working capital mgt 19-09-2009

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Slide 1: 

WORKING CAPITAL MANAGEMENT (IMT-07)

Financial Management – Introduction : 

Financial Management – Introduction It is management of flow of funds in a firm and it deals with financial decision making of the firm. It encompasses procurement of funds in the most economic and prudent manner and employment of these funds in most optimum way to maximize the returns for the owners.

Finance – Area of Study : 

Finance – Area of Study Types of financial actions 1) Financial management of trading or manufacturing firms 2)Financial Management of financial institutions 3) Financial activities relating to investment activities.

Functions/Scope of Finance Manager : 

Functions/Scope of Finance Manager Overall financial planning and control Raising funds from different sources Selection of fixed assets Management of Working Capital Any other individual financial event

Different scenarios faced by Financial Manager : 

Different scenarios faced by Financial Manager What should be the size of the firm and how fast should it grow? What are various types of assets to be acquired? What should be the pattern of raising funds from various sources?

Decisions : 

Decisions Investment Decision Financing Decision Dividend Decision

Working Capital Management : 

Working Capital Management Working capital management is a significant in Financial Management due to the fact that it plays a pivotal in keeping the wheels of a business enterprise running. Working capital is defined as the excess of current assets over current liabilities.

Slide 8: 

Current assets are those assets which will be converted into cash within the current accounting period or within the next year as a result of the ordinary operations of the business. They are cash or near cash resources. These include: Cash and bank balances Receivables

Slide 9: 

inventory Raw materials, stores and spares Work in progress Finished goods Prepaid expenses Short-term advances Temporary Investments etc.

Slide 10: 

Current liabilities are the debts if the firms that have to be paid during the current accounting period or within a year. These include: Creditors for goods purchased Outstanding expenses i.e., expenses due but not paid Short term borrowing Advances received against sales.

Slide 11: 

Taxes and dividends payable Other liabilities maturing within a year. Working capital is also known as circulating capital, fluctuating capital and revolving capital. The magnitude and composition keep on changing continuously in the course of business.

WORKING CAPITAL SHOULD BE ADEQUATE NEITHER EXCESSIVE NOR INADEQUATE : 

WORKING CAPITAL SHOULD BE ADEQUATE NEITHER EXCESSIVE NOR INADEQUATE ADVANTAGES OF ADEQUATE WOKING CAPITAL SOLVENCY OF THE BUSINESS GOODWILL REGULAR PAYMENTS TO EMPLOYEES FAVOURABLE POLICY DECISIONS AS PER MARKET TRENDS QUICK AND REGULAR RETURN ON INVESTMENT

Slide 13: 

DISADVANTAGES OF INADEQUATE WORKING CAPITAL DIFFICULTY IN MEETING OPERATIONAL EXPENSES LOSS OF FAVOURABLE BUSINESS OPPORTUNITY LOSS OF GOODWILL DISADVANTAGES OF EXCESSIVE WORKING CAPITAL BLOCKAGE OF FUNDS EXCESSIVE PURCHASING EXCESSIVE DEBTORS

SHORT TERM VS. LONG TERM FINANCING : 

SHORT TERM VS. LONG TERM FINANCING COST FLEXIBILITY RISK RISK RETURN TRADE OFF

OPTIMUM WORKING CAPITAL : 

OPTIMUM WORKING CAPITAL

WORKING CAPITAL MANAGEMENT : 

WORKING CAPITAL MANAGEMENT Management of current assets Includes: Inventory Management Cash Management Receivables Management

Working Capital – Planning & Management : 

Working Capital – Planning & Management Gross Working Capital: Investment in all current assets taken together. Net Working Capital: Excess of Current Assets over Current Liabilities. Current Assets: are those assets which are convertible into cash with in a period of one year. Current Liabilities: Payable with in a period of one year.

CLASSIFICATION OF WORKING CAPITAL : 

CLASSIFICATION OF WORKING CAPITAL ON THE BASIS OF CONCEPT GROSS WORKING CAPITAL NET WORKING CAPITAL ON THE BASIS OF TIME PERMANENT WORKING CAPITAL VARIABLE WORKING CAPITAL

GROSS & NET WORKING CAPITAL : 

GROSS & NET WORKING CAPITAL Generally the working capital is significance in two perspectives – Gross Working Capital and Net Working Capital, The term Gross Working Capital refers to the firm’s investment in current assets. The term Net Working capital refers to the excess of current assets over current liabilities, These gross working capital and net working capital are called Balance Sheet approach of working capital.

PERMANENT AND TEMPORARY WORKING CAPITAL : 

PERMANENT AND TEMPORARY WORKING CAPITAL Considering time as the basis of classification, there are two types of working capital viz., ‘Permanent’ and Temporary’. Permanent working capital represents the assets required on continuing basis over the entire year. Temporary working capital represents additional assets required at different times during the operation of the year.

Slide 21: 

A firm will finance its seasonal and current fluctuations in business operations through short term debt financing. For example, in peak seasons, more raw materials has to be purchased, more manufacturing expenses to be incurred, more funds will be locked in debtors balances etc. in such times excess requirement of working capital would be financed from short term financing sources.

Slide 22: 

The permanent working capital represents such components of current assets which are required throughout the year will generally be financed from long term debt and equity. Tandon Committee has referred to this type of working capital as ‘Core Current Assets’. Core Current Assets are those required by the firm to ensure the continuity of operations which represents the minimum levels of various items of current assets.

Slide 23: 

This minimum level of assets will be financed by the long term sources and any fluctuations over the minimum level of current assets will be financed by the short term financing.

FINANCING OF WORKING CAPITAL : 

FINANCING OF WORKING CAPITAL Sources of financing of working capital differ as per the classification of working capital into permanent working capital and variable working capital.

SOURCES OF PERMANENT WORKING CAPITAL : 

SOURCES OF PERMANENT WORKING CAPITAL Owner’s Fund Bond Financing Term Loan from banks or Financing Institutions.

SOURCES OF TEMPORARY CAPITAL : 

SOURCES OF TEMPORARY CAPITAL Trade Creditors Bank Loan from 30 days to several months basis. Commercial Paper Depreciation as a source of working capital. Tax Liabilities Other Miscellaneous Sources are : Dealers’ Deposits, Customers’ Advances etc.

Financing of working capital & Bank Policy : 

Financing of working capital & Bank Policy Sources of Finance classified as: 1 Spontaneous source 2 Commercial paper 3. Bank Credit

Spontaneous Source : 

Spontaneous Source It result from normal course of business. Getting goods and services for which payment to be made at later stage. Two important sources are: 1. Trade Credit There are two components to extend credit (a) Open Account (b) Bills Payable 2. Accrued Expenses : it refers to the services availed by the firm , but the payment has not yet been made.

Commercial Paper---Money MarketBank Credit : 

Commercial Paper---Money MarketBank Credit It is a credit facility provided by commercial Bank. Trade credit and Accrued exp are Spontaneous source while the bank credit is deliberate.

Types of bank credit : 

Types of bank credit 1. Overdraft 2. Cash credit 3. Bill Discounting 4. Letter of credit 5. working capital term Loan 6. Funded Interest term Loan

Security of Bank Credit : 

Security of Bank Credit 1. Hypothecation: refers to a situation where moveable property, generally stock is given as security agst. Loan 2.Pledge: Goods or property/ Investment be provided /deposited physically with bank 3.Mortgage: immovable property (plant, building) provided as security. Lien: property beneficial right belonging to another person is retained by a party who is having possession unless the amount due is paid.

FACTORS DETERMINING THE WORKING CAPITAL : 

FACTORS DETERMINING THE WORKING CAPITAL There is no set of universally applicable rules to ascertain working capital needs of a business organization. A host of factors influencing of working capital needs of a firm can be categorized into two categories viz., internal factors and external factors.

INTERNAL FACTORS : 

INTERNAL FACTORS Nature of Business Size of Business Firm’s production Policy Firm’s credit Policy Access to Money Market Growth and Expansion of Business Profit Margin and Dividend Policy Depreciation Policy Operating Efficiency of Firm.

EXTERNAL FACTORS : 

EXTERNAL FACTORS Business Fluctuations. Technological Development Transport and Communication Development Import Policy Taxation Policy

Slide 35: 

Proper and Effective working capital forecasting and control on working capital will lead to efficient working capital management. The effectiveness in the above twin can be achieved if the complete information about the operating cycle are known. The operating cycle of a firm begins with the acquisition of raw materials and ends with the collection of receivable.

Slide 36: 

It may be divided into four stages (i) Raw materials and stores stage, (ii) work-in-progress stage (iii) finished goods inventory stage and (iv) debtors collection stage.

Slide 37: 

Each stage involves the investment of fund. A finance manager will have to ensure the optimum investment at each stage. In addition, he will have to spend a considerable time on dealing with shorter term financial problems. His company will not be making new issues of debt of equity capital every day or even every year. But he will be taking decisions every week, if not every day, about granting credit to customer, inventory levels, when to pay suppliers and how much to leave in the current account at the company’s banker.

Operating Cycle : 

Operating Cycle Time duration required from procurement of raw material and ending with sales realization. Chronological sequence: 1. Procurement of raw material. 2. Conversion of raw material to WIP 3. Conversion of WIP to Finished goods 4.Sale of Finished Goods (Cash or Credit) 5. Conversion of receivables into cash

Operating Cycle Period : 

Operating Cycle Period 1. Inventory conversion Period: It is the time required for conversion of raw material to finished goods. 2. Receivables Conversion Period: It is the time required to convert the credit sales to sales realization.

Slide 40: 

GROSS OPERATING CYCLE ICP+RCP NET OPERATING CYCLE GOC-CDP

NET OPERATING CYCLE (NOP) : 

NET OPERATING CYCLE (NOP) Net operating Cycle= Inventory conversion period+ Receivables conversion period – deferral period (Credit period allowed by suppliers)

ESTIMATION OF WORKING CAPITAL : 

ESTIMATION OF WORKING CAPITAL

Slide 43: 

CURRENT ASSETS Stock of Raw Materials XXX Stock of WIP MATERIALS XXX WAGES XXX OVERHEAD XXX Stock of Finished Goods XXX Debtors xxx

Slide 44: 

CURRENT LIABILITIES: CREDITORS XXX WAGES O/S XXX OVERHEAD XXX TOTAL CURRENT LIABILITY (B) XXX WORKING CAPITAL (A-B) XXXX

CURRENT ASSETS: : 

CURRENT ASSETS: Stock of Raw Materials XXX (Annual production x raw material cost per unit x Stocking period ) Total no. of days in a year Stock of WIP MATERIALS XXX (Annual production x raw material cost per unit x Processing period ) Total no. of days in a year WAGES XXX (Annual production x Labour cost per unit x Processing period )x 50% Total no. of days in a year OVERHEAD XXX (Annual production x Overheads per unit x Processing period )x 50% Total no. of days in a year Stock of Finished Goods XXX (Annual production x Total cost per unit x Stocking period ) Total no. of days in a year

Slide 46: 

Debtors ( at Cost) XXX (Annual production x Credit Sales% x Total cost per unit x Credit period ) Total no. of days in a year Advance for Exps. CASH TOTAL CURRENT ASSETS (A) XXXX

CURRENT LIABILITIES : 

CURRENT LIABILITIES CREDITORS XXX (Annual production x raw material cost per unit x Credit period ) Total no. of days in a year WAGES O/S XXX (Annual production x Labour cost per unit x Credit period ) Total no. of days in a year OVERHEAD XXX (Annual production x Overheads per unit x Credit period ) Total no. of days in a year TOTAL CURRENT LIABILITY (B) XXX WORKING CAPITAL (A-B) XXXX

WORKING CAPITAL INVESTMENT POLICIES : 

WORKING CAPITAL INVESTMENT POLICIES Conservative Approach under this policy the firm holds relatively large proportion of total asset in the form of current assets. This policy lowers expected profitability, assuming that current liabilities remain constant. This policy also increases the firm’s net working capital position resulting in a lower risk that firm will encounter financial problems.

Slide 49: 

Aggressive Approach Under this policy, a firm holds relatively small proportion of its total assets in the form of current assets and thus, has relatively less net working capital. Consequently, this policy yields higher expected profit and higher risk.

Slide 50: 

Moderate Approach. Under this policy, expected profitability and risk will fall between those by conservative approach and aggressive approach.

TANDON COMMITTEE-Lending Norms : 

TANDON COMMITTEE-Lending Norms Ist Recom The borrower has to contribute a minimum 25% of working capital gap from long term funds . IInd Recom The borrower has to contribute a minimum of 25% of the total current assets from long term funds.

Slide 52: 

The borrower has to contribute the entire core current assets and a minimum of 25% of the balance of the current assets from long term funds.

ESTIMATING WORKING CAPITAL NEEDS : 

ESTIMATING WORKING CAPITAL NEEDS RATIO OF SALES RATIO OF FIXED INVESTMENT CURRENT ASSETS HOLDING PERIOD

Factors Determining the working capital needs : 

Factors Determining the working capital needs 1.Nature of Business: Trader or Manufacturer 2. Size of business: Small Scale or large scale 3.Business cycle : Boom or Recession 4.Seasonal Factors 5. Market Competitiveness : Credit to customer 6. Credit Policy: Time of Payment for creditor & debtors. 7. Supply Conditions

Lending Norms- Maximum Permissible Banks Finance : 

Lending Norms- Maximum Permissible Banks Finance Tandon Committee: Ist Method: Borrower will contribute 25% of working capital gap and 75% can be financed by banker. IInd Method: Borrower will contribute 25% of Current Assets and the remaining of the working capital gap can be financed by banker

Management of Cash : 

Management of Cash It refers to Management of Cash Balance and bank balance. Most Liquid Assets Appropriate usage

Motives of Holding Cash : 

Motives of Holding Cash 1. Transaction Motive: to meet the obligation in normal course of business. 2.Precautionary Motive: to act as a cushion or buffer against unexpected events. 3.Speculative Motive: To take advantage of potential profit making situation ( windfall of heavy discount at the time of sealing of shops / showrooms in delhi). 4.Compensation motive: Necessary Balance in bank account.

Objectives of Cash Management : 

Objectives of Cash Management Mainly Two goals 1. Provide cash needed to meet the obligations (meeting the cash outflows) 2. To minimise the idle cash balance held by the firm

Starting An Export Business: (Categories of Exporters) : 

Starting An Export Business: (Categories of Exporters) Merchant Exporter Manufacturing Exporter Sales Agent/ commission agent/ indenting agent Buying Agent

Starting an Export Business-- : 

Starting an Export Business-- Location Letterhead: Banker's name Business Card Export Personnel/Staff Bank Account: A current account has to be opened in the name of the organization in whose name it is intended to export,in a branch of a commercial bank which is authorized to deal in foreign exchange Permanent Income –Tax Account Number

Starting an Export Business : 

Starting an Export Business Effective Business Correspondence Export Decision 1- Selecting a quality product 2- Selecting a particular overseas market 3- Beginners should concentrate only on a few products and minimum two or three countries 4- Ensuring that the selected products can be manufactured or procured from other sources at the competitive prices and in sufficient quantity that will enable the delivery schedule to be met.

Starting an Export Business : 

Starting an Export Business Getting the full information of similar products of other manufacturers,their prices, marketing techniques, terms of business etc Assessing the degree of competitiveness Selecting the Markets: 1- Political Embargo 2-Scope of Exporter's Select Product 3- Demand Stability 4-Preference to products from developing countries 5-Market Penetration by competitive countries and products

Export Business--- : 

Export Business--- 6-Distance of Potential Market 7-Transport Problem 8-Language Problems 9- Tariff and Non-Tariff Barriers 10- Distribution Infrastructure 11-Size of Demand 12-Expected Life Span of market and product requirements 13- Sales and Distribution Channels Sources of Information: EPCs, Commodity Boards, FIEO, IIFT, ITPO, Indian Embassies Abroad, Foreign Embassies in India, Import Promotion Institution Abroad, Overseas Chambers of Commerce and Industries, various journals, market survey reports, Internet etc

Export Business:Export Commodity Selection : 

Export Business:Export Commodity Selection 1- Exporters manufacturing capacity 2-The availability of commodity from other sources 3-Demand for Commodity 4- Govt of India’s Policy 5- Total profitability of commodity including cash incentives available 6- Import replenishment available, if any 7-Quota fixation,if any,in respect of such commodities in both the countries 8- Knowledge and experiences of similar exporters

Export Business---Obtaining Particulars of Foreign Buyers : 

Export Business---Obtaining Particulars of Foreign Buyers Sources: 1- Trade Representatives of Foreign Govt in India as well as various Indian Trade Representative abroad 2-International Trade Directories and International Yellow pages 3-Participating/visiting International Trade Fairs, Exhibitions in India & Abroad 4-Advertising in Indian as well as foreign newspaper , magazines and journals 5- Relatives, friends and other contacts in foreign countries

Export Business---Selecting Channels of Distribution : 

Export Business---Selecting Channels of Distribution 1- Export through Export Consortia 2-Export Through Canalizing Agencies 3- Export through other Established Merchant Exporters or Export Houses,or Trading Houses 4- Direct Exports 5- Export through Overseas Sales Agencies

Export Business--- : 

Export Business--- 1-Negotiating with Prospective Buyers 2-Processing An Export Order Item specification Pre-shipment inspection Payment Conditions Special Packaging Labeling and Market Requirements Shipments and Delivery Date Marine Insurance Documentation,etc

Export Business--- : 

Export Business--- Entering into Export Contract: carefully drafted,no ambiguity regarding the exact specifications of goods and terms of sale including export price,mode of payment, storage and distribution methods, type of packaging,port of shipment, delivery schedule etc. Export Pricing and Costing: The prices will be determined by the following factors: 1- Range of products offered 2- Prompt deliveries and continuity in supply 3-After-sales services in products like machine tools and consumer durables 4-Product Differentiation and brand image 5-Frequency of Purchase 6- Frequency of Purchase

Export Business--- : 

Export Business--- 6- Presumed relationship between quality and price 7-Specialty of value goods and gift items 8-Credit Offered 9-Preference or prejudice for products originating from a particular source 10-Aggressive marketing and sales promotion 11-Prompt Acceptance and Settlement of claims 12- Unique Value goods

Export Business---Understanding Risks in International Trade : 

Export Business---Understanding Risks in International Trade Credit Risk : can be covered by irrevocable Letter of Credit, through ECGC Currency Risk: Export order in Indian Rupee, forward cover Carriage Risk: through marine insurance policy Country Risk: ECGC

Export Business--- : 

Export Business--- Arbitration: All disputes or differences shall be settled by arbitration in accordance with the rules of arbitration of the Indian Council of Arbitration and the award made in pursuance thereof shall be binding on the parties” Importer- Exporter Code Number ( IEC Number) from the Regional Import/ Export Licensing Authority.Apply in duplicate in prescribed form IEC Certificate : apply in prescribed form Registration with Export Promotion Council ( EPCS) 1-A License to export/import 2- Any other benefit or concession under the EXIM Policy, is required to furnish a RCMC ( Registration-cum-Membership Certificate)

Export Business--- : 

Export Business--- 3-Number granted by the authorities like Export Promotion Councils, Commodity Boards, Federation of Indian Export Organization (FIEO) and Processed Foods Export Development Authorities ( APEDA), Marine Product Export Development Authority ( MPEDA) Registered Exporters: RCMC are known as a registered exporters. The registered exporters can be (1) Manufacturer Exporters (2) Merchant -Exporters

Export Business--- : 

Export Business--- One Registration Registering Authorities: An EPC from the total of 22 EPEs 6 Commodity Boards out of seven APEDA FIEO in case of Export Houses, Trading House, Star Trading Houses and Super Star Trading House Any Regional Licensing Authority for the products not covered by EPC’S Commodity Boards, APEDA

Export Business--- : 

Export Business--- Product- Specific Compulsory Registration: For example , registration with Tribal Co-operative Marketing Federation of India Ltd ( TRIFED) for export of shellac and all forms of lac, APEDA for export of flour and ragi,etc. Registration with the Textile Commissioner for export of raw cotton, soft cotton, waste hard cotton, waste is compulsory. It will be an addition to registration with EPCs an d obtaining RCMC Membership/ Registration: Since RCMC will be issued by an EPC or FIEO , etc to its members only , membership or registration with them is a prerequisite

FINANCIAL MANAGEMENT: AN OVERVIEW : 

FINANCIAL MANAGEMENT: AN OVERVIEW Business decisions are mostly measured in financial terms and, therefore, financial management plays a key role in the operations of an enterprise. Financial management is primarily concerned with planning and controlling the financial resources of an enterprise. The focal point of financial management remains maximization of shareholders’ wealth by proper considerations of contributing factors as timing of return, cash flows, risk etc.

FINANCIAL MANAGEMENT-MEANING : 

FINANCIAL MANAGEMENT-MEANING Financial management primarily concerns with the management of financial aspect of an enterprise. It deals with procurement of funds and their effective utilization in the business. Basic questions that are dealt with in financial management are:

Slide 84: 

Which new proposals for employing capital should be accepted by the firm? How much working capital will be needed to support the company’s operations? Where should the firm go to raise long term capital and how much will it cost? Should the firm declare dividends on its equity capital and, if so, how large a dividend should be declared? What steps can be taken to increase the value of firm’s equity capital?

Slide 85: 

The above issues are solved by taking three decisions- Investment decision Financing Decision and Dividend decision. Together, they determine the value of the firm to its shareholders.

Slide 86: 

As objective of the financial Management is to maximize the value (i.e. wealth of shareholders), the firm should strive for an optimal combination of the three interrelated decisions, solved jointly. The decision to invest in a new capital project, for example, necessitates financing the investment. The financing decision, in turn, influences, and is influenced by the dividend decision. The retained earnings used in internal financing represent dividends foregone by the shareholders. With a proper conceptual framework, joint decisions that tend to be optimal can be reached.

SCOPE OF FINANCIAL MANAGEMENT : 

SCOPE OF FINANCIAL MANAGEMENT Financial management, as an integral part of the overall management, is primarily concerned with acquisition and use of funds by a business. Based on Ezra Solomon’s concept of financial management, following aspects are taken up in detail under the study of financial management: Determination of size of the enterprise and determination of rate of its growth. Determining the composition of assets of the enterprise. Determining the mix of firms financing i.e., consideration of level of debt to equity, etc. Analysis planning and control of financial affairs of the enterprise.

Slide 88: 

The scope of financial management has undergone significant changes over the years. Until the middle of this century, its scope was restricted to procurement of funds under major events in the life of the enterprise such as promotion, expansion, merger and reorganization. According to modern approach, now financial management includes besides procurement of funds: Investment decisions Financing decisions Dividend decision

INVESTMENT DECISIONS : 

INVESTMENT DECISIONS Investment decisions involve investment both in long-term assets (capital budgeting) and short term assets (working capital management). Capital investment is a decision of far-reaching consequences as it allocates funds in investment proposals, whose benefits are realized in future. This involves consideration of risk factor. Accordingly, investment decisions are evaluated in relation to their expected return and risk.

FINANCING DECISIONS : 

FINANCING DECISIONS Financing decisions involve selection of optimum proportion of debt and equity. Ideally, a debt-equity mix is presumed to have reached its optimum, where the average cost of capital is found to be the least minimum possible

DIVIDEND DECISION : 

DIVIDEND DECISION Dividend decision is a most crucial decision to determine the amount of surplus to be distributed as dividend to shareholders. Formulation of dividend policy brings into focus the retention policy of the firm and vice versa.

OBJECTIVES OF FINANCIAL MANAGEMENT: : 

OBJECTIVES OF FINANCIAL MANAGEMENT: Following are the two widely discussed objectives of financial management: Profit Maximisation Wealth Maximization

PROFIT MAXIMISATION : 

PROFIT MAXIMISATION For any business firm, the maximization of the profits is often considered as the implied objective and therefore it is natural to retain the maximization of profit as the goal of the financial management also. Various types of financial decisions be taken with a view to maximize the profit of the firm. So, out of different mutually exclusive options only that one should be selected which will result in maximum increase in profit.

PROFIT MAXIMISATION : 

PROFIT MAXIMISATION The term profit can be used in two ways (i) as an owner-oriented concept, i.e., the amount which is paid to the owners of business, (ii) a variant of the term is profitability. It is operational concept and signifies economic efficiency. In other words, profitability refers to a situation, where output exceeds input, i.e., the value created by the use of resources is mot\re than the total of input resources. Based on this criterion, a firm should be guided in financial decision-making by one test i.e., select assets, projects and decisions which are profitable and reject those, which are not.

PROBLEMS WITH THE PROFIT MAXIMIZATION AS THE OBJECTIVE : 

PROBLEMS WITH THE PROFIT MAXIMIZATION AS THE OBJECTIVE The profit maximization does not take into account the amount of risk which the firm undertakes in attempting to increase the profits. With profit maximization as the objective, the management may undertake all profitable investment opportunities regardless of the associated risk, whereas that investment may not be worth the risk, despite its potential profitability. The profit maximization concentrates on the profitability only and ignores the financing aspect of that decision and the risk associated with that financing.

Slide 96: 

It ignores the timings of costs and returns and thereby ignores the time value of money. The profit maximization as an objective is vague and ambiguous. The profit maximization may widen the gap between the perception of the management and that of the shareholders. Since the profit maximization is not directly related to any measure of shareholders benefits, this principle seems to be self centered at the cost of loosing attention from the interest of the shareholders, which should be of utmost importance to any firm.

Slide 97: 

The profit maximization borrows the concept of profit from the field of accounting and thus tends to concentrate on the immediate effect of a financial decision as reflected in the increase in the profit of that year or in near future. This will not necessarily be correct because many decision have their costs and benefits scattered over many years. A variant of the Profit maximization is often suggested as the maximization of the return on investment

Slide 98: 

On the basis of the above discussion, it may be concluded that the profit maximization fails to be an operationally feasible objective of financial management. As goal as already stated should be precise, well defined and must be capable to take cognizance of all possible costs and benefits of all the alternatives being evaluated. One such goal is termed as the maximization of shareholders wealth.

MAXIMIZATION OF SHAREHOLDERS’ WEALTH : 

MAXIMIZATION OF SHAREHOLDERS’ WEALTH In the theory of financial management, it is well accepted that the objective of financial management is the maximization of shareholders wealth. This objective is generally expressed in term of maximization of the value of a share of a firm. The measure of wealth which is used in financial management is the concept of economic value. The economic value is defined as the present value of the future cash flows generated by a decision, discounted at appropriate rate of discount which reflects the degree of associated risk.

Slide 100: 

The measure of economic value is based on cash flows rather than profit. The economic value concept is objective in its approach and also takes into account the timing of cash flows and the level of risk through the discounting process. The shareholders wealth is represented by the present value of all the future cash flows in the form of dividends or other benefits from the firm. The market price of share reflects this present value.

Slide 101: 

Therefore, the economic value of the shareholders wealth is the market-price of the share which is the present value of all future dividends and benefits expected from the firm. Since each shareholder’s wealth at any time is equal to the market value of all his holdings in shares, an increase in the market price of firm’s shares should increase the shareholder’s wealth.

Slide 102: 

Therefore,, maximization of shareholders wealth as an objective of financial management implies that the financial decisions will be taken in such a way that the shareholders receive highest combination of dividends and the increase in market price of the share. In other words, the shareholders proportional ownership of a firm represented by a share should be maximized. All financial decisions therefore, are evaluated in terms of their effect on the firm’s future cash flows and hence on the market price of the share.

PROBLEMS WITH WEALTH MAXIMISATION AS OBJECTIVE : 

PROBLEMS WITH WEALTH MAXIMISATION AS OBJECTIVE The main problem is the assumption underlying this goal i.e., there is an efficient capital market wherein the effect of a decision is truly reflected in the market of share. In practice the share price is influenced by the overall economic and political scenario in the country. More often than not, the market price of a share may also fluctuate because of speculative activities. All those factors are assumed to be given and constant in this objective.

Slide 104: 

Moreover, this objective seems to be uncontroversial in theoretical grounds but in practice there are three basic stakeholders in any firm i.e., the shareholders, the professional managers and the creditors. The objectives of these three stakeholders in the are often very different resulting in conflict among them. Managers may take decisions that are in their best interest at the cost of making unhappy the shareholders and the creditors. The problem is further accentuated if the interest of other stakeholders e.g. employees etc. is also considered.

Slide 105: 

The profit maximization can be considered as a part of the wealth maximization strategy, but should never be permitted to over shadow the latter. Throughout this work, the objective of maximization of shareholders wealth has been taken as the primary goal of financial decisions making. From the above it is clear that net present value maximization is superior to profit maximization as an objective of financial management. It should also be kept in mind that where the time period is short and degree of uncertainty is not great, value maximization and profit maximization account for essentially the same thing.

TECHNIQUES OF FINANCIAL MANAGEMENT : 

TECHNIQUES OF FINANCIAL MANAGEMENT Some of the various techniques of financial management are: Ratio Analysis; Funds flow Statement; Cash flow statement; Capital budgeting and investment decisions; Corporate restructuring Capital structuring

Slide 107: 

Dividend decisions; Bonus share, buy back and stock splits; Financial decision-making including multiple performance measures; Working capital management; Corporate Risk management involving, hedging forwards and options.

FINANCIAL STATEMENTS ANALYSIS(RATIO ANALYSIS) : 

FINANCIAL STATEMENTS ANALYSIS(RATIO ANALYSIS) Financial statements contain a wealth of information which, if properly analyzed and interpreted, can provide valuable insights into a firm’s performance and position. Financial statement analysis may be done for a variety of purpose, which may range from a simple analysis of the short-term liquidity, strengths and weaknesses of the firm in various areas. The principal tool of financial statement analysis is financial ratio analysis.

Slide 109: 

An absolute figure does not convey anything unless it is related with the other relevant figures. Magnitude of current liabilities of a company does not tell anything about solvency position of the company. It is only when it is related with current assets figures of the same company an idea about solvency position of the company can be had. Ratios make a humble attempt in this direction.

Slide 110: 

Ratios are significant both in vertical and horizontal analysis. In vertical analysis ratios help the analyst to form a judgment whether performance of the corporation at a point of time is good, questionable or poor. Likewise, use of ratios in horizontal analysis indicates whether the financial condition of the corporation is improving or deteriorating and whether the cost, profitability is showing an upward or downward trend.

IMPORTANCE OF RATIO ANALYSIS : 

IMPORTANCE OF RATIO ANALYSIS Useful in financial position analysis. Useful in simplifying accounting figures Useful in assessing the operational efficiency Useful in forecasting purposes. Useful in locating the weak spots of the business. Useful in comparison of performance.

USES : 

USES Financial Ratio Analysis is used by three main groups Management : To exercise control over the activities and thus improve the firm’s operation. Credit Analysts: Such as bankers or credit managers who analyze ratios to ascertain company’s ability to pay its debts.

Slide 113: 

Security Analysts: Including share analysis, who are interested in a company’s efficiency and growth prospects, and bond analysis, who are concerned with a company’s ability to pay interest on its bonds also the assets that would be available to bondholders in the events of the company went bankrupt.

TYPES OF FINANCIAL RATIOS : 

TYPES OF FINANCIAL RATIOS The various financial ratios are broken into five categories namely : Liquidity Ratios Activity Ratios Leverage Ratios Profitability Ratios Market Value Ratios

LIQUIDITY RATIOS : 

LIQUIDITY RATIOS Liquidity ratios provide test to measure the ability of the company to cover its short-term obligations out of its short-term resources. Interpretations of liquidity ratios provide considerable insight into the present cash solvency of the company and its ability to remain solvent in times of adversities. The important liquidity ratios are current ratio and quick or acid test ratio.

ACTIVITY RATIOS : 

ACTIVITY RATIOS Activity ratios also referred as Asset Management ratios measure how efficiently the company is managing its assets. These ratios are based on relationship between the level of activity, represented by sales or cost of goods sold and levels of various assets. The important ratios under this category are:- inventory turnover, debtors turnover, fixed assets turnover and total assets turnover ratios.

LEVERAGE RATIOS : 

LEVERAGE RATIOS These ratios are generally designed to measure the contribution of the company’s owners vis-à-vis the funds provided by its creditors. These ratios are computed to solicit information along with the following lines: The Company’s ability to weather times of stress and to cover all its obligations including short-term and long-term obligations. The margin of safety afforded to the creditors.

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The extent of control of shareholders over the enterprise and The potential earning from the use of loan funds. The important ratios in this category are: debt to total ratio, debt-equity ratio and interest coverage ratio.

PROFITABILITY RATIOS : 

PROFITABILITY RATIOS Profitability ratios are the indicators of overall efficiency of the business concern. There are two types of profitability ratios: Profit Margin Ratios: it includes gross profit margin and net profit margin ratios. Rate Of Return Ratios: These ratios reflect the relationship between profit and investment. The important rate of return measures are: Net income to total assets ratio, return on capital employed and return on equity.

MARKET VALUE RATIOS : 

MARKET VALUE RATIOS Market value ratios indicate how the equity share of the company is assessed in the capital market. Since the market value of equity reflects the combined influence of risk and return, these ratios are the most comprehensive measures of a firm’s performance. The important ratios under this category are- earning per share (EPS), price-earning ratio (P/E ratio), dividend yield ratio and market value to book value ratio.

CURRENT RATIO ORWORKING CAPITAL RATIO : 

CURRENT RATIO ORWORKING CAPITAL RATIO Current ratio = Current Assets Current Liabilities Fair ratio = 2:1 Current Assets Includes cash, bank, debtors, B/R, Short Term, Advance, Investment, Stock, prepaid expenses, non trade investment (market Value). Current liabilities; BOD, C/C Creditors, Short term loan, B/P O/S exp., provision for taxation (net) ( after advance of tax)

LIQUID RATIO/ ACID TEST RATIO : 

LIQUID RATIO/ ACID TEST RATIO Liquid ratio = Liquid Assets Liquid Liabilities Fair Ratio = 1:1 LA = CA – (Stock + Prepaid) LL = Cl – (BOD & C/C) Debtors are taken after provision.

CASH RATIO : 

CASH RATIO CASH RATIO = cash reserve Current Liabilities Cash reserve = Cash + Bank balance + Non trade quoted investments (at Market Value)

CASH INTERVAL : 

CASH INTERVAL CASH INTERVAL = Current Assets- Inventory Average daily cash exp.

NET WORKING CAPITAL RATIO : 

NET WORKING CAPITAL RATIO Net Working Capital Ratio = Net Working Capital Net Assets NWC= Current assets – current Liabilities (excl. short term Bank Borrowing) Net Assets = Current assets + Fixed Assets

LEVERAGE RATIOS : 

LEVERAGE RATIOS DEBT RATIO = Total Debt Total Debt+ net worth or Total Debt Capital Employed Total Debt means long term & short term borrowings Capital employed means Share cap.+ res & surplus+ LTL- Non trade investments- Fictitious Assets

DEBT EQUITY RATIO : 

DEBT EQUITY RATIO DEBT EQUITY RATIO = Total Debt Net worth Fair Ratio = 2:1 or lesser

PROPRIETORY RATIO : 

PROPRIETORY RATIO PROPRIETARY RATIO = Proprietor’s fund Total Assets Total Assets = Fixed Assets + Current Assets Proprietors funds= net worth

INTEREST COVERAGE RATIO : 

INTEREST COVERAGE RATIO INTEREST COVERAGE RATIO = EBIT . Interest EBIT means Profits before interest and Tax Interest on LTL only be taken here.

DEBT SERVICE COVERAGE RATIO : 

DEBT SERVICE COVERAGE RATIO Debt Service Coverage Ratio = Profit after tax + non cash expenses + interest Loan installment

ACTIVITY RATIOS : 

ACTIVITY RATIOS These are also called as TURNOVER Ratios. Inventory Turnover Ratio = cost of goods sold Average Inventory Always shown as No. of Times Cost of Goods Sold means Sales- Gross Profits or Op. stock +purchases+ direct exps- cls. Stock Av. Inventory means op stock +cl. Stock 2

DEBTORS TURNOVER : 

DEBTORS TURNOVER Debtors Turnover = Net Credit Sales Average Debtors Av. Collection Period = No. of Days in a year (i.e 360) Debtors Turnover Or No. of Days in a year (i.e 360) X Av. Debtors Net Credit Sales

ASSETS TURNOVER RATIOS : 

ASSETS TURNOVER RATIOS Assets Turnover Ratios = Net sales Av. Net Assets Fixed Assets Turnover Ratios = Net sales Av. Fixed Assets

CAPITAL TURNOVER RATIOS : 

CAPITAL TURNOVER RATIOS Capital Turnover Ratios = Net sales Av. Capital Employed Working Capital Turnover Ratios = Net sales Av. Working Capital

PROFITABILITY RATIOS : 

PROFITABILITY RATIOS GROSS PROFIT RATIO = G/P X 100 Net sales Gross Profit = Sales - Cost Of Goods Sold

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NET PROFIT RATIO = N/P X 100 Net sales Net Profits means Profits after Tax NET PROFIT RATIO = NOPAT X 100 Net sales NOPAT means EBIT(1-TAX)

OPERATING RATIO : 

OPERATING RATIO Operating Ratio = Operating Cost X 100 Net sales Operating Cost = Cost of Goods sold + office & administrative exp + selling & distribution exps

OPERATING PROFITS RATIO : 

OPERATING PROFITS RATIO Operating Profit Ratio = Operating profit X 100 Net sales Operating Profits = net sales – operating cost

RETURN ON INVESTMENTS(ROI) : 

RETURN ON INVESTMENTS(ROI) Return On Investments (ROI) ( After Tax) ROTA =EBIT ( 1-Tax) X 100 Total Assets RONA =EBIT ( 1-Tax) X 100 Net Assets

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Return On Investments (ROI) ( Before Tax) ROTA =EBIT X 100 Total Assets RONA =EBIT X 100 Net Assets

RETURN ON CAPITAL EMPLOYED : 

RETURN ON CAPITAL EMPLOYED RETURN ON CAPITAL EMPLOYED = EBIT X 100 Average capital employed = EBITX 100 Average capital employed

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ROCE = Profit Margin X Capital Turnover Profit Margin = NP before Int & Tax X 100 Sales Capital Turnover = Sales X 100 Average capital employed Profit

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Profit Margin = NP before Int & Tax X 100 Sales Capital Turnover = Sales X 100 Average capital employed

RETURN ON EQUITY : 

RETURN ON EQUITY ROE = Profits after Tax Net Worth (Equity)

CAPITAL MARKET RATIOS : 

CAPITAL MARKET RATIOS Earnings Per Share = Net profit after Interest, tax & Pref. Dividend No. of equity shares

PRICE EARNING RATIO : 

PRICE EARNING RATIO P/E RATIO = Market Price EPS DPS (DIVIDEND PER SHARE) = Total Dividend No. of Equity Shares

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EARNING YIELD RATIO = EPS X 100 Market price per share DIVIDEND YIELD RATIO = DPS X 100 Market price per share

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MARKET VALUE TO BOOK VALUE RATIO = Market Value per Share Book Value per Share BOOK VALUE PER SHARE = Net Worth No. of equity shares

Tobin’s q : 

Tobin’s q Tobin’s q = Market Value of Assets Replacement Cost of Assets

TREND ANALYSIS : 

TREND ANALYSIS In financial analysis the direction of charges over a period of years is of crucial importance. Time series or trend analysis of ratios indicates the direction of change. This kind of analysis is particularly applicable to the items of profit and loss account. It is advisable that trends of sales and net income may be studied in the light of two factors: The rate of fixed expansion or secular trend in the growth of the business and The general price level.

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It might be found in practice that a number of firms would show a persist growth over a period of years. But to get a true trend of growth, the sales figures should be adjusted by a suitable index of general prices. In other words sales figures should be deflated for rising price level. When the resulting figures are shown on a graph, we will get trend of growth devoid of price charges. Another method of securing trend of growth and one, which can be used instead of the adjusted sales figures or as check on them is to tabulate and plot the output or physical volume of sales expressed in suitable units of measure.

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If the general price level is not considered while analyzing trend of growth, it can mislead management. They may become unduly optimistic in periods of prosperity and pessimistic in dull periods For trend analysis, the use of index numbers is generally advocated. The procedure followed is to assign the number 100 to items of the base year. This procedure may be called as “trend-percentage method”

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Table gives trend percentages for profit and loss statement and balance sheet items. Hindustan’s EBIT has increased faster than the growth in sales, while PAT has shown slightly better performance than sales. Current assets and current liabilities have moved together. Total assets have grown faster than net worth which implies the greater reliance on outsiders’ money by HMC.

INTER-FIRM ANALYSIS : 

INTER-FIRM ANALYSIS A firm would like to know its financial standing vis-à-vis its major competitors and the industry group. As explained earlier, the analysis of the financial performance of all firms in an industry and their comparison at a given point of time is referred to the Cross-section analysis or the inter-firm analysis. To ascertain the relative financial standing of a firm, its financial ratios are compared either with its immediate competitors or with the industry average. We have used the data of construction firms to illustrate the inter-firm comparison. Table contains the financial data of eleven construction firms.

CAPITAL BUDGETING : 

CAPITAL BUDGETING New Investment Criteria. The methods employed for ascertainment of profitability of new investments are as follows: - Payback Method Average Rate of Return Present value Method Profitability Index Internal rate of Return Method

PAYBACK METHOD : 

PAYBACK METHOD The payback period of a fixed asset tells us the number of years required to recover the initial investment of that asset. This period is calculated by dividing the cost of the fixed asset by the annual savings in costs or additional earnings after tax but before depreciation. The payback period is calculated as follows:- Pay Back Period Cost of the Investment = Annual Cash in Flow

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The best investment would be that which has the shortest payback period. The working life of the asset should be more than the payback period so that some profits also be earned in addition to the recovery of the cost of the asset. A capital project will make profit only if its life is more than the payback period. The shorter is the payback period, the less risky is the investment, and the greater is its liquidity.

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E +(B/C)

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The method is simple to understand and operate and shows the period within which the cost of the investment will be recovered. But this method does not take account of the magnitude or timing of cash flows during the payback period; it takes into consideration only the recovery period as a whole.

AVERAGE RATE OF RETURN OR ACCOUNTING RATE OF RETURN : 

AVERAGE RATE OF RETURN OR ACCOUNTING RATE OF RETURN This method represents the ratio of the average annual profits after taxes to the average investment in the project. Average rate of return is calculated as follows:- Average rate of Return Average Annual Profit (After Taxes) = Average Investment in the Project

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The most important advantage of this method is its simplicity because it makes use of readily available accounting information. It is simple to calculate and takes into consideration benefits over the entire life of the project. The principal drawbacks of the method are that it is based upon accounting income rather than upon cash flows. It does not take into consideration the timing of cash inflows and outflows.

Present value Method (PV Method) : 

Present value Method (PV Method) The present value method is a discounted cash flow mwthod. In this method all net cash inflows are discounted to present value using the required rate of return. Mathematically, the method can be expressed as follows: PV. Of Annual Cash in Flows = Annual Cash in Flow X PVAF Net Present Value = PV of CIF- PV of Investments

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PVF = 1/(1+r)t

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If the present value of expected cash inflows exceeds the initial cost of the project, the project should be accepted. The net present value of the investment can also be calculated by deducting the initial cost of the investment from the present value of net cash inflows. If we are to select a project out of various alternative projects, the best project is that which has the highest net present value. The method lays emphasis on the comparison of net present value and disregards the initial investment involved. This method does not measure percentage return on investment.

PROFITABILITY INDEX METHOD : 

PROFITABILITY INDEX METHOD This method measures the % return on investments. This method is useful when the amount of investment is significantly different in two projects. It is calculated as follows: Profitability index = PV of Cash in Flows Investments Acceptance/rejection rule: If profitability index ≥ 1 then accept the project If profitability index < 1 then Reject the project

INTERNAL RATE OF RETURN METHOD (IRR) : 

INTERNAL RATE OF RETURN METHOD (IRR) Because of the drawback of not taking account of the magnitude and the timing of cash flows in the average rate of return and payback methods, it is felt that discounted cash flow methods provide a more objective basis for evaluating capital expenditure. These methods take into consideration the magnitude and the timing of expected earnings in each period of a project’s life and discount the future earnings to the present value. The two discounted cash flow methods are the internal rate of return and the present value method.

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The internal rate of return for an investment proposal is the discount rate that equates the present value of initial cost of the investment with the present value of the expected net cash flows. It may be remembered that discounted cash flow methods take into consideration cash flows rather than accounting profits. If the internal rate of return is more than the required rate of return, the project is accepted, if not, it should be rejected. If there are a number of alternative proposals, the internal rates of all alternatives should be compared and the alternative which gives the maximum internal rate should be selected as the most profitable one

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AT IRR PV OF CIF = INVESTMENTS (PVAF x ANNUAL CIF) = INVESTMENT PVAF = INVEST ANNUAL CIF

COST OF CAPITAL : 

COST OF CAPITAL The Main objective of business firm is to maximize the wealth of shareholders in the long-run, the management should only invest in projects which give a return in excess of cost of funds invested in the projects of the business. The cost of capital is the rate of return the company has to pay to various suppliers of funds in the company. There are variations in the costs of capital due to the fact that different kinds of investment carry different levels of risks which is compensated for by different levels of return on the investment.

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There are two main sources of capital for a company: Shareholders and lenders usually debentures holders are financial institutions. The costs of equity and costs of debts are the rates of return that need to be offered to those two groups of suppliers of capital in order to attract funds from them.

USE OF COST OF CAPITAL IN CAPITAL BUDGETING : 

USE OF COST OF CAPITAL IN CAPITAL BUDGETING Determination of cost of capital is essential for capital budgeting decisions. The cost of capital is used as the discount rate in NPV calculations and as a target rate of return for comparing with a project’s Internal rate of return. Cost of capital is defined, as the maximum rate of return that firm must earn on its investment so that market value per share remains unchanged. When the internal rate of return (IRR) method is used in the project appraisal, the IRR of the project is compared with the cost of capital. It provides a yardstick to measure the worth of investment proposal and thus performs the role of accept or reject criterion. It is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return and standard return etc.

ELEMENTS OF COST OF CAPITAL : 

ELEMENTS OF COST OF CAPITAL The cost of capital consists of the following elements: Cost of equity (KE) Cost of retained earnings (KR) Cost Preferred Capital (KP) Cost of Debt (KD)

COST OF DEBT (Kd) : 

COST OF DEBT (Kd) The capital structure of a firm normally include the debt component also. Debt may be in the form of Debentures, Bonds, term loans from financial institutions and Bank etc. The debt is carried a fixed rate of interest payable to them, irrespective of the profitability of the company. Since the coupon rate is fixed, the firm increases its earnings through debt financing.

COST OF PERPETUAL DEBT : 

COST OF PERPETUAL DEBT The cost of perpetual debt (irredeemable debt) is calculated with the following formula : I(1-T) KD = ------- NP Where, KD = Cost of Debt I = Annual Interest payment T = Corporate tax rate NP = Net proceeds

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np = face value of deb. +premium on issue –discount on issue – exps on issue.

COST OF REDEEMABLE DEBT : 

COST OF REDEEMABLE DEBT The cost of redeemable debt is calculated by applying the following formula : I(1-T) + (MV-NP) N KD = ---------------------------- MV + NP 2 Where, KD = Cost of debt I = Annual Interest payment; NP = Net proceeds MV =Maturity Value N= Term or maturity period T = Company’s effective tax rate

COST OF PREFERENCE SHARES (Kp) : 

COST OF PREFERENCE SHARES (Kp) The cost of preference share capital is the rate of return that must be earned on preference capital financed investments, to keep unchanged the earnings available to the equity shareholders.

Cost Of Irredeemable Preference Shares : 

Cost Of Irredeemable Preference Shares The cost of irredeemable preference share capital is the rate of preference dividend, also called the coupon rate dividend by net issue proceeds. Pref. Dividend KP = ------------------ NP Where, KP = Cost of irredeemable preference shares Np = Net proceeds received from issue of preference shares after meeting the issue expenses.

Cost Of Redeemable Preference Shares : 

Cost Of Redeemable Preference Shares The cost of redeemable preference shares is calculated as follows : PD +(MV – NP) N KP = ------------------- NP + MV 2 KP = Cost of preference shares; D = Constant annual dividend payment ; N=No. of years to redemption NP = Net proceeds; MV = Maturity Value

COST OF EQUITY (Ke) : 

COST OF EQUITY (Ke) The funds required for the project are raised from the equity shareholders, which are of permanent nature. These funds need not to repayable during the lifetime of the organization. The equity shareholders are the owners of the company. The Main objective of the firm is to maximize the wealth of the equity shareholders. The cost of equity may be defined as the minimum rate of return that a company must earn on the equity financed portion of an investment projects so that market price of the shares remain unchanged. The following methods are used in calculation of cost of equity.

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Dividend Yield Method D1 KE = -------x 100 Po Where, KE = Cost of equity D1 = Annual dividend per share at the end of year 1 Po = Market Price per share

DIVIDEND GROWTH MODEL : 

DIVIDEND GROWTH MODEL Shareholders will normally expect dividend to increase year after year and not to remain constant in perpetuity. In this method, an allowance for future growth in dividend is added to the current dividend yield. It is recognized that the current market price of a share reflects expected future dividends. The dividend growth model is also called as ‘Gordon dividend growth model’.

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D1 KE = -------x 100 + g% Po Where, D1 = Current dividend per equity share Po = Market Price per equity share g = Growth in expected dividend

PRICE EARNING METHOD : 

PRICE EARNING METHOD This method takes into consideration the Earning per Share (EPS) and the market price of the share. It is based on the assumption that the investors capitalize the stream of future earnings of the share and the earnings of a share need not be in the form of dividend and also it need not be disbursed to the shareholders. In calculation of cost of equity share capital, the earnings per share is divided by the current market price.

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E KE = ------- Po Where, E = Current earning per share Po = Market Price per share

CAPITAL ASSET PRICING MODEL (CAPM) : 

CAPITAL ASSET PRICING MODEL (CAPM) The CAPM divides the cost of equity into two components, the near risk free return available on investing in government bonds and an additional risk premium for investing in a particular share or investment. The risk premium in turn comprises the average return on the overall market portfolio and the beta factor (or risk) of the particular investment. Putting this all together the CAPM assesses the cost of equity for an investment as the following:

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Ke = Rf + β[Rm-Rf] Where, Rf = Risk free rate of return Rm = Average market return β = Beta of the investment

Cost of Retained Earnings (Kr) : 

Cost of Retained Earnings (Kr) The retained earnings is one of the major sources of finance available for the established companies to finance its expansion and diversification programmes. These are the funds accumulated over years of the company by keeping part of the funds generated without distribution. The equity shareholders of the company are entitled to these funds and sometimes, these funds are also taken into account while calculating the cost of equity. But so long as the retained profits are not distributed to the shareholders, the company can use the funds within the company for further profitable investment opportunities. Hence cost of equity includes retained earnings.

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The cost of retained earnings to the shareholders is basically an opportunity cost of such funds to them. It is equal to the income that they would otherwise obtain by placing these funds in alternative investment. The cost of retained earnings is determined based on the opportunity rate of earnings of equity shareholders which is being forgone continuously. If bthe retained earnings are distributed to the equity shareholders attract personal taxation of the individual shareholders and therefore, the cost of earnings is calculates as follows :

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KE (1-T)(1-B) KR = ----------------- (1-TC) Where KR = Cost of retained earnings KE = Cost of equity capital T = Tax rate of individuals B = Brokerage TC = Tax on Capital Gain

WEIGHTED AVERAGE COST OF CAPITAL (WACC) : 

WEIGHTED AVERAGE COST OF CAPITAL (WACC) Cost of capital is the overall composite cost of capital may be defined as the average of the cost of each specific fund. Weighted average cost of capital (WACC) is defined as the weighted average of the cost of various sources of finance, weight being the market value of each source of finance outstanding cost of various sources of finance refers to the return expected by the respective investors. The CIMA defines the weighted average cost of capital “as the average cost of the company’s finance (equity, debentures, bank loans) weighted according to the proportion each element bears to the total pool of capital, weighting is usually based on market valuations current yields and costs after tax.”

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The argument in favour of using WACC stems from the concept that investment capital from various sources should be seen as a pool of available capital for all the capital projects of an organisation. Hence cost of capital should be weighted average cost of capital. Financing decision, which determines the optional capital mix, is traditionally made without making any reference to the acceptance or otherwise of a specific project. Similarly a specific project is evaluated without considering the mode of financing of that project. Optimal capital structure is assumed at a point where WACC is minimum. Thus, WACC gets much importance in decision making process.

VALUATION OF SECURITIES : 

VALUATION OF SECURITIES VALUE OF BOND WITH MATURITY: VALUE= PV OF INTEREST +PV OF MATURITY VALUE YIELD TO MATURITY = IRR OF BOND AT CURRENT MARKET PRICE. YIELD TO CALL = SAME AS YTM

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CURRENT YIELD = ANNUAL INTEREST MARKET PRICE OF BOND VALUE OF DEEP DISCOUNT BOND = MATURITY VALUE x PVF

VALUATION OF EQUITY SHARES : 

VALUATION OF EQUITY SHARES SINGLE PERIOD VALUATION: i.e where the shares are to be sold in one year. Po = (Div. +P1) 1+Ke i.e. Pv of div and price at the end of year1

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Multi period Valuation i.e where the shares are to be held for more than one year. Po =(Div1) + (Div2) + ……. (Divn +Pn) 1+Ke (1+Ke)2 (1+Ke)n i.e. Pv of div and price to be recd. Over no. of years

Multi period Valuation : 

Multi period Valuation Where there is growth in dividend: Constant Growth: Po = DIV1 (Ke - g) G = growth rate

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Variable Growth: Po= pv of div and price at the end of year n

DIVIDEND POLICIES : 

DIVIDEND POLICIES RELEVANCE APPROACH- WALTER METHOD P = D + (r/ke)(E-D) ke ke

GROWTH MODEL : 

GROWTH MODEL GORDON’S MODEL: P = E(1-b) ke- br

IRRELEVANCE APPROACH : 

IRRELEVANCE APPROACH MODIGILANI MILLER MODEL: Po = (D1+P1) (1+Ke)

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