annum <45 days 9% 46 days to 179 days 10% 180 days to 365 days 10.5% 365 days and above 11% How much does an investment of R. 10000 invested today grow to in 3 years?

Solution: FVn=PV(1+i) n or PV*FVIF(11%, 3y) =10000*1.368 (from the tables) =Rs. 13680

Doubling period: A very common question arising in the minds of an investor is “how long will it take for the amount invested to double for a given rate of interest”. There are 2 ways of answering this question. One is called ‘rule of 72’. This rule states that the period within which the amount doubles is obtained by dividing 72 by the rate of interest. For instance, if the given rate of interest is 10%, the doubling period is 72/10, that is, 7.2 years.

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A much accurate way of calculating doubling period is the ‘rule of 69’, which is expressed as 0.35+69/interest rate. Going by the same example given above, we get the number of years as 7.25 years {0.35 + 69/10 (0.35 +6.9)}.

Increased frequency of compounding It has been assumed that the compounding is done annually. If a scheme is offered where compounding is done more frequently, let us see its effect on interest earned. For example, if we have deposited Rs. 10000 in a bank which offers 10% interest per annum compounded semi­ annually, the interest earned will be as follows: Amount invested Rs. 10000 Interest earned for first 6 months 10000*10%*1/2 (for 6 months) Rs. 500 Amount at the end of 6 months Rs. 10500 Interest earned for second 6 months 10500*10%*1/2 Rs. 525 Amount at the end of the year Rs. 11025

If in the above case compounding is done only once a year the interest earned will be 10000*10% which is equal to Rs. 1000 and we will have Rs. 11000 at the end of first year. We find that we get more interest if compounding is done on a more frequent basis. The generalized formula for shorter compounding periods is: m*n FVn=PV (1+i/m)

Where, FVn= Future value after n years PV= Cash flow today i= Nominal interest rate per annum m= No. of times compounding is done during a year n= No. of years for which compounding is done.

Example: Under the Andhra Bank’s Cash Multiplier Scheme, deposits can be made for periods ranging from 3 months to 5 years. Every quarter, interest is added to the principal. The applicable rate of interest is 9% for deposits less than 23 months and 10% for periods more than 24 months. What will the amount of Rs. 1000 today be after 2 years?

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Solution: m*n FVn= PV (1+i/m) 1000 (1+0.10/4) 4*2 1000 (1+0.10/4) 8 Rs. 1218

Effective vs. nominal rate of interest: We have just learnt that interest accumulation by frequent compounding is much more than the annual compounding. This means that the rate of interest given to us, that is, 10% is the nominal rate of interest per annum. If the compounding is done more frequently, say semi­annually, the principal amount grows at 10.25% per annum. 0.25% is known as the “Effective Rate of Interest”. The general relationship between the effective and nominal rates of interest is as follows: r = {(1+i/m) m }­1 Where, r= Effective rate of interest i= Nominal rate of interest m= Frequency of compounding per year.

Example: Calculate the effective rate of interest if the nominal rate of interest is 12% and interest is compounded quarterly.

Solution: r = {(1+i/m) m }­1 r = {(1+0.12/4) 4 }­1 r=0.126 or 12.6% p.a.

3.2.4 Future Value Of Series Of Cash Flows We have considered only single payment made once and its accumulation effect. An investor may be interested in investing money in installments and wish to know the value of his savings after n years. For example, Mr. Madan invests Rs. 500, Rs. 1000, Rs. 1500, Rs.2000 and Rs. 2500 at the end of each year for 5 years. Calculate the value at the end of 5 years compounded annually if the rate of interest is 5% p.a.

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Solution: End of Amount Number of Compounded FV in year invested years interest factor Rs. compounded from tables 1 Rs. 500 4 1.216 608 2 Rs. 3 1.158 1158 1000 3 Rs. 2 1.103 1654 1500 4 Rs.2000 1 1.050 2100 5 Rs. 0 1.000 2500 2500 Amount at the end of 5 th Year Rs. 8020

3.2.5 Future Value Of An Annuity Annuity refers to the periodic flows of equal amounts. These flows can be either termed as receipts or payments. For example, if you have subscribed to the Recurring Deposit Scheme of a bank requiring you to pay Rs. 5000 annually for 10 years, this stream of pay­outs can be called “Annuities”. Annuities require calculations based on regular periodic contribution of a fixed sum of money.

The future value of a regular annuity for a period of n years at i rate of interest can be summed up as under: n FVAn = A{(1+i) ­1} / i

Where FVAn=Accumulation at the end of n years i= Rate of interest n= Time horizon or no. of years A= Amount deposit/invested at the end of every year for n years.

The expression {(1+i) n ­1}/ i is called the Future Value Interest Factor for Annuity (FVIFA). This represents the accumulation of Re. 1 invested at the end of every year for n number of years at i rate of interest. The tables at the end of this book give us the calculations for different combinations of i and n. We just have to multiply the relevant value with A and get the accumulation in the formula given above.

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Example: M. Ram Kumar deposits Rs. 3000 at the end of every year for 5 years into his account for 5 years, interest being 5% compounded annually. Determine the amount of money he will have at the end of the 5 th year. End of Amount Number of Compounded FV in Rs. year invested years interest compounded factor from tables 1 Rs. 4 1.216 2432 2000 2 Rs. 3 1.158 2316 2000 3 Rs. 2 1.103 2206 2000 4 Rs.2000 1 1.050 2100 5 Rs. 0 1.000 2000 2000 Amount at the end of 5 th Year Rs. 11054 OR Using formula and the tables we can find that: =2000 FVIFA(5%, 5y) =2000*5.526 =Rs. 11052

We notice that we can get the accumulations at the end of n period using the tables. Calculations for a long time horizon are easily done with the help of reference tables. Annuity tables are widely used in the field of investment banking as ready reckoners.

Example: Calculate the value of an annuity flow of Rs. 5000 done on a yearly basis for 5 years, yielding an interest of 8% p.a. Solution: =5000 FVIFA(8%, 5y) =5000* 5.867 =Rs. 29335

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3.2.5.1 Sinking Fund Sinking fund is a fund which is created out of fixed payments each period to accumulate to a future sum after a specified period. The sinking fund factor is useful in determining the annual amount to be put in a fund to repay bonds or debentures or to purchase a fixed asset or a property at the end of a specified period. A=FVA*i / {(1+i) n ­1} i / {(1+i) n ­1} is called the Sinking Fund Factor.

Self Assessment Questions 1 1. The important factors contributing to time value of money are ______, ______and ______.

2. During periods of inflation, a rupee has a ______than a rupee in future.

3. As future is characterized by uncertainty, individuals prefer ______consumption to ______consumption.

4. There are two methods by which time value of money can be calculated by ______and ______techniques.

3.3 Present Value We have so far seen how the compounding technique can be used. They can be used to compare the cash flows separated by more than one time period, given the interest rate. With this technique, the amount of present cash can be converted into an amount of cash of equivalent value in future. Likewise, we may be interested in converting the future cash flows into their present values. The Present Value PV of a future cash flow is the amount of the current cash that is equivalent to the investor. The process of determining present value of a future payment or a series of future payments is known as discounting.

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3.3.1 Discounting or Present Value of a Single Flow: We can determine the PV of a future cash flow or a stream of future cash flows using the formula: n PV = FVn / (1+i) Where PV= Present Value

FVn= Amount i= Interest rate n= Number of years

Example: If Ms. Sapna expects to have an amount of Rs. 1000 after one year what should be the amount she has to invest today if the bank is offering 10% interest rate?

Solution: n PV = FVn / (1+i) =1000/(1+0.10)1 =Rs. 909.09

The same can be calculated with the help of tables. =1000*PVIF(10%, 1y) =1000*0.909 =Rs. 909

Example: An investor wants to find out the value of an amount of Rs. 100000 to be received after 15 years. The interest offered by bank is 9%. Calculate the PV of this amount.

Solution: n PV=FVn/(1+i) or 100000 PVIF(9%, 15y) =100000*0.275 = Rs. 27500

3.3.2 Present Value of a Series of Cash Flows In a business scenario, the businessman will receive periodic amounts (annuity) for a certain number of years. An investment done today will fetch him returns spread over a period of time. He would like to know if it is worthwhile to invest a certain sum now in anticipation of returns he expects over a certain number of years. He should therefore equate the anticipated future returns to the present sum he is willing to forego. The PV of a series of cash flows can be represented by the following formula:

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PV=Ct / (1=i) 1 + Ct / (1=i) 2 + Ct / (1=i) 3 Ct / (1=i) 4 + ………………..+ Ct / (1=i) n Which reduces to: n n PVAn = A {1+i) ­1 / i(1+i) }

The expression {1+i) n ­1 / i(1+i) n } is known as Present Value Interest Factor Annuity (PVIFA). It represents the PVIFA of Re. 1 for the given values of i and n. The values of PVIFA(I, n) can be found out using the tables at the end of the book. It should be noted that these values are true only if the cash flows are equal and the flows occur at the end of every year.

Example: Calculate the PV of an annuity of Rs. 500 received annually for 4 year, when discounting factor is 10%. End of year Cash PV factor PV in inflows Rs. 1 Rs. 500 0.909 454 2 Rs. 500 0.827 413 3 Rs. 500 0.751 375 4 Rs.500 0.683 341

Present Value of an annuity Rs. 1585.

OR by directly looking at the table we can calculate: =500*PVIFA(10%, 4y) =500*3.170 =Rs. 1585

Example: Find out the present value of an annuity of Rs. 10000 over 3 years when discounted at 5%.

Solution: =10000*PVIFA(5%, 3y) =10000*2.773 =Rs. 27730

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3.3.2.1 Present Value of Perpetuity An annuity for an infinite time period is perpetuity. It occurs indefinitely. A person may like to find out the present value of his investment assuming he will receive a constant return year after year. The PV of perpetuity is calculated as P=A/i

Example: If the principal of a college wants to institute a scholarship of Rs. 5000 to a meritorious student in finance every year, find out the PV of investment which would yield Rs. 5000 in perpetuity, discounted at 10%.

Solution: P=A/i =5000/0.10 =Rs. 50000 This means he should invest Rs. 50000 to get an annual return of Rs. 5000.

Present value of an uneven periodic sum: In some investment decisions of a firm, the returns may not be constant. In such cases, the PV is calculated as follows: 2 3 4 n P = A1/(1+i) + A2/(1+i) + A3/(1+i) + A4/(1+i) +…………………+An/(1+i) OR

PV= A1 PVIF(i, 1) + A2 PVIF(i, 2) + A3 PVIF(i, 3) + A4 PVIF(i, 4) +……………….+ An PVIF(i, n) Example: An investor will receive Rs. 10000, Rs. 15000, Rs. 8000, Rs. 11000 and R. 4000 respectively at the end of each of 5 years. Find out the present value of this stream of uneven cash flows, if the investor’s interest rate is 8%. PV= 10000/(1+0.08)+ 15000/(1+0.08) 2 + 8000/(1+0.08) 3 + 11000/(1+0.08) 4 + 4000/(1+0.08) 5 =Rs. 39276 Or PV=10000 PVIF(8,1)+ 15000 PVIF(8,2)+ 8000 PVIF(8,3)+ 11000 PVIF(8,4)+ 4000 PVIF(8,5) =10000*0.926+15000*0.857+8000*0.794+11000*0.735+4000*0.681 =Rs. 39276

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3.3.2.2 Capital Recovery Factor Capital recovery is the annuity of an investment for a specified time at a given rate of interest. The reciprocal of the present value annuity factor is called Capital Recovery Factor. n n A=PVAn {i(1+i) } / (1+i) ­1} {i(1+i) n } / (1+i) n ­1} is known as the Capital Recovery Factor.

Example: A loan of Rs. 100000 is to be repaid in 5 equal annual installments. If the loan carries a rate of 14% p. a, what is the amount of each installment?

Solution: Installment*PVIFA(14%, 5)=100000 Installment=100000/3.433=Rs. 29129

Self Assessment Questions 2 1. ______is created out of fixed payments each period to accumulate to a future sum after a specified period. 2. The ______of a future cash flow is the amount of the current cash that is equivalent to the investor. 3. An annuity for an infinite time period is called ______. 4. The reciprocal of the present value annuity factor is called ______.

3.4 Summary Money has time preference. A rupee in hand today is more valuable than a rupee a year later. Individuals prefer possession of cash now rather than at a future point of time. Therefore cash flows occurring at different points in time cannot be compared. Interest rate gives money its value and facilitates comparison of cash flows occurring at different periods of time. Compounding and discounting are two methods used to calculate the time value of money.

Solved Problems – Time Value of Money 1. What is the future value of a regular annuity of Re.1.00 earning a rate of 12% interest p.a. for 5 years? Solution: 1*FVIFA(12%, 5y) = 1*6.353 = Rs. 6.353

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2. If a borrower promises to pay Rs. 20000 eight years from now in return for a loan of Rs. 12550 today, what is the annual interest being offered? Solution: 20000*PVIF(k%, 8y) = Rs. 12550 K is approximately 6%. 3. A loan of Rs. 500000 is to be repaid in 10 equal installments. If the loan carries 12% interest p.a. what is the value of one installment? Solution: A*PVIFA(12%, 10y) = 500000 So A = 500000/5.650 = Rs. 88492 4. A person deposits Rs. 25000 in a bank that pays 6% interest half­yearly. Calculate the amount at the end of 3 years. Solution: 25000*(1+0.06)3*2 = 25000*1.194 = Rs. 29850 5. Find the present value of Rs. 100000 receivable after 10 years if 10% is the time preference for money. Solution: 100000*(0.386) = Rs. 38600

Terminal Questions 1. If you deposit Rs. 10000 today in a bank that offers 8% interest, in how many years will this amount double? 2. An employee of a bank deposits Rs. 30000 into his PF A/c at the end of each year for 20 years. What is the amount he will accumulate in his PF at the end of 20 years, if the rate of interest given by PF authorities is 9%? 3. A person can save ______annually to accumulate Rs. 400000 by the end of 10 years, if the saving earns 12%.

4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the present value of the annuity assuming he can earn interest on his investment at 10% p.a.

5. Aparna invests Rs. 5000 at the end of each year at 10% interest p.a. What is the amount she will receive after 4 years?

Answers to Self Assessment Questions Self Assessment Questions 1 1. Investment opportunities, preference for consumption, risk. 2. Higher purchasing power 3. Current and future

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4. Compounding and discounting

Self Assessment Questions 2 1. Sinking fund 2. Present Value PV 3. Perpetuity 4. Capital Recovery Factor.

Answers to Terminal Questions 1. (Hint: Use rule of 72 and 69) 2. 30000*FVIFA(9%, 20Y) = 30000*51.160 = Rs. 1534800 3. A*FVIFA(12%, 10y) = 400000 which is 400000/17.549 = Rs. 22795 4. 20000*PVIFA(105, 5y)=20000*3.791 = Rs. 75820 5. 5000*FVIFA(10%, 5y) = 5000*6.105 = Rs. 23205

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Unit 4 Valuation Of Bonds And Shares

4.1 Introduction 4.2 Valuation of Bonds Types of Bonds 4.2.1 Irredeemable or Perpetual Bonds 4.2.2 Redeemable or Bonds with Maturity Period 4.2.3 Zero Coupon Bond Bond­yield Measures 4.2.1 Holding Period Rate of Return 4.2.2 Current Yield 4.2.3 Yield to Maturity (YTM) 4.2.4 Bond Value Theorems 4.3 Valuation of Shares 4.3.1 Valuation of Preference Shares 4.3.2 Valuation of Ordinary Shares 4.4 Summary Solved Problems Terminal Questions Answers to SAQs and TQs

4.1 Introduction Valuation is the process of linking risk with returns to determine the worth of an asset. Assets can be real or financial; securities are called financial assets, physical assets are real assets. The ultimate goal of any individual investor is maximization of profits. Investment management is a continuous process requiring constant monitoring. The value of an asset depends on the cash flow it is expected to provide over the holding period. The fact that as on date there is no method by which prices of shares and bonds can be accurately predicted should be kept in mind by an investor before he decides to take an investment decision. The present chapter will help us to know why some

Sikkim Manipal University 50 Financial Management Unit 4 securities are priced higher than others. We can design our investment structure by exploiting the variables to maximize our returns.

Ordinary shares are riskier than bonds or debentures and some shares are more risky than others. The investor would therefore commit funds on a share only if he is convinced about the rate of return being commensurate with risk.

Learning Objectives:

After studying this unit, you should be able to understand the following.

1. Know the meaning of value as used in Finance Theory.

2. Understand the mechanics of Bond valuation, and

3. Understand the mechanics of valuation of equity shares.

Concept of Intrinsic value: A security can be evaluated by the series of dividends or interest payments receivable over a period of time. In other words, a security can be defined as the present value of the future cash streams – the intrinsic value of an asset is equal to the present value of the benefits associated with it. The expected returns (cash inflows) are discounted using the required return commensurate with the risk. Mathematically, it can be represented by: 1 2 3 n V0=C1/(1+i) + C2/(1+i) + C3/(1+i) + Cn/(1+i) n = Cn/(1+i)

Where V0=Value of the asset at time zero (t=0)

P0=Present value of the asset

Cn=Expected cash flow at the end of period n i=Discount rate or required rate of return on the cash flows n=Expected life of an asset.

Example: Assuming a discount rate of 10% and the cash flows associated with 2 projects A and B over a 3 year period, determine the value of the assets.

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Year Cash flows Cash flows of A(Rs.) of B(Rs) 1 20000 10000 2 20000 20000 3 20000 30000 Solution: Value of asset A= 20000 PVIFA(10%,3y) =20000*2.487 =Rs. 49470 Value of asset B=10000PVIF(10%,1) + 20000PVIF(10%,2) + 30000PVIF (10%,3) =10000*0.909 + 20000*0.826 + 30000*0.751 =9090+16520+22530 =Rs. 48140 Example: Calculate the value of an asset if the annual cash inflow is Rs. 5000 per year for the next 6 years and the discount rate is 16%.

Solution: n Value of the asset= Cn/(1+i) =5000/(1+0.16) 6 Or =5000PVIFA(16%, 6y) =5000*3.685 =Rs. 18425

4.1.1 Concepts of Value Book value: Book value is an accounting concept. Value is what an asset is worth today in terms of their potential benefits. Assets are recorded at historical cost and these are depreciated over years. Book value may include intangible assets at acquisition cost minus amortized value. The book value of a debt is stated at the outstanding amount. The difference between the book value of assets and liabilities is equal to the shareholders’ net worth. (Net worth is the sum total of paid­up capital and reserves and surplus). Book value of a share is calculated by dividing the net worth by the number of shares outstanding.

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Replacement value is the amount a company is required to spend if it were to replace its existing assets in the present condition. It is difficult to find cost of assets presently used by the company.

Liquidation value is the amount a company can realize if it sold the assets after the winding up of its business. It will not include the value of intangibles as the operations of the company will cease to exist. Liquidation value is generally the minimum value the company might accept if it sold its business.

Going concern value is the amount a company can realize if it sells its business as an operating one. This value is higher than the liquidation value.

Market value is the current price at which the asset or security is being sold or bought in the market. Market value per share is generally higher than the book value per share for profitable and growing firms.

4.2 Valuation of Bonds Bonds are long term debt instruments issued by government agencies or big corporate houses to raise large sums of money. Bonds issued by government agencies are secured and those issued by private sector companies may be secured or unsecured. The rate of interest on bonds is fixed and they are redeemable after a specific period. Some important terms in bond valuation:

Face value: Also known as par value, this is the value stated on the face of the bond. It represents the amount that the unit borrows which is to be repaid at the time of maturity, after a certain period of time. A bond is generally issued at values such as Rs. 100 or Rs. 1000.

Coupon rate is the specified rate of interest in the bond. The interest payable at regular intervals is the product of the par value and the coupon rate broken down to the relevant time horizon.

Maturity period refers to the number of years after which the par value becomes payable to the bond­holder. Generally, corporate bonds have a maturity period of 7­10 years and government bonds 20­25 years.

Redemption value is the amount the bond­holder gets on maturity. A bond may be redeemed at par, at a premium (bond­holder gets more than the par value of the bond) or at a discount (bond­holder gets less than the par value of the bond).

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Market value is the price at which the bond is traded in the stock exchange. Market price is the price at which the bonds can be bought and sold and this price may be different from par value and redemption value.

Types of Bonds Bonds are of three types: (a) Irredeemable Bonds (also called perpetual bonds) (b) Redeemable Bonds (i.e., Bonds with finite maturity period) and (c) Zero Coupon Bonds.

4.2.1 Irredeemable Bonds or Perpetual Bonds Bonds which will never mature are known as irredeemable or perpetual bonds. Indian Companies Acts restricts the issue of such bonds and therefore these are very rarely issued by corporates these days. In case of these bonds the terminal value or maturity value does not exist because they are not redeemable. The face value is known; the interest received on such bonds is constant and received at regular intervals and hence the interest receipts resemble a perpetuity. The present value (the intrinsic value) is calculated as:

V0=I/id If a company offers to pay Rs. 70 as interest on a bond of Rs. 1000 par value, and the current yield is 8%, the value of the bond is 70/0.08 which is equal to Rs. 875

4.2.2 Redeemable Bonds :

There are two types viz.,bonds with annual interest payments and bonds with semi­annual interest payments.

Bonds with annual interest payments;

Basic Bond Valuation Model: The holder of a bond receives a fixed annual interest for a specified number of years and a fixed principal repayment at the time of maturity. The intrinsic value or the present value of bond can be expressed as: n n n V0 or P0=∑ t=1 I/(I+kd) +F/(I+kd) Which can also be stated as folloows

V0=I*PVIFA(kd, n) + F*PVIF(kd, n)

Where V0= Intrinsic value of the bond

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P0= Present Value of the bond I= Annual Interest payable on the bond F= Principal amount (par value) repayable at the maturity time n= Maturity period of the bond

Kd= Required rate of return

Example: A bond whose face value is Rs. 100 has a coupon rate of 12% and a maturity of 5 years. The required rate of interest is 10%. What is the value of the bond?

Solution: Interest payable=100*12%=Rs. 12 Principal repayment is Rs. 100 Required rate of return is 10%

V0=I*PVIFA(kd, n) + F*PVIF(kd, n) Value of the bond=12*PVIFA(10%, 5y) + 100*PVIF(10%, 5y) = 12*3.791 + 100*0.621 = 45.49+62.1 = Rs. 107.59

Example: Mr. Anant purchases a bond whose face value is Rs. 1000, maturity period 5 years coupled with a nominal interest rate of 8%. The required rate of return is 10%. What is the price he should be willing to pay now to purchase the bond?

Solution: Interest payable=1000*8%=Rs. 80 Principal repayment is Rs. 1000 Required rate of return is 10%

V0=I*PVIFA(kd, n) + F*PVIF(kd, n)

Value of the bond=80*PVIFA(10%, 5y) + 1000*PVIF(10%, 5y) = 80*3.791 + 1000*0.621 = 303.28 + 621 =Rs. 924.28

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This implies that the company is offering the bond at Rs. 1000 but is worth Rs. 924.28 at the required rate of return of 10%. The investor may not be willing to pay more than Rs. 924.28 for the bond today.

Bond Values with Semi­Annual Interest payment: In reality, it is quite common to pay interest on bonds semi­annually. With the effect of compounding, the value of bonds with semi­annual interest is much more than the ones with annual interest payments. Hence, the bond valuation equation can be modified as: n n 2n V0 or P0=∑ t=1 I/2/(I+id/2) +F/(I+id/2)

Where V0=Intrinsic value of the bond

P0=Present Value of the bond I/2=Semi­annual Interest payable on the bond F=Principal amount (par value) repayable at the maturity time 2n=Maturity period of the bond expressed in half­yearly periods

kd/2=Required rate of return semi­annually.

Example: A bond of Rs. 1000 value carries a coupon rate of 10%, maturity period of 6 years. Interest is payable semi­annually. If the required rate of return is 12%, calculate the value of the bond.

Solution: n n 2n V0 or P0=∑ t=1 (I/2)/(I+kd/2) +F/(I+kd/2) =(100/2)/(1+0.12/2)6 + 1000/(1+0.12/2) 6 =50*PVIFA(6%, 12y) + 1000*PVIF(6%, 12y) =50*8.384 + 1000*0.497 =419.2 + 497 =Rs. 916.20 It is to be kept in mind that the required rate of return is halved (12%/2) and the period doubled (6y*2) as the interest is paid semi­annually.

4.2.3 Valuation of Zero Coupon Bonds. In India Zero coupon bonds are alternatively known as Deep Discount Bonds. For close to a decade, these bonds became very popular in India because of issuance of such bonds at regular intervals by IDBI and ICICI. Zero­coupon bonds have no coupon rate, i.e. there is no interest to be

Sikkim Manipal University 56 Financial Management Unit 4 paid out. Instead, these bonds are issued at a discount to their face value, and the face value is the amount payable to the holder of the instrument on maturity. The difference between the discounted issue price and face value is effective interest earned by the investor. They are called deep discount bonds because these bonds are long term bonds whose maturity some time extends up to 25 to 30 years. Example: River Valley Authority issued Deep Discount Bond of the face value of Rs.1,00,000 payable 25 years later, at an issue price of Rs.14,600. What is the effective interest rate earned by an investor from this bond? Solution:

The bond in question is a zero coupon or deep discount bond. It does not carry any coupon rate. Therefore, the implied interest rate could be computed as follows:

Step 1. Principal invested today is Rs.14600 at a rate of interest of “r”% over 25 years to amount to Rs.1,00,000.

n Step 2. It can be stated as A = P0 (1+r)

1,00,000 = 14,600 (1+r) 25

Solving for ‘r’, we get 1,00,000/14600 = (1+r) 25

6.849 = (1+r) 25

Reading the compound value (FVIF) table, horizontally along the 25 year line, we find ‘r’ equals 8%. Therefore, bond gives an effective return of 8% per annum.

4.2.4 Bond­yield Measures 4.2.4.1 Current Yield: Current yield measures the rate of return earned on a bond if it is purchased at its current market price and the coupon interest received. Current Yield = Coupon Interest / Current Market Price

Example: Continuing with the same example above calculate the CY if the current market price is Rs. 920

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Solution: CY=Coupon Interest / Current Market Price =80/920 =8.7%

4.2.4.2 Yield to Maturity (YTM) It is the rate earned by an investor who purchases a bond and holds it till its maturity. The YTM is the discount rate equaling the present values of cash flows to the current market price.

Example: A bond has a face value of Rs. 1000 with a 5 year maturity period. Its current market price is Rs. 883.4. It carries an interest rate of 6%. What shall be the rate of return on this bond if it is held till its maturity?

Solution: n n n V0 or P0=∑ t=1 I/(I+kd) +F/(I+kd) OR V0=I*PVIFA(kd, n) + F*PVIF(kd, n) = 60*PVIFA(Kd, 10) + 1000*PVIF(Kd,10)=883.4 We obtain 10% for kd

Example: A bond has a face value of Rs. 1000 with a 9 year maturity period. Its current market price is Rs. 850. It carries an interest rate of 8%. What shall be the rate of return on this bond if it is held till its maturity?

Solution: n n n V0 or P0=∑ t=1 I/(I+kd) +F/(I+kd) OR V0=I*PVIFA(kd, n) + F*PVIF(kd, n) =80*PVIFA(Kd%, 9) + 1000*PVIF(Kd%, 9)=850

To find out the value of Kd, trial an error method is to be followed. Let us therefore start the value of Kd to be 12% and the equation now looks like =80*PVIFA(12%, 9) + 1000*PVIF(12%, 9)=850

Let us now see if LHS equals RHS at this rate of 12%. Looking at the tables we get LHS as

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80*5.328 + 1000*0.361=Rs. 787.24

Since this value is less than the value required on the RHS, we take a lesser discount rate of 10%. At 10%, the equation is =80*PVIFA(10%, 9) + 1000*PVIF(10%, 9)=850

Let us now see if LHS equals RHS at this rate of 11%. Looking at the tables we get LHS as 80*5.759 + 1000*0.424=Rs. 884.72

We now understand that Kd clearly lies between 10% and 12%. We shall interpolate to find out the true value of Kd. 10% + {(884.72­850)/(884.72­787.24)}*(12%­10%) 10% + (34.72/97.48)*2 10% + 0.71 Therefore Kd=10.71%

An approximation: The following formula may be used to get a rough idea about Kd as Trial and Error Method is a very tedious procedure and requires lots of time. This formula can be used as a ready reference formula. YTM={I+(F­P)/n} / {(F+P)/2} Where YTM =Yield to Maturity I=Annual interest payment F=Face value of the bond P=Current market price of the bond n=Number of years to maturity.

Example: A company issues a bond with a face value of 5000. It is currently trading at Rs. 4500. The interest rate offered by the company is 12% and the bond has a maturity period of 8 years. What is YTM?

Solution: YTM={I+(F­P)/n} / {(F+P)/2} = 600 + {(5000­4500)/8} / {(5000+4500)/2} ={600 + 62.5} / 4750 = 13.94%

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4.2.5 Bond Value Theorems The following factors affect the bond values: • Relationship between the required rate of interest (Kd) and the discount rate. • Number of years to maturity. • YTM

Relationship between the required rate of interest (Kd) and the discount rate: • When Kd is equal to the coupon rate, the intrinsic value of the bond is equal to its face value, that is, if Kd=coupon rate, then value of bond=face value. • When Kd is greater than the coupon rate, the intrinsic value of the bond is less than its face value, that is, if Kd>coupon rate, then value of bondface value.

Example: Sugam industries wishes to issue bonds with Rs. 100 as par value, coupon rate 12% an YTM 5 years. What is the value of the bond if the required rate of return of an investor is 12%, 14% and 10% If Kd is 12%, V0=I*PVIFA(kd, n) + F*PVIF(kd, n) =12*PVIFA(12%, 5) + 100*PVIF(12%, 5) =12*3.605 + 100*0.567 =43.26 + 56.7 =Rs. 99.96 or Rs. 100

If Kd is 14%, V0=I*PVIFA(kd, n) + F*PVIF(kd, n) =12*PVIFA(14%, 5) + 100*PVIF(14%, 5) =12*3.433 + 100*0.519 =41.20 + 51.9 =Rs. 93.1

If Kd is 10%, V0=I*PVIFA(kd, n) + F*PVIF(kd, n) =12*PVIFA(10%, 5) + 100*PVIF(10%, 5) =12*3.791 + 100*0.621 =45.49 + 62.1 =Rs. 107.59

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Number of years to maturity • When Kd is greater than the coupon rate, the discount on the bond declines as maturity approaches. • When Kd is less than the coupon rate, the premium on the bond declines as maturity approaches.

To show the effect of the above, consider a case of a bond whose face value is Rs. 100 with a coupon rate of 11% and a maturity of 7 years.

If Kd is 13%, then, V0=I*PVIFA(kd, n) + F*PVIF(kd, n) =11*PVIFA(13%, 7) + 100*PVIF(13%, 7) =11*4.423 + 100*0.425 =48.65 + 42.50 =Rs. 91.15 After 1 year, the maturity period is 6 years, the value of the bond is V0=I*PVIFA(kd, n) + F*PVIF(kd, n) =11*PVIFA(13%, 6) + 100*PVIF(13%, 6) = 11* 3.998 + 100*0.480 =43.98 + 48 = Rs. 91.98. We see that the discount on the bond gradually decreases and value of the bond increases with the passage of time at Kd being a higher rate than the coupon rate.

Continuing with the same example above, let us see the effect on the bond value if required rate is 8%.

If Kd is 8%, V0=I*PVIFA(kd, n) + F*PVIF(kd, n) =11*PVIFA(8%, 7) + 100*PVIF(8%, 7) =11*5.206 + 100*0.583 =57.27 + 58.3 =Rs. 115.57

One year later, Kd at 8%, V0=I*PVIFA(kd, n) + F*PVIF(kd, n) =11*PVIFA(8%, 6) + 100*PVIF(8%, 6) =11*4.623 + 100* 0.630

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=50.85 + 63 =Rs. 113.85

For a required rate of return of 8%, the bond value decreases with passage of time and premium on bond declines as maturity approaches.

YTM: YTM determining the market value of the bond, the bond price will fluctuate to the changes in market interest rates. A bond’s price moves inversely proportional to its YTM.

4.3 Valuation of Shares A company’s shares may be categorized as (a) Ordinary or Equity shares and (b) Preference shares. The returns these shareholders get are called dividends. Preference shareholders get a preferential treatment as to the payment of dividend and repayment of capital in the event of winding up. Such holders are eligible for a fixed rate of dividends. Some important features of preference and equity shares. • Dividends: Rate is fixed for preference shareholders. They can be given cumulative rights, that is, the dividend can be paid off after accumulation. The dividend rate is not fixed for equity shareholders. They change with an increase or decrease in profits. During years of big profits, the management may declare a high dividend. The dividends are not cumulative for equity shareholders, that is, they cannot be accumulated and distributed in later years. Dividends are not taxable. • Claims: In the event of the business closing down, the preference shareholders have a prior claim on the assets of the company. Their claims shall be settled first and the balance if any will be paid off to equity shareholders. Equity shareholders are residual claimants to the company’ income and assets. • Redemption: Preference shares have a maturity date on which day the company pays off the face value of the share to the holders. Preference shares can be of two types – redeemable and irredeemable. Irredeemable preference shares are perpetual. Equity shareholders have no maturity date. • Conversion: A company can issue convertible preference shares and not vice versa. After a particular period as mentioned in the share certificate, the preference shares can be converted into ordinary shares.

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4.3.1 Valuation of Preference Shares: Preference shares, like bonds carry a fixed rate of dividend/return. Symbolically, this can be expressed as: n n P0= Dp/{1+Kp) } + Pn/{(1+Kp) } OR

P0 = Dp*PVIFA(Kp, n) + Pn *PVIF(Kp, n) Where P0=Price of the share Dp=Dividend on preference share Kp=Required rate of return on preference share n=Number of years to maturity

4.4 Valuation of Ordinary Shares People hold common stocks for two reasons – to obtain dividends in a timely manner and to get a higher amount when sold. Generally, shares are not held in perpetuity. An investor buys the shares, holds them for some time during which he gets dividends and finally sells it off to get capital gains. The value of a share which an investor is willing to pay is linked with the cash inflows expected and risks associated with these inflows. Intrinsic value of a share is associated with the earnings (past) and profitability (future) of the company, dividends paid and expected and future definite prospects of the company. It is the economic value of a company considering its characteristics, nature of business and investment environment.

4.4.1 Dividend Capitalization Model

When a shareholder buys a share, he is actually buying the stream of future dividends. Therefore the value of an ordinary share is determined by capitalizing the future dividend stream at an appropriate rate of interest. So under the dividend capitalization approach, the value of an equity share is the discounted present value of dividends received plus the present value of the resale price expected when the share is disposed. Two assumptions are made to apply this approach: • Dividends are paid annually. • First payment of dividend is made after one year the equity share is bought.

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4.4.1.1 Single period valuation model This model holds well when an investor holds an equity share for one year. The price of such a share will be:

P0= D1 + P1 (1+Ke) (1+Ke)

Where P0=Current market price of the share

D1=Expected dividend after one year

P1=Expected price of the share after one year Ke=Required rate of return on the equity share

Example: Gammon India Ltd.’s share is expected to touch Rs. 450 one year from now. The company is expected to declare a dividend of Rs. 25 per share. What is the price at which an investor would be willing to buy if his required rate of return is 15%?

Solution:

P0=D1/(1+Ke) + P1/(1+Ke) {25/(1+0.15)} + {450/(1+0.15)} =21.74 + 391.30 =Rs. 413.04 is the price he is willing to pay today

4.4.1.2 Multi­period valuation model: An equity share can be held or an indefinite period as it has no maturity date, in which case the value of a price at time zero is: 1 2 3 ∞ P0=D1/(1+Ke) + D2/(1+Ke) + D3/(1+Ke) +……………..+ D∞/(1+Ke) ∞ Or P0=∑ t=1 Dn {(1+Ke) n }

Where P0=Current market price of the share

D1=Expected dividend after one year

P1=Expected price of the share after one year

D∞=Expected dividend at infinite duration Ke=Required rate of return on the equity share.

The above equation can also be modified to find the value of an equity share for a finite period.

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1 2 3 ∞ n P0=D1/(1+Ke) + D2/(1+Ke) + D3/(1+Ke) +………..+ D∞/(1+Ke) + Pn/(1+Ke) ∞ n n = P0=∑ t=1 Dn/{(1+Ke) } + Pn/(1+Ke)

We can come across three instances of dividends in companies: • Constant dividends • Constant growth of dividends • Changing growth rates of dividends.

Valuation with constant dividends: If constant dividends are paid year after year, then 1 2 3 ∞ P0=D1/(1+Ke) + D2/(1+Ke) + D3/(1+Ke) +………..+ D∞/(1+Ke) Simplifying this we get P=D/Ke

Valuation with constant growth in dividends: Here we assume that dividends tend to increase with time as and when businesses grow over time. If the increase in dividend is at a constant compound rate, then P0=D1/Ke­g, where g stands for growth rate.

Example: Sagar automobiles ltd.’s share is traded at Rs. 180. The company is expected to grow at 8% per annum and the dividend expected to be paid off is Rs. 8. If the rate of return is expected to be 12%, what is the price of the share one would be expected to pay today? Solution:

P0=D1/Ke­g =8/0.12­0.08 =Rs. 200.

Example: Monica labs is expected to pay Rs. 4 as dividend per share next year. The dividends are expected to grow perpetually@8%. Calculate the share price today if the market capitalization is 12%.

Solution:

P0=D1/Ke­g

P0=4/(0.12­0.08) =Rs. 100 Valuation with variable growth in dividends: Some firms may not have a constant growth rate of dividends indefinitely. There are periods during which the dividends may grow super­normally, that is, the growth rate is very high when the demand for the company’s products is very high. After a certain period of time, the growth rate may fall to normal levels when the returns fall due to fall in demand for

Sikkim Manipal University 65 Financial Management Unit 4 products (with competition setting in or due to availability of substitutes). The price of the equity share of such a firm is determined in the following manner: • Step 1. Expected dividend flows during periods of supernormal growth is to be considered and present value of this is to be computed with the following equation: ∞ n P0=∑ t=1 Dn/(1+Ke) • Value of the share at the end of the initial growth period is calculated as:

Pn=(Dn+1)/(Ke­gn) (constant growth model). This is discounted to the present value and we get: n (Dn+1)/(Ke­gn)*1 / (1+Ke) ∞ • Add both the present value composites to find the value P0 of the share, that is, P0=∑ t=1 n n Dn/(1+Ke) + (Dn+1)/(Ke­gn)*1/(1+Ke) Example: Souparnika Pharma’s current dividend is Rs. 5.It expects to have a supernormal growth period running to 5 years during which the growth rate would be 25%. The company expects normal growth rate of 8% after the period of supernormal growth period. The investors’ required rate of return is 15%. Calculate what the value of one share of this company is worth.

Solution: D0=5, n=5y, ga (supernormal growth)=25%, gn (normal growth)=8%, Ke=14% ∞ n Step I: P0=∑ t=1 Dn/(1+Ke) D1=5 (1.25) 1 D2= 5 (1.25) 2 D3=5 (1.25) 3 D4=5 (1.25) 4 D5=5 (1.25) 5 The present value of this flow of dividends will be: 5(1.25)/(1.15) + 5(1.25) 2 /(1.15)2 + 5(1.25) 3 /(1.15) 3 + 5(1.25) 4 /(1.15) 4 + 5(1.25) 5 /(1.15) 5 5.43+ 5.92 + 6.42 + 6.98 + 7.63 = 32.38

Step II: Pn=(Dn+1)/(Ke­g) P5=D6/Ke­gn =D5(1+gn)/Ke­gn ={5(1.25) 5 (1+0.08)} / (0.15­0.08) = 15.26(1.08) / 0.07

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= 16.48 / 0.07 = 235.42 The discounted value of this price is 235.42 / (1.15) 5 = Rs. 117.12

∞ n n Step III: P0=∑ t=1 Dn/(1+Ke) + (Dn+1)/(Ke­gn)*1/(1+Ke)

The value of the share is Rs. 32.38 + Rs. 117.12 = Rs.149.50 Other approaches to equity valuation In addition to the dividend valuation approaches discussed in the previous section, there are other approaches to valuation of shares based on “Ratio Approach”.

Book value approach: The book value per share (BVPS) is the net worth of the company divided by the number of outstanding equity shares. Net worth is represented by the sum total of paid up equity shares, reserves and surplus. Alternatively, this can also be calculated as the amount per share on the sale of the assets of the company at their exact book value minus all liabilities including preference shares.

Example: A One Ltd. has total assets worth Rs. 500 Cr., liabilities worth Rs. 300 Cr., and preference shares worth Rs. 50 Cr. and equity shares numbering 10 lakhs The BVPS is Rs. 150 Cr/10 lakhs = R. 150 BVPS does not give a true investment picture. This relies on historical book values than the company’s earning potential.

Liquidation value: The liquidation value per share is calculated as: {(Value realized by liquidating all assets) – (Amount to be paid to all Crs and Pre SH)} divided by Number of outstanding shares. In the above example, if the assets can be liquidated at Rs. 450 Cr., the liquidation value per share is (450Cr­350Cr) / 10 lakh shares which is equal to Rs. 1000 per share.

4.4.2 Price Earnings Ratio: The price­earnings ratio reflects the amount investors are willing to pay for each rupee of earnings.

Expected earning per share = (Expected PAT) – (Preference dividend) / Number of outstanding shares. Expected PAT is dependent on a number of factors like sales, gross profit

Sikkim Manipal University 67 Financial Management Unit 4 margin, depreciation and interest and tax rate. The P/E ratio is also to consider factors like growth rate, stability of earnings, company size, company management team and dividend pay­out ratio. P/E ratio = (1­b) / r­(ROE*b) Where 1­b is dividend pay out ratio r is required rate of return ROE*b is expected growth rate.

Self Assessment Questions 1 1. ______is the minimum value the company accepts if it sold its business. 2. ______per share is generally higher than the book value per share for profitable and growing firms. 3. Bonds issued by ______are secured and those issued by private sector companies may be ______or ______. 4. ______is the rate earned by an investor who purchases a bond and holds it till its maturity. 5. When Kd is lesser than the coupon rate, the value of the bond is ______than its face value. 6. ______of a share is associated with the earnings (past) and profitability (future) of the company, dividends paid and expected and future definite prospects of the company. 7. The ______is the net worth of the company divided by the number of outstanding equity shares.

4.5 Summary Valuation is the process which links the risk and return to establish the asset worth. The value of a bond or a share is the discounted value of all their future cash inflows (interest/dividend) over a period of time. The discount rate is the rate of return which the investors expect from the securities. In case of bonds, the stream of cash flows consists of annual interest payment and repayment of principal (which may take place at par, at a premium or at a discount). The cash flows which occur in each year is a fixed amount.

Cash flows for preference share are also a fixed amount and these shares may be redeemed at par, at a premium or at a discount.

The equity shareholders do not have a fixed rate of return. Their dividend fluctuates with profits. Therefore the risk of holding an equity share is higher than holding a preference share or a bond.

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Solved problems 1. The current price of a Ashok Leyland share is Rs. 30. The company is expected to pay a dividend of Rs. 2.50 per share which goes up annually at 6%. If an investor’s required rate of return is 11%, should he buy this share or not? Advise.

Solution: P = D1(1+g) / Ke­g = 2.5(1+0.06) / 0.11­0.06 = Rs. 53. The investor should certainly buy this share at the current price of Rs. 30 as the valuation model says the share is worth Rs. 53.

2. A bond with a face value of Rs. 100 provides an annual return of 8% and pays Rs. 125 at the time of maturity, which is 10 years from now. If the investor’s required rate of return is 12%, what should be the price of the bond? Solution: P = Int*PVIFA(12%, 10y) + Redemption price*PVIF(12%, 10y) = 8*PVIFA(12%, 10y) + 125*PVIF(12%, 10y) = 8*5.65 + 125*0.322 = 45.2 + 40.25 = Rs. 85.45 The price of the bond should be Rs. 85.45 3. The bond of Silicon Enterprises with a par value of Rs. 500 is currently traded at Rs. 435. The coupon rate is 12% with a maturity period of 7 years. What will be the yield to maturity? Solution: r = I + {(F­P)/n} / (F+P)/2 = 60 + {(500­435)/7} / (500+435)/2 = 15.03%

4. The share of Megha Ltd is sold at Rs. 500 a share. The dividend likely to be declared by the company is Rs. 25 per share after one year and the price one year hence is expected to be Rs. 550. What is the return at the end of the year on the basis of likely dividend and price per share? Solution: Holding period return = (D1 + Price gain/loss) / purchase price = (25 + 50) / 500 = 15%

5. A bond of face value of Rs. 1000 and a maturity of 3 years pays 15% interest annually. What is the market price of the bond if YTM is also 15%? Solution: P = Int*PVIFA(15%, 3y) + Redemption value*PVIF(15%, 3y) P = 150*2.283 + 1000*0.658 P = 342.45 + 658 = Rs. 1000.45

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1. A perpetual share pays an annual dividend of Rs. 15 on a face value of Rs. 100 and the rate of return required by investors on such investments is 20%. What should be the market price of the preference share? Solution: Expected yield = Expected income /current market price Expected yield = 15/0.2 = Rs. 75

Terminal Questions 1. What should be price of a bond which has a par value of Rs.1000 carrying a coupon rate of 8% and having a maturity period of 9 years? The required rate of return of the investor is 12%. 2. A bond of Rs. 1000 value carries a coupon rate of 10% and has a maturity period of 6 years. Interest is payable semi­annually. If the required rate of return is 12%, calculate the value of the bond. 3. A bond whose par value is Rs. 500 bearing a coupon rate of 10% and has a maturity of 3 years. The required rate of return is 8%. What should be the price of the bond? 4. If the current year’s dividend is Rs. 24, growth rate of a company is 10% and the required return on the stock is 16%, what is the intrinsic value of the stock? 5. If a stock is purchased for Rs. 120 and held for one year during which time Rs. 15 dividend per share is paid and the price decreases to Rs. 115, what is the nominal return on the share?

Answers to Self Assessment Questions

Self Assessment Questions 1 1. Liquidation value 2. Market value 3. Government agencies, secured or unsecured 4. Yield to Maturity 5. Greater 6. Intrinsic value 7. Book value per share (BVPS)

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Answers to Terminal Questions 1. P = Int*PVIFA(12%, 9y) + Redemption price*PVIF(12%, 10y) 80*PVIFA(12%, 9) + 1000*PVIF(12%, 9y) 80*5.328 + 1000*0.361 426.24 + 361 = Rs. 787.24

2. 50*PVIFA(6%+12y) + 1000*PVIF(12%, 6y) 50*8.384 + 1000*0.497 Rs. 916.2

3. P = Int*PVIFA(8%, 3y) + Redemption price*PVIF(6%+12y) 50*2.577 + 500*0.794 128.85 + 397 = Rs. 525.85

4. Intrinsic value = 24 {(1+0.1)} / 0.16­0.1 = Rs. 440

5. Holding period return = (D1 + Price gain/loss) / purchase price {15 + (­5)} / 120 = 8.33%

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Unit 5 Cost of Capital Structure

5.1 Introduction 5.2 Design of an Ideal Capital Structure 5.3 Cost of Different Sources of Finance 5.3.1 Cost of Debentures 5.3.2 Cost of Term Loans 5.3.3 Cost of Preference Capital 5.3.4 Cost of Equity capital 5.3.5 Cost of Retained Earnings 5.3.5.1 Capital Asset Pricing Model Approach 5.3.5.2 Earnings Price Ratio Approach 5.4 Weighted Average Cost of Capital 5.5 Summary Solved Problems Terminal Questions Answers to SAQs and TQs

5.1 Introduction Capital structure is the mix of long­term sources of funds like debentures, loans, preference shares, equity shares and retained earnings in different ratios. It is always advisable for companies to plan their capital structure. Decisions taken by not assessing things in a correct manner may jeopardize the very existence of the company. Firms may prosper in the short­run by not indulging in proper planning but ultimately may face problems in future. With unplanned capital structure, they may also fail to economize the use of their funds and adapt to the changing conditions.

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Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Define cost of capital. 2. Bring out the importance of cost of capital. 3. Explain how to design an ideal capital structure. 4. Compute Weighted Average Cost of Capital.

5.2 Designing an Ideal Capital Structure It requires a number of factors to be considered such as: • Return: The capital structure of a company should be most advantageous. It should generate maximum returns to the shareholders for a considerable period of time and such returns should keep increasing. • Risk: As already discussed in the previous chapter on leverage, use of excessive debt funds may threaten the company’s survival. Debt does increase equity holders’ returns and this can be done till such time that no risk is involved. • Flexibility: The company should be able to adapt itself to situations warranting changed circumstances with minimum cost and delay. • Capacity: The capital structure of the company should be within the debt capacity. Debt capacity depends on the ability for funds to be generated. Revenues earned should be sufficient enough to pay creditors’ interests, principal and also to shareholders to some extent. • Control: An ideal capital structure should involve minimum risk of loss of control to the company. Dilution of control by indulging in excessive debt financing is undesirable.

With the above points on ideal capital structure, raising funds at the appropriate time to finance firm’s investment activities is an important activity of the Finance Manager. Golden opportunities may be lost for delaying decisions to this effect. A combination of debt and equity is used to fund the activities. What should be the proportion of debt and equity? This depends on the costs associated with raising various sources of funds. The cost of capital is the minimum rate of return a company must earn to meet the expenses of the various categories of investors who have made investment in the form of loans, debentures, equity and preference shares. A company no being able to meet these demands may face the risk of investors taking back their investments thus leading to bankruptcy.

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Loans and debentures come with a pre­determined interest rate, preference shares also have a fixed rate of dividend while equity holders expect a minimum return of dividend based on their risk perception and the company’s past performance in terms of pay­out of dividends.

The following graph on risk­return relationship of various securities summarizes the above discussion. Error!

Equity share n r

u Preference t e

r share

of e

t Debt a r ed

r Govt bonds i equ

R Risk free security

Risk­Return relationship of various securities

5.3 Cost of Different Sources of Finance The various sources of finance and their costs are explained below:

5.3.1 Cost of debentures The cost of debenture is the discount rate which equates the net proceeds from issue of debentures to the expected cash outflows—interest and principal repayments. Kd= I(1—T) + {(F—P)/n} (F+P)/2

Where Kd is post tax cost of debenture capital, I is the annual interest payment per unit of debenture, T is the corporate tax rate, F is the redemption price per debenture, P is the net amount realized per debenture,

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n is maturity period.

Example: Lakshmi Enterprise wants to have an issue of non­convertible debentures for Rs. 10 Cr. Each debenture is of a par value of Rs. 100 having an interest rate of 15%. Interest is payable annually and they are redeemable after 8 years at a premium of 5%. The company is planning to issue the NCD at a discount of 3% to help in quick subscription. If the corporate tax rate is 50%, what is the cost of debenture to the company? Solution: Kd = I(1—T) + {(F—P)/n} (F+P)/2 15(1—0.5) + (105—97)/8 (105+97)/2 = 7.5 + 1 101 = 0.084 or 8.4%

5.3.2 Cost of Term Loans Term loans are loans taken from banks or financial institutions for a specified number of years at a pre­determined interest rate. The cost of term loans is equal to the interest rate multiplied by 1—tax rate. The interest is multiplied by 1—tax rate as interest on term loans is also taxed. Kt=I(1—T) Where I is interest, T is tax rate.

Example: Yes Ltd. has taken a loan of Rs. 5000000 from Canara Bank at 9% interest. What is the cost of term loan?

Solution Kt=I(1—T) = 9(1—0.4) = 5.4%

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5.3.2 Cost of Preference Capital The cost of preference share Kp is the discount rate which equates the proceeds from preference capital issue to the dividend and principal repayments which is expressed as:

Kp = D + {(F—P)/n} (F+P)/2 Where Kp is the cost of preference capital, D is the preference dividend per share payable, F is the redemption price, P is the net proceeds per share, n is the maturity period.

Example: C2C Ltd. has recently come out with a preference share issue to the tune of Rs. 100 lakhs. Each preference share has a face value of 100 and a dividend of 12% payable. The shares are redeemable after 10 years at a premium of Rs. 4 per share. The company hopes to realize Rs. 98 per share now. Calculate the cost of preference capital.

Solution Kp = D + {(F—P)/n} (F+P)/2 = 12 + (104­98)/10 (104+98)/2 = 12.6 101 Kp = 0.1247 or 12.47%

5.3.4 Cost of Equity Capital Equity shareholders do not have a fixed rate of return on their investment. There is no legal requirement (unlike in the case of loans or debentures where the rates are governed by the deed) to pay regular dividends to them. Measuring the rate of return to equity holders is a difficult and complex exercise. There are many approaches for estimating return ­ the dividend forecast approach, capital asset pricing approach, realized yield approach, etc. According to dividend forecast

Sikkim Manipal University 76 Financial Management Unit 5 approach, the intrinsic value of an equity share is the sum of present values of dividends associated with it. Ke=(D1/Pe) + g

This equation is modified from the equation Pe={D1/Ke­g}. Dividends cannot be accurately forecast as they may sometimes be nil or have a constant growth or sometime supernormal growth periods.

Is Equity Capital free of cost? Some people are of the opinion that equity capital is free of cost for the reason that a company is not legally bound to pay dividends and also the rate of equity dividend is not fixed like preference dividends. This is not a correct view as equity shareholders buy shares with the expectation of dividends and capital appreciation. Dividends enhance the market value of shares and therefore equity capital is not free of cost.

Example: Suraj Metals are expected to declare a dividend of Rs. 5 per share and the growth rate in dividends is expected to grow @ 10% p.a. The price of one share is currently at Rs. 110 in the market. What is the cost of equity capital to the company?

Solution Ke=(D1/Pe) + g =(5/110) + 010 =0.1454 or 14.54%

5.3.5 Cost of Retained Earnings A company’s earnings can be reinvested in full to fuel the ever­increasing demand of company’s fund requirements or they may be paid off to equity holders in full or they may be partly held back and invested and partly paid off. These decisions are taken keeping in mind the company’s growth stages. High growth companies may reinvest the entire earnings to grow more, companies with no growth opportunities return the funds earned to their owners and companies with constant growth invest a little and return the rest. Shareholders of companies with high growth prospects utilizing funds for reinvestment activities have to be compensated for parting with their earnings. Therefore the cost of retained earnings is the same as the cost of shareholder’s expected return from the firm’s ordinary shares. That is, Kr=Ke

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5.3.5.1 Capital Asset Pricing Model Approach This model establishes a relationship between the required rate of return of a security and its systematic risks expressed as β. According to this model, Ke = Rf + β (Rm—Rf) Where Ke is the rate of return on share, Rf is the risk free rate of return, Β is the beta of security, Rm is return on market portfolio.

The CAPM model is based on some assumptions, some of which are: • Investors are risk­averse. • Investors make their investment decisions on a single­period horizon. • Transaction costs are low and therefore can be ignored. This translates to assets being bought and sold in any quantity desired. The only considerations mattering are the price and amount of money at the investor’s disposal. • All investors agree on the nature of return and risk associated with each investment.

Example: What is the rate of return for a company if its β is 1.5, risk free rate of return is 8% and the market rate or return is 20%

Solution Ke = Rf + β (Rm—Rf) = 0.08 + 1.5(0.2­0.08) = 0.08 + 0.18 = 0.26 or 26%

5.3.5.2 Earnings Price Ratio Approach According to this approach, the cost of equity can be calculated as: Ke = E1/P where E1 is expected EPS one year hence and P is the current market price per share.

E1 is calculated by multiplying the present EPS with (1 + Growth rate). Cost of Retained Earnings and Cost of External Equity

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As we have just learnt that if retained earnings are reinvested in business for growth activities the shareholders expect the same amount of returns and therefore Ke=Kr. But it should be borne in mind by the policy makers that floating a new issue and people subscribing to it will involve huge amounts of money towards floatation costs which need not be incurred if retained earnings are utilized towards funding activities. Using the dividend capitalization model, the following model can be used for calculating cost of external equity. Ke={D1/P0(1—f)} + g

Where Ke is the cost of external equity, D1 is the dividend expected at the end of year 1, P0 is the current market price per share, g is the constant growth rate of dividends, f is the floatation costs as a % of current market price.

The following formula can be used as an approximation: K’e=ke/(1—f) Where K’e is the cost of external equity, ke is the rate of return required by equity holders, f is the floatation cost.

Example: Alpha Ltd. requires Rs. 400 Cr to expand its activities in the southern zone of India. The company’s CFO is planning to get Rs. 250 Cr through a fresh issue of equity shares to the general public and for the balance amount he proposes to use ½ of the reserves which are currently to the tune of Rs. 300 Cr. The equity investors’ expectations of returns are 16%. The cost of procuring external equity is 4%. What is the cost of external equity?

Solution We know that Ke=Kr, that is Kr is 16% Cost of external equity is K’e=ke/(1—f) 0.16/(1—0.04) = 0.1667 or 16.67%

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5.4 Weighted Average Cost of Capital In the previous section we have calculated the cost of each component in the overall capital of the company. The term cost of capital refers to the overall composite cost of cap or the weighted average cost of each specific type of fund. The purpose of using weighted average is to consider each component in proportion of their contribution to the total fund available. Use of weighted average is preferable to simple average method for the reason that firms do not procure funds equally from various sources and therefore simple average method is not used. The following steps are involved to calculate the WACC. Step I: Calculate the cost of each specific source of fund, that of debt, equity, preference capital and term loans. Step II: Determine the weights associated with each source. Step III Multiply the cost of each source by the appropriate weights. Step IV: WACC = WeKe + WrKr + WpKp + WdKd + WtKt

Assignment of weights Weights can be assigned based on any of the below mentioned methods: (1) The book values of the sources of funds in the capital structure, (2) Present market value of the funds in the capital structure and (3) in the proportion of financing planned for the capital budget to be adopted for the next period.

As per the book value approach, weights assigned would be equal to each source’s proportion in the overall funds. The book value method is preferable. The market value approach uses the market values of each source and the disadvantage in this method is that these values change very frequently. Example: Prakash Packers Ltd. has the following capital structure: Rs. in lakhs Equity capital (Rs. 10 par value) 200 14% Preference share capital Rs. 100 100 each Retained earnings 100 12% debentures (Rs. 100 each) 300 11% Term loan from ICICI bank 50 Total 750

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The market price per equity share is Rs. 32. The company is expected to declare a dividend per share of Rs. 2 per share and there will be a growth of 10% in the dividends for the next 5 years. The preference shares are redeemable at a premium of Rs. 5 per share after 8 years and are currently traded at Rs. 84 in the market. Debenture redemption will take place after 7 years at a premium of Rs. 5 per debenture and their current market price is Rs. 90 per unit. The corporate tax rate is 40%. Calculate the WACC.

Solution Step I is to determine the cost of each component. Ke =( D1/P0) + g = (2/32) + 0.1 = 0.1625 or 16.25%

Kp = [D + {(F—P)/n}] / {F+P)/2} = [14 + (105—84)/8] / (105+84)/2 =16.625/94.5 = 0.1759 or 17.59%

Kr=Ke which is 16.25% Kd = [I(1—T) + {(F—P)/n}] / {F+P)/2} = [12(1—0.4) + (105—90)/7] / (105+97)/2 = [7.2 + 2.14] / 101 = 0.092 or 9.2% Kt = I(1—T) =0.11(1—0.4) = 0.066 or 6.6%

Step II is to calculate the weights of each source. We = 200/750 = 0.267 Wp = 100/750 = 0.133 Wr = 100/750 = 0.133 Wd = 300/750 = 0.4 Wt = 50/750 = 0.06

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Step III Multiply the costs of various sources of finance with corresponding weights and WACC calculated by adding all these components. WACC = WeKe + WpKp +WrKr + WdKd + WtKt = (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625) + (0.4*0.092) + (0.06*0.066) = 0.043 + 0.023 + 0.022 + 0.034 + 0.004 = 0.1256 or 12.56%

Example: Johnson Cool Air Ltd would like to know the WACC. The following information is made available to you in this regard. The after tax cost of capital are: • Cost of debt 9% • Cost of preference shares 15% • Cost of equity funds 18%

The capital structure is as follows: • Debt Rs. 600000 • Preference capital Rs. 400000 • Equity capital Rs. 1000000

Solution Fund source Amount Ratio Cost Weighted cost Debt Rs. 600000 0.3 0.09 0.027 Preference Rs. 400000 0.2 0.15 0.03 capital Equity capital Rs. 0.5 0.18 0.09 1000000 Total Rs. 1.0 0.147 2000000 WACC is 14.7%

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Example: Manikyam Plastics Ltd. wants to enter into the arena of plastic moulds next year for which it requires Rs. 20 Cr. to purchase new equipment. The CFO has made available the following details based on which you are required to compute the weighted marginal cost of capital. • The amount required will be raised in equal proportions by way of debt and equity (new issue and retained earnings put together account for 50%). • The company expects to earn Rs. 4 Cr as profits by the end of year of which it will retain 50% and pay off the rest to the shareholders. • The debt will be raised equally from two sources—loans from IOB costing 14% and from the IDBI costing 15%. • The current market price per equity share is Rs. 24 and dividend pay out one year hence will be Rs. 2.40. Solution Source of funds Weights After tax Weighted cost cost Equity capital 0.4 0.1 0.04 Retained earnings 0.1 0.1 0.01 14% loan from IOB 0.25 0.07 0.0175 15% IDBI loan 0.25 0.075 0.01875 Total 0.0863 or 8.63%

Ke =( D1/P0) + g = (2.40/24) = 0.1 or 10% Kt = I(1—T) = 0.14(1—0.5) = 0.07 or 7% Kt = I(1—T) = 0.15(1—0.5) = 0.075 or 7.5%

Example: Canara Paints has paid a dividend of 40% on its share of Rs. 10 in the current year. The dividends are growing @ 6% p.a. The cost of equity capital is 16%. The Company’s top Finance Managers of various zones recently met to take stock of the competitors’ growth and dividend policies and came out with the following suggestions to maximize the wealth of the shareholders. As the CFO of the

Sikkim Manipal University 83 Financial Management Unit 5 company you are required to analyze each suggestion and take a suitable course keeping the shareholders’ interests in mind.

Alternative 1: Increase the dividend growth rate to 7% and lower Ke to 15% Alternative 2: Increase the dividend growth rate to 7% and increase Ke to 17% Alternative 3: Lower the dividend growth rate to 4% and lower Ke to 15% Alternative 4: Lower the dividend growth rate to 4% and increase Ke to 17% Alternative 5: increase the dividend growth rate to 7% and lower Ke to 14%

Solution We all know that P0 = D1/(Ke—g) Present case = 4/(0.16­0.06) = Rs 40 Alternative 1 = 4.28/(0.15—0.07) = Rs. 53.5 Alternative 2 = 4.28/(0.17—0.07) = Rs. 42.8 Alternative 3 = 4.16/(0.15—0.04) = Rs. 37.8 Alternative 4 = 4.16/(0.17—0.04) = Rs. 32 Alternative 5 = 4.28/(0.14—0.07) = Rs. 61.14

Recommendation: The last alternative is likely to fetch the maximum price per equity share thereby increasing their wealth.

Self Assessment Questions 1 1. ______is the mix of long­term sources of funds like debentures, loans, preference shares, equity shares and retained earnings in different ratios. 2. The capital structure of a company should generate ______to the shareholders. 3. The capital structure of the company should be within the______. 4. An ideal capital structure should involve ______to the company. 5. ______do not have a fixed rate of return on their investment. 6. According to Dividend Forecast Approach, the intrinsic value of an equity share is the sum of ______associated with it.

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5.5 Summary Any organization requires funds to run its business. These funds may be acquired from short­term or long­term sources. Long­term funds are raised from two important sources—capital (owners’ funds) and debt. Each of these two has a cost factor, merits and demerits. Having excess debt is not desirable as debt­holders attach many conditions which may not be possible for the companies to adhere to. It is therefore desirable to have a combination of both debt and equity which is called the ‘optimum capital structure’. Optimum capital structure refers to the mix of different sources of long term funds in the total capital of the company.

Cost of capital is the minimum required rate of return needed to justify the use of capital. A company obtains resources from various sources – issue of debentures, availing term loans from banks and financial institutions, issue of preference and equity shares or it may even withhold a portion or complete profits earned to be utilized for further activities. Retained earnings are the only internal source to fund the company’s future plans.

Weighted Average Cost of Capital is the overall cost of all sources of finance.

The debentures carry a fixed rate of interest. Interest qualifies for tax deduction in determining tax liability. Therefore the effective cost of debt is less than the actual interest payment made by the firm.

The cost of term loan is computed keeping in mind the tax liability.

The cost of preference share is similar to debenture interest. Unlike debenture interest, dividends do not qualify for tax deductions.

The calculation of cost of equity is slightly different as the returns to equity are not constant.

The cost of retained earnings is the same as the cost of equity funds.

Solved Problems 1. Deepak steel has issued non­convertible debentures for Rs. 5 Cr. Each debenture is of a par value of Rs. 100 carrying a coupon rate of 14%. Interest is payable annually and they are redeemable after 7 years at a premium of 5%. The company issued the NCD at a discount of 3%. What is the cost of debenture to the company? Tax rate is 40%.

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Solution Kd = I(1—T) + {(F—P)/n} (F+P)/2 14(1—0.4) + (105—97)/7 (105+97)/2 = 8.4 + 1.14 = 0.094 or 9.4% 101

2. Supersonic industries Ltd. has entered into an agreement with Indian Overseas Bank for a loan of Rs. 10 Cr with an interest rate of 10%. What is the cost of the loan if the tax rate is 45%? Solution Kt=I(1—T) = 10(1—0.45) = 5.5% 3. Prime group issued preference shares with a maturity premium of 10% and a coupon rate of 9%. The shares have a face a value of Rs. 100. and are redeemable after 8 years. The company is planning to issue these shares at a discount of 3% now. Calculate the cost of preference capital. Solution Kp = D + {(F—P)/n} (F+P)/2 = 9 + (110­97) / 8 = 9 + 1.625 = 10.27% (110 + 97) / 2 103.5

Terminal Questions 1. The following data is available in respect of a company: Equity Rs. 10 lakhs, cost of capital 18% Debt Rs. 5 lakhs, cost of debt 13% Calculate the weighted average cost of funds taking market values as weights assuming tax rate is 40%. 2. Bharat Chemicals has the following capital structure: Rs. 10 face value equity shares Rs. 400000 Term loan @ 13% Rs.150000 9% Preference shares of Rs. 100, currently traded Rs. 100000 at Rs. 95 with 6 years maturity period Total Rs. 650000

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The company is expected to declare a dividend of Rs. 5 next year and the growth rate of dividends is expected to be 8%. Equity shares are currently traded at Rs. 27 in the market. Assume tax rate of 50%. What is WACC? 3. The market value of debt of a firm is Rs. 30 lakhs, which of equity is Rs. 60 lakhs. The cost of equity and debt are 15% and 12%. What is the WACC? 4. A company has 3 divisions – X, Y and Z. Each division has a capital structure with debt, preference shares and equity shares in the ratio 3:4:3 respectively. The company is planning to raise debt, preference shares and equity for all the 3 divisions together. Further, it is planning to take a bank loan @ 12% interest. The preference shares have a face value of Rs. 100, dividend @ 12%, 6 years maturity and currently priced at Rs. 88. Calculate the cost of preference shares and debt if taxes applicable are 45% 5. Tanishk Industries issues partially convertible debentures of face value of is Rs. 100 each and realizes Rs. 96 per share. The debentures are redeemable after 9 years at a premium of 4%, taxes applicable are 40%. What is the cost of debt?

5.8 Answers to Self Assessment Questions Self Assessment Questions 1 1. Capital structure 2. Maximum returns 3. Debt capacity 4. Minimum risk of loss of control 5. Equity shareholders 6. Present values of dividends

Answers to Terminal Questions:

1, 2, 3 : WACC = WeKe + WpKp +WrKr + WdKd + WtKt 4. Hint: Apply the formula Kp = D + {(F—P)/n} (F+P)/2 5. Hint: Apply the formula Kd = I(1—T) + {(F—P)/n} (F+P)/2

Sikkim Manipal University 87 Financial Management Unit 6

Unit 6 Leverage

Structure

6.1 Introduction 6.2 Operating Leverage 6.2.1 Application of Operating Leverage 6.3 Financial Leverage 6.3.1 Uses of Financial Leverage 6.4 Combined Leverage 6.4.1 Uses of Combined Leverage 6.5 Summary Solved Problems Terminal Questions Answers to SAQs and TQs

6.1 Introduction A company uses different sources of financing to fund its activities. These sources can be classified as those which carry a fixed rate of return and those whose returns vary. The fixed sources of finance have a bearing on the return on shareholders. Borrowing funds as loans have an impact on the return on shareholders and this is greatly affected by the magnitude of borrowing in the capital structure of a firm. Leverage is the influence of power to achieve something. The use of an asset or source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage. Leverage is the influence of an independent financial variable on a dependent variable. It studies how the dependent variable responds to a particular change in independent variable. There are two types of leverage – operating leverage and financial leverage. Leverage associated with the asset purchase activities is known as operating leverage, while those associated with financing activities is called as financial leverage.

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Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Explain the meaning of leverage. 2. Mention the different types of leverage. 3. Discuss the advantages of leverage.

6.2 Operating Leverage Operating leverage arises due to the presence of fixed operating expenses in the firm’s income flows. A company’s operating costs can be categorized into three main sections: • Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time. These are incurred irrespective of the income and volume of sales and generally cannot be reduced. • Variable costs are those which vary in direct proportion to output and sales. An increase or decrease in production or sales activity will have a direct effect on such types of costs incurred. • Semi­variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to a certain level beyond which they vary with the firm’s activities.

The operating leverage is the firm’s ability to use fixed operating costs to increase the effects of changes in sales on its earnings before interest and taxes. Operating leverage occurs any time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume. Example: A firm sells a product for Rs. 10 per unit, its variable costs are Rs. 5 per unit and fixed expenses amount to R. 5000 p.a. Show the various levels of EBIT that result from sale of 1000 units, 2000 units and 3000 units. Solution Sales in units 1000 2000 3000 Sales revenue Rs. 10000 20000 30000 Variable cost 5000 10000 15000 Contribution 5000 10000 15000 Fixed cost 5000 5000 5000

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EBIT 000 5000 10000 If we take 2000 units as the normal course of sales, the results can be summed as under: • A 50% increase in sales from 2000 units to 3000 units results in a 100% increase in EBIT. • A 50% decrease in sales from 2000 units to 1000 units results in a 100% decrease in EBIT.

The illustration clearly tells us that when a firm has fixed operating expenses, an increase in sales results in a more proportionate increase in EBIT and vice versa. The former is a favourable operating leverage and the latter is unfavourable.

Another way of explaining this phenomenon is examining the effect of the degree of operating leverage DOL. The DOL is a more precise measurement. It examines the effect of the change in the quantity produced on EBIT.

DOL=% change in EBIT / % change in output To put in a different way, (ΔEBIT/EBIT) (ΔQ/Q) EBIT is Q(S—V)—F where Q is quantity, S is sales, V is variable cost and F is fixed cost. Substituting this we get, {Q(S—V)} {Q(S—V)—F} Example: Calculate the DOL of Guptha enterprises. Quantity produced and sold – 1000 units Variable cost – Rs. 100 per unit’ Selling price per unit – Rs. 300 per unit Fixed expenses – Rs. 20000 Solution DOL={Q(S—V)} {Q(S—V)—F} =1000(300—200) 1000(300—200)—20000 =100000/80000 DOL=1.25 If the company does not incur any fixed operating costs, there is no operating leverage.

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Example: Sales in units 1000 Sales revenue Rs. 10000 Variable cost 5000 Contribution 5000 Fixed cost 0 EBIT 5000

Solution: DOL={Q(S—V)} {Q(S—V)—F} {1000(5000)} / {1000(5000) – 0} =5000000/5000000 =DOL=1 As operating leverage can be favourable or unfavourable, high risks are attached to higher degrees of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the operating risks of the company and hence a higher degree of operating leverage. Higher operating risks can be taken when income levels of companies are rising and should not be ventured into when revenues move southwards.

6.2.1 Application of Operating Leverage Measurement of business risk: Risk refers to the uncertain conditions in which a company performs. Greater the DOL, more sensitive is the EBIT to a given change in unit sales. A high DOL is a measure of high business risk and vice versa.

Production planning: A change in production method increases or decreases DOL. A firm can change its cost structure by mechanizing its operations, thereby reducing its variable costs and increasing its fixed costs. This will have a positive impact on DOL. This situation can be justified only if the company is confident of achieving a higher amount of sales thereby increasing its earnings.

Sikkim Manipal University 91 Financial Management Unit 6

6.3 Financial Leverage Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of EBIT on EPS of the company. A company’s sources of funds fall under two categories – those which carry a fixed financial charge – debentures, bonds and preference shares and those which do not carry any fixed charge – equity shares. Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firm’s revenues. Though dividends are not contractual obligations, dividend on preference shares is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met.

Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results from the presence of fixed financial charges in the company’s income stream. Such expenses have nothing to do with the firm’s performance and earnings and should be paid off regardless of the amount of EBIT. It is the firm’s ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs to increase the returns to shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as “Trading on Equity”.

Example: The EBIT of a firm is expected to be Rs. 10000. The firm has to pay interest @ 5% on debentures worth Rs. 25000. It also has preference shares worth Rs. 15000 carrying a dividend of 8%. How does EPS change if EBIT is Rs. 5000 and Rs. 15000? Tax rate may be taken as 40% and number of outstanding shares as 1000. Solution: EBIT 10000 5000 15000 Interest on deb. 1250 1250 1250 EBT 8750 3750 13750 Tax 40% 3500 1500 5500 EAT 5250 2250 8250 Preference div. 1200 1200 1200 Earnings available 4050 1050 7050 to equity holders

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EPS 4.05 1.05 7.05 Interpretation: • A 50 % increase in EBIT from Rs. 10000 to Rs. 15000 results in 74% increase in EPS. • A 50 % decrease in EBIT from Rs. 10000 to Rs. 5000 results in 74% decrease in EPS.

This example shows that the presence of fixed interest source funds leads to a more than proportional change in EPS. The presence of such fixed sources implies the presence of financial leverage. This can be expressed in a different way. The degree of financial leverage DFL is a more precise measurement. It examines the effect of the fixed sources of funds on EPS. DFL=%change in EPS %change in EBIT DFL={ΔEPS/EPS} {ΔEBIT/EBIT} Or DFL = EBIT {EBIT—I—{Dp/(1­T)}} I is Interest, Dp is dividend on preference shares, T is tax rate. Example: Kusuma Cements Ltd. has an EBIT of Rs. 500000 at 5000 units production and sales. The capital structure is as follows: Capital structure Amount Rs. Paid up capital 500000 equity shares of 5000000 Rs. 10 each 12% Debentures 400000 10% Preference shares of Rs. 100 each 400000 Total 5800000

Corporate tax rate may be taken at 40%

Solution: EBIT 500000 Less Interest on debentures 48000 EBT 452000

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DFL= EBIT {EBIT—I—{Dp/(1­T)}} 500000 (500000—48000—{40000/(1—0.40)} DFL=1.30

6.3.1 Use of Financial Leverage Studying DFL at various levels makes financial decision­making on the use of fixed sources of funds for funding activities easy. One can assess the impact of change in EBIT on EPS.

Like operating leverage, the risks are high at high degrees of financial leverage. High financial costs are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments. A firm not capable of honouring its financial commitments may be forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these circumstances. On the one hand trading on equity improves considerably by the use of borrowed funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All these factors should be considered while formulating the firm’s mix of sources of funds. One main goal of financial planning is devise a capital structure in order to provide a high return to equity holders. But at the same time, this should not be done with heavy debt financing which drives the company on to the brink of winding up.

Impact of financial leverage: Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities. On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities. Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used. This can be explained with the help of the following example: Following are the balance sheets of 2 firms A and B

Sikkim Manipal University 94 Financial Management Unit 6

Balance sheet of A Balance sheet of B Equity 10000 Assets 10000 Equity 40000 Assets 10000 capita 0 0 capital 0 l Debt 60000 @ 15% Total 10000 Total 10000 Total 10000 Total 10000 0 0 0 0

Both the companies earn an income before interest and tax of Rs. 40000. Calculate the DFL and interpret the results thereof. EBIT DFL= { EBIT − I − { Dp /( 1 − T )}}

4000 Company A = = 1 40000 − 0 − 0 4000 Company B = = 1 .2 9 40000 − 9000 − 0 The company not using debt to finance its assets has a higher DFL. Financial leverage does not exist when there is no fixed charge financing.

6.4 Total or Combined Leverage The combination of operating and financial leverage is called combined leverage. Operating leverage affects the firm’s operating profit EBIT and financial leverage affects PAT or the EPS. These cause wide fluctuation in EPS. A company having a high level of operating or financial leverage will find a drastic change in its EPS even for a small change in sales volume. Companies whose products are seasonal in nature have fluctuating EPS, but the amount of changes in EPS due to leverages is more pronounced. The combined effect is quite significant for the earnings available to ordinary shareholders. Combined leverage is the product of DOL and DFL. Q( S − V ) DTL = Q ( S − V ) − F − I − { Dp /( 1 − T )} Example: Calculate the DTL of M/s Pooja Enterprises Ltd. given the following information. Quantity sold 10000 units

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Variable cost per unit Rs. 100 per unit Selling price per unit Rs. 500 per unit Fixed expenses Rs. 1000000 Number of equity shares 100000 Debt Rs. 1000000 @ 20% interest Preference shares 10000 shares of Rs. 100 each @ 10% dividend Tax rate 50%

Q( S − V ) DTL = Q ( S − V ) − F − I − { Dp /( 1 − T )}

10000 ( 500 − 100 ) 10000 ( 500 − 100 ) − 1000000 − 200000 − { 100000 / 0 .5 } DTL=1.54 Cross verification: { Q ( S − V )} DOL= { Q ( S − V ) − F}

10000( 500 − 100 ) = 10000 ( 500 − 100 ) − 1000000 DOL=1.33 EBIT DFL= EBIT − I − { Dp /( 1 − T )}}

3000000 3000000 − 200000 − { 100000 / 0 .5 } DFL=1.15 DTL=DOL*DFL 1.33*1.15=1.54

6.4.1 Uses of DTL DTL measures the total risk of the company as it is a combined measure of both operating and financial risk. It measures the variability of EPS.

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Self Assessment Questions 1 1. ______arises due to the presence of fixed operating expenses in the firm’s income flows. 2. EBIT is calculated as ______. 3. Higher operating risks can be taken when ______of companies are rising. 4. Dividend on ______is a fixed charge. 5. Financial leverage is also referred to as ______.

6.5 Summary Leverage is the use of influence to attain something else. The advantage a company has with its current status is used to gain some other benefit. There are three measures of leverage – operating leverage, financial leverage and total or combined leverage. Operating leverage examines the effect of change in quantity produced upon EBIT and is useful to measure business risk and production planning. Financial leverage measures the effect of change in EBIT on the EPS of the company. It also refers to the debt­equity mix of a firm. Total leverage is the combination of operating and financial leverages.

Solved Problems 1. The following information has been collected from the annual report of Garden Silks. What is the degree of financial leverage? Total sales Rs. 1400000 Contribution ratio 25% Fixed expenses Rs. 150000 Outstanding bank loan Rs. 400000 @ 12.5% Applicable tax rate 40% Solution: DFL = EBIT / (EBIT­I) = 200000/200000­50000 = 1.33 EBIT = Sales*25% less fixed expenses 1400000*25% = 350000­150000 = 200000

2. X and Y have provided the following information. Which firm do you consider risky?

Sikkim Manipal University 97 Financial Management Unit 6

X Ltd. Y Ltd. Sales in units 40000 40000 Price per unit 60 60 Variable cost p.u 20 25 Fixed financing Rs. 100000 Rs. 50000 cost Fixed financing Rs. 300000 Rs. cost 200000 Solution: DOL = Q(S­V) / Q(S­V)­F Company X: 40000(60­20) / 40000(60­20)­400000 1600000/1200000 = 1.33 Company Y: 40000(60­25) / 40000(60­25)­250000 1400000/1100000= 1.22 3. Calculate EPS with the following information. EBIT Rs. 1180000 Interest Rs. 220000 No. of shares outstanding 40000 Tax rate applicable 40% Solution: EBIT 1180000 Less Int 220000 EBT 960000 Tax 40% 384000 EAT 576000 EPS = EAT/no of shares outstanding 576000/40000 = Rs. 14.4 4. The leverages of three firms are given below. Which one of the combinations should be chosen for the combined leverage to be maximum and what are the inferences? A B C Operating leverage 1.14 1.23 1.33 Financial leverage 1.27 1.3 1.33

Sikkim Manipal University 98 Financial Management Unit 6

Solution: We should calculate the combined leverage to draw inferences. Combined leverage of A is 1.14*1.27 = 1.45, Combined leverage of B is 1.23*1.3 = 1.60, Combined leverage of C is 1.33*1.33 = 1.77 We find that the combined leverage is highest for firm C and this suggests that this firm is working under very high risky situation.

Terminal Questions 1. Mishra Ltd. provides the following information. What is the degree of operating leverage? Output 100000 Units Fixed costs Rs. 15000 Variable cost per unit Rs. 0.50 Interest on borrowed funds Rs. 10000 Selling price per unit Rs. 1.50 2. X Ltd. provides the following information. What is the degree of financial leverage? Output 25000 units Fixed costs Rs. 25000 Variable cost Rs. 2.50 per unit Interest on borrowed funds Rs. 15000 Selling price Rs. 8 per unit 3. The following information is available in respect of 2 firms. Comment on their relative performance through leverage A Ltd. (Rs. In lakhs) B Ltd. (Rs. In lakhs) Sales 1000 1500 Variable cost 300 600 Fixed cost 250 400 EBIT 450 500 Interest 50 100

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4. ABC Ltd. provides the following information. Calculate the DFL.

Output 200000 units Fixed costs Rs.3500 Variable cost Rs. 0.05 per unit Interest on borrowed funds Nil Selling price per unit 0.20

Answers to Self Assessment Questions Self Assessment Questions 1 1. Operating leverage 2. Q(S—V)—F 3. Income levels 4. Preference shares 5. Trading on Equity

Answers to Terminal Questions: { Q ( S − V )} 1. Hint DOL = { Q ( S − V ) − F}

EBIT 2. Hint DFL = { EBIT − I − { Dp /( 1 − T )}} 3. Hint calculate DFL

Sikkim Manipal University 100 Financial Management Unit 7

Unit 7 Capital Structure

Structure 7.1 Introduction 7.2 Features of Ideal Capital Structure 7.3 Factors Affecting Capital Structure 7.4 Theories of Capital Structure 7.4.1 Net Income Approach 7.4.2 Net Operating Income Approach 7.4.3 Traditional Approach 7.4.4 Miller and Modigliani Approach 7.4.4.1 Criticism of Miller and Modigliani Approach 7.5 Summary Terminal Questions Answers to SAQs and TQs

7.1 Introduction The capital structure of a company refers to the mix of long­term finances used by the firm. In short, it is the financing plan of the company. With the objective of maximizing the value of the equity shares, the choice should be that pattern of using debt and equity in a proportion that will lead towards achievement of the firm’s objective. The capital structure should add value to the firm. Financing mix decisions are investment decisions and have no impact on the operating earnings of the firm. Such decisions influence the firm’s value through the earnings available to the shareholders.

The value of a firm is dependent on its expected future earnings and the required rate of return. The objective of any company is to have an ideal mix of permanent sources of funds in a manner that will maximize the company’s market price. The proper mix of funds is referred to as Optimal Capital Structure.

The capital structure decisions include debt­equity mix and dividend decisions. Both these have an effect on the EPS.

Sikkim Manipal University 101 Financial Management Unit 7

Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Explain the features of ideal capital structure. 2. Name the factors affecting the capital structure. 3. Mention the various theories of capital structure.

7.2 Features of an Ideal Capital Structure • Profitability: The firm should make maximum use of leverage at minimum cost. • Flexibility: It should be flexible enough to adapt to changing conditions. It should be in a position to raise funds at the shortest possible time and also repay the moneys it borrowed, if they appear to be expensive. This is possible only if the company’s lenders have not put forth any conditions like restricting the company from taking further loans, no restrictions placed on the assets usage or laying a restriction on early repayments. In other words, the finance authorities should have the power to take decisions on the basis of the circumstances warrant. • Control: The structure should have minimum dilution of control. • Solvency: Use of excessive debt threatens the very existence of the company. Additional debt involves huge repayments. Loans with high interest rates are to be avoided however attractive some investment proposals look. Some companies resort to issue of equity shares to repay their debt for equity holders do not have a fixed rate of dividend.

7.3 Factors Affecting Capital Structure Leverage: The use of fixed charges sources of funds such as preference shares, loans from banks and financial institutions and debentures in the capital structure is known as “trading on equity” or “financial leverage”. Creditors insist on a debt equity ratio of 2:1 for medium sized and large sized companies, while they insist on 3:1 ratio for SSI. Debt equity ratio is an indicator of the relative contribution of creditors and owners. The debt component includes both long term and short term debt and this is represented as Debt/Equity. A debt equity ratio of 2:1 indicates that for every 1 unit of equity, the company can raise 2 units of debt. By normal standards, 2:1 is considered a healthy ratio, but it is not always a hard and fast rule that this standard is insisted upon. A ratio of 1.5:1 is considered good for a manufacturing company while a ratio of 3:1 is good for heavy engineering

Sikkim Manipal University 102 Financial Management Unit 7 companies. It is generally perceived that lower the ratio, higher is the element of uncertainty in the minds of lenders.

Increased use of leverage increases commitments of the company, the outflows being in the nature of higher interest and principal repayments, thereby increasing the risk of the equity shareholders. The other factors to be considered before deciding on an ideal capital structure are: • Cost of capital – High cost funds should be avoided however attractive an investment proposition may look like, for the profits earned may be eaten away by interest repayments. • Cash flow projections of the company – Decisions should be taken in the light of cash flows projected for the next 3­5 years. The company officials should not get carried away at the immediate results expected. Consistent lesser profits are any way preferable than high profits in the beginning and not being able to get any after 2 years. • Size of the company • Dilution of control – The top management should have the entire flexibility to take appropriate decisions at the right time. The capital structure planned should be one in this direction. • Floatation costs – A company desiring to increase its capital by way of debt or equity will definitely incur floatation costs. Effectively, the amount of money raised by any issue will be lower than the amount expected because of the presence of floatation costs. Such costs should be compared with the profits and right decisions taken.

7.4 Theories of Capital Structure As we are aware, equity and debt are the two important sources of long­term sources of finance of a firm. The proportion of debt and equity in a firm’s capital structure has to be independently decided case to case. A proposal though not being favourable to lenders may be taken up if they are convinced with the earning potential and long­term benefits. Many theories have been propounded to understand the relationship between financial leverage and firm value.

Assumptions The following are some common assumptions made: • The firm has only two sources of funds – debt and ordinary shares. • There are no taxes – both corporate and personal.

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• The firm’s dividend pay­out ratio is 100%, that is, the firm pays off the entire earnings to its equity holders and retained earnings are zero. • The investment decisions of a company are constant, that is, the firm does not invest any further in its assets. • The operating profits EBIT are not expected to increase or decline. • All investors shall have identical subjective probability distribution of the future expected EBIT. • A firm can change its capital structure at a short notice without the occurrence of transaction costs. • The life of the firm is indefinite. Based on the above, we derive the following: 1. Debt capital being constant, Kd is the cost of debt which is the discount rate at which discounted future constant interest payments are equal to the market value of debt, that is, Kd = I/B where, I refers to total interest payments and B is the total market value of debt. Therefore value of the debt B = I/Kd 2. Cost of equity capital Ke = (D1/P0) + g where D1 is dividend after one year, P0 is the current market price and g is the expected growth rate. 3. Retained earnings being zero, g = br where r is the rate of return on equity shares and b is the retention rate, therefore g is zero. Now we know Ke = E1/P0 + g and g being zero, so Ke = NI/S where NI is the net income to equity holders and S is market value of equity shares. 4. The net operating income being constant, overall cost of capital is represented as K0 = W1K1 + W2K2. That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the debt, S market value of equity and V total market value of the firm (B+S). The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, ( K1 being the debt component and Ke being the equity component) which can be expressed as K0 = I + NI/V or EBIT/V or in other words, net operating income/market value of firm.

7.4.1 Net Income Approach This theory is suggested by Durand and he is of the view that capital structure decision is relevant to the valuation of the firm. Any change in the financial leverage will have a corresponding change in the overall cost of capital and also the total value of the firm. As the ratio of debt to equity increases, the WACC declines and market value of firm increases. The NI approach is based on 3 assumptions

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– no taxes, cost of debt less than cost of equity and use of debt does not change the risk perception of investors. We know that K0 = [B/(B+S)]Kd + [S/(B+S)]Ke The following graphical representation of net income approach may help us understand this better.

st Ke co

e g a t

n K0

rce Kd Pe

Leverage B/S

Example: Given below are two firms A and B, which are identical in all aspects except the degree of leverage employed by them. What is the average cost of capital of both firms? Firm A Firm B Net operating income EBIT Rs. 100000 Rs. 100000 Interest on debentures I Nil Rs. 25000 Equity earnings E Rs. 100000 Rs. 80000 Cost of equity Ke 15% 15% Cost of debentures Kd 10% 10% Market value of equity S = E/Ke Rs. 666667 Rs. 533333 Market value of debt B Nil Rs. 250000 Total value of firm V Rs. 666667 Rs. 783333

Average Cost of capital of firm A is: 10% * 0/Rs. 666667 + 15% * 666667/666667 which is 15%

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Average Cost of capital of firm B is: 10% * 25000/783333 + 15% * 533333/783333 which is 10.53% Interpretation: The use of debt has caused the total value of the firm to increase and the overall cost of capital to decrease.

7.4.2 Net Operating Income Approach This theory is again propounded by Durand and is totally opposite of the Net Income Approach. He says any change in leverage will not lead to any change in the total value of the firm, market price of shares and overall cost of capital. The overall capitalization rate is the same for all degrees of leverage. We know that: K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

As per the NOI approach the overall capitalization rate remains constant for all degrees of leverage. The market values the firm as a whole and the split in the capitalization rates between debt and equity is not very significant.

The increase in the ratio of debt in the capital structure increases the financial risk of equity shareholders and to compensate this, they expect a higher return on their investments. Thus the cost of equity is Ke = Ko +[ (Ko – Kd)(B/S)]

Cost of debt: The cost of debt has two parts – explicit cost and implicit cost. Explicit cost is the given rate of interest. The firm is assumed to borrow irrespective of the degree of leverage. This can mean that the increasing proportion of debt does not affect the financial risk of lenders and they do not charge higher interest. Implicit cost is increase in Ke attributable to Kd. Thus the advantage of use of debt is completely neutralized by the implicit cost resulting in Ke and Kd being the same. Graphically this is represented as:

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Ke st co

e g a t n Ko rce Pe

Kd

Leverage B/S

Example: Given below are two firms X and Y which are similar in all aspects except the degree of leverage employed. Firm A Firm B Net operating income EBIT Rs. 10000 Rs. 10000 Overall capitalization rate Ko 18% 18% Total market value V = EBIT/Ko 55555 55555 Interest on debt I Rs. 1000 Rs. 2000 Debt capitalization rate Kd 11% 11% Market value of debt B= I/Kd Rs. 9091 Rs. 18181 Market value of equity S=V—B Rs. 46464 Rs. 37374 Leverage B/S 0.1956 0.2140 The equity capitalization rates are Firm A = 9000/46464 which is 19.36% Firm B = 8000/37374 which is 21.40% The equity capitalization rates can also be calculated with the formula Ke = Ko +[ (Ko – Kd)(B/S)] Firm A = 0.18 + [(0.18 – 0.11)(0.1956)] = 19.36% Firm B = 0.18 + [(0.18 – 0.11)(0.4865)] = 21.40%

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7.4.3 Traditional Approach: The Traditional Approach has the following propositions: • Kd remains constant until a certain degree of leverage and thereafter rises at an increasing rate. • Ke remains constant or rises gradually until a certain degree of leverage and thereafter rises very sharply. • As a sequence to the above 2 propositions, Ko decreases till a certain level, remains constant for moderate increases in leverage and rises beyond a certain point. Graphically, we can represent these as under:

Ke

st co

Ko e g a t n Kd rce Pe

Leverage B/S 7.4.4 Miller and Modigliani Approach Miller and Modigliani criticize that the cost of equity remains unaffected by leverage up to a reasonable limit and Ko being constant at all degrees of leverage. They state that the relationship between leverage and cost of capital is elucidated as in NOI approach. The assumptions for their analysis are: • Perfect capital markets: Securities can be freely traded, that is, investors are free to buy and sell securities (both shares and debt instruments), there are no hindrances on the borrowings, no presence of transaction costs, securities infinitely divisible, availability of all required information at all times. • Investors behave rationally, that is, they choose that combination of risk and return that is most advantageous to them.

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• Homogeneity of investors risk perception, that is, all investors have the same perception of business risk and returns. • Taxes: There is no corporate or personal income tax. • Dividend pay­out is 100%, that is, the firms do not retain earnings for future activities. Basic propositions: The following three propositions can be derived based on the above assumptions: Proposition I: The market value of the firm is equal to the total market value of equity and total market value of debt and is independent of the degree of leverage. It can be expressed as: Expected NOI Expected overall capitalization rate V + (S+D) which is equal to O/Ko which is equal to NOI/Ko V + (S+D) = O/Ko = NOI/Ko Where V is the market value of the firm, S is the market value of the firm’s equity, D is the market value of the debt, O is the net operating income, Ko is the capitalization rate of the risk class of the firm.

Error!

l a t i p ca

Ko Ke f o

st o C

Leverage D/V

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The basic argument for proposition I is that equilibrium is restored in the market by the arbitrage mechanism. Arbitrage is the process of buying a security at lower price in one market and selling it in another market at a higher price bringing about equilibrium. This is a balancing act. Miller and Modigliani perceive that the investors of a firm whose value is higher will sell their shares and in return buy shares of the firm whose value is lower. They will earn the same return at lower outlay and lower perceived risk. Such behaviours are expected to increase the share prices whose shares are being purchased and lowering the share prices of those share which are being sold. This switching operation will continue till the market prices of identical firms become identical. Proposition II: The expected yield on equity is equal to discount rate (capitalization rate) applicable plus a premium. Ke = Ko +[(Ko—Kd)D/S] Proposition III: The average cost of capital is not affected by the financing decisions as investment and financing decisions are independent.

7.4.4.1 Criticisms of MM Proposition Risk perception: The assumption that risks are similar is wrong and the risk perceptions of investors are personal and corporate leverage is different. The presence of limited liability of firms in contrast to unlimited liability of individuals puts firms and investors on a different footing. All investors lose if a levered firm becomes bankrupt but an investor loses not only his shares in a company but would also be liable to repay the money he borrowed. Arbitrage process is one way of reducing risks. It is more risky to create personal leverage and invest in unlevered firm than investing in levered firms.

Convenience: Investors find personal leverage inconvenient. This is so because it is the firm’s responsibility to observe corporate formalities and procedures whereas it is the investor’s responsibility to take care of personal leverage. Investors prefer the former rather than taking on the responsibility and thus the perfect substitutability is subject to question.

Transaction costs: Another cost that interferes in the system of balancing with arbitrage process is the presence of transaction costs. Due to the presence of such costs in buying and selling securities, it is necessary to invest a higher amount to earn the same amount of return.

Taxes: When personal taxes are considered along with corporate taxes, the Miller and Modigliani approach fails to explain the financing decision and firm’s value.

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Agency costs: A firm requiring loan approach creditors and creditors may sometimes impose protective covenants to protect their positions. Such restriction may be in the nature of obtaining prior approval of creditors for further loans, appointment of key persons, restriction on dividend pay­outs, limiting further issue of capital, limiting new investments or expansion schemes etc.

Self Assessment Questions 1 1. Financing mix decisions are ______and have no impact on the ______of the firm. 2. The value of a firm is dependent on its ______and the ______. 3. ______and ______are two important sources of long­term sources of finance of a firm. 4. As the ratio of debt to equity increases, the ______declines and ______of firm increases. 5. As per the NOI approach the ______remains constant for all degrees of leverage. 6. ______is the process of buying a security at lower price in one market and selling it in another market at a higher price bringing about ______. 7.5 Summary According to the NI Approach, overall cost of capital continuously decreases as and when debt goes up in the capital structure. Optimal capital structure exists when the firm borrows maximum. NOI Approach believes that capital structure is not relevant. Ko is dependent business risk which is assumed to be constant. Traditional Approach tells us that Ko decreases with leverage in the beginning, reaches its maximum point and further increases. Miller and Modigliani Approach also believes that capital structure is not relevant.

Terminal Questions 1. What are the assumptions of MM approach? 2. The following data are available in respect of 2 firms. What is the average cost of capital? Firm A Firm B Net operating income Rs. 500000 Rs. 500000 Interest on debt Nil Rs. 50000 Equity earnings Rs. 500000 Rs. 450000

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Cost of equity capital 15% 15% Cost of debt Nil 10% Market value of equity shares Rs. 2000000 Rs.1400000 Market value of debt Nil Rs. 400000 Total value of firm Rs. 2000000 Rs. 1800000 3. Two companies are identical in all respects in all aspects except the debt equity profile. Company X has 14% debentures worth Rs. 2500000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 5000000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, what is the value of the company X and Y using Net operating income approach? 4. The market value of debt and equity of a firm are Rs. 10 cr and Rs. 20 Cr. respectively and their respective costs are 12% and 14%. The overall capital is 13%. Assuming the company has a 100% dividend pay­out ratio and there are no taxes, calculate the net operating income of the firm. 5. If a company has equity worth Rs. 300 lakhs, debentures worth Rs. 400 lakhs and term loan worth Rs. 50 lakhs, calculate the WACC.

Answers to Self Assessment Questions Self Assessment Questions 1. Investment decisions, operating earnings 2. Expected future earnings, required rate of return 3. Equity; debt 4. WACC; market value 5. Overall capitalization rate 6. Arbitrage; equilibrium

Answers to Terminal Questions: 1. Refer to 6.4.4 2, 3, 4. K0 = [B/(B+S)]Kd + [S/(B+S)]Ke 5. WACC = WeKe + WpKp +WrKr + WdKd + WtKt

Hint: We=0.4 ; Wd=0.533 ; Wt=0.067

Sikkim Manipal University 112 Financial Management Unit 8

Unit 8 Capital Budgeting

Structure

8.1. Introduction 8.2. Importance of Capital budgeting 8.3. Complexities involved in Capital budgeting decisions 8.4. Phases of Capital expenditure decisions 8.5. Identification of investment opportunities 8.6. Rationale of Capital budgeting proposals 8.7. Capital Budgeting process 8.7.1 Technical appraisal 8.7.2 Economic Appraisal 8.8. Investment Evaluation 8.9. Appraisal criteria 8.9.1 Traditional techniques 8.9.2 Discounted pay back period 8.10. Summary Terminal Questions Answer to SAQs and TQs

8.1 Introduction HDFC Bank takes over Centurion Bank of Punjab. ICICI Bank took over Bank of Madurai. The motive behind all these mergers is to grow because in this era of globalization the need of the hour is to grow as big as possible. In all these, one could observe that the desire of the management to create value for shareholders is the motivating force. Another way of growing is through branch expansion, expanding the product mix and reducing cost through improved technology for deeper penetration into the market for the company’s products. For example, a bank which is urban based, for expansion takes over a bank with rural network. Here urban based bank can open more urban branches only when it meets the Reserve Bank of India guideline of having a minimum number of rural branches. This is the motive for the merger of urban based bank of ICICI with the rural based Bank of Madurai.

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In this competitive arena pro­active organization makes attempts to convert challenges into opportunities. Indian economy is growing at 9%. It has far reaching implications. New lines of business such as retailing, investment advisory services and private banking are emerging. All these involve investment decisions. These investment decisions that corporates take to reap the benefits arising out of the emerging business opportunities are known as Capital Budgeting decisions. Capital budgeting decisions involve evaluation of specific investment proposals. Here the word capital refers to the operating assets used in production of goods or rendering of services. Budgeting involves formulating a plan of the expected cash flows during the future period. When we combine Capital with budget we get Capital budget. Capital budget is a blue print of planned investments in operating assets. Therefore, Capital budgeting is the process of evaluating the profitability of the projects under consideration and deciding on the proposal to be included in the Capital budget for implementation. Capital budgeting decisions involve investment of current funds in anticipation of cash flows occurring over a series of years in future. All these decisions are Strategic because they change the profile of the organizations. Successful organizations have created wealth for their shareholders through Capital budgeting decisions. Investment of current funds in long­term assets for generation of cash flows in future over a series of years characterizes the nature of Capital Budgeting decisions.

Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Explain the concept of capital budgeting. 2. Bring out the importance of capital budgeting. 3. Examine the complexity of capital budgeting procedures. 4. Discuss the various techniques of appraisal methods. 5. Evaluate capital budgeting decision

8.2 Importance of Capital budgeting Capital budgeting decisions are the most important decisions in Corporate financial management. These decisions make or mar a business organization. These decisions commit a firm to invest its current funds in the operating assets (i,e long­term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into

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1. Replacement decisions: These decisions may be decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions. 2. Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution. 3. Decisions for products of new goods or rendering of new services. 4. Decisions on penetrating into new geographical area. 5. Decisions to comply with the regulatory structure affecting the operations of the company. Investments in assets to comply with the conditions imposed by Environmental Protection Act come under this category. 6. Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant.

There are many reasons that make the Capital budgeting decisions the most crucial for finance managers 1. These decisions involve large outlay of funds now in anticipation of cash flows in future. For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast. a. For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes had declined drastically. The end result is that Metal Box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of lining and cash flow position of its employees. This highlights the element of risk involved in these type of decisions. b. Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology creating wealth for shareholders. The best example is the Reliance group. c. Any serious error in forecasting Sales and hence the amount of capital expenditure can significantly affect the firm. An upward bias may lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness.

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d. Any downward bias in forecasting may lead the firm to a situation of losing its market to its competitors. Both are risky fraught with grave consequences.

2. A long term investment of funds some times may change the risk profile of the firm. A FMCG company with its core competencies in the business decided to enter into a new business of power generation. This decision will totally alter the risk profile of the business of the company. Investor’s perception of risk of the new business to be taken up by the company will change his required rate of return to invest in the company. In this connection it is to be noted that the power pricing is a politically sensitive area affecting the profitability of the organization. Therefore, Capital budgeting decisions change the risk dimensions of the company and hence the required rate of return that the investors want. 3. Most of the Capital budgeting decisions involve huge outlay. The funds requirements during the phase of execution must be synchronized with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over run. These two problems of time over run and cost over run have to be prevented from occurring in the beginning of execution of the project. Quite a lot empirical examples are there in public sector in India in support of this argument that cost over run and time over run can make a company’s operations unproductive. But the major challenge that the management of a firm faces in managing the uncertain future cash inflows and out flows associated with the plan and execution of Capital budgeting decisions. 4. Capital budgeting decisions involve assessment of market for company’s products and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment. If a firm were to realize after committing itself considerable sums of money in the process of implementing the Capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. Sometimes these equipments will be specialized costly equipments. Therefore, Capital budgeting decisions are irreversible. 5. The most difficult aspect of Capital budgeting decisions is the influence of time. A firm incurs Capital expenditure to build up capacity in anticipation of the expected boom in the demand for its products. The timing of the Capital expenditure decision must match with the expected boom in demand for company’s products. If it plans in advance it may effectively manage the

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timing and the quality of asset acquisition. But many firms suffer from its inability to forecast the future operations and formulate strategic decision to acquire the required assets in advance at the competitive rates. 6. All Capital budgeting decisions have three strategic elements. These three elements are cost, quality and timing. Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing the products of required quality for customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of Capital expenditure decision taken will strategically affect the firm’s profitability. 7. Liberalization and globalization gave birth to economic institutions like World Trade organization. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric Company. Ability of G E to sell its products in India at a rate less than the rate at which Indian Companies sell cannot be ignored. Therefore, the growth and survival of any firm in today’s business environment demands a firm to be pro­active. Pro­active firms cannot avoid the risk of taking challenging Capital budgeting decisions for growth. Therefore, Capital budgeting decisions for growth have become an essential characteristics of successful firms today. 8. The social, political, economic and technological forces generate high level of uncertainty in future cash flows streams associated with Capital budgeting decisions. These factors make these decisions highly complex. 9. Capital expenditure decisions are very expensive. To implement these decisions firm’s will have to tap the Capital market for funds. The composition of debt and equity must be optimal keeping in view the expectation of investors and risk profile of the selected project.

Self Assessment Questions 1 1. ______make or mar a business. 2. _____ decisions involve large outlay of funds now in anticipation of cash inflows in future. 3. Social, political, economic and technological forces make capital budgeting decisions ______. 4. ______are very expensive.

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8.3 Complexities involved in Capital budgeting decisions Capital expenditure decision involves forecasting of future operating cash flows. Such forecasting suffers from uncertainty because the future is highly uncertain. Forecasting the future cash flows demands the necessity to make certain assumptions about the behaviour of costs and revenues in future. Fast changing environment makes the technology considered for implementation many times obsolete. For example, the arrival of mobile revolution totally made the pager technology obsolete. The firm’s which invested in pagers faced the problem of pagers losing its relevance as a means of communication. The firms with the ability to adapt the new know­how in mobile technology could survive the effect of this phase of technological obsolescence. Others who could not manage the effect of change in technology had a natural death and so most Capital expenditure decisions are irreversible. Estimation of future cash flows of Capital budgeting decisions is really complex and difficult commitment of funds on long term basis along with the associated problem of irreversibility of decisions and difficulty in estimating cash flows makes Capital expenditure decisions complex in nature.

Self Assessment Questions 2 1. Capital expenditure decisions are ______. 2. Forecasting of future operating cash flows suffers from ____ because the future is ______.

8.4 Phases of Capital expenditure decisions: The following steps are involved in Capital budgeting decisions: 1. Identification of investment opportunities. 2. Evaluation of each investment proposal. 3. Examine the investments required for each investment proposal. 4. Prepare the statements of Costs and benefits of investment proposals. 5. Estimate and compare the net present values of the investment proposals that have been cleared by the management on the basis of screening criteria. 6. Examine the government policies and regulatory guidelines to be observed for execution of each investment proposal screened and cleared based on the criteria stipulated by the management. 7. Budgeting for capital expenditure for approval by the management. 8. Implementation. 9. Post_ completion audit.

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Self Assessment Questions 3 1. Post­completion audit is _____ in the phases of capital budgeting decisions. 2. Identification of investment opportunities is the ______in the phases of capital budgeting decisions.

8.5 Identification of investment opportunities: A firm is in a position to identify investment proposal only when it is responsive to the ideas for capital projects emerging from various levels of the organization. The proposal may be adding new products to the company’s product line, expansion of capacity to meet the emerging market at demand for company’s products to meet the emerging market demand for company’s product or new technology based process of manufacture that will reduce the cost of production. For example, a sales manager may come with a proposal to produce a new product as per the requirements of company’s consumers. Marketing manager, based on the sales managers proposal may conduct a market survey to determine the expected demand for the new product under consideration. Once the marketing manager is convinced of the market potential for proposed new product the proposal goes to the engineers to examine the same with all aspects of production process. Then the proposal goes to the cost accountant to translate the entire gamut of the proposal into costs and revenues in terms of incremental cash flows both outflows and inflows. The cost­benefit statement generated by cost accountant shall include all incremental costs and benefits that the firm will incur and derive on commercialization of the proposal under consideration. Therefore, generation of ideas with the feasibility to convert the same into investment proposals occupies a crucial place in the Capital budgeting decisions. Proactive organizations encourage a continuous flow of investment proposals from all levels in the organization. In this connection following deserves to be considered: 1. Market Characteristics: Analysing the demand and supply conditions of the market for the company’s product could be a fertile source of potential investment proposals. 2. Various reports submitted by production engineers coupled with the information obtained through market surveys on customer’s perception of company’s product could be a potential investment proposal to redefine the company’s products in terms of customer’s expectations. 3. Companies which invest in Research and Development constantly get exposure to the benefit of adapting the new technology quite relevant to keep the firm competitive in the most dynamic business environment. Reports emerging from R & D section could be a potential source of investment proposal.

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4. Economic growth of the country and the emerging middle class endowed with purchasing power could generate new business opportunities to existing firms. These new business opportunities could be potential investment ideas. 5. Public awareness of their rights compels many firm’s to initiate projects from environmental protection angle. If ignored, the firm may have to face the public wrath through PILs entertained at the Supreme court and High courts. Therefore, project ideas that would improve the competitiveness of the firm by constantly improving the production process with the sole objective of cost reduction and costumer welfare are accepted by well­managed firms. Therefore, generation of ideas for capital projects and screening the same can be considered the most crucial phase of Capital budgeting decisions.

Self Assessment Questions 4 1. Analyzing the demand and supply conditions of the market for the company’s products could be______of potential investment proposal. 2. Generation of ideas for capital budgets and screening the same can be considered ______of capital budgetary decisions.

8.6 Rationale of Capital budgeting proposals: The investors and stake holders expect a firm to function efficiently to satisfy their expectations . Through the stake holder’s expectation of the performance of the company may clash among themselves, the one that touches all these stakeholder’s expectation could be visualized in terms of the firms obligation to reduce the operating costs on a continuous basis and increasing its revenues. These twin obligations of a firm form the basis of all Capital budgeting decisions. Therefore, Capital budgeting decisions could be grouped into two categories: 1. Decisions on cost reduction programmes. 2. Decisions on revenue generation through expansion of installed capacity.

Self Assessment Questions 5 1. ______decisions could be grouped into two categories. 2. ______and revenue generation are the two important categries of capital budgeting.

8.7 Capital Budgeting process: Once the screening of proposals for potential involvement is over the next. The company should take up the following aspects of Capital Budgeting process.

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1. Commercial: A proposal should be commercially viable. The following aspects are examined to ascertain the commercial viability of any investment proposal. a. Market for the product b. Availability of raw materials c. Sources of raw materials d. The elements that influence the location of a plant i,e, the factors to be considered in the site selection. 2. Infrastructural facilities such as roads, communications facilities, financial services such as banking, public transport services. Among the aspects mentioned above the crucial one is the need to ascertain the demand for the product or services. It is done by market appraisal. In appraisal of market for the new product, the following details are compiled and analyzed. a. Consumption trends. b. Competition and players in the market c. Availability of substitutes d. Purchasing power of consumers e. Regulations stipulated by Government on pricing the proposed products or services f. Production constraints: Relevant forecasting technologies are employed to get a realistic picture of the potential demand for the proposed product or service. Many projects fail to achieve the planned targets on profitability and cash flows if the firm could not succeed in forecasting the demand for the product on a realistic basis.

8.7.1 Technical appraisal: This appraisal is done to ensure that all technical aspects of the implementation of the project are considered. The technical examination of the project considers the following:­ a. Selection of process know how b. Decision on determination of plant capacity c. Selection of plant and equipment and scale of operation d. Plant design and layout e. General layout and maternal flow f. Construction schedule

8.7.2 Economic Appraisal: This appraisal examines the project from the social point of view. It is also known as social cost benefit analysis. It examines:

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g. The impact of the project on the environment h. The impact of the project on the income distribution in the society. i. The impact of the project on fulfillment of certain social objective like generation of employment, attainment of self sufficiency etc. j. Will it materially alter the level of savings and investment in the society?

3. Financial appraisal: This appraisal is to examine the financial viability of the project. It assesses the risk and returns at various stages of project execution. Besides, it examines whether the risk adjusted return from the project exceeds the cost of financing the project. The following aspects are examined in the process of evaluating a project in financially terms. a. Cost of the project b. Investment outlay c. Means of financing and the cost of capital d. Expected profitability e. Expected incremental cash flows from the project f. Breakeven point g. Cash break even point h. Risk dimensions of the project i. Will the project materially alter the risk profile of the company ? j. If the project is financed by debt, expected “Debt Service Coverage Ratio” k. Tax holiday benefits, if any

Self Assessment Questions 6 1. ______examines the project from the social point view. 2. All technical aspects of the implementation of the project are considered in _____. 3. ___ of a project is examined by financial appraisal. 4. Among the elements that are to be examined under commernal appraised the most crucial one is the ______. 8.8 Investment Evaluation: following steps are involved in the evaluation of any investment proposal: 1. Estimates of Cash flows both inflows and outflows occurring at different stages of project life cycle. 2. Examination of the risk profile of the project to be taken up and arriving at the required rate of return

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3. Formulating the decision criteria.

Estimation of Cash flows: Estimating the cash flows associated with the project under consideration is the most difficult and crucial step in the evaluation of an investment proposal. It is the result of the team work of many professionals in an organization. 1. Capital outlays are estimated by engineering departments after examining all aspects of production process. 2. Marketing department on the basis of market survey forecasts the expected sales revenue during the period of accrual of benefits from project executions. 3. Operating costs are estimated by cost accountants and production engineers 4. Incremental cash flows and cash out flow statement is prepared by the cost accountant on the basis of the details generated in the above steps. The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root of the success of the implementation of any capital expenditure decision. Investment (Capital budgeting) decision required the estimation of incremental cash flow stream over the life of the investment. Incremental cash flows are estimated on after tax basis. Incremental cash flows stream of a capital expenditure decision has three components. 1. Initial Cash outlay (Initial investment): Initial cash outlay to be incurred is determined after considering any post tax cash inflows if any, In replacement decisions existing old machinery is disposed of and a new machinery incorporating the latest technology is installed in its place. On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be computed on post tax basis. The net cash out flow (total cash required for investment in capital assets minus post tax cash inflow on disposal of the old machinery being replaced by a new one) therefore is the incremental cash outflow. Additional net working capital required on implementation of new project is to be added to initial investment. 2. Operating Cash inflows: Operating Cash inflows are estimated for the entire economic life of investment (project). Operating cash inflows constitute a stream of inflows and outflows over the life of the project. Here also incremental inflows and outflows attributable to operating activities are considered. Any savings in cost on installation of a new machinery in the place of the old machinery will have to be accounted to on post tax basis. In this connection incremental cash flows refer to the change in cash flows on implementation of a new proposal over the existing positions.

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3. Terminal Cash inflows: At the end of the economic life of the project, the operating assets installed now will be disposed off. It is normally known as salvage value of equipments. This terminal cash inflows is computed on post tax basis. Prof. Prasanna Chandra in his book Financial Management has identified certain basic principles of cash flow estimation. The knowledge of these principles will help a student in understanding the basis of computing incremental cash flows. These principles, as given by Prof. Prasanna Chandra are: a. Separation principle b. Incremental principle c. Post tax principle d. Consistency principle a. Separation principle: The essence of this principle is the necessity to treat investment element of the project separately (i,e independently) from that of financing element. The financing cost is computed by the cost of capital. Cost of capital is the cut off rate and rate of return expected on implementation of the project is compared with the cost of capital. Therefore, we compute separately cost of funds for execution of project through the financing mode. The rate of return expected on implementation if the project is arrived at by the investment profile of the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows. The following formulae is used to calculate profit after tax. Incremental PAT = Incremental EBIT ( 1­t ) (Incremental) (Incremental) EBIT = Earnings (Profit) before interest and taxes. t = tax rate EBIT infact represents incremental earnings before interest and tax When depreciation charges on computing incremental post tax profit is added back to incremental profit after tax, we get incremental operating cash inflow.

b. Incremental principle: Incremental principle says that the cash flows of a project are to be considered in incremental terms. Incremental cash flows are the changes in the firms total cash flows arising directly from the implementation of the project. The following are to be kept in mind in determining incremental cash flows. 1. Ignore Sunk costs: A sunk cost means an outlay already incurred. It is not a relevant cost for the project decisions to be taken now. It is ignored when the decisions on project now under consideration is to be taken.

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2. Opportunity Costs: If the firm already owns an asset or resource which could be used in the execution of the project under consideration the asset or resource has an opportunity cost. The opportunity of cost of such resources will have to be taken into account in the evaluation of the project for acceptance or rejection. For example, the firm wants to open a branch in Chennai for expansion of its market in Tamil Nadu. The firm already owns a building in Chennai. The building in Chennai is let out to some other firm on an annual rent of Rs.1 Crore. The firm takes a decision to open a brands at Chennai. For opening the branch at Chennai the firm uses the building it owns by sacrificing the rental income which it receives now. The opportunity cost of the building at Chennai is Rs.1 crores. This will have to be considered in arriving at the operating cash flows associated with the decision to open a branch at Chennai. 3. Need to take into account all incident effect: Effects of a project on the working of other parts of a firm also known as externalities must be taken into account. For example, expansion or establishment of a branch at a new place may increase the profitability of existing branches because the branch at the new place has a complementary relationship with the other existing branches or reduce the profitability of existing branches because the branch at the new place competes with the business of other existing branches or takes away some business activities from the existing branches. Cannibalization: Another problem that a firm faces on introduction of a new product is the reduction in the sale of an existing product. This is called cannibalization. The most challenging task is the handling of problems of cannibalization. Depending on the company’s position with that of the competitors in the market, appropriate strategy has to follow. Correspondingly the cost of cannibalization will have to be treated either as revelent cost of the decision or ignored. Product cannibalization will affect the company’s sales if the firm is marketing its products in a market characterized by severe competition, without any entry barriers. In this case costs are not relevant for decision. On the other hand if the firm’s sales are not affected by competitor’s activities due to certain unique protection that it enjoys on account of brand positioning or patent protection the costs of cannibalization cannot be ignored in taking decisions c.Post Tax Principle: all cash flows should be computed on post tax basis d. Consistency principle: cash flows and discount rates used in project evaluation need to consistent with the investor group and inflation.

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In capital budgeting, the cash flows applicable to all investors (i.e equity, preference share holders and debt holders) and weighted average cost of capital are considered. Nominal cash flows and nominal discounts are considered in capital budgeting decision. Example (illustration) A firm considering replacement of its existing machine by a new machine. The new machine will cost Rs 1,60,000 and have a life of five years. The new machine will yield annual cash revenue of Rs 2,50,000 and incur annual cash expenses of Rs 1,30,000. The estimated salvage of the new machine at the end of its economic life is Rs 8,000. The existing machine has a book value of Rs 40,000 and can be sold for Rs 20,000. The existing machine, if used for the next five years is expected to generate annual cash revenue of Rs 2,00,000 and to involve annual cash expenses of Rs 1,40,000. If sold after five years, the salvage value of the existing machine will be negligible. The company pays tax at 30%. It writes off depreciation act 25% on the written down value. The company’s lost of capital is 20% Compute the incremental cash flows of replacement decisions.

Solution: Initial Investment: Gross investment for the new machine (1,60,000) Less: Cash received from the sale of Existing machine 20,000 Net cash out lay (1,40,000)

Annual Cash flows from operations Incremental cash flows from revenue 50,000 Incremental decrease in expenditure (10,000) Incremental Depreciation Schedule

Year Depreciation Depreciation Incremental (New Machine (Rs.) (Old Machine) Depreciation (Rs.) 1 45,000 10,000 35,000 2 33,750 7,500 26,250 3 25,312 5,625 19,687

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4 18,984 4,219 14,765 5 14,238 3,164 11,074

Depreciation is calculated as under Book Value 40,000 Add: Cost of new machine 1,60,000 2,00,000 Less: Sale proceeds of Old Machine 20,000 1,80,000 Depreciation for I year 25 % 45,000 1,35,000 Depreciation for II year 25% 33,750 1,01,250 Depreciation for III year 25% 25,312 75,938 Depreciation for IV year 25% 18,984 56,954 Depreciation for V year 25% 14,238 Book value after 5 years 42,716

Statement of incremental Cash flows Particulars Year 0 Rs 1 Rs 2 Rs 3 Rs 4 Rs 5 Rs 1. Investment in new (1,60,000) machine 2. After tax salvage value 20,000 of old machine 3. Net Cash Out lay (1,40,000)

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4. Increase in revenue 50,000 50,000 50,000 50,000 50,000 5. Decrease in expenses 10,000 10,000 10,000 10,000 10,000 6. Increase in depreciation 35,000 26,250 19,687 14,765 11,074 7. Increase in EBIT 25,000 33,750 40,313 45,235 48,926 8. EBIT (1 – T) 17,500 23,625 28,219 31,665 34,248 9. Incremental Cash flows 52,500 49,875 47,906 46,430 45,322 from operation (8 + 6) 10. Salvage value of new 8,000 machine 11. Incremental Cash (1,40,000) 52,500 49,875 47,906 46,430 53,322 flows negative

The following points to be kept in deciding on the appraisal technique: 1. Appraisal technique should measure the economic worth of the project. 2. Wealth maximization of share holders shall be the guiding principle. 3. It shall consider all cash flows over the entire life of the project to ascertain the profitability of the project. 4. It shall rank the projects on a scientific basis. 5. It should ensure an accepted criterion when faced with the need to select from among the projects which are mutually exclusive so as to make a correct choice. 6. It should recognize the fact that initial higher cash flows are to be preferred to smaller ones. 7. Earlier cash flows are preferred to that occurring later.

Self Assessment Questions 7 1. Formulating _ is the third step in the evaluation of investment proposal. 2. A ______is not a relevant cost for the project decision. 3. Effect of a project on the working of other parts of a firm is know as ______. 4. The essence of separation principle is the necessity to treat ______of a project separately from that of ______. 5. Payback period ______­ time value of money. 6. IRR gives a rate of return that reflects the __ the project.

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8.9 Appraisal Criteria: The methods of appraising an investment proposal can be grouped into 1. Traditional methods. 2. Modern methods. Traditional Method are: i. Payback method. ii. Accounting Rate of Return. Modern techniques are: a. Net present value. b. Internal Rate of Rate. c. Modified internal rate of return. d. Profitability index.

8.9.1 Traditional Techniques: a. Payback method: payback period is defined as the length of time required to recover the initial cash out lay. Example: The following details are available in respect of the cash flows of two projects A & B

Year Project A Project B Cash flows (Rs.) Cash flows (Rs.) 0 (4,00,000) (5,00,000) 1 2,00,000 1,00,000 2 1,75,000 2,00,000 3 25,000 3,00,000 4 2,00,000 4,00,000 5 1,50,000 2,00,000 Compute pay back period for A and B Solution: Year Project A Project B Cash flows (Rs.) Cumulative Cash flows (Rs.) Cumulative Cash flows Cash flows 1 2,00,000 2,00,000 1,00,000 1,00,000 2 1,75,000 3,75,000 2,00,000 3,00,000

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3 25,000 4,00,000 3,00,000 6,00,000 4 2,00,000 6,00,000 4,00,000 10,00,000 5 1,50,000 7,50,000 2,00,000 12,00,000

From the cumulative cash flows column project A recovers the initial cash outlay of Rs 4,00,000 at the end of the third year. Therefore, payback period of project A is 3 years. From the cumulative cash flow column the initial cash outlay of Rs 5,00,000 lies between 2 nd year and 3 rd year in respect of project B. Therefore, payback period for project B is: 5,00,000 ­ 3,00,000 2 + 3,00,000 = 2.67 years Evaluation of payback period: Merits: 1. Simple in concept and application. 2. Since emphasis is on recovery of initial cash outlay it is the best method for evaluation of projects with very high uncertainty. 3. With respect to accept or reject criterion pay back method favors a project which is less than or equal to the standard pay back set by the management. In this process early cash flows get due recognition than later cash flows. Therefore, pay back period could be used as a tool to deal with the ranking of projects on the basis of risk criterion. 4. For firms with shortage funds this is preferred because it measures liquidity of the project. Demerits: 1. It ignores time value of money. 2. It does not consider the cash flows that occur after the pay back period. 3. It does not measure the profitability of the project. 4. It does not throw any light on the firm’s liquidity position but just tells about the ability of the project to return the cash out lay originally made. 5. Project selected on the basis of pay back criterion may be in conflict with the wealth maximization goal of the firm. Accept or reject criterion: a. If projects are mutually exclusive, select the project which has the least pay back period. b. In respect of other projects, select the project which have pay back period less than or equal to the standard pay back stipulated by the management. Illustration:

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Following details are available Pay back period:­ Project A = 3 years Project B = 2.5 years Standard set up by management = 3 years If projects are mutually exclusive, accept project B which has the least pay back period. If projects are not mutually exclusive, accept both the project because both have pay back period less than or equal to original to the standard pay back period set by the management Pay back period formula Year Prior to full recovery + Balance of initial out lay to be recovered Of initial out lay at the beginning of the year in which full Recovery takes place Cash in flow of the year in which full recovery takes place

8.9.2 Discounted Pay Back Period: The length in years required to recover the initial cash out lay on the present value basis is called the discounted pay back period. The opportunity cost of capital is used for calculating present values of cash inflows. Discounted pay back period for a project will be always higher than simple pay back period because the calculation of discounted pay back period is based on discounted cash flows.

For example: Year Project A PV factor at 10 PV of Cash Cumulative positive Cash flows % flows Cash flows 0 (4,00,000) 1 (4,00,000) ­ 1 2,00,000 0.909 1,81,800 1,81,800 2 1,75,000 0.826 1,44,550 3,26,350 3 25,000 0.751 18,775 3,45,125 4 2,00,000 0.683 1,36,600 4,81,725 5 1,50,000 0.621 93,150 5,74,875

Discounted Pay back period:

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4,00,000 ­ 3,45,125 3 + 1,36,600 = 3.4 years

Accounting rate of returns: ARR measures the profitability of investment (project) using information taken from financial statements: Average income ARR = Average investment

Average of post tax operating profits = Average investment

Average investment =

Book value of the investment + Book value of investment at the end of In the beginning the life of the project or investment

2 Illustration: The following particular refer to two projects :­ X Y Cost 40,000 60,000 Estimated life 5 years 5 years Salvage value Rs.3,000 Rs.3,000 Estimate income After tax Rs Rs 1 3,000 10,000 2 4,000 8,000 3 7,000 2,000 4 6,000 6,000 5 8,000 5,000 Total 28,000 31,000 Average 5,600 6,200

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Average investment 21,500 31,500 ARR 5,600 6,200 21,500 31,500

= 26 % 19.7%

Merits of Accounting rate of return: 1. It is based on accounting information. 2. Simple to understand. 3. It considers the profits of entire economic life of the project. 4. Since it is based on accounting information the business executives familiar with the accounting information under stand this technique. Demerits: 1. It is based on accounting income and not based on cash flows, as the cash flow approach is considered superior to accounting information based approach. 2. It does not consider the time value of money. 3. Different investment proposals which require different amounts of investment may have the same accounting rate of return. The ARR fails to differentiate projects on the basis of the amount required for investment. 4. ARR is based on the investment required for the project. There are many approaches for the calculation of denominator of average investment. Existence of more than one basis for arriving at the denominator of average investment may result in adoption of many arbitary bases. Because of this the reliability of ARR as a technique of appraisal is reduced when two projects with the same ARR but with differing investment amounts are to be evaluated. Accept or reject criterion: Any project which has an ARR more the minimum rate fixed by the management is accepted. If actual ARR is less than the cuff rate (minimum rate specified by the management ) then that project is rejected). When projects are to be ranked for deciding on the allocation of capital on account of the need for capital rationing, project with higher ARR are preferred to the ones with lower ARR.

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Discounted cash flow method: Discounted cash flow method or time adjusted technique is an improvement over the traditional techniques. In evaluation of the projects the need to give weight age to the timing of return is effectively considered in all DCF methods. DCF methods are cash flow based and take the cognizance of both the interest factors and cash flow after the pay back period. DCF technique involves the following. 1. Estimation of cash flows, both inflows and outflows of a project over the entire life of the project. 2. Discounting the cash flows by an appropriate interest factor (discount factor). 3. Sum of the present value of cash outflows is deducted from the sum of present value of cash inflows to arrive at net present value of cash flows, the most popular techniques of DCF methods. DCF methods are of 3 types: 1. The net present value. 2. The internal rate of return. 3. Profitability index.

The net present value: NPV method recognizes the time value of money. It correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is the need to find out the present values of all cash flows. NPV method is the most widely used technique among the DCF methods. Steps involved in NPV method: 1. Forecast the cash flows, both inflows and outflows of the projects to be taken up for execution. 2. Decisions on discount factor or interest factor. The appropriate discount rate is the firms cost of capital or required rate of return expected by the investors. 3. Compute the present value of cash inflows and outflows using the discount factor selected. 4. NPV is calculated by subtracting the PV of cash outflows from the present value of cash inflows.

Accept or reject criterion: If NPV is positive, the project should be accepted. If NPV is negative the project should be rejected.

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Accept or reject criterion can be summarized as given below: 1. NPV > Zero = accept 2. NPV < Zero = reject NPV method can be used to select between mutually exclusive projects by examining whether incremental investment generates a positive net present value. Merits of NPV method: 1. It takes into account the time value of money. 2. It considers cash flows occurring over the entire life of the project. 3. NPV method is consistent the goal of maximizing the net wealth of the company. 4. It analyses the merits of relative capital investments. 5. Since cost of capital of the firm is the hurdle rate, the NPV ensures that the project generates profits from the investment made for it. Demerits: 1. Forecasting of cash flows in difficult as it involves dealing with the effect of elements of uncertainties on operating activities of the firm. 2. To decide on the discounting factor, there is the need to assess the investor’s required rate of return But it is not possible to compute the discount rate precisely. 3. There are practical problems associated with the evaluation of projects with unequal lives or under funds constraints. For ranking of projects under NPV approach the project with the highest positive NPV is preferred to that with lower NPV.

Example: A project t costs Rs.25000 and is expected to generate cash in flows as Year Cash in flows 1 10,000 2 8,000 3 9,000 4 6,000 5 7,000 The cost of capital is 12 %. The present value factors are: Year PV factor at 12 % 1 0.893 2 0.797 3 0.712

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4 0.636 5 0.567 Compute the NPV of the project Solution: Year Cash flows PV factor at 12 PV of Cash % flows 1 10,000 0.893 8,930 2 8,000 0.797 6,376 3 9,000 0.712 6,408 4 6,000 0.636 3,816 5 7,000 0.567 3,969 29,499

Sum of the present value of cash inflows Less: Sum of the present value of cash outflows 25,500 NPV 4,499

The project generates a positive NPV of Rs.4499. Therefore, project should be accepted.

Problem: A company is evaluating two alternatives for distribution within the plant. Two alternatives are 1. C system with a high initial cost but low annual operating costs. 2. F system which costs less but have considerably higher operating costs. The decision to construct the plant has already been made, and the choice here will have no effect on the overall revenues of the project. The cost of capital of the plant is 12% and the projects expected net costs are listed below: Year Expected Net Cash Costs C Systems F Systems 0 (3,00,000) (1,20,000) 1 (66,000) (96,000) 2 (66,000) (96,000) 3 (66,000) (96,000) 4 (66,000) (96,000) 5 (66,000) (96,000)

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What is the present value of costs of each alternative? Which method should be chosen.? Solution: Computation of present value

Year C Systems F Systems Incremental 1 (66,000) (96,000) 30,000 2 (66,000) (96,000) 30,000 3 (66,000) (96,000) 30,000 4 (66,000) (96,000) 30,000 5 (66,000) (96,000) 30,000 Present value of incremental savings = 30,0000 x PV IFA (12%, 5) = 30,000 x 3.605 = 1,08,150 Incremental cash out lay = 1,80,000 (71,850)

Since the present value of incremental net cash inflows of C system over F system is negative. C system is not recommended. Therefore, F system is recommended . Properties of the NPV 1. NPVs are additive. If two projects A and B have NPV (A) and NPV (B) then by additive rule the net present value of the combined investment is NPV (A + B) 2. Intermediate cash inflows are reinvested at a rate of return equal to the cost of capital. Demerits of NPV: 1. NPV expresses the absolute positive or negative present value of net cash flows. Therefore, it fails to capture the scale of investment. 2. In the application of NPV rule in the evaluation of mutually exclusive projects with different lives, bias occurs in favour of the long term projects.

Internal Rate of Return: It is the rate of return (i,e discount rate) which makes the NPV of any project equal to zero. IRR is the rate of interest which equates the PV of cash inflows with the PV of cash flows. IRR is also called yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of return, time adjusted rate of return. IRR is the rate of return that a project earns.

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Evaluation of IRR: 1. IRR takes into account the time value of money 2. IRR calculates the rate of return of the project, taking into account the cash flows over the entire life of the project. 3. It gives a rate of return that reflects the profitability of the project. 4. It is consistent with the goal of financial management i,e maximization of net wealth of share holders 5. IRR can be compared with the firm’s cost of capital. 6. To calculate the NPV the discount rate normally used is cost of capital. But to calculate IRR, there is no need to calculate and employ the cost of capital for discounting because the project is evaluated at the rate of return generated by the project. The rate of return is internal to the project.

Demerits: 1. IRR does not satisfy the additive principle. 2. Multiple rates of return or absence of a unique rate of return in certain projects will affect the utility of this techniques as a tool of decision making in project evaluation. 3. In project evaluation, the projects with the highest IRR are given preference to the ones with low internal rates. Application of this criterion to mutually exclusive projects may lead under certain situations to acceptance of projects of low profitability at the cost of high profitability projects. 4. IRR computation is quite tedious.

Accept or Reject Criterion: If the project’s internal rate of return is greater than the firm’s cost of capital, accept the proposal. Otherwise reject the proposal. IRR can be determined by solving the following equation for r =

Ct where t = 1 to n CF0 = ∑ (1 + r) t

CF0 = Investment Sum of the present values of cash inflows at the rate of interest of r :­ C where t = 1 to n ∑ t (1 + r) t

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Example: A project requires an initial out lay of Rs.1,00,000. It is expected to generate the following cash inflows: Year Cash inflows 1 50,000 2 50,000 3 30,000 4 40,000

What is the IRR of the project? Step I Compute the average of annual cash inflows Year Cash inflows 1 50,000 2 50,000 3 30,000 4 40,000 Total 1,70,000 Average = 1,70,000 = Rs.42,500 4 Step II: Divide the initial investment by the average of annual cash inflows: = 1,00,000 = 2.35 42,500 Step III: From the PVIFA table for 4 years, the annuity factor very near 2.35 is 25%. Therefore the first initial rate is 25% Year Cash flows PV factor at 25 PV of Cash % flows 1 50,000 0.800 40,000 2 50,000 0.640 32,000 3 30,000 0.512 15,360 4 40,000 0.410 16,400 Total 1,03,760 Since the initial investment of Rs.1,00,000 is less than the computed value at 25% of Rs.1,03,760 the next trial rate is 26%.

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Year Cash flows PV factor at 26 PV of Cash % flows 1 50,000 0.7937 39,685 2 50,000 0.6299 31,495 3 30,000 0.4999 14,997 4 40,000 0.3968 15,872 Total 1,02,049

The next trial rate is 27% Year Cash flows PV factor at 27 PV of Cash % flows 1 50,000 0.7874 39,370 2 50,000 0.6200 31,000 3 30,000 0.4882 14,646 4 40,000 0.3844 15,376 Total 1,00,392

The next trial rate is 28% Year Cash flows PV factor at 26 PV of Cash % flows 1 50,000 0.7813 39,065 2 50,000 0.6104 30,520 3 30,000 0.4768 14,3047 4 40,000 0.3725 14,900 Total 98,789

Since initial investment of Rs.1,00,000 lies between 98789 (28 %) and 1,00,392 (27%) the IRR by interpolation. 1,00,392 ­ 1,00,000 27 + 1,00,392 – 98,789 X 1 . 392 27 + 1603 X 1

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= 27 + 0.2445 = 27 .2445 = 27.24 %

Modified Internal Rate of Return: MIRR is a distinct improvement over the IRR. Managers find IRR intuitively more appealing than the rupees of NPV because IRR is expressed on a percentage rates of return. MIRR modifies IRR. MIRR is a better indicator of relative profitability of the projects. MIRR is defined as PV of Costs = PV of terminal value TV PVC = n (1 + MIRR) PVC = PV of costs To calculate PVC, the discount rate used is the cost of capital. To calculate the terminal value, the future value factor is based on the cost of capital Then obtain MIRR on solving the following equation. TV PV of Costs = n (1 + MIRR) Superiority of MIRR over IRR 1. MIRR assumes that cash flows from the project are reinvested at the cost of capital. The IRR assumes that the cash flows from the project are reinvested at the projects own IRR. Since reinvestment at the cost of capital is considered realistic and correct, the MIRR measures the project’s true profitability 2. MIRR does not have the problem of multiple rates which we come across in IRR.

Illustration: Year 0 1 2 3 4 5 6 Cash flows (100) (100) 30 60 90 120 130 (Rs in million)

Cost of Capital is 12 % Present value of cost = 100 + 100 1.12 = 100 + 89.29 = 189.29

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Terminal value of cash flows: = 30 (1.12)4 + 60 (1.12) 3 + 90 (1.12) 2 + 120 (1.12) + 130 = 30 x 1.5735 + 60 x 1.4049 + 90 x 1.2544 + 120 x 1.12 + 130 = 47.205 + 84.294 + 112.896 + 134.4 + 130 = 508.80 MIRR is obtained on solving the following equation 508.80 189.29 = (1 + MIRR)6 508.80 6 (1 + MIRR) = 189.29 (1 + MIRR) 6 = 2.6879 MIRR = 17.9 % Profitability Index: it is also known as Benefit cost ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay.The discount factor based on the required rate of return is used to discount the cash in flows.

Present value of cash inflows PI = Initial Cash outlay

Accept or Reject Criterion: 1. Accept the project if PI is greater than 1 2. Reject the project if PI is less than 1

If profitability index is 1 then the management may accept the project because the sum of the present value of cash inflows is equal to the sum of present value of cash outflows. It neither adds nor reduces the existing wealth of the company. Merits of PI: 1. It takes into account the time value of money 2. It is consistent with the principle of maximization of share holders wealth. 3. It measures the relative profitability.

Demerits: 1. Estimation of cash flows and discount rate cannot be done accurately with certainty.

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2. A conflict may arise between NPV and profitability index if a choice between mutually exclusive projects has to be made.

Example X Y PV of Cash inflows 4,00,000 2,00,000 Initial cash outlay 2,00,000 80,000 NPV 2,00,000 1,20,000 Profitability Index 2 2.5

As per NPV method project X should be accepted. As per profitability index project Y should be accepted. This leads to a conflicting situation. The NPV method is to be preferred to profitability index because the NPV represents the net increase in the firm’s wealth.

Example: A firm is considering an investment proposal which requires an intial cash outlay of Rs 8 lakh now and Rs 2 lakh at the end of the third year. It is expected to generate cash flows as under: Year Cash inflows 1 3,50,000 2 8,00,000 3 2,50,000

Apply the discount rate of 12% calculate profitability index Solution: Present Value of Cash out flows

Year PV factor at 12 Cash out flows PV of Cash % flows 1 Rs.8 lakhs Rs.8 lakhs 2 3 0.712 2 lakhs 1.424 lakhs Total 9.424 lakhs

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Present Value of Cash inflows Year PVIF (12%) Cash inflows PV of Cash flows 1 0.893 3,50,000 3.1255 lakhs 2 0.797 8,00,000 6.376 lakhs 4 0.636 2,50,000 1.5900 lakhs Total 11.0915 lakhs

PI = Total of present value of cash inflows Total of present value of cash outflows = 11.0915 = 1.177 9.424 For every Re.1 invested the project is expected to give a cash inflow of Rs.1.177 i,e for every rupee invested a profit of Rs.0.177 is obtained.

8.10 Summary Capital investment proposals involve current outlay of funds in the expectation of a stream of cash in flow in future. Various techniques are available for evaluating investment projects. They are grouped into traditional and modern techniques. The major traditional techniques are payback period and accounting rate of return. The important discounting criteria are net present value, internal rate of return and profitability index. A major deficiency of payback period is that it does not take into account the time value of money. DCF techniques overcome this limitation. Each method has both positive and negative aspect. The most popular method for large project is the internal rate of return. Payback period and accounting rate of return are popular for evaluating small projects.

Terminal Questions 1. Examine the importance of capital budgeting. 2. Briefly examine the significance of identification of investment opportunities in capital budgeting process. 3. Critically examine the pay back period as a technique of approval of projects. 4. Summaries the features of DCF techniques.

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Answer for Self Assessment Questions Self Assessment Questions 1 1. Capital budgeting 2. Capital budgeting 3. Highly complex 4. Capital budgeting decisions

Self Assessment Questions 2 1. Irreversible. 2. Uncertainty, highly uncertain.

Self Assessment Questions 3 1. Final step. 2. First step Self Assessment Questions 4 1. A fertile source 2. The most crucial phase

Self Assessment Questions 5 1. Capital budgeting 2. Cost reduction.

Self Assessment Questions 6 1. Economic appraisal 2. Technical appraisal 3. Financial viability 4. Demand for the product or service.

Self Assessment Questions 7 1. Decision criteria 2. Sunk cost 3. Externalities. 4. Investment element. 5. Ignores.

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6. Profitability of

Answer for Terminal Questions. 1. Refer to unit 8.2 2. Refer to unit 8.5 3. Refer to unit 8.8.1 4. Refer to unit 8.8.2

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Unit 9 Risk Analysis in Capital Budgeting

Structure

9.1 Introduction 9.2 Types and sources of Risk in capital Budgeting 9.3 Risk Adjusted Discount Rate 9.4 Certainty Equivalent 9.5 Sensitivity Analysis 9.6 Probability Distribution Approach: 9.7 Decision – tree approach 9.8 Summary: Terminal Questions Answer to SAQs and TQs

9.1 Introduction In the previous chapter on capital budgeting the project appraisal techniques were applied on the assumption that the project will generate a given set of cash flows. It is quite obvious that one of the limitations of DCF techniques is the difficulty in estimating cash flows with certain degree of certainty. Certain projects when taken up by the firm will change the business risk complexion of the firm. This business risk complexion of the firm influences the required rate of return of the investors. Suppliers of capital to the firm tend to be risk averse and the acceptance of a project that changes the risk profile of the firm may change their perception of required rates of return for investing in firm’s project. Generally the projects that generate high returns are risky. This will naturally alter the business risk of the firm. Because of this high risk perception associated with the new project a firm is forced to asses the impact of the risk on the firm’s cash flows and the discount factor to be employed in the process of evaluation. Definition of Risk: Risk may be defined as the variation of actual cash flows from the expected cash flows. The term risk in capital budgeting decisions may be defined as the variability that is likely to occur in future between the estimated and the actual returns. Risk exists on account of the inability of the firm to make perfect forecasts of cash flows.

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Risk arises in project evaluation because the firm cannot predict the occurrence of possible future events with certainty and hence, cannot make any correct forecast about the cash flows. The uncertain economic conditions are the sources of uncertainty in the cash flows. For example, a company wants to produce and market a new product to their prospective customers. The demand is affected by the general economic conditions. Demand may be very high if the country experiences higher economic growth. On the other hand economic events like weakening of US dollar, sub prime crises may trigger economic slow down. This may create a pessimistic demand drastically bringing down the estimate of cash flows. Risk is associated with the variability of future returns of a project. The greater the variability of the expected returns, the riskier the project. Every business decision involves risk. Risk arises out of the uncertain conditions under which a firm has to operate its activities. Because of the inability of firms to forecast accurately cash flows of future operations the firms face the risks of operations. The capital budgeting proposals are not based on perfect forecast of costs and revenues because the assumptions about the future behaviour of costs and revenue may change. Decisions have to be made in advance assuming certain future economic conditions. There are Many factors that affect forecasts of investment, cost and revenue. 1) The business is affected by changes in political situations, monetary policies, taxation, interest rates, policies of the central bank of the country on lending by banks etc. 2) Industry specific factors influence the demand for the products of the industry to which the firm belongs. 3) Company specific factors like change in management, wage negotiations with the workers, strikes or lockouts affect company’s cost and revenue positions. Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk management. The best business decisions may not yield the desired results because the uncertain conditions likely to emerge in future can materially alter the fortunes of the company. Every change gives birth to new challenges. New challenges are the source of new opportunities. A proactive firm will convert every problem into successful enterprise opportunities. A firm which avoids new opportunities for the inherent risk associated with it, will stagnate and degenerate. Successful firms have empirical history of successful management of risks. Therefore, analysing the risks of the project to reduce the element of uncertainty in execution has become an essential aspect of today’s corporate project management.

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Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Define risk in capital budgeting. 2. Examine the importance of risk analysis in capital budgeting. 3. Methods of incorporating the risk factor in capital budgeting decision. 4. Understand the types and sources of risk in capital budgeting descision

9.2 Types and sources of Risk in capital Budgeting Risks in a project are many. It is possible to identify three separate and distinct types of risk in any project. 1) Stand – alone risk: it is measured by the variability of expected returns of the project. 2) Portfolio risk: A firm can be viewed as portfolio of projects having as certain degree of risk. When new project added to the existing portfolio of project the risk profile the firm will alter. The degree of the change in the risk depend on the covariance of return from the new project and the return from the existing portfolio of the projects. If the return from the new project is negatively correlated with the return from portfolio, the risk of the firm will be further diversified away. 3) Market or beta risk: It is measured by the effect of the project on the beta of the firm. The market risk for a project is difficult to estimate. Stand alone risk is the risk of a project when the project is considered in isolation. Corporate risk is the projects risks to the risk of the firm. Market risk is systematic risk. The market risk is the most important risk because of the direct influence it has on stock prices. Sources of risk: The sources of risks are 1. Project – specific risk 2. Competitive or Competition risk 3. Industry – specific risk 4. International risk 5. Market risk 1. Project – specific risk: The sources of this risk could be traced to something quite specific to the project. Managerial deficiencies or error in estimation of cash flows or discount rate may lead to a situation of actual cash flows realised being less than that projected. 2. Competitive risk or Competition risk: unanticipated actions of a firm’s competitors will materially affect the cash flows expected from a project. Because of this the actual cash flows from a project will be less than that of the forecast.

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3. Industry – specific: industry – specific risks are those that affect all the firms in the industry. It could be again grouped into technological risk, commodity risk and legal risk. All these risks will affect the earnings and cash flows of the project. The changes in technology affect all the firms not capable of adapting themselves to emerging new technology. The best example is the case of firms manufacturing motor cycles with two strokes engines. When technological innovations replaced the two stroke engines by the four stroke engines those firms which could not adapt to new technology had to shut down their operations. Commodity risk is the risk arising from the effect of price – changes on goods produced and marketed. Legal risk arises from changes in laws and regulations applicable to the industry to which the firm belongs. The best example is the imposition of service tax on apartments by the Government of India when the total number of apartments built by a firm engaged in that industry exceeds a prescribed limit. Similarly changes in Import – Export policy of the Government of India have led to the closure of some firms or sickness of some firms. 4. International Risk: these types of risks are faced by firms whose business consists mainly of exports or those who procure their main raw material from international markets. For example, rupee – dollar crisis affected the software and BPOs because it drastically reduced their profitability. Another best example is that of the textile units in Tirupur in Tamilnadu, exporting their major part of the garments produced. Rupee gaining and dollar Weakening reduced their competitiveness in the global markets. The surging Crude oil prices coupled with the governments delay in taking decision on pricing of petro products eroded the profitability of oil marketing Companies in public sector like Hindustan Petroleum Corporation Limited. Another example is the impact of US sub prime crisis on certain segments of Indian economy. The changes in international political scenario also affect the operations of certain firms. 5. Market Risk: Factors like inflation, changes in interest rates, and changing general economic conditions affect all firms and all industries. Firms cannot diversify this risk in the normal course of business. Techniques used for incorporation of risk factor in capital budgeting decisions There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology so far as incorporation of risk in the evaluation process is concerned. Conventional techniques Pay Back Period

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The oldest and commonly used method of recognising risk associated with a capital budgeting proposal is pay back period. Under this method, shorter pay back period is given preference to longer ones. Firms establish guidelines for acceptance or rejections of projects based on standards of pay back periods. Payback period prefers projects of short – term pay backs to that of long – term pay backs. The emphasis is on the liquidity of the firm through recovery of capital. Traditionally Indian business community employs this technique in evaluating projects with very high level of uncertainty. The changing trends in fashion make the fashion business, one of high risk and therefore, pay back period has been endorsed by tradition in India to take decisions on acceptance or rejection of such projects. The usual risk in business is more concerned with the fore cast of cash flows. It is the down side risk of lower cash flows arising from lower sales and higher costs of operation that matters in formulating standards of pay back. Pay back period ignores time value of many (cash flows). For example, the following details are available in respect of two projects.

Particulars Project A (Rs) Project B (Rs) Initial cash outlay 10 lakhs 10 lakhs Cash flows Year 1 5 lakhs 2 lakhs Year 2 3 lakhs 2 lakhs Year 3 1 lakhs 3 lakhs Year 4 1 lakhs 3 lakhs

Both the projects have a pay back period of 4 years. The project B is riskier than the Project A because Project A recovers 80% of initial cash outlay in the first two years of its operation where as Project B generates higher Cash inflows only in the latter half of the payback period. This undermines the utility of payback period as a technique of incorporating risk in project evaluation. This method considers only time related risks and ignores all other risks of the project under consideration.

Self Assessment Questions 2 1. ______is measured by the variability of expected returns of the project. 2. Market risk is measured by the effect of the project on the ____ of the firm. 3. Firms cannot ____ market risk in the normal course of business. 4. Impact of U.S sub prime crisis on certain segments of Indian economy is and example of ______.

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9.3 Risk Adjusted Discount Rate The basis of this approach is that there should be adequate reward in the form of return to firms which decide to execute risky business projects. Man by nature is risk­averse and tries to avoid risk. To motivate firms to take up risky projects returns expected from the project shall have to be adequate, keeping in view the expectations of the investors. Therefore risk premium need to be incorporated in discount rate in the evaluation of risky project proposals. Therefore the discount rate for appraisal of projects has two components. Those components are 1. Risk – free rate and risk premium Risk Adjusted Discount rate = Risk free rate + Risk premium Risk free rate is computed based on the return on government securities. Risk premium is the additional return that investors require as compensation for assuming the additional risk associated with the project to be taken up for execution. The more uncertain the returns of the project the higher the risk. Higher the risk greater the premium. Therefore, risk adjusted Discount rate is a composite rate of risk free rate and risk premium of the project. Example: An investment will have an initial outlay of Rs 100,000. It is expected to generate cash inflows as under: Year Cash in flows 1 40,000 2 50,000 3 15,000 4 30,000

Risk free rate of interest is 10%. Risk premium is 10% (the risk characterising the project) (a) compute the NPV using risk free rate (b) Compute NPV using risk – adjusted discount rate Solutions = (a) using risk – free rate

Year Cash flows (inflows) Rs PV Factor at 10% PV of Cash flows (in flows) 1 40,000 0.909 36,360 2 50,000 0.826 41,300 3 15,000 0.751 11,265 4 30,000 0.683 20,490 PV of cash in flows 1,09,415

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PV of Cash outflows 1,00,000 NPV 9,415

(b) Using risk – adjusted discount rate Year Cash in flows Rs PV factor at 20% PV of cash inflows 1 40,000 0.833 33,320 2 50,000 0.694 34,700 3 15,000 0.579 8,685 4 30,000 0.482 14,460 PV of Cash in flows 91,165 PV of Cash out flows 100,000 NPV (8,835)

The project would be acceptable when no allowance is made for risk. But it will not be acceptable if risk premium is added to the risk free rate. It moves from positive NPV to negative NPV. If the firm were to use the internal rate of return, then the project would be accepted when IRR is greater than the risk – adjusted discount rate. Evaluation of Risk – adjusted discount rate: Advantages: 1. It is simple and easy to understand. 2. Risk premium takes care of the risk element in future cash flows. 3. It satisfies the businessmen who are risk – averse.

Limitations: 1. There are no objective bases of arriving at the risk premium. In this process the premium rates computed become arbitrary. 2. The assumption that investors are risk – averse may not be true in respect of certain investors who are willing to take risks. To such investors, as the level of risk increases, the discount rate would be reduced. 3. Cash flows are not adapted to incorporate the risk adjustment for net cash in flows.

Self Assessment Questions 2

1. Risk premium is the ______that the investors require as compensation for

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assumption of additional risks of project. 2. RADR is the sum of ______and ______. 3. Higher the risk ______the premium. 4. Man by nature is risk­averse and tries to avoid risk.

9.4 Certainty Equivalent: Under this method the risking uncertain, expected future cash flows are converted into cash flows with certainty. Here we multiply uncertain future cash flows by the certainty – equivalent coefficient to convert uncertain cash flows into certain cash flows. The certainty equivalent coefficient is also known as the risk – adjustment factor. Risk adjustment factor is normally denoted by αt (Alpha). It is the ratio of certain net cash flow to risky net cash flow = Certainty Equivalent = Certain Cash flow Risky Cash flow

The discount factor to be used is the risk free rate of interest. Certainty equivalent coefficient is between 0 and 1. This risk – adjustment factor varies inversely with risk. If risk is high a lower value is used for risk adjustment. If risk is low a higher coefficient of certainty equivalent is used

Illustration (Example) A project costs Rs 50,000. It is expected to generate cash inflows as under Year Cash in flows Certainty Equivalent 1 32,000 0.9 2 27,000 0.6 3 20,000 0.5 4 10,000 0.3

Risk – free discount rate is 10% compute NPV Answer: Year Uncertain cash C E Certain cash PV Factor at PV of certain cash in flows flows 10% inflows 1 32,000 0.9 28,800 0.909 26,179 2 27,000 0.6 16,200 0.826 13,381 3 20,000 0.5 10,000 0.751 7,510 4 10,000 0.3 3,000 0.683 2,049

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PV of certain cash in 49,119 flows Initial cash out lay 50,000 NPV (881) negative

The project has a negative NPV. Therefore, it is rejected.

If IRR is used the rate of discount at which NPV is equal to zero is computed and then compared with the minimum (required) risk free rate. If IRR is greater than specified minimum risk free rate, the project is accepted, other wise rejected.

Evaluation: It recognises risk. Recognition of risk by risk – adjustment factor facilitates the conversion of risky cash flows into certain cash flows. But there are chances of being inconsistent in the procedure employed from one project to another. When forecasts pass through many layers of management, original forecasts may become highly conservative. Because of high conservation in this process only good projects are likely to be cleared when this method is employed. Certainty – equivalent approach is considered to be theoretically superior to the risk – adjusted discount rate. Self Assessment Questions 3 1. CE coefficient is the ______. 2. Discount factors to be used under CE approach is ______. 3. Because of high ______CE clears only good projects. 4. ______is considered to be superior to RADR 9.5 Sensitivity Analysis: There are many variables like sales, cost of sales, investments, tax rates etc which affect the NPV and IRR of a project. Analysing the change in the project’s NPV or IRR on account of a given change in one of the variables is called Sensitivity Analysis. It is a technique that shows the change in NPV given a change in one of the variables that determine cash flows of a project. It measures the sensitivity of NPV of a project in respect to a change in one of the input variables of NPV.

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The reliability of the NPV depends on the reliability of cash flows. If fore casts go wrong on account of changes in assumed economic environments, reliability of NPV & IRR is lost. Therefore, forecasts are made under different economic conditions viz pessimistic, expected and optimistic. NPV is arrived at for all the three assumptions. Following steps are involved in Sensitivity analysis: 1. Identification of variables that influence the NPV & IRR of the project. 2. Examining and defining the mathematical relationship between the variables. 3. Analysis of the effect of the change in each of the variables on the NPV of the project.

Example: A company has two mutually exclusive projects under consideration viz project A & project B. Each project requires an initial cash outlay of Rs 3,00,000 and has an effective life of 10 years. The company’s cost of capital is 12%. The following fore cast of cash flows are made by the management.

Economic Project A Project B Environment Annual cash inflows Annual cash in flows Pessimistic 65,000 25,000 Expected 75,000 75,000 Optimistic 90,000 1,00,000

What is the NPV of the project? Which project should the management consider? Given PVIFA = 5.650 Answer / Solutions NPV of project A

Economic Project PVIFA PV of cash in flows NPV Environment cash inflows at 12% 10 years Pessimistic 65,000 5.650 3,67,250 67,250 Expected 75,000 5.650 4,23,750 1,23,750 Optimistic 90,000 5.650 5,08,500 2,08,500

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NPV of Project B Pessimistic 25,000 5.650 1,41,250 (1,58,750) Expected 75,000 5.650 4,23,750 1,23,750 Optimistic 1,00,000 5.650 5,65,000 2,65,000

Decision 1. Under pessimistic conditions project A gives a positive NPV of Rs 67,250 and Project B has a negative NPV of Rs 1,58,750 Project A is accepted. 2. Under expected conditions, both gave some positive NPV of Rs 1,23,000. Any one of two may be accepted. 3. Under optimistic conditions Project B has a higher NPV of Rs 2,65,000 compared to that of A’s NPV of Rs 2,08,500. 4. Difference between optimistic and pessimistic NPV for Project A is Rs 1,41,250 and for Project B the difference is Rs 4,23,750. 5. Project B is risky compared to Project A because the NPV range is of large differences. Statistical Techniques: Statistical techniques use analytical tools for assessing risks of investments.

Self Assessment Questions 4

1. ______analysis the changes in the project NPV on account of a given change in one of the input variables of the project. 2. Examining and defining the mathematical relation between the variable of the NPV is ______. 3. Forecasts under sensitivity analysis are made under ______.

9.6 Probability Distribution Approach: When we incorporate the chances of occurrences of various economic environments computed NPV becomes more reliable. The chances of occurrences are expressed in the form of probability. Probability is the likelihood of occurrence of a particular economic environment. After assigning probabilities to future cash flows expected net present value is computed.

Illustration: A company has identified a project with an initial cash outlay of Rs 50,000. The following distribution of cash flow is given below for the life of the project of 3 years.

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Year 1 Year 2 Year 3 Cash in flow Probability Cash in flow Probability Cash in flow Probability 15,000 0.2 20,000 0.3 25,000 0.4 18,000 0.1 15,000 0.2 20,000 0.3 35,000 0.4 15,000 0.2 20,000 0.3 32,000 0.3 30,000 0.2 45,000 0.1

Discount rate is 10% Year 1 = 15,000 x 0.2 + 18,000 x 0.1 + 35,000 x 0.4 + 32,000 x 0.300 3,000 + 1,800 + 14,000 + 9,600 = 28,400 Year 2 20,000 x 0.3 + 15,000 x 0.2 + 30,000 x 0.3 + 30,000 x 0.2 = 6,000 + 3,000 + 9,000 + 6,000 = 24,000 Year 3 25,000 x 0.4 + 20,000 x 0.3 + 40,000 x 0.2 + 5,000 x 0.1 = 10,000 + 6,000 + 8,000 + 4,500 == 28,500

PV of expected Year Expected cash inflows PV factor at 10% cash in flows 1 28,400 0.909 25,816 2 24,000 0.826 19,824 3 28,500 0.751 21,403 PV of expected cash in flows 67,043 PV of initial cash out lay 50,000 Expected NPV 17,043 Variance: A study of dispersion of cash flows of projects will help the management in assessing the risk associated with the investment proposal. Dispersion is computed by variance or standard deviation. Variance measures the deviation of each possible cash flow from the expected. Square root of variance is standard deviation.

Example: Following details are available in respect of a project which requires an initial cost of Rs 5,00,000.

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Year Economic Conditions Cash flows Probability 1 High growth 2,00,000 0.3 Average growth 1,50,000 0.6 No growth 40,000 0.1 2 High growth 3,00,00 0.3 Average growth 2,00,000 0.5 No growth 5,00,000 0.2 3 High growth 4,00,000 0.2 Average growth 2,50,000 0.6 No growth 30,000 0.2

Discount rate is 10% Solution: Year 1 Economic Condition Cash in flow Probability Expected value of Cash in flow 1 2 3 High growth 2,00,000 0.3 60,000 Average growth 1,50,000 0.6 90,000 No growth 40,000 0.1 4,000 Expected Value 1,54,000

Year 2 Economic Condition Cash in flow Probability Expected value of Cash in flow High growth 3,00,000 0.3 90,000 Average growth 2,00,000 0.5 1,00,000 No growth 50,000 0.2 10,000 Expected Value 2,00,000

Year 3 Economic Condition Cash in flow Probability Expected value of Cash in flow High growth 4,00,000 0.2 80,000 Average growth 2,50,000 0.6 1,50,000 No growth 30,000 0.2 6,000

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Expected Value of 2,36,000 Cash inflows 1,54,000 2,00,000 2,36,000 Expected NPV = 1.10 + (1­10) 2 + (1.10) 3 ­ 5,00,000 = 1,40,000 + 1, 65, 289 + 1, 77, 310 – 5,00,000 = (17,401) negative NPV

Standard Deviation for I year

Cash in flow Expected Value (C – E) 2 (C – E) 2 x prob C E 2,00,000 1,54,000 (46,000) 2 (46,000) 2 x 0.3 = 634800 000 1,50,000 1,54,000 (­ 4000) 2 (­ 4,000) 2 x 0.3 = 9600 000 40,000 1,54,000 ( ­ 1,14,000)2 (­ 1,14,000) 2 x 0.3 = 12996 00 000 Total 1944 000 000

Standard deviation of Cash flows for I year = 44091 For 2 nd year Cash in flow Expected Value (C – E) 2 (C – E) 2 x prob C E 3,00,000 2,00,000 (1,00,000) 2 (1,00,000) 2 x 0.3 = 3000 000 000 2,00,000 2,00,000 (0) 2 (0) 2 x 0.5 = 0 50,000 2,00,000 ( ­ 1,50,000)2 (­ 1,50,000) 2 x 0.2 = 45 00 000 000 Total 7500 00 000

Variance of Cash flows for 2 nd year = 7500 000 000 Standard Deviation of cash flows for 2 nd year = 8660 For the third year Cash in flow Expected Value (C – E) 2 (C – E) 2 x prob C E 4,00,000 2,36,000 (1,64,000) 2 (1,64,000) 2 x 0.2 = 53792 00 000 2,50,000 2,36,000 (14,000) 2 (14,000) 2 x 0.6 = 1176 00 000 30,000 2,36,000 ( ­ 2,00,000)2 (­ 2,00,000) 2 x 0.2 = 8000 000 000 Total 13496800 000

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Variance of Cash flows for 3 rd year = 13496800 000 Standard Deviation of cash flows for 3 rd year = 116175 Standard Deviation of NPV

√(44091) 2 (8660) 2 (116175) 2 σNPV = + + √(1.10) 2 (1.10) 4 (1.10) 6 = √1606625026 + 51223004 + 7618496131 = √9276344161 = 96314

Here the assumption is that there is no relationship between cash flows from one period to another. Under this assumption the standard deviation of NPV is Rs 96,314. On the other hand, if cash flows are perfectly correlated, cash flows of all years have linear correlation to one another, then

44091 8660 116175 σ = 2 3 NPV 1.10 + (1.10) + (1.10) = 40083 + 7157 + 87284 = 134524

The standard deviation of NPV when cash flows are perfectly correlated will be higher than that under the situation of independent cash flows. Self Assessment Questions. 5 1. Probability distribution approach incorporates the probability of occurrences of various economic environment, to make the NPV ______. 2. ______is likelihood of occurrence of a particular economic environment.

9.7 Decision – tree approach: Many project decisions are complex investment decisions. Such complex investment decisions involve a sequence of decisions over time. Decisions tree can handle the sequential decisions of complex investment proposals. The decision of taking up an investment project is broken into different stages. At each stage the proposal is examined to decide whether to go ahead or not. The multi – stages approach can be handled effectively with the help of decision trees. A decision tree presents graphically the relationship between a present decision and future events, future decisions and the consequences of such decisions.

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Example R & D section of a company has developed an electric moped. The firm is ready for pilot production and test marketing. This will cost Rs 20 million and take six months. Management believes that there is a 70% chance that the pilot production and test marketing will be successful. If successful the company can build a plant costing Rs 200 million. The plant will generate annual cash in flow of Rs 50 million for 20 years if the demand is high or an annual cash inflow or 20 million if the demand is low.

High demand has a probability of 0.6 and low demand has a probability of 0.4. Cost of capital is 12%. Suggest the optimal course of action using decision tree analysis (Bangalore University MBA, adapted). High Demand Probability 0.6 C21 D21 Investment Annual Cash inflow Rs.200 million Rs.50 million C2 D11 Carry out pilot Production C11 Success Annual Cash inflow D Rs.20 million And Market 0.7 2 test (20 million) D22 Stop C22 Low Demand C1 Probability 0.4

D D3 C12 failure D31 Stop Probability 0.3

D12 Do Nothing

Working Notes: From right hand side of the decision tree I step: Computation of Expected Monetary Value at point C2. Here EMV represents expected NPV.

Cash in flow Probability Expected value of cash inflows 50 0.6 30 20 0.4 8 EMV 38

Present Value of EMV = Expected value of cash inflow x PVIFA (12% 20) 38 x 7.469 = Rs 283.82 million

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Step 2: Computation of EMV at decision point D2. Decision taken Consequences The resulting EMV at this level D2 Invest Rs 200 million 283.82 – 200 83.82 million D22 Stop 0 Here the decision criterion is “select the EMV with the highest value”.

Stage 3: Therefore EMV with Rs 83.82 million will be considered therefore; we select the decision taken at D2, Stage 4: Computation of EMV at the point C, EMV Probability Expected Value 83.82 0.7 58.67 0 0.3 0 EMV at this stage 58.67

Step 5: Compute EMV at decisions point D, Decision taken Consequences The resulting Em at this level D11 carry out pilot Invest 58.67 – 20 = Rs 38.67 Million production and market test 20 million D12 Do nothing 0 0 EMV at this stage 38.67 Million (Apply the EMV criterion) i.e select the EMV with the highest value

Therefore optimal strategy is 1. Carry out pilot production and market test. 2. If the result of pilot production and market test is successful, go ahead with the investment decision of Rs 200 million in establishing a plant. 3. If the result of pilot production and market test is future, stop.

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Evaluation of Decision tree approach: 1. It portrays inter – related, sequential and critical multi dimensional elements of major project decisions. 2. Adequate attention is given to the critical aspects in an investment decision which spread over a time sequence. 3. Complex projects involve huge out lay and hence risky. There is the need to define and evaluate scientifically the complex managerial problems arising out of the sequence of interrelated decisions with consequential outcomes of high risk. It is effectively answered by decision tree approach. 4. Structuring a complex project decision with many sequential investment decisions demands effective project risk management. This is possible only with the help of an analytical tool like decision tree approach. 5. Able to eliminate unprofitable outcomes and helps in arriving at optimum decision stages in time sequence.

Self Assessment Questions 6 1. Decision tree can handle the ______of complex investment proposals. 2. _____ portrays inter­related, sequential and critical multi dimensional elements of major project decisions. 3. Adequate attention is given to the ______in an investment decision under decision tree approach’s. 4. ______are effectively handled by decision tree approach’s .

9.8 Summary Risk in project evaluation arises on account of the inability of the firm to predict the performance of the firm with certainty. Risk in capital budgeting decision may be defined as the variability of actual returns from the expected. There are many factors that affect forecasts of investment, costs and revenues of a project. It is possible to identify three type of risk in any project, viz stand­ alone risk, corporate risk and market risk. The sources of risks are: a. Project b. Competition c. Industry d. International factors and e. Market

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The techniques for incorporation of risk factor in capital budgeting decision could be grouped into conventional techniques and statistical techniques.

Terminal Questions 1. Define risk. Examine the need for assessing the risks in a project. 2. Examine the type and sources of risk in capital budgeting . 3. Examine risk adjusted discount rate as a technique of incorporating risk factor in capital budgeting. 4. Examine the steps involved in sensitivity analysis. 5. Examine the features of Decision­tree approaches.

Answer for Self Assessment Questions Self Assessment Questions 1 1. Stand­alone risk. 2. Beta 3. Diversify 4. International risk

Self Assessment Question 2 1. Additional return 2. Risk free rate, risk premium. 3. Greater.

Self Assessment Question 3 1. Risk­ adjustment factor 2. Risk free rate of interest. 3. Conservation. 4. CE

Self Assessment Question 4 1. Sensitivity analysis 2. One of the steps of sensitivity analysis 3. Different economic conditions

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Self Assessment Question 5 1. More reliable 2. Probability

Self Assessment Question 6 1. Sequential decisions 2. Decision tree. 3. Critical aspects 4. Complex projects.

Answer for Terminal Questions 1. Refer to units 9.1 2. Refer to units 9. 2 3. Refer to units 9.3 4. Refer to unit 9.5 5. Refer to unit 9.7

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Unit 10 Capital Rationing

Structure

10.1 Introduction 10.2 Meaning of Capital Rationing 10.3 Steps involved in Capital Rationing 10.4 Summary Terminal Questions Answer to SAQs and TQs

10.1 Introduction: Capital budgeting decisions involve huge outlay of funds. Funds available for projects may be limited. Therefore, a firm has to prioritize the projects on the basis of availability of funds and economic compulsion of the firm. It is not possible for a company to take up all the projects at a time. There is the need to rank them on the basis of strategic compulsion and funds availability. Since companies will have to choose one from among many competing investment proposal the need to develop criteria for Capital rationing cannot be ignored. The companies may have many profitable and viable proposals but cannot execute because of shortage of funds. Another constraint is that the firms may not be able to generate additional funds for the execution of all the projects. When a firm imposes constraints on the total size of firm’s capital budget, it is requires Capital Rationing. When Capital is rationed there is a need to develop a method of selecting the projects that could be executed with the company’s resources yet give the highest possible net present value.

Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Explain the meaning of capital rationing. 2. Explain the need for capital rationing. 3. Explain the process of capital rationing. 4. Explain the various approaches to capital rationing.

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10.2 Meaning of Capital Rationing: Because of the limited financial resources, firms may have to make a choice from among profitable investment opportunities. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control.

Why Capital Rationing Reasons for Capital Rationing: Capital Rationing may be due to a. External factors b. Internal constraints imposed by management

External Capital Rationing: External Capital Rationing is due to the imperfections of capital markets Imperfection may be caused by:­ a. Deficiencies in market information b. Rigidities that hamper the force flow of Capital between firms. When capital markets are not favourable to the company the firm cannot tap the capital market for executing new projects even though the projects have positive net present values. The following reasons attribute to the external capital rationing:­ 1. Inability of the firm to procure required funds from Capital market because the firm does not command the required investor’s confidence. 2. National and international economic factors may make the market highly volatile and instable. 3. Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the market for funds. 4. High Cost of issue of Securities I,e High floatation cost. Smaller firms smaller firms may have to incur high costs of issue of securities. This discourages small firms from tapping the capital markets for funds.

Internal Capital Rationing: Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects. Another internal restriction for Capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of

Sikkim Manipal University 168 Financial Management Unit 10 generating the management’s expectation on the rate of return will be cleared. Generally internal capital rationing is used by a firm as a means of financial control.

Self Assessment Questions 1 1. When a firm imposes constraints on the total size of its capital budget, it is known as ______. 2. Internal capital rationing is used by a firm as a ______. 3. Rigidities that affect the free flow of capital between firms cause ______. 4. Inability of a firm to satisfy the regularity norms for issue of equity shares for tapping the market for funds causes ______.

10.3 Steps involved in Capital Rationing Steps involved in Capital Rationing are: 1. Ranking of different investment proposals 2. Selection of the most profitable investment proposal

Ranking of different investment proposals The various investment proposals should be ranked on the basis of their profitability. Ranking is done on the basis of NPV, Profitability index or IRR in the descending order. Profitability index as the basis of Capital Rationing The following details are available: Cash Inflows Project Initial Cash outlay Year 1 Year 2 Year 3 A 1,00,000 60,000 50,000 40,000 B 50,000 20,000 40,000 20,000 C 50,000 20,000 30,000 30,000 Cost of Capital is 15 % Computation of NPV Year Cash in flows PV factor at 15% PV of Cash in flows 1 60,000 0.870 52,200 2 50,000 0.756 37,800 3 40,000 0.658 26,320

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PV of Cash inflow 1,16,320 Initial Cash out lay 1,00,000 NPV 16,320

PV of Cash inflows Profitability index = PV of Cash outflows

1,16,320 = 1,00,000 = 1.1632

Project B

Year Cash in flows PV factor at 15% PV of Cash in flows 1 20,000 0.870 17,400 2 40,000 0.756 30,240 3 20,000 0.658 13,160 PV of Cash inflow 60,800 Initial Cash out lay 50,000 NPV 10,800

Profitability index = 60,800 = 1.216 50,000 Project C Year Cash in flows PV factor at 15% PV of Cash in flows 1 20,000 0.870 17,400 2 30,000 0.756 22,680 3 30,000 0.658 19,740 PV of Cash inflow 59,820 Initial Cash out lay 50,000 NPV 9,820

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Profitability index = 59,820 = 1.1964 50,000 Ranking of Projects Project NPV Profitability Index Absolute Rank Absolute Rank A 16320 1 1.1632 3 B 10800 2 1.216 1 C 9820 3 1.1964 2

If the firm has sufficient funds and no capital rationing restriction, then all the projects can be accepted because all of them have positive NPVs. Let us assume that the firm is forced to resort to capital rationing because the total funds available for execution of project is only Rs.1,00,000. In this case on the basis of NPV Criterion, project A will be cleared. It incurs an initial cash outlay of Rs.1,00,000. After allocating Rs.1,00,000 to project A, left over funds is nil. Therefore, on the basis of NPV criterion other projects i,e B & C cannot be taken up for execution by the firm. It will increase the net wealth of the firm by Rs.16,320. On the other hand on the basis of profitability index, project B and C can be executed with Rs.1,00,000 because both of them incur individually an initial cash outlay of Rs.50,000. Therefore, with the execution of projects B and C, increase in net wealth of the firm will be 10800 + 9820 = Rs20620 The objective is to maximize NPV per rupee of Capital and projects should be ranked on the basis of the profitability index. Funds should be allocated on the basis ranks assigned by profitability index.

Evaluation: 1. PI rule of selecting projects under Capital rationing may not yield satisfactory result because of project indivisibility. When projects involving high investment is accepted many small projects will have to be excluded. But the sum of the NPVs of small projects to be accepted may be higher than the NPV of single large project. 2. It also suffers from the multi­period Capital constraints. Programming approach: There are many programming techniques to Capital rationing. Among them are:­

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1. Linear Programming: LP approach to Capital rationing tries to achieve maximum NPV subject to many constraints. Here the objective function is maximisation of sum of the NPVs of the projects. Here the constraints matrix incorporates all the restrictions associated with Capital rationing imposed by the firm. 2. Integer Programming: LP may give an optimal mix of projects in which there may be need to accept fraction of a project. Accepting fraction of a project is not feasible. Therefore, optimum may not be attainable. The actual implementation of projects may be suboptimal. When projects are not divisible, integer programming can be employed to avoid the chances of accepting fraction of projects. The advantage of programming approach is that it provides information on dual variables. It also gives information on shadow prices of budget constraints. Dual variables provide information for decision on transfer of funds from one year to another year

The demerits of programming approach is that a. Costly to use when large, indivisible projects are being examined. b. They are deterministic models. But variables of Capital budgeting are subject to change making the assumption of deterministic highly invalid.

Self Assessment Questions 2 1. The two steps involved in capital rationing are ______and ______. 2. Project indivisibility can lead to sub optimal result when ______is used for capital rationing. 3. Objective function under linear programining approach is ______. 4. When project are not divisible ______can be employed to avoid the changes of accepting fraction of a project.

10.4 Summary Often firms are forced to ration the funds among the eligible projects that the firm wants to take up. The inability of the firm in finding adequate funds for execution of the projects could be due to many factors. It may be due to external factors or internal constraints imposed by the management. External capital rationing occurs mainly because of imperfections in capital markets. Internal capital rationing is caused by restrictions imposed by the managements.

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Terminal Questions 1. Examine the need for capital rationing. 2. Examine the reasons for external capital rationing. 3. Internal capital rationing is uses by firms for exercising financial control” How does a firm achieve this ? 4. Brief explain the process of capital rationing.

Answer to Self Assessment Questions Self Assessment Questions 1 1. Capital rationing. 2. Means of financial control. 3. External capital rationing. 4. External capital rationing.

Self Assessment Questions 2 1. Ranking the project, selection of the most profitable investment proposal 2. Profitability index 3. Maximisation of sum of NPVs of the projects. 4. Integer programming

Answer for Terminal Questions 1. Refer to unit 10.1 2. Refer to unit 10.1 3. Refer to unit 10.1 4. Refer to unit 10.3

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Unit 11 Working Capital Management

Structure

11.1 Introduction 11.2 Components of Current Assets and Current Liabilities 11.3 Concepts of Working Capital 11.4 Objective of Working Capital Management 11.5 Need for working Capital 11.6 Operating Cycle 11.7 Determinants of Working Capital 11.8 Estimation of Working Capital 11.9 Summary Terminal Questions Answer to SAQs and TQs

11.1 Introduction Sound working Capital Management has become a necessity in an era of information technology for a company to succeed. The best example to support this argument is the performance of Dell computers as reported in one of the recent Fortune article. A perusal of the article will give us an insight into how Dell could use technology for improving the performance of components of working capital. 1. Use of internet as a tool for reducing costs of linking manufacturer with their suppliers and dealers. 2. Outsourcing an operations if the firm’s core competence does not permit the performance of the operation effectively. 3. Train the employees to accept change. 4. Introduction of internet business 5. Releasing Capital by reduction in investment in inventory for improving the profitability of operating capital. A financial manger spends a large part of his time in managing working capital. There are two important elements of working capital management.

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1. Decisions on the amount of current assets to be held by a firm for efficient operations of its business. 2. Decisions on financing working capital requirement. Inadequacy or mismanagement of Working Capital is the leading cause of many business failures. Working Capital is that portion of asset of a business which are used in current operations. They are used in the operating cycle of the firm. It is defined as the excess of Current Assets over Current Liabilities and provisions.

Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Explain the meaning, definition and concepts of Working Capital 2. State the objectives of Working Capital management. 3. Bring out the importance of Working Capital management. 4. Explain the process of estimation of Working Capital.

11.2 Components of Current Assets and Current Liabilities 11.2.1 Current Assets are:­ 1) Inventories 2) Sundry Debtors 3) Bills Receivables 4) Cash and Bank Balances 5) Short term investments 6) Advances such as advances for purchase of raw materials, components and consumable stores, prepaid expenses etc. 11.2.2 Current Liabilities are:­ 1) Sundry Creditors 2) Bills Payable 3) Creditors for outstanding expenses 4) Provision for tax 5) Other provisions against the liabilities payable within a period of 12 months. Working Capital Management is concerned with managing the different components of current assets and current liabilities. A firm must have adequate Working Capital neither excess nor shortage. Maintaining adequate Working Capital at the satisfactory level is crucial for maintaining the competitiveness of a firm. Any lapse of a firm on this account may lead a firm to the state of insolvency.

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Self Assessment Questions 1 1. Maintaining adequate working capital at the satisfactory level is crucial for ______the ______of a firm. 2. Prepaid expenses are ______. 3. Provision for tax is ______. 4. A firm must ______neither excess nor shortage.

11.3 Concepts of Working Capital There are two important concepts of Working Capital – gross and net Gross Working Capital: Gross Working Capital refers to the amounts invested in the various components of current assets. This concept has the following practical relevance. a. Management of current assets is the crucial aspect of Working Capital Management. b. It is an important component of operating capital. Therefore, for improving the profitability on its investment a finance manager of a company must give top priority to efficient management of current assets. c. The need to plan and monitor the utilization of funds of a firm demands working capital management as applied to current assets. d. It helps in the fixation of various areas of financial responsibility.

Net Working Capital Net Working Capital is the excess of current assets over current liabilities and provisions. Net Working Capital is positive. when current assets exceed current liabilities and negative when current liabilities exceed current assets. This concept has the following practical relevance. 1. It indicates the ability of the firm to effectively use the spontaneous finance in managing the firm’s Working Capital requirements. 2. A firm’s short term solvency is measured through the net Working Capital position it commands.

Permanent Working Capital Permanent Working Capital is the minimum amount of investment required to be made in current assets at all times to carry on the day to day operation of firm’s business. This minimum level of current asset has been given the name of core current assets by the Tandon Committee. It is also known as fixed Working Capital.

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Temporary Working Capital It is also known as Variable Working Capital or fluctuating Working Capital. The firm’s working capital requirements vary depending upon the seasonal and cyclical changes in demands for a firm’s products. The extra Working Capital required as per the changing production and sales levels of a firm is known as Temporary Working Capital.

Self Assessment Question 2 1. ______refers to the amounts invested in current assets. 2. To ______and monitor the ______to (current assets) is to be given top priority. 3. When current assets exceed current liabilities the net working capital is _____. 4. Permanent working is called ____ working capital.

11.4 Objective of Working Capital Management The basic objective of financial management is maximizing the net wealth of shareholders. A firm must earn sufficient returns from its operations to ensure the realization of this objective. There exists a positive correlation between sales and firm’s return on its investment. The amount of earnings that a firm earns depends upon the volume of sales achieved. There is the need to ensure adequate investment in current assets, keeping pace with accelerating sales volume. Firms make sales on credit. There is always a time gap between sale of goods on credit and the realization of proceeds of sales from the firm’s customers. Finance manger of a firm is required to finance the operation during this time gap. Therefore, objective of Working Capital Management is to ensure smooth functioning of the normal business operations of a firm. The firm has to decide on the amount of Working Capital to be employed. The firm may have a conservative policy of holding large quantum of current assets to ensure larger market share and to prevent the competitors from snatching any market for their products. But such a policy will affect the firm’s return on its investment. The firm will have higher than the required amount of investment in current asset. This excess funds locked in current assets will reduce the firm’s profitability on operating capital. On the other hand a firm may have an aggressive policy of depending on spontaneous finance to the maximum extent. Credit obtained by a firm from its suppliers is known as spontaneous finance. Here a firm will try to reduce its investments in current assets as much as possible but without affecting the firm’s ability to meet working capital needs for sales growth targets. Such a policy will ensure higher return on its investment as the firm will not be locking in any excess

Sikkim Manipal University 177 Financial Management Unit 11 funds in current assets. However, any error in forecasting can affect the operations of the firm unfavorably if the error is fraught with the down side risk. There is also another risk of firm losing on maintaining its liquidity position. Objective of working capital management is achieving a trade – off between liquidity and profitability of operations for the smooth conduct of normal business operations of the firm.

Self Assessments Questions 3 1. Objective of working capital management is achieving a trade off between ______and ______. 2. Credit obtained by firm from its suppliers is know as ______. 3. An aggressive policy of working capital management means depending on ______to the maximum extent. 4. To prevent the competitors from snatching any market for their products the firm may have a ______policy of holding ______of current assets.

11.5 Need for working Capital The need for working capital arises on account of two reasons: a. To finance operations during the time gap between sale of goods on credit and realization of money from customer’s of the firm. b. To finance investments in current assets for achieving the growth target in sales. Therefore finance the operations in operating cycle of a firm working capital is required.

Self Assessment Questions 4 1. To finance the operations in ______of a firm working capital is required. 2. To finance operations during the time gap between ______and ______working capital is required.

11.6 Operating Cycle Operating cycle of a firm has the following elements. 1. Acquisition of resources from suppliers. 2. Making payments to suppliers. 3. Conversion of raw materials into finished products. 4. Sale of finished products to customers. 5. Collection of cash from customers for the goods sold.

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The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle. These five phases occur on a continuous basis. There is no synchronization between the activities in operating cycle. Cash out flows occur before the occurrences of cash inflows in operating cycle cash out flows are certain. On the other hand cash in flows are uncertain because of uncertainty associated. With effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods. Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements. Operating cycle = IC period + RC period IC period = Inventory conversion period RC period = Receivables conversion period Inventory conversion period is the average length of time required to produce and sell the product.

1. Inventory Conversion period = Average Inventory x 365 Annual cost of goods sold

2. Receivables conversion period = Average Accounts Receivables x 365 Annual Sales

Accounts payables period is also known as payables deferral period. 3. Accounts payables period = Average creditors (Payables deferral period) purchases per day Purchases per day = Total Purchases for year 365 Receivables conversion period is the average length of time required to convert the firm’s receivables into cash.

4. Cash Conversion Cycle: Is the length of time between the firm’s actual cash expenditure and its own cash receipt. The cash conversion cycle is the average length of time a rupee is tied up in current assets. Cash Conversion Cycle is

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CCC = ICP + RCP – PDP CCC = Cash Conversion Cycle ICP = Inventory Conversion Period RCP = Receivables Conversion Period PDP = Payables deferral period

Example: The following details are available for XYZ Ltd for the year ended 31.03.08 Sales 80,000 Inventory Cost of goods 56,000 31.03.07 9,000 31.03.08 12,000 Accounts Receivables 31.03.07 12,000 31.03.08 16,000 Accounts Payable 31.03.07 7,000 31.03.08 10,000

What is the length of the operating cycle? What is the cash cycle? Assume 365 days in the year (MBA Adopted) Answer Operating Cycle = Inventory Conversion Period + Accounts Receivables conversion Period

Inventory Conversion Period Average Inventory ( 9000 + 12000 ) / 2 X 365 X 365 Annual Cost of goods sold 56000 10500 x 365 = 68.4 days 56000

Average Accounts Receivables X 365 Receivables Conversion Period = Annual sales

( 12000 + 16000 ) / 2 x 365 = 63.9 days 80000

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Average Accounts Payables Receivables Conversion Period = X 365 Annual Cost of goods sold ( 7000 + 10000 ) / 2 x 365 = 63.9 days 56000

8500 x 365 = 55.4days 56000 Operating Cycle = ICP + RCP = 68.4 + 63.9 = 132.3 days Cash Conversion cycle = OC – PDP = 132.3 – 55.4 = 76.9 days The Cash conversion cycle shows the time interval over which additional non spontaneous sources of working capital financing must be obtained to carry out firm’s activities. An increase in the length of operating cycle, without a corresponding increase in payables deferral period, increases the cash conversion cycle. Any increase in cash conversion cycle leads to additional working capital needs of the firm.

Self Assessment Question 5 1. The time gap between acquisition of resources from suppliers and collection of cash from customers is known as ______. 2. ______is the average length of time required to produce and sell the product. 3. ______is the average lenth of time required to concept the firms receivables into cash. 4. ______is conversion cycle is the length of time between firm’s actual cash expenditure and its own receipt.

11.7 Determinants of Working Capital A large number of factors influence Working Capital needs of a firm. The basic objective of a firm’s Working Capital management is to ensure that the firm has adequate working capital for its operations, neither too much not too little. Investing heavily in current assets will drain the firm’s earnings and inadequate investment in current assets will reduce the firm’s credibility as it affects

Sikkim Manipal University 181 Financial Management Unit 11 the firm’s liquidity. Therefore, the need to strike a balance between liquidity and profitability cannot be ignored. The following factors determine a firm’s working capital requirements. 1. Nature of business: Working Capital requirements are basically influenced by the nature of business of the firm. Trading organizations are forced to carry large stocks of finished goods, accounts receivables and accounts payables. Public utilities require lesser investment in working capital. 2. Size of Business Operation: Size is measured in terms of a scale of operation. A firm with large scale of operation normally requires more Working Capital than a firm with a low scale of operation. 3. Manufacturing Cycle: Capital intensive industries with longer manufacturing process will have higher requirements of Working Capital because of the need to run their sophisticated and long production process. 4. Products Policy: Production schedule of a firm influences the investments in inventories. A firm, exposed to seasonal changes in demand when following a steady production policy will have to face the costs and risks associated with inventory accumulation during the off­season periods. On the other hand a firm with a variable production policy will be facing different dimensions of management of working capital. Such a firm may have to effectively handle problem of production planning and control associated with utilization of installed plant capacity under conditions of varying volumes of production of products of seasonal demand. 5. Volume of sales: There is a positive direct correlation between the volume of sales and the size of working capital of a firm. 6. Term of Purchase and Sales: A firm which allows liberal credit to its customers will need more working capital than that of a firm with strict credit policy. A firm which enjoys liberal credit facilities from its suppliers requires lower amount of working capital when compared to a firm which does not have such a facility. 7. Operating efficiency: The firm with high efficiency in operation can bring down the total investment in working capital to lower levels. Here effective utilization of resources helps the firm in bringing down the investment in working capital. 8. Price level changes: Inflation affects the working capital levels in a firm. To maintain the operating efficiency under an inflationary set up a firm should examine the maintenance of working capital position under constant price level. The financial capital maintenance demands a firm to maintain higher amount of working capital keeping pace with rising price levels. Under inflationary conditions same levels of inventory will require increased

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investment. The ability of a firm to revise its products prices with rising price levels will decide the additional investment to be made to maintain the working capital intact. 9. Business Cycle: During boom, sales rise as business expands. Depression is marked by a decline in sale. During boom, expansion of business can be achieved only by augmenting investment in various assets that constitute working capital of a firm. When there a decline in business on account of depression in economy, inventory glut forces a firm to maintain working capital at a level far in excess of the requirements under normal conditions. 10. Processing technology: Longer the manufacturing cycle the larger the investment in working capital when raw material passes through several stages in the production process work in process inventory will increase correspondingly. 11. Fluctuations in the supply of raw materials: Companies which use raw materials available only from one or two sources are forced to maintain buffer stock of raw materials to meet the requirements of uncertainty in lead time Such firms normally carry more inventory than it would have, had the materials been available in normal market conditions.

Self Assessment Questions 6 1. Capital intensive industries required ___ amount of working capital . 2. There is a ______between volume of sales and the size of working capital of a firm. 3. Under inflationing conditions same level of inventory will require ______investment in working capital 4. Longer the manufacturing cycle the _ the investment in working capital.

11.8 Estimation of Working Capital The best approach to estimate is based on operating cycle. Therefore, the two components of working capital are current assets and current liabilities. This approach is based on the assumption that production and sales occur on a continuous basis and all costs occur accordingly. Estimation of Current Assets. 1. Raw materials inventory: Average investment in raw material is estimated. 2. Average investment in work­in­progress inventory is estimated. 3. Average investment in finished goods inventory is estimated.

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4. Average investment in receivables (i,e both in debtors and bills receivables) is estimated based on credit policy that the firm wishes to pursue. 5. Based on the firm’s attitude towards risk, access to borrowing sources, past experience and nature of business, firms decide on the policy of maintaining the minimum cash balances.

Estimation of Current Liabilities: 1. Trade Creditors: Based on production budget, raw material consumption, credit period enjoyed from suppliers average amount of financing available to the firm is estimated. 2. Direct wages: Based on production budget, direct labour cost per unit, average time­lag in payment of wages estimation is made on total wages to be paid on an average basis. 3. Overheads: Based on production budget, overhead cost per unit and average time­lag in payment of overhead an estimation on an average basis of the amount outstanding to be paid to creditors for overhead.

Example: A Proforma cost sheet of a company provides the following data Costs per Unit Raw Material 52.00 Direct Labout 19.50 Overheads 39.00 Total Cost 110.50 Profit 19.50 Selling Price 130.00 The following additional information is available: a. Average raw material in stock: One month b. Average materials in process: Half a month c. Credit allowed by Suppliers: One month d. Credit allowed to debtors: Two months e. Time lag in payment of wages: one and a half weeks f. Time lag in payment of overheads one month g. One­fourth of sales on cash basis h. Cash balance expected to be maintained is Rs.1,20,000 You are required to prepare a statement showing the working capital required to finance a level of activity of 70,000 units of output. You may assume that production is carried on evenly through

Sikkim Manipal University 184 Financial Management Unit 11 out the year and wages and overheads occur similarly. Assume 360 days in a year (MBA adapted) Solution: Estimation of Working Capital a. Investment in inventory 1. Raw material RMC = 70000 x 52 X RMCP X 30 = 303333.33 360 360 2. Work – in process inventory COP = 70000 x 110.5 X WIPCP X 15 = 322291.67 360 360

3. Finished goods inventory COS = 70000 x 110.5 x 30 644583.33 X FGCP = 360 360 1270208.33

b. Investment in debtors Cost of Credit Sales 52500 x 110.5 X DCP 360 360 X 60 = 966875.00

c. Cash balance 120000 d. Total current Asset (A + B + C) 2357083.33 e. Current Liabilities 1. Creditors Purchase of raw materials x PDP 360 70000 x 52 x30 = 303333.33 360 2. Wages 70000 x 19.5 x 10 = 37916.67 360 3. Overheads 70000 x 39 x 30 = 227500.00 360

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f. Total Current Liabilities 568750.00 g. Net working Capital (D – F) 1788958.33

Examples 2 : The following annual figures relate to XYZ :­ Sales (at two months credit) 36 00 000 Materials consumed (Suppliers extend two months credit) 9 00 000 Wages Paid (monthly in arrears) 720 000 Manufacturing expenses outstanding at the end of the year 80 000 (Cash expenses are paid one month in arrears) Total administrative expenses paid, as above 240 000 Sales promotion expenses, Paid quarterly in advance 120 000

The company sells its products on gross profit of 25% counting depreciation as part of the cost of production. It keeps one month’s stock each of raw materials and finished goods, and a cash balance of Rs.100 000. Assume a 20 percent safety margin. Calculate the working capital requirements of the company on cash cost basis. Ignore work in process. [CA Final Adapted]

Solution Working Notes :­ Computation of manufacturing expenses Sales 36 00 000 Less: gross profit at 25% 9 00 000 Total manufacturing cost 27 00 000 Less: Materials 9 00 000 Wages 7 20 000 16 20 000

Manufacturing expenses 1080000

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Cash manufacturing expenses 960000 Depreciation : Total manufacturing expenses – Cash manufacturing expenses 10 80 000 – 960000 = Rs.120000 Total cash cost Total manufacturing cost 27 00 000 Less: Depreciation 120000 Cash manufacturing cost 2580000 Total manufacturing expenses 240000 Sales Promotion expenses 120000 Total cash cost 2940000

Statement of working capital required current assets:

Raw Materials stock Material Cost 90000 x 1 = 75000 X 1 12 12 Finished goods stock Cash manufacturing cost x 1 12 2580 000 x ½ = 215000 Debtors: Total cash cost of sales x 2 /12 = 2940000 x 2 / 12 = 490000 Sales promotion expenses 30000 = 120000 x 1/4 Cash required 100000 (A) Total Assets 910000 Current Liabilities

Sundry Creditors Material Cost 90000 x 2 = 150000 X 2 12 12

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Wages outstanding = 720000 x 1/12 = 60000 Manufacturing expenses outstanding = 80000 Total administrative expenses Outstanding 240000 / 12 = 20000 (B) Total current Liabilities 310000 Working Capital A – B 600000 Add 20% safety margin 120000 Working Capital required 720000

Self Assessment Questions 7 1. ______is used to estimate working capital requirements of a firm. 2. Operating cycle approach is based on the assumption that production and sales occur on a ______.

11.9 Summary All companies are required to maintain a minimum level of current assets at all point of time. This level is called core or permanent working. Capital of the company. Working capital management is concerned with the determination of optimum level of working capital and its effective utilization. To assets the working capital required for a form to conduct its operations smoothly, firm use operating cycle concept and compute each component of working capital.

Terminal Questions 1. Examine the Components of working capital. 2. Explain the concepts of working capital 3. What are the objectives of working capital management ? 4. Briefly explain the various elements of operating cycle.

Answer for Self Assessment Questions Self Assessment Questions 1 1. Maintaining, Competitiveness. 2. Current assets. 3. Current Liabilities 4. Adequate working capital

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Self Assessment Questions 2 1. Gross working capital 2. Plan, utilization of funds of a firm working capital management as applied. 3. Positive 4. Fixed Self Assessment Questions 3 1. Liquidity, Profitability. 2. Spontaneous finance. 3. Spontaneous finance. 4. Conservative, Large quantum. Self Assessment Questions 4 1. Operating cycle 2. Sales of goods on credit, realization of money from customers. Self Assessment Questions 5 1. Operating cycle 2. Inventory conversion period 3. Receivables conversion period 4. Cash Conversion cycle Self Assessment Questions 6 1. Higher 2. Positive direct correlation. 3. Increased 4. Larger Self Assessment Questions 7 1. Operating cycle 2. Continuous bases Answer for Terminal Questions 1. Refer to unit 11.2 2. Refer to unit 11.3 3. Refer to unit 11.4 4. Refer to unit 11.6

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Unit 12 Cash Management

Structure

12.1 Introduction 12.1.1 Meaning of Cash 12.2 Meaning and importance of cash management 12.3 Motives for holding cash balances 12.4 Objectives of Cash Management 12.5 Determining the Cash Needs– Models for Determining Optimal Cash 12.5.1 Baumol Model 12.5.2 Miller­Orr model 12.5.3 Cash Planning 12.5.4 Cash Forecasting and Budgeting 12.6 Summary Terminal Questions Answers to TQs and SAQs.

12.1 Introduction Cash is the most important current asset for a business operation. It is the energy that drives business activities and also the ultimate output expected by the owners. The firm should keep sufficient cash at all times. Excessive cash will not contribute to the firm’s profits and shortage of cash will disrupt its manufacturing operations.

12.1.1 Meaning of Cash The term ‘cash’ can be used in two senses – in a narrow sense it means the currency and other cash equivalents such as cheques, drafts and demand deposits in banks. In a broader sense, it includes near­cash assets like marketable securities and time deposits in banks. The distinguishing nature of this kind of asset is that they can be converted into cash very quickly. Cash in its own form is an idle asset. Unless employed in some form or another, it does not earn any revenue.

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Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Meaning of cash and near cash assets 2. The importance of cash management in a firm 3. The different models of determining the optimal cash balances 4. Techniques for forecasting the cash inflows and outflows.

12.2 Meaning and importance of Cash Management

Cash management is concerned with (a) management of cash flows into and out of the firm, (b) cash management within the firm and (c) management of cash balances held by the firm – deficit financing or investing surplus cash. Cash management tries to accomplish at a minimum cost the various tasks of cash collection, payment of outstandings and arranging for deficit funding or surplus investment. It is very difficult to predict cash flows accurately. Generally, there is no correlation between inflows and outflows. At some points of time, cash inflows may be lower than outflows because of the seasonal nature of product sale thus prompting the firm to resort to borrowings and sometimes outflows may be lesser than inflows resulting in surplus cash. There is always an element of uncertainty about the inflows and outflows. The firm should therefore evolve strategies to manage cash in the best possible way. These can be broadly summarized as: • Cash planning: Cash flows should be appropriately planned to avoid excessive or shortage of cash. Cash budgets can be prepared to aid this activity • Managing cash flows: The flow of cash should be properly managed. Steps to speed up cash collection and inflows should be implemented while cash outflows should be slowed down. • Optimum cash level: The firm should decide on the appropriate level of cash balance. Balance should be struck between excess cash and cash deficient stage. • Investing surplus cash: The surplus cash should be properly invested to earn profits. Many investment avenues to invest surplus cash are available in the market such as, bank short term deposits, T­Bills, inter corporate lending etc.

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The ideal cash management system will depend on a number of issues like, firm’s product, competition, collection program, delay in payments, availability of cash at low rates of interests and investment opportunities available.

12.3 Motives of Holding Cash There are four motives of holding cash. They are: Transaction motive: This refers to a firm holding cash to meet its routine expenses which are incurred in the ordinary course of business. A firm will need finances to meet a plethora of payments like wages, salaries, rent, selling expenses, taxes, interests, etc. The necessity to hold cash will not arise if there were a perfect co­ordination between the inflows and outflows. These two never coincide. At times, receipts may exceed outflows and at other times, payments outrun inflows. For such periods when payments exceed inflows the firm should maintain sufficient balances to be able to make the required payments. For transactions motive, a firm may invest its cash in marketable securities. Generally, they purchase such securities whose maturity will coincide with payment obligations.

Precautionary motive: This refers to the need to hold cash to meet some exigencies which cannot be foreseen. Such unexpected needs may arise due to sudden slow­down in collection of accounts receivable, cancellation of an order by a customer, sharp increase in prices of raw materials and skilled labour etc. The moneys held to meet such unforeseen fluctuations in cash flows are called precautionary balances. The amount of precautionary balance also depends on the firm’s ability to raise additional money at a short notice. The greater the creditworthiness of the firm in the market, the lesser is the need for such balances. Generally, such cash balances are invested in highly liquid and low risk marketable securities.

Speculative motive: This relates to holding cash to take advantage of unexpected changes in business scenario which are not normal in the usual course of firm’s dealings. It may also result in investing in profit­backed opportunities as the firm comes across. The firm may hold cash to benefit from a falling price scenario or getting a quantity discount when paid in cash or delay purchases of raw materials in anticipation of decline in prices. By and large, business firms do not hold cash for speculative purposes and even if it is done, it is done only with small amounts of cash. Speculation may sometimes also boomerang in which case the firms lose a lot.

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Compensating motive: This is yet another motive to hold cash to compensate banks for providing certain services and loans. Banks provide a variety of services like cheque collection, transfer of funds through DD, MT, etc. To avail all these purposes, the customers need to maintain a minimum balance in their account at all times. The balance so maintained cannot be utilized for any other purpose. Such balances are called compensating balances. Compensating balances can take any of the following two forms – (a) maintaining an absolute minimum, say for example, a minimum of Rs. 25000 in current account or (b) maintaining an average minimum balance of Rs. 25000 over the month. A firm is more affected by the first restriction than the second restriction.

12.4 Objectives of Cash Management: There are two major objectives for cash management in a firm (a) meeting payments schedule and (b) minimizing funds held in the form of cash balances.

Meeting payments schedule: In the normal course of functioning, a firm will have to make many payments by cash to its employees, suppliers, infrastructure bills, etc. It will also receive cash through sales of its products and collection of receivables. Both these do not happen simultaneously. A basic objective of cash management is therefore to meet the payment schedule in time. Timely payments will help the firm to maintain its creditworthiness in the market and to foster good and cordial relationships with creditors and suppliers. Creditors give a cash discount if payments are made in time and the firm can avail this discount as well. Trade credit refers to the credit extended by the supplier of goods and services in the normal course of business transactions. Generally, cash is not paid immediately for purchases but after an agreed period of time. There is deferral of payment and is a source of finance. Trade credit does not involve explicit interest charges, but there is an implicit cost involved. If the credit terms are, say, 2/10, net 30, it means the company will get a cash discount of 2% for prompt payment made within 10 days or else the entire payment is to be made within 30 days. Since the net amount is due within 30 days, not availing discount means paying an extra 2% for 20­day period.

The other advantage of meeting the payments in time is that it prevents bankruptcy that arises out of the firm’s inability to honour its commitments. At the same time, care should be taken not to keep large cash reserves as it involves high cost.

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Minimize funds committed to cash balances: Trying to achieve the second objective is very difficult. A high level of cash balances will help the firm to meet its first objective discussed above, but keeping excess reserves is also not desirable as funds in its original form is idle cash and a non­ earning asset. It is not profitable for firms to keep huge balances. A low level of cash balances may mean failure to meet the payment schedule. The aim of cash management is therefore to have an optimal level of cash by bringing about a proper synchronization of inflows and outflows and check the spells of cash deficits and cash surpluses. Seasonal industries are classic examples of mismatches between inflows and outflows. The efficiency of cash management can be augmented by controlling a few important factors described below:

Prompt billing and mailing: There is a time lag between the dispatch of goods and preparation of invoice. Reduction of this gap will bring in early remittances.

Collection of cheques and remittances of cash: It is generally found that there is a delay in the receipt of cheques and their deposits into banks. The delay can be reduced by speeding up the process of collection and depositing cash or other instruments from customers. The concept of ‘float’ helps firms to a certain extent in cash management. Float arises because of the practice of banks not crediting firm’s account in its books when a cheque is deposited by it and not debit firm’s account in its books when a cheque is issued by it until the cheque is cleared and cash is realized or paid respectively. A firm issues and receives cheques on a regular basis. It can take advantage of the concept of float. Whenever cheques are deposited with the bank, credit balance increases in the firm’s books but not in bank’s books until the cheque is cleared and money realized. This refers to ‘collection float’, that is, the amount of cheques deposited into a bank and clearance awaited. Likewise the firm may take benefit of ‘payment float’. The difference between payment float and collection float is called as ‘net float’. When net float is positive, the balance in the firm’s books is less than the bank’s books; when net float is negative; the firm’s book balance is higher than in the bank’s books.

12.5 Determining the Cash Needs – Models for Determining Optimal Cash One of the prime responsibilities of a Finance Manager is to maintain an appropriate balance between cash and marketable securities. The amount of cash balance will depend on risk­return

Sikkim Manipal University 194 Financial Management Unit 12 trade­off. A firm with less cash balances has a weak liquidity position but may be earning profits by investing its surplus cash and on the other hand it loses on the profits by holding too much cash. A balance has to be maintained between these aspects at all times. So how much is optimum cash? This section explains the models for determining the appropriate balance. Two important models are studied here – Baumol model and Miller­Orr model.

12.5.1 Baumol Model The Baumol model helps in determining the minimum cost amount of cash that a manager can obtain by converting securities into cash. It is an approach to establish a firm’s optimum cash balance under certainty. As such, firms attempt to minimize the sum of the cost of holding cash and the cost of converting marketable securities to cash. The Baumol model is based on the following assumptions: • The firm is able to forecast its cash requirements in an accurate way. • The firm’s pay­outs are uniform over a period of time. • The opportunity cost of holding cash is known and does not change with time. • The firm will incur the same transaction cost for all conversions of securities into cash.

A company will sell securities and realizes cash and this cash is used to make payments. As the cash balance comes down and reaches a point, the Finance Manager replenishes its cash balance by selling marketable securities available with it and this pattern continues. Cash balances are refilled and brought back to normal levels by the acts of sale of securities. The average cash balance is C/2. The firm buys securities as and when they have above­normal cash balances. This pattern is explained below: Error! C ce

an C/2 Average ash bal C

0 T1 T2 T3 Baumol’s Model Time

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The total cost associated with cash management has two elements—(a) cost of conversion of marketable securities into cash and (b) the opportunity cost.

The firm incurs a holding cost for keeping cash balance which is the opportunity cost. Opportunity cost is the benefit foregone on the next best alternative for the current action. Holding cost is k(C/2).

The firm also incurs a transaction cost whenever it converts its marketable securities into cash. Total number of transactions during the year will be the total funds requirement, T, divided by the cash balance, C, i.e. T/C. If per transaction cost is c, then the total transaction cost is c(T/C).

The total annual cost of the demand for cash is k(C/2) + c(T/C). Error!

Total cost

Holding cost ost C

Transaction cost

Cash balance C*

Baumol’s Cut­off Model

The optimum cash balance C* is obtained when the total cost is minimum which is expressed as C* = √2cT/k where C* is the optimum cash balance, c is the cost per transaction, T is the total cash needed during the year and k is the opportunity cost of holding cash balance. The optimum cash balance will increase with increase in the per transaction cost and total funds required and decrease with the opportunity cost.

Example: A firm’s annual cost requirement is Rs. 20000000. The opportunity cost of capital is 15% per annum. Rs. 150 is the per transaction cost for the firm when it converts is short­term securities to cash. Find

Sikkim Manipal University 196 Financial Management Unit 12 out the optimum cash balance. What is the annual cost of the demand for the optimum cash balance?

Solution C* = √2cT/k = √ [2(150)(20000000)] / 0.15 = Rs. 200000 The annual cost is 150(20000000/200000) + 0.15 (200000/2) = Rs. 30000. Example: Mysore Lamps Ltd. requires Rs. 30 lakhs to meet its quarterly cash requirements. The annual return on its marketable securities which are of the tune of Rs. 30 lakhs is 20%. The conversion of the securities into cash necessitates a fixed cost of Rs. 3000 per transaction. Compute the optimum conversion amount.

Solution C* = √2cT/k = √[2*3000*3000000] / 0.05 @ = Rs. 600000 @ is 20% / 4 as 20% is annual return and fund requirement is done on a quarterly basis.

12.5.2 Miller­Orr model Miller­Orr came out with another model due to the limitation of the Baumol model. Baumol model assumes that cash flow does not fluctuate. In the real world, rarely do we come across firms which have their cash needs as constant. Keeping other factors such as expansion, modernization, diversification constant, firms face situations wherein they need additional cash to maintain their present position because of the effect of inflationary pressures. The firms therefore cannot forecast their fund requirements accurately. The Miller­Orr model overcomes this shortcoming and considers daily cash fluctuations. The MO model assumes that cash balances randomly fluctuate between an upper bound (upper control limit) and a lower bound (lower control limit). When cash balances hit the upper limit, the firm has too much cash and it is time to buy enough marketable securities to bring back to the optimal bound. When cash balances touch zero level, the level is brought up by selling securities into cash. Return point lies between the upper and lower limits. Symbolically, this can be expressed as Z = 3√3/4*(cσ 2 /i) where Z is the optimal cash balance, c is the transaction cost, σ 2 is the standard deviation of the net cash flows and i is the interest rate. MO model also suggests the optimum upper boundary b as three times the optimal cash balance and lower limit, i.e. upper limit b=lower limit + 3Z and return point=lower limit + Z. This is shown graphically as follows:

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Error!

Upper limit ce an ash bal C

Return point

Miller­Orr Model Lower limit

Example: Time Mehta industries have a policy of maintaining Rs. 500000 minimum cash balance. The standard deviation of the company’s daily cash flows is Rs. 200000. The interest rate is 14%. The company has to spend Rs. 150 per transaction. Calculate the upper and lower limits and the return point as per MO model.

Solution Z = 3√3/4*(cσ 2 /i) 3√3/4*(150*200000 2 ) / 0.14/365 = Rs. 227226 The Upper control limit = lower limit + 3Z = 500000 + 3*227226 = Rs. 1181678 Return point = lower limit + Z = 500000 + 227226 = Rs. 727226 Average cash balance = lower limit + 4/3Z = 500000 + 4/3*227226 = Rs. 802968

12.5.3 Cash Planning Cash planning is a technique to plan and control the use of cash. It helps in developing a projected cash statement from the expected inflows and outflows of cash. Forecasts are based on the past performance and future anticipation of events. Cash planning can be done a daily, weekly or on a monthly basis. Generally, monthly forecasts are commonly prepared by firms.

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12.5.4 Cash Forecasting and Budgeting Cash budget is a device to plan for and control cash receipts and payments. It gives a summary of cash flows over a period of time. The Finance Manager can plan the future cash requirements of a firm based on the cash budgets. The first element of a cash budget is the selection of the time period which is referred to as the planning horizon. Selecting the appropriate time period is based on the factors exclusive to the firms. Some firms may prefer to prepare weekly budget while others may work out monthly estimates while some others may be preparing quarterly or yearly budgets. Firms should keep in mind that the period selected should be neither too long nor too short. Too long a period, estimates will not be accurate and too short a period requires periodic changes. Yearly budgets can be prepared by such companies whose business is very stable and they do not expect major changes affecting the company’s flow of cash.

The second element that has a bearing on cash budget preparation is the selection of factors that have a bearing on cash flows. Only items of cash nature are to be selected while non­cash items such as depreciation and amortization are excluded.

Cash budgets are prepared under three methods: 1. Receipts and Payments method 2. Income and Expenditure method 3. Balance Sheet method

We shall be discussing only the receipts and payments method of preparing cash budgets.

Example : Given below is the prepared a cash budget of M/s. Panduranga Sheet Metals Ltd. for the 6 months ending 30 th June 2007. It has an opening cash balance of Rs. 60000 on 1s t Jan 2007. Month Sales Purchases Wages Production Selling overheads overheads Jan 60000 24000 10000 6000 5000 Feb 70000 27000 11000 6300 5500 March 82000 32000 10000 6400 6200 April 85000 35000 10500 6600 6500 May 96000 38800 11000 6400 7200 June 110000 41600 12500 6500 7500

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The company has a policy of selling its goods 50% on cash basis and the rest on credit terms. Debtors are given a month’s time period to pay their dues. Purchases are to be paid off two months from the date of purchase. The company has a time lag in the payment of wages of ½ a month and the overheads are paid after a month. The company is also planning to invest in a machine which will be useful for packing purposes, the cost being Rs. 45000, payable in 3 equal installments starting bi­monthly from April. It also expects to make a loan application to a bank for Rs. 50000 and the loan will be granted in the month of July. The company has to pay advance income tax of Rs. 20000 in the month of April. Salesmen are eligible for a commission of 4% on total sales effected by them and this is payable one month after the date of sale.

Solution Jan Feb March April May June Opening cash 60000 85000 126100 153000 118850 150100 balance Cash receipts: Cash sales 30000 35000 41000 42500 48000 55000 Credit sales 30000 35000 41000 42500 48000 Total cash 90000 150000 202100 236500 209350 253100 available Cash payments Materials 24000 27000 32000 35000 Wages 5000 10500 10500 10250 10750 11750 Production 6000 6300 6400 6600 6400 overheads Selling 5000 5500 6200 6500 7200 overheads Sales 2400 2800 3280 3400 3840 commission Purchase of 15000 15000 asset Payment of 20000 advance IT Total cash 5000 23900 49100 117650 59250 79190 payments Closing cash 85000 126100 153000 118850 150100 173930 balances

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Working note: Wages calculation Jan Feb Mar Apr May Jun 10000 11000 10000 10500 11000 12500 5000 5500­feb 5000­mar 5250­apr 5500­may 6250­jun 5000­mar 5500­feb 5000­mar 5250­apr 5500­may 5000 10500 10500 10250 10750 11750

Self Assessment Questions 1 1. Management of cash balances can be done by ______and ______. 2. The four motives for holding cash are ______, ______, ______and ______. 3. The greater the creditworthiness of the firm in the market lesser is the need for ______balances. 4. ______refers to the credit extended by the supplier of goods and services in the normal course of business transactions. 5. When cheques are deposited in a bank, credit balance increases in the firm’s books but not in bank’s books until the cheque is cleared and money realized. This is called as ______. 6. According to Baumol model, the total cost associated with cash management has two elements ______and ______. 7. The MO model assumes that cash balances randomly fluctuate between a ______and a ______.

12.6 Summary All companies are required to maintain a minimum level of current assets at all points of time. Cash management is concerned with determination of relevant levels of cash balances and near cash assets and their efficient use.

The need for holding cash arises due to a variety of motives – transaction motive, speculation motive, precautionary motive and compensating motive. The objective of cash management is to make short­term forecasts of cash inflows and outflows, investing surplus cash and finding means to arrange for cash deficits. Cash budgets help Finance Manager to forecast the cash requirements.

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Terminal Questions 1. Miraj Engineering Co. has forecast its sales for the 3 months ending Dec. as follows: Oct. Rs. 500000 Nov Rs. 600000 Dec. Rs. 650000 The goods are sold on cash and credit basis 50% each. Credit sales are realized in the month following the sale. Purchases amount to 50% of the month’s sales and are paid in the following month. Wages and administrative expenses per month amount to Rs. 150000 and Rs. 80000 respectively and are paid in the following month. On 1s t Dec. the company has purchased a testing equipment worth Rs. 20000 payable on 15th Nov. On 31s t Dec. a cash deposit with a bank will mature for Rs. 150000. The opening cash balance on 1 st Nov. is Rs. 100000. What is the closing balance in Nov. and Dec.? 2. Michael Industries Ltd. requests you to help them in preparing a cash budget for the period ending Dec. 2007. Rs. in lakhs Particulars May June July Aug Sep Oct Nov Dec Jan Sales 15 20 22 3 34 25 25 15 15 Materials 7 20 22 29 15 15 8 8 Nil Rent – – 0.50 0.5 0.5 0.50 0.5 0.5 – Salaries – – 1.5 2 2.5 1.5 1 1 – Misc – – 0.15 0.2. 0.2 0.4. 0.3. 0.2 – charges Taxes – – – – – 4 – – – Purchase – – – – – – 10 – – of asset

Credit terms: Customers are allowed 1 month time. Suppliers of materials are paid after 2 months. The company pays salaries after a gap of 15 days. Rent is paid after a gap of 1 month. The company has an opening balance of Rs. 200000 on 1 st June. Prepare a cash budget and find out what is the closing cash balance on 31 st Dec.

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Answers to Self Assessment Questions Self Assessment Questions 1 1. Deficit financing or investing surplus cash 2. Transaction, speculative, precautionary and compensating 3. Precautionary 4. Trade credit 5. Collection float 6. Cost of conversion of marketable securities into cash and opportunity cost. 7. Upper bound (upper control limit) and lower bound (lower control limit).

Answer to Terminal Questions

1. Prepare a Cash Budget for November and December. Refer to the Example 12.5.4 2. Prepare a cash budget as shown in Example 12.5.4.

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Unit 13 Inventory Management

Structure

13.1 Introduction 13.2 Costs associated with inventories are 13.3 Inventory management Techniques 13.3.1 Determination of Stock Levels 13.3.2 Pricing of inventories 13.4 Summary Terminal Questions Answer to SAQs and TQs

13.1 Introduction Inventories are the most significant part of current aspects of most of the firms in India. Since they constitute an important element of total current assets held by a firm the need to manage inventories efficiently and effectively for ensuring optimal investment in inventory cannot be ignored. Any lapse on the part of management of a firm in managing inventories may cause the failure of the firm. The major objectives of inventory management are: a. Maximum satisfaction to customer. b. Minimum investment in inventory. c. Achieving low cost plant operation. These objectives conflict each other. Therefore, a scientific approach is required to arrive at an optimal solution for earning maximum profit on investment in inventories. Decisions on inventories involve many departments: a. Raw material policies are decided by purchasing and production departments; b. Production department plays an important role in work – in – process inventory, policy and c. Finished goods inventory policy is shaped by production and marketing departments. But the decisions of these departments have financial implications. Therefore, as an executive entrusted with the responsibility of managing finance of the company, the financial manager of the firm has to ensure that monitoring and controlling inventories of the firm are executed in a scientific manner for attaining the goal of wealth maximization of the firm.

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Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Explain the meaning of inventory management. 2. State the objectives of inventory management. 3. Bring out the importance of inventory management. 4. State the purpose of inventory. 5. Discuss the techniques of inventory control.

Role of inventory in working Capital: Inventories constitute an important component of a firm’s working capital. The following features of inventory highlight the significance of inventory in working capital management. 1. Characteristics of inventory as current assets. Current assets are those assets which are expected to be realized in cash or sold or consumed during the normal operating cycle of the business. Various forms of inventory in any manufacturing unit are: a. Raw materials to be converted into finished goods through the process of production. b. Work – in – process inventories are semi finished products in the process of being converted into finished good. c. Finished goods inventories are completely manufactured products that can be sold immediately. The first two are inventories concerned with production and the third is meant for smooth performance of marketing function of the firm. Nature of business influences the levels of inventory that a firm has to maintain in these three kinds. A manufacturing unit will have to maintain high levels of inventory in all the three forms. A retail firm will be maintaining very high level of finished goods inventory only. The three kinds of inventories listed above are direct inventories. There is an another form of indirect inventories. These indirect inventories are those item which are necessary for manufacturing but do not become part of the finished goods. They are lubricants, grease, oil, petrol, office material maintenance material etc. The Inventories are held for the following reasons. 1. Smooth production: to ensure smooth production as per the requirements of marketing department, inventories are procured and sold.

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2. To achieve Competitive edge: Most of the retail and industrial organizations carry inventory to ensure prompt delivery to customers. No firm likes to lose customers on account of the item being out of stock. 3. To reap the benefits of buying in large volume. Sometimes buying in large volumes may give the firm quantity discounts. This quantity discounts may be substantial that the firm will take benefit of it. 4. Hedge against uncertain lead times: Lead time is the time required to procure fresh supplies of inventory. Uncertainty due to supplier taking more than the normal lead time will affect the production schedule and the execution of the orders of customers as per the orders received from customers. To avoid all these problems arising from uncertainty in procurement of fresh supplies of inventories, the firms maintain higher levels of inventories for certain items of inventory. 2. Level of liquidity: Inventories are meant for consumption or sale. Both excess and shortage of inventory affect of the firm’s.Profitability . Though inventories are called current assets, in calculating absolute liquidity of a firm inventories are excluded because it may have slow moving or dormant items of inventory which cannot be easily disposed of. Therefore level and composition of inventory significantly influence the quantum of working capital and hence profitability of the firm. 3. Liquidity Lags: Inventories have three types of lags. a. Creation lag: Raw materials are purchased on credit and consumed to produce finished goods. There is always a lag in payment to suppliers from whom raw materials are procured. This is called spontaneous finance. The amount of spontaneous finance that a firm is capable of enjoying influences the quantum of working capital of a firm. b. Storage lag: The goods manufactured or held for sale cannot be converted into cash immediately. Before dispatching the goods to customers on sale, there is always a time lag. During this time lag goods are stored in warehouse. Many expenses of storage will be recurring in nature and cannot be avoided. The level of expenditure that a firm incurs on this account is influenced by the inventory levels of the firm. This influences the working capital management of a firm. c. Sale Lag: Firms sell their products on credit. There is some time lag between sale of finished goods and collection of dues from customers. Firms which are aggressive in capturing markets for their products maintain high levels of inventory and allow its customers liberal credit period. This will increase its investment in

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receivables. This increase in investment in receivables will have its effect on working capital of the firm.

Purpose of inventory: The purpose of holding inventory is achieving efficiency through cost reduction and increased sales volume. The following are the purpose of holding inventories. 1. Sales : Customers place orders for goods only when they need it. But when customers approach the firm with orders the firms must have adequate inventory of finished goods to execute it. This is possible only when firms maintain ready stock of finished goods in anticipation of orders from customers. If a firm suffers from complaints from customers of constantly the product being out of stock, customers may migrate to other producers. It will affect the firm’s customer’s base, customer loyalty and market share. 2. To avail quantity discounts: Suppliers give discounts for bulk purchases. Such discounts decrease the cost per unit of inventory purchased. Such cost reduction increase firm’s profits. Firms may go in for orders of large quantity to avail themselves of the benefit of quantity discounts. 3. Reducing ordering Costs and time Every time a firm places an order it incurs cost of procuring it. It also involves a lead time in procurement. In some cases the uncertainty in supply due to certain administrative problems of the supplier of the product will affect the production schedules of the organization. Therefore, firms maintain higher levels of inventory to avoid the risks of lengthening the lead time in procurement. Therefore, to save on time and costs firms may place orders for large quantities. 4. Reduce risk of production stoppages Manufacturing firms require a lot of raw materials and spares and tools for production and maintenance of machines. Non availability of any vital item can stop the production process. Production stoppage has serious consequences. Loss of customers on account of the failure to execute their orders will affect the firm’s profitability. To avoid such situations, firms maintain inventories as hedge against production stoppages. Therefore, it can be concluded that the motives for holding inventories are 1. Transaction motive: for making available inventories to facilitate smooth production and sales. 2. Precautionary motive: For guarding against the risk of unexpected changes in demand and supply.

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3. Speculative motive: To take benefit out of the changes in prices firms increase or decrease the inventory levels. 13.2 Costs associated with inventories are: 1. Material costs: These are the costs of purchasing the goods and related costs such as transportation and handling costs associated with it. 2. Ordering Cost: The expenses incurred to place orders with suppliers and replenish the inventory of raw material are called ordering costs. They include costs of the following. a. Requisitioning b. Purchase ordering or set­up c. Transportation d. Receiving, inspecting and receiving at the ware house. These costs increase in proportion to the number of orders placed. Firms maintaining large inventory levels, place a few orders and incur less ordering costs. 3. Carrying Costs: costs incurred for maintaining the inventory in ware house are called carrying costs. They include interest on capital locked up in inventory, storage, insurance, taxes, obsolescence, deterioration spoilage, salaries of ware house staff and expenses on maintenance of ware house building. The greater the inventory held the higher the carrying costs. 4. Shortage costs or stock out costs: These are the costs associated with either a delay in meeting the demand or inability to meet the demand at all due to shortage of stock. These costs include. a. Loss of profit on account sales lost caused by the stock out. b. Loss of future sales customers migrate to other dealers. c. Loss of customer goodwill and d. Extra costs associated with urgent replenishment purchases. Measurement of shortage cost attributable to the firm’s failure to meet customers demand is difficult because it is intangible in nature and it affects the operation of the firm now and in future. Self Assessment Questions 1 1. Lead time is the time required to ______. 2. Both excess and shortage of inventory affect the firm’s ______. 3. Precautionary motive of holding inventory is for guarding against the risk of ______and supply. 4. Costs incurred for maintaining the inventory in warehouse are called ______.

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13.3 Inventory management Techniques There are many techniques of management of inventory. Some of them are:

Economic Order Quantity: EOQ refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage. EOQ model answers the following key quantum of inventory management. a. What should be the quantity ordered for each replenishment of stock? b. How many orders are to be paced in a year to ensure effective inventory Management? EOQ is defined as the order quantity that minimizes the total cost associated with inventory management. It is based on the following assumptions: 1. Constant or uniform demand. The demand or usage is even throughout the period. 2. Known demand or usage: Demand or usage for a given period is known i.e deterministic. 3. Constant Unit price: Per unit price of material does not change and is constant irrespective of the order size. 4. Constant Carrying Costs The cost of carrying is a fixed percentage of the average value of inventory. 5. Constant ordering cost Cost per order is constant whatever be the size of the order. 6. Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Consequently there is no shortage of inventory. 7.

Total Cost Carrying Costs x Cost

Ordering Costs Q

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Economic order Quantity √2DK Q x = √Kc D = Annual usage or demand Q x = Economic order Quantity K = ordering cost per order kc = pc = price per unit x percent carrying cost = carrying cost of inventory per unit per annum. Example: Annual consumption of raw materials is 40,000 units. Cost per unit Rs 16 Carrying cost is 15% per annum. Cost of placing an order = Rs 480

Solution: √2 x 40000 x 480 EOQ = = 4000 units √16 x 0.15 Example: A company has gathered the following information: Annual demand 30,000 units Ordering cost per order = Rs 20 (Fixed) Carrying cost = Rs 10 per unit per annum Purchase cost per unit i.e price per unit = Rs 32 per unit Determine EOQ, total number of orders in a year and the time – gap between two orders. Solution:

√2DK √2 x 30000 x 20 Q x = = √Kc 10 = 346 units K = Rs.20

Kc = Rs.10 D = 30000 The total number of orders in a year = 30,000 346 = 87 orders

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Time gap between two orders = 365 = 4 days 87 1. ABC System: the inventory of an industrial firm generally comprises of thousands of items with diverse prices, large lead time and procurement problems. It is not possible to exercise the same degree of control over all these items. Items of high value require maximum attention while items of low value do not require same degree of control. The firm has to be selective in its approach to control its investment in various items of inventory. Such an approach is known as selective inventory control. ABC system belongs to selective inventory control. ABC analysis classifies all the inventory items in an organization into three categories. A: Items are of high value but small in number. A items require strict control. B: Items of moderate value and size which require reasonable attention of the management.. C: Items represent relatively small value items and require simple control. Since this method concentrates attention on the basis of the relative importance of various items of inventory it is also known as control by importance and exception. As the items are classified in order of their relative importance in terms of value, it is also known as proportional value Analysis. Advantages of ABC analysis: 2. It ensures closer controls on costly elements in which firm’s greater part of resources are invested. 3. By maintaining stocks at optimum level it reduces the clerical costs of inventory control. 4. Facilitates inventory control and control over usage of materials, leading to effective cost control.

Limitations: 1. A never ending problem in inventory management is adequately handling thousands of low value of c items. ABC analysis fails to answer this problem. 2. If ABC analysis is not periodically reviewed and updated, it defeats the basic purpose of ABC approach.

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13.3.1 Determination of Stock Levels Most of the industries are subject to seasonal fluctuations and sales during different months of the year are usually different. If, however, production during every month is geared to sales demand of the month, facilities have to installed to cater to for the production required to meet the maximum demand. During the slack season, a large portion of the installed facilities will remain idle with consequent uneconomic production cost. To remove this disadvantage, attempt has to be made to obtain a stabilized production programme throughout the year. During the slack season, there will be accumulation of finished products which will be gradually cleared as sales progressively increase. Depending upon various factors of production, storing and cost, a normal capacity will be determined. To meet the pressure of sales during the peak season, however, higher capacity may have to be sued for temporary periods. Similarly, during the slack season, to avoid loss due to excessive accumulation, capacity usage may have to be scaled down. Accordingly, there will be a maximum capacity and minimum capacity, only consumption of raw material will accordingly vary depending upon the capacity usage. Again, the delivery period or lead time for procuring the materials may fluctuate. Accordingly, there will be maximum and minimum delivery period and the average of these two is taken as the normal delivery period. Maximum Level: Maximum level is that level above which stock of inventory should never rise. Maximum level is fixed after taking in to account the following factors: 1. Requirement and availability of capital 2. Availability of storage space and cost of storing. 3. Keeping the quality of inventory intact 4. Price fluctuations 5. Risk of obsolescence, and 6. Restrictions, if any, imposed by the government.

Maximum Level = Ordering level – (MRC x MDP) + standard ordering quantity.

Where, MRC = minimum rate of consumption MDP= minimum lead time. Minimum Level: Minimum level is that level below which stock of inventory should not normally fall. Minimum level = OL – (NRC x NLT)

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Where, OL = ordering level NRC = Normal rate of consumption NLT = Normal Lead Time. Ordering Level: Ordering level is that level at which action for replenishment of inventory is initiated. OL = MRC X MLT Where, MRC = Maximum rate of consumption MLT = Maximum lead time.

3. Average stock level Average stock level can be computed in two ways 1. minimum level + maximum level 2 2. Minimum level + 1 /2 of re­order quantity.

Average stock level indicates the average investment in that item of inventory. It in of quite relevant from the point of view of working capital management.

Managerial significance of fixation of Inventory level : 1. It ensure the smooth productions of the finished goods by making available the raw material of right quality in right quantity at the right time. 2. It optimizes the investment in inventories. In this process, management can avoid both overstocking and shortage of each and every essential and vital item of inventory. 3. It can help the management in identifying the dormant and slow moving items of inventory. This brings about better co­ordination between materials management and production management on the one hand and between stores manager and marketing manager on the other.

Re – order Point: “When to order” is another aspect of inventory management. This is answered by re – order point. The re – order point is that inventory level at which an order should be placed to replenish the inventory.

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To arrive at the re – order point under certainty the two key required details are: 1. Lead time 2. Average usage lead time refers to the average time required to replenish the inventory after placing orders for inventory Re – order point = lead time x Average usage Under certainty, re – order point refers to that inventory level which will meet the consumption needs during the lead time.

Safety Stock: Since it is difficult to predict in advance usage and lead time accurately, provision is made for handling the uncertainty in consumption due to changes in usage rate and lead time. The firm maintains a safety stock to manage the stock – out arising out of this uncertainty. When safety stock is maintained, (When Variation is only in usage rate) Re – order point = lead time x Average usage + Safety stock Safety stock = [(maximum usage rate) – (Average usage rate)] x lead time. Or Safety stock when the variation in both lead time and usage rate are to be incorporated. Safety stock = (Maximum possible usage) – (Normal usage) Maximum possible usage = Maximum daily usage x Maximum lead time Normal usage = Average daily usage x Average lead time Example: A manufacturing company has an expected usage of 50,000 units of certain product during the next year. Re cost of processing an order is Rs 20 and the carrying cost per unit per annum is Rs 0.50. Lead time for an order is five days and the company will keep a reserve of two days usage. Calculate 1. EOQ 2. Re – order point. Assume 250 days in a year Solution:

√2DK √2 x 50000 x 20 EOQ = = √Kc 0.50 = 2000 units

Re order point Daily usage = 50000 = 200 units 250

Safety stock = 2 x 200 400 units.

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Re – order point (lead time x Average usage) + safety stock (5 x 200) + 400 = 1,400 units

13.3.2 Pricing of inventories There are different ways of pricing inventories used in production. If the items in inventory are homogenous (identical except for in significant differences) it is not necessary to use specific identification method. The convenient price is using a cost flow assumption referred to as a flow assumption. When flow assumption is used it means that the firm makes an assumption as to the sequence in which units are released from the stores to the production department. The flow assumptions selected by a company need not correspond to the actual physical movement of raw materials. When units of raw material are identical, it does not matter which units are issued from the stores to the production department. The method selected should match the costs with the revenue to ensure that the profits are uncertain in a manner that reflects the conditions actually prevalent. 1. First in, first out (FIFO): It assumes that the raw materials (goods) received first are used first. The same sequence is followed in pricing the material requisitions. 2. LIFO (last in, first out): The consignment last received is first used and if this is not sufficient for the requisitions received from production department then the use is made from the immediate previous consignment and so on. The requisitions are priced accordingly. This method is considered to be suitable under inflationary conditions. Under this method the cost of production reflects the current market trend. The closing inventory of raw material will be valued on a conservative basis under the inflationary conditions. 3. Weighted average: Material issues are priced, at the weighted average cost of materials in stock. This method considers various consignments in stock along with their unit’s prices for pricing the material issues from stores. 4. other methods are: a. Replacement price method: This method prices the issues at the value at which it can be procured from the market. b. Standard price method: under this method the materials are priced at standard price. Standard price is decided based on market conditions and efficiency parameters. The difference between the purchase price and the standard price is analyzed through variance analysis.

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Self Assessment Questions 2 1. ABC system belongs to ______. 2. ______are of high value but small in number. 3. ABC system is known as ______because the items are classified in order of their relative importance in terms of value. 4. ______is defined as the order quantity that minimizes the total cost of inventory management.

13.4 Summary Inventories form part of current assets of firm. Objectives of inventory management are. a. Maximum customer satisfaction b. Optimum investment in inventory and c. Operation of the plant at the least cost structure. Inventories could be grouped into direct inventories are raw materials, work­in­ process inventories and finished goods inventory. Indirect inventories are those items which are necessary for production process but do not become part of the finished goods. There are many reasons attributable to holding of inventory by the managements.

Terminal Questions 1. Examine the reasons for holding inventories by a firm. 2. Discuss the techniques of inventory control. 3. Discuss the relevance and factors that influence the determination of stock level. 4. Explain the various cost of inventory decision.

Answer for Self Assessment Questions Self Assessment Questions 1 1. Obtain fresh supplies of inventory 2. Profitability 3. Unexpected changes in demand, supply 4. Carrying costs

Self Assessment Questions 2 1. Selective inventory control. 2. A items 3. Proportional value analysis

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4. EOQ. Answer for Terminal Questions 1. Refer to unit 13.1 2. Refer to 13.3 3. Refer to 13.3.3 4. Refer to 13.2

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Unit 14 Receivables Management

Structure

14.1 Introduction 14.2 Costs associated with maintaining receivables 14.3 Credit policy variables 14.4 Evaluation of credit policy 14.5 Summary Terminal Questions 14.6 Answer to SAQs and TQs

14.1 Introduction: Firms sell goods on credit to increase the volume of sales. In the present era of intense competition, business firms, to improve their sales, offer to their customers relaxed conditions of payment. When goods are sold on credit, finished goods get converted into receivables. Trade credit is a marketing tool that functions as a bridge for the movement of goods from the firm’s wear house to its customers. When a firm sells goods on credit receivables are created. The receivables arising out of trade credit have three features.

1. It involves an element of risk. Therefore, before sanctioning credit, careful analysis of the risk involved needs to be done; 2. It is based on economic value. Buyer gets economic value in goods immediately on sale, while the seller will receive an equivalent value later on and 3. It has an element of futurity. The buyer makes payment in a future period.

Amounts due from customers, when goods are sold on credit, are called trade debits or receivables. Receivables form part of current assets. They constitute a significant portion of the total current assets of the buyers next to inventories. Receivables are asset – accounts representing amounts owing to the firm as a result of sale of goods/services in the ordinary course of business. Objectives: The main objective of selling goods on credit is to promote sales for increasing the profits of the firm. Customers will always prefer to buy on credit to buying

Sikkim Manipal University 218 Financial Management Unit 14 on cash basis. They always go to a supplier who gives credit. All firms therefore grant credit to their customers to increase sales, profits and to meet competition.

Learning Objectives:

After studying this unit, you should be able to understand the following. 1.Understand the meaning of receivables management. 2. What are the costs associated with maintaining receivable ? 3. Understand the credit policy variables. 4. Understand the process of evaluation of credit policy.

Meaning of Receivables Management: Receivables are a direct result of credit sales are resorted to, by a firm to push up its sales which ultimately result in pushing up the profits earned by the firm. At the same time, selling goods on credit results in blocking of funds in accounts receivables. Additional funds are, therefore, required for the operating needs of the business which involve extra costs in terms of interest. Moreover, increase in receivables also increases the chances of bad debts. Thus, creation of accounts receivables is beneficial as well as dangerous to the firm. The financial manager needs to follow a policy of using cash funds economically to the extent possible in extending receivables without adversely affecting the chances of increasing sales and making more profits. Management of accounts receivables may, therefore, be defined as, the process of making decision relating to the investment of funds in receivables which will result in maximising the overall return on the investment of the firm. Thus, the objective of receivables management is to promote sales and projects until the level where the return on investment in further finding of receivables is less then the cost of funds raised to finance that additional credit.

14.2 Costs associated with maintaining receivables: Costs of maintaining receivables are: 1) Capital costs: A firm when sells goods credit achieves higher sales. Selling goods on credit has consequences of blocking the firm’s resources in receivables as there is

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a time lag between a credit sale and cash receipt from customers. To the extent the funds are held up in receivables, the firm has to arrange for additional funds to meet its own obligation of monthly as well as daily recurring expenditure. Additional funds may have to be raised either out of profits or from outside. In both the cases, the firm incurs a cost. In the former case there is the opportunity cost of the income the firm could have earned had the same been invested in same other profitable avenue. In the latter case of obtaining funds from outside, the firm has to pay interest on the loan taken. Therefore, sanctioning credit to customers on sale of goods on credit has a capital cost. 2) Administration Cost: When a firm sells goods on credit it has to incur two types of administration cost viz a. Credit investigation and supervision costs and b. Collection Costs. Before sanctioning credit to any customer the firm has to investigate the credit rating of the customer to ensure that credit given will recovered on time. Therefore, administration costs have to be incurred in this process. Costs incurred in collecting receivables are administrative in nature. These include additional expenses on staff for administering the process of collection of receivables from customers. 3. Delinquency Costs: The firm incurs this cost when the customer fails to pay the amount to it on the expiry of credit period. These costs take the form of sending remainders and legal charges.

Bad – Debts or Default cost: When the firm is unable to recover the amount due from its customers, it results in bad debts. When a firm relaxes its credit policy, selling to customers with relatively low credit rating occurs. In this process a firm may make credit sales to its customers who do not pay at all. Therefore, the assessing the effect of a change in credit policy of a firm involves examination of a. Opportunity Cost of lost contribution b. Credit administration Cost

Sikkim Manipal University 220 Financial Management Unit 14 c. Collection Costs d. Delinquency Cost e. Bad – debt loses

Self Assessment Questions 1 1. Costs of maintaining receivables are ______, ______cost and ______. 2. A period of “Net 30” means that it allows to its customers 30 days of credit with ____ for ______. 3. Selling goods on credit has consequences of blocking the firm’s resources in receivables as there is a time lag between ______and ______. 4. When a firm sells goods on credit it has to incur two types of administration cost viz _____ and ______.

14.3 Credit policy Variables 1. Credit standards. 2. Credit period. 3. Cash discounts and 4. Collection programme. 1. Credit standards: The term credit standards refer to the criteria for extending credit to customers. The bases for setting credit standards are. a. Credit rating. b. References c. Average payment period d. Ratio analysis There is always a benefit to the company with the extension of credit to its customers but with the associated risks of delayed payments or non – payment, funds blocked in receivables etc. The firm may have light credit standards. It may sell on cash basis and extend credit only to financial strong customers. Such strict credit standards will bring down bad – debt losses and reduce the cost of credit administration. But the firm may not be able to increase its sales. The profit on lost sales may be more than the costs

Sikkim Manipal University 221 Financial Management Unit 14 saved by the firm. The firm should evaluate the trade – off between cost and benefit of any credit standards.

2. Credit period: credit period refers to the length of time allowed to its customers by a firm to make payment for the purchases made by customers of the firm. It is generally expressed in days like 15 days or 20 days. Generally, firms give cash discount if payments are made within the specified period. If a firm follows a credit period of ‘net 20’ it means that it allows to its customers 20 days of credit with no inducement for early payments. Increasing the credit period will bring in additional sales from existing customers and new sales from new customers. Reducing the credit period will lower sales, decrease investments in receivables and reduce the bad debt loss. Increasing the credit period increases sales increases investment in receivables and increases the incidence of bad debt loss. The effects of increasing the credit period on profits of the firm are similar to that of relaxing the credit standards. 3. Cash discount Firms offer cash discounts to induce their customers to make prompt payments. Cash discounts have implications on sales volume, average collection period, investment in receivables, incidence of bad debts and profits. A cash discount of 2/10 net 20 means that a cash discount of 2% is offered if the payment is made by the tenth day; other wise full payment will have to made by 20 th day. 4 Collection programme The success of a collection programme depends on the collection policy pursued by the firm. The objective of a collection policy is to achieve. Timely collection of receivables, there by releasing funds locked in receivables and minimizes the incidence of bad debts. The collection programmes consists of the following. 1. Monitoring the receivables 2. Reminding customers about due date of payment 3. On line interaction through electronic media to customers about the payments due around the due date. 4. Initiating legal action to recover the amount from overdue customers as the last resort to recover the dues from defaulted customers.

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Collection policy formulated shall not lead to bad relationship with customers

Self Assessment Question 2 1. Credit period is a ______. 2. ______refer to the criteria for extending credit to customers. 3. ______refers to the length of time allowed to its customers by a firm to make payment for purchase made by customers of the firm. 4. A cash discount of 2 / 10 net 20 means that a ______is offered if the payment is made ______

14.4 Evaluation of Credit Policy: Optimum credit policy is one which would maximize the value of the firm. Value of a firm is maximized when the incremental rate of return on an investment is equal to the incremental cost of funds used to finance the investment. Therefore, credit policy of a firm can be regarded as a trade – off between higher profits from increased sales and the incremental cost of having large investment in receivables. The credit policy to be adopted by a firm is influenced by the strategies pursued by its competitors. If competitors are granting 15 days credit and if the firm decides to extend the credit period to 30 days, the firm will be flooded with customers demand for company’s products. Credit policy variables of a firm are 1. Credit Standard

The effect of relaxing the credit standards on profit can be estimated as under: Change in profit = P Increase in sales = S Contribution = c = 1 – V Where V = Variable cost to sales

Bad – Debts on new sales = S x bn K = post tax cost of capital Increase in receivables investment = I Therefore

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Change in profit = (Additional contribution on increase in sales – Bad Debts on new sales) (1 – tax rate) – cost of incremental investment. (1 – tax rate) – cost of capital x Incremental investment in receivables. Increase in profit i.e change in profit = [Incremental contribution – Bad debts on new sales]

Example: Following details are available in respect of x ltd: Current sales = Rs 100 million The company is considering relaxation of its credit policy. Such relaxation would increase the sales by Rs 15 million on which bad debt losses would be 10%. The contribution margin ratio for the firm is 20%. Average collection period is 40 days. Post – tax cost of funds is 10%. Tax rate applicable to the firm is 30%. Assume 360 days in a year. Examine the effect of relaxing the credit policy on the profitability of the organization. (MBA) adopted. Solution: Incremental contribution = 1,50,00,000 x 0.20 = Rs 30,00,000 Bad debts on new sales = 1,50,00,000 x 0.10 = Rs 15,00,000 Cost of capital is 10% Incremental investment in receivables = Investment in sales = X Average Collection Period X Variable Cost to Sales ratio No. of days in the year

15 000 000 = X 40 X 0.8 = Rs.13,33,333 360 Cost of Incremental Investment 10 = x 13,33,333 100 Therefore change in profit is calculated as under

Incremental Contribution = 3 000 000 Less: Bad debts on new sales = 15 00 000

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Less: Income tax at 30% = 4 50 000 10 50 000 Less: Opportunity cost of Incremental investment in Receivables 13,33,333 Increase in profit 9 16 667

Since the impact of change in credit standards on profit is positive the change in credit standards may be considered.

2. Credit period The effect of changing the credit period on profits of the firm can be computed as under : Change in profit = (Incremental contribution – Bad debts on new sales) (1 – tax rate) – cost of incremental investment in receivables. Example: A company is currently allowing its customers, 30 days of credit. Its present sales are Rs 100 million. The firm’s cost of capital is 10% and the ratio of variables cost to sales is 0.80. The company is considering extending its credit period to 60 days. Such an extension will increase the sales of the firm by Rs 100 million. Bad debts on additional sales would be 8%. Tax rate is 30%. Assume 360 days in a year. (MBA) adopted. Solution: Incremental contribution = 10,000,000 x 0.2 = Rs 2,000,000 Bad debts on new sales = 10,000,000 x 0.8 = Rs 8,000,000 Existing investment in receivables = 30 1 00 000 000 x Rs.8 333 333 360 Expected investment in receivables after increasing the credit period to 60 days: Expected investment in receivables on current sales = 1 00 000 000 = X 60 = Rs.16 666 667 360

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Additional investment in receivable on new sales 60 1 00 000 000 x X 0.80 = Rs.13 33 333 360 Expected total investment in receivables on increasing the period of credit = 1 80 00 000 Incremental investment in receivables = 1 80 00 000 – 8 333 333 = Rs.9666667 Opportunity cost of Incremental investment in receivables = 0.10 x 9666667 = Rs.966667

Statement showing the effect of increasing the credit period from 30 days to 60 days as firm’s project Incremental Contribution 2 00 000 Less: Bad debts on new sales 8 00 000 12 00 000 Less: Income tax at 30 % 3 60 000 8 40 000 Less: Opportunity cost of incremental Investment in receivables 9 66 667 Change in profit (126667) negative

Since the impact of increasing the credit period on profits of the firm is negative, the proposed change in credit period is not desirable. 2. Cash Discount

For assessing the effect of cash discount the following formula can be used. Change in profit = (Incremental contribution – increase in discount cost) (1 – t) + opportunity cost of savings in receivables investment. Example Present credit terms of a company are 1/10 net 30. Its sales are Rs 100 million, average collection period is 20 days, variable cost to sales ratio is 0.8, and cost of capital is 10%. The proportion of sales on which customers currently take discount is 0.5.

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The company is considering relaxing its discount terms to 2/10, net 30 Such a relaxation is expected to increase sales by Rs 10 million, reduce Average collection period to 14 days, increase discount sales to 0.8. Tax rate is 0.30. Examine the effect of relaxing the discount policy on profits of the organisation Assume 360 days in a year (MBA adopted).

Solution Incremental Contribution = 10 000 000 x 0.2 = Rs.2 000 000 Increase in discount Discount cost before liberalising discount terms = 0.5 x 1 00 000 000 x 0.01 = Rs.5 00 000

Discount cost after liberalisation of discount terms = 0.8 x 110 000 000 x 0.002 = Rs.1760 000 Increase in discount cost = Rs.1260 000 Computation of savings in receivables investment 1 00 000 000 10 000 000 = 20 – 14 – 0.8 x X 14 360 360

1 00 000 000 = ­ 311 111 60 = 1666667 – 311111 = Rs.1355556 Opportunity cost (savings of reduction in investment in receivables = 0.1 x 135556 = Rs.135556 Statement showing the effect of change in discount policy as profit of the company Increase in Contribution 2 000 000 Less: increase in discount cost 12 60 000 7 40 000 Less: Tax at 30 % 2 22 000 5 18 000 Add: Benefit of savings due to Reduction in investment in

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Receivables profit 135556 653556 It is desirable to change the discount policy as it will improve the profitability of the firm.

4.Collection policy

For computation of the effect of new collection programme can be evaluated with the help of following formula .

Change in profit = (Incremental contribution – Increase in bad debts) (1 – tax rate) – cost of increase in investment in receivables. Example A company is considering relaxing its collection effort. Its present sales are Rs 50 million, ACP = 20 days, variable cost to sales ratio = 0.8, cost of capital 10%. Its bad debt ratio is 0.05. The relaxation in collection programme is expected to increase sales by Rs 5 million, increase ACP to 40 days and bad debts ratio to 0.56. Tax rate is 30%. Examine the effect of change in collection programme on firm’s profits. Assume 360 days in a year. (MBA adopted and also ACS) Solution Increase in Contribution = 5 000 000 x 0.2 = Rs.1 000 000 Increase in bad debts Bad debts on existing sales = 50 000 000 x 0.05 = 250 00 00 Bad debts on total sales after increase in sales = 55 000 000 x 0.56 = 33 00 000 Increase in bad debts = Rs.8 00 000 Incremental investment in receivables 50 000 000 (40 – 20) 5 000 000 x 40 x 0.8 = + 360 360 = 2777778 + 444444 = Rs.3222222 Opportunity cost of incremental investment in receivables = 0.1 x 3222222 = Rs.322222

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Statement showing the impact of new collection programme on profits of the organisation Incremental Contribution 1 000 000 Less: Increase in bad debts 8 00 000 2 00 000 Less: Income tax at 30% 60 000 1,40,000 Less: Opportunity cost of increase In investment in receivables 3,22,222 Profit (182222) loss

Since the change will lead to decrease in profit (i,e a loss of Rs.182222) it is not desirable to relax the collection programme of the firm

Self Assessment Questions 3 1. Credit policy of a firm can be regarded as a trade­off between ______and ______. 2. Optimum credit policy maximises the ______. 3. Value of a firm is maximised when the incremental rate of return on investment in receivable is ______to the incremental cost of funds used to finance that investment. 4. Credit policy to be adopted by a firm is influenced by strategies pursued by its competitions.

14.5 Summary Receivables are a direct result of credit sales. Management of accounts receivables is the process of making decision relating to investment of funds in receivable which will result in maximising the overall return on the investment of the firm. Cost of maintaining receivables are capital costs, administration costs and delinquency costs. Credit policy variables are credit standards, credit period, cash discounts and collection programme. Optimum credit policy is that which Maximises the value of the firm.

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Terminal Questions 1. Examine the meaning of receivable management. 2. Examine the costs of maintaining receivables. 3. Examine the variables of credit policy. 4. What are the features of optimum credit policy

Answer for self Assessment Questions Self Assessment Questions 1 1. Capital costs, administration, Delinquency costs. 2. No inducement for early payments 3. Credit sale, Cash receipt from customers. 4. Credit investigation and supervision cost, collection costs Self Assessment Questions 2 1. Credit policy variable. 2. Credit standards 3. Credit period 4. Cash discount of 2% , on the tenth day. Self Assessment Questions 3 1. Higher profits from increased sales, incremental cost of having large investment in receivable. 2. Value of the firm. 3. Equal

Answer for Terminal Questions 1. Refer to unit 14.1 2. Refer to unit 14.2 3. Refer to unit 14.3 4. Refer to unit 14.4

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Unit 15 Dividend Decision

Structure

15.1 Introduction 15.2 Traditional Approach 15.3 Dividend Relevance Model 15.3.1 Walter Model 15.3.2 Gordon’s Dividend Capitalization Model 15.4 Dividend Irrelevance Theory: Miller and Modigliani Model 15.5 Stability of Dividends 15.6 Forms of Dividends 15.7 Stock Split 15.8 Summary Terminal Questions Answers to SAQs and TQs

15.1 Introduction Dividends are that portion of a firm’s net earnings paid to the shareholders. Preference shareholders are entitled to a fixed rate of dividend irrespective of the firm’s earnings. Equity holders’ dividends fluctuate year after year. It depends on what portion of earnings is to be retained by the firm and what portion is to be paid off. As dividends are distributed out of net profits, the firm’s decisions on retained earnings have a bearing on the amount to be distributed. Retained earnings constitute an important source of financing investment requirements of a firm. However, such opportunities should have enough growth potential and sufficient profitability. There is an inverse relationship between these two – larger retentions, lesser dividends and vice versa. Thus two constituents of net profits are always competitive and conflicting.

Dividend policy has a direct influence on the two components of shareholders’ return – dividends and capital gains. A low payout and high retention may have the effect of accelerating earnings growth. Investors of growth companies realize their money in the form of capital gains. Dividend yield will be low for such companies. The influence of dividend policy on future capital gains is to happen in

Sikkim Manipal University 231 Financial Management Unit 15 distant future and therefore by all means uncertain. Share prices are a reflection of many factors including dividends. Some investors prefer current dividends to future gains as prophesied by an English saying – A bird in hand is worth two in the bush. Given all these constraints, it is a major decision of financial management.

Dividend policy of a firm is a residual decision. In true sense, it means that a firm with sufficient investment opportunities will retain the entire earnings to fund its growth avenues. Conversely, if no such avenues are forthcoming, the firm will pay­out its entire earnings. So there exists a relationship between return on investments r and the cost of capital k. So long as r exceeds k, a firm shall have good investment opportunities. That is, if the firm can earn a return r higher than its cost of capital k, it will retain its entire earnings and if this source is not sufficient, it will go in for additional sources in the form of additional financing like equity issue, debenture issue or term loans. Thus, the dividend decision is a trade­off between retained earnings and financing decisions.

Different theories have been given by various people on dividend policy. We have the traditional theory and new sets of theories based on the relationship between dividend policy and firm value. The modern theories can be grouped as – (a) theories that consider dividend decision as an active variable in determining the value of the firm and (b) theories that do not consider dividend decision as an active variable in determining the value of the firm.

Learning Objectives:

After studying this unit, you should be able to understand the following. 1. Explain the importance of dividends to investors. 2. Discuss the effect of declaring dividends on share prices. 3. Mention the advantages of a stable dividend policy. 4. List out the various forms of dividend. 5. Give reasons for stock split.

15.2 Traditional Approach This approach is given by B. Graham and D. L. Dodd. They clearly emphasize the relationship between the dividends and the stock market. According to them, the stock value responds positively

Sikkim Manipal University 232 Financial Management Unit 15 to high dividends and negatively to low dividends, that is, the share values of those companies rises considerably which pay high dividends and the prices fall in the event of low dividends paid. Symbolically, P = [m (D+E/3)] Where P is the market price, M is the multiplier, D is dividend per share, E is Earnings per share.

Drawbacks of the Traditional Approach: As per this approach, there is a direct relationship between P/E ratios and dividend pay­out ratio. High dividend pay­out ratio will increase the P/E ratio and low dividend pay­out ratio will decrease the P/E ratio. This may not always be true. A company’s share prices may rise in spite of low dividends due to other factors.

15.3 Dividend Relevance Model Under this section we examine two theories – Walter Model and Gordon Model.

15.3.1 Walter Model Prof. James E. Walter considers dividend pay­outs are relevant and have a bearing on the share prices of the firm. He further states, investment policies of a firm cannot be separated from its dividend policy and both are inter­linked. The choice of an appropriate dividend policy affects the value of the firm. His model clearly establishes a relationship between the firm’s rate of return r, its cost of capital k, to give a dividend policy that maximizes shareholders’ wealth. The firm would have the optimum dividend policy that will enhance the value of the firm. This can be studied with the relationship between r and k. If r>k, the firm’s earnings can be retained as the firm has better and profitable investment opportunities and the firm can earn more than what the shareholders could by re­investing, if earnings are distributed. Firms which have r>k are called ‘growth firms’ and such firms should have a zero pay­out ratio.

If return on investment r is less than cost of capital k, the firm should have a 100% pay­out ratio as the investors have better investment opportunities than the firm. Such a policy will maximize the firm value.

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If a firm has a ROI r equal to its cost of capital k, the firm’s dividend policy will have no impact on the firm’s value. The dividend pay­outs can range between zero and 100% and the firm value will remain constant in all cases. Such firms are called ‘normal firms’.

Walter’s Model is based on certain assumptions: • Financing: All financing is done through retained earnings.Retained earnings is the only source of finance available and the firm does not use any external source of funds like debt or new equity. • Constant rate of return and cost of capital: The firm’s r and k remain constant and it follows that any additional investment made by the firm will not change the risk and return profile. • 100% pay­out or retention: All earnings are either completely distributed or reinvested entirely immediately. • Constant EPS and DPS: The earnings and dividends do not change and are assumed to be constant forever. • Life: The firm has a perpetual life. Walter’s formula to determine the market price is as follows: D [r ( E − D ) / Ke ] P = + Ke Ke Where P is the market price per share, D is the dividend per share, Ke is the cost of capital, g is the growth rate of earnings, E is Earnings per share, r is IRR. Example: The following information relates to Alpha Ltd. Show the effect of the dividend policy on the market price of its shares using the Walter’s Model Equity capitalization rate Ke 11% Earnings per share Rs. 10 ROI (r) may be assumed as follows: 15%, 11% and 8% Show the effect of the dividend policies on the share value of the firm for three different levels of r, taking the DP ratios as zero, 25%, 50%, 75% and 100%

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Solution Ke 11%, EPS 10, r 15%, DPS=0 D [r / Ke ( E − D )] P = + Ke Ke Case I r>k (r=15%, K=11%)

0 + [0 .1 5 / 0 .1 1 ( 10 − 0 )] a. DP = 0 = 13.64/0.11 = Rs. 123.97 0 .1 1 2 .5 + [0 .1 5 / 0 .1 1 ( 10 − 2 .5 )] b. DP = 25% = 12.73/0.11 = Rs. 115.73 0 .1 1 5 + [0 .1 5 / 0 .1 1 ( 10 − 5 )] c. DP = 50% = 11.82/0.11 = Rs. 107.44 0 .1 1 7 .5 + [0 .1 5 / 0 .1 1 ( 10 − 7 .5 )] d. DP = 75% = 10.91/0.11 = Rs. 99.17 0 .1 1 10 + [0 .1 5 / 0 .1 1 ( 10 − 10 )] e. DP = 100% = 10/0.11 = Rs. 90.91 0 .1 1 Case II r = k (r = 11%, K = 11%) 0 + [0 .1 1 / 0 .1 1 ( 10 − 0 )] a. DP = 0 = 10/0.11 = Rs. 90.91 0 .1 1 2 .5 + [0 .1 1 / 0 .1 1 ( 10 − 2 .5 )] b. DP = 25% = 10/0.11 = Rs. 90.91 0 .1 1 5 + [0 .1 1 / 0 .1 1 ( 10 − 5 )] c. DP = 50% = 10/0.11 = Rs. 90.91 0 .1 1 7 .5 + [ 0 .1 1 / 0 .1 1 ( 10 − 7 .5 )] d. DP = 75% = 10/0.11 = Rs. 90.91 0 .1 1 10 + [0 .1 1 / 0 .1 1 ( 10 − 10 )] e. DP = 100% = 10/0.11 = Rs. 90.91 0 .1 1

Case III r

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5 + [0 .1 1 / 0 .0 8 ( 10 − 5 )] h. DP = 50% = 11.88/0.08 = Rs. 107.95 0 .0 8 7 .5 + [0 .1 1 / 0 .0 8 ( 10 − 7 .5 )] i. DP = 75% = 10.94/0.08 = Rs. 99.43 0 .0 8

10 + [0 .1 1 / 0 .0 8 ( 10 − 10 )] j. DP= 100% = 10/0.08 = Rs. 90.91 0 .0 8 Interpretation: The above workings can be summarized as follows: 1. When r>k, that is, in growth firms, the value of shares is inversely related to DP ratio, as the DP increases, market value of shares decline. Market value of share is highest when DP is zero and least when DP is 100%. 2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected whether the firm retains the profits or distributes them. 3. In the third situation, when r

Limitations Walter has assumed that investments are exclusively financed by retained earnings and no external financing is used. This model is applicable only to all­equity firms. Secondly r is assumed to be constant which again is not a realistic assumption. Finally, Ke is also assumed to be constant and this ignores the business risk of the firm which has a direct impact on the firm value.

15.3.2 Gordon’s Dividend Capitalization Model Gordon also contends that dividends are relevant to the share prices of a firm. Myron Gordon uses the Dividend Capitalization Model to study the effect of the firm’s dividend policy on the stock price.

Assumptions • All equity firm: The firm is an all equity firm with no debt. • No external financing is used and only retained earnings are used to finance any expansion schemes. • Constant return r • Constant cost of capital Ke • The life of the firm is indefinite. • Constant retention ratio: The retention ratio g=br is constant forever.

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• Cost of capital greater than br, that is Ke>br

Gordon’s model assumes investors are rational and risk­averse. They prefer certain returns to uncertain returns and therefore give a premium to the constant returns and discount uncertain returns. The shareholders therefore prefer current dividends to avoid risk. In other words, they discount future dividends. Retained earnings are evaluated by the shareholders as risky and therefore the market price of the shares would be adversely affected. Gordon explains his theory with preference for current income. Investors prefer to pay higher price for stocks which fetch them current dividend income. Gordon’s model can be symbolically expressed as: E ( 1 − b ) P = Ke − br Where P is the price of the share, E is Earnings Per Share, b is Retention raio, (1 – b) is dividend payout ratio, Ke is cost of equity capital, br is growth rate in the rate of return on investment.

Example: Given Ke as 11%, E is Rs. 10, calculate the stock value of Mahindra Tech. for (a) r=12%, (b) r=11% and (c) r=10% for various levels of DP ratios given under: DP ratio (1 – b) Retention ratio A 10% 90% B 20% 80% C 30% 70% D 40% 60% E 50% 50%

Solution Case I r>k ( r=12%, K=11%) P = E(1—b) Ke—br

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a. DP 10%, b 90% 10(1—0.9) equals 1/.002 = Rs. 500 0.11­(0.9*0.12) b. DP 20%, b 80% 10(1—0.8) equals 2/.014 = Rs. 142.86 0.11­(0.8*0.12) c. DP 30%, b 70% 10(1—0.7) equals 3/.026 = Rs. 115.38 0.11­(0.7*0.12) d. DP 40%, b 60% 10(1—0.6) equals 4/.038 = Rs. 105.26 0.11­(0.6*0.12) e. DP 50%, b 50% 10(1—0.5) equals 5/.05 = Rs. 100 0.11­(0.5*0.12)

Case II r=k ( r=11%, K=11%) P = E(1—b) Ke—br a. DP 10%, b 90% 10(1—0.9) equals 1/.011 = Rs. 90.91 0.11­(0.9*0.11) b. DP 20%, b 80% 10(1—0.8) equals 2/.022 = Rs. 90.91 0.11­(0.8*0.11) c. DP 30%, b 70% 10(1—0.7) equals 3/.033 = Rs. 90.91 0.11­(0.7*0.11) d. DP 40%, b 60% 10(1—0.6) equals 4/.044 = Rs. 90.91 0.11­(0.6*0.11)

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e. DP 50%, b 50% 10(1—0.5) equals 5/.55 = Rs. 90.91 0.11­(0.5*0.11)

Case III r

Interpretation: Gordon is of the opinion that dividend decision does have a bearing on the market price of the share. 1. When r>k, the firm’s value decreases with an increase in pay­out ratio. Market value of share is highest when DP is least and retention highest. 2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected whether the firm retains the profits or distributes them. 3. When r

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15.4 Miller and Modigliani Model The MM hypothesis seeks to explain that a firm’s dividend policy is irrelevant and has no effect on the share prices of the firm. This model advocates that it is the investment policy through which the firm can increase its share value and hence this should be given more importance.

Assumptions • Existence of perfect capital markets: All investors are rational and have access to all information free of cost. There are no floatation or transaction costs, securities are infinitely divisible and no single investor is large enough to influence the share value. • No taxes: There are no taxes, implying there is no difference between capital gains and dividends. • Constant investment policy: The investment policy of the company does not change. The implication is that there is no change in the business risk position and the rate of return. • No Risk – Certainty about future investments, dividends and profits of the firm. This assumption was, however, dropped at a later stage.

Based on the above assumptions, Miller and Modigliani have explained the irrelevance of dividend as the crux of the arbitrage argument. The arbitrage process refers to setting off or balancing two transactions which are entered into simultaneously. The two transactions are paying out dividends and raising external funds to finance additional investment programs. If the firm pays out dividend, it will have to raise capital by selling new shares for financing activities. The arbitrage process will neutralize the increase in share value (due to dividends) with the issue of new shares. This makes the investor indifferent to dividend earnings and capital gains as the share value is more dependent on the future earnings of the firm than on its current dividend policy. Symbolically, the model is given as: Step I: The market price of a share in the beginning is equal to the PV of dividends paid and market price at the end of the period. P0 = 1 * (D1 + P1) (1+Ke) Where P0 is the current market price, P1 is market price at the end of period 1, D1 is dividends to be paid at the end of period 1, Ke is the cost of equity capital.

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Step II: Assuming there is no external financing, the value of the firm is: nP0 = = 1 * (nD1 + nP1) (1+Ke) Where n is number of shares outstanding. Step III: If the firm’s internal sources of financing its investment opportunities fall short of funds required, new shares are issued at the end of year 1 at price P1. The capitalized value of the dividends to be received during the period plus the value of the number of shares outstanding is less than the value of new shares. nP0 = = 1 * (nD1 + (n + n1)P1 – n1p1) (1+Ke) Firms will have to raise additional capital to fund their investment requirements after utilizing their retained earnings, that is, n1P1 = I—(E—nD1) which can be written as n1P1 = I—E + nD1 Where I is total investment required, nD1 is total dividends paid, E is earnings during the period, (E—nD1) is retained earnings. Step IV: The value of share is thus: nP0 = = 1 * (nD1 + (n + n1)P1 –I + E—nD1) (1+Ke) Example: A company has a capitalization rate of 10%. It currently has outstanding shares worth 25000 shares selling currently at Rs. 100 each. The firm expects to have a net income of Rs. 400000 for the current financial year and it is contemplating to pay a dividend of Rs. 4 per share. The company also requires Rs. 600000 to fund its investment requirement. Show that under MM model, the dividend payment does not affect the value of the firm.

Solution Case I: When dividends are paid: Step I: P0 = 1 * (D1 + P1) (1+Ke)

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100 = 1/(1+0.1) * (4 + P1) P1 = Rs. 106 Step II: n1P1 = I—(E—nD1), nD1 is 25000*4 n1P1 = 600000—(400000—100000)=Rs. 300000 Step III: Number of additional shares to be issued 300000/106 = 2831 shares Step IV: The firm value nP0 = = (n + n1)P1 –I + E (1+Ke) (25000 + 2831)*106—600000 + 400000 equals Rs. 2500000 (1+0.1)

Case II: When dividends are not paid: Step I: P0 = 1 * (D1 + P1) (1+Ke) 100 = 1/(1+0.1) * (0 + P1) P1 = Rs. 110 Step II: n1P1 = I—(E—nD1), nD1 is 25000*4 n1P1 = 600000—(400000—0)=Rs. 200000 Step III: Number of additional shares to be issued 200000/110 = 1819 shares Step IV: The firm value nP0 = = (n + n1)P1 –I + E (1+Ke) (25000 + 1819)*110—600000 + 400000 equals Rs. 2500000 (1+0.1) Thus, the value of the firm remains the same in both the cases whether or not dividends are declared.

Critical Analysis of MM Hypothesis: Floatation costs: Miller and Modigliani have assumed the absence of floatation costs. Floatation costs refer to the cost involved in raising capital from the market, that is, the costs incurred towards underwriting commission, brokerage and other costs. These costs ordinarily account to around 10%­

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15% of the total issue and they cannot be ignored given the enormity of these costs. The presence of these costs affects the balancing nature of retained earnings and external financing. External financing is definitely costlier than retained earnings. For instance, if a share is issued worth Rs. 100 and floatation costs are 12%, the net proceeds are only Rs. 88.

Transaction costs: This is another assumption made by MM that there are no transaction costs like brokerage involved in capital market. These are the costs associated with sale of securities by investors. This theory implies that if the company does not pay dividends, the investors desirous of current income sell part of their holdings without any cost incurred. This is very unrealistic as the sale of securities involves cost, investors wishing to get current income should sell higher number of shares to get the income they are to receive.

Under­pricing of shares: If the company has to raise funds from the market, it should sell shares at a price lesser than the prevailing market price to attract new shareholders. This follows that at lower prices, the firm should sell more shares to replace the dividend amount.

Market conditions: If the market conditions are bad and the firm has some lucrative opportunities, it is not worth­approaching new investors at this juncture, given the presence of floatation costs. In such cases, the firms should depend on retained earnings and low pay­out ratio to fuel such opportunities.

15.5 Stability of Dividends Stability of dividends is the consistency in the stream of dividend payments. It is the payment of certain amount of minimum dividend to the shareholders. The steadiness is a sign of good health of the firm and may take any of the following forms – (a) constant dividend per share, (b) constant DP ratio and (c) constant dividend per share plus extra dividend.

Constant dividend per share: As per this form of dividend policy, a firm pays a fixed amount of dividend per share year after year. For example, a firm may have a policy of paying 25% dividend per share on its paid­up capital of Rs. 10 per share. It implies that Rs. 2.50 is paid out every year irrespective of its earnings. Generally, a firm following such a policy will continue payments even if it incurs losses. In such years when there is a loss, the amount accumulated in the dividend equalization reserve is utilized. As and when the firm starts earning a higher amount of revenue it will consider payment of higher dividends and in future it is expected to maintain the higher level.

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Constant DP ratio: With this type of DP policy, the firm pays a constant percentage of net earnings to the shareholders. For example, if the firm fixes its DP ratio as 25% of its earnings, it implies that shareholders get 25% of earnings as dividend year after year. In such years where profits are high, they get higher amount.

Constant dividend per share plus extra dividend: Under this policy, a firm usually pays a fixed dividend ordinarily and in years of good profits, additional or extra dividend is paid over and above the regular dividend. The stability of dividends is desirable because of the following advantages: • Build confidence amongst investors: A stable dividend policy helps to build confidence and remove uncertainty in the minds of investors. A constant dividend policy will not have any fluctuations suggesting to the investors that the firm’s future is bright. In contrast, shareholders of a firm having an unstable DP will not be certain about their future in such a firm. • Investors’ desire for current income: A firm has different categories of investors – old and retired persons, pensioners, youngsters, salaried class, housewives, etc. Of these, people like retired persons prefer current income. Their living expenses are fairly stable from one period to another. Sharp changes in current income, that is, dividends, may necessitate sale of shares. Stable dividend policy avoids sale of securities and inconvenience to investors. • Information about firm’s profitability: Investors use dividend policy as a measure of evaluating the firm’s profitability. Dividend decision is a sign of firm’s prosperity and hence firm should have a stable DP. • Institutional investors’ requirements: Institutional investors like LIC, GIC and MF prefer to invest in companies which have a record of stable DP. A company having erratic DP is not preferred by these institutions. Thus to attract these organizations having large quantities of investible funds, firms follow a stable DP. • Raise additional finance: Shares of a company with stable and regular dividend payments appear as quality investment rather than a speculation. Investors of such companies are known for their loyalty and whenever the firm comes with new issues, they are more responsive and receptive. Thus raising additional funds becomes easy. • Stability in market price of shares: The market price of shares varies with the stability in dividend rates. Such shares will not have wide fluctuations in the market prices which is good for investors.

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Self Assessment Questions I 1. ______constitute an important source of financing investment requirements of a firm. 2. Dividend policy has a direct influence on the two components of shareholders’ return______and ______. 3. ______considers dividend pay­outs are relevant and have a bearing on the share prices of the firm. 4. If a firm has a ROI r equal to its cost of capital k, it is called a ______5. ______model explains that consumers prefer certain returns to uncertain returns and therefore give a premium to the constant returns and discount uncertain returns. 6. The ______process refers to setting off or balancing two transactions which are entered into simultaneously. 7. ______costs refer to the cost involved in raising capital from the market. 8. ______are the costs associated with sale of securities by investors.

15.6 Forms of Dividends Dividends are that potion of earnings available to shareholders. Generally, dividends are distributed in cash, but sometimes they may also declare dividends in other forms which are discussed below: • Cash dividends: Most companies pay dividends in cash. The investors also, especially the old and retired investors depend on this form of payment for want of current income. • Scrip dividend: In this form of dividends, equity shareholders are issued transferable promissory notes with shorter maturity periods which may or may not have interest bearing. This form is adopted if the firm has earned profits and it will take some time to convert its assets into cash (having more of current sales than cash sales). Payment of dividend in this form is done only if the firm is suffering from weak liquidity position. • Bond dividend: Scrip and bond dividend are the same except that they differ in terms of maturity. Bond dividends carry longer maturity period and bear interest, whereas scrip dividends carry shorter maturity and may or may not carry interest. • Stock dividend (Bonus shares): Stock dividend, as known is USA or bonus shares in India, is the distribution of additional shares to the shareholders at no additional cost. This has the effect of increasing the number of outstanding shares of the firm. The reserves and surplus (retained earnings) are capitalized to give effect to bonus issue. This decision has the effect of

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recapitalization, that is, transfer from reserves to share capital not changing the total net worth. The investors are allotted shares in proportion to their present shareholding. Declaration of bonus shares has a favourable psychological effect on investors. They associate it with prosperity.

15.7 Stock Split A stock split is a method to increase the number of outstanding shares by proportionately reducing the face value of a share. A stock split affects only the par value and does not have any effect on the total amount outstanding in share capital. The reasons for splitting shares are: • To make shares attractive: The prime reason for effecting a stock split is to reduce the market price of a share to make it more attractive to investors. Shares of some companies enter into higher trading zone making it out of reach to small investors. Splitting the shares will place them in more popular trading range thus providing marketability and motivating small investors to buy them. • Indication of higher future profits: Share split is generally considered a method of management communication to investors that the company is expecting high profits in future. • Higher dividend to shareholders: When shares are split, the company does not resort to reducing the cash dividends. If the company follows a system of stable dividend per share, the investors would surely get higher dividends with stock split.

15.8 Summary Dividends are the earnings of the company distributed to shareholders. Payment of dividend is not mandatory, but most companies see to it that dividends are paid on a regular basis to maintain the image of the company. As payment of dividend is not compulsory, the question which arises in the minds of policy makers is­ “Should dividends be paid, if yes, what should be the quantum of payment?” Various theories have come out with various suggestions on the payment of dividend. B. Graham and D. L. Dodd are of the view that there is a close relationship between the dividends and the stock market. The stock value responds positively to high dividends and vice versa.

Prof. James E. Walter considers dividend pay­outs are necessary but if the firm’s ROI is high, earnings can be retained as the firm has better and profitable investment opportunities.

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Gordon also contends that dividends are significant to determine the share prices of a firm. Shareholders prefer certain returns (current) to uncertain returns (future) and therefore give a premium to the constant returns and discount uncertain returns.

Miller and Modigliani explain that a firm’s dividend policy is irrelevant and has no effect on the share prices of the firm. They are of the view that it is the investment policy through which the firm can increase its share value and hence this should be given more importance.

Dividends can be paid out in various forms such as cash dividend, scrip dividend, bond dividend and bonus shares.

Terminal Questions 1. Write a short note on the different types of dividend. 2. What is stock split? What are its advantages? 3. The following information is available in respect of a company. Equity capitalization 15% EPS Rs. 25 Dividend pay­out ratio25% ROI 12% What is the price of the share as per Walter Model?

4. Considering the following information, what is the price of the share as per Gordon’s Model? Net sales Rs. 120 lakhs Net profit margin 12.5% Outstanding preference shares Rs. 50 lakhs @ 12% dividend No. of equity shares 250000 Cost of equity shares 12% Retention ratio 40% ROI 16% 5. If the EPS is Rs.5, dividend pay­out ratio is 50%, cost of equity is 20%, growth rate in the ROI is 15%, what is the value of the stock as per Gordon’s Dividend Equalization Model? 6. Nile Ltd. makes the following information available. What is the value of the stock as per Gordon Model?

Sikkim Manipal University 247 Financial Management Unit 15

Ke 14%, EPS Rs. 20, D/P ratio 35% Retention ratio 65%, ROI 16% 7. What is the stock price as per Gordon Model if DP ratio is 60% in the above case?

Answers to Self Assessment Questions Self Assessment Questions 1 1. Retained earnings 2. Dividends and capital gains 3. Prof. James E. Walter 4. Normal firm 5. Gordon 6. Arbitrage 7. Floatation costs 8. Transaction costs

Answers to Terminal Questions: 1. Refer to10.6 2. Refer to10.7 3. Hint: Apply the formula­­Walter’s formula to determine the market price P = D + [r(E—D)/Ke] Ke Ke 4, 5, 6, 7 : Hint: Apply the Gordon formula of P = E(1—b) Ke—br

Sikkim Manipal University 248