Financial Management

FINANCIAL MANAGEMENT: AN OVERVIEW
Introduction
The primary task of Financial Manager is to deal with funds. Management of

funds is an important aspect of Financial Management. In a business undertaking or
in an educational institution or in a hospital or in an art society or else where
management of funds is the primary concern of the Financial Management.
Finance is regarded as the lifeblood of a business enterprise. This is because

in the modern money-oriented economy finance is one of the basic foundations of all
kinds of economic activities. Without adequate finance no business can survive or
accomplish its objectives. In general, finance may be defined as the provision of
money at the time it is wanted. Thus, finance refers to making provision of money at
the time when it is required.
Meaning of Business Finance
Business finance is that business activity which is concerned with the

acquisition and conservation of capital funds in meeting financial needs and overall
objectives of a business enterprise. In other words, it refers to the process of raising,
providing and administering of money used in a business concern.
Wheeler defines business finance as “That Business activity, which is

concerned with the acquisition and conservation of capital funds in meeting the
financial needs and over all objectives of business enterprise”.
In the words of Prather and Wert, “Business Finance deals primarily with
raising, administering and disbursing funds by privately owned business units
operating in non-financial fields of industry”.
Finance Function
Finance Function refers to the providing of funds needed by a business

concern on most suitable terms. In other words, it refers to the raising of funds and
their effective utilization. It does not stop only by finding out sources and raising of
funds but it also covers proper utilization of funds.
Objectives of Finance Function
The main aim of finance function is to arrange adequate funds as required by

the business enterprise from time to time.
The main objectives of finance function are: -
1. Acquiring sufficient funds

The main objective of financial function is to estimate the financial needs of
the business and then finding out suitable sources for raising them. If funds
are required for long-term investments then long term sources like issue of
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shares, debentures, long-term loans, etc. may be preferred. If funds are
required for working capital purposes then short-term sources like bank
credit, trade credit, factoring, etc. may be used.
2. Proper utilization of funds

Another important objective of finance function is proper utilization of funds.
The funds must be used in such a way that the maximum benefit is derived
from them. The returns must be more than their expected cost.
3. Increasing profitability
When funds are used effectively it may lead to increase in profitability. The
finance function must ensure availability of sufficient funds at all times.
4. Maximizing concerns value

Finance function also aims at maximizing the value of the firm. Usually the
value of the firm is determined by its profitability. The value of the firm is also
influenced by other factors such as sources of funds, cost of capital, money
market conditions, etc.
Organization Chart of Finance Function
The Chief Finance Executive worked directly under the President or the
Managing Director of the company. Besides routine work, he keeps the Board of
Directors informed about all the phases of business activity, including economic,
social and political developments affecting the business behavior. He also furnishes
information about the financial status of the company by reviewing it from time to
time. The chief finance executive may have different officers under him to carry out
his functions. Broadly, his functions are divided into two: (i) Treasury Functions and
(ii) Control Functions.
An Organization Chart of Finance Function in a big organization is given

below.
ORGANIZATION CHART OF FINANCE FUNCTION
BOARD OF DIRECTORS
PRESIDENT
V.P. (Production) V.P. (Finance) V.P. (Sales)
Treasurer Controller
Credit Management Corporate General Accounting

Cash Management Taxes
Banking Relations Internal Audit
Portfolio Management Budgeting
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Meaning & Definition of Financial Management
The term Financial Management has been defined differently by different

authors. Financial management refers to that part of the management activity, which
is concerned with the planning, and controlling of firm’s financial resources. It deals
with finding out various sources for raising funds and most appropriate use of such
funds.
Thus, financial management is considered as a subject, which deals in

planning and control of financial operations of corporate enterprises. This deals with
the procurement of funds and their effective utilization.
According to Solomon, “Financial Management is concerned with the efficient

use of an important economic resource, namely Capital Funds”.
Objectives of Financial Management
The basic objectives of financial management can be broadly classified into

two categories, namely: -
a) Basic Objectives
b) Other Objectives
Basic Objectives
The basic objectives of financial management have been
a) Profit Maximization and
b) Wealth Maximization
Profit Maximization
Profit earning is the main aim of every economic activity. A business being an
economic institution must earn profit to cover its costs and provide funds for growth.
No business can survive without earning profit. Profit maximization refers to
increasing the profit of a business organization to the maximum extent possible. In
other words, it denotes the maximum profit to be earned by an organization in a
given time period.
The following arguments are advanced in favor of Profit Maximization: -
a) When profit earning is the main aim of the business then, profit maximization
should be its main objective.
b) Profitability is a barometer for measuring efficiency and economic prosperity
of a business enterprise.
c) Profits are the main sources of finance for the growth and development of a
business.
d) A business will be able to survive under unfavorable situations like recession,
depression, sever competition, etc. only if it has some past earnings.
e) Profitability is essential for fulfilling social needs also.
f) Profit maximization attracts the investors to invest their savings in securities
of the firm.
g) Profit indicates the efficient use of funds of the business concern.
h) The goodwill of the firm is based on profitability
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The following arguments are advanced against Profit Maximization: -
a) The term profit is vague and it cannot be precisely defined. It means different
things for different people.
b) Profit maximization objective ignores the time value of money and does not
consider the magnitude and timing of earnings. It treats all earnings as equal
though they occur in different periods.
c) It does not take into consideration the risk of the prospective earning stream.
d) Profit maximization encourages corrupt practices to increase the profit.
e) The effect of dividend policy on the market price of shares is also not
considered in the objective of profit maximization.
f) Profit maximization attracts cutthroat competition.
g) Huge amount of profit may invite government intervention.
Wealth Maximization
Wealth maximization refers to the increase in value of capital of the firm in

terms of market price. This increase in market price is determined by the volume of
capital, the capital structure, the cost of capital and rate of return to the investors.
How to maximize wealth?
In order to maximize wealth, a firm should take the following steps: -

1. Avoid high level of risks
The firm should avoid such projects, which involve high profits together with
high risks.
2. Pay Dividends
Payment of regular dividends increases the firm’s reputation and
consequently the value of the firm’s shares.
3. Maintain Growth in sales

The firm should have a large, stable and diversified volume of sales. This
protects the firm from adverse consequences of recessions, changes in
customer’s preferences or fall in demand for the firm’s products on account of
other reasons.
4. Maintain price of firm’s equity shares

Maximization of shareholders wealth is closely connected with the
maximization of the value of the firm’s equity shares. A firm can take a
number of steps to maintain the value of equity shares at reasonable levels.
Advantages of Wealth Maximization
a) Wealth Maximization considers the concept of time value of money.

b) Wealth Maximization takes care of economic welfare of the owner, which is
reflected in the market share of a company.
c) Wealth Maximization also takes care of creditors, employees, public and
management.
d) Wealth Maximization guides the management in formulating realistic dividend
policy.
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Disadvantages of Wealth Maximization
The Wealth Maximization has been criticized on the following grounds: -
a) Wealth Maximization is a prescriptive idea. The objective is not descriptive of

what the firms actually do.
b) The objective of wealth maximization is not necessarily socially desirable.
In conclusion, it can be said that the firm should follow the objective of wealth
maximization to a extent it is viable in the context of its social responsibility and
constraints imposed by the government.
Other Objectives
Besides, the above basic objectives the following are the other objectives of
financial management.
1) Ensuring a fair return to a shareholder.

2) Building up resource for growth and expansion.
3) Ensuring maximum operational efficiency by efficient and effective utilization
of finances.
4) Ensuring financial discipline in the organization.
Functions of Financial Management
At present Financial Management is not restricted to raising and allocating

funds. It also includes the study of financial institutions like stock exchange, capital
markets, etc. Some of the important functions performed by Financial Management
are: -
1) Planning the Financial Needs

The first task of a financial executive is to determine the finance needs of the
concern. The funds are needed to meet fixed assets and working capital
needs. The requirement of fixed assets is related to the type of industry. The
working capital needs depend upon the scale of operation..
2) Acquisition of Funds
After making the finance forecasting and planning, the next step will be to
acquire funds. The finance executive must find out the various sources
available for acquiring funds. These sources may be long-term or short-term.
The various long-term sources are issue of shares, debentures, long-term
loans from financial institutions, etc. The various short-term sources are bank
credit i.e., short-term loans, cash credit, overdraft facilities, discounting of
bills of exchange, trade credit, factoring, lease finance, etc.
3) Investment of Funds
Investment decision refers to planning the deployment of available capital for
the purpose of maximization the long-term profitability of the firm. It is the
firm’s decision to invest its current funds most efficiently in long-term
activities in anticipation of flow of future benefits over a series of year. Capital
budgeting decisions are the most crucial and critical business decisions
because the success or failure of a concern based on these decisions.
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4) Dividend decision
Dividend is the portion of earning, which is distribution among the
shareholders. Dividend policy on the other hand determines the division of
earning between payments to shareholders and retains earnings. Formulation
of a proper dividend policy is one of major financial decision taken by the
finance executive.
5) Working Capital Management

Working capital refers to the excess of current assets over current liabilities.
In other words, it is net current assets or net working capital. Working capital
is essential to maintain the smooth running of business. No business can
survive without adequate amount of working capital proper management of
working capital is an important area of financial management.
6) Analysis and Interpretation of Financial Statement

The analysis and interpretation of financial statements is one of the important
tasks of a financial executive. He is expected to know the short-term, long-
term solvency and profitability of the concern.
7) Profit planning and control

Profit planning and control is an important responsibility of a financial
management. The profit planning and control also influence the declaration of
dividends, creation of reserves, replacement of assets, redemption of debts,
future productions, future expansions., etc.
Role of Finance Manager
The changed business environment has widened the role of a finance

manager. The development of multi-national companies, innovation of information
technology, intense competition, etc. have increased the needs for financial planning
and control. A finance manager is expected to perform the following functions: -
1) Funds Requirement Decision

This is the most important function performed by the finance manager. A
careful estimate has to be made about the total funds required for both the
fixed and working capital requirements.
2) Financing Decision
This is an important decision for the finance manager. It is concerned with
determination of the quantum of finance, the amount that can be raised from
each source and the cost and other consequences involved.
3) Investment Decision
This comprises decisions relating to investment in both fixed assets and
current assets. The finance manger has to evaluate different capital
investment proposals and select the best keeping in view the overall objective
of the enterprise.
4) Dividend Decision
The establishment of dividend policy is another important function of finance
manager. The dividend decision involves the determination of the percentage
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of profits earned by the enterprise, which is to be paid to shareholders and
percentage of profits that should be retained as retained earnings.
5) Valuation Decisions
A number of merger and consolidation take place in the present competitive
industrial world. A finance manager must assist the management in making
valuations.
Apart from the above main functions, following subsidiary functions are also
performed by the finance manager: -
a) To ensure supply of funds to all parts of the organization

It is also the function of the finance manager to ensure supply of funds to
all parts of the organization to help in smooth operations of the activities
of the organization.
b) To evaluate Financial Performance

The financial performance of the various units of the organization is to be
evaluated from time to time to detect any fault in the financial policy.
c) To negotiate with Banker, Financial Institutions, etc.

The financial executive must negotiate with Banker, Financial Institutions
and other suppliers of credit.
d) To keep track of Stock Exchange

The financial executive must keep track of stock exchange quotations and
behavior of stock market prices, etc.
Financial Planning
Finance is an important function of business. The application of planning to

this function is Financial Planning. Financial Planning is mainly concerned with the
economical procurement of funds and profitable use of such funds.
A financial plan is a statement of estimating the amount of capital and

determining its composition. It states: -
a) The quantum of finance is the amount needed for implementing the business
plan.
b) The patterns of financing i.e., the form and proportion of various corporate
securities to be issued to raise the required amount, and
c) The policies to be pursued for the flotation of various corporate securities.
Need for Financial Planning
The need for financial planning arises to ensure the following objectives: -
a) To determine the quantum of finance to be raised.
b) To determine patterns of financing i.e., the form and proportion of various
securities.
c) To determine policies to be pursued for the floatation of various corporate
securities.
d) To maintain liquidity throughout the year.
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e) To ascertain the availability of surplus funds for expenses or external
investments.
f) To ensure availability of sufficient cash for meeting expenditure, emergencies
and fluctuations in the level of working capital.
g) To eliminate waste resulting from complexity of operation.
h) To prepare plans to renew or replace the existing assets.
i) To prepare policies and procedure to co-ordinate various financial operations
of the enterprise.
Steps in Financial Planning
Financial Planning involves the following steps: -
1) Estimating Financial Objectives

The financial objectives of a company i.e., both short-term and long-term
objectives must be clearly and carefully prepared.
2) Formulating Financial Policies

Financial policies are guides to all actions, which deal with procuring,
administering, and disbursing the funds of business firms.
3) Formulating Procedures
The procedures are formed to ensure consistency of actions. The procedures
follow the formulation of policies.
4) Providing for Flexibility

The financial planning should ensure flexibility in objectives, policies and
procedures, so as to adjust according to changing economic situations.
Principles Governing a Financial Plan
The financial plan should be prepared keeping in view the following principles.
1) Simplicity
A financial plan should be simple and easily understood by everybody. A
complicated financial structure creates complications and confusions.
2) Clear Cut Objectives

Financial planning should be done by keeping in view the overall objectives of
the company. The objectives must be clear and unambiguous.
3) Flexibility
The financial plan should not be rigid. It should be flexible i.e., capable of
being adjusted according to the needs and circumstances. Flexibility is helpful
in making changes in plan with minimum possible delay.
4) Long-term View
The financial plan should be formulated keeping in view the long-term needs
of the organization rather than finding out easiest way of obtaining the
original capital.
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5) Foresight
The financial plan should be prepared keeping in view the future requirements
of capital for the business.
6) Liquidity
Financial planning should ensure liquidity and solvency of the enterprise.
Adequate liquidity gives a degree of flexibility too.
7) Contingencies
The financial plan should keep in view the requirements of funds for
contingencies likely to arise in future.
8) Economy
The cost of raising the capital should be kept minimum. It should not impose
any unnecessary burden on the company. This is possible by having a proper
debt- equity mix.
9) Optimum Use
The financial plan should provide for meeting the genuine needs of the
company. The available funds must be used effectively and efficiently.
Chapter Roundup
 Business Finance refers to that business activity which is concerned with the
acquisition and conservation of capital funds in meeting the financial needs
and overall objectives of business enterprise.
 Finance function refers to the providing of funds by a business concern on

most suitable terms.
 Financial management refers to that part of management activity which is

concerned with planning and controlling of firm’s financial resources. It deals
with finding out various sources for raising funds and most appropriate use of
such funds.
 Profit maximization refers to increase in the profit of a business organization

to the maximum possible extent. In other words, it denotes the maximum
profit to be earned in an organization in a given time period.
 Wealth maximization refers to the increase in the value of capital of the firm
in terms of market price. The increase in market price is determines the value
of capital, capital structure, cost of capital and rate of return to the investors
etc..
Quick Quiz
1. Define business finance.

2. What is meant by finance function?
3. What are the objectives of financial management?
4. What is financial management?
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5. Define financial management.
6. What is profit maximization?
7. What is wealth maximization?
8. What is financial plan?
9. Mention the steps in financial plan.
10. What is financing decision?
11. What is investing decision?
12. What is dividend decision?
13. Explain the need for financial planning.
14. How should the finance function of an enterprise be organized? What
functions are performed by the financial manager in this direction?
15. In what respect is the objective of wealth maximization superior to the profit
maximization? Analyze.
16. What are the various factors considered while drafting a financial plan for an
industrial concern?
17. What is financial planning? Explain the principles governing a sound financial
planning.
18. Explain the functions of financial management.
19. “Profit maximization is the basic goal of a Finance Manager”. Do you agree?
Discuss.
20. Explain the functions of a Controller and a Treasurer.
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FINANCING DECISION
Introduction
We have already explained that the basic task of finance manager is the
procurement of funds. We have also learnt that basic objective of financial
management is wealth maximization. The finance manager for the procurement of
funds is therefore required to select such a finance mix or capital structure, which
maximizes shareholders wealth. For designing the optimum capital structure he is
required to select such a mix of sources of finance so that overall cost of capital is
minimum.
Financial Decision is an important decision of a financial executive. It is

concerned with determination of the quantum of finance, the amount that can be
raised from each sources and the cost and other consequences involved.
Meaning of Capital Structure
Capital structure refers to the kinds of securities and the proportionate

amounts of each security in the total capitalization of a firm. In other words, it
means the composition of long-term sources of funds such as debentures, long-term
loans, preference share capital and equity share capital including reserves and
surplus. In simple words, it represents the mix of different sources of long-term
funds in the total capitalization of the company.
According to Gerestenberg “Capital structure of a company refers to the

composition or make up of its capitalization and it includes all long-term capital
resources viz. loans, reserves, shares and bonds”.
Factors determining the Capital Structure
The capital structure of a company is to be determined initially at the time of

floating the company, while determining the capital structure the following points
must be kept in view: -
1. Financial Leverage
The use of long-term debt and preference share capital along with equity
share capital is called financial leverage or trading on equity. If the firm uses
more of debts in its capital structure, increases the earning per equity share,
if the firm yields a return higher than the cost of debt. However, leverage can
operate adversely also if the rate of interest on loan is more than the
expected rate of return of the firm.
2. Growth and Stability of Sales
The capital structure of a company is also influenced by the growth and

stability of its sales. If the sales of a company are fairly stable, the company
can use more of debts in its capital structure. Stability of sales ensures easy
payment of interest on debt financing. Similarly, the rate of growth in sales
also affects the capital structure decision.
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Financial Leverage
Growth and Stability of Sales
Cost of Capital
Nature and Size of a Firm

FACTORS DETERMINING THE CAPITAL STRUCTURE
Flexibility
Control
Capital Market Conditions
Purpose of Financing
The Period of Finance
Legal Requirements
Marketability
Timing
Requirement of Investors
Provision for Future
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3. Cost of Capital
Cost of capital refers to the minimum return expected by its suppliers. The
capital structure should provide for the minimum cost of capital. While
formulating a capital structure, an effort must be made to minimize the
overall cost of capital.
4. Nature and Size of a Firm
Nature and size of a firm also influences its capital structure. A concern,
which cannot provide stable earnings due to the nature of its business, will
have to rely mainly on equity share capital. A concern whose earnings are
stable due to the nature of its business can offer to have more of debt
financing in its capital structure.
5. Flexibility
Capital structure of a firm should be flexible i.e., it should be capable of being

adjusted according to the needs of the changing conditions. It should be
possible to raise additional funds without any difficulty or delay.
6. Control
The capital structure of a company is also influenced by the policy of control.

If the shareholders are not interested in inviting new members to enter the
company, then debt financing is preferable. If the shareholders have no
objection in inviting the new members to enter the company then they can
think of raising funds through equity shares.
7. Capital Market Conditions
Capital market conditions are ever changing. Sometimes there may be boom
in the market while at other times there may be depression in the market. If
the share market is in boom, it would be advisable to issue equity shares but
in case of depression the company should go for debt financing.
8. Purpose of Financing
Purpose of financing is another factor that influences the capital structure of a

firm. If funds are required for productive purposes, borrowed funds are
suitable and the company should go for issue of debentures as interest can be
paid out of the profits generated from such investments. However, if funds
are required for unproductive purposes, the company should prefer equity
share capital.
9. The Period of Finance
The period for which finance is required also affects the determination of
capital structure. Incase the funds are required for a long-term requirement
say 8 to 10 years, it will be appropriate to raise borrowed funds. However, if
funds are required more or less permanently, it will be appropriate to raise
them by the issue of equity shares.
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10.Legal Requirements
The finance manager has to keep in view the legal requirements while
deciding about the capital structure of the company.
11.Marketability
To obtain a balanced capital structure it is necessary to consider the ability of

the company to market corporate securities.
12.Timing
Closely related to flexibility is the timing for issue of securities. Proper timing
of the security issue often brings substantial savings because of the dynamic
nature of the capital market. Intelligent management tries to anticipate the
climate in capital market with a view to minimize the cost of raising funds and
also to minimize the dilution resulting from an issue of new ordinary shares.
13.Requirement of Investors
Different types of securities are issued to different classes of investors

according to their requirement.
14.Provision for Future
While planning capital structure the provision for future requirement of capital
is also required to be considered.
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Illustration: 1
Determine the EPS of a company, which has an Earnings Before Interest and
Tax (EBIT) of Rs. 2,00,000. Its capital structure consists of the following securities.
 10% Debentures Rs. 6,00,000
 12% Preference Shares Rs. 2,00,000
 Equity Shares of Rs. 100 each Rs. 5,00,000
The company is in the 50% tax bracket. Determine the percentage change in
EPS associated with 25% increase and 25% decrease in EBIT.
Solution: -
Computation of EPS
25% 25%
Particulars Existing
Increase Decrease
EBIT 2,00,000 2,50,000 1,50,000
Less: Interest 60,000 60,000 60,000
EBT 1,40,000 1,90,000 90,000
Less: Tax @ 50% 70,000 95,000 45,000
EAT 70,000 95,000 45,000
Less: Preference Dividend 24,000 24,000 24,000
Earnings available to Equity Share Holders 46,000 71,000 21,000
EPS = Earnings available to equity share
holders / No. of equity shares 9.2 14.2 4.2
5 x 100 -5 x 100
% increase / decrease in EPS ---
9.2 9.2
54.34% -54.34%
Illustration: 2
A company ltd. has a share capital of Rs. 1,00,000 divided into Equity shares
of Rs. 10 each. It has major expansion programme requiring an investment of
another Rs. 50,000. The management is considering the following alternatives for
raising this amount: -
(i) Issue of 5,000 Equity shares of Rs. 10 each.
(ii) Issue of 5,000, 12% Preference Shares of Rs. 10 each.
(iii) Issue of 10% Debentures of Rs. 50,000.
The company’s present Earnings before Interest and Tax (EBIT) is Rs. 30,000
p.a. You are required to calculate the effect of each of the above modes of financing
on the Earnings per Share (EPS) presuming
a) EBIT continues to be the same even after expansion.
b) EBIT increases by Rs. 10,000.
c) Assume tax liability is 50%.
Solution: -
Analysis Table
Particulars I II III
Equity Share Capital 1,50,000 1,00,000 1,00,000
12% Preference Share capital --- 50,000 ---
10% Debentures --- --- 50,000
No. of Equity Shares 15,000 10,000 10,000
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Computation of EPS
When Earnings Before Interest and Tax is Rs. 30,000

EBIT 30,000 30,000 30,000
Less: Interest --- --- 5,000
EBT 30,000 30,000 25,000
Less: Tax @ 50% 15,000 15,000 12,500
EAT 15,000 15,000 12,500
Less: Preference Dividend --- 6,000 ---
EPS = Earnings available to equity share holders

1 0.9 1.25
No. of equity shares
When Earnings Before Interest and Tax is Rs. 40,000

EBIT 40,000 40,000 40,000
Less: Interest --- --- 5,000
EBT 40,000 40,000 35,000
Less: Tax @ 50% 20,000 20,000 17,500
EAT 20,000 20,000 17,500
Less: Preference Dividend --- 6,000 ---
1.33 1.4 1.75
Illustration: 3
Penta Four Ltd., has currently an all equity share consisting of 15,000 equity
shares of Rs. 100 each. The management is planning to raise another Rs. 25,00,000
to finance a major programme of expansion and is considering three alternative
methods of financing:
1) To issue 25,000 Equity Shares of Rs. 100 each.
2) To issue 25,000, 8% Debentures of Rs. 100 each.
3) To issue 25,000, 8% Preference Shares of Rs. 100 each.
The company’s expected earnings before interest and taxes will be Rs.
8,00,000. Assuming corporate tax rate is 50%. Determine the earnings per share
(EPS) in each alternative and comment which alternative is best and why?
Solution: -
Analysis Table
8% Debentures --- 25,00,000 ---
8% Preference Shares --- --- 25,00,000
No. of Equity Shares 40,000 15,000 15,000
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Computation of EPS
EBIT 8,00,000 8,00,000 8,00,000
Less: Interest --- 2,00,000 ---
EBT 8,00,000 6,00,000 8,00,000
Less: Tax @ 50% 4,00,000 3,00,000 4,00,000
EAT 4,00,000 3,00,000 4,00,000
Less: Preference Dividend --- --- 2,00,000
Earnings available to Equity Share Holders 4,00,000 3,00,000 2,00,000

10 20 13.33
Conclusion: - Second alternative is considered to be the best alternative because

EPS is more when compared to the other two alternatives.
Illustration: 4
X Ltd., capitalized with Rs. 10,00,000 divided in to 1,00,000 Equity Shares of

Rs. 10 each. The management desires to raise another Rs. 10,00,000 to finance a
major expansion programme.
There are four possible financing plans:

1) All Equity Shares
2) Rs. 5,00,000 in Equity Shares and Rs. 5,00,000 in Debentures carrying 10%
interest.
3) All debentures carrying 8% interest.
4) Rs. 5,00,000 in Equity Shares and Rs. 5,00,000 in Preference Shares carrying
10% Dividend.
The existing EBIT amounts to Rs. 1,20,000 per annum.

1) You are required to calculate earnings per Equity Share under each of the
above four financial plans.
2) Calculate the earnings per equity share, if on account of expansion the level
of EBIT is doubled.
Solution: -
Analysis Table
Particulars I II III IV
Equity Share Capital 20,00,000 15,00,000 10,00,000 15,00,000
10% Debentures --- 5,00,000 --- ---
8% Debentures --- --- 10,00,000 ---

10% Preference Share Capital --- --- --- 5,00,000
No. of Equity Shares 2,00,000 1,50,000 1,00,000 1,50,000
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Computation of earning per equity share
When earnings before interest and tax is Rs.1,20,000

EBIT 1,20,000 1,20,000 1,20,000 1,20,000
Less: Interest --- 50,000 80,000 ---
EBT 1,20,000 70,000 40,000 1,20,000
Less: Tax 60,000 35,000 20,000 60,000
EAT 60,000 35,000 20,000 60,000
Less: Preference Dividend --- --- --- 50,000
Earnings available to Equity Share
Holders 60,000 35,000 20,000 10,000
EPS = Earnings available to equity
share holders / No. of equity shares 0.3 0.233 0.2 0.067

When earnings before interest is Rs.2,40,000
EBIT 2,40,000 2,40,000 2,40,000 2,40,000
Less: Interest --- 50,000 80,000 ---
EBT 2,40,000 1,90,000 1,60,000 2,40,000
Less: Tax 1,20,000 95,000 80,000 1,20,000
EAT 1,20,000 95,000 80,000 1,20,000
Holders 1,20,000 95,000 80,000 70,000
share holders / No. of equity shares 0.6 0.633 0.8 0.47
Illustration: 5
Excellent Ltd., has currently Equity Share capital of Rs. 25,00,000, consisting
of 25,000 shares of Rs. 100 each. The management is planning to raise another
Rs. 20,00,000 to finance a major programme of expansion through one of the four
possible financial plans. The options are:
1) All through Equity Shares.

2) Rs. 10,00,000 through Equity Shares and Rs. 10,00,000 through long-term
borrowings at 8% interest per annum.
3) Rs. 5,00,000 through Equity Shares and Rs. 15,00,000 through long-term
borrowings at 9% interest per annum.
4) Rs. 10,00,000 through Equity Shares and Rs. 10,00,000 through Preference
Shares with 5% Dividend.
The company’s expected earnings before interest and tax (EBIT) will be
Rs. 8,00,000. Assuming a corporate tax rate of 50%, determine the earnings per
share in each alternative and comment, which alternative is best and why?
8
Solution:
Analysis Table
Equity Share Capital 45,00,000 35,00,000 30,00,000 35,00,000
8% Long-term Loan --- 10,00,000 --- ---
9% Long-term Loan --- --- 15,00,000 ---
5% Preference Share Capital --- --- --- 10,00,000
No. of Equity Shares 45,000 35,000 30,000 35,000

EBIT 8,00,000 8,00,000 8,00,000 8,00,000
Less: Interest --- 80,000 1,35,000 ---
EBT 8,00,000 7,20,000 6,65,000 8,00,000
Less: Tax @ 50% 4,00,000 3,60,000 3,32,500 4,00,000
EAT 4,00,000 3,60,000 3,32,500 4,00,000
Holders 4,00,000 3,60,000 3,32,500 3,50,000
share holders / No. of equity shares 8.89 10.3 11.1 10
Conclusion: - Third alternative is best because EPS is more when compared to other
three alternatives.
Illustration: 6
A newly established company wishes to determine an appropriate capital

structure. It can issue 12% debentures and 10% preference capital and the existing
tax rate is 35%. The company requires Rs. 50,00,000.
The possible capital structure is:

Plan Debenture Capital Preference Capital Equity Capital
1. 0 0 100%
2. 30% 0 70%
3. 30% 20% 50%
4. 50% 0 50%
5. 50% 20% 30%
The EBIT is 12%. Calculate EPS assuming that the face value per equity share
is Rs. 100.
Solution:
Analysis Table
Particulars I II III IV V
Equity Share Capital 50,00,000 35,00,000 25,00,000 25,00,000 15,00,000
12% Debentures --- 15,00,000 15,00,000 25,00,000 25,00,000
10% Preference --- --- 10,00,000 --- 10,00,000
Share Capital
No. of Equity Shares 50,000 35,000 25,000 25,000 15,000
9
Particulars I II III IV V
EBIT 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000
Less: Interest --- 1,80,000 1,80,000 3,00,000 3,00,000
EBT 6,00,000 4,20,000 4,20,000 3,00,000 3,00,000
Less: Tax @ 35% 2,10,000 1,26,000 1,26,000 1,05,000 1,05,000
EAT 3,90,000 2,94,000 2,94,000 2,95,000 2,95,000
Less: Preference Dividend --- --- 1,00,000 --- 1,00,000
Earnings available to
Equity Share Holders 3,90,000 2,94,000 1,94,000 2,95,000 1,95,000
EPS = Earnings available
to equity share holders / 7.8 8.4 7.76 11.8 13
Illustration: 7
Firms X and Y are identical expect that Firm X is not levered while, Firm Y is
levered. The following data relate to them.
Firm X Firm Y
Assets 5,00,000 5,00,000
Debt Capital 0 2,50,000 [9% Interest]
Equity Share Capital 5,00,000 2,50,000
No. of Shares (50,000) (25,000)
Rate of return on assets 20% 20%
Calculate EPS for both the firms assuming tax rate of 50%. Will it be
advantageous to Firm Y to raise the level of capital to 75%?
Solution:
Particulars Firm X Firm Y
EBIT 1,00,000 1,00,000
Less: Interest --- 22,500
EBT 1,00,000 77,500
Less: Tax @ 50% 50,000 38,750
EAT 50,000 38,750
Less: Preference Dividend --- ---
Earnings available to Equity Share Holders 50,000 38,750
EPS = Earnings available to equity share holders / No. of
1 1.55
equity shares
Calculation of No. of Equity Shares of Firm Y

Assets Rs.
Assets 5,00,000
9% Debentures 3,75,000
Equity Share Capital 1,25,000
No. of Equity Shares 12,500
10
Particulars Firm Y
EBIT 1,00,000
Less: Interest 33,750
EBT 66,250
Less: Tax @ 50% 33,125
EAT 33,125
Less: Preference Dividend ---
Earnings available to Equity Share Holders 33,125
EPS = Earnings available to equity share holders / No. of equity shares 2.65
Conclusion: - It is advantageous to Firm Y to raise the debt financing to 75%

because it increases the EPS from Rs. 1.55 to Rs. 2.65.
Illustration: 8
A company needs Rs. 12,00,000 for installation of a new factory, which would
yield an annual EBIT of Rs. 2,00,000. The company has the objective of maximizing
the EPS. It is considering the possibility of issuing equity shares plus raising debt of
Rs. 2,00,000, or Rs. 6,00,000, or Rs. 10,00,000. The current market price per share
is Rs. 40, which is expected to drop to Rs. 25 per share. If the market borrowings
were to exceed Rs. 7,50, 000. Cost of borrowings is indicated as under: -
Up to Rs. 2,50,000, @10% p.a.
Rs. 2,50,001 – Rs. 6,25,000 @ 14% p.a.
Rs. 6,25,001 – Rs. 10,00,000 @ 16% p.a.
Assuming a tax rate of 50%, workout the EPS and scheme which would meet
the objective of the management.
Solution:
Analysis Table
Debentures 2,00,000 6,00,000 10,00,000
No. of Equity Shares 10,00,000 6,00,000 2,00,000
25 40 40
40,000 15,000 5,000
Computation of EPS
EBIT 2,00,000 2,00,000 2,00,000
Less: Interest 20,000 74,000 1,37,500
EBT 1,80,000 1,26,000 62,500
Less: Tax @ 50% 90,000 63,000 31,250
EAT 90,000 63,000 31,250
Less: Preference Dividend --- --- ---

2.5 4.2 6.25
Conclusion: - Third scheme maximizes EPS. Therefore, it is considered to be the

best scheme.
11
Point of Indifference
Point of indifference refers to that EBIT level at which Earnings per Share
(EPS) remains the same irrespective of the Debt and Equity mix. In other words, at
this point, the rate of return on capital employed is equal to the rate of interest on
debt. This is also known as Break even level of EBIT for alternative financial plans.
This can be calculated by using the following formula.
(X – int1) (1 – T) – PD (X – int2) (1 – T) – PD
=
S1 S2
Where X = EBIT,
int1 = Interest under first alternative
int2 = Interest under second alternative
T = Tax rate
PD = Preference Dividend
S1 = No. of equity shares under first alternative
S2 = No. of equity shares under second alternative
Illustration: 9
A project under consideration by your company requires a capital investment

of Rs. 120 lakhs. Interest on term loan is 10% per annum and tax rate is 50%.
Calculate the point of indifference for the project if the debt equity ratio insisted by
the financing agencies is 2:1. Assuming the face value per equity share is Rs. 10.
Solution: -
Analysis Table
Particulars I II
Equity Share Capital 120 lakhs 40 lakhs
10% Term-loan --- 80 lakhs
No. of Equity Shares 12 lakhs 4 lakhs
(X – int1) (1 – T) – PD (X – int2) (1 – T) – PD
=
S1 S2
(X – 0) (1 – 0.5) – 0 (X – 8) (1 – 0.5) – 0
=
12 4
0.5 X 0.5 X – 4
=
12 4
6X – 48 = 2X
4X = 48
X = 12 lakhs
12
Illustration: 10
Apple Limited has a total capitalization of Rs. 10,00,000 consisting entirely of

equity shares of Rs. 50 each. It wishes to raise another Rs. 5,00,000 for expansion
through one of its two possible financial plans.
(i) All equity shares of Rs. 50 each.
(ii) All debentures carrying 9% p.a. interest.
The present level of EBIT is Rs. 1,40,000 and income tax rate is 50%.
Calculate EBIT level at which EPS would remain the same irrespective of raising
funds through equity shares or debentures.
Solution:
Analysis Table
Particulars I II
Equity Share Capital 15,00,000 10,00,000
9% Debentures --- 5,00,000
No. of Equity Shares 30,000 20,000
(X – int1) (1 – T) – PD (X – int2) (1 – T) – PD
=
S1 S2
(X – 0) (1 – 0.5) – 0 (X – 45,000) (1 – 0.5) – 0

=
30,000 20,000
0.5 X 0.5 X – 22,500

=
30,000 20,000
15X – 675000 = 10X

15X – 10X = 675000
5X = 675000
X = 1,35,000
Illustration: 11
A company limited has the choice for raising an additional sum of Rs.
50,00,000 either by issue of 10% debentures or by issue of additional equity shares
at Rs. 50 each.
The current capitalization structure of the company consists of 10,00,000
equity shares and no debt. At what level of EBIT after the issue of new capital would
EPS be the same whether the new funds has been raised either by issuing equity
shares or by rising through debentures?
Solution:
Analysis Table
Particulars I II
10% Debentures --- 50 lakhs
No. of Equity Shares 11 lakhs 10 lakhs
13
(X – int1) (1 – T) – PD (X – int2) (1 – T) – PD
=
S1 S2
(X – 0) (1 – 0.5) – 0 (X – 5) (1 – 0.5) – 0
=
11 10
0.5 X 0.5 X – 2.5

=
11 10
5.5X – 27.5 = 5X
5.5X – 5X = 27.5
0.5X = 27.5
X = 55 lakhs
Illustration: 12
‘X’ Limited has the choice of raising an additional sum of Rs. 50,00,000 either
by issue of 10% debentures or by the issue of additional equity shares at Rs. 50
each. The current capitalization structure of the company consists of 1,00,000
ordinary shares and no debt. At what level of EBIT after the issue of new capital
would EPS be the same whether the new funds has been raised either by issuing
equity shares or by rising through debentures? Assume a tax rate of 50%.
Solution:
Analysis Table
Particulars I II
10% Debentures --- 50 lakhs
No. of Equity Shares 2 lakhs 1 lakh
(X – int1) (1 – T) – PD (X – int2) (1 – T) – PD
=
S1 S2
(X – 0) (1 – 0.5) – 0 (X – 5) (1 – 0.5) – 0
=
2 1
0.5 X 0.5 X – 2.5

=
2 1
X – 5 = 0.5X
0.5X = 5
X = 10 lakhs
14
CAPITAL STRUCTURE THEORIES
Equity and Debt Capital are the two important sources of long-term finance for a
firm. How much financial leverage should a firm employ? The answer is quite difficult
and is based on an understanding the relationship between the financial leverage and firm
valuation or financial leverage and cost of capital. To understand the relationship
between the financial leverage and firm valuation, there are many approaches have been
propounded, some say that there exists a relationship between the two and some state that
there is no relation.
Net Income Approach
The essence of the net income approach is that the firm can increase its value or
lower the overall cost of capital by increasing the proportion of debt in the capital
structure. The crucial assumptions of this approach are: -
 There are no taxes.

 The cost of debt capital is less than the cost of equity.
 The use of debt does not change the risk perception of investors.
According to this approach capital structure decisions is relevant to the value of

the firm i.e., a change in the capital structure will lead to a corresponding change to the
overall cost of capital as well as the total value of the firm.
a) If the degree of the financial leverage as measured by the ratio of debt equity is
increased, then
- the weighted average cost of capital will decline
- the value of the firm will increase
- the market price of equity share will increase
b) If the degree of financial leverage as measured by the ratio of debt to equity is

decreased, then
- the overall cost of capital will increase
- the value of the firm will decrease
- the market price per ordinary share will decrease
Net Income Approach Formula
The total market value of a firm on the basis of Net income approach can be
ascertained as below
V=S+D
Where, V = Value of a firm
S = Market value of equity
D = Market value of debt
S = Earnings available to equity share holders
15
Cost of Equity Capital
Thus, according to net income approach

i) The value of the firm will increase if the amount of equity is decreased by
issue of debentures, bonds, etc.
ii) The value of firm will decrease if the amount of debt is decreased by issue
of additional equity shares.
The net income approach is illustrated in the following example: -
Illustration 13
a) A Company’s expected annual net operating income (EBIT) is Rs. 50,000. The
company has Rs. 2,00,000, 10% debentures. The equity capitalization rate (Ke) of
the company is 12.5%. Calculate the value of firm and overall cost of capital.
b) If the firm decided to raise the amount of debentures to Rs. 3,00,000, what will be
the value of the firm and overall cost of capital?
c) If the firm decided to decrease the amount of debentures to Rs. 1,00,000, what
will be the value of the firm and overall cost of capital?
Illustration 14
Consider two Firms X and Y, which are identical in all respects except the degree
of leverage employed by them. The following is the financial data for these two firms.
Firm X Firm Y
Net Operating Income 2,00,000 2,00,000
10% Debentures --- 50,000
Cost of Equity 12% 12%
Calculate the value of the firms and overall cost of capital.
Illustration 15
A Company’s expected annual net operating income (EBIT) is Rs. 1,00,000.
The company has Rs. 5,00,000, 6% debentures. The equity capitalization rate
(Ke) of the company is 10%. Calculate the value of firm and overall cost of
capital.
b) If the firm decided to raise the amount of debentures to Rs. 7,00,000, what will be
the value of the firm and overall cost of capital?
Conclusion: - Thus by increasing the debt proportion in the capital structure, the
firm is able to increase the value of the firm and lower the overall cost of capital.
16
Net Operating Income Approach
Another theory of capital structure is the net operating income approach. This
approach is opposite to the net income approach. According to this approach, the overall
cost of capital and the value of firm will remain constant for all degrees of leverage i.e.,
any change in the degree leverage will not lead to any change in the total value of the
firm and the market price of shares as well as overall cost of capital is independent of the
degree of leverage.
The net operating income approach is based on the following assumptions: -

 The overall cost of capital (Ko) is constant for a degree of debt equity mix;
 The market capitalizes the value of the firm as whole and therefore, the split
between debt and equity is not relevant.
 The use of debt having low cost increases the risk of equity shareholders, this
result in increase in equity capitalization rate. The advantage of debt is set off
exactly by the increase in the equity capitalization rate.
 There are no corporate taxes.
a) The value of the firm V =

EBIT Earnings before interest and tax
OR
Ke Cost of equity capital
Here the market value evaluates the firm as a whole and the split of capitalization
between debt and equity is not significant.
b) The residual value of equity S = V – D;

Where, V = Value of the firm
D = Value of debt
S = Market value of equity
According to this approach, there is nothing like optimum capital structure as the
total value of the firm remains constant. However, any capital structure will be optimum
as per net operating income approach.
17
Illustration 16
(i) A company expects a net operating income of Rs. 2,00,000. It has Rs. 10,00,000; 6%
debentures. The overall capitalization rate is 10%. Calculate the value of the firm and
the equity capitalization rate according to the Net Operating Income Approach.
(ii) If the debenture debt is increased to Rs. 15,00,000; What will be the effect on the
value of the firm and the equity capitalization rate?
Solution
(i) Net Operating Income = Rs. 2,00,000

Overall Capitalization Rate = 10%
Net Operating Income

Market value of the firm (V) =
Overall Capitalization Rate
2,00,000
Market value of the firm (V) = = 20,00,000
10%
Market Value of firm 20,00,000

Less: Market Value of debentures 10,00,000
Market Value of Equity (S) 10,00,000
Earnings available to Equity Share holders EBIT – Int.

Cost of Equity (Ke) = or
Market Value of Equity V–D
2,00,000 – 60,000
Cost of Equity (Ke) = = 14%
10,00,000
(ii) If the debenture debt is increased to Rs. 15,00,000

Market Value of firm 20,00,000
Earnings available to Equity Share holders EBIT – Int.

Cost of Equity (Ke) = or
Market Value of Equity V–D
2,00,000 – 90,000
Cost of Equity (Ke) = = 22%
5,00,000
The Traditional Approach
According to this theory, the value of firm can be increased or the overall cost of
capital can be decreased by using more of borrowed funds than equity. This is because
the cost of debt is cheaper than the cost of equity. After this stage, the value of firm or the
overall cost of capital remains more or less unchanged for moderate increase in borrowed
funds. Thus, the optimum capital structure can be reached by a proper debt equity mix.
18
Thereafter, the value of firm decreases and overall cost of capital increases beyond a
certain point. Thus, the Traditional Approach implies that the cost of capital is not
independent of the capital structure of the firm and that there is an optimal capital
structure.
The traditional view point on the relationship between the Leverage, Cost of
Capital, and Value of Firm has been explained in the following illustration.
Illustration 17
Compute the value of the firm, market value of equity and the overall cost of
capital from the following details.
Net Operating Income 3,00,000

Total Investment 15,00,000
Equity Capitalization Rate
(i) If the firm uses no debt 10%
(ii) If the firm uses Rs. 6,00,000 debt 11%
(iii) If the firm uses Rs. 9,00,000 debt 13%
Assume that Rs. 6,00,000 debt can be raised at 5% whereas Rs. 9,00,000 debt can
be raised at 6% rate of interest.
Solution
Computation of the Market Value of Firm, Overall Cost of Capital & Market Value
of Equity
No Debt Rs. 6,00,00 debt Rs. 9,00,000 debt
at 5% at 6%
Net Operating Income 3,00,000 3,00,000 3,00,000
Less: Interest 30,000 54,000
Earnings available to 3,00,000 2,70,000 2,46,000
Equity Share Holders
Equity Capitalization Rate 10% 11% 13%
Market Value of Shares 3,00,000 / 0.10 2,70,000 / 0.11 2,46,000 / 0.13
30,00,000 24,54,545 18,92,308
Market Value of Debt ---- 6,00,000 9,00,000
Market Value of Firm 30,00,000 30,54,545 27,92,308
Overall cost of Capital 3,00,000 / 3,00,000 / 3,00,000 /
EBIT / V 30,00,000 = 10% 30,54,545 = 27,92,308 = 10.7%
9.8 %
From the above table it is clear that if the firm uses debt. of Rs. 6,00,000; the
value of firm increases and overall cost of capital decreases. But if more debt is used; that
is Rs. 9,00,000 debt, and the overall cost of Capital Increases.
19
Modigliani & Miller Approach
Modigliani & Miller in their paper have stated that the relationship between
Leverage and Cost of Capital is explained by the net operating income approach in terms
of 3 basic propositions. They argue against the traditional approach by offering
behavioral justification for having the cost of capital remain constant throughout all
degrees of Leverage.
The M & M Approach is based upon the following assumptions.
a) There is no corporate or personal income tax.

b) Investors are assumed to be rational and behave accordingly i.e., choose a
combination of risk and return that is most advantageous to them.
c) There is perfect capital market, information is cost less and readily available to all
investors.
d) There are no transaction costs and all securities are infinitely divisible.
e) All earnings are distributed to Share Holders.
f) Firms can be grouped into “equivalent return” classes on the basis of their
business risks. All firms falling into one class have the same degree of business
risk.
M & M Approach in the absence of corporate taxes has been explained with the
following illustration. According to them, the value of an un-levered firm can be
calculated as:
Net Operating Income EBIT

Value of Un-Levered Firm (Vu) = =
Overall Capitalization Rate Ko

Value of Levered Firm (VL) = =
Value of Levered Firm (VL) = Vu + tD

a
Where , Vu = Value of Un-Levered Firm
VL = Value of Levered Firm
t = Tax Rate
D= Debt Capital
Illustration 18
A company has earnings before Interest & Taxes of Rs. 1,25,000. It expects a
return on its investment at a rate of 12.5%. You are required to find out the total value of
the firm according to M & M Theory.
20
Value of Un-Levered Firm (Vu) = =
1,25,000
Value of Un-Levered Firm (Vu) = = 10,00,000
O.125
The value of levered and un-levered firms under the M & M Approach (Assuming that
corporate taxes exist) can be calculated as

Value of Un-Levered Firm (Vu) = = (1 – t)
Illustration 19
There are 2 firms A & B which are exactly identical except that A does not use
any debt in its financing while B has Rs. 5,00,000; 5% debentures in its capital structure.
Both the firms having earnings before tax and the equity capitalization rate is 10%.
Assuming the corporate tax rate of 50%, calculate the value of the firms using M & M
Approach.
Solution
The market value of firm A which does not use any debt

Value of Un-Levered Firm (Vu) = = (1 – t)
1,25,000
Value of Un-Levered Firm (Vu) = x (1 – 0.5) = 6,25,000
0.10
The market value of firm B which uses debt financing of Rs. 5,00,000
Value of Levered Firm (VL) = 6,25,000 + 0.5 (5,00,000)
= 8,75,000.
21
Chapter Roundup
 Financing decision is concerned with the determination of the quantum of

finance, the amount that can be raised from each source and the cost and
other consequences involved.
 Capital structure refers to the composition of long term sources of funds such
as Debentures, Long-term Loans, Preference Share Capital and Equity Share
Capital including Reserves and Surplus.
 Earnings per share refer to expressing the relationship between net profit
available to equity shareholders and the number of equity shares.
 Point of indifference refers to that EBIT level at which Earnings Per Share
(EPS) remains the same irrespective of the Debt and Equity mix. In other
words, at this point, the rate of return on capital employed is equal to the
rate of interest on debt.
 The capital structure is said to be optimal capital structure when the firm has
selected such a combination of equity and debt so that the wealth of the firm
is maximum. At this capital structure, the cost of capital is minimum and
market price per share is maximum.
Quick Quiz
1. What is Financing Decision?

2. Define Capital Structure.
3. What is Optimal Capital Structure?
4. What is Point of Indifference?
5. Give the meaning of Earnings per Share.
6. Briefly explain the factors which influence the planning of the Capital
Structure of a Company.
7. The capital structure of X ltd. consists of the following securities: -
 10% Debentures Rs. 5,00,000
 12% Preference Shares Rs. 1,00,000
 Equity Shares of Rs. 100 each Rs. 4,00,000
Operating Profit (EBIT) of the company is Rs. 1,60,000 and the company is in
50% tax bracket.
(i) Determine the company’s EPS
(ii) Determine the percentage change in EPS associated with 30% increase
and 30% decrease in EBIT.
(iii) Determine the degree of Financial Leverage.
8. Don’t worry ltd. needs Rs. 24,00,000 for the installation of a new factory,
which would yield an annual EBIT of Rs. 5,00,000. it is considering the
possibility of issuing equity share plus raising a debt of Rs. 4,00,000, Rs.
12,00,000 and Rs. 20,00,000. The current market price of equity share is Rs.
40, which is expected to drop to Rs. 25 per share of the market borrowing
here to exceed Rs. 15,00,000 costs of borrowed capital indicated as follows.
Up to Rs. 5,00,000 12% p.a.
22
Between Rs. 5,00,000 & Rs. 12,50,000 16% p.a.
Between Rs. 12,50,000 & Rs. 20,00,000 16% p.a.
Assuming the tax rate of 50%, calculate the earnings per share and indicate
the scheme that would yield maximum EPS.
9. A ltd. company has equity share capital of Rs. 5,00,000 divided into shares of
Rs. 100 each. It wishes to raise further Rs. 3,00,000 for expansion cum
modernization plans. The company plans the following financing schemes.
(a) All common stock
(b) Rs. 1,00,000 in common stock and Rs. 2,00,000 in debt at 10% per
annum.
(c) All debt at 10% per annum.
(d) Rs. 1,00,000 in common stock and Rs. 2,00,000 in preference share
capital at 8%.
The company’s existing EBIT is Rs. 1,50,000. The corporate tax rate is 50%.
Determine the earnings per share in each plan and comment on the
implication of financial leverage.
10. ‘X’ Ltd. is considering three financial plans. The key information is as follows:
(a) Total investment to be raised Rs. 2,00,000.
(b) Plans of financing proportion.
PLANS EQUITY DEBT PREFERENCE
SHARES
A 100% –– ––
B 50% 50% ––
C 50% –– 50%
(c) Cost of Debt 8%, Cost of Preference Shares 8%.
(d) Tax rate 50%.
(e) Equity shares of the face value of Rs. 10 each
(f) Expected EBIT is Rs. 80,000
Determine earnings per share for each plan.
11. It is proposed to start a business requiring a capital Rs. 10,00,000 and
assured return of 15% on investment. Calculate EPS if: -
(i) The entire capital is raised by means of Rs. 100, equity shares.
(ii) If 50% is raised from equity shares and 50% of capital is raised by
means of 10% debenture.
12. A new project under consideration by your company requires a capital
investment of Rs. 150 lakhs. Interest on term-loan is 12% and tax rate is
50%. If the debt equity ratio insisted upon by financing agencies is 2:1.
Calculate point of indifference for the project assuming that the face value of
equity share is Rs. 10 per share.
13. Wal-Mart Stores with total capitalization of Rs. 10,00,000 consisting of
entirely equity share capital has before it two choices to meet the additional
capital needs of Rs. 15,00,000.
You are required to calculate the point of indifference in each of the following
cases assuming 35% of corporate tax rate and face value of equity shares of
Rs. 100.
(i) Equity capital of Rs. 15,00,000 or Rs. 7,50,000, 10% Debenture and Rs.
7,50,000 of Equity Capital.
(ii) Equity capital of Rs. 15,00,000 or Rs. 7,50,000 equity capital and Rs.
7,50,000, 15% Preference Shares.
14. A project under consideration by a company requires a capital investment of
Rs. 75,00,000. Interest on term loan is 10% and tax rate is 50%. Calculate
the point of indifference for the project if the debt equity ratio insisted by the
financing agencies is 2:1.
23
24
INVESTMENT DECISION
Introduction
The investment and financing of funds are two crucial functions of finance
manager. The investment of funds requires a number of decisions to be taken in a
situation in which, funds are invested and benefits are expected over a long period.
The finance manager of a concern has to decide about the assets composition of the
firm. The assets of the firm are broadly classified into two categories namely fixed
assets and current assets. The aspect of taking the financial decision with regard to
fixed assets is known as investment decision or capital budgeting.
Investment decision is a long-range financial decision. This is concerned with

the allocation of Capital. In other words, this comprises decision relating to
investment in fixed assets. It is the most important financial decision, since the funds
involve cost and are available in a limited quantity to achieve the goals of
management.
Capital Budgeting
Capital Budgeting refers to planning the deployment of available capital for

the purpose of maximizing the long-term profitability of a firm. It is the firm’s
decision to invest its current funds most efficiently in the long-term activities in
anticipation of flow of future benefits over a series of years. Charles T Horngreen has
defined capital budgeting, as “Capital Budgeting is long-term planning for making
and financing proposed capital outlays”. In the words of lynch, “Capital Budgeting
consists in planning deployment of available capital for the purpose of maximizing
the long-term profitability of the concern.”
Features of Capital Budgeting
Capital Budgeting decisions have the following features: -
a) Capital Budgeting decisions involve the exchange of current funds for the
benefits to be achieved in future.
b) The future benefits are expected to be realized over a series of years.
c) The funds are invested in long-term activities.
d) They have a long-term effect on the profitability of the concern.
e) They generally involve huge funds.
f) The capital budgeting decisions are irreversible.
g) They have the effect of increasing the capacity, efficiency or economy of
operation of existing fixed assets.
1
Significance of Capital Budgeting
Capital Budgeting decisions are the most crucial and important business
decisions. The need, significance or importance of capital budgeting arises mainly
due to the following:
a) Substantial Expenditure: - Capital budgeting decisions involve the

investment of substantial amount of funds. Therefore, it is necessary that the
firm should carefully plan its investment programme so that funds are put to
most profitable use.
b) Long-term Commitment of Funds: - Capital budgeting decisions have its

effect over a long period of time. These decisions not only affect the future
benefits and costs of the firm but also influence the rate and direction of the
growth of the firm. The effects of capital budgeting decisions extend into the
future.
c) Irreversible Nature: - Capital budgeting decisions are of irreversible in

nature. Once they are taken, the firm may not be in a position to reverse
them back. This is because as it is difficult to find a buyer for the second-hand
capital items.
d) Most Difficult Decision: - The capital investment decisions involve an

accurate assessment of future events, which infact is difficult to predict.
Further, it is quite difficult to estimate in quantitative terms all the benefits or
the costs relating to a particular investment decision.
e) Long-term effect on profits: - Capital budgeting decisions have a long-

term effect on the profitability of a concern.
Phases of Investment Decisions
It is important for the finance manager to have an understanding of the

various stages of capital budgeting. The capital budgeting process can be divided
into seven significant phases: -
1. Finding Investment Opportunities: - Before investment, opportunities can

be evaluated, they must first be identified. Since the long-term profitability of
most companies depends on the nature and quality of their capital
investments, locating appropriate projects is particularly important. Certain
capital expenditures can result from the strategic planning process.
Employees are another source of ideas and they should be encouraged to
submit proposals.
2. Collect Information about Opportunities: In order to effectively evaluate

investment opportunity, the expected cash flows from project must be
estimated and the total outlay necessary to place the investment in operative
form must be determined. In addition, a plan for implementing the
opportunity must be developed and other non-financial information must be
assembled.
2
3. Select Discount Rate: Before the cash flows can be evaluated, the discount
rate must be established.
4. Financial Analysis of Cash Flows: In this phase, the techniques of capital

budgeting are applied to the estimated cash flows developed in the second
phase.
5. Decision: Before the final decision is made as to the selection of a particular

investment, many factors must be given consideration. The financial analysis
of cash flows is one of the most important factors, but there are other factors
that may outweigh the most favorable cash flow. These factors social impact
to other aspects of the company operations and long-term goals, the timing
of the cash flows, the availability of funds for investment purposes, and the
impact the opportunity will have on the financial structure of the company.
6. Project Implementation: - Once the decision has been made to invest

funds, more detailed plans for making the project operational are developed.
Responsibility for implementing the project is assigned and the necessary
steps are taken to get the project underway. The time involved in
implementing the project naturally varies. For major expansions, where
additional facilities must be constructed, it may take several years, whereas
some equipment replacements can be made in a matter of days.
7. Project Evaluation and Appraisal: - An important, but often omitted phase

of capital budgeting is an assessment of how effective the investment actually
is? The evaluation may be in the form of continuous monitoring of the project
so that corrective action can be taken.
Factors Influencing Investment Decision
Capital Investment Decision are only concerned with the replacement of old
equipment by a new one, but also with changing technology, products, processes,
organization, and so on, to make the entire system more efficient. Consequently,
there are a number of factors which, directly or indirectly influence a capital
investment decision. The main factors are discussed below.
1. Technological Change: In modern times, one often finds fast obsolescence

of technology. New technology, which is relatively more efficient, takes the
place of old technology. However, in taking a decision of this type the
management has to consider the cost of new equipment vis-à-vis the
productive efficiencies of the new as well as the old equipments. However,
while evaluating the cost of the equipment the management should not take
into account, its full accounting cost but its incremental cost. Also the cost of
new equipment is often partly offset by the salvage value of the replace
equipment.
2. Competitors Strategy: Many a time an investment is taken to maintain the

competitive strength of a firm. If the competitors are installing new
equipment to expand output or to improve quality of their products, the firm
under consideration will have no alternative but to follow suit, else it will
perish. It is, therefore often found that the competitive strategy regarding
3
capital investment plays a very significant role in forcing capital decisions on a
firm.
3. Demand Forecast: The long run forecast of demand is one of the

determinant of investment decision. If it is found that there is a market
potential for the product in the long run, the dynamic firm will have to take
decisions for capital expansion.
4. Fiscal Policy: Various tax policies of the government such as rebate on new
investment, method of allowing depreciation, tax concessions on investment
income etc. also have favorable influence on capital investment.
5. Cash Flows: Every firm makes a cash flow budget. Its analysis influences
capital investment decisions. With its help, the firm plans the funds for
acquiring the capital asset. The budget also shows the timing of availability of
cash flows for alternative investment proposals.
6. Type of Management: The capital investment decisions are also influenced

by the type of management. Whether the capital investment decision would
be encouraged or not depends to a large extent on the view point of the
management. If the management is modern and progressive in its outlook,
the innovations will be encouraged.
7. Returns Expected from the Investment: In most of the cases, investment

decisions are made in anticipation of future returns. While evaluating
investment proposals, it is therefore essential for the firm to estimate future
returns.
8. Non-Economic Factors: Sometimes, non-economic factors also influence

investment decisions, for example – an investment to improve the working
place may result in reduction in absenteeism and improved productivity.
Investment in a mission ensuring greater safety in operation would similarly
improve production by avoiding injury to the workers.
Techniques of Evaluation of Investment
There are many methods for evaluating capital investment proposals. In

every method, the basic approach is to compare the benefits derived from the
project with the investment in the project.
These methods can be broadly classified as follows: -
A) Traditional methods:
1) Payback period method and
2) Accounting rate of return method.
B) Discounted cash flow methods:

1) The net present value method
2) The internal rate of return method and
3) The profitability index method.
4
1. Payback Period Method
The payback period method is one of the simplest and traditional methods of
capital investment evaluation technique. It is defined as “the initial outlet required
divided by gross earnings”. In other words, the term payback period refers to the
time in which the project will generate the necessary cash to recover the initial
investment.
Advantages of Payback Period
1) This method is easy to compute and simple to understand.

2) It enables quick ascertainment of degree of risk.
3) It enables the firm to select a project that will yield a quick return of cash if it
is short of cash.
4) This method of project appraisal is suitable when management is risk averse
or concerned with early recovery of investment, or when the industry is
subject to fast obsolescence of technology or products.
5) This method is of great help in those industries which are subject to rapid
technological changes as it reduces the possibility of loss through
obsolescence.
Disadvantages of Payback Period
1) This method ignores the time value of money.

2) It does not take into consideration the income after the payback period.
3) Profitable projects maybe foregone under this method, for fear of liquidity.
Computation of Payback Period
The payback period can be calculated as follows: -
In case of constant annual cash inflows
If the project generates constant annual cash inflows, the payback period can
be calculated by using the following formula:
Original Investment
Payback Period =
Annual Cash Inflow
Illustration: 1
A project requires an initial investment of Rs. 1,00,000 and yields annual cash
inflow of Rs. 20,000 for ten years. What is the payback period?
Solution: -
Original Investment
Payback Period =
Annual Cash Inflow
1,00,000
Payback Period = = 5 years
20,000
5
Illustration: 2
A project requires Rs. 2,50,000 as initial investment and it will generate an

annual cash inflow of Rs. 42,000 for eight years. What is the payback period?
Solution: -
Original Investment
Payback Period =
Annual Cash Inflow
2,50,000
42,000
Illustration: 3
ABC Company Ltd., is considering 2 alternative machines, first alternative

costs Rs. 12,000 and estimated annual cash inflow from it amounts to Rs. 4,000. Its
economic life is 5 years. The Second alternative costs Rs. 10,000 and its estimated
cash inflow is also Rs. 4,000 p.a. its economic life is however, only 4 years. Advise
the management by using pay back period model.
Solution: -
lnitial Investment
Payback Period =
Annual Cash Inflow
12,000
First alternative = = 3 years
4,000
10,000
Second alternative = = 2.5 years
4,000
Illustration: 4
A company is considering expanding its production. It can go in either for an

automatic machine costing Rs. 4,48,000 with an estimated life of 6 years or an
ordinary machine costing Rs. 1,20,000 having an estimated life of 8 years. The
annual sales and costs are estimated as follows: -
Automatic Machine Ordinary Machine

Rs. Rs.
Sales 3,00,000 3,00,000
Costs:
Materials 1,00,000 1,00,000
Labor 24,000 1,20,000
Variable Overheads 48,000 40,000
Calculate payback period and advice the management.
6
Solution:
Calculation of annual cash inflow
Automatic Ordinary
Machine Machine
Rs. Rs.
A. Sales 3,00,000 3,00,000
B. Variable Costs:
Materials 1,00,000 1,00,000
Labour 24,000 1,20,000
Variable Overheads 48,000 40,000
Total Variable Costs 1,72,000 2,60,000
Annual Cash Inflow (A – B) 1,28,000 40,000
lnitial Investment
Payback Period =
Annual Cash Inflow
Automatic Machine
4,48,000
Payback Period = = 3.5 years
1,28,000
Ordinary Machine
1,20,000
40,000
Conclusion: Ordinary machine is preferable because its payback period is

less when compared to that of Automatic machine.
Illustration: 5
The directors of Alpha limited are contemplating the purchase of a new

machine, which has been in operation in the factory for the last 5 years. Ignoring
interest but considering tax at 50% of net earnings, suggest which of the two
alternatives should be preferred using payback period method. The following are the
details.
Old Machine New Machine
Purchase Price Rs. 40,000 Rs. 60,000
Estimated life of machine 10 years 10 years
Machine running hours per annum 2,000 2,000
Units per hour 24 36
Wages per running hour Rs. 3 Rs. 5.25
Power per annum Rs. 2,000 Rs. 4,500
Consumable stores per annum Rs. 6,000 Rs. 7,500
All other charges per annum Rs. 8,000 Rs. 9,000
Material cost per unit Re. 0.50 Re. 0.50
Selling price per unit Rs. 1.25 Rs. 1.25
You may assume that the above information regarding sales and cost of sales
will hold well throughout the economic life of each of the machines.
7
Solution: -
Calculation of annual cash inflow
Old New
Machine Machine
Rs. Rs.
A. Sales 60,000 90,000
B. Costs:
Direct Material 24,000 36,000
Wages 6,000 10,500
Power 2,000 4,500
Consumable Stores 6,000 7,500
Other charges 8,000 9,000
Depreciation 4,000 6,000
Total Cost 50,000 73,500
Profit before Tax (A – B) 10,000 16,500
Less: Tax @ 50% 5,000 8,250
Profit after Tax 5,000 8,250
Add: Depreciation 4,000 6,000
Annual Cash Inflow 9,000 14,250
Calculation of Payback Period
lnitial Investment
Payback Period =
Annual Cash Inflow
Old Machine
40,000
9,000
New Machine
60,000
14,250
Conclusion: New machine is preferable because its payback period is less as

compared to that of Old machine.
8
Illustration: 6
X Limited is considering the purchase of a new machine, which would carry

out some operations at present being performed by manual labour. Two alternative
models under consideration are A and B. Following is the information.
Particulars Machine A Machine B

Cost of machines 1,50,000 2,50,000
Expected life in years 5 6
Cost of indirect material per annum 6,000 8,000
Estimated savings in scrap per annum 10,000 15,000
Additional cost of maintenance per annum 19,000 27,000
Estimated savings in wages:
Employees not required (Nos.) 150 200
Wages per employee per annum (Rs.) 600 600
Tax is to be regarded as 50% (Ignore depreciation for calculating Tax). Using

“Payback period” suggest which model should be purchased.
Solution: -
Calculation of Annual Cash Inflow
Particulars Machine A Machine B

Savings in scrap 10,000 15,000
Estimated savings in wages 90,000 1,20,000
TOTAL ESTIMATED SAVINGS 1,00,000 1,35,000
Cost of indirect material 6,000 8,000
Additional cost of maintenance 19,000 27,000
TOTAL ANNUAL EXPENDITURE 25,000 35,000
E.B.T (Savings – Expenditure) 75,000 1,00,000
Less: Tax at 50% 37,500 50,000
ANNUAL CASH INFLOW 37,500 50,000
Computation of Payback Period:
Initial Investment 1,50,000 2,50,000

Payback period = =
Annual cash inflow 37,500 50,000
4 years 5 years
On the basis of payback period, Model A is preferable because its payback

period is less as compared to Model B.
9
Illustration: 7
Someshwar Industries Ltd. is considering the purchase of a new machine,

which would carry out some operations at present being performed by hands. The
two alternative models under consideration are camelex and shreelex.
The following information is available in respect of both models:
Particulars Camelex Shreelex

Cost of machines Rs. 6,00,000 Rs. 10,00,000
Estimated life in years 10 12
Estimated savings in scrap per annum Rs. 40,000 Rs. 60,000
Additional cost of supervision per annum Rs. 48,000 Rs. 64,000
Additional cost of maintenance per annum Rs. 28,000 Rs. 44,000
Cost of indirect materials per annum Rs. 24,000 Rs. 32,000
Estimated savings in wages:
Wages per worker per annum Rs. 2,400 Rs. 2,400
Number of workers not required 150 200
Using the method of payback period, suggest which model should be

purchased.
Solution:
Calculation of Annual Cash Inflow: -

Particulars Camelex Shrilex
A. Estimated Annual Savings Rs. Rs.
Savings in scrap 40,000 60,000
Savings in wages 3,60,000 4,80,000
Total estimated savings 4,00,000 5,40,000
B. Estimated Annual Expenses
Additional cost of supervision 48,000 64,000
Additional cost of maintenance 28,000 44,000
Cost of indirect material 24,000 32,000
Total estimated annual expenses 1,00,000 1,40,000
Annual cash inflow (A – B) 3,00,000 4,00,000
Computation of Payback Period:
Camele Shrilex
x
Initial Investment 6,00,000 10,00,000
Payback period = =
Annual cash inflow 3,00,000 4,00,000
2 years 2.5 years
Conclusion: Model Camelex has a shorter pay back period hence, it is to be

purchased.
10
Concept of Cash Inflow
The term cash inflow refers to earnings after tax but before depreciation
Cash inflow=Earnings after Tax + Depreciation.
This can be calculated as follows: -
Case 1: - If profit after tax but before depreciation is given:

This it is called cash inflow.
Case 2: - If profit after tax is given:
Cash Inflow = PAT + Depreciation.
Case 3: - If profit before tax is given:
Cash Inflow = PBT – Tax = PAT + Depreciation.
Case 4: - If profit before depreciation and tax is given:
Cash Inflow = PBDT – Depreciation = PBT – Tax = PAT + Depreciation.
Illustration: 8
A company has an investment opportunity costing Rs. 40,000 with the

following expected net cash flows after taxes but before depreciation.
Year 1 to 5 Rs. 7,000 each year

Year 6 to 9 Rs. 8,000 each year
Determine the payback period.
Solution: -
Year Cash Inflow Cumulative Cash Inflow

Rs. Rs.
1 7,000 7,000
2 7,000 14,000
3 7,000 21,000
4 7,000 28,000
5 7,000 35,000
6 8,000 43,000
7 8,000 51,000
8 8,000 59,000
9 8,000 67,000
Payback Period = 5 years + (5,000/8,000)

= 5 years, 7 months and 13 days.
11
Illustration: 9
Ganesh and Company is considering the purchase of a machine. Two

machines X and Y each costing Rs. 50,000 is available. Earnings after taxation are
expected to be as under. Calculate Payback Period.
Year Machine X Machine Y

Rs. Rs.
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Solution: -

Year EAT Dep. Cash Cumulative EAT Dep. Cash Cumulative
(X) Inflow Cash (Y) Inflow Cash
Inflow (x) Inflow (y)
1 15,000 10,000 25,000 25,000 5,000 10,000 15,000 15,000
2 20,000 10,000 30,000 55,000 15,000 10,000 25,000 40,000
3 25,000 10,000 35,000 90,000 20,000 10,000 30,000 70,000
4 15,000 10,000 25,000 1,15,000 30,000 10,000 40,000 1,10,000
5 10,000 10,000 20,000 1,35,000 20,000 10,000 30,000 1,40,000
Payback Period X = 1 year + (25,000 / 30,000) = 1 year and 10 months

Payback Period Y = 2 years + (10,000 / 30,000) = 2 years and 4 months
Illustration: 10
A Limited Company is considering investment in a project requiring a capital

outlay of Rs. 2,00,000. Forecast for annual income after depreciation but before tax
is as follows:
Income after depreciation
Year
before tax [Rs.]
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000
Depreciation may be taken as 20% on original cost and taxation at 50% of

net income. You are required to evaluate the project by the method of payback
period.
12
Solution: -
Cash Inflow Cum.

Year EBT TAX EAT
(EAT + Dep.) Cash Inflow
1. 1,00,000 50,000 50,000 90,000 90,000
2. 1,00,000 50,000 50,000 90,000 1,80,000
3. 80,000 40,000 40,000 80,000 2,60,000
4. 80,000 40,000 40,000 80,000 3,40,000
5. 40,000 20,000 20,000 60,000 4,00,000

= 2 years and 3 months.
Illustration: 11
A company is considering an investment proposal to install a new machine.

The machine will cost Rs. 50,000 and will have a life of 5 years and no salvage value.
The company’s tax rate is 50%. The company uses straight-line method of
depreciation. The estimated net income before depreciation and tax from the
proposed investment proposal is as follows:
Year Rs.
1 10,000
2 11,,000
3 14,,000
4 15,,000
5 25,,000
Calculate Payback Period.
Solution: -
Cash Inflow Cum.

TAX at
Year EBDT Dep. EBT EAT (EAT+ dep.) Cash
50%
Inflow
1. 10,000 10,000 0 0 0 10,000 10,000
2. 11,000 10,000 1,000 500 500 10,500 20,500
3. 14,000 10,000 4,000 2,000 2,000 12,000 32,500
4. 15,000 10,000 5,000 2,500 2,500 12,500 45,000
5. 25,000 10,000 15,000 7,500 7,500 17,500 62,500

13
Illustration: 12
The following information is available pertaining to Machine X

Initial investment Rs. 10,00,000
Required rate of return – 10%
Cash inflows in various years
Cash Inflows
Year
Rs.
1 1,00,000
2 4,00,000
3 6,00,000
4 6,00,000
5 2,00,000
Calculate:
a) Payback period ignoring the interest factor.
b) Payback period taking into account the interest factor.
Solution: -
1. Calculation of Payback Period ignoring interest factor.
Cumulative
Year Cash Inflows
Cash Inflow
1 1,00,000 1,00,000
2 4,00,000 5,00,000
3 6,00,000 11,00,000
4 6,00,000 17,00,000
5 2,00,000 19,00,000
Payback Period = 2 years + (5,00,000/6,00,000)

= 2 years, and 10 months.
2. Calculation of Payback Period taking interest factor into account

(Discounted payback period)
Cash Present Value Present Cum. Present

Year
Inflows Factor Value Value
1 1,00,000 0.909 90,900 90,900
2 4,00,000 0.826 3,30,400 4,21,300
3 6,00,000 0.751 4,50,600 8,71,900
4 6,00,000 0.683 4,09,800 12,81,700
5 2,00,000 0.621 1,24,200 14,05,900
Discounted Payback Period = 3 years + (1,28,100/4,09,800)

14
2. Accounting Rate of Return Method
Accounting rate of return means the average annual yield on the project. It is
one of the important methods of capital investment technique, which takes into
account earnings over the whole life of the project. It is also known as average rate
of return method. Under this method, various projects are ranked on the basis of
rate of return.
Advantages of Accounting Rate of Return
1) This method is easily understandable, computable and is based on readily

available accounting information.
2) The method takes into account the entire cash flow spread over the life of the
project.
3) This method can be easily used for comparing and ranking the projects.
Disadvantages of Accounting Rate of Return
1) It is based upon accounting profit and not cash flows.

2) This method also ignores the time value of money.
3) This method is inadequate for comparing projects of different duration.
4) Returns on investment are calculated in terms of post-tax book profits.
Computation of Accounting Rate of Return
Accounting rate of return may be calculated as follows: -
(i)
Average Annual Income
ARR = x 100
Original Investment
(ii)
ARR = x 100
Average Investment
Average Annual Income:
The term average annual income refers to average of the earnings over the
economic life of the project. This can be calculated as follows: -
Total Profit after Tax

Average Annual Income =
No. of Years
Average Investment:
The amount of average investment may be calculated in any of the following

ways: -
1) If the investment in working capital is not given: -
Original Investment – Scrap
Average Investment =
2
15
2) If the investment in working capital is given: -

Average Investment = + Working Capital + Scrap
2
Illustration: 13
A limited is proposing to take up a project, which requires an investment of

Rs. 1,20,000. The net income before depreciation and tax is estimated as follows: -
Year Rs.
1 30,000
2 36,000
3 42,000
4 48,000
5 60,000
Depreciation is to be charged on straight-line basis. Tax rate is 50%.

Calculate accounting return method.
Solution: -
Calculation of Average Annual Income
Rs.
Total profit before depreciation and tax 2,16,000
Less: Total depreciation [Original Cost – Scrap] 1,20,000
Total profit before tax 96,000
Less: Tax @ 50% 48,000
Total profit after tax 48,000
48,000
Average Annual Income = = 9,600
5
Calculation of Average Investment
Original Investment – Scrap 1,20,000 – 0

Aveg. Investment = = = 60,000
2 2
Calculation of ARR

ARR = x 100
Average Investment
9,600
ARR = x 100 = 16%
60,000
16
Illustration: 14
A project requires an investment of Rs. 5,00,000 and has a scrap value of

Rs. 20,000 after five years. It is expected to yield profits after taxes during the five
years are as follows: -
Year Rs.
1 40,000
2 60,000
3 70,000
4 50,000
5 20,000
Calculate the average rate of return.
Solution: -
Total Profit after Tax 2,40,000

Average Annual Income = = = 48,000
No. of Years 5
500000-20000
Average investment = = 240000
2
Calculation of Average Rate of Return

ARR = x 100
Average Investment
48,000
ARR = x 100 = 20%
2,40,000
Illustration: 15
A limited is considering investing in a project requiring a capital outlay of

Rs. 2,40,000. Forecast of annual income after depreciation but before tax is as
follows: -
Year Rs.
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000
Depreciation is 20% on original cost and income tax @ 50% of net income.
Calculate the accounting rate of return.
17
Solution: -
Rs.
Total profit before tax 4,00,000
Less: Tax @ 50% 2,00,000
Total profit after tax 2,00,000
Total Profit after Tax 2,00,000

Number of Years 5
Original Investment – Scrap 2,40,000 – 0

Aveg. Investment = = = 1,20,000
2 2

ARR = x 100
Average Investment
40,000
ARR = x 100 = 33.33%
1,20,000
Illustration: 16
A Ltd. Co. has under consideration of the following two projects the details
are as under: -
Particulars Project X Project Y
Investment in machinery 10,00,000 15,00,000
Working capital 5,00,000 5,00,000
Life of machinery 4 years 6 years
Tax rate 50% 50%
Scrap Value 10% 10%
Income before depreciation and Tax:
X Rs. Y Rs.
1st year 8,00,000 15,00,000
2nd year 8,00,000 9,00,000
3rd year 8,00,000 15,00,000
4th year 8,00,000 8,00,000
th
5 year 6,00,000
6th year 3,00,000
You are required to calculate the ARR and suggest which project is to be
preferred.
18
Solution: -

Average Investment = + Working Capital + Scrap
2
10,00,000 – 1,00,000
Project X = + 5,00,000 + 1,00,000
2
= 4,50,000 + 6,00,000
= 10,50,000
15,00,000 – 1,50,000
Project Y = + 5,00,000 + 1,50,000
2
= 6,75,000 + 6,50,000
= 13,25,000
Total Profit after Tax

Average Annual Income =
Number of Years
Project X Project Y
Total profit before Dep. and Tax 32,00,000 56,00,000
Less: Total Depreciation [Original Cost – Scrap] 9,00,000 13,50,000
Total profit before Tax 23,00,000 42,50,000
Less: Tax @ 50% 11,50,000 21,25,000
Total profit after tax 11,50,000 21,25,000
Project X = (11,50,000 / 4) = 2,87,500.

Project Y = (21,25,000 / 6) = 3,54,167.

ARR = x 100
Average Investment
2,87,500
Project X = x 100 = 27%
10,50,000
3,54,167
Project Y = x 100 = 26%
13,25,000
19
3. Net Present Value
The NPV method is one of the discounted cash flow techniques, which
recognizes time value of money. It is considered to be the best method for
evaluating the capital investment projects. It is based on the assumption that cash
flow arising at different time periods differs in value and is comparable only when
their present values are found out. The term NPV refers to the excess of present
value of cash inflows over the present values of cash outflows.
NPV= Total Present Value of Cash Inflow–Total Present Value of Cash Outflow
Advantages of Net Present Value
1) This method takes into account time value of money.

2) The whole stream of cash flows spread over the life of the project is
considered.
3) Projects can be ranked according to their rate of return.
4) Makes use of the rapidly available information from accounting records.
Disadvantages of Net Present Value
1) Method is difficult to understand.

2) Depends upon the knowledge of the firm’s cost of capital or discount rate.
3) Projects with higher NPV cannot be completed as huge amount of investment
is required.
Illustration: 17
Mahesh Electronics Company Ltd. is considering the purchase of a machine.

Two machines P and Q each costing Rs. 50,000 is available. In comparing the
profitability of these machines a discount rate of 10% is to be used. Earnings after
taxes are expected to be as follows:
Year Machine ‘P’ Machine ‘Q’

Rs. Rs.
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
The following are the present value factors at 10%.
YEAR 1 2 3 4 5
P.V. Factors at 10% 0.909 0.826 0.751 0.683 0.621
Evaluate the proposals under:

1. The Payback Period
2. The Accounting Rate of Return
3. The Net Present Value
20
Solution: -
Computation of Cash Inflows
Year Machine ‘P’ Dep. Cash Machine ‘Q’ Dep. Cash

(PAT) Inflow ‘P’ (PAT) Inflow ‘Q’
1 15,000 10,000 25,000 5,000 10,000 15,000
2 20,000 10,000 30,000 15,000 10,000 25,000
3 25,000 10,000 35,000 20,000 10,000 30,000
4 15,000 10,000 25,000 30,000 10,000 40,000
5 10,000 10,000 20,000 20,000 10,000 30,000
Calculation of Depreciation
Depreciation = (Original cost – Scrap) / Life of Asset
P = (50,000 – 0) / 5 = 10,000.
Q = (50,000 – 0) / 5 = 10,000.
a) Calculation of Payback Period

Year Cash Inflow Cumulative Cash Inflow Cumulative Cash
‘P’ Cash Inflow ‘Q’ Inflow
1 25,000 25,000 15,000 15,000
2 30,000 55,000 25,000 40,000
3 35,000 90,000 30,000 70,000
4 25,000 1,15,000 40,000 1,10,000
5 20,000 1,35,000 30,000 1,40,000
Payback Period (P) = 1 year + 25,000 / 30,000 = 1 year, 10 months
Payback Period (Q) = 2 years + 10,000 / 30,000 = 2 years, 4 months
b) Calculation of Accounting Rate of Return

ARR = x 100
Average Investment
Total Profit after Tax 85,000

Average Annual Income (P) = = = 17,000
Number of Years 5
Total Profit after Tax 90,000

Average Annual Income (Q) = = = 18,000
Number of Years 5
Original Investment – Scrap 50,000 – 0

Avg. Investment (P) = = = 25,000
2 2

Avg. Investment (Q) = = = 25,000
2 2
17,000
ARR (P) = x 100 = 68%
25,000
21
18,000
ARR (Q) = x 100 = 72%
25,000
c) Calculation of Net Present Value

Year P.V.F @ 10% Cash Inflow P P.V of (P) Cash Inflow Q P.V of (Q)
1 0.909 25,000 22,725 15,000 13,635
2 0.826 30,000 24,780 25,000 20,650
3 0.751 35,000 26,285 30,000 22,530
4 0.683 25,000 17,075 40,000 27,320
5 0.621 20,000 12,420 30,000 18,630
Total P.V. of Cash Inflow 1,03,285 1,02,765
LESS: Initial Investment 50,000 50,000
Net Present Value 53,285 52,765
Illustration: 19
From the following information calculate the NPV of the two projects and
suggest which of the two projects should be accepted assuming a discount rate of
10%.
Project X Project Y
Initial Investment Rs. 20,000 Rs. 30,000
Estimated Life 5 years 5 years
Scrap Value Rs. 1,000 Rs. 2,000
The profit before depreciation, after taxes (cash
inflows) are as follows: -
Year X Rs. Y Rs.
1 5,000 20,000
2 10,000 10,000
3 10,000 5,000
4 3,000 3,000
5 2,000 2,000
The P.V. Factor @ 10% discount rate is as follows: -
YEAR 1 2 3 4 5
P.V. Factors at 10% 0.909 0.826 0.751 0.683 0.621
Solution: -
Calculation of Net Present Value
Year P.V.F @ 10% Cash Inflow X P.V of (X) Cash Inflow Y P.V of (Y)
1 0.909 5,000 4,545 20,000 18,180
2 0.826 10,000 8,260 10,000 8,260
3 0.751 10,000 7,510 5,000 3,755
4 0.683 3,000 2,049 3,000 2,049
5 0.621 2,000 1,242 2,000 1,242
5 0.621 1,000 621 2,000 1,242
Total P.V. of Cash Inflow 24,227 34,728
22
Illustration: 20
Two competing projects, which require an equal investment of Rs. 50,000 and
are expected to generate net cash flows as under:
Year Project X Project Y

1 25,000 10,000
2 15,000 12,000
3 10,000 18,000
4 ---- 25,000
5 12,000 8,000
6 6,000 4,000
The cost of the capital of the company is 10%. The following are the present
value factors at 10%.
YEAR 1 2 3 4 5 6
P.V. Factors at 10% 0.909 0.826 0.751 0.683 0.621 0.564
Evaluate the project proposals under:

a) Pay back period.
b) NPV method.
Solution: -
(a) Calculation of Payback Period
Year Project X Cumulative Inflow Project Y Cumulative Inflow

1 25,000 25,000 10,000 10,000
2 15,000 40,000 12,000 22,000
3 10,000 50,000 18,000 40,000
4 ---- 50,000 25,000 65,000
5 12,000 62,000 8,000 73,000
6 6,000 68,000 4,000 77,000
P.B.P (X) = 3 years

P.B.P (Y) = 3 years + 10,000/25,000
= 3 years, 4 months and 24 days
(b) Calculation of Net Present Value
Year Cash Inflow X P.V.F @ 10% P.V of (X) Cash Inflow Y P.V of (Y)
1 25,000 0.909 22,725 10,000 9,090
2 15,000 0.826 12,390 12,000 9,912
3 10,000 0.751 7,510 18,000 13,518
4 ---- 0.683 ---- 25,000 17,075
5 12,000 0.621 7,452 8,000 4,968
6 6,000 0.564 3,384 4,000 2,256
Total Present Value 53,461 56,819
23
Illustration: 21
A firm’s cost of capital is 10%. It is considering two mutually exclusive

projects X and Y. The details are given below.
Project X Project Y
Rs. Rs.
Investment 1,40,000 1,40,000
Net cash inflow
YEAR
1 20,000 1,20,000
2 40,000 80,000
3 60,000 40,000
4 90,000 20,000
5 1,20,000 20,000
Compute:
a) Pay back period.
b) Net present value.
c) Accounting rate of return.
P.V. Factor @ 10% for 5 years:
YEAR 1 2 3 4 5
P.V. Factor 0.909 0.826 0.751 0.683 0.621
Solution: -
a) Computation of Payback Period
Year Cash Inflow Cumulative Cash Inflow Cumulative Cash

‘X’ Cash Inflow ‘Y’ Inflow
1 20,000 20,000 1,20,000 1,20,000
2 40,000 60,000 80,000 2,00,000
3 60,000 1,20,000 40,000 2,40,000
4 90,000 2,10,000 20,000 2,60,000
5 1,20,000 3,30,000 20,000 2,80,000
Pay back period (X) = 3 years + 20,000/90,000

= 3 years, 2 months and 20 days
Pay back period (Y) = 1 year + 20,000/80,000
= 1 year and 3 months
b) Computation of Net Present Value
Year P.V Factor Cash Inflow X P.V of (X) Cash Inflow Y P.V of (Y)
1 0.909 20,000 18,180 1,20,000 1,09,080
2 0.826 40,000 33,040 80,000 66,080
3 0.751 60,000 45,060 40,000 30,040
4 0.683 90,000 61,470 20,000 13,660
5 0.621 1,20,000 74,520 20,000 12,420
Total P.V. of Cash inflow 2,32,270 2,31,280
LESS: Initial Investment 1,40,000 1,40,000
24
c) Calculation of Accounting Rate of Return

ARR = x 100
Average Investment
X Y
Total cash inflow 3,30,000 2,80,000
LESS: Total Depreciation 1,40,000 1,40,000
Total P A T 1,90,000 1,40,000
Average Annual Income = 1,90,000/5 1,40,000/5

= 38,000 28,000
Calculation of Average Investments
Original Investment – Scrap 140000 – 0

Avg. Investment (X) = = = 70,000
2 2
Original Investment – Scrap 140000 – 0

Avg. Investment (Y) = = = 70,000
2 2
38,000
ARR (X) = x 100 = 54.29%
70,000
28,000
ARR (Y) = x 100 = 40%
70,000
Illustration: 22
A company is considering purchase of machinery, which costs Rs. 8,00,000

and which has an estimated life of 10 years. This machine will generate additional
Rs. 1,00,000 per year. The cost of the machine is depreciated on a straight-line and
has no salvage value at the end of its 10-year life. The company has a cost of capital
of 12 percent and a corporate tax rate of 40 percent.
You are required to calculate:
a) Annual cash inflow
b) The net present value and
c) The payback period
The present value factor at 12% is as under:
Year 1 2 3 4 5 6 7 8 9 10
PV
0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322
Factor
25
Solution: -
(A) Calculation of Annual Cash Inflow
Particulars Rs.
Additional Revenue 1,00,000
Less: Depreciation 80,000
Annual P.B.T 20,000
Less; Tax at 40% 8,000
Annual P.A.T 12,000
Add: Depreciation 80,000
Annual Cash Inflow 92,000
(B) Calculation of Net Present Value
Particulars Rs. Total P.V. Factor Total P.V.

Cash Inflow 92,000 5.651 5,19,892
Less: Initial Investment 8,00,000
Net Present Value – 2,80,108
(C) Calculation of Payback Period
Original Investment
Payback Period =
Annual Cash Inflow
8,00,000
92,000
Illustration: 23
No project is acceptable unless the yield is 10%. Cash inflows of a project

along with cash outflows are given below: -
YEAR Cash Cash Inflows

Outflows
Rs. Rs.
0 1,50,000 ----
1 30,000 20,000
2 ---- 30,000
3 ---- 60,000
4 ---- 80,000
5 ---- 30,000
The salvage value at the end of the 5th year is Rs. 40,000. Calculate the net
present value. P.V. Factor at 10% discount is as follows: -
Year 1 2 3 4 5
P. V. Factors @ 10% 0.909 0.826 0.751 0.683 0.621
26
Solution: -Calculation of Present Value of Cash Inflow
Year P. V. Factor Cash Inflow P. V.
1 0.909 20,000 18,180
2 0.826 30,000 24,780
3 0.751 60,000 45,060
4 0.683 80,000 54,640
5 0.621 30,000 18,630
5 0.621 40,000 24,840
Total P. V. of Cash Inflow 1,86,130
Calculation of Present Value of Cash Outflow
Year P. V. Factor Cash Inflow P. V.

0 1 1,50,000 1,50,000
1 0.909 30,000 27,270
Total P. V. of Cash Outflow 1,77,270

Total Present Value of Cash Inflow 1,86,130
Total Present Value of Cash Outflow 1,77,270
Net Present Value 8,860
Illustration: 24
Electrometal Private Ltd. is evaluating two mutually exclusive proposals for
new capital investment. The following information about the proposals is available.
Project X Project Y
Rs. Rs.
Net cash outlay 80,000 1,00,000
Salvage value ---- ----
Estimate life 4 years 5 years
Depreciation : Straight-line method.

Cut-off discount rate : 10%
Corporate Income Tax : 50%
Earnings before depreciation and Taxes:
Year X Y
Rs. Rs.
1 24,000 28,000
2 28,000 32,000
3 32,000 36,000
4 44,000 44,000
5 ---- 40,000
You are required to advise the company as to which proposal would be

financially viable on the basis of net present value method.
The present value of Re. 1 for 5 years @ 10% discount rate is as follows:
YEAR 1 2 3 4 5
P.V. Factor 0.909 0.826 0.751 0.683 0.621
27
Solution:
Calculation of Cash Inflow of Proposal X
YEAR PBDT Dep. PBT Tax @ 50% PAT Cash Inflow

PAT + Dep.
1 24,000 20,000 4,000 2,000 2,000 22,000
2 28,000 20,000 8,000 4,000 4,000 24,000
3 32,000 20,000 12,000 6,000 6,000 26,000
4 44,000 20,000 24,000 12,000 12,000 32,000
Calculation of Cash Inflow of Proposal Y
YEAR PBDT Dep. PBT Tax @ 50% PAT Cash Inflow

PAT + Dep.
1 28,000 20,000 8,000 4,000 4,000 24,000
2 32,000 20,000 12,000 6,000 6,000 26,000
3 36,000 20,000 16,000 8,000 8,000 28,000
4 44,000 20,000 24,000 12,000 12,000 32,000
5 40,000 20,000 20,000 10,000 10,000 30,000
Year P.V Factor Cash Inflow X P.V of (X) Cash Inflow Y P.V of (Y)
1 0.909 22,000 19,998 24,000 21,816
2 0.826 24,000 19,824 26,000 21,476
3 0.751 26,000 19,526 28,000 21,028
4 0.683 32,000 21,856 32,000 21,856
5 0.621 ---- ---- 30,000 18,630
Total P.V. of Cash inflow 81,204 1,04,806
LESS: Initial Investment 80,000 1,00,000
Conclusion: Proposal Y is preferable because its Net Present Value is

greater than that of Proosal X.
Illustration: 25
A project involves an investment of Rs. 10,00,000 and the amount is to be

spent as follows:
Beginning of I year Rs. 2,50,000
Beginning of II year Rs. 2,50,000
Beginning of III year Rs. 2,50,000
Beginning of IV year Rs. 2,50,000
The project is expected to give cash inflows as follows:
YEAR Rs.
1 2,30,000
2 2,28,000
3 2,78,000
4 2,98,000
5 2,53,000
6 1,73,000 Including scrap value
28
The cost of capital may be assumed as 12%.
Evaluate the proposal using NPV method. The discount factor @ 12% is as follows:
YEAR 1 2 3 4 5 6
Discount Factor 0.893 0.797 0.712 0.635 0.567 0.507
Solution: -
a. Present value of Cash Inflow
Year P.V Factor @ 12% Cash Inflow P.V of Cash Inflow

1 0.893 2,30,000 2,05,390
2 0.797 2,28,000 1,81,716
3 0.712 2,78,000 1,97,936
4 0.635 2,98,000 1,89,230
5 0.567 2,53,000 1,43,451
6 0.507 1,73,000 87,711
Total P.V. of Cash inflow 10,05,434
b. Present value of Cash Outflow
Year P.V Factor @ 12% Cash Outflow P.V of Cash Outflow

0 1.000 2,50,000 2,50,000
1 0.893 2,50,000 2,23,250
2 0.797 2,50,000 1,99,250
3 0.712 2,50,000 1,78,000
Total P.V. of Cash Outflow 8,50,500
Total P. V. of Cash Inflow = 10,05,434

Total P. V. of Cash Outflow = 8,50,500
Net Present Value = 1,54,934
Illustration: 26
M/s Laxman and Co. has Rs. 2,00,000 to invest. The following proposals are
under consideration. The cost of capital for the company is estimated to be 15%
Project Initial Outlay (Rs.) Annual cash flow (Rs.) Life of project
A 1,00,000 25,000 10
B 70,000 20,000 08
C 30,000 6,000 20
D 50,000 15,000 10
E 50,000 12,000 20
Rank the above projects on the basis of:
a) N P V Method
b) Profitability index Method
Project value of annuity of Re. 1 received in steady stream discounted @ 15%
08 years = 4.6586
10 years = 5.1790
20 years = 6.3345
29
Solution: -Calculation of Net Present Value
Project Annual cash P.V. Total P.V. of Initial NPV Rank

inflow Factor cash inflow Investment
A 25,000 5.1790 1,29,475 1,00,000 29,475 1
B 20,000 4.6586 93,172 70,000 23,172 4
C 6,000 6.3345 38,007 30,000 8,007 5
D 15,000 5.1790 77,685 50,000 27,685 2
E 12,000 6.3345 76,014 50,000 26,014 3
Calculation of Profitability index
Project Total P.V. of cash inflow Initial Investment P. I Rank

A 1,29,475 1,00,000 1.295 4
B 93,172 70,000 1.331 3
C 38,007 30,000 1.267 5
D 77,685 50,000 1.553 1
E 76,014 50,000 1.520 2
Illustration: 27
A company is considering an investment proposal to install a new machine.
The project will cost Rs. 50,000 and will have a life of 5 years and no salvage value.
The company’s tax rate is 50% and no investment allowance is allowed. The firm
uses straight-line method of deprecation. The estimated net income before
depreciation and tax from the proposed investment proposal are as follows:
Year Net income before depreciation and Tax (Rs.)

1 10,000
2 11,000
3 14,000
4 15,000
5 25,000
Compute the following:
a) Pay back period.
b) Average rate of return.
c) Net present value @ 10% discount rate.
d) Profitability index @ 10% discount rate.
Following are the present value factor @ 10% per annum:
YEAR 1 2 3 4 5
P.V. Factor at 10% 0.909 0.826 0.751 0.683 0.621
Solution: -
1. Calculation of Pay back period
YEAR P B T D Dep. PBT Tax @ 50% PAT Cash Inflow
PAT + Dep.
1 10,000 10,000 ---- ---- ---- 10,000
2 11,000 10,000 1,000 500 500 10,500
3 14,000 10,000 4,000 2,000 2,000 12,000
4 15,000 10,000 5,000 2,500 2,500 12,500
5 25,000 10,000 15,000 7,500 7,500 17,500
TOTAL PAT --------------> 12,500
30
Pay back period = 4 years + (5,000 / 7,500)
= 4 years and 8 months.
2. Calculation of accounting rate of Return

Total PAT 12,500
No. of Years 5

Average Investment = = = 25,000
2 2
Average Annual Income 2,500

ARR = x 100 = x 100 = 10%
Average Investment 25,000
Year PV Factor @ 10% Cash Inflow Present Value

1 0.909 10,000 9,090
2 0.826 10,500 8,673
3 0.751 12,000 9,012
4 0.683 12,500 8,538
5 0.621 17,500 10,867
Total PV of Cash Inflow 46,180
Less: Initial Investment 50,000
Net Present Value -3,820
Calculation of Profitability Index
Total Present Value of Cash Inflow

Profitability Index =
Initial Investment
46,180
Profitability Index = = 0.9236
50,000
Illustration: 28
After conducting a survey that cost Rs. 2,00,000. Karnataka zeal Ltd. decided
to undertake a project for placing a new product in the market. The company’s cut
off rate is 12%. It was estimated that the project would have a life of 5 years. The
project would cost of Rs. 40,00,000 in plant and machinery in addition to working
capital of Rs. 10,00,000. The scrap value of plant and machinery at the end of 5
years was estimated @ Rs. 5,00,000. After providing depreciation on straight-line
basis, profits after taxes were estimated as follow:
31
Year Profit (Rs.)
1 5,00,000
2 8,00,000
3 10,00,000
4 6,00,000
5 5,00,000
Present value factor @ 12% per annum are given below:

Year 1 2 3 4 5
P.V. Factor @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674
Ascertain the Net present value of the project.
Solution: –
Calculation of Depreciation
Original cost – Scrap

Depreciation =
Life of Asset
42,00,000 – 5,00,000
Depreciation = = 7,40,000
5
Year PAT Depreciation Cash Inflow P.V. Factor @ P.V of

PAT + Dep. 12% Cash inflow
1 5,00,000 7,40,000 12,40,000 0.8929 11,07,196
2 8,00,000 7,40,000 15,40,000 0.7972 12,27,688
3 10,00,000 7,40,000 17,40,000 0.7118 12,38,532
4 6,00,000 7,40,000 13,40,000 0.6355 8,51,570
5 5,00,000 7,40,000 12,40,000 0.5674 7,03,576
6 (Scrap + Working Capital) 15,00,000 0.5674 8,51,100
Total Present Value of Cash inflow 59,79,662
LESS: Initial outlay including working capital 52,00,000
[42,00,000 + 10,00,000]
Net Present Value 7,79,662
Illustration: 29
Quick Ltd. has a machine having an additional life of 5 years which costs
Rs. 1,00,000 and which has a book value of Rs. 25,000. A new machine costing
Rs. 2,00,000 is available. Though its capacity is the same as that of old machine, it
will mean a saving in variable costs to the extent of Rs. 70,000 per annum. The life
of the machine will be 5 years at the end of which it will have a scrap value of Rs.
20,000. The rate of income tax is 60% and Quick Ltd. does not make an investment,
if it yields less than 12%. The old machine, if sold, will fetch Rs. 10,000.
32
Using present value method advises whether the old machine should be
replaced or not:
P.V of Re. 1 receivable annually for 5 years @ 12% = 3.605
P.V of Re. 1 receivable at the end of 5 years @ 12% = 0.567
P.V of Re. 1 receivable at the end of 1 year @ 12% = 0.893
Solution: –
Calculation of Annual Cash inflow
Rs. Rs.
Savings in variable cost 70,000
LESS: Additional Depreciation
Annual Depreciation on New Machine (2,00,000 – 20,000)/5 36,000
Annual Depreciation on Old Machine (25,000 / 5) 5,000 31,000
Annual P.B.T 39,000
LESS: Tax @ 60% 23,400
Annual P A T 15,600
ADD: Depreciation 31,000
Annual Cash inflow 46,600
P. V. of Cash Inflow 46,600 X 3.605 = 1,67,993

LESS: Initial Investment [2,00,000 – 10,000] = 1,90,000
Net Present Value = – 22,007
Illustration: 30
Metal castings Ltd. Hosur wishes to install machinery in rented premises for
the production of a component the demand for which is expected to last for only 5
years.
Initial cash out lay will be:
Plant and Machinery = Rs. 2,70,000

Working Capital = Rs. 40,000
Total = Rs. 3,10,000
The working capital will be fully realized at the end of 5 th year. The scrap
value of the plant expected to be realized at the end of 5 th year is Rs. 5,000. The
expected cash inflows from business operations are:
Year Cash inflows

1 70,000
2 1,00,000
3 1,30,000
4 90,000
5 15,000
Cost of capital is 15%. Calculate the N.P.V of the project using P.V factor @
15%.
Year 1 2 3 4 5
PV Factor @ 15% 0.8696 0.7561 0.6575 0.5718 0.4972
33
Solution: –
Calculation of N. P. V
Year P.V Factor @ 15% Cash Outflow P.V of Cash Inflow

1 0.8696 70,000 60,872
2 0.7561 1,00,000 75,610
3 0.6575 1,30,000 85,475
4 0.5718 90,000 51,462
5 0.4972 15,000 7,458
5 0.4972 45,000 22,374
Total P.V. of Cash Inflow 3,03,251
LESS: Initial Investment 3,10,000
Net Present Value - 6,749
Illustration: 31
From the particulars given below relating to Adarsh Ltd. you are required to
calculate:
(i) Pay back period

(ii) Discounted pay back period
(iii) N. P. V. and
(iv)Profitability Index
Cost of the Project: Rs. 50,000

Cash flow after Taxes
Year Rs.
1 5,000
2 20,000
3 30,000
4 30,000
5 10,000
The cost of capital of the company is 10%
Note: Discounting factor @ 10% is
Year 1 2 3 4 5
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621
Solution: –
c) Calculation of Pay back period, discounted pay back period and NPV
Year PAT Dep. PAT + Dep. P.V.F @ 10% P.V of Cash Inflow
Cash Inflow
1 5,000 10,000 15,000 0.909 13,635
2 20,000 10,000 30,000 0.826 24,780
3 30,000 10,000 40,000 0.751 30,040
4 30,000 10,000 40,000 0.683 27,320
5 10,000 10,000 20,000 0.621 12,420
Present Value of Cash Inflow 1,08,195
LESS: Initial Investment 50,000
Net Present Value 58,195
34
a) Pay back period = 2 years + (5000 / 40,000)
= 2 years, 1 month and 15 days.
b) Discounted Pay back period = 2 years + (11,585 / 30,040)

d) Profitability Index

Initial Investment
1,08,195
50,000
35
4. Internal Rate of Return
Internal rate of return is the rate at which the sum of discounted cash inflows
equals to the sum of discounted cash outflows. The internal rate of return of a
project is the discount rate which makes net present value equal to zero. This is
equivalent to equating the present value of all future cash inflows to initial outlay of
the project. This rate can be calculated by using the following formula.
C–O
Internal Rate of Return = A + (B – A)
C–D
Where, A = Discount factor @ low trial

B = Discount factor @ high trial
C = Present value of cash inflow @ low trial
D = Present value of cash inflow @ high trial
O = Original investment
Advantages of Internal Rate of Return
 The IRR methods take into account the factor of time productivity of money.
 It ranks the project according to their NPV.
 Real and scientific method of appraising capital projects.
 All the cash flows in the project are considered.
Disadvantages of Internal Rate of Return
 Under rapid change of technology this may fail to provide solution. In such
cases payback period is very helpful.
 The cost of capital which is the required rate of return is difficult to
understand. It is also difficult to arrive at the IRR at the first attempt and
some trial runs may become necessary.
 May not give unique answer in all the situations.
Illustration: 32
A project is estimated to cost Rs. 16,200. It is expected to have a life of 3

years and generate cash inflows of Rs. 8,000, Rs. 7,000 and Rs. 6,000.
Calculate I R R
Present value of Rs. 1 at varying discount rate for a period of 3 years.
Year 13% 14% 15% 16%

1 0.8850 0.8772 0.8696 0.8621
2 0.7831 0.7695 0.7651 0.7432
3 0.6930 0.6750 0.6575 0.6407
36
Solution: –
Calculation of Internal rate of return
Year Cash Inflow P.V. Factor P.V. of P.V. Factor P.V. of

@ 10% Cash Inflows @ 15% Cash Inflows
1 8,000 0.8772 7,018 0.8696 6,957
2 7,000 0.7695 5,386 0.7561 5,293
3 6,000 0.6750 4,050 0.6575 3,945
Total P. V of Cash Inflow 16,454 16,195
C–O
IRR = A + (B – A)
C–D
16,454 – 16,200
IRR = 14 + (15 – 14)
16,454 – 16,195
254
IRR = 14 + (1) = 14.98%
259
Illustration: 33
A company has an investment opportunity costing Rs. 40,000 with the

following Expected net Cash Inflows (i.e., after taxes and before depreciation):
Year Net Cash Inflows
Rs.
1 7,000
2 7,000
3 7,000
4 7,000
5 7,000
6 8,000
7 10,000
8 15,000
9 10,000
10 4,000
Determine the “Internal Rate of Return” with the help of 10% discount factor
and 15% discount factor, which is given below:
Year P.V. Factor @ 10% P.V. Factor @ 15%
1 0.909 0.870
2 0.826 0.756
3 0.751 0.658
4 0.683 0.572
5 0.621 0.497
6 0.564 0.432
7 0.513 0.376
8 0.467 0.327
9 0.424 0.284
10 0.386 0.247
37
Solution: –
Calculation of Internal Rate of Return
P.V.Factor P.V. of P.V.Factor P.V. of

Year Cash Inflow
@ 10% Cash Inflow @ 15% Cash Inflow
1 7,000 0.909 6,363 0.870 6,090
2 7,000 0.826 5,782 0.756 5,292
3 7,000 0.751 5,257 0.658 4,606
4 7,000 0.683 4,781 0.572 4,004
5 7,000 0.621 4,347 0.497 3,479
6 8,000 0.564 4,512 0.432 3,456
7 10,000 0.513 5,130 0.376 3,760
8 15,000 0.467 7,005 0.327 4,905
9 10,000 0.424 4,240 0.284 2,840
10 4,000 0.386 1,544 0.247 988
Total P. V of Cash Inflow 48,961 39,420
A = 10; B = 15; C = 48,961; D = 39,420; O = 40,000.
C–O
IRR = A + (B – A)
C–D
48,961 – 40,000
IRR = 10 + (15 – 10)
48,961 – 39,420
8,961
IRR = 10 + (5) = 14.70%
9,541
Illustration: 34
A company has to select one of the two alternative projects whose particulars
are given below:
PROJECT ‘A’ PROJECT ‘B’

Initial out lay 1,18,720 1,00,670
Net cash flow:
Year
1 1,00,000 10,000
2 20,000 10,000
3 10,000 20,000
4 10,000 1,00,000
The company can arrange necessary funds at 8%. Compute the N.P.V and
I.R.R of each project and comment on the results. If there is any contradiction in the
results, state the reasons for such contradiction. How would you resolve such
contradiction?
38
The P.V factor of Re. 1 received at the end of each year at different rates is
given below:
Year 8% 10% 12% 14%
1 0.926 0.909 0.893 0.877
2 0.857 0.826 0.797 0.769
3 0.794 0.751 0.712 0.675
4 0.735 0.683 0.636 0.592
Solution: –
Computation of I R R of Project A
Year Cash Inflow P.V.Factor P.V. of P.V.Factor P.V. of

1 1,00,000 0.909 90,900 0.893 89,300
2 20,000 0.826 16,520 0.797 15,940
3 10,000 0.751 7,510 0.712 7,120
4 10,000 0.683 6,830 0.636 6,360
Total P. V of Cash Inflow 1,21,760 1,18,720
A = 10; B = 12; C = 1,21,760; D = 1,18,720; O = 1,18,720.
C–O
IRR = A + (B – A)
C–D
1,21,760 – 1,18,720
IRR = 10 + (12 – 10)
1,21,760 – 1,18,720
IRR = 10 + 2 = 12%
Computation of I R R of Project B
P.V.Factor P.V. of P.V.Factor P.V. of

Year Cash Inflow
1 10,000 0.909 9,090 0.926 9,260
2 10,000 0.826 8,260 0.857 8,570
3 20,000 0.751 15,020 0.794 15,880
4 1,00,000 0.683 68,300 0.735 73,500
Total P. V of Cash Inflow 1,00,670 1,07,210
A = 8; B = 10; C = 1,07,210; D = 1,00,670; O = 1,00,670.
C–O
IRR = A + (B – A)
C–D
1,07,210 – 1,00,670
IRR = 8 + (10 – 8)
1,07,210 – 1,00,670
IRR = 8 + 2 = 10%
39
5. Profitability Index (PI)
It is the ratio of present value of future cash benefits at the required rate of
return to the initial cash outflow of the investment.

Initial Investment
Illustration: 35
The initial cash outlay of the project is Rs. 1,00,000, and it generates cash
inflows of Rs. 40,000, Rs. 30,000, Rs. 50,000, and Rs. 20,000. Assume a 10% rate
of discount. Calculate profitability index.
Year 1 2 3 4
10% 0.909 0.826 0.751 0.683
Solution: -
Calculation of Profitability Index
Year CIF PVF 10% PV

1 40000 0.909 36360
2 30000 0.826 24780
3 50000 0.751 37550
4 20000 0.683 13660
TPV 112350

Initial Investment
1,12,350
1,00,000
Chapter Roundup
 Investment Decision is referred to the activity of deciding the pattern of

investment. It is a long range financial decision and deals with allocation of
capital. It has to show how the funds can be invested in assets which would
yield maximum return to the business concern.
 Capital Budgeting refers to planning the deployment of available capital for

the purpose of maximizing the long term profitability of a firm.
 The term Payback Period refers to the time in which the project will generate
the necessary cash to recover the initial investment.
 Average rate of return or return on investment is obtained by dividing

average annual post-tax profit by the average investment.
40
 Net Present Value refers to the excess of present value of future cash inflows
over the present value of cash outflows. It is considered to be the best
method for evaluating the capital investment projects.
 Internal Rate of Return is the rate at which the sum of discounted cash
inflows is equal to the sum of discounted cash outflows. It is the rate at which
the net present value of investment is zero.
 Profitability Index is the ratio of present value of future cash inflows at the
required rate of return to the initial cash outflow of the investment.
Quick Quiz
1. What is Investing Decision?

2. Define Capital Budgeting.
3. Define the term Payback Period.
4. What is Net Present Value?
5. What is Internal Rate of Return?
6. Define Profitability Index.
7. Compare and contrast N.P.V. method with I.R.R method.
8. Critically examine the various steps involved in Capital Budgeting.
9. What is Capital Budgeting? Examine its need and significance.
10. Critically evaluate the payback method as a method of investment appraisal.
11. A company purchased a machine at a cost of Rs. 13,00,000. Sales Revenue
per annum is Rs. 16,00,000. Variable cost is 60% of sales. Fixed cost of
Rs. 2,40,000 Tax rate 50%. Calculate pay back period. Ignore depreciation.
12. Find out the N P V for a project which requires an initial investment of
Rs. 50,000 and which involves a net cash inflow of Rs. 10,000 each year for 6
years. There is no scrap value. Cost of funds is 10% of an annuity of Re. 1 for
6 years at 10% per annum is Rs. 4.355.
13. A company has three projects, which have a capital outlay of Rs. 1,00,000
each. The following is the information about cash flows:
Project C0 C1 C2 C3 C4 C5
1 1,00,000 40,000 45,000 30,000 25,000 25,000
2 1,00,000 35,000 35,000 30,000 20,000 20,000
3 1,00,000 30,000 30,000 30,000 30,000 30,000
You are required to rank the above projects according to each of the following
methods:
(a) Payback Period
(b) Accounting Rate of Return
(c) Net Present Value
(d) Internal Rate of Return [assuming discount rates of 10% and 20%]
Present value of Re. 1

Year 1 2 3 4 5
PV @ 10% 0.909 0.826 0.751 0.683 0.621
PV @ 20% 0.833 0.694 0.579 0.482 0.402
41
14. Rahul company is considering the purchase of one of the following machines,
whose relevant data are as follows: -
Machine X Machine Y
Estimated Life 3 years 3 years
Capital Cost Rs. 90,000 Rs. 90,000
Earnings after tax: -
X Rs. Y Rs.
1st year 40,000 20,000
2nd year 50,000 70,000
3rd year 40,000 50,000
The company follows the straight-line method of depreciation; the estimated

salvage value of both the machines is zero. Show the most profitable invest
based on: -
a) Payback Period
b) Accounting Rate of Return
c) NPV and Profitability Index assuming at 10% cost of capital.
Note: - P.V. Factor @ 10% is as follows
YEAR 1 2 3
P.V. Factors at 10% 0.909 0.826 0.751
15. A choice will have to be made between two competing projects proposals,
which require an investment of Rs. 1,50,000 each and are expected to
generate net cash flow as under:
Year Project A Project B

Rs. Rs.
1 75,000 30,000
2 45,000 36,000
3 30,000 54,000
4 ---- 75,000
5 36,000 24,000
6 18,000 12,000
The cost of capital of a company is 10%. The following are the project value
factor @ 10%.
YEAR 1 2 3 4 5 6
P.V. Factor 0.909 0.826 0.751 0.683 0.621 0.564
Which project proposal should be chosen and why?

Evaluate the project proposal under:
Pay back period
Net present value
42
16. ABC Ltd. has under consideration two mutually exclusive proposals for the
purchases of new equipment.
A B
Net cash outlay 1,00,000 75,000
Life 5 years 5 years
Salvage Value Nil Nil
Profits before depreciation and taxes:

A Rs. B Rs.
1st year 25,000 18,000
2nd year 30,000 20,000
rd
3 year 35,000 22,000
4th year 25,000 20,000
5th year 20,000 16,000
Using the tax rate to be 50%. Suggest the management the best alternative
using:
a) Payback Period
b) NPV method @ 10%
Note: - P.V. Factor @ 10% is as follows
YEAR 1 2 3 4 5
P.V. Factors at 10% 0.909 0.826 0.751 0.683 0.621
17. X Ltd. wants to replace its existing stamping machine. Two machines are
currently available in the market. The superior stamping machine costs Rs.
50,000 and will require a cash summing expenses of Rs. 20,000 per year. The
star machine costs Rs. 75,000 but cash running expenses are expected to be
Rs. 15,000 per year. Both the machines have a ten-year useful life with no
salvage value and would be depreciated on a straight-line method.
If the company pays 50% tax and wants a 10% after tax-required rate of
return which machine should it purchase? The present value factors @ 10%
are:
Year 1 2 3 4 5
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621
Year 6 7 8 9 10
PV Factor @ 10% 0.564 0.513 0.467 0.424 0.386
43
WORKING CAPITAL MANAGEMENT
Introduction
One of the most important areas in the day-to-day management of the firm is
the management of Working Capital. Working Capital Management is the functional
area of finance that covers all the current assets of the firm. It is concerned with
management of the level of individual current assets as well as current liabilities and
also the management of total working capital.
The term working capital refers to the capital required for day-to-day
operations of the business. It is defined as the excess of Current Assets over Current
Liabilities and provisions. In other words, it is called “Net Current Assets or Net
Working Capital”.
The following table highlights the components of current assets and current
liabilities.
Current Assets Current Liabilities

Cash in Hand Sundry Creditors
Cash at Bank Bills Payable
Bills Receivable Bank Overdraft
Sundry Debtors Outstanding Expenses
Closing Stock Incomes received in advance
Prepaid Expenses Unclaimed Dividend
Outstanding Incomes Provision for Tax
Temporary Investments Proposed Dividend
Advances Short-term Loans
Concept of Working Capital
From the point of view of time, the term working capital can be divided into
two categories:
1) Permanent Working Capital: It refers to the Hardcore Working Capital. It is

that minimum level of investment in the current assets that is carried by the
business at all times to carry out minimum level of its activities. It is also known
as Fixed Working Capital.
Features of Permanent Working Capital:

a) Amount of permanent working capital remains in the business in one or
another form.
b) There is a positive correlation between the size of the business and the
amount of permanent working capital.
c) Permanent working capital should be financed from long-term funds.
2) Temporary Working Capital: It refers to that part of Working Capital, which is

required by a business over and above the Permanent Working Capital. It is also
called Variable Working Capital or Fluctuating Working Capital. The amount of
temporary working capital keeps on changing depending upon the changes in
production and sale.
1
Amt. of Working Capital
Temporary
[Rs.]
Permanent
Time
Amt. of Working Capital
Temporary
[Rs.]
Permanent
Time
Diagram: ADEQUACY OF WORKING CAPITAL
From the point of view of concept the term Working Capital can be used in
two different ways: -
1) Gross Working Capital: The gross working capital refers to investment in all
the current assets taken together. The total investments in all current assets
are known as Gross Working Capital.
2) Net Working Capital: the term net working capital refers to the excess of
total current assets over total current liabilities. Current assets refer to those
assets which can be converted in to money immediately. It may be noted that
the current liabilities refers to those liabilities which are payable within a
period of one year.
Working Capital Cycle or Operating Cycle
The working capital cycle refers to the length of time between the firms
paying cash for materials, entering into the production process, stock and the inflow
of cash from accounts receivable. In other words, it refers to the duration of the time
required to complete the following cycle of events in a manufacturing firm. It is also
called as the Operating Cycle.
a) Conversion of cash into raw materials.

b) Conversion of raw material into work in progress.
c) Conversion of work in progress into finished stock.
d) Conversion of finished stock into accounts receivables through sales and
e) Conversion of account receivables into cash.
2
The duration of the operating cycle for the purpose of estimating working
capital is equal to the sum of the durations of each of the above said events, less the
credit period allowed by suppliers.
CASH
ACCOUNTS RAW MATERIAL

RECEIVABLE
WORK IN PROCESS
FINISHED GOODS
Working Capital Cycle
In the form of an equation, the operating cycle process can be expressed as follows:-
Operating Cycle = R + W + F + D – C
R = Raw material storage period
W = Work-in-progress holding period
F = Finished goods storage period
D = Debtors collection period
C = Credit payment period
The various components of operating cycle may be calculated as shown below:
Average stock of raw material

1 Raw material storage period =
Average cost of raw material consumption per day
Average work-in-progress inventory

2 Work-in-progress holding period =
Average cost of production per day
Average stock of finished goods

3 Finished goods storage period =
Average cost of goods sold per day
Average book debts

4 Debtors collection period =
Average credit sales per day
Average trade creditors

5 Credit payment period =
Average credit purchases per day
3
Illustration:
From the following information, calculate the operating cycle in days and amount of
working capital employed
Period covered 365days

Total production cost Rs.11,000
Total cost of sales Rs.12,000
Raw material consumption Rs. 4,600
Average total debtors outstanding Rs 500
Credit sales for the year Rs.15,000
Value of average stocks maintained

Raw materials Rs.340
Work-in-progress Rs 380
Finished goods Rs280
Amount given represents lakhs.
Solution:
Determinants of Working Capital
A large number of factors influence working capital needs of a firm. The

following are the important factors, which determine the amount of working capital.
1) Nature of Industry
One of the important factors influencing the amount of working capital is the
nature of Industry. The term nature of Industry refers to whether a concern is a
manufacturing concern or public utility concern. The shorter the manufacturing
process, the lower is the requirements for the working capital. This is because, in
such a case, inventories have to be maintained at a low level. Longer the
manufacturing process the higher would be the requirements of working capital. This
is the reason why highly capital-intensive industries require a large amount of
working capital to run their sophisticated and long production process. Similarly, a
public utility concern requires lower amount of working capital than a manufacturing
concern.
2) Size of Business
Size of business is another important factor influencing the amount of working
capital. The term size of business refers to the scale of operation. A large-scale
organization may require more amount of working capital than a small one.
3) Production Policies
The Production Policy i.e., the plan for production has great influence on the
amount of working capital. Production policy refers to whether the firm is capital
intensive or labour intensive. In case of labour intensive industries the working
capital requirements will be more when compared to capital-intensive industries. In
such industries the requirement of long-term funds will be more than the amount of
working capital.
4) Volume of Sales
The volume of sales and size of working capital are directly related to each
other. As the volume of sales increases there is an increase in the investment of
working capital.
4
5) Credit Policy
A firm, which allows liberal credits to its customer, may enjoy higher sales but
may need more amount of working capital when compared to a firm enforcing strict
credit terms. Similarly, the working capital requirements are also affected by the
credit facilities enjoyed by the firm. A firm enjoying liberal credit facilities from its
supplier requires lower amount of working capital when compared to a firm that does
not enjoy such liberal credit facilities.
6) Business Cycle
Business fluctuations lead to cyclical and seasonal changes in production and
sales and affect the working capital requirements. The business expands during the
period of prosperity and declines during the period of depression. Consequently,
more working capital is required during the period of prosperity and less during the
period of depression.
7) Fluctuation in the supply of Raw Materials

If prompt and adequate supply of raw materials, spares, stores, etc. is
available, it is possible to manage with small amount of working capital. However, if
supply is seasonal, or chanelised through government agencies, etc., it is essential to
keep larger stocks increasing working capital requirements. This is particularly true
in case of companies requiring special kind of raw materials, which is available only
in a particular season.
8) Price Level Changes

Inflationary trends in the economy necessitate more working capital to
maintain the same level of activity. Generally, raising price level requires a firm to
maintain higher amount of working capital and vice versa.
9) Profit Margin
A high net profit margin contributes towards the working capital
requirements. Therefore, the amount of working capital required will be less. A low
profit margin requires a greater amount of working capital. Infact, the net profit is a
source of working capital to the extent it has been earned in cash.
10) Dividend Policy

The amount of profit available towards working capital needs would be
affected by the way in which profits are appropriated. The availability of cash from
operation depends upon dividend policy. Payment of dividend utilizes cash while
retaining profits acts as a source of working capital. Thus, dividend policies affect
working capital.
11) Abnormal Factors

Abnormal factors like strikes and lockouts also require additional working
capital. Recessionary conditions necessitate a higher amount of stock of finished
goods remaining in stock. Similarly, inflationary conditions necessitate more funds
for working capital to maintain the same amount of current assets.
12) Corporate Taxes

The amount of taxes paid depends on taxation laws. These amounts usually
have to be paid in advance. Thus need for working capital varies with tax rates and
advance tax provisions.
5
Problems Associated with Excess & Inadequate Working Capital
Both the excessive and inadequate working capital positions are dangerous
from the firm’s point of view. Excess working capital results in idle funds, which do
not earn any income. Shortage of working capital intercepts production as well as
profitability.
Dangers of Excess of Working Capital
1) It results in unnecessary accumulation of inventory, thus the chances of

inventory mishandling, waste, theft and losses increase.
2) It is an indication of defective credit policy and slack collection period.
Consequently, higher incident of bad debts adversely affects profits.
3) Excess working capital results in idle funds, which do not earn any return for the
firm.
4) Tendencies of accumulating inventories to make speculative profits liberal and
difficult to cope with in future when the firm is unable to make speculative
profit.
Dangers of Inadequate Working Capital
1) It stagnates growth and it becomes difficult for the firm to undertake profitable
project due to inadequate working capital.
2) It becomes difficult to implement the operating plans and achieve the firms
profit target.
3) Operating in efficiencies increases when the firm finds it difficult even to meet
day-to-day commitments.
4) Lack of working capital renders the firm unable to avail of attractive credit
opportunities.
5) A firm looses its reputation when it is not in a position to honor its short-term
obligations.
6) Fixed assets are not efficiently utilized for the lack of working capital funds. This
may result in fall in the returns on investment.
Sources of Working Capital
The working capital requirement of a concern can be classified as:
I. Permanent working capital requirements.

II. Temporary working capital requirements.
The various sources for the financing of the working capital are as follows:
6
Sources of Working Capital
PERMANENT TEMPORARY
1) Shares. 1) Indigenous Bankers.
2) Debentures. 2) Trade Credit.
3) Public deposits. 3) Commercial Bank.
4) Retained earnings. 4) Installment Credit.
5) Loans from financial institutions. 5) Advances.
6) Factoring.
7) Accrued expenses.
8) Deferred Incomes.
9) Commercial papers.
Permanent or Long Term Working Capital
1) Shares: Issue of shares is the most important source for raising the permanent
working capital. A company can issue various types of shares such as equity
shares, preference and deferred shares. As far as possible a company should
raise the maximum amount of permanent capital by issue of shares.
2) Debentures: A debenture is an instrument issued by the company

acknowledging its debt to its holder. It is also an important method of rising long-
term working capital. The debenture holders are the creditors of the company. A
fixed rate of interest is paid on debentures. The company issuing debentures
enjoys a number of benefits such as trading on equity, retention of control, tax
benefit etc.
3) Public Deposits: Public deposits are the fixed deposits accepted by a business
concern directly from the public. This source of rising working capital was very
popular in the absence of bank facility. The RBI had laid down certain limits on
public deposits. Non-banking concerns cannot barrow by way of public deposits
more than 25% of its paid capital and reserves.
4) Retained Earnings: Retained earnings or ploughing back of profits means the

reinvestment by concern of its surplus earnings in its business. It is an internal
source of finance and is most suitable for an establishment etc. This method of
finance is the cheapest and cost free sources of finance.
5) Loans from Financial Institution: Financial institutions like Commercial Banks,

LIC, IFCI, SFC, ICICI, IDBI etc also provide short-term, medium-term and long-
term loans. This source of finance is more suitable to meet the medium term
demands of working capital.
7
Temporary Working Capital
The main sources of temporary working capital are:
1) Indigenous Bankers: Private moneylender and other country bankers used to

be the main sources of finance prior to the establishment of commercial bank.
Now a day with the development of commercial banks they have lost their
monopoly. But even today some business houses have to depend upon indigenous
bankers for obtaining loans to meet their working capital requirements.
2) Trade Credit: Trade credit refers to the credit extended by the supplier of goods
in the normal course of business. The trade credit arrangement of a firm with its
suppliers is an important source of short-term finance. The credit worthiness of a
firm and the confidence of its supplier are the main basis of securing trade credit.
Every firm must utilize this source to the fullest extent, because this source is
cost free. i.e. borrower need not pay any interest.
3) Commercial Banks: Commercial banks are the most important source of short-
term capital. The different forms in which the banks normally provide loans and
advances are as follows:
a) Loans: When a bank makes an advance in lump sum against some security,
it is called a loan. In case of a loan a specified amount is sanctioned by the
bank to the customer. The entire loan amount is paid to the borrower either
in cash or by credit to his account. The borrower is required to pay interest on
the entire amount of loan from the date of sanction.
b) Cash Credit: Cash credit is an arrangement by which a bank allows his
customer to borrow money up to a certain limit against some tangible
securities. A customer can withdraw from his cash credit limit according to his
need and interest is calculated on the daily balance and not on the entire
amount.
c) Over Draft: Over draft is an arrangement by which a current account holder
is allowed to withdraw more than the balance to his credit up to a certain
limit. The interest is charged on daily over drawn balances.
d) Discounting of bill of exchange: Purchasing and discounting of bills of
exchange is the most important form in which the banks lend money without
any collateral security.
4) Installment Credit: This is another method by which the possession of goods is

taken immediately. The payment is made in installment over a predetermined
period of time. Generally interest is charged on the unpaid price but in any case, it
provides fund for some time and is used as a source of short-term working capital
by many business houses.
5) Advances: Some business houses get advances from the customers and
middlemen against order and this source is a short-term source of finance. It is a
cheap source of finance and in order to minimize their investment in working
capital the manufacturing industries prefer to take advances from their customers.
6) Factoring/Account Receivable Credit: Another method of raising short-term

finance is through account receivable or credit offered by commercial banks and
factors. A commercial bank may provide finance through discounting the bills or
8
invoices of its customers. Thus, a firm gets immediate payment for sales made on
credit through factoring.
7) Accrued Expenses: Accrued expenses, which have been incurred but not yet
paid. These simply represent a liability that a firm has to pay services already
received by it. Thus, all accrued expenses can be used as a source of short-term
finance.
8) Deferred Incomes: Deferred incomes are incomes received in advance before

supplying services. They represent funds received by a firm for which it has to
supply goods or services in future. These funds increase the liquidity of a firm and
constitute an important source of short-term finance.
9) Commercial Paper: Commercial paper represents unsecured promissory notes

issued by firms to raise short-term funds. It is an important money market
instrument in advanced countries like U.S.A. Commercial paper is a cheapest
source of rising short-term finance as compare to the bank credit. Commercial
paper is usually bought by investors including Bank, Insurance Company, Unit
Trust of India and firms to invest surplus funds for a short period.
9
Illustration: 1
The Board of management of Apple company Ltd. request you to prepare a
statement showing the working capital requirements for a level of activity of
1,56,000 units of production.
The following information is available for your calculation:
Per Unit
Rs.
Raw-material 90
Direct Labour 40
Overheads 75
Total Cost 205
Profit 60
Selling Price per unit 265
i. Raw materials are in stock, on average one month.

ii. Materials are in process, on average 2 weeks.
iii. Finished goods are in stock, on average one month.
iv. Credit allowed by suppliers, one month.
v. Time lag in payment from debtors, 2 months.
vi. Lag in payment of wages, 1 ½ weeks.
20% of the output is sold against cash. Cash in hand and at bank is expected
to be Rs. 60,000. It is to be assumed that production is carried on evenly
throughout the year, wages and overheads accrue similarly and a time period
of 4 weeks is equivalent to a month.
Solution: -
Statement of Cost Sheet
Elements of Cost Rs.

Raw materials 1,40,40,000
Direct Labour 62,40,000
Overheads 1,17,00,000
Total Cost 3,19,80,000
Profit 93,60,000
Sales 4,13,40,000
Statement showing working capital requirements
Components Rs.
A – Current Assets
1) Inventory
Raw materials – 4 weeks
1,40,40,000 x 4/52 10,80,000
Work in progress – 2 weeks
Raw materials
1,40,40,000 x 2/52 5,40,000
Labour
62,40,000 x 2/52 x 50% 1,20,000
Overheads
1,17,00,000 x 2/52 x 50% 2,25,000
10
Finished Goods – 4 weeks
Raw materials
1,40,40,000 x 4/52 10,80,000
Labour
62,40,000 x 4/52 4,80,000
Overheads
1,17,00,000 x 4/52 9,00,000
2) Debtors
3,19,80,000 x 80/100 x 8/52 39,36,000
3) Cash 60,000
Total Current Assets 84,21,000
B – Current Liabilities
1) Creditors
1,40,40,000 x 4/52 10,80,000
2) Accrued Wages
62,40,000 x 1.5/52 1,80,000
Total Current Liabilities 12,60,000
Working Capital Requirements (A – B) 71,61,000
Illustration: 2
The management of Vishal Ltd. has called for a statement showing the
working capital needed to finance a level of activity of 3,00,000 units of output for
the year. The cost structure for the company’s product, for the above-mentioned
activity level, is detailed below:
Per Unit
Rs.
Raw materials 20
Direct Labour 5
Overheads 15
Total 40
Profit 10
i. Past experience indicates that raw materials are held in stock, on an average
for two months.
ii. Work-in-progress (100% complete in regard to materials and 50% for labour
and overheads) will approximately be to half a month’s production.
iii. Finished goods remain in warehouse, on an average for a month.
iv. Suppliers of materials extend a month’s credit.
v. Two months credit is allowed to debtors, calculation of debtors may be made
at selling price.
vi. A minimum cash balance of Rs. 25,000 is expected to be maintained.
vii. The production pattern is assumed to be even during the year. Prepare the
statement for working capital requirements.
11
Solution: -

Raw materials [3,00,000 x 20] 60,00,000
Direct Labour [3,00,000 x 5] 15,00,000
Overheads [3,00,000 x 15] 45,00,000
Profit [3,00,000 x 10] 30,00,000
Sales 1,50,00,000
Components Rs.
1) Inventory
Raw materials – two months
60,00,000 x 2/12 10,00,000
Work in progress – half a month
Raw materials
60,00,000 x 0.5/12 2,50,000
Labour
15,00,000 x 0.5/12 x 50% 31,250
Overheads
45,00,000 x 0.5/12 x 50% 93,750
Finished Goods – one month
Raw materials
60,00,000 x 1/12 5,00,000
Labour
15,00,000 x 1/12 1,25,000
Overheads
45,00,000 x 1/12 3,75,000
2) Debtors – two months
1,50,00,000 x 2/12 25,00,000
3) Cash 25,000
1) Creditors – one month
60,00,000 x 1/12 5,00,000
12
Illustration: 3
A proforma cost sheet of a company provides the following particulars:
Elements of Cost Per Unit

Rs.
Raw materials 80
Direct Labour 30
Overheads 60
Total Cost 170
Profit 30
Selling Price 200
The following further particulars are available:

Raw materials are in stock on average for one month.
Materials are in process on an average for half a month.
Finished goods are in stock on an average for one month.
Credit allowed by suppliers is one month.
Credit allowed to customers is two months.
Lag in payment of wages is 1 ½ weeks.
Lag in payment of overhead expenses is one month.
One-fourth of the output is sold against cash.
Cash in hand and at bank is expected to be Rs. 25,000.
You are required to prepare a statement showing the working capital needed
to finance a level of activity of 1,04,000 units of production.
You may assume that production is carried on evenly throughout the year,
wages and overheads accrue similarly and a time period of 4 weeks is equivalent to a
month.
Solution: -

Raw materials [1,04,000 x 80] 83,20,000
Direct Labour [1,04,000 x 30] 31,20,000
Overheads [1,04,000 x 60] 62,40,000
Profit [1,04,000 x 30] 31,20,000
Sales 2,08,00,000
Components Rs.
1) Inventory
83,20,000 x 4/52 6,40,000
Raw materials
13
83,20,000 x 2/52 3,20,000
Labour
31,20,000 x 2/52 x 50% 60,000
Overheads
62,40,000 x 2/52 X 50% 1,20,000
Raw materials
83,20,000 x 4/52 6,40,000
Labour
31,20,000 x 4/52 2,40,000
Overheads
62,40,000 x 4/52 4,80,000
2) Debtors – 8 weeks
1,76,80,000 x 3/4 x 8/52 20,40,000
3) Cash 25,000
1) Creditors – 4 weeks
83,20,000 x 4/52 6,40,000
2) Accrued Wages – 1 ½ weeks
31,20,000 x 1.5/52 90,000
3) Accrued Overheads – 4 weeks
62,40,000 x 4/52 4,80,000
14
Illustration: 4
Solution: -
Components Rs.
1) Inventory
Stock of finished goods 5,000
Stock of stores, materials, etc. 8,000
2) Debtors
Inland Sales – 6 weeks credit
3,12,000 x 6/52 36,000
Export Sales 1 ½ weeks credit
78,000 x 1.5/52 2,250
3) Payment in Advance
Sundry Expenses [8,000 x ¼] 2,000
Total Current Assets 53,250
1) Creditors [48,000 x 1.5/12] 6,000
2) Accrued Wages [2,60,000 x 1.5/52] 7,500
3) Accrued Rent, royalties, etc. [10,000 x 6/12] 5,000
4) Accrued Clerical salary [62,400 x 0.5/12] 2,600
5) Accrued Manager salary [4,800 x 0.5/12] 200
6] Accrued Miscellaneous Expenses [48,000 x 1.5/12] 6,000
Total Current Liabilities 27,300
Working Capital Requirements (A – B) 25,950

Add: 10% towards contingences 2,595
Average amount of Working Capital Required 28,545
Illustration: 5
A proforma cost sheet of a company provides the following particulars:

Raw materials 40%
Direct Labour 20%
Overheads 20%

i. It is proposed to maintain a level of activity of 2,00,000 units.
ii. Selling price is Rs. 12 per unit.
iii. Raw materials are expected to remain in stores for an average period of one
month.
iv. Materials will be in process, on averages half a month.
v. Finished goods are required to be in stock for an average period of one
month.
vi. Credit allowed to debtors is two months.
vii. Credit allowed by suppliers is one month.
15
You may assume that sales and production follow a consistent pattern. You
are required to prepare a statement of working capital requirements.
Solution: -

Raw materials [24,00,000 x 40%] 9,60,000
Direct Labour [24,00,000 x 20%] 4,80,000
Overheads [24,00,000 x 20%] 4,80,000
Total Cost 19,20,000
Profit 4,80,000
Sales [2,00,000 x 12] 24,00,000
Components Rs.
1) Inventory
Raw materials – one month
9,60,000 x 1/12 80,000
Work in progress – half a month
Raw materials
9,60,000 x 0.5/12 40,000
Labour
4,80,000 x 0.5/12 x 50% 10,000
Overheads
4,80,000 x 0.5/12 x 50% 10,000
Finished Goods – one month
Raw materials
9,60,000 x 1/12 80,000
Labour
4,80,000 x 1/12 40,000
Overheads
4,80,000 x 1/12 40,000
2) Debtors – two months
19,20,000 x 2/12 3,20,000
1) Creditors – one month
9,60,000 x 1/12 80,000
16
Illustration: 6
A proforma cost sheet of a manufacturing company provides the following

particulars:

Rs.
Raw materials 8
Direct Labour 3
Overheads (exclusive of depreciation) 6
Total cost 17
Selling Price Rs. 20 per unit

Level of activity 1,04,000 units of output per annum (52 weeks)
Raw material in stock On an average 4 weeks
Processing time On an average 2 weeks
Finished goods in store On an average 4 weeks
Credit Period:
(a) Customers On an average 8 weeks
(b) Suppliers of materials On an average 4 weeks
Lag in Payment:
(a) Wages On an average 1 ½ weeks
(b) Overhead Expenses On an average 2 weeks
75% of the output is sold on credit basis. Cash on hand and at bank is
expected to be Rs. 5,000.
You are required to prepare a statement showing the working capital
requirements (a) in total, and (b) as regards each constituent part of the same to
finance a level of activity of 1,04,000 units of production per annum. You may
assume that all wages and overheads accrue evenly and are completely introduced
for half the processing time, i.e., 1 week.
Solution: -

Raw materials [1,04,000 x 8] 8,32,000
Direct Labour [1,04,000 x 3] 3,12,000
Overheads [1,04,000 x 6] 6,24,000
Total Cost 17,68,000
Profit [1,04,000 x 3] 3,12,000
Sales [1,04,000 x 20] 20,80,000
17
Components Rs.
1) Inventory
8,32,000 x 4/52 64,000
Raw materials
8,32,000 x 2/52 32,000
Labour
3,12,000 x 2/52 x 50% 6,000
Overheads
6,24,000 x 2/52 x 50% 12,000
Raw materials
8,32,000 x 4/52 64,000
Labour
3,12,000 x 4/52 24,000
Overheads
6,24,000 x 4/52 48,000
17,68,000 x 3/4 x 8/52 2,04,000
3) Cash 5,000
8,32,000 x 4/52 64,000
2) Accrued Wages – 1 ½ weeks
3,12,000 x 1.5/52 9,000
3) Accrued Overheads – 2 weeks
6,24,000 x 2/52 24,000
18
Illustration: 7
From the information given below, you are required to purpose a projected
balance sheet, P&L account and then an estimate of working capital requirements.
a. Issued share capital – 3,00,000
6% Debentures – 2,00,000
Fixed Assets at Cost – 2,00,000
b. The expected ratios to selling price are –
Raw materials – 50%
Labour – 20%
Overheads – 20%
Profit – 10%
c. Raw materials are kept in stores for an average of 2 months.
d. Finished goods remain in stock for an average period of 3 months.
e. Production during the previous year was 1,80,000 units and it is planned to
maintain the same in the current year also.
f. Each unit of production is expected to be in process for ½ a month (with 50%
completion of labour and overheads).
g. Credit allowed to customers is 3 months and given by suppliers is 2 months.
h. Selling price is Rs. 4 per unit.
i. There is a regular production and sales cycle.
j. Calculation of debtors may be made at selling price.
Solution: -
Calculation of Sales
Sales = 1,80,000 x 4 = Rs. 7,20,000

Raw materials [7,20,000 x 50%] 3,60,000
Direct Labour [7,20,000 x 20%] 1,44,000
Overheads [7,20,000 x 20%] 1,44,000
Total Cost 6,48,000
Profit [Bal. fig.] 72,000
Sales 7,20,000
Components Rs.
1) Inventory
Raw materials – 2 months
3,60,000 x 2/12 60,000
Work in progress – ½ month
Raw materials
3,60,000 x 0.5/12 15,000
Labour
1,44,000 x 0.5/12 x 50% 3,000
Overheads
19
1,44,000 x 0.5/12 x 50% 3,000
Finished Goods – 3 months
Raw materials
3,60,000 x 3/12 90,000
Labour
1,44,000 x 3/12 36,000
Overheads
1,44,000 x 3/12 36,000
2) Debtors – 3 months
7,20,000 x 3/12 1,80,000
3) Cash 9,000
1) Creditors – 2 months (always on R.M.)
3,60,000 x 2/12 60,000
Projected P&L account for the year
Particulars Rs. Particulars Rs.

To Cost of Materials 3,60,000 By Sales 7,20,000
To cost of Labour 1,44,000
To cost of Overheads 1,44,000
To gross profit c/d 72,000
7,20,000 7,20,000
To Interest on Debentures
(2,00,000 x 6%) 12,000 By Gross Profit b/d 72,000
Net Profit c/d 60,000
72,000 72,000
Projected Balance Sheet
Liabilities Rs. Assets Rs.

1. Share Capital 3,00,000 1. Fixed Assets 2,00,000
2. Reserves & Surplus 2. Investments ---
Net Profit 60,000 3. Current Assets
3. Secured Loans Stock of Raw Material 60,000
Debentures 2,00,000 Stock of WIP 21,000
Outstanding Interest 12,000 Stock of Finished Goods 1,62,000
4. Unsecured Loans --- Debtors 1,80,000
5. Current Liabilities Cash at Bank (bal. fig.) 9,000
Creditors 60,000
6,32,000 6,32,000
20
Illustration: 8
Prepare an estimate of working capital requirements from the information of a

Trading concern.
a. Projected annual sales 1,00,000 units
b. Selling Price Rs. 8 per unit.
c. Percentage of Net Profit on Sales 25%.
d. Average Credit Period allowed to customers – 8 weeks.
e. Average Credit Period allowed by suppliers – 4 weeks.
f. Average stock holding in terms of sales requirement 12 weeks.
g. Allowed 10% for contingency.
Solution: -
Calculation of Sales
Sales = 1,00,000 x 8 = Rs. 8,00,000
Calculation of Cost
Cost = 8,00,000 x 75% = Rs. 6,00,000
Components Rs.
1) Inventory – 12 weeks
6,00,000 x 12/52 1,38,462
6,00,000 x 8/52 92,308
6,00,000 x 4/52 46,154

Add: 10% Contingency 18,462
Total Working Capital 2,03,078
21
Chapter Roundup
 al refers to that part of Working Capital, which is required by a business

oveWorking capital is the amount of funds necessary to cover the cost of
operating the enterprise. In other words, it is the capital required to meet day
to day expenses of the organization.
 Permanent working capital refers to the minimum level of investment in the
current assets that is carried by the business at all times to carry out
minimum level of its activities. It is also known as Fixed Working Capital.
 Temporary working capital and above the Permanent Working Capital. It is
also called Variable Working Capital or Fluctuating Working Capital. The
amount of temporary working capital keeps on changing depending upon the
changes in production and sale.
 Gross working capital refers to investment in all the current assets taken
together. The total investments in all current assets are known as Gross
Working Capital.
 Net working capital refers to the excess of total current assets over total
current liabilities. Current assets refer to those assets which can be converted
in to money immediately. It may be noted that the current liabilities refers to
those liabilities which are payable within a period of one year.
 The working capital cycle refers to the length of time between the firms
paying cash for materials, entering into the production process, stock and the
inflow of cash from accounts receivable. It is also called as the Operating
Cycle.
Quick Quiz
1. What is working capital?

2. Distinguish between gross working capital and net working capital.
3. What is operating cycle?
4. What are the dangers of excess working capital?
5. What are the dangers of inadequate working capital?
6. What are the advantages of adequate working capital?
7. Explain the factors influencing the amount of working capital.
8. Explain the various sources of working capital.
9. The Board of directors of Ashok Engineering Company Ltd. requests you to

prepare a statement showing the working capital requirements forecast for a
level of activity of 72,000 units of production p.a.
The following information is available for your calculation:
Particulars Per Unit

Rs.
Raw-material 90
Direct Labour 40
Overheads 75
Total Cost 205
Profit 60
i) Raw materials are in stock, on average one month.
22
ii) Finished goods are in stock, on average one month.
iii) Credit allowed by suppliers, one month.
iv) Time lag in payment from debtors, 2 months.
v) Lag in payment of wages, ½ month.
vi) Lag in payment of overhead is one month.
20% of the output is sold against cash. Cash in hand and at bank is expected
to be Rs. 30,000. It is to be assumed that production is carried on evenly
throughout the year.
Ans: Net Working Capital Rs. 26,58,000.
10. A proforma cost sheet of a company provides the following particulars:

Raw materials 50%
Direct Labour 15%
Overheads 15%

a. It is proposed to maintain a level of activity of 3,00,000 units.
b. Selling price is Rs. 20 per unit.
c. Raw materials are expected to remain in stores for an average period of
two months.
d. Materials will be in process on an average of one month (Labour and
Overheads are assumed to be 50% completed).
e. Finished goods are required to be in stock for an average period of two
months.
f. Credit allowed to debtors is two months.
g. Credit allowed by suppliers is two months.
You may assume that sales and production follow a consistent pattern. You
are required to prepare a statement of working capital requirements.
Ans: Net Working Capital Rs. 19,25,000.
11. From the information given below, you are required to purpose projected
balance sheet. P&L account and then an estimate of working capital
requirements.
Issued share capital – 15,00,000
8% Debentures – 2,00,000
Fixed Assets at Cost – 13,00,000
The expected ratios to selling price are –
Raw materials – 40%
Labour – 20%
Overheads – 20%
The following further particulars are available.
a. It is proposed to maintain a level of activity of 2,00,000 units.
b. Selling price is Rs. 12 per unit.
c. Raw materials are kept in stores for an average of one month.
d. Raw materials will be in process on an average of one month with 100%
completion of material and with 50% completion of conversion cost.
e. Finished goods remain in stock for an average period of one month.
23
f. Credit allowed to debtors is 2 months and given by suppliers is one
month.
Ans: Net Working Capital Rs. 2,00,000; Balance Sheet Rs. 22,60,000.
12. Prepare an estimate of Working Capital Requirements from the following

information of a Trading Concern.
a. Projected annual sales 1,20,000 units.
b. Selling Price Rs. 10 per unit.
c. Percentage of Net Profit on Sales 30%.
d. Average Credit Period allowed to customers – 10 weeks.
e. Average Credit Period allowed by suppliers – 5 weeks.
f. Average stock holding in terms of sales requirement 5 weeks.
g. Allowed 15% for contingency.
24

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FINANCIAL MANAGEMENT: AN OVERVIEW

The primary task of Financial Manager is to deal with funds. Management of

Finance is regarded as the lifeblood of a business enterprise. This is because

Meaning of Business Finance

Business finance is that business activity which is concerned with the

Wheeler defines business finance as “That Business activity, which is

Finance Function refers to the providing of funds needed by a business

Objectives of Finance Function

The main aim of finance function is to arrange adequate funds as required by

The main objectives of finance function are: -

1. Acquiring sufficient funds

2. Proper utilization of funds

4. Maximizing concerns value

Organization Chart of Finance Function

An Organization Chart of Finance Function in a big organization is given

ORGANIZATION CHART OF FINANCE FUNCTION

V.P. (Production) V.P. (Finance) V.P. (Sales)

Credit Management Corporate General Accounting

The term Financial Management has been defined differently by different

Thus, financial management is considered as a subject, which deals in

According to Solomon, “Financial Management is concerned with the efficient

Objectives of Financial Management

The basic objectives of financial management can be broadly classified into

The following arguments are advanced in favor of Profit Maximization: -

Wealth maximization refers to the increase in value of capital of the firm in

How to maximize wealth?

In order to maximize wealth, a firm should take the following steps: -

3. Maintain Growth in sales

4. Maintain price of firm’s equity shares

Advantages of Wealth Maximization

a) Wealth Maximization considers the concept of time value of money.

The Wealth Maximization has been criticized on the following grounds: -

a) Wealth Maximization is a prescriptive idea. The objective is not descriptive of

1) Ensuring a fair return to a shareholder.

Functions of Financial Management

At present Financial Management is not restricted to raising and allocating

1) Planning the Financial Needs

5) Working Capital Management

6) Analysis and Interpretation of Financial Statement

7) Profit planning and control

Role of Finance Manager

The changed business environment has widened the role of a finance

1) Funds Requirement Decision

a) To ensure supply of funds to all parts of the organization

b) To evaluate Financial Performance

c) To negotiate with Banker, Financial Institutions, etc.

d) To keep track of Stock Exchange

Finance is an important function of business. The application of planning to

A financial plan is a statement of estimating the amount of capital and

Need for Financial Planning

Steps in Financial Planning

Financial Planning involves the following steps: -

1) Estimating Financial Objectives

2) Formulating Financial Policies

4) Providing for Flexibility

Principles Governing a Financial Plan

2) Clear Cut Objectives

 Finance function refers to the providing of funds by a business concern on

 Financial management refers to that part of management activity which is

 Profit maximization refers to increase in the profit of a business organization