Professional Documents
Culture Documents
Sources of Long Term Finance
Sources of Long Term Finance
Finance
Types of capital
Types of debentures/bonds
Term loan
Ordinary Equity Capital
Equity Shareholders are the owners of the business.
They enjoy the residual profits of the company after having paid the preference
shareholders and other creditors of the company.
Their liability is restricted to the amount of share capital they contributed to the
company.
Equity capital provides the issuing firm the advantage of not having any fixed
obligation for dividend payment but offers permanent capital with limited liability for
repayment.
However, the cost of equity capital is highest. Firstly, since the equity dividends are
not tax-deductible expenses and secondly, the high costs of issue.
Equity shareholders enjoy voting rights, excess of equity capital in the firms’ capital
structure will lead to dilution of effective control.
Preference capital
Preference shares have some attributes similar to equity shares and some to debentures. Like in the case of equity shareholders, there is
no obligatory payment to the preference shareholders; and the preference dividend is not tax deductible. Unlike in the case of the
debenture holders, wherein interest payment is obligatory. However, similar to the debenture holders, the preference shareholders earn a
fixed rate of return for their dividend payment. In addition to this, the preference shareholders have preference over equity shareholders
to the post-tax earnings in the form of dividends; and assets in the event of liquidation.
Other features of the preference capital include the call feature, wherein the issuing company has the option to redeem the shares,
(wholly or partly) prior to the maturity date and at a certain price.
Prior to the Companies Act, 1956 companies could issue preference shares with voting rights. However, with the commencement of the
Companies Act, 1956, the issue of preference shares with voting rights has been restricted only in the following cases:
i. There are arrears in dividends for two or more years in case of cumulative preference shares;
ii. Preference dividend is due for a period of two or more consecutive preceding years, or
iii. In the preceding six years including the immediately preceding financial year, if the company has not paid the preference dividend for a
period of three or more years.
Types of Preference Capital: Preference shares can be of two types in three categories.
i. Cumulative or Non-cumulative preference shares
ii. Redeemable or Perpetual preference shares.
iii. Convertible or non-convertible preference shares.
For cumulative preference shares, the dividends will be paid on a cumulative basis, in case they remain unpaid in any financial year due to
insufficient profits. The company will have to pay up all the arrears of preference dividends before declaring any equity dividends. While
on the other hand, the non-cumulative shares do not enjoy such right to dividend payment on cumulative basis.
Redeemable preference shares will be redeemed after a given maturity period while the perpetual preference share capital will remain
with the company forever.
Debenture capital
• A debenture is a marketable legal contract whereby the company
promises to pay its owner, a specified rate of interest for a defined
period of time and to repay the principal at the specific date of maturity.
• The company can also attach call and put options. With the call option
the company can redeem the debentures at a certain price before the
maturity date and similarly the put option allows the debenture holder to
surrender the debentures at a certain price before the maturity period.
Types of debentures
• Non convertible debentures (NCD) (Plain
vanilla bonds)
ICICI offered for public subscription for cash at par, 20,00,000 16% unsecured
redeemable Bonds (Debentures) of Rs.1,000 each. These bonds are fully non
convertible and so here, the investor is just not given the option of converting it into
equity.
Interest on the ICICI bonds will be paid half-yearly on June 30 and December
31 each year. The Company proposes to redeem these bonds at par on the expiry of 5
years from the date of allotment i.e., the maturity period is 5 years.
But ICICI has also allowed its investors the option of requesting the company to
redeem all or part of the bonds held by them on the expiry of 3 years from the date of
allotment, provided the bond holders give the prescribed notice to the company.
FCD
These debentures will be converted into equity shares after a specified period of time at one stroke or in
instalments. These debentures may or may not carry interest till the date of conversion. In the case of an
established company with an established reputation and good, stable market price, FCD’s are very attractive to
the investors as their bonds are getting automatically converted to shares which may at the time of conversion be
quoted much higher in the market compared to what the debenture holders paid at the time of FCD issue.
Recently 3 reputed companies, Apple Industries Limited, Arvind Polycot Limited and Jindal Iron and Steel
Company Limited have come out with the issue of Zero percent FCDs for cash at par. Let us take a look at the
Jindal issue.
The total issue was for 3,01,72,080 secured Zero Interest Fully Convertible Debentures. Of these, 1,29,30,000
FCDs of Rs.60 each were offered to the existing shareholders of the company on Rights basis in the ratio of one
FCD for every one fully paid equity share held as on 30.03.93. The balance of 1,72,42,080 secured zero-interest
FCDs were offered to the public at par value of Rs.100 each.
The terms of conversion were as follows: Each fully paid FCD will be automatically and compulsorily converted
into one equity share of Rs.10 each at a premium of Rs.90 per share. Credited as fully paid-up, conversion into
equity shares will be done at the end of 12 months from the date of allotment
PCD
These are debentures, a portion of which will be converted into equity share capital after a specified period, whereas
the non-convertible (NCD) portion of the PCD will be redeemed as per the terms of the issue after the maturity
period. The non-convertible portion of the PCD will carry interest right up to redemption whereas the interest on the
convertible portion will be only up to the date immediately preceding the date of conversion.
Let us look at the illustration given earlier on Ponni Sugars and Chemicals in greater detail. The company is offering
PCDs worth Rs.2,205 lakh of which Rs.605 lakh is being offered to the existing shareholders. The issue is for
14,70,000 16% Secured Redeemable PCDs of Rs.150 each. Out of this, 4,06,630 PCDs is by way of Rights Issue, in
the ratio of one PCD for every ten equity shares held. The balance of 10,63,370 PCDs are offered to the public.
Of the total face value of Rs.150, the convertible portion will have a face value of Rs.60 and the non-convertible
portion, a face value of Rs.90. A ‘tradable warrant’ will be issued in the ratio of one warrant for every 5 fully paid
PCDs. Each such warrant will entitle the holder to subscribe to one equity share at a premium which will not exceed
Rs.20 per share within a period of 3 years from the date of allotment of the PCDs. This is not included in the
conversion at the rate of 1:10.
The tradable warrants will also be listed in stock exchanges to ensure liquidity. Interest at 16% on the paid-up value of
the PCD allotted shall accrue from the date of allotment, but interest on the convertible portion of the PCD will be paid
only up to the date immediately preceding the date of conversion. The non-convertible portion of the PCD will be
redeemed in 3 stages at the end of the 6th, 7th and 8th year from the allotment of the PCD.
Secured Premium Notes (SPN)
This is a kind of NCD with an attached warrant that has recently started appearing in the
Indian Capital Market. This was first introduced by TISCO which issued SPNs aggregating
Rs.346.50 crore to existing shareholders on a rights basis.
Each SPN is of Rs. 300 face value. No interest will accrue on the instrument during the first
3 years after allotment. Subsequently the SPN will be repaid in 4 equal instalments of
Rs.75 each from the end of the fourth year together with an equal amount of Rs.75 with
each instalment. This additional Rs.75 can be considered either as interest (regular
income) or premium on redemption (capital gain) based on the tax planning of the
investor.
The warrant attached to the SPN gives the holder the right to apply for and get allotment
of one equity share for Rs. 100 per share through cash payment. This right has to be
exercised between one and one-and-half year after allotment, by which time the SPN will
be fully paid-up.
Issue of securities
Public issue (Initial Public Offering)
Rights issue
Private placement
Bought out deals
Euro issues
Public issue (IPO)
Companies issue securities to the public in the primary market and get them listed on the stock
exchanges. These securities are then traded in the secondary market.
The major activities involved in making a public issue of securities are as follows:
3. Appointment of Intermediaries
Underwriters, registrars, bankers to the issue, brokers and advertising agencies. Apart from these it also involves
promotion of the issue, printing and despatch of prospectus and application forms, obtaining statutory clearances, filing
the initial listing application, final allotment and refund activities. The cost of a public issue ranges between 12-15% of
the issue size and can go up to 20% in bad market conditions.
Rights issue
Under Section 81 of the Companies Act, 1956, when a firm issues additional
equity capital, it has to first offer such securities to the existing shareholders on a
pro rata basis.
The rights offer should be kept open for a period of 60 days and should be
announced within one month of the closure of the books. The shareholders can
also renounce their rights in favour of any other person at market determined rate.
The cost of floating of rights issue will be comparatively less than the public issue,
since these securities are issued to the existing shareholders, thereby eliminating
the marketing costs and other relevant public issue expenses.
The rights issue will also be priced lower than the public issue since it will be
offered to the existing shareholders.
Ex-rights Value of a Share
Market price of a share = ₹ 30
Subscription price of right = ₹ 25
No. Of shares required to exercise right = 3 shares
Ex rights value of share = ₹ 28.75
Value of right = ₹ 1.25
Market value of investors wealth with ex rights 115 Market value of 3 shares at the ex rights price 86.25
price (4x28.75) (3x28.75)
Change in wealth 0 Change in wealth 0
Considering that you hold 100 shares of the company, how would your wealth change if you
1. Exercise your right
2. Renounce your right
3. Sell your right
Also find out how much would be the value of rights and ex rights issue share price.
No of shares outstanding = 10,00,000
Current market price = ₹ 40
Amount required by company = ₹ 40,00,000
Rights issue price = ₹ 20 per share
No of extra shares for sale = ₹ 40 lakh / ₹ 20 = 200,000 shares
No of shares required to subscribe for 1 additional share = Existing shares / New shares = 10 lakh / 2 lakh =5
Market value of investors wealth with ex rights 4400 Market value of shares at the ex rights price 3667
price (120x36.66) (100x36.66)
Change in wealth 0 Change in wealth 0
This avoids the delay involved in going public and also reduces the
expenses involved in a public issue.
The bought-out deal route is relatively inexpensive, funds accrue without much delay (in a public issue funds
reach the company only after a period of 2-3 months from the date of closure of the subscription list). In addition
to this, it affords greater flexibility in terms of the issue and matters relating to off-loading with proper
negotiations with the sponsor or the Merchant Banker involved.
• Companies, both existing and new, which do not satisfy conditions laid down by SEBI for premium issues,
may issue at a premium through the BOD method.
• The procedural complexities are reduced considerably and the funds reach the firm upfront. Added to this there
is a cut in the issue costs.
• An advantage accruing the investor is that the issue price usually reflects the company’s intrinsic value.
Euro issues (Foreign money)
The Government has allowed Indian companies to float their stocks in
Foreign capital markets. The Indian corporates face high rates of
interest in the domestic markets are now free to tap the global capital
markets for meeting resource requirements at less costs and
administrative problems.
The instruments which the company can issue are Global Depository
Receipts (GDRs), Euro- Convertible Bonds (ECBs), Foreign Currency
Convertible Bonds (FCCBs).
These instruments are issued abroad and listed and traded on a foreign
stock exchange. Once they are converted into equity, the underlying
shares are listed and traded on the domestic exchange.
Term loans
Term Loans constitute one of the major sources of debt finance for a long-term project. Term
loans are generally repayable in more than one year but less than 10 years. These term loans
are offered by the All India Financial Institutions viz., IDBI, ICICI etc. and by the State Level
Financial Institutions. The salient features of the term loans are the interest rates, security
offered and the restrictive covenants.
The interest rate on the term loans will be fixed after the financial institution appraises the
project and assesses the credit risk.
Term Loans, which can be either in rupee or foreign currency, are generally
secured through a first mortgage or by way of depositing title deeds of immovable
properties or hypothecation of movable properties. In addition to the security,
financial institutions also place restrictive covenants while granting the term loan.
These depend mostly on the nature of the project and can include placing the
nominees of the financial institution on the company’s board, refrain the company
from undertaking any new project without their prior approval, disallow any
further charges on the assets, maintain the debt-equity ratio to a certain level, etc.
The major advantage of this source of finance is its post-tax cost, which is lower
than the equity/preference capital and there will be no dilution of control.
However, the interest and principal payments are obligatory and threaten the
solvency of the firm. The restrictive covenants may, to a certain extent, hinder
the company’s future plans.
Internal accrual
Financing through internal accruals can be done through the depreciation charges
and the retained earnings. While depreciation amount will be used for replacing an
old machinery etc., retained earnings on the other hand can be utilized for funding
other long-term objectives of the firms.
The major advantages the company gets from using this as a source of long-term
finance are its easy availability, elimination of issue expenses and the problem of
dilution of control.
However, the disadvantage is that there will be limited funds from this source. In
addition to this ploughing back of retained earnings implies foregoing of dividend
receipts by the investors which may actually lead to higher opportunity costs for the
firm.
Deferred credit
The deferred credit facility is offered by the supplier of
machinery, whereby the buyer can pay the purchase
price in instalments spread over a period of time.
Leasing is a contractual agreement between the lessor and the lessee, wherein companies
(lessee) can enter into a lease deal with the manufacturer of the equipment (lessor) or
through some other intermediary.
This deal will give the company the right to use the asset till the maturity of the lease deal
and can later return the asset or buy it from the manufacturer. During the lease period
the company will have to pay lease rentals, which will generally be at negotiated rate and
payable every month.
Very similar to leasing is hire purchase, except that in hire purchase the ownership will be
transferred to the buyer after all the hire purchase instalments are paid-up. With the
mushrooming of non-banking finance companies offering the leasing and hire purchase of
equipments, many companies are opting for this route to finance their assets. The cost of
such financing generally lies between 20-25%.
Government subsidies
The central and state governments provide subsidies to Industrial units in backward areas. The central
government has classified backward areas into three categories of districts: A, B and C. The central subsidy
applicable to industrial projects in these districts is:
• Category A Districts 25 percent of the fixed capital investment subject to a maximum of Rs.25 lakh
• Category B Districts 15 percent of the fixed capital investment subject to a maximum of Rs.15 lakh
• Category C Districts 10 percent of the fixed capital investment subject to a maximum of Rs.10 lakh
The state governments also offer cash subsidies to promote widespread dispersal of industries within their
states. Generally, the districts notified for the state subsidy schemes are different from those covered under
the central subsidy scheme. The state subsidies vary between 5 percent to 25 percent of the fixed capital
investment in the project, subject to a ceiling varying between Rs.5 lakh and Rs.25 lakh depending on the
location.
Satavahana Ispat Limited has been set up with the capacity to manufacture 1,20,000 tonnes of pig iron. The
cost of project has been appraised by IDBI at Rs.5,450 lakh and is to be mainly financed through equity
capital and term loans. The unit is also eligible for a State Government Subsidy (Andhra Pradesh) of Rs.20
lakh which will also be a source of long-term finance. The unit is located at Anantapur District of Andhr
Pradesh and falls into ‘C’ Category backward area.
Sales Tax Deferments and Exemptions
To attract industries, the state provides incentives, inter alia, in the form of sales tax
deferments and sales tax exemptions. Under the sales tax deferment scheme, the payment of
sales tax on the sale of finished goods may be deferred for a period ranging between five to
twelve years.
Essentially, it implies that the project gets an interest-free loan, represented by the quantum
of Sales Tax deferment period.
Under the sales tax exemption scheme, some states exempt the payment of sales tax
applicable on purchase of raw materials, consumables, packing, and processing materials
from within the state which are used for manufacturing purposes.
Thus, with a definite increase in the variety of sources for long-term funds rising, an
efficient finance manager will be the one who devises the optimum financing mix. The
funding process should be a trade-off between the cost of funding, the risk involved and the
returns expected, so that a reasonable spread is maintained for the firm.
Lupin Chemicals Ltd. have stated in their prospectus that they are eligible for sales tax
incentive for a period of five years or till they reach the ceiling of 60% of fixed capital
investment whichever is earlier.
Conclusions
Recall all the topics
Leverage
Capitalizing on one’s strength
Wielding an influence
Without a lever
Interpretation:
If the independent variable changes by 1 unit, then the dependent variable changes
by 2 units.
Year Total cost Fixed cost Variable cost Proportion of fixed cost in the DOL
total cost
2019 4000 1000 3000 25% 2
2020 7000 1000 6000 14.28% 1.33
DOL
It is a measure used to evaluate how a company's Gross profit (EBIT) changes with 1%
change in its sales.
The DOL reflects the operating risk a company faces as a result of the structure of its
fixed and variable costs.
A low degree of operating leverage implies that a company has a high proportion of
variable costs, and the company does not have to dramatically increase sales to cover its
lower fixed costs.
Interpretation:
If the independent variable changes by 1 unit, then the dependent variable
changes by 1.21 units.
If the EBIT changes by 1 unit, then the EPS changes by 1.21 units.
If the EBIT increases by 1 unit, then the EPS increases by 1.21 units.
If the EBIT decreases by 1 unit, then the EPS decreases by 1.21 units.
For the year 2019
DFL = EBIT / EBT
DFL = 1000 / 700 = 1.428
Interpretation:
If the independent variable changes by 1 unit, then the dependent variable
changes by 2.43 units.
If the revenue changes by 1 unit, then the EPS changes by 2.43 units.
If the revenue increases by 1 unit, then the EPS increases by 2.43 units.
If the revenue decreases by 1 unit, then the EPS decreases by 2.43 units.
For the year 2019
DTL = Contribution / EBT
DTL = 2000 / 700 = 2.85
Year DTL
2019 2.85
2020 1.66
Income statement of XYZ Ltd for the year ending 31 March 2020
Revenue
Less Variable cost
Contribution
Less Fixed cost
Gross income (EBIT)
Less Interest paid
Earnings before Tax (EBT)
Less Tax @ x%
PAT
Less Preference dividend
Earnings for shareholders
Total number of outstanding shares
EPS
EBIT – EPS analysis
Understand the relationship between EBIT and EPS under different
financing alternatives.
Wonderland Ltd:
Existing capital structure: 10 lakh equity share of ₹ 10 each
Tax rate: 50%
If the most likely value of EBIT exceeds the indifference value of EBIT,
the debt financing option, prima facie, may be advantageous.
The larger the difference between the expected value of EBIT and its
indifference value, the stronger the case for debt financing, other things
being equal.
Given the variability of EBIT, arising out of the business risk of the
company, the probability of EBIT falling below the indifference level
of EBIT may be assessed.
■ The ROE under the two capital structures is the same when ROI is equal to the cost of debt. Hence the indifference (or
breakeven) value of ROI is equal to the cost of debt.
■ The ROE under capital structure B is higher than the ROE under capital structure A when ROI is more than the cost of
debt.
where ROE is the return on equity, ROI is the return on investment, r is the cost of debt, D/E
is the debt-equity ratio, and t is the tax rate.
Applying the above equation to Joker Limited when its D/E ratio is 1, we may calculate the value of ROE for two values of
ROI, namely, 15 percent and 20 percent.
ROI = 15%
ROE = [15 + (15 - 10) 1] (0.5) = 10.0%
ROI = 20 percent
ROE = [20 + (20 - 10) 1] (0.5) = 15.0%
These results, as expected, are in conformity with our earlier analysis.
Capital structure and Firm Value
Debt based capital (Interest)
Equity based Capital (Participation)
Financing Decision
Investment Decision
Dividend decision
WACC= 11.5%
Impact of capital structure of a firm on its value
Capital Structure
For raising finance, the company went in for a public issue of:
1,93,45,000 equity shares of Rs.10 each at par
28,25,000 secured PCDs of Rs.200 each.
The capital structure of the company including the present issue as per the
prospectus of the company was:
Importance of the Capital Structure
Decision
The objective of any company is to mix the permanent sources of funds used by it in a
manner that will maximize the company’s market price. In other words companies seek to
minimize their cost of capital. This proper mix of funds is referred to as the Optimal
Capital Structure.
The capital structure decision is a significant managerial decision which influences the
risk and return of the investors. The company will have to plan its capital structure at the
time of promotion itself and also subsequently whenever it has to raise additional funds
for various new projects. Wherever the company needs to raise finance, it involves a
capital structure decision because it has to decide the amount of finance to be raised as
well as the source from which it is to be raised.
FACTORS AFFECTING THE
CAPITAL STRUCTURE
• Leverage (Financial leverage)
• Cost of capital (Inverse relationship with firm value)
• Cash flow projections of the company
• Size of the company
• Sector (Capital intensive) Debt is high
• Dilution of control (Fixed cost obligation)
• Floatation costs
Assumptions
• There is no income tax, corporate or personal.
Based on the assumption of 100% dividend pay-out and constant earnings, cost of equity is
the discount rate at which the discounted future dividend are equal to the MV of equity, i.e.
Assuming the net operating income to be constant, the cost of capital of the firm, ko is
the discount rate at which the present value of net operating income is equal to the
market value of the firm (i.e., sum of the market values of debt and equity). Hence,
Where V = D + E and ko is the overall capitalization rate for the firm.
Since it is the weighted average cost of capital, it may be expressed as
Measured by the ratio D/E, what happens to kd, ke and ko when financial leverage changes
Net Income Approach
According to this approach, the cost of equity capital (ke) and the cost of debt capital (kd)
remain unchanged when D/E, the degree of leverage varies. This means that ko, the average
cost of capital, measured as
declines as D/E increases. This happens because when D/E increases, kd, which is lower
than ke, receives a higher weight in the calculation of ko.
Consider two firms X and Y, which are identical in all respects except in the degree of
leverage employed by them. The following is the financial data for these firms.
There are two firms A and B similar in all aspects except in the degree of
leverage employed by them. Financial data for these firms are shown below:
In the above graph, it is the point X which is the optimal capital structure. At the
optimal capital structure, the real marginal cost of debt and equity is the same.
Before the optimal point the real marginal cost of debt is less than the real
marginal cost of equity and beyond the optimal point the real marginal cost of
debt is more than the real marginal cost of equity.
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.
Let’s suppose that a firm has 20:80 debt to equity in its capital structure. The cost of debt and equity is 10% and
15 % respectively. What is the overall cost of capital as per the traditional model.
With the rise in cost of debt and equity, the cost of overall capital has decreased.
Most likely, the increase in the cost of debt and equity has not fully offset the advantage of inexpensive debt.
The firm want to increase the percentage of debt to 70%.
Due to increased financial risk, the cost of debt and equity would rise to 14% and 20 % respectively.
The following is a numerical Illustration of the traditional approach. This table shows the
average cost of capital for a firm which has a net operating income (EBIT) of Rs.1,25,000
that is split variously between interest and equity earnings depending on the degree of
leverage employed by the firm.
Compute the market value of the firm, value of shares and
average cost of capital from the following information:
Assume that Rs.4, 00,000 debentures can be raised at 5% rate of interest whereas Rs.
6, 00,000 Debentures can be raised at 6% rate of interest.
MM
1. The total value of the firm is equal to the capitalized value of the operating earnings of the
firm. (Expected operating income divided by the overall discount rate appropriate to its risk
class). It is similar to NOI theory.
MM invoked an arbitrage argument to prove this proposition. In equilibrium, identical assets must sell for the same price,
irrespective of how they are financed. Put differently, no matter how you package a set of cash flows its value remains
unchanged. This is what the law of conservation of value implies. We have already encountered this idea in capital
budgeting where it is called the principle of value additivity.
2. The total value of the firm is independent of the financial mix. It is similar to NOI theory.
The ke is equal to the capitalisation rate of pure equity stream plus a premium for financial risk equal to the difference
between the pure equity capitalisation rate (ke) and ki times the ratio of debt to equity. In other words ke increases in a
manner to offset exactly the use of less expensive source of funds viz. Debt. MM asserts that corporate’s cost of equity
consists of two elements:
1) ko, the required rate of return on total assets of the firm whose value depend on business risk.
2) (ko-ki)*(D/E) that is determined by company’s capital structure. The second component is zero for a zero debt
company.
As the company starts taking debt, the ke increases and the equity investor is compensated for it. Higher the debt, higher
the financial risk and thus higher the financial risk premium.
3. The cut off rate of the investment decision of the firm depends upon the risk class to which
the firm belongs, and thus is not affected by the financing pattern of this investment.
The M&M model argues that if two firms are identical in all respects except their
financing pattern and their market value, then the investors will sell the shares of the
overvalued firm and buy the shares of the undervalued firm till the two firms have same
market value.
Suppose there are two firms, LEV & Co. and ULEV & Co.. These are identical in all
respect except that the LEV & Co. is a leveraged firm with 10% debt of Rs. 5,00,000 in its
capital structure. The ULEV & Co. is an unlevered firm. Both these firms have an EBIT of
Rs. 1,00,000. The equity capitalization rate of levered and unlevered firm is 16% and
12.5% respectively
LEV & Co. UNLEV & Co.
EBIT 1,00,000 1,00,000
Less Interest 50,000 0
EBT 50,000 1,00,000
Tax 0 0
PAT 50,000 1,00,000
Equity capitalization rate ke 16% 12.5%
Debt capitalization rate kd 10% 0%
MV of equity 3,12,500 8,00,000
MV of debt 5,00,000 0
MV of total capital 8,12,500 8,00,000
Ko = EBIT/V 12.3% 12.5%
Debt to equity ratio 1.6 0
Though both the firm has same EBIT still the Levered firm has a lower Ko and higher value
as against the Unlevered firm. MM argues that this position cannot exist for a long and
there will be equality in the value of the two firms through the Arbitrage process.
Arbitrage
The arbitrage process refers to undertaking by a person of two related actions or steps
simultaneously in order to derive the some benefits.
E.g. buying by a speculator in one market and selling the same at the same time in some
other market.
The benefit from the arbitrage process may be in any form: increased income from the same
level of investment or same income from lesser investment.
The value of the levered firm L is higher than that of the unlevered firm even though both
the firms have the same operating income and belong to the same risk.
Such a situation, argue MM, cannot persist because equity investors would do well
to sell their equity in firm LEV & Co. (the firm which is valued more) and invest in firm
UNLEV & Co. (the firm which is valued less) with personal leverage.
Modus operandi of arbitrage
Suppose X holds 10% of outstanding shares in the levered firm. His holdings would amount to ₹ 31,250
(i.e. 10% of market value of equity 3,12,500) and his share in earnings that belong to the equity
shareholders is ₹ 5,000 (i.e. 10% of earnings available to equity holders 50,000).
X would sell his holdings in the levered firm (as it is overvalued) and invest in unlevered firm (as it is
undervalued). Since, the unlevered firm has no debt in its capital structure, the degree of financial risk
to Mr. X is less when compared to the levered firm.
In order to reach to the level of financial risk equivalent to that of the levered firm, Mr X would borrow
Money (homemade leverage) equal to his proportionate share in levered firm’s debt on his personal
account.
Mr. X would borrow ₹ 50,000 @ 10%. His proportionate holding in (10%) in the unlevered firm would
amount to ₹ 80,000 on which he receive a dividend of ₹ 10,000 (12.5% of 80,000).
Out of the equity income of ₹ 10,000 from Mr X’s holding in the unlevered firm, he has to pay ₹ 5,000
as interest on his personal borrowing. He would be left with ₹ 5,000 that is the same amount as he was
getting from the levered firm. However, his investment outlay in the unlevered firm is less (₹ 30,000)
when compared to the unlevered firm (₹ 31,250) with identical risk.
Effect of Arbitrage
A. Mr X’s position in levered firm with 10% equity holding
i. Investment outlay (10% of market value of equity) ₹ 31,250
ii. Dividend income (10% of earnings available to equity-holders) ₹ 5,000
B. Mr X’s position in unlevered firm with 10% equity holding
i. Total funds available (Own funds ₹ 31,250 + borrowed funds ₹ 50,000) ₹ 81,250
ii. Investment outlay (Own funds ₹ 30,000 + borrowed funds ₹ 50,000) ₹ 80,000
iii. Dividend income (Total income i.e. 10% of earnings available to equity holders (₹ 10,000 - ₹ 5,000)
minus = ₹ 5,000
interest payable on borrowed funds i.e. 10% of borrowed funds)
C. Mr X’s position in unlevered firm if he invests the total funds available
i. Investment costs (10% of market value of equity) ₹ 81,250
ii. Total income (12% of earnings available to equity-holders) ₹ 10,156.25
iii. Net Dividend income (Total income i.e. 12.5% of earnings available to equity holders ₹ 5,156.25
minus
interest payable on borrowed funds i.e. 10% of borrowed funds)
With identical risk characteristics of the two firms, he gets same income with lower investment outlay in the unlevered
firm.
Mr X is better off by selling his securities in the levered firm and buying the shares of the unlevered firm. This process
continues till equilibrium is reached where the total value of two firms would be same.
The cost of capital of the two firms would also be same. Hence, it is unimportant what the capital structure of levered firm
is.
The weighted cost of capital (ko) after investors exercise their home made leverage is constant because investors exactly
offset the firm’s leverage with their home made leverage.
Trade Off Theory
Costs of Financial distress:
When a firm is unable to meet its obligations, it results in financial distress that can lead to
bankruptcy. When a firm experiences financial distress several things can happen.
1. Arguments between shareholders and creditors delay the liquidation of assets. Bankruptcy cases
often take years to settle and during this period machineries and equipments rust, buildings
deteriorate, inventories become obsolete, so on and so forth.
2. If assets are sold under distress conditions, they may fetch a price that is significantly less than
their economic value.
3. The legal and administrative costs associated with bankruptcy proceedings are quite high.
4. Managers become myopic. They may lower the quality of goods, provide inadequate after sales
service, ignore employee welfare, and unfairly stretch payments to suppliers and creditors. In a
bid to survive in the short run, they may sacrifice actions meant to build value in the long run.
5. Employees, customers, suppliers, distributors, investors, and other stakeholders dilute their
commitment to the firm and this has an adverse impact on sales, operating costs, and financing
costs.
Agency cost
Because shareholders may exploit creditors in these and other ways,
creditors seek protection in the form of various restrictive covenants
which may hamper the operational flexibility of the firm.
This implies that VL rises as debt (D) increases. However, as debt increases, financial
distress and agency costs would cause VL to decline.
Considering the tax effect and financial distress and agency costs, the value of a levered
firm may be expressed as:
Value of the levered firm = (Value of the unlevered firm + Tax advantage of debt)
- (Present value of expected costs of financial distress - Present value of agency costs)
According to the trade-off theory, every firm has an optimal debt-equity ratio that maximises its value.
The optimal debt-equity ratio of a profitable firm that has stable, tangible assets would be higher than
the optimal debt-equity ratio of an unprofitable firm with risky, intangible assets. Why?
The answer is simple. A profitable firm can avail of tax shelter associated with debt fully. Further,
when assets are stable and tangible financial distress costs and agency costs tend to be lower.
How well does the trade-off theory explain corporate financing behaviour? It explains reasonably well
some industry differences in capital structures. For example, power companies and refineries use more
debt as their assets are tangible and safe.
Software companies, on the Other hand, borrow less because their assets are mostly intangible and
somewhat risky.
The trade-off theory, however, cannot explain why some profitable companies depend so little on debt.
For example, Hindustan Unilever Limited and Colgate Palmolive India Limited, two highly profitable
companies, use very little debt. They pay large amounts by way of income tax which they can possibly
save to some extent by using debt without causing any concern about their solvency.
There is an alternative theory, the signalling theory, which explains why profitable firms use little debt.
When it resorts to external finance, it will first issue debt, then convertible debt, and finally equity
stock.
Put differently, there is a pecking order of financing which goes as follows:
■ Internal finance (retained earnings)
■ Debt finance
■ External equity finance
Signalling Theory
Given the pecking order of financing, there is no well-defined target debt-equity
ratio, as there are two kinds of equity, internal and external.
While the internal equity (retained earnings) is at the top of the pecking order, the
external equity is at the bottom. This explains why highly profitable firms
generally use little debt. They borrow less as they don't need much external
finance and not because they have a low target debt-equity ratio.
On the other hand, less profitable firms borrow more because their financing
needs exceed retained earnings and debt finance comes before external equity in
the pecking order.
Noting the inconsistency between the trade-off theory and the pecking order of
financing, Myers proposed a new theory, called the signalling, or asymmetric
information, theory of capital structure.
A critical premise of the trade-off theory is that all parties have the same information and
homogeneous expectations. Myers argued that if there is asymmetric information and
Divergent expectations then Donaldson's findings can be explained logically.
To illustrate, consider Alpha Limited that has 1,000,000 outstanding equity shares selling
at Rs.18 per share. Alpha's management, however, has better information about the future
prospects of the firm and believes that the intrinsic value per share of Alpha is Rs.22.
Suppose that the management has now identified a new project that requires Rs 1,000,000
of external financing and has an expected NPV of Rs.100,000. Investors are unaware of
The project, so its expected NPV of Rs. 100,000 is not reflected in the equity market
value of Rs.18,000,000.
Should Alpha undertake the project? To begin with assume that Alpha will issue equity
shares to raise Rs. 1,000,000 required for the project. There are several possible scenarios:
Working capital management
Introduction to Working Capital Management
Assets and liabilities of a company can be classified on the basis of duration into:
Fixed Assets or Non current assets and Current Assets
Long-term liabilities and short-term liabilities.
Fixed assets are permanent in nature and are held for use in business activities (not for sale).
E.g. land, building, machinery, long-term investment, etc.
Current assets are liquid in nature and are held in the form of cash or cash equivalent that
can be easily converted into cash (without much loss of time or value) within an accounting
period.
E.g. cash, short-term investments, sundry debtors or accounts receivable, stock, loans and
advances, etc.
Liabilities are economic obligations of the company to pay cash or provide goods or
services to outsiders including shareholders. Liabilities may be long-term or current.
Long-term liabilities are those which are repayable over a period greater than the
accounting period like share capital, debentures, long-term loans etc.
Current liabilities have to be paid within the accounting period like sundry creditors or
accounts payable, bills payable, outstanding expenses, short-term loans, etc.
Components of Current Assets
and Current Liabilities
Current Assets Current Liabilities
Cash and cash equivalent
The investment in current assets for a given level of forecasted sales will be higher if the management
follows a conservative attitude than when it follows an aggressive attitude.
Thus a company following a conservative approach is subjected to a lower degree of risk than the one
following an aggressive approach. Further, in the former situation the high amount of investment in
current assets imparts greater liquidity to the company than under the latter situation wherein the quantum
of investment in current assets is less. This aspect considers exclusively the liquidity dimension of
working capital. There is another dimension to the issue, viz., the ‘profitability’.
Further, since current assets are more under the conservative approach, the turnover of current assets
(calculated as the ratio of net sales to current assets) will be less than what they would be under the
aggressive approach.
Thus, at the same level of sales revenue, operating profit before interest and tax and net (operating) fixed
assets, A company following a conservative policy will have a low percentage of operating profitability
compared to its counterpart following an aggressive approach
Covering the CL with their CA and have some buffer
100 lakh
CA = 80 lakh (20 lakh) conservative (less risky) (less
profitable) (high liquid)
It can be seen from item J, that following a conservative approach results in low profitability (27.8%)
compared to (33.3%) obtained under the aggressive approach. The reason for this can be directly traced to the
low turnover of current assets leading to a lower turnover of total operating assets under the conservative
approach compared to that under the aggressive approach.
LIQUIDITY versus PROFITABILITY
Nature of business
Nature of raw materials
Stages between raw material and finished goods
Nature of finished goods
Degree of competition in the market
INTER DEPENDENCE AMONG
COMPONENTS OF WORKING CAPITAL
Operating Cycle Approach to
Working Capital Management
Cash
Average
Raw
collection
materials
period
Sale on
Conversi
cash/credi
on (WIP)
t
Finished
goods
The total duration of all the segments above is known as ‘gross operating cycle period’.
Cash sales would make average collection period disappear from the gross operating cycle period
and to that extent the total duration of the cycle gets reduced.
Advance payments made for procuring materials, increases the operating cycle period.
Purchase of raw materials etc., are usually made on credit basis, giving rise to current liability.
When the average payment period of the company to its suppliers is deducted from the gross
operating cycle period then it is called net operating cycle period.
Step by step calculation of
segments of operating cycle
RAW MATERIAL STORAGE PERIOD
Then,
Gross operating cycle period = (D1 + D2 + D3 + D4) days
Net operating cycle period = (D1 + D2 + D3 + D4) – (D5) days
When the operating cycle period is short it implies that the locking up of funds in
current assets is for a relatively short duration and the company can obtain greater
mileage from each rupee invested in current assets.
Data
Particulars Amount (₹ in lakh)
1. Opening Balance of
a. Raw Materials, Stores and Spares, etc 3454.84
b. Work-in-Process 56.15
c. Finished Goods 637.92
d. Accounts Receivable 756.45
e. Accounts Payable 2504.18
2. Closing Balance of
a. Raw Materials, Stores and Spares, etc 4095.41
b. Work-in-Process 72.50
c. Finished Goods 1032.74
d. Accounts Receivable 1166.32
e. Accounts Payable 3087.47
3. Purchases of Raw Materials, Stores and Spares, etc. 10676.10
4. Manufacturing Expenses 1146.76
5. Depreciation 247.72
6. Customs and Excise duties 35025.56
7. Selling, Administration and Financial Expenses 4557.48
8. Sales 54210.65
calculation of RAW MATERIAL
STORAGE PERIOD
calculation of WIP PERIOD
calculation of Finished
goods storage PERIOD
calculation of AVERAGE
COLLECTION PERIOD
calculation of AVERAGE
payment PERIOD
WC
Working capital can be viewed in two ways.
1) Working capital is viewed as the difference between ‘current assets’ and ‘current
liabilities’. The objective of working capital is to provide adequate cover to meet the current
obligations of a company as and when they become due.
This approach lays greater emphasis on the ‘liquidity’ aspect of working capital.
2) Working capital is considered as the amount held in different forms of current assets to
provide adequate support for the smooth functioning of the normal business operations of a
Company.
This approach lays greater emphasis on the trade-off between liquidity and profitability.
Inventory Management
Contents
The Role of Inventory in Working Capital
Inventory Planning
2. Level of Liquidity: Inventories are viewed as a source of near cash. For most products,
this description is accurate. At the same time, exceptions are there. (inventory)
3. Liquidity Lags: Inventories are tied to the firm’s pool of working capital in a process
that involves three specific lags, namely:
a. Creation Lag: In most cases, inventories are purchased on credit, creating an account
payable. When the raw materials are processed in the factory, the cash to pay
production expenses is pushed to future. This liquidity lag offers a benefit to the firm.
b. Storage Lag: Once goods are available for resale, they will not be immediately
converted into cash. Thus, the firm will usually pay suppliers, workers, and overhead
expenses before the goods are actually sold. This lag represents a cost to the firm.
c. Sale Lag: Once goods have been sold, they normally do not create cash immediately.
Most sales occur on credit and become accounts receivable. The firm must wait to
collect its receivables. This lag also represents a cost to the firm.
4. Circulating Activity: Inventories are in a rotating pattern with other current assets.
They get converted into receivables which generate cash and invested again in inventory
to continue the operating cycle.
Purpose of inventory
Raw material
WIP
Finished goods
Costs associated with
inventory
Material Costs (1200 kg of plastic @ ₹ 10 per kg = ₹ 12000)
By calculating an EOQ, the firm attempts to determine the order size that will
minimize the total inventory costs.
Important Inputs:
Annual usage of quantity (2000 Kg)
Order placement cost (Single order) (₹ 100)
Storage cost per unit per annum (₹ 5)
Price per unit (Material cost) (₹ 50)
3. What would be the optimal order size if the company opts to avail
the discount offered?
U = 40,000 units
F = Rs.200 per order
P = Rs.50 per unit
C = 0.20
D = Rs.2 per unit
(EQ2)
(EQ3)
Net incremental benefit = (EQ1) + (EQ2) - (EQ3) = 80000 + 1000 – 875 = ₹ 80, 125
Reorder point
In the EOQ model we assume that the lead time for procuring material is zero.
In real life there is always a time lag from the date of placing an order for material and the
date on which materials are received.
As a result the reorder level is always at a level higher than zero, and the firm places the
order when the inventory reaches the reorder point.
The determination safety stock level is the trade-off between the risk of stock-out,
resulting in possible customer dissatisfaction and lost sales, and the increased costs
associated with carrying additional inventory.
REORDER POINT
Alternative method of calculating reorder level is the the calculation of usage rate
per day, lead time (i.e. The period of time between placing an order and receiving
the Goods)
If the average daily usage rate of a material is 50 units and the lead time is 7
days.
When the inventory level reaches 350 units an order should be placed for
material.
Reorder Level
It determines when to order the materials.
The probabilities and the values of usage rate and lead time are based on optimistic,
realistic and pessimistic perceptions of the executives concerned.
The stock-out cost is estimated to be Rs.10 per unit while carrying cost for the period
under consideration is Rs.3 per unit.
Average daily usage Prob of occurance Lead time (No. Of Prob of occurance
rate days)
The expected usage rate is nothing but the weighted average daily usage rate, where the weights
are taken to be the corresponding probability values. Thus, expected daily usage rate
= (200 x 0.25) + (500 x 0.5) + (800 x 0.25)
= 50 + 250 + 200
= 500 units
Normal consumption during lead time can be obtained by multiplying the above two values.
(i.e.,) Normal consumption during lead time
= 500 units per day x 16 days = 8,000 units
Since normal consumption during lead time has been obtained as 8000 units, stock-outs can occur
only if the consumption during lead time is more than 8,000 units.
Let us enumerate the situations with lead time consumption of more than 8,000 units, along
with their respective probabilities of occurrence.
The situations with the lead time consumption of more than 8,000 units (normal usage) are:
A) 10,000 units with a probability of 0.1250 and the level of stock out is 2000 units,
B) 9,600 units with a probability of 0.0625 and the level of stock out is 1600 units,
C) 12,800 units with a probability of 0.1250 and the level of stock out is 4800 units
D) 16,000 units with a probability of 0.0625. And the levels of stock-out are 8,000 units.
Average daily usage rate Lead time in days Possible levels of use
(Units) Probability Days Probability Units Probability
12 0.25 2400 0.0625
200 0.25 16 0.50 3200 0.1250
20 0.25 4000 0.0625
12 0.25 6000 0.1250
500 0.50 16 0.50 8000 0.2500
20 0.25 10000 0.1250
12 0.25 9600 0.0625
800 0.25 16 0.50 12800 0.1250
20 0.25 16000 0.0625
Thus, safety stock level can be maintained at any of the above levels and the stock out cost and carrying cost
associated with these various levels are shown in the table.
Qty used Safety Stock out Prob. Expected stock Exp stock Carrying Total
(units) stock (units) out out cost cost cost
(C*D) unit (E*10) (B*3) (F+G)
16000 8000 0 0 0 0 24000 24000
12800 4800 3200 0.0625 200 2000 14400 16400
10000 2000 6000 0.0625 375 7250 6000 13250
2800 0.1250 350
9600 1600 6400 0.0625 400 8500 4800 13300
3200 0.1250 400
400 0.1250 50
8000 0 8000 0.0625 500 14500 0 14500
4800 0.1250 600
2000 0.1250 250
1600 0.0625 100
Reorder Point Formula
A much simpler formula giving reasonably reliable results in calculating at what point in the
level of inventory a reorder has to be placed for replenishment of stock.
Where,
S = Usage in units per day
L = Lead time in days
R = Average number of units per order
F = Stock out acceptance factor
The stock-out acceptance factor, ‘F’, depends on the stock-out percentage rate specified and the probability distribution of
usage (assumed to follow a Poisson distribution). For any specified acceptable stock out percentage the value of ‘F’ can be
obtained from the figure presented below.
For Apex company the average daily usage of a material is 100 units, lead time for procuring
material is 20 days and the average number of units per order is 2000 units.
Reorder for replenishment of stock should be placed when the inventory level reaches 4,600 units.
Stock-level Subsystem
The stock level subsystem keeps track of the goods held by the firm, the issuance of
goods, and the arrival of orders.
It maintains records of the current level of inventory. For any period of time, the current
level is calculated by taking the beginning inventory, adding the inventory received,
and subtracting the cost of goods sold.
Whenever this subsystem reports that an item is at or below the reorder point level, the
firm will begin to place an order for the item.
OTHER INVENTORY MANAGEMENT
TECHNIQUES
The ABC system
Firm’s using the ABC system segregates its inventory into three groups – A, B and C.
The A items are those in which it has the largest rupee investment. A group consists
about 10 percent of the inventory items that account approximately for 70 percent of the
firm’s rupee investment. These are the most costly or the slowest turning items of
inventory. (Less in number but very expensive)
The B group consists of the items accounting for the next largest investment. This group
consists approximately 20 percent of the items accounting for about 20 percent of the
firm’s rupee investment.
The C group typically consists of a large number of items accounting for a small rupee
investment. C group consists of approximately 70 percent of all the items of inventory
but accounts for only about 10 percent of the firm’s rupee investment. Items such as
screws, nails, and washers would be in this group. (More in number but inexpensive)
Receivables management
Working capital management
Cash
Raw materials
Finished goods
Receivables
Cash
Contents
• Receivables
• Purpose of Maintaining Receivables
• Credit Policy (CS; CP; CD; CP)
• TReDs
Firms sell goods on credit, to facilitate more sales.
To increase total sales; because when a company sells goods on credit, it will be
in a position to sell more goods than if it insists on immediate cash payment.
To meet increasing competition; so the company may have to grant better credit
facilities than those offered by its competitors.
The decision to liberalize the existing credit policy will be justified only when the
incremental benefits are greater than the incremental costs.
COST OF MAINTAINING RECEIVABLES
Additional fund requirement for the company
Resources are blocked as there is a time lag between the credit sale and cash
receipt. Firm has to arrange additional finance to meet its obligations like payments
for purchases, salaries and other production/administrative expenses. Whether this
additional finance is met from own resources or from outside, it involves a cost to
the firm in terms of interest (if financed from outside) or opportunity costs (if using
internal resources).
Administrative costs
When a company maintains receivables, it has to incur additional administrative
expenses in the form of salaries to clerks who maintain records of debtors,
expenses on investigating the creditworthiness of debtors, etc.
Collection costs
These are costs which the firm has to incur for collection of the amounts at the
appropriate time from the customers.
Defaulting costs
When customers make default in payments, not only is the collection effort to be
increased but the firm may also have to incur losses from bad debts.
CREDIT POLICY
The credit policy of a company can be assumed as a kind of trade-off
between increased credit sales leading to increase in profit and the
cost of having larger amount of cash locked up in the form of
receivables and the loss due to the incidence of bad debts.
The average collection period is likely to be 45 days and the incidence of bad debt losses is
10 % for the new customers. The contribution to sales ratio for Clean Ltd. is 20 percent and
the cost of funds is 15 percent.
We have now calculated the relevant amounts in terms of additional benefits and
additional costs.
Additional Costs:
2. Cost of financing additional investment in receivables = Rs.36,000
3. Amount of bad debt losses on new sales = Rs.2,40,000
Since the net additional benefit is positive being Rs. 2,04,000 liberalization of credit
standards is to the advantage of the company and should, therefore, be followed.
The effect of relaxing the credit standards on profit may also be estimated by using the following formula.
where
ΔP = change in profit
ΔS = increase in sales
V = variable costs to sales ratio
k = cost of capital
bn = bad debts loss ratio on new sales
1 – V = contribution to sales ratio
If a firm allows, say, 45 days of credit with no discount to induce early payment,
its credit terms are stated as “net 45”.
If a firm allows, say, 45 days of credit with 2% discount to induce early payment,
its credit terms are stated as “2/10, net 45 days”
The company is contemplating to increase its sales by Rs.16 lakh to be achieved by means
of lengthening the existing period to ‘net 45 days’. The bad debt losses on additional sales is
expected to be 5 percent.
To answer the above question, we have to consider the incremental benefits and
incremental costs associated with the policy change and a favorable decision taken only if
the incremental benefits exceed the incremental costs.
As a result of elongation in the credit period, the existing customers will pay after 45 days, instead of 30 days.
As the increase in receivables is only on existing sales which have arisen because of lengthening credit period by 15 days,
the full amount of Rs.7,50,000 will be regarded as investment in receivables.
The amount of additional cost associated with increasing credit period
= (EQ2) + (EQ3) = Rs.1,36,500 + Rs.80,000 or Rs.2,16,500
As the net additional benefit is a positive amount of Rs.1,03,500 the policy change
is beneficial to the company.
The effects of increasing the credit period are similar to that of relaxing credit standards.
Hence we can estimate the effect on profit of change in credit period using the same formula.
where
ΔP = change in profit
ΔS = increase in sales
V = variable costs to sales ratio
k = cost of capital
bn = bad debts loss ratio on new sales
1 – V = contribution to sales ratio
Cash discount
Firms generally offer cash discounts to induce prompt payments. Credit terms reflect the
percentage of discount and the period during which it is available.
For example, credit terms of 1/20, net 30 mean that a discount of 1 percent is offered if
the payment is made by the 20th day, otherwise the full payment is due by the 30th day.
A company which is not offering cash discount may introduce it later to induce prompt
payment. Alternatively, a company which has already been offering an incentive of say
‘1/10, net 30 days may further liberalize by either increasing the rate of discount and/or
extending the period of discount.
It may be noted that extending the period of discount will only result in customers’ taking
the discount at the end of the extended period and may not be very fruitful.
Even in the case of cash discount the incremental benefits arising out of additional sales
and the reduction in the cost of funds locked up in the form of receivables have to be
compared with the amount to be paid in the form of discount and a decision to
provide/liberalize cash discount has to be taken only when the incremental net benefit is
positive.
Rama company is presently having sales of Rs.108 lakh. Its existing credit terms are
1/10, net 45 days and the average collection period is 30 days.
50 % of customers in terms of sales revenue are utilizing the cash discount incentive.
The contribution to sales ratio of the company is 20 % and cost of funds 15 %.
In order to hasten the collection process further as also to increase sales, if possible, the
company is contemplating liberalization of its existing credit terms to 2/10, net 45 days.
It is expected that sales are likely to increase by Rs.3 lakh and average collection period
to decline to 20 days. 80% of customers in terms of sales revenue are expected
to avail themselves of the cash discount under the liberalization scheme.
It is contemplating to increase the collection effort through special programs to reduce the
amount of receivables and the incidence of bad debt losses.
Program A is likely to reduce the average collection period to 45 days, decrease bad debt losses to
4 percent of sales and involve collection expenses of Rs.3 lakh.
Program B is envisaged to reduce the average collection period to 30 days, decrease bad debt
losses to 3 percent sales and involve collection expenses of Rs.5 lakh.
On the assumption that sales are not likely to get affected, should the company go in for any of
the programs under consideration?
Receivables Exchange of India Limited
(RxIL)
Receivables Exchange of India Ltd (RXIL) was incorporated on February 25, 2016 as
a joint venture between Small Industries Development Bank of India (SIDBI) – the
apex financial institution for promotion and financing of MSMEs in India and
National Stock Exchange of India Limited (NSE) - premier stock exchange in India.
RXIL operates the Trade Receivables Discounting System (TReDS) Platform as per
the TReDS guideline issued by Reserve Bank of India (RBI) on December 3, 2014.
RXIL is the first entity to receive the approval from RBI on December 01, 2016 to
launch India's First TReDS Exchange.
Vision
To be an integrated provider of financing platform par excellence benchmarked
with global best for supporting the growth and development of Micro, Small and
Medium enterprises for their inclusive, sustainable economic and social
development.
Mission
To be a numero uno provider of trade receivable financing platform and act as a
catalyst to achieve the entrepreneurial growth, economic success and financial
stability for/of the Micro, Small and Medium enterprises.
What is TReDS?
The scheme for setting up and operating the institutional mechanism for
facilitating the financing of trade receivables of MSMEs from corporate and
other buyers, including Government Departments and Public Sector
Undertakings (PSUs), through multiple financiers is known as Trade
Receivables Discounting System (TReDS).
Sellers – The Sellers should be a MSME as defined under Section 7 of the Micro, Small
and Medium Enterprises Development Act, 2006 (“MSMED Act”), supplying goods and
/ or services to buyers.
Financiers – Banks, NBFC Factors, and such other institutions as may be permitted by
RBI from time to time to participate in the TReDS platform as Financiers.
TReDS
1. What is TReDS?
Ans. TReDS is an electronic platform for facilitating the financing / discounting of
trade receivables of Micro, Small and Medium Enterprises (MSMEs) through
multiple financiers. These receivables can be due from corporates and other buyers,
including Government Departments and Public Sector Undertakings (PSUs).
10. Whether the MSME seller would have to pay to the financier in case the
buyer defaults in repayment?
Ans. No. The transactions processed under TReDS are “without recourse” to the
MSMEs.
13. Where can I find the details of TReDS entities authorised by RBI?
Ans. List of all authorised Payment System Operators (PSOs), including TReDS, is
available at the following path: www.rbi.org.in → “Payment and Settlement
Systems” dropdown → “Information Useful to Customer” → “List of Authorised
Entities – Payment System Operators”. Following is the web link for accessing the
same: https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=12043
Share repurchase
Bonus issue
Stock split
DIVIDENDS
There are basically two options which a firm has while utilizing its PAT. Either plough back the
earnings or distribute the same to the shareholders.
The dividend policy of a firm determines the proportion of earnings paid to shareholders
through dividends and the proportion of retained earnings in the firm for reinvestment
purposes.
A higher dividend payment will entail a greater dependence on external financing. Thus the
dividend policy has a bearing on the choice of financing.
A higher payment will also cause shrinkage of its capital budget and vice versa. Thus, the
dividend policy has a bearing on the capital budgeting decision.
As the main objective of finance manager is to maximize the market value of equity shares,
the key question of interest is:
What is the relationship between dividend policy and market price of equity shares?
Traditional Position
According to this approach, the stock value responds positively to higher dividends and
negatively when there are low dividends.
where,
P = Market Price
m = Multiplier
D = Dividend per share
E = Earnings per share
Limitations of the traditional approach
The traditional approach states that the P/E ratios are directly related to the dividend pay-out
ratios i.e., a high dividend pay-out ratio will increase the P/E ratio and vice-versa.
However, this may not be true in all situations. A firm’s share price may rise even in case of a
low pay-out ratio if its earnings are increasing. Here the capital gains for the investor will be
higher than the cash dividends.
Similarly for a firm having a high dividend pay-out ratio with a slow growth rate there will
be a negative impact on the market price (because of lower earnings).
In addition to this there may be a few investors of the company preferring dividends to the
uncertain capital gains and others preferring lower taxed capital gains.
These conflicting factors that have not been properly explained from the major shortcomings
of the dividend policy given by the traditional approach.
Walter model
Similar to the traditional approach, Walter model also considers that dividends are relevant
and they do affect the share price.
In this model he studied the relationship between the internal rate of return (r) and
the cost of capital of the firm (ko), to give a dividend policy that maximizes the shareholders’ wealth.
The model studies the relevance of the dividend policy in three situations:
(i) r > ke
(ii) r < ke
(iii) r = ke
WHEN THEN SO
r > ke The earnings can be retained by the firm since it has better and No dividend pay out
more profitable investment opportunities than the investors.
r = ke The firms’ dividend policy will not affect the value of the firm. Indifferent
r < ke The investor will have a better investment opportunity than the 100% dividend pay out
firm
According to Walter, the market price of the share is taken as the sum of the present value of the future cash
dividends and capital gains.
His formula is based on the share valuation model and is arrived at in the following manner:
Thus we have,
Where,
Market price per share is denoted by P
Dividend amount per share is denoted by D
Earnings per share is denoted by E
Internal rate of return is denoted by r
The cost of equity is denoted by ke
Change in price is denoted by ΔP
Growth rate in earnings is denoted by g
Example
Given the following information about ZED Ltd, show the effect of the dividend policy on
the market price of its shares, using the Walter’s model:
Given,
E=₹8
D=₹0
r = 15%
ke = 12%
Example
Given the following information about ZED Ltd, show the effect of the dividend policy on
the market price of its shares, using the Walter’s model:
Given,
E=₹8
Ke = 12%
Given,
E=₹8
Ke = 12%
To show the effect of the different dividend policies on the share value of the firm
for the three levels of r let us consider the dividend pay-out (D/P) ratios of
0%, 25%, 50%, 75% and 100%.
r > ke r = ke r < ke
E = ₹ 8; r = 15%; ke = 12%;
DP ratio = 0%
E = ₹ 8; r = 15%; ke = 12%;
DP ratio = 25%
E = ₹ 8; r = 15%; ke = 12%;
DP ratio = 50%
E = ₹ 8; r = 15%; ke = 12%;
DP ratio = 75%
E = ₹ 8; r = 15%; ke = 12%;
DP ratio = 100%
When the return on investment is The dividend policy does not When the return on investment is
greater than the cost of capital, there is affect the share price of lesser than the cost of capital, there
an inverse relation between the value the firm. The price of the firm is a directly proportional relation
of the share and the pay-out ratio. remains Rs.66.67 for all the given between the value of the share and
Thus, the value of the firm is the levels of the dividend payout ratio. the pay-out ratio.
highest when the dividend payout ratio However, in actual practice r and k Thus, the value of the firm is the
is zero and this goes on declining as the will not be the same and it can only highest when the dividend payout
dividend payout ratio increases. be a hypothetical case. ratio is 100% and this goes on
Hence the optimum dividend policy for declining as the dividend payout
a growth firm is a zero dividend pay- ratio decreases.
out ratio. Hence the optimum dividend
policy for a declining firm is a
100% dividend pay-out ratio.
Gordon’s dividend capitalization
model assumptions
i. The firm will be an all-equity firm with the new investment proposals being
financed solely by the retained earnings.
ii. Return on investment (r) and the cost of equity capital (ke) remain constant.
iv. The retention ratio remains constant and hence the growth rate also is constant
(g = br).
v. ke > g or ke > br i.e. cost of equity capital is greater than the growth rate.
Gordon’s Model assumes that the investors are rational and risk-averse.
They prefer certain returns to uncertain returns and thus put a premium to the
certain returns and discount the uncertain returns.
Thus, investors would prefer current dividends and avoid risk.
Retained earnings involve risk and so the investor discounts the future dividends.
This risk will also affect the stock value of the firm.
Gordon explains this preference for current income by the bird-in-hand argument.
The investors would prefer the income that they earn currently to that income in future
which may or may not be available.
Thus, investors would prefer to pay a higher price for the stocks which earn them
current dividend income and would discount those stocks which either postpone/ reduce
the current income.
The discounting will differ depending on the retention rate (% of retained earnings)
and the time.
Gordon’s dividend capitalization model gave the value of the stock as:
where,
P = Share price
E = Earnings per share
b = Retention ratio
(1 – b) = Dividend pay-out ratio
ke = Cost of equity capital (or cost of capital of the firm)
br = Growth rate (g) in the rate of return on investment
Example
If ke = 11%, and E = Rs. 8, calculate the stock value of ABC Ltd. for r = 12% for dividend
payout of 10%. (Use Gordon’s model)
Given,
Ke = 11%
E=₹8
R = 12%
Dividend payout ratio = 10%
Retention ratio = 90%
Growth rate g = br = 0.9*0.12 = 0.108 = 10.8%
If ke = 11%, and E = Rs.8 calculate the stock value of ABC Ltd. for
(i) r = 12%
(ii) r = 11%
(iii) r = 10%
for the various levels of the dividend payout ratios given below
E = ₹ 8; DP ratio = 10%; g = br = 0.9 * 0.12 = 0.108 g = br = 0.9 * 0.11 = 0.099 g = br = 0.9 * 0.10 = 0.09
Ret ratio = 90%;
E = ₹ 8; DP ratio = 40%; g = br = 0.6 * 0.12 = 0.072 g = br = 0.6 * 0.11 = 0.066 g = br = 0.6 * 0.10 = 0.06
Ret ratio = 60%;
E = ₹ 8; DP ratio = 50%; g = br = 0.5 * 0.12 = 0.06 g = br = 0.5 * 0.11 = 0.055 g = br = 0.5 * 0.10 = 0.05
Ret ratio = 50%;
E = ₹ 8; DP ratio = 80%; g = br = 0.2 * 0.12 = 0.024 g = br = 0.2 * 0.11 = 0.022 g = br = 0.2 * 0.10 = 0.02
Ret ratio = 20%;
When the rate of return is When the rate of return is equal When the rate of return is
greater than the cost of capital, to the cost of capital, then firms lower than the cost of capital,
then firms should have a dividend payout ratio is then firms should have a
higher retention ratio (or a irrelevant. lower retention ratio (or a
lower dividend payout ratio). higher dividend payout ratio).
MM model of dividend
Miller and Modigliani have propounded the MM hypothesis to explain the
irrelevance of a firms’ dividend policy.
This model rejects the importance of the dividend policy and effects thereof
on the share price of the firm.
According to the model, it is only the firms’ investment policy that will have an
impact on the share value of the firm and hence it should be given more
importance rather than the dividend policy.
MM model of dividend
Symbolically the model is given as:
Thus, as per the MM model, the market value of the share is not affected by the dividend
policy.
(Notice that the dividend does not figure in the equation used to calculate the share
price).
The capitalization rate (overall cost of capital) of ABC Ltd. is 12%.
It has 25,000 shares outstanding selling at the rate of ₹ 100 each.
Anticipating a net income of ₹ 3,50,000 for the current financial year,
However, it may show some adjustments in case the dividends declared are higher or
lower than the expected level. For instance, when a firm declares dividends higher than
what was expected, it would result in an upward movement of the share price as there
would be expectations of higher earnings and similarly low dividends would be taken as a
fall in future earnings.
Thus, the rational expectations model suggests that alterations in the market price will not
be necessary where the dividends meet the expectations and only in case of unexpected
dividends will there be a change in the market price.
Bonus shares
Bonus shares can be issued only out of free reserves built out of
genuine profits or share premium collected in cash only.
Part A of the exhibit shows the equity portion of the balance sheet
before the bonus issue and Part B of the exhibit shows the equity
portion of the balance sheet after the bonus issue.
Stock Splits
In a stock split, the par value per share is reduced and the number of shares are
increased proportionately
From an economic point of view there is no difference between bonus share and
stock split.
They are different only from an accounting point of view.
Comparison
Bonus issue Stock split
The par value of share remains unchanged The par value of share gets reduced
The book value, market value and The book value, market value and
earnings per share decline earnings per share decline
In the tender method, a company offers to buy back shares at a fixed price which is
usually higher than the prevailing price. It determines the maximum number of shares it is
willing to buy and specifies an outer time limit for accepting the offer.
In the open market purchase method, which is more popular, a company buys from stock
market through brokers. The company fixes the maximum price for the open market
purchase, stipulates the number of shares it plans to buy, and specifies the closing date of
the offer. A company that chooses to buyback has to appoint a merchant banker and make
a public announcement of the offer seven days before the commencement of the buyback.
The buyback has to be completed in a period of 12 months from the date of passing the
special resolution.
Cash management
Operating cycle
Cash (Most liquid) 1 lakh
Raw materials (Least liquid) 1 lakh
Semi finished goods (WIP) (more liquid) 1 lakh
Finished goods (more liquid) 1 lakh
Sales (more liquid) 1.1 lakh
Accounts receivables (more liquid) 1.1 lakh
Cash (Most liquid) 1.1 lakh
Jan + 50K; Feb +55K; Mar -18K; Apr +20K; May +5K; June +10K
• Identify the motives and needs for holding
cash.
• Understand the techniques for preparing cash
budget. (Cash position in near future)
• Enumerate the factors that determine the
required cash balances.
• Cash management models
Profits versus Cash
Why do Companies Hold Cash?
TRANSACTION MOTIVE Running the business
PRECAUTIONARY MOTIVE Repairing
Cash and credit sales are expected to be 20 percent and 80 percent respectively.
Receivables from credit sales are expected to be collected as follows: 50% percent of receivables,
on an average, one month from the date of sale and balance 50 percent, on an average, two months from
the date of sale.
Rs.50,000 expected from the sale of a machine in March and Rs. 2,000 expected as interest on securities
in June.
The payments for these purchases are made a month after the purchase. The payment for
purchases in December will be made in January.
Miscellaneous cash purchases of Rs.2,500 per month are planned from January through June.
Wage payments are expected to be Rs.16,000 per month, January through June.
Manufacturing expenses expected to be Rs.20,000 per month; general administrative and selling
expenses are expected to be Rs.10,000 per month.
Dividend payment of Rs.20,000 and tax payment of Rs.18,000 are scheduled in June.
Opening cash balance is Rs.20,000. The management policy is to maintain a minimum cash
balance of Rs.18,000.
FACTORS FOR EFFICIENT CASH
MANAGEMENT
Not crediting the customer’s account in its books when a cheque is deposited by him
AND
Not debiting his account in its books when a cheque is issued by him until the cheque is
cleared and cash is realized or paid respectively.
In the normal course of business, a company issues cheques to suppliers and deposits
cheques received from customers. It can take advantage of the concept of float, while
doing so.
Whenever cheques are deposited with the bank, the credit balance increases in the
company’s books of account but not in the books of the bank until the cheques are cleared
and money realized. The amount of cheques deposited by a company in the bank awaiting
clearance is called ‘collection float’.
Similarly, the amount of cheques issued by the company awaiting payment by the bank is
called ‘payment float’.
The difference between ‘payment float’ and ‘collection float’ is called ‘net float’.
Obviously, when the net float is positive, the balance in the books of the
company is less than that in the bank’s books; when net float is negative the
book balance of the company is more than that in the bank’s books.
When a company has a ‘positive net float’ it may issue cheques to the extent
that the amount shown in the bank’s books is higher than the amount shown
in the company’s books, even if the company’s books indicate an overdrawn
position.
Let us also assume that the company issues cheques daily to the amount of
Rs.30,000 and it takes five days for actual payment. The opening balance in the
company’s books as also in the bank’s books will remain the same at Rs.10,000.
it can be noticed that from day six onwards the closing balance remains stable at
Rs.70,000 in the books of the bank.
The closing balance in the company’s books will, however, remain at Rs.10,000.
So, the company will continue to enjoy a net float of Rs.60,000 (Rs.70,000 – Rs.10,000).
As a result of this, the company issues cheques amounting to Rs.40,000 or Rs.50,000 even
if the company’s book balance is only Rs.10,000 because of the net float of Rs.60,000
available to it.
While the number of cheques issued and deposited by the company is assumed to be the
same for the sake of simplicity, it can differ. Then, the net float will become the difference
between the balance in the bank’s books and the balance in the company’s books.
Risks associated with playing Float
While a company can obtain greater mileage out of its cash balance by playing the
float, there are certain inherent risks involved.
When the clearing system operates much faster than anticipated, the cheques issued
may come for payment earlier than anticipated leading to financial embarrassment to
the company.
When the word goes round that the cheques issued by the company to a supplier had
bounced the company’s image will be at stake.
In order to minimize the risks associated with playing the float a company can take
some of the following precautionary measures and obtain greater mileage out of its
cash resources.
The cash in excess of the firm’s normal cash requirements is termed as surplus
cash. Before determining the amount of surplus cash, the minimum cash balance
required by the firm has to be accounted. This minimum level may be termed as
a ‘safety level for cash.’
The safety level of cash is determined by the Finance Manager separately for
normal and peak period. In both the cases, the two basic factors to be decided
are:
a. Desired days of cash: This is the number of days for which cash balance
should be sufficient to cover payments.
Example
The finance manager feels that a safety level should provide sufficient cash to cover cash
payments for a week and firm’s average daily cash outflows are Rs.15,000.
Example
During the four busiest days in the month of March, a firm’s cash outflows were Rs.6,000,
Rs.7,000, Rs.8,000 and Rs.9,000. The Finance manager desires sufficient cash to cover
payments for 4 days during the peak periods. Calculate the safety level.
Solution
During normal periods:
The firm has a cash balance of Rs.1,00,000. The average daily cash outflows are
Rs.25,000. It means the firm has cash available only for 4 days as compared to a
requirement for 7 days. Hence, the firm is cash deficient.
Temporary cash surplus consists of funds which are available for investment on a
short-term basis (maximum 6 months), since they are required to meet regular
obligations such as those of taxes, dividends, etc.
Permanent cash surplus consists of funds which are kept by the firm to use in
some unforeseen profitable opportunity of expansion or acquisition of some
asset. Such funds are, therefore, available for investment for a period ranging
from six months to a year.
Criteria for Investment of surplus cash
a. Security: This can be ensured by investing money in securities whose price remains more
or less stable and where a minimum return is guaranteed.
c. Yield: Most corporate managers give less emphasis to yield as compared to security and
liquidity of investment. They, therefore, prefer short-term Government securities for
investing surplus cash. However, some corporate managers follow aggressive investment
policies which maximize the yield on their investments.
d. Maturity: Surplus cash is not available for an indefinite period. Hence, it will be
advisable to select securities according to their maturities keeping in view the period for
which surplus cash is available. If such selection is done carefully, the Finance Manager can
maximize the yield as well as maintain the liquidity of investments.
Models for Determining Optimal Cash
Given the overall transactions and precautionary balances, the finance manager of
a firm would like to consider the appropriate balance between cash and marketable
securities.
This is because, optimal levels of cash and marketable securities would reduce and
minimize the costs such as
(a) Transaction costs – costs incurred for transferring marketable securities to cash
or vice versa,
(c) Opportunity costs – the interest earnings foregone on marketable securities for
holding cash.
Models for determining the balance
between cash and marketable securities.
• Inventory model (Baumol)
In this model, the opportunity (carrying) cost of holding cash, is balanced against the fixed
costs associated with securities transactions to arrive at an optimal balance.
Using the EOQ formula, the firm determines the funds transfer size that will minimize the
total cash costs. i.e total transaction cost and total carrying (opportunity) costs.
Where,
F = Fixed transaction cost associated with a transaction *
T = Total demand for cash over the specified period
I = Interest rate on marketable securities for the period **
C = Cash balance for the period
Note that:
* Assumed to be independent of the amount transferred.
** Assumed to be constant.
In the below given formula,
T/C reflects the number of transactions during the period. If we multiply T/C with F that is,
fixed cost per transaction, we will get total fixed cost for the period.
C/2 implies the average level of cash balance over the period of time involved and when it
is multiplied with the interest rate (I), we will obtain the total carrying (opportunity) cost.
From the above equation, we conclude that the larger the C or C/2, the smaller the total
transaction cost [F (T/C)] and the higher the opportunity cost [I (C/2)]. Balancing the two
costs can minimize total costs.
The optimal level of cash can be determined using the underlying equation.
Suppose ABC Ltd., a manufacturing firm, expects its total cash payments over the planning
period (2-months) to be Rs.10,00,000, while the fixed cost per transaction is Rs.100 and
the interest rate on marketable securities is 12 percent per annum, or 2.0 percent for the 2-
month period.
Thus, if the firm maintains an average cash balance of Rs.10,000, it can minimize its total
costs.
It is noted that the limitations and assumptions of this model are similar to that of the EOQ
inventory model.
Stochastic Models
Since the EOQ model assumes a constant demand for cash, this inventory model becomes
inappropriate when the cash flows of the firms are relatively or reasonably unpredictable,
and some other models must be employed to determine optimal cash balances.
If cash balances fluctuate randomly, we can apply control theory to the problem. To apply,
assume that the cash flows are stochastic and random, and then set control limits such that
when cash balance touches the upper bound, a conversion of cash into marketable securities
is undertaken, and when it approaches the lower bound, a transfer from marketable
securities to cash is activated.
No transactions take place as long as the cash balance remains within these bounds.
Here, the question is how to set these boundaries (bounds) such that they should depend
upon both fixed costs of a transaction and the opportunity cost of holding cash.
This model specifies two bounds – h dollars as an upper bound and 0 (zero) dollars as a
lower bound
When the cash balance reaches the upper bound h, then z dollars (cash) are converted into marketable securities
and the new balance becomes z dollars (return point).
When the cash balances hit the lower bound (zero dollars), z dollars of marketable securities are transferred to
cash, and the new balance again becomes z dollars. As long as the cash balances stays within the bounds, no
transaction is undertaken.
Note that the lower bound (control limit) is taken as zero only for our better explanation, and can be set higher
than zero.
Where ‘F’ is the fixed transaction cost, ‘ σ ’ is the variance of daily net cash balances, and ‘i’ is the interest rate
per day on marketable securities. The optimal value of ‘h’ is 3z.
The model reduces the total fixed transaction cost and total opportunity cost by setting these bounds.
Financing current assets
• Behavior of Current Assets and Pattern of Financing
• Spontaneous Sources of Finance
• Trade Credit
• Short-term Bank Finance
• Public Deposits for Financing Current Assets
• Commercial Paper
• Factoring
BEHAVIOR OF CURRENT ASSETS
AND PATTERN OF FINANCING
A manufacturing company will have some minimum level of current assets. It is largely
influenced by the operating cycle period of the company and management policy.
The minimum level of current assets maintained by a company has more of the nature of
fixed assets. So, it is regarded as ‘permanent or fixed component’ of current assets.
The ‘permanent component’ of current assets has more nature of a fixed asset than
of a current asset.
The permanent component of current assets goes through all stages of the
operating cycle but are not locked-up permanently as the fixed assets. However,
the current assets released will be replaced thereby giving the appearance of
‘permanency’.
First, the usual credit terms offered by suppliers give rise to a high cost of trade credit. This
will inevitably result in a decision to avail oneself of cash discount.
However, it is preferable to calculate the implicit cost of trade credit and compare the same
with the opportunity cost of cash. A decision to avail oneself of cash discount can be taken
only when the cost of trade credit exceeds the opportunity cost of cash.
For example, the cost of trade credit associated with the credit terms 1/10, Net 60 and, 1/10,
Net 45 are only 7.27 percent and 10.39 percent respectively. In such situations, foregoing cash
discounts is likely to be more advantageous from the company’s point of view as the
opportunity cost of cash can be much higher.
Ways to finance
Short term bank finance Public deposit
A company inviting deposits
Cash credit from the public is required to
issue an advertisement disclosing the many
Overdraft details and the same has to be filed
with the Registrar of Companies before
Purchase/Discounting bill releasing it to the press.
LoC (Letter of credit)
CP: Commercial Papers (CPs) are short-term
usance promissory notes with a fixed maturity
period, issued mostly by leading, reputed,
Security: well-established, large corporations who have
a very high credit rating.
Hypothecation
Pledge
Cash credit
Factoring
Factoring is a “continuing” arrangement between a financial intermediary called a
“Factor” and a “Seller” (also called a client) of goods or services.
Based on the type of factoring, the factor performs the following services in
respect of the Accounts Receivables arising from the sale of such goods or
services.
Purchases all accounts receivables of the seller for immediate cash.
Administers the sales ledger of the seller.
Collects the accounts receivable.
Assumes the losses which may arise from bad debts.
Provides relevant advisory services to the seller.
2. Non-recourse or Full Factoring: The factor has no recourse to the client if the
receivables are not recovered, i.e., the client gets total credit protection.
3. Maturity Factoring: The factor does not make any advance or pre-payment. The
factor pays the client either on a guaranteed payment date or on the date of collection
from the customer. This is as opposed to “Advance factoring” where the factor makes
prepayment of around 80% of the invoice value to the client.
4. Invoice Discounting: The factor provides a pre-payment to the client against the
purchase of accounts receivables and collects interest (service charges) for the period
extending from the date of pre-payment to the date of collection.