Financial Management Set 2

7/30/2019 Financial Management Set 2

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Assessment set 2 Mb0045

Q4. Examine the importance of capital budgeting?

Ans.

Capital budgeting (or investment appraisal) is the planning process used to determine whether an

organization's long terminvestments such as new machinery, replacement machinery, new plants,new products, and research development projects are worth pursuing. It is budget for majorcapital,or investment, expenditures.

Many formal methods are used in capital budgeting, including the techniques such as

Accounting rate of return

Net present value

Profitability index

Internal rate of return

Modified internal rate of return

Equivalent annuityThese methods use the incremental cash flows from each potential investment, orproject.Techniques based on accounting earnings and accounting rules are sometimes used - thougheconomists consider this to be improper - such as the accounting rate of return, and "return oninvestment." Simplified and hybrid methods are used as well, such aspayback periodanddiscounted payback period.

Net present valueEach potential project's value should be estimated using adiscounted cash flow (DCF) valuation, tofind its net present value (NPV). (First applied to Corporate Financeby Joel Dean in 1951; see alsoFisher separation theorem,John Burr Williams: Theory.) This valuation requires estimating the size

and timing of all the incremental cash flows from the project. (These future cash highest NPV(GE).)The NPV is greatly affected by thediscount rate, so selecting the proper rate - sometimes called thehurdle rate - is critical to making the right decision. The hurdle rate is theMinimum acceptable rateof return on an investment. This should reflect the riskiness of the investment, typically measured

by thevolatility of cash flows, and must take into account the financing mix. Managers may usemodels such as the CAPM or the APTto estimate a discount rate appropriate for each particular

project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected.A common practice in choosing a discount rate for a project is to apply a WACC that applies to theentire firm, but a higher discount rate may be more appropriate when a project's risk is higher thanthe risk of the firm as a whole.

Internal rate of returnThe internal rate of return (IRR) is defined as thediscount rate that gives a net present value(NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually exclusive)projects in an unconstrained environment, in the usual cases where a negative cash flow occurs atthe start of the project, followed by all positive cash flows. In most realistic cases, all independent

projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutuallyexclusive projects, the decision rule of taking the project with the highest IRR - which is often used- may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists

and is unique if one or more years of net investment (negative cash flow) are followed by years ofnet revenues. But if the signs of the cash flows change more than once, there may be several IRRs.The IRR equation generally cannot be solved analytically but only via iterations.
http://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Capital_(economics)http://en.wikipedia.org/wiki/Accounting_rate_of_returnhttp://en.wikipedia.org/wiki/Net_present_valuehttp://en.wikipedia.org/wiki/Profitability_indexhttp://en.wikipedia.org/wiki/Internal_rate_of_returnhttp://en.wikipedia.org/wiki/Modified_internal_rate_of_returnhttp://en.wikipedia.org/wiki/Equivalent_Annual_Costhttp://en.wikipedia.org/wiki/Return_on_investmenthttp://en.wikipedia.org/wiki/Return_on_investmenthttp://en.wikipedia.org/wiki/Payback_periodhttp://en.wikipedia.org/wiki/Payback_periodhttp://en.wikipedia.org/wiki/Discounted_cash_flowhttp://en.wikipedia.org/wiki/Discounted_cash_flowhttp://en.wikipedia.org/wiki/Net_present_valuehttp://en.wikipedia.org/wiki/Corporate_Financehttp://en.wikipedia.org/wiki/Corporate_Financehttp://en.wikipedia.org/wiki/Joel_Dean_(economist)http://en.wikipedia.org/wiki/Fisher_separation_theoremhttp://en.wikipedia.org/wiki/Discount_ratehttp://en.wikipedia.org/wiki/Discount_ratehttp://en.wikipedia.org/wiki/Discount_ratehttp://en.wikipedia.org/wiki/Minimum_acceptable_rate_of_returnhttp://en.wikipedia.org/wiki/Minimum_acceptable_rate_of_returnhttp://en.wikipedia.org/wiki/Minimum_acceptable_rate_of_returnhttp://en.wikipedia.org/wiki/Volatility_(finance)http://en.wikipedia.org/wiki/Volatility_(finance)http://en.wikipedia.org/wiki/Capital_asset_pricing_modelhttp://en.wikipedia.org/wiki/Arbitrage_pricing_theoryhttp://en.wikipedia.org/wiki/Arbitrage_pricing_theoryhttp://en.wikipedia.org/wiki/Weighted_average_cost_of_capitalhttp://en.wikipedia.org/wiki/Internal_rate_of_returnhttp://en.wikipedia.org/wiki/Discount_ratehttp://en.wikipedia.org/wiki/Discount_ratehttp://en.wikipedia.org/wiki/Net_present_valuehttp://en.wikipedia.org/wiki/Capital_(economics)http://en.wikipedia.org/wiki/Accounting_rate_of_returnhttp://en.wikipedia.org/wiki/Net_present_valuehttp://en.wikipedia.org/wiki/Profitability_indexhttp://en.wikipedia.org/wiki/Internal_rate_of_returnhttp://en.wikipedia.org/wiki/Modified_internal_rate_of_returnhttp://en.wikipedia.org/wiki/Equivalent_Annual_Costhttp://en.wikipedia.org/wiki/Return_on_investmenthttp://en.wikipedia.org/wiki/Return_on_investmenthttp://en.wikipedia.org/wiki/Payback_periodhttp://en.wikipedia.org/wiki/Discounted_cash_flowhttp://en.wikipedia.org/wiki/Net_present_valuehttp://en.wikipedia.org/wiki/Corporate_Financehttp://en.wikipedia.org/wiki/Joel_Dean_(economist)http://en.wikipedia.org/wiki/Fisher_separation_theoremhttp://en.wikipedia.org/wiki/Discount_ratehttp://en.wikipedia.org/wiki/Minimum_acceptable_rate_of_returnhttp://en.wikipedia.org/wiki/Minimum_acceptable_rate_of_returnhttp://en.wikipedia.org/wiki/Volatility_(finance)http://en.wikipedia.org/wiki/Capital_asset_pricing_modelhttp://en.wikipedia.org/wiki/Arbitrage_pricing_theoryhttp://en.wikipedia.org/wiki/Weighted_average_cost_of_capitalhttp://en.wikipedia.org/wiki/Internal_rate_of_returnhttp://en.wikipedia.org/wiki/Discount_ratehttp://en.wikipedia.org/wiki/Net_present_valuehttp://en.wikipedia.org/wiki/Investment


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One shortcoming of the IRR method is that it is commonly misunderstood to convey the actualannual profitability of an investment. However, this is not the case because intermediate cash flowsare almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almostcertainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return(MIRR) is often used.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over

NPV although they should be used in concert. In a budget-constrained environment, efficiencymeasures should be used to maximize the overall NPV of the firm. Some managers find itintuitively more appealing to evaluate investments in terms of percentage rates of return than dollarsof NPV.

Equivalent annuity methodThe equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the

present value of the annuity factor. It is often used when assessing only the costs of specific projectsthat have the same cash inflows. In this form it is known as the equivalent annual cost(EAC)

method and is the cost per year of owning and operating an asset over its entire lifespan.It is often used when comparing investment projects of unequal life spans. For example if project Ahas an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would beimproper to simply compare the net present values (NPVs) of the two projects, unless the projectscould not be repeated.

The use of the EAC method implies that the project will be replaced by an identical project.

Alternatively the chain methodcan be used with theNPV method under the assumption that theprojects will be replaced with the same cash flows each time. To compare projects of unequallength, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3 year

project are compare to three repetitions of the 4 year project. The chain method and the EACmethod give mathematically equivalent answers.

The assumption of the same cash flows for each link in the chain is essentially an assumption ofzeroinflation, so a real interest raterather than a nominal interest rate is commonly used in thecalculations.

Real optionsReal options analysis has become important since the 1970s asoption pricing models have gottenmore sophisticated. The discounted cash flow methods essentially value projects as if they wererisky bonds, with the promised cash flows known. But managers will have many choices of how to

increase future cash inflows, or to decrease future cash outflows. In other words, managers get tomanage the projects - not simply accept or reject them. Real options analysis try to value thechoices - the option value - that the managers will have in the future and adds these values to the

NPV.

Ranked ProjectsThe real value of capital budgeting is to rank projects. Most organizations have many projects thatcould potentially be financially rewarding. Once it has been determined that a particular project hasexceeded its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index

to lowest Profitability index). The highest ranking projects should be implemented until thebudgeted capital has been expended.
http://en.wikipedia.org/wiki/Modified_Internal_Rate_of_Returnhttp://en.wikipedia.org/wiki/Net_present_valuehttp://en.wikipedia.org/wiki/Net_present_valuehttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Real_interest_ratehttp://en.wikipedia.org/wiki/Real_interest_ratehttp://en.wikipedia.org/wiki/Nominal_interest_ratehttp://en.wikipedia.org/wiki/Real_optionshttp://en.wikipedia.org/wiki/Valuation_of_optionshttp://en.wikipedia.org/wiki/Valuation_of_optionshttp://en.wikipedia.org/wiki/NPVhttp://en.wikipedia.org/wiki/Profitability_indexhttp://en.wikipedia.org/wiki/Modified_Internal_Rate_of_Returnhttp://en.wikipedia.org/wiki/Net_present_valuehttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Real_interest_ratehttp://en.wikipedia.org/wiki/Nominal_interest_ratehttp://en.wikipedia.org/wiki/Real_optionshttp://en.wikipedia.org/wiki/Valuation_of_optionshttp://en.wikipedia.org/wiki/NPVhttp://en.wikipedia.org/wiki/Profitability_index


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Funding SourcesWhen a corporation determines its capital budget, it must acquire said funds. Three methods aregenerally available to publicly traded corporations:corporate bonds,preferred stock, and commonstock. The ideal mix of those funding sources is determined by the financial managers of the firm

and is related to the amount offinancial riskthat corporation is willing to undertake. Corporatebonds entail the lowest financial risk and therefore generally have the lowest interest rate. Preferredstock have no financial risk but dividends, including all in arrears, must be paid to the preferredstockholders before any cash disbursements can be made to common stockholders; they generallyhave interest rates higher than those of corporate bonds. Finally, common stocks entail no financialrisk but are the most expensive way to finance capital projects. The Internal Rate of Return is veryimportant.

IMPORTANCE OF CAPITAL BUDGETING

1. Long-term Implications: A capital budgeting decision has its effect over a long time span andinevitably affects the companys future cost structure and growth. A wrong decision can prove

disastrous for the long-term survival of firm. On the other hand, lack of investment in asset wouldinfluence the competitive position of the firm. So the capital budgeting decisions determine thefuture destiny of the company.

2. Involvement of large amount of funds: Capital budgeting decisions need substantial amount ofcapital outlay. This underlines the need for thoughtful, wise and correct decisions as an incorrectdecision would not only result in losses but also prevent the firm from earning profit from otherinvestments which could not be undertaken.

3. Irreversible decisions: Capital budgeting decisions in most of the cases are irreversible becauseit is difficult to find a market for such assets. The only way out will be scrap the capital assets soacquired and incur heavy losses.

4. Risk and uncertainty: Capital budgeting decision is surrounded by great number ofuncertainties. Investment is present and investment is future. The future is uncertain and full ofrisks. Longer the period of project, greater may be the risk and uncertainty. The estimates aboutcost, revenues and profits may not come true.

5. Difficult to make: Capital budgeting decision making is a difficult and complicated exercise forthe management. These decisions require an overall assessment of future events which areuncertain. It is really a marathon job to estimate the future benefits and cost correctly in quantitative

terms subject to the uncertainties caused by economic-political social and technological factors.

Kinds of capital budgeting decisions:

Generally the business firms are confronted with three types of capital budgeting decisions.

(i) The accept-reject decisions;

(ii) Mutually exclusive decisions;

(iii) Capital rationing decisions.
http://en.wikipedia.org/wiki/Corporate_bondshttp://en.wikipedia.org/wiki/Corporate_bondshttp://en.wikipedia.org/wiki/Preferred_stockhttp://en.wikipedia.org/wiki/Preferred_stockhttp://en.wikipedia.org/wiki/Common_stockhttp://en.wikipedia.org/wiki/Common_stockhttp://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Dividendshttp://en.wikipedia.org/wiki/Corporate_bondshttp://en.wikipedia.org/wiki/Preferred_stockhttp://en.wikipedia.org/wiki/Common_stockhttp://en.wikipedia.org/wiki/Common_stockhttp://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Dividends


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1. Accept-reject decisions: Business firm is confronted with alternative investment proposals. Ifthe proposal is accepted, the firm incur the investment and not otherwise. Broadly, all thoseinvestment proposals which yield a rate of return greater than cost of capital are accepted and theothers are rejected. Under this criterion, all the independent proposals are accepted.

2. Mutually exclusive decisions: It includes all those projects which compete with each other in away that acceptance of one precludes the acceptance of other or others. Thus, some technique has to

be used for selecting the best among all and eliminates other alternatives.

3. Capital rationing decisions: Capital budgeting decision is a simple process in those firms wherefund is not the constraint, but in majority of the cases, firms have fixed capital budget. So largeamount of projects compete for these limited budgets. So the firm rations them in a manner so as tomaximize the long run returns. Thus, capital rationing refers to the situations where the firm hasmore acceptable investment requiring greater amount of finance than is available with the firm. It isconcerned with the selection of a group of investment out of many investment proposals ranked inthe descending order of the rate or return.

Q. no.5

CAPITAL RATIONING

Generally, firms fix up maximum amount that can be invested in capital projects, during a

given period of time, say a year. The firm then attempts to select a combination of

investment proposals that will be within the specific limits providing maximum profitability

and ranks them in descending order according to their rate of return; such a situation is of

capital rationing.

A firm should accept all investment projects with positive NPV, with an objective

to maximize the wealth of shareholders. However, there may be resource constraints due

to

which a firm may have to select from among various projects. Thus there may

arise a situation of capital rationing where there may be internal or external

constraints on procurement of necessary funds to invest in all investment proposals with

positive NPVs.

Capital rationing can be experienced due to external factors, mainly imperfections in

capital markets which can be attributed to non-availability of market information, investor

attitude etc. Internal capital rationing is due to the self-imposed restrictions imposed by

management like not to raise additional debt or laying down a specified minimum rate of

return on each project.

There are various ways of resorting to capital rationing. For instance, a firm may affect

capital rationing through budgets. It may also put up a ceiling when it has been financing

investment proposals only by way of retained earnings (sloughing back of profits). Since

the amount of capital expenditure in that situation cannot exceed the amount of retained


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earnings, it is said to be an example of capital rationing. Capital rationing may also be

introduced by following the concept of Responsibility

Accounting, whereby management may introduce capital rationing by authorising a

particular department to make investment only up to a specified limit, beyond which the

investment decisions are to be taken by higher-ups.The selection of project under capital rationing involves two steps:

a. To identify the projects which can be accepted by using the technique of evaluation

discussed above.

b. To select the combination of projects.

In capital rationing it may also be more desirable to accept several small investment

proposals than a few large investment proposals so that there may be full utilization of

budgeted amount.

This may result in accepting relatively less profitable investment proposals if full utilization

of budget is a primary consideration. Similarly, capital rationing may also mean that the

firm foregoes the next most profitable investment following after the budget ceiling even

though it is estimated to yield a rate of return much higher than the required rate of return.

Thus capital rationing does not always lead to optimum results.

Steps of Calculation:

Step 1: Calculation of cash outflow

Cost of project/asset xxxxTransportation/installation charges xxxx

Working capital xxxx

Cash outflow xxxx

Step 2: Calculation of cash inflow

Sales xxxx

Less: Cash expenses xxxx

PBDT xxxx

Less: Depreciation xxxx

PBT xxxx

Less: Tax xxxx

PAT xxxx

Add: Depreciation xxxx

Cash inflow p.a xxxx

Note:

Depreciation = Straight Line method

PBDT Tax is Cash inflow ( if the tax amount is given)

PATBD = Cash inflow

Cash inflow- Scrap and working capital must be added.


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Step 3: Apply the different techniques

Payback period= No. of years + Amt to recover/ total cash of next years.

ARR = Average Profits after tax/ Net investment x 100

NPV= PV of cash inflows PV of cash outflows

Profitability index = PV of cash inflows/ PV of cash outflows IRR :

Pay back factor: Cash outflow/ Avg cash inflow p.a.

Find IRR range

PV of Cash inflows for IRR range and then calculate IRR

Module-5: Dividend Decision

Meaning: The tern dividend refers to that part to that part of profits of a company which is

distributed by the company among its shareholders. It is the reward of the shareholders for

investments made by them in the shares of the company.

Dividend policy and significance of dividend policy

It refers to the policy that the management formulates in regard to earnings for distribution

as dividends among shareholders. It determines the division of earnings between

payments to shareholders and retained earnings.

Significance of dividend policy

The firm has to balance between the growth of the company and the distribution to the

shareholders

It has a critical influence on the value of the firm

It has to also to strike a balance between the long term financing decision( company

distributing dividend in the absence of any investment opportunity) and the wealth

maximisation

The market price gets affected if dividends paid are less.

Retained earnings helps the firm to concentrate on the growth, expansion and

modernization of the firm

To sum up, it to a large extent affects the financial structure, flow of funds, corporate

liquidity, stock prices, and growth of the company and investors satisfaction.

Factors influencing the dividend decision

Stability of earnings

Financing policy of the firm

Liquidity of funds

Dividend policy of competitive firms

Past dividend rates

Debt obligation


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Ability to borrow

Growth needs of the company

Profit rates

Legal requirements

Policy of control

Corporate taxation policy

Tax position of shareholders

Effect of trade policy

Attitude of the investor group

Stability of dividends/ regularity

It is the desirable policy of the management to distribute the shareholders a certain

percentage of earnings as a reward for their investment. It may not always relate to the

earnings of the company.

Dividend practices:

Constant dividend per share

Constant percentage of net earnings

Small constant dividend per share plus extra earnings

Dividend as a fixed percentage of market value

Significance of stability of dividend:

Confidence among shareholders

Investors desire for current income Institutional investors requirement

Stability in market prices of shares

Raising additional finances

Spreading of ownership of outstanding shares

Reduces the chances of loss of control

Market for debentures and preference shares.

Forms of Dividend

Scrip Dividend

Bond Dividend

Property Dividend

Cash Dividend

Debenture Dividend

Bonus share or Stock dividends

Optional Dividend

Objectives of stock dividend

Conservation of cash

Lower rate of dividend


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Financing expansion programmes

Transferring the formal ownership of surplus and reserves to the shareholders

Enhanced prestige

Widening share market

True presentation of earning capacity

Merits of Stock dividend

To the company

1. Maintenance of liquidity position

2. Satisfaction of shareholders

3. Economical issue of capitalisation

4. Remedy for under capitalisation

5. Enhance prestige

6. Widening the share for market

7. Finance for expansion programmes8. Conservation of control

To the shareholders

1. Increase in their equity

2. Marketability of shares increases

3. Increase in income

4. Increase demand for shares

Demerits of stock dividend

To the company

1. Increase in the capitalisation of the company

2. It results in more liability

3. Denies other investors to shareholders

4. Management control not diluted it may lead to fraud

To the shareholder

1. It lowers the market value

2. Shareholders prefers cash dividend

3. EPS also falls

Q. no 6.

WORKING CAPITAL MANAGEMENT

Concept of Working Capital

Like the broader concept of capital, there is no universally accepted definition of working capital. As GilbertHarold puts this problem, Unfortunately there is so much disagreement among financiers, accountants,

businessmen and economists as to the exact meaning of the term working capital. it is quite true. Variousfinancial theorists have used this term in a number of ways. Some explain it in a narrow sense while some

others in a very wide sense. In narrow sense, some authorities define the term as the difference betweencurrent assets and current liabilities. Other writers think of working capital as being equal to the total of thecurrent assets. On the other hand, some writers like Gerstenberg are not ready to call it as working capital.They prefer to all it as Circulating Capital so we shall have to go through the various concepts of working


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capital before reaching at any conclusion.

Definitions of working Capital

In the broad sense, the term working capital is used to denote the total current assets. The following aresome definitions of this group.

(1) Working Capital means current assets.

- Mead Baker Malott.(2) The sum of the current assets is the working capital of a business.

- J.S. Mill.(3) Any acquisition of funds which increases the current assets increase working capital also, for they

are one and the same.- Bonneville

(4) Working capital refers to a firms investment in short-term assets cash, short-term securities,accounts receivable and inventories.

- Weston & Brigham

In the narrow sense, the working capital is regarded as the excess of current assets over current

liabilities. This is the definition used by most financial experts and authors emphasizing the accountingphase of finance. They include the name of E.E. Lincoln, E.A. Saliers, and C.W. Gerstenberg etc.Gerstenberg defines it as follows : It has ordinarily been defined as the excess of current assets overcurrent liabilities.

Thus we see there is no difference in authorities over the true concept of working capital. the truedifference is on it quantity. The total current assets minus current liabilities approach refers to networking capital. the total current assets approach has a broader application and it is more inviting to thefinancial management. It takes into consideration all the current resources of the enterprise, fromwhatever source derived and their application to the current and future activities of the enterprise. In thewords of Walker and Bauglin. A good current ratio may mean a good umbrella for creditors againstrainy day, but to the management it reflects and financial planning or presence of ideal assets or overcapitalisation. Actually speaking, a successful financial executive is interested not in maintaining a

good current ratio but in maintaining an adjustable account assets so that the business may operatesmoothly. Thats if the term working capital is used without future qualification, it generally refers tothe gross working capital.

Kinds of Working Capital

Working capital can be classified on the basis of its composition. Thus, we can have gross workingcapital comprising current assets and net working capital representing current assets minus currentliabilities. From the viewpoint of the finance manager this basis of classification is helpful since itcategories the various areas of financial responsibility. For instance, funds invested in cash, inventoriesand receivable require careful planning and control if the firm is to maximize its return on investment.While the above classification is very significant to the financial management, it is not completelyadequate as it does not mention about time. Time is an important variable which influences pattern of

financing working capital requirements. Using times as a basis, working capital may be categorized aspermanent and variable working capital.

Permanent working capital represents current assets required on a continuous basis over the entire year.A manufacturing enterprise has to carry irreducible minimum amount of inventories necessary to ensurecontinued production and sales. Likewise, some amount of funds lie tied in receivables where the firmsells goods on credit terms. Some amount of cash has also to be held by the firm so as a to exploit

business fluctuations. Thus, minimum amount of current assets which firm has to hold for all the time tocome to carry on operations at any time is termed as permanent or regular working capital. It representshare core of the working capital. permanent working capital changes constantly its form from one assetto another whereas fixed assets retain their form over a long period of time. Further, fund of valuerepresenting permanent working capital never leaves the business process and therefore, the suppliersshould not expect its return until the business ceases to exit. Finally, permanent working capital will tend

to expand so long as the firm experiences growth in its operation.Over and above permanent working capital, the firm may need additional current assets temporarily tosatisfy seasonal/cyclical demands. Thus, for example, added inventory must be held to support the peak


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selling periods. Receivable increase following periods of high sale. Extra cash may be need to pay foradditional supplies following expansion in business activity. Similarly, in periods of dull businessconditions when most of the produce remains held in stock due to precipitate fall in demand, thecompany would require additional cash to tide over the crises. Excess amount of working capital may becarried to face cut-throat competition or any other contingencies like strikes and lockouts.This additional amount of working capital represents variable or temporary working capital, size ofwhich depends upon changes in levels of production and sales resulting from changes in market

conditions. Funds requirements for this purpose are of short duration.

Importance of Working Capital

Working Capital is just like the heart of business. If it becomes weak, the business can hardly prosperand survive. It is an index of the solvency of a concern. Its proper circulation provides to the business theright account of cash to maintain regular flow of its operations. The following are the some worthmentioning advantages of maintaining an ample working capital fund in the business.-

(1) Cash Discount If proper cash balance is maintained, the business can avail of the cash discountsfacilities offered to it by the suppliers.

(2) Liquidity and Solvency The proper administration of working Capital enhances the liquidity infunds and solvency and credit worthiness of the concern.

(3) Meeting unseen Contingencies It Provides Funds for unseen emergencies so that a business cansuccessfully said through the periods of crisis.(4) High Morale The provision of adequate working capital improves the morale of the executive and

their efficiency reaches it highest climax.

(5) Good Bank Relations Good relations with banks can also be maintained. The enterprise bymaintaining an adequate amount of working capital is able to maintain a sound bank credit, tradecredit and can escape insolvency.

(6) Fixed Assets Efficiency Incurred Fixed assets of the firm also can not work without properamount of working capital. without it, fixed assets are like guns which can not shoot as there areno cartridges.

(7) Research and Innovation Programmes No research programme, innovation and technicaldevelopments are possible to undertake without sufficient among of working capital.

(8) Expansion Facilitated The expansion programme of a firm is highly successful, if it is financedthrough own working capital.

(9) Profitability Increased The profitability of a concern also depends, in no small measure, on theright proportion of fixed assets and current assets. Every activity of the business directly orindirectly affects the current position of the enterprise hence its needs should be properlyestimated and calculated.

Thus the need for maintain an adequate working capital can hardly be questioned. Just as circulation of bloodis very necessary in the human body to maintain life, smooth flow of funds is very necessary to maintain thehealth of the enterprise. The importance of working capital can be very well explained in the words ofHusband and Dockery : The price object of management is to make a profit. Whether or not thisaccomplished in most business depends largely on the manner in which the working capital is administered.

Determinants of Working Capital (The amount of working capital)

There are numerous factors which affect the working capital of a concern, the appraisal of which assetsmanagement in formulating its policies and estimating its prospective requirements. The important factorsare as follows:

(1) Nature of Business The effect of the general nature of the business on the working capitalrequirements can not be exaggerated. Rail roads, and other, public utility services have largefixed investment, so they have the lower requirements for current assets. Industrial andmanufacturing enterprises on the other hand, generally required a large amount of workingcapital. A rapid turnover of capital (sales divided by total assets) will inevitably meant a larger

proportion of current assets.

(2) Production Policies The nature of production policy also exercises its impact on capital needs.Strong seasonal movement have special workings capital problems and requirements. A highlevel production plan also involves higher investment in working capital.

(3) The proportion of the cost of Raw Materials to Total Costs In those industries where cost of


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materials is a large proportion of the total cost of the goods produced or where costly rawmaterial is used, requirements of working capital will be rather large. But if the importance ofraw materials is small, the requirements of working capital will naturally be small.

(4) Length of period of manufacture The time which elapses between the commencement andend of the manufacturing process has an important being upon the requirements of workingcapital. if it takes long to manufacture the finished project, naturally a large sum of money willhave to be kept invested in the form of working capital.

(5) Rapidity of Turnover Turnover represents the speed with which the working capital isrecovered by the sale of goods.In certain business, sales are made quickly so that stocks aresoon exhausted and new purchases have to be made. In this manner, a small sum of moneyinvested in stocks will result in sales of a much large amount. It will reduce the requirements ofmore working capital.

(6) Terms of Purchases If continuous credit is allowed by supplier, payment can be postponed forsome time and can be made out of the sale proceeds of the goods produced. In such a case therequirements of working capital will be reduced. The period of credit received and allowed alsodetermines the working capital requirements of the enterprise.

(7) Growth with Expansion of Business As a company gross, it is logical to except the largeramount of working capital will be required. Growing concerns require more working capital than

those that are static. The requirement of working capital also varies with economiccircumstances and corporate practices.

(8) Business Cycles Requirements of working capital also very with the business cycles. Whenthe price level is up due to boom conditions, he inflationary conditions create demand for moreworking capital. During depression also a heavy amount of working capital is needed due to theinventories being locked unsold and book debts uncollected.

(9) Requirements of Cash The working capital requirements of a company is also influenced bythe amount of cash required by it for various purposes. The greater the requirements of cash, thehigher will be the working capital costs of the company.

(10) Dividend Policy of the Concern If conservative divided policy is followed by themanagement the needs of working capital can be met with the retained earnings. Often variationsin need, of working capital bring about an adjustment of dividend policy. The relationship

between divided policy and working capital is well established and mostly companies declaredivided after careful study of cash requirements.

(11) Other Factors In addition to the above considerations there are a number of other factorsaffecting the requirements of working capital, for example, lack of co-ordination in productionand distribution policies, the fiscal and tariff policies of the government etc.

A prudent financial manager is always manger is always interested in obtaining the correct amount of theworking capital at the right time, at a reasonable cost at the best possible favourable terms. To adopt the rightsources it is very necessary for him to have a through understanding of the firms short-term funds needs,market for short-term funds, required level of liquidity in funds and risk assumption. A firm interested toobtain short-term funds has a choice of securing finance from alternative sources internal as well asexternal. In making any final choice as regards to sources of working capital the relative cost of financing,

dependability upon the source and flexibility in financial planning must be given due weightgae.

Sources of Working Capital :

The following chart gives a snapshot view of various sources of working capital available for a firm:

Working Capital SourcesLong term Sources Short term sources

1. Sale of shares2. Sale of debentures

Internal3. Ploughing back of

profits4. Sale of idle fixed5. Long-term loans

1. Depreciation funds2. Provision for taxation3. Accrued expenses

1. Trade Credit2. Credit papers3. Bank credit4. Public deposits5. Customers credit6. Govt. Assistance7. Loans from Directors etc.8. Security of Employees9. Factoring


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Financing of Long-tem working Capital

The long-term working capital requirements include the initial working capital and the regular workingcapital. along with it, the minimum level of investment in various current assets also determines therequirement of long-term working capital. This capital can be conveniently financed by the followingsources

(1) Share Capital A part of long-term working capital can be financed with the share capital.(2) Sale of Debentures Debentures are also an important source of long-tern working capital because

they are fixed cost sources. Rights Debentures have also been very popular in India since 1978.

(3) Ploughing back of profits A part of the earned profits may be ploughed back by the firm inmeeting their working capital requirements. It is regular and cheapest sources of working capital as itdoes not involve any explicit cost of capital.

(4) Sale of Fixed Assets Any idle fixed asset can be sold out and sale proceeds can be utilized for

financing the working capital requirements.(5) Term Loans - The loans raised for a period varying from 3 to 5-7 years are also important sources

for working capital. this type of finance is ordinarily repayable in installments. Such loan usuallyincreases the working capital of the enterprises.

Financing of short-term Working Capital

This category of funds covers the need of working capital for financing day-to-day business requirements.Normally, the duration of such requirements does not exceed beyond a year. The sources of short-termworking capital may be internal as well as external.

(a) Internal Sources

(1) Depreciation Funds The depreciation funds constitute important source for working capital. someauthors of business finance do not accept them as a source of funds but it is not reasonable.

(2) Provision for Taxation The provisions for taxation can also be used by the companies as a sourceof working capital during the intermitant periods.

(3) Accrued Expenses The firm can postpone the payment of expanses for short periods. Hence theseaccrued expenses also constitute an important source of working capital.

(b) External Sources

(1) Trade Credit One of the most important forms of short term finance is the trade credit extendedby one business enterprise to another on the purchase and sale of goods and equipment. The use oftrade credit has increased in recent years due mainly perhaps to the credit squeeze. The trade creditmay also assume three forms :purchase on open account, purchasing on furnishing a pronote forspecified period and purchase on trade acceptance (i.e. bills payable)

(2) Bank Credit Commercial banks are also principal source of working capital. they providedworking capital in a number of ways such as overdrafts, cash credits, line of credit, short term loansetc. Compared with other methods of borrowing this is the most flexible source because when thedebt is no longer required it can be quickly and early reduced. It is also comparatively cheap.

(3) Credit Papers In the category of credit papers, bills of exchange and promissory notes of shorterduration varying between a month and six months are used. These papers are discounted with a bankand capital can be arranged. Accommodation bills is an important method of such finance.

(4) Public Deposit Public deposits are also an important source of shot-term and medium termfinance. Due to shortages of bank credit in recent past, the importance of public deposits hasincreased. They have been very popular among Indian companies during last three years.

(5) Customers Credit Advances may also be obtained on contracts entered into by the enterprise.The customers are often asked to make some advance payment in cash in lieu of a contract to

purchase. Such advance can be utilized in purchasing raw material paying wages and so on.

(6) Governmental Assistance Sometimes, central and state governments also provide short-termfinance on easy terms.


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(7) Loans from Directors etc. An enterprise can also obtain loans from it officers, directors,managing directors etc. These loans are often obtained at almost negligible rates of interest. Sometimes, no interest is charges on them. Loans an also to obtained from other fellow companiesworking within the same group.

(8) Security of Employee - If employees are required to make deposits with their employercompanies, such companies can utilize those amounts in meeting their working capital needs.

(9)Factoring Factoring involves raising funds on the security of the companys debts, so that cash is

received earlier than it the company waited of the debtors to pay. Thus the factors help in improvingthe companys liquidity position. But this finance is not cheap in comparison to bank credit etc.

The forecast of working capital requirements of a concern is not an easy job. The concept of working capitalis closely related to that current assets. So, some experts of finance suggest that in estimations the workingcapital requirements, the total current assets requirement should be forecasted. But, however, is contention isnot justified on logic as the short term needs of the funds are equally vitally affected by the nature andcomposition of fixed assets. Hence, the problem of working capital forecast should be dealt within theoverall financial requirements of the concern.

Forecasting Techniques of Working Capital

If the working capital is to be estimated for the ensuring year, then the current requirements of the assets and

cash flow for that period are to be estimated. The study of cash flow will reveal how much cash is availableto meet the current assets requirements. The basic object of forecasting working capital needs is either tomeasure the cash position of the enterprise or to exercise control over the liquidity position of the concern.But, the circular flow of working capital does not occur automatically and it is the essential responsibility ofmanagement to guide it in proper proportions through the production machine.There are three popular methods available for forecasting working capital requirements:

(a) Cash Forecasting Method In this method the position of cash at the end of the period is shownafter considering the receipts and payments to be made during that period. Its form assuring more orless a summary of cashbook. This shows the deficiency or surplus of cash at the definite point oftime.

(b) The Balance Sheet Method In the balance sheet method of forecasting, a forecast it made of thevarious assets and liabilities of the business. Afterwards, the difference between the two is taken

which will indicate either cash surplus or cash deficiency.(c) Profit and Loss Adjustment Method Under this method the forecasted profits are adjusted after

adding the cash inflow and deducting the cash outflows. The basic idea under method is to adjust theestimated profits on cash basis.

A forecast of working capital requirements can also be called a working capital budget. The main object ofpreparing a working capital budget is to source an effective utilization of the investment in current assets. Itshows the behaviour of working capital with the volume of output or estimated sales.Estimating Working Capital Requirements

In order to determine the amount of working capital needed by a firm, a number of factors viz. Productionpolicies, nature of business, length of manufacturing process, credit policy, rapidity of turn-over, seasonalfluctuation, etc. are to be considered by the Financial Manager. Besides this a Finance Manager can apply

any of the following techniques for assessing the working capital requirement of a firm.Techniques for assessment of Working Capital Requirements. Following is a brief explanation for thevarious techniques for assessment of a firms working Capital requirements.

1. Estimation of Components of Working Method : Since Working capital is the excess of current assetsover current liabilities, an assessment of the working capital requirements can be made byestimating the amounts of different constituents of working capital e.g., inventories, accountsreceivable, cash, accounts payable etc.

2. Percent of Sales Method: This is a traditional and simple method of estimating working capitalrequirements. According to this method, on the basis of pas experience between sales and workingcapital requirements, a ratio can be determined for estimating the working capital requirements infuture. For example, if the past experience show that working capital has been 30% of sales and its is

estimated that the sales for the next year would amount to Rs. One lack, the amount of workingcapital requirement can be assessed as Rs. 30,00The basic criticism of this method that it presumes a linear relationship between sales and working


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capital. This is not true in all cases san method is nto universally accepted.

3. Operating Cycle Approach : According to this approach, the requirements of working capitaldepends upon the operating cycle of the business. The operating cycle begins with the acquisition ofraw materials and ends with the collection of receivables. It may be broadly classified into thefollowing four stages viz.(i) Raw materials and stores stage;(ii) Work-in progress stage;(iii) Finished goods inventory stage; and(iv) Receivable collection stage;

The duration of the operating cycle for the purpose of estimating working capital requirements is equivalentto the sums of the duration of each of these stages less the credit period allowed by the suppliers of the firms.Symbolically, the duration of the working capital cycle can be put as follows:

O = R + W + F + D CWhere,O = Duration of opening cycleR = Raw materials and stores storage period;W = Work in process period;

F = Finished stock storage period;D = Debtors collection period;C = Creditors payment period.Each of the component of the operating cycle can be calculated as follows:

Average stock of raw materials and storesR = ---------------------------------------------------------------------------------Average Raw Materials and stores consumption per day

Average work in process inventoryW = --------------------------------------------------------------------------------

Average cost of production per day

Average finished stock inventoryF = ---------------------------------------------------------------------------------

Average cost of goods sold per day

Average book debtsD = ----------------------------------------------------

Average credit sales per day

Average trade creditorsC = ----------------------------------------------------

Average credit purchases per day

After computing the period of one operating cycle, total number of operating cycles that can be completedduring a year can be computed by dividing 365 days with the number of operating days in a cycle. The totaloperating expenditure in the year when divided by the number of operating cycles in a year will give theaverage amount of the working capital requirements.

Approaches for Determining the Finance Mix

There are three approaches for determining the working capital financing mix.

(i) The hedging approach According to this approach, the maturity of sources of funds shouldmatch the nature of assets to be financed. The approach is therefore also termed as MatchingApproach. It divides the requirements of total working capital funds into two categories.

a. Permanent Working Capital, i.e. funds required for purchase of core current assets. Suchfunds do not vary over time.

b. Temporary or Seasonal Working Capital, i.e. funds which fluctuate over time.


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The permanent working capital requirements should be financed by long-term funds while the seasonalworking capital requirements should be financed out of short-term funds.

(ii) The Conservative Approach According to this approach all requirements of funds should bemeet from long-term sources. The short-term sources should be used only for emergencyrequirements.The conservative approach is less risky, but mote costly as compared to the hedging approach. Inother words conservative approach is low profit low risk (or high cost, high net workingcapital) while hedging approach results in high profit-high risk (for low cost, low net workingcapital).

(iii) Trade-off between hedging and conservative approached. The hedging and

conservative approach are both on two extremes. Neither of them can therefore help in

efficient working capital measurement. A trade-off between these two can give

satisfactory results. The level of such trade-off will differ from case to case depending

upon perception of the risky by the persons involved in financial decision- making.

However, one way of determining the level of trade-off is by finding the average working

capital so obtained may be financed by long-term funds and the balance by short-termfunds. For example, if during the quarter ending 31 st March, the minimum working

capital required is estimated at Rs. 10,000 while the maximum at Rs. 15,000, the

average level comes to Rs. 12,500 [i.e. (10,000 + 15,000) 2]. The firm should therefore

finance Rs. 12,000 from long-term sources while any extra capital required any time

during the period, from short-term sources while any extra capital required any time

during the period, from short-term sources (i.e., current liabilities)

Q. no.1

WEIGHTED AVERAGE COST OF CAPITAL

(WACC)

The firms WACC is the cost of Capital for the firms mixture of debt andstock in their capital structure.

WACC = wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. stock)

So now we need to calculate these to find the WACC!


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wd = weight of debt (i.e. fraction of debt in the firms capital structure)

ws = weight of stock

wp= weight of prefered stock

COST OF DEBT (Kd)

We use the after tax cost of debt because interest payments are tax

deductible for the firm.

Kd after taxes = Kd (1 tax rate)

EXAMPLE

wd

ws

w

p

Think of the firms

capital structure as a

pie, that you can slice

into different shaped

pieces. The firm strives

to pick the weights of

debt and equity (i.e. slicethe pie) to minimize the

cost o ca ital.

THE FIRMS

CAPITAL

STRUCTURE IS

THE MIX OF DEBT

ND EQUITY

USED TO

FINANCE THE


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If the cost of debt for Cowboy Energy Services is 10% (effective rate) andits tax rate is 40% then:

Kd after taxes = Kd (1 tax rate)

= 10 (1 0.4) = 6.0 %

We use the effective annual rate of debt based on current market conditions(i.e. yield to maturity on debt). We do not use historical rates (i.e. interest

rate when issued; the stated rate).

Cost of Preferred Stock (Kp)

Preferred Stock has a higher return than bonds, but is less costly thancommon stock. WHY?

In case of default, preferred stockholders get paid before common stockholders. However, in the case of bankruptcy, the holders of preferred stockget paid only after short and long-term debt holder claims are satisfied.

Preferred stock holders receive a fixed dividend and usually cannot voteon the firms affairs.

preferred stock dividend

Kp = market price of preferred stock


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Kp = market price of preferred stock (1 flotation cost)

Unlike the situation with bonds, no adjustment is made for taxes, becausepreferred stock dividends are paid after a corporation pays income taxes.Consequently, a firm assumes the full market cost of financing by issuing

preferred stock. In other words, the firm cannot deduct dividends paid asan expense, like they can for interest expenses.

Example

If Cowboy Energy Services is issuing preferred stock at $100 per share,with a stated dividend of $12, and a flotation cost of 3%, then:


Kp = market price of preferred stock (1 flotation cost)

$12

= $100 (1-0.03) = 12.4 %

Cost of Equity (i.e. Common Stock & Retained Earnings)

The cost of equity is the rate of return that investors require to make anequity investment in a firm. Common stock does not generate a tax benefitas debt does because dividends are paid after taxes.

The cost of common stock is the highest. Why?

Retained earnings are considered to have the same cost of capital as newcommon stock. Their cost is calculated in the same way, EXCEPT that no


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adjustment is made for flotation costs.

3 Ways to Calculate

1. Use CAPM

2. (GORDON MODEL) The constant dividend growth model same asDCF method

3. Bond yield plus risk premium

1. Ks using CAPM (capital asset pricing model)


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The CAPM is one of the most commonly used ways to determine the costof common stock. This cost is the discount rate for valuing commonstocks, and provides an estimate of the cost of issuing common stocks.

Ks = Krf+ (Km - Krf)

Where: Krf is the risk free rate

is the firms beta

Km is the return on the market

EXAMPLE:

Cowboy Energy Services has a B = 1.6. The risk free rate on

T-bills is currently 4% and the market return has averaged 15%.

Ks = Krf+ (Km - Krf)

= 4 + 1.6 (15 4) = 21.6 %

For information on estimating the cost of equity based on the dividendgrowth model, or the bond-yield plus risk premium, refer to the

background readings textbook.


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WACC: PUTTING IT ALL TOGETHER

RECALL:

WACC = wd (cost of debt after tax) + ws (cost of stock/RE) + wp(cost of PS)

EXAMPLE

Cowboy Energy Services maintains a mix of 40% debt, 10% preferredstock, and 50% common stock in its capital structure. The WACC is:

WACC = 0.4(6%) + 0.1 (12.4) + 0.5(21.6)

= 2.4 + 1.24 + 10.8

= 14.4 %

Reminder: Read the article: Best Practices in Estimating the Cost of

Capital: Survey and Synthesis. It provides excellent information on howsome of the most financially sophisticated companies and financialadvisers estimate capital costs.

Determining the Weights to be Used:

My example above gives you the weights to use in calculating the WACC.How do you calculate the weights yourself?

The firms balance sheet shows thebook values of the common stock,

preferred stock, and long-term bonds. You can use the balance sheetfigures to calculatebook value weights, though it is more practicable towork with market weights. Basically, market value weights represent


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current conditions and take into account the effects of changing marketconditions and the current prices of each security. Book value weights,however, are based on accounting procedures that employ the par values ofthe securities to calculate balance sheet values and represent past

conditions. The table on the next page illustrates the difference betweenbook value and market value weights and demonstrates how they arecalculated.

VALUE DOLLAR

AMOUNT

WEIGHTS

OR % OF

TOTAL

VALUE

ASSUMED

COST OF

CAPITAL (%)

Book Value

Debt

2,000 bonds at par, or $1000

2,000,000 40.4 10

Preferred stock

4,500 shares at $100 par value

450,000 9.1 12

Common equity

500,000 shares outstanding at $5.00par value

2,500,000 50.5 13.5

Total book value of capital 4,950,000 100 11.24 is theWACC

Market Value

Debt

2,000 bonds at $900 current marketprice

1,800,000 30.2 10

Preferred stock

4,500 shares at $90 current marketprice

405,000 6.8 12

Common equity

500,000 shares outstanding at $75current market price

3,750,000 63.0 13.5

Total market value of capital 5,955,000 100 What is theWACC?

Note that the book values that appear on the balance sheet are usually


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different from the market values. Also, the price of common stock isnormally substantially higher than its book value. This increases theweight of this capital component over other capital structure components(such as preferred stock and long-term debt). The desirable practice is to

employ market weights to compute the firms cost of capital. This rationalerests on the fact that the cost of capital measures the cost of issuingsecurities stocks as well as bonds to finance projects, and that thesesecurities are issued at market value, not at book value.

Target weights can also be used. These weights indicate the distribution ofexternal financing that the firm believes will produce optimal results.Some corporate managers establish these weights subjectively; others will

use the best companies in their industry as guidelines; and still others willlook at the financing mix of companies with characteristics comparable tothose of their own firms. Generally speaking, target weights willapproximate market weights. If they dont, the firm will attempt to financein such a way as to make the market weights move closer to target weights.

Hurdle rates:

Hurdle rates are the required rate of return used in capital budgeting.Simply put, hurdle rates are based on the firms WACC. To understand theconcept of hurdle rates, I like to think of it this way. A runner in track

jumps over a hurdle. Projects the firm is considering must jump thehurdle or in other words exceed the firms borrowing costs (i.e.WACC). If the project does not clear the hurdle, the firm will lose moneyon the project if they invest in it and decrease the value of the firm. Thehurdle rate is used by firms in capital budgeting analysis (one of the next

topics we will be studying). Large companies, with divisions that havedifferent levels of risk, may choose to have divisional hurdle rates.

Divisional hurdle rates are sometimes used because firms are not internallyhomogeneous in terms of risk. Finance theory and practice tells us thatinvestors require higher returns as risk increases. For example, do the

following investment projects have the same level of risks? Engineeringprojects such as highway construction, market-expansion projects into


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foreign markets, new-product introductions, E-commerce startups, etc.

Breakpoints (BP) in the WACC:

Breakpoints are defined as the total financing that can be done before thefirm is forced to sell new debt or equity capital. Once the firm reaches this

breakpoint, if they choose to raise additional capital their WACC increases.

For example, the formula for the retained earnings breakpoint belowdemonstrates how to calculate the point at which the firms cost of equityfinancing will increase because they must sell new common stock. (Note:The formula for the BP for debt or preferred stock is basically the same, by

replacing retained earnings for debt and using the weight of debt.)

BPRE = Retained earnings

Weight of equity

Example:

Cowboy Energy Services expects to have total earnings of $840,000 forthe year, and it has a policy of paying out half of its earnings as dividends.Thus, the addition to retained earnings will be $420,000 during the year.We now want to know how much total new capital debt, preferred andretained earnings can be raised before the $420,000 of retained earningsis exhausted and the company is forced to sell new common stock. We areseeking the amount of capital which represents the total financing that can

be done before Cowboy Energy Services is forced to sell new common

stock to maintain their target weights in their WACC. Lets assume thatCowboy Energy Services maintains a capital structure of 60% equity, 40%debt. Using the formula above:

BPRE = Retained earnings

Weight of equity

= $420,000/0.60 = $700,000


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Thus, Cowboy Energy Services can raise a total of $700,000 in newfinancing, consisting of 0.6($700,000) = $420,000 of retained earnings and0.40($700,000) = $280,000 of debt, without altering its capital structure.The BPRE = $700,000 is defined as the retained earnings break point, or the

amount of total capital at which a break, or jump, occurs in the marginalcost of capital.

Can there be other breaks? Yes, there can depending on if there is somepoint at which the firm must raise additional capital at a higher cost.

Financial Management Set 2

Documents

Transcript of Financial Management Set 2