Sources of Long Term Finance

Sources of long term finance
Finance
Long term Short term

Required for long term Projects Required for short term needs
Capital budgeting Working capital
Bond/debenture; Preference share/Ordinary Term loan; Short term Instruments

share
Capital market Money market

Asset Liability Management (ALM)
• Companies will have to face a severe asset-liability
mismatch if the long-term projects are funded by the
short-term sources of funds and vice-versa.
• Such a mismatch will lead to:

• An interest rate risk thereby enhancing the interest
burden of the firm when short term projects fund
themselves using long term funds.
• A liquidity risk with the short-term funds being held

up in long-term projects.
Long term project for 10 years
Short term sources of finance (3 years)
Interest rate is lower
Short term project for 3 years

Long term sources of finance (10 years)
Interest rate is higher
Floating rate = LIBOR / MIBOR + 0.50% (Cost of
credit Price discovery)
2019= 5% + 0.50% = 5.50%
2020= 5.25% + 0.50% = 5.75%
2021= 4.85% + 0.50% = 5.35%
Long term finance
Debt based instrument Equity based instrument
• Bond / Debenture • Equity / Share /Stock
• Interest • Dividend
• Creditor • Owner (Lifelong creditor)
• Interest compulsory • Dividend not compulsory
• Not last in queue • Last in queue (Residual
claimant)
Example
Need for long term finance (Long term project;
Diversify; Modernize; Expansion into foreign)
Types of capital
Types of debentures/bonds
Issue of securities (Financial securities)

Types of capital
These types of capital distinguish amongst themselves
in the risk, return and ownership pattern.
Equity capital or ordinary share
Preference capital or preference share
Debenture capital or bond
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 interest of the debenture holders is usually represented by a trustee

(which is typically a bank or an insurance company or a firm of
attorneys) is responsible for ensuring that the borrowing company fulfils
the contractual obligations embodied in the contract.
• If the company issues debentures with a maturity period of more than 18

months, then it has to create a Debenture Redemption Reserve (DRR),
which should be at least half of the issue amount before the redemption
commences.
• 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)
• Fully convertible debentures (FCD)
• Partially convertible debentures (PCD)

NCD
These debentures cannot be converted into equity shares and will be redeemed at
the end of the maturity period.
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:
1. Appointment of the Lead Manager

Before making a public issue of securities the firm should appoint a SEBI registered Category-I Merchant Banker to
manage the issue. The lead manager will be responsible for all the pre and the post-issue activities, liaison with the other
intermediaries, statutory bodies like SEBI, Stock Exchanges and the Registrar of Companies (ROC) and finally ensures
that the securities are listed on the stock exchanges.
2. Preparation of the Prospectus
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
Exercises his right Sells his right in favour of someone

₹ ₹
Present market value of shareholding 90 Present market value of shareholding 90
(3x30) (3x30)
Price paid for exercising right 25 Value realised from the sale of right (28.75 - 25) 3.75
Total investment 115 Total investment 86.25
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
Lets his right expire

Present market value of shareholding (3x30) 90
Market value of 3 shares at the ex rights price (3x28.75) 86.25
Change in wealth 3.75

Another example
No of shares outstanding = 10,00,000
Current market price = ₹ 40
Amount required by company = ₹ 40,00,000
Rights issue price = ₹ 20 per share
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
Ex rights price = (n1*P + n2*S) / (n1+n2)

= (1000000*40 + 2,00,000*20) / (1000000 + 200000) = ₹ 36.66
Ex rights price = (NP + S) / (N+1) = (5*40 + 20)/ 6 = 220/6 = ₹ 36.66
Value of 5 rights = (Ex rights price - S) = (36.66 - 20) = ₹ 16.66
Value of each right = ₹ 3.33

Market price of a share = ₹ 40
Subscription price of right = ₹ 20
No. Of shares required to exercise right = 5 shares
Ex rights value of share = ₹ 36.66
Value of right = ₹ 16.66
Exercises his right Sells his right in favour of someone

₹ ₹
Present market value of shareholding 4000 Present market value of shareholding 4000
(100x40) (100x40)
Price paid for exercising right 400 Value realised from the sale of right (20x16.66) 333
Total investment 4400 Total investment 3667
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
Lets his right expire

Present market value of shareholding (100x40) 4000
Market value of shares at the ex rights price (100x36.66) 3667
Change in wealth 333

Private Placement
The private placement method of financing involves direct selling of
securities to a limited number of institutional investors or high net worth
investors.
This avoids the delay involved in going public and also reduces the
expenses involved in a public issue.
The company appoints a merchant banker to network with the

Institutional investors and negotiate the price of the issue.
The major advantage of privately placing the securities are:
• Easy access to any company

• Fewer procedural formalities
• Lower issue cost
• Access to funds is faster.
Bought out Deal
A process whereby an investor or a group of investors buy-out a significant portion of the equity of an unlisted
company with a view to sell the equity to public within an agreed time frame. The company places the equity
shares, to be offered to the public, with a sponsor. At the right time, the shares will be off loaded to the public
through the OTCEI route or by way of 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.
Major advantages of entering into a bought-out deal are:
• 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.
The interest and the repayment period are negotiated

between the supplier and the buyer and there are no
uniform norms.
Bill Rediscounting Scheme, Supplier’s Line of Credit, Seed

Capital Assistance and Risk Capital Foundation Schemes
offered by financial institutions are examples of deferred
credit schemes.
Leasing and Hire purchase
The other sources of finance for companies are the leasing and hire purchase of assets.
These two types of financing options, which are supplementary to the actual long-term
sources, are offered by financial institutions, Non- Banking Finance Companies, Banks and
manufacturers of equipment/assets.
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
Energy applied = Work done
1 unit of energy applied = 1 unit of work done

With a lever
1 unit of energy applied = more than 1 unit of work done

Less than 1 unit of energy applied = 1 unit of work done
Energy applied changes by 1% = Amount of work done changes by more than 1%
Energy applied has to change by less than 1% = Amount of work done 1%

Unit Sans lever With lever With lever
Energy applied Joule (J) 1 J 1J <1J
Work done Joule (J) 1 L >1J 1J
Interpretation Without a lever, With a lever, the With a lever, the
the amount of amount of work amount of energy
work done is done is greater than applied is less than
equal to the the amount of the amount of work
amount of energy energy applied. done.
applied.
Give me a lever long enough and a fulcrum on
which to place it, and I shall move the world.
Archimedes
Concept of leverage
Relationship between two variables
Relationship between two variables
Y axis X axis
Dependent variables Independent variables
Regressand Regressor
Vertical line Horizontal line
Crop yield Amount of rainfall
Marks obtained No. Of hours studied
Distance travelled Litres of petrol
Height of children Height of father
Runs scored No. Of overs
Air pollution No. Of vehicles
Leverage is measured between two financial
variables it explains how the dependent variable
responds to a change in the independent variable.
To explain further, let X be an independent financial

variable and Y its dependent variable, then the
leverage which Y has with X can be assessed by the
percentage change in Y to a percentage change in X.
Measures of leverage
Leverage Dependent Variable Independent variable Reason
Operating leverage EBIT Revenue Fixed cost
Financial Leverage EPS EBIT Interest cost
Total Leverage EPS Revenue (Fixed Cost + Interest
cost)
Operating leverage (Fixed cost) (Revenue and EBIT)
Financial leverage (Interest paid) (EBIT and EPS)
Total leverage or Combined leverage (Revenue and

EPS)
Format of Income statement
Income statement of XYZ Ltd as on 31 March 2020
Revenue or Sales
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
Format of Income statement
Income statement of XYZ Ltd for the year ending 31 March 2020
Revenue or Sales
Less Variable cost
Contribution
Less Fixed cost
Gross income (EBIT)
Less Interest paid
Less Tax @ x%
PAT
EPS
Degree of Total Leverage = Degree of Operating leverage x Degree of financial leverage
Income statement of XYZ Ltd for the year ending 31 Mar 2019 and 31 Mar 2020
2019 2020
Revenue 5000 10000
Less Variable cost 3000 6000
Contribution 2000 4000
Less Fixed cost 1000 1000
Gross income (EBIT) 1000 3000
Less Interest paid 300 600
Earnings before Tax (EBT) 700 2400
Less Tax @ 50 % 350 1200
PAT 350 1200
Less Preference dividend 0 0
Earnings available for shareholders 350 1200
Total number of outstanding shares 100 100
EPS 3.50 12
2019 2020 % change
Revenue 5000 10000 100
Less Variable cost 3000 6000 100
Contribution 2000 4000 100
Less Fixed cost 1000 1000 0
Gross income (EBIT) 1000 3000 200
Less Interest paid 300 600 0
Earnings before Tax (EBT) 700 2400 243
Less Tax @ 50 % 350 1200 243
PAT 350 1200 243
Less Preference dividend 0 0 0
Earnings available for shareholders 350 1200 243
Total number of outstanding shares 100 100 0
EPS 3.50 1200 243
DOL
DOL = % Δ in dependent variable / % Δ in independent variable
DOL = % Δ in EBIT / % Δ in revenue
DOL = 200 / 100 = 2
Interpretation:
If the independent variable changes by 1 unit, then the dependent variable changes
by 2 units.
If the revenue changes by 1 unit, then the EBIT changes by 2 units.
If the revenue increases by 1 unit, then the EBIT increases by 2 units.

If the revenue decreases by 1 unit, then the EBIT decreases by 2 units.
For the year 2019
DOL = Contribution / EBIT
DOL = 2000 / 1000 = 2
For the year 2020

DOL = Contribution / EBIT
DOL = 4000 / 3000 = 1.33
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 high degree of operating leverage indicates that a company is likely to experience

volatility in its earnings with a change in its sales because it has a large proportion of
fixed costs in its total 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.
The EBIT of the company is zero at the operating break-even point.

DFL
Degree of financial leverage formula calculates the change in net
income occurring because of change in earnings before interest
and taxes of the company.
It helps in determining how sensitive the profit of the company is to

the changes in the capital structure.
2019 2020
Revenue 5000 10000
Less Tax @ 50 % 350 1200
PAT 350 1200
EPS 3.50 12
2019 2020 % change
Revenue 5000 10000 100
Less Tax @ 50 % 350 1200 243
PAT 350 1200 243
EPS 3.50 12 243
DFL = % Δ in dependent variable / % Δ in independent variable
DFL = % Δ in EPS / % Δ in EBIT
DFL = 243 / 200 = 1.21
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
For the year 2020

DFL = EBIT / EBT
DFL = 3000 / 2400 = 1.25
Year Interest paid Proportion of interest payment DFL

2019 300 30% 1.42
2020 600 20% 1.25
DTL
It is the product of operating leverage and financial leverage
DTL = DOL * DFL

2019 2020
Revenue 5000 10000
Less Tax @ 50 % 350 1200
PAT 350 1200
EPS 3.50 12
2019 2020 % change
Revenue 5000 10000 100
Less Tax @ 50 % 350 1200 243
PAT 350 1200 243
EPS 3.50 12 243
DTL = % Δ in dependent variable / % Δ in independent variable
DTL = % Δ in EPS / % Δ in revenue
DTL = 243 / 100 = 2.43
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
For the year 2020

DTL = Contribution / EBT
DTL = 4000 / 2400 = 1.66
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
Less Tax @ x%
PAT
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%
Wants to raise an additional capital of ₹ 1 crore for expansion.

Alternative 1: Issue 10 lakh shares @ ₹ 10 each
Alternative 2: Issue debentures @ 14 percent coupon rate
Find the EPS under both the alternatives when EBIT is

₹ 20 lakh; ₹ 40 lakh
EPS under alternative financing plan
Equity financing Debt financing

EBIT 20,00,000 40,00,000 EBIT 20,00,000 40,00,000
Interest - - Interest 14,00,000 14,00,000
EBT 20,00,000 40,00,000 EBT 600,000 26,00,000
Tax 10,00,000 20,00,000 Tax 300,000 13,00,000
PAT 10,00,000 20,00,000 PAT 300,000 13,00,000
# of equity 20,00,000 20,00,000 # of equity 10,00,000 10,00,000
EPS 0.50 1.00 EPS 0.30 1.30
Break even EBIT level
The break even EBIT under alternative financing plans is that value of EBIT at
which the EPS for both the plans become equal.
EPS under alternative financing plan
Equity financing Debt financing

EBIT 20,00,000 28,00,000 40,00,000 EBIT 20,00,000 28,00,000 40,00,000
Interest - - - Interest 14,00,000 14,00,000 14,00,000
EBT 20,00,000 28,00,000 40,00,000 EBT 600,000 14,00,000 26,00,000
Tax 10,00,000 14,00,000 20,00,000 Tax 300,000 7,00,000 13,00,000
PAT 10,00,000 14,00,000 20,00,000 PAT 300,000 7,00,000 13,00,000
# of equity 20,00,000 20,00,000 20,00,000 # of equity 10,00,000 10,00,000 10,00,000
EPS 0.50 0.70 1.00 EPS 0.30 0.70 1.30

Risk considerations (Effect of leverage
on risk)
The finance manager may do two things:
(i) Compare the expected value of EBIT with its indifference value
(ii) Assess the probability of EBIT falling below its indifference value.
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.
When such probability is negligible, the debt financing option is

advantageous. On the other hand, if such probability is high, the debt
financing alternative is risky.
The graph shown below exhibits two probability distributions of EBIT (A and B) superimposed on
the EBIT - EPS chart.
Distribution A is relatively safe, as there is hardly any probability that PBIT will fall below its
indifference level. With such a distribution, the debt alternative appears to be advantageous.
Distribution B, on the other hand, is clearly risky because there is a significant probability that
PBIT will decline below its indifference value. In this case, the debt alternative may not be
regarded as desirable.
ROI – ROE analysis
Relationship between the return on investment (ROI) and the return on equity
(ROE) for different levels of financial leverage.
Suppose a firm, Joker Limited, which requires an investment outlay of Rs.100

million, is considering two capital structures:
Capital structure A Capital structure B

(₹ in million) (₹ in million)
Equity 100 Equity 50
Debt 0 Debt 50
The average cost of debt is fixed at 10 percent.

The tax rate of the firm is 50 percent.
The ROE is defined as equity earnings divided by net worth.

The ROI is defined as EBIT divided by total assets may vary widely.
Relationship between ROI and ROE under Capital Structures
A and B
A B
ROI 5% 10% 15% 20% 25% 5% 10% 15% 20% 25%
EBIT (₹ in million) 5 10 15 20 25 5 10 15 20 25
Interest 0 0 0 0 0 5 5 5 5 5
EBT 5 10 15 20 25 0 5 10 15 20
Tax paid 2.5 5 7.5 10 12.5 0 2.5 5 7.5 10
PAT 2.5 5 7.5 10 12.5 0 2.5 5 7.5 10
ROE 2.5% 5% 7.5% 10% 12.5% 0% 5% 10% 15% 20%
Relationship between ROI and ROE under Alternative Capital
Structures
Looking at the relationship between ROI and ROE we find that:

■ The ROE under capital structure A is higher than the ROE under capital structure B when ROI is less than the cost of debt.
■ 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
Working capital management decision
Dividend decision
Less value for cost of capital = Higher firm value

Hurdle rate
Loan 5 lakh 8%
Deb 10 lakh 10%
Pref 10 lakh 12%
Equity 12 lakh 15%
Capital 37 lakh x%
WACC= 11.5%
Impact of capital structure of a firm on its value
Capital Structure
Capital Structure Theories

Net Income Theory
Net Operating Income Theory
Traditional Model Theory
MM Theory Modigliani Miller
Trade off Theory
Pecking order Theory
Signalling Theory
The capital structure of a company refers to the mix of the long-term
Finances used by the firm. It is the financing plan of the company. Let us
take a look at the capital structure of a company that went for public issue.
Pennar Aluminium Company Limited has gone in for a project to

manufacture Aluminium Rolled Products, Conductors and Alloys.
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.
• The firm has a policy of paying its earnings as dividend, i.e.

a 100% dividend pay-out ratio is assumed.
• Investors have identical subjective probability distributions

of net operating income (earnings before income and taxes)
for each company.
• The net operating income (EBIT) is not expected to grow or

decline over time.
• Without incurring transaction costs, a firm can change its

capital structure instantaneously.
Market Value of Debt and Equity
Assuming that the debt capital is perpetual, kd represent the cost of debt is the discount rate at
which discounted future constant interest payments are equal to the market value of debt i.e.
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:
Particulars Notation 2019 2020

Operating income (EBIT) O 10,000 10,000
Interest on debt I 0 3,000
EBT (Equity holders) Div 10,000 7,000
Cost of equity Ke 10% 10%
Cost of debt Kd 6% 6%
Market value of equity E 100,000 70,000
Market value of debt D 0 50,000
Total value of firm V or (D+E) 100,000 120,000
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:
Particulars Notation 2019 2020

Operating income (EBIT) O 10,000 10,000
Interest on debt I 0 3,000
EBT (Equity holders) Div 10,000 7,000
Cost of equity Ke 10% 10%
Market value of debt D 0 50,000
Net Operating Income
Two firms, A and B, are similar in all respects except the degree
of leverage employed by them
Particulars Notation Firm A Firm B
Net Operating income (EBIT) O 10,000 10,000
Overall capitalization rate ko 15% 15%
Interest on debt I 1,000 3,000
Market value of debt D 10,000 30,000
Debt to equity ratio D/E 17.6% 81.8%
Traditional Approach
The principal implication of the approach is that the cost of capital is dependent
on the capital structure and there is an optimal capital structure which minimizes
the cost of capital.
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.
The firm want to increase the percentage of debt to 50%.

Due to increased financial risk, the cost of debt and equity would rise to 11% and 16 % respectively.
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 capital markets are perfect and the complete

information is available to all the investors free of
cost.
2. The securities are infinitely divisible.
3. Investors are rational and well informed about the
risk return of all the securities.
4. The personal leverage and the corporate leverage
are perfect substitute.
On the basis of the above assumptions, the M&M Model derived that:
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.
In addition, the firm has to be monitored to ensure that the covenants

are being adhered to and the costs of monitoring are almost
invariably passed on to shareholders in the form of higher debt costs.
The loss in efficiency on account of restrictions on operational

freedom plus the cost of monitoring represent agency costs
associated with debt.
Effect of financial distress and agency
cost
If the MM model with tax effect is valid, the value of a levered firm is expressed as
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.
We discuss this theory next.

Pecking order theory
Gordon Donaldson examined how companies actually establish their capital structure. The findings of
his study are summarised below:
1. Firms prefer to rely on internal accruals, that is, on retained earnings and depreciation cash flow.
2. Expected future investment opportunities and expected future cash flows influence target dividend
payout ratios. Firms set the target payout ratios at such a level that capital expenditures, under normal
circumstances, are covered by internal accruals.
3. Dividends tend to be sticky in the short run. Dividends are raised only when the firm is confident that
the higher dividend can be maintained; dividends are not lowered unless things are very bad.
4. If a firm's internal accruals exceed its capital expenditure requirements, it will invest in marketable
securities, retire debt, raise dividends, resort to acquisitions, or buyback its shares.
5. If a firm's internal accruals are less than its non-postponable capital expenditures, it will first draw
down its marketable securities portfolio and then seek external finance.
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
Inventory (Raw materials; WIP; Finished goods) Provisions
Sundry debtors (Receivables) customers Sundry creditors (Payables) suppliers
Loans and advances extended Loans and advances received
Gross Working Capital = Current assets

Net Working Capital = Current assets – Current Liabilities
Net Working Capital = Gross Working Capital – Current Liabilities
Objective of WCM
LIQUIDITY versus PROFITABILITY
The objective of working capital is to support smooth functioning of the normal business operations of a
company. Therefore the quantum of investment in current assets should meet the requirements and also
provide cushion to meet unforeseen contingencies.
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)
CA = 20 lakh (80 lakh) aggressive (more risky) (high

profit) (low liquid)
S. Particulars Conservative Moderate Aggressive

No. (A) (B) (C)
A Net Sales 50,00,000 50,00,000 50,00,000
B Operating profit before interest and tax 5,00,000 5,00,000 5,00,000
C Net operating Fixed asset 10,00,000 10,00,000 10,00,000
D Current asset 8,00,000 6,50,000 5,00,000
E Total operating asset (C+D) 18,00,000 16,50,000 15,00,000
F Net operating profit margin (B/A) 10% 10% 10%
G Turnover of net operating fixed asset FAT (A/C) 5 times 5 times 5 times
H Turnover of current asset CAT (A/D) 6.25 times 7.69 times 10 times
I Turnover of total operating asset TAT (A/E) 2.78 times 3.03 times 3.33 times
J Rate of return on total operating asset (F*I) 27.8% 30.3% 33.3%
K Ratio of current asset to net operating fixed asset (D/C) 80% 65% 50%
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.
Management of current assets is a trade-off between ‘profitability’ and ‘liquidity’
An aggressive approach results in greater profitability but lower liquidity.

A conservative approach results in lower profitability but higher liquidity.
A moderate policy is between the above two extremes.
Views of WCM
Static Dynamic
The purpose of current assets is to provide WC is the capital for uninterrupted business
adequate cover for current liabilities operations of company ranging from the
procurement of raw materials, converting them into
GWC is equal to current assets (including ‘loans finished products for sale and realizing cash along
and advances) of a company. With profit from the accounts receivables that
NWC is the difference between GWC and current arise from the sale of finished goods on credit.
liabilities (including provisions).
To meet the production plans some amount of raw
Both GWC and NWC are in the balance sheet, materials has to be maintained in the form of
they denote the position of current assets as at the inventory
end of a company’s accounting year.
Once the raw materials are put into the production
Current liabilities arise in the context of and hence process, the company has to incur manufacturing
are derived from current assets. Consequently, a expenses like wages and salaries, fuel and other
lot of emphasis is traditionally placed on the Manufacturing overheads.
current assets vis-à-vis current liabilities.
The finished goods are sold on a credit basis.
As a rule of thumb, the value of 2:1 for the ratio of It can receive credit from its suppliers of materials.
current assets to current liabilities is good
WC
Factors affecting the
composition of WCM
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
CONVERSION PERIOD (WIP)
FINISHED GOODS STORAGE PERIOD
AVERAGE COLLECTION PERIOD
AVERAGE PAYMENT PERIOD

RAW MATERIAL STORAGE PERIOD
CONVERSION (WIP) PERIOD
FINISHED GOODS STORAGE PERIOD
AVERAGE COLLECTION PERIOD
AVERAGE PAYMENT PERIOD
Operating cycle
When,
D1 denotes the raw material storage period,
D2 denotes the period for conversion of raw materials into finished goods,
D3 denotes the finished goods storage period,
D4 denotes the average collection period.
D5 denotes the average payment 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
The Purpose of Inventories
Types of Inventory and Costs Associated with it
Inventory Management Techniques
Inventory Planning
Other Inventory Management Techniques (ABC system)

Inventory management
Inventory Management involves the control of current assets, produced for the
purposes of sale in the normal course of the company’s operations.
Inventories include raw material inventory, work-in process inventory and

finished goods inventory.
The goal of effective inventory management is to minimize the total costs

associated with holding inventories.
Ordering cost and Carrying cost

Role of Inventory in Working Capital
1. Current Asset: It is assumed that inventories will be converted to cash in the current
accounting cycle i.e. One year. However, there are exceptions. (industry specific)
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
Avoiding Lost Sales

Availing Quantity Discounts
Reducing Order Costs
Achieving Efficient Production Runs
Reducing Risk of Production Shortages
Types of inventory
Raw material
WIP
Finished goods
Costs associated with
inventory
Material Costs (1200 kg of plastic @ ₹ 10 per kg = ₹ 12000)
Ordering Costs (purchase requisition form etc.) (1200 kg)

Size of order (units) 100 150 200 1200 1
Number of orders in a year 12 8 6 1 1200
Total ordering costs @ Rs.100 per order 1,200 800 600 100 120000
Carrying Costs (Safekeeping and maintenance of inventory)

Let’s assume that the price per unit of material is Rs.10 and that on an average about half
of the inventory will be held in storage. Then, the average values of inventory for sizes of
order 100, 150 and 200 along with carrying cost @ 25% of the inventory held in storage:
Size of order (units) 100 150 200
Average value of inventory 500 750 1,000
Carrying cost @ 25% 125 187.5 250
Cost of Funds Tied up with Inventory (Locked up) Opportunity cost
Cost of Running out of Goods

INVENTORY MANAGEMENT
TECHNIQUES
EOQ (Economic Order Quantity; Reorder quantity)

Reorder point
Stock level
Economic Order Quantity
The economic order quantity (EOQ) refers to the optimal order size that will result
in the lowest total costs for an item of inventory.
By calculating an EOQ, the firm attempts to determine the order size that will
minimize the total inventory costs.
Total inventory cost = Ordering cost + Carrying cost

As the lead time (time required for procurement of material) is assumed to be zero an order
for replenishment is made when the inventory level reduces to zero.
Economic Order Quantity (EOQ)
The unit of materials to be placed order to reduce cost.
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)
Total material cost: (2000 x 50) = ₹ 100000

Average Average storage

# Of units # Of order Order Cost quantity cost Purchase cost (Order+Storage) cost Total Cost
2000 1 100 1000 5000 100000 5100 105100
1600 1.25 125 800 4000 100000 4125 104125
1000 2 200 500 2500 100000 2700 102700
500 4 400 250 1250 100000 1650 101650
300 6.66 666.66 150 750 100000 1416.66 101416.7
283 7.06 706.71 141.5 707.5 100000 1414.21 101414
250 8 800 125 625 100000 1425 101425
100 20 2000 50 250 100000 2250 102250
50 40 4000 25 125 100000 4125 104125
10 200 20000 5 25 100000 20025 120025
At EOQ = Ordering cost = Storage cost
Ordering cost = (Annual usage / Order lot) * Ordering cost
Storage cost = (Order lot / 2) * Storage cost

Modified EOQ
The annual usage of a raw material is 40,000 units for ABC Ltd.
The price of the raw material is Rs.50 per unit.
The ordering cost is Rs.200 per order and the carrying cost 20 percent
of the average value of inventory.
The supplier has recently introduced a discount of 4 percent on the

price of material for orders of 1,500 units and above.
1. What was the company’s EOQ prior to the introduction of discount?
2. Should the company opt for availing the discount?
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
EOQ without discount

For utilizing the discount the minimum order size Q’ is 1500 units.
As EOQ is less than Q’, we would calculate the incremental cost and incremental benefit.
(EQ1)
Savings due to reduction in ordering costs
(EQ2)
Extra expenses due to incremental carrying costs
(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.
Two factors that determine the appropriate order point are:

1. The procurement or delivery time stock which is the inventory needed during the lead
time.
2. The safety stock which is the minimum level of inventory held as protection against
shortages.
Reorder Point = Normal consumption during lead time + Safety Stock.
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)
Reorder level = Average daily usage rate x lead time in days.
If the average daily usage rate of a material is 50 units and the lead time is 7
days.
Reorder level = Average daily usage rate x Lead time in days

= 50 units x 7 days
= 350 units
When the inventory level reaches 350 units an order should be placed for
material.
Reorder Level
It determines when to order the materials.
Usage of material Lead time

Minimum 5 2
Normal 10 3
Maximum 15 4

Reorder quantity (EOQ) =
Reorder level = Maximum usage * Maximum time
Maximum level (Storage capacity) = Reorder level + Reorder

quantity (EOQ) – (Minimum usage * Minimum time)
Minimum level = Reorder level – (Normal usage * Normal time)
Average level = (Minimum level + Maximum level) / 2

Average level = {Minimum level + (0.5 * Reorder quantity)}
Reorder quantity (EOQ) =
Reorder level = 15 * 4 = 60 units
Maximum level (Storage capacity) = 60 + 283 – (10) = 333 units
Minimum level = 60 – (10 * 3) = 30 units
Average level = (333 + 30) / 2 = 181.5 units

Average level = {30 + (0.5 * 283)} = 171.5 units
Probabilistic data
Below are presented the daily usage rate of a material and the lead time required to
procure the material along with their respective probabilities (which are independent)
for Sigma Company Ltd.
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.
What should be the reorder level based on financial considerations?
Average daily usage Prob of occurance Lead time (No. Of Prob of occurance
rate days)
200 0.25 12 0.25

500 0.50 16 0.50
800 0.25 20 0.25
From the data contained in the table we can calculate the expected usage rate and expected
lead time.
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
Similarly expected lead time

= (12 x 0.25) + (16 x 0.5) + (20 x 0.25)
= 3 + 8 + 5 = 16 days
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.
This can be achieved by considering the possible levels of usage.

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
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.
The stock-out acceptance factor is considered to be 1.3.
What is the reorder level for the company?
From the data contained in the problem we have

S = 100 units
L = 20 days
R = 2,000 units
F = 1.3
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
WIP (Semi finished goods)
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.
Finished goods sold on credit get converted into receivables which

when realized, generate cash.
Average receivables = Average daily credit sales * Average collection period.
For example, if the average daily credit sales of a firm are

Rs.3,00,000 and the average collection period is 40 days, the average
balance in the receivables account would be Rs.1,20,00,000.
Since receivables often account for a significant proportion of the

total assets, management of receivables take up a lot of the Finance
Manager’s time.
objective of receivables
management
The objective of receivables management is to promote sales until
that point is reached where the returns that the company gets from
funding of receivables is less than the cost that the company has to
incur in order to fund these receivables.
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 increase profits; because companies generally charge a higher margin of profit

on credit sales as compared to cash sales.
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.
Thus, the various variables associated with credit policy are:

1. Credit standards
2. Credit period
3. Cash discount
4. Collection program
Credit standards
The set of standards that a company uses to determine whether to

extend the line of credit to a customer.
The existing sales of Clean Ltd. are ₹ 2 crore. The current customers have ‘high’ or ‘good’
credit rating.
With partially liberalized credit standards, sales are likely to go up by ₹ 24 lakh. The mix of
new customers being 67 % and 33 % from groups rated ‘fair’ and ‘limited’ respectively.
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.
1. Additional profit on new sales = Rs.4,80,000
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
Total of additional costs (EQ2 + EQ3) = Rs.2,76,000

Net additional benefit [1 – (2 + 3)] = Rs. 2,04,000
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
= 4,80,000 – 36,000 – 2,40,000 = Rs 2,04,000

Credit Period
The credit period refers to the length of time allowed to customers to pay for their
purchases. It generally varies from 15 days to 60 days.
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”
If the customer pays within 10 days, he is eligible to avail a 2% discount.

Otherwise he has to pay within 45 days without any discount
1/15, net 30 days

Ceaser Ltd. existing sales are Rs.180 lakh. It is currently extending a credit period of ‘net 30
days’ to its customers. The company’s contribution to sales ratio is 20 percent and the cost of
funds is 15 percent.
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.
Should the company go in for a policy change or not?
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
The net additional benefit

= EQ1 – (EQ2 + EQ3)
= Rs.3,20,000 – Rs.2,16,500 = Rs.1,03,500
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.
Should the company increase its cash discount?

The incremental benefits are:
Profit associated with additional sales to be generated
Cost savings on the release of funds locked up in receivables.
The incremental costs are:

The cost of funds invested in the receivables arising out of new sales.
Additional amount to be paid as cash discount.
Collection program
The collection effort of a company is decided by the collection policy, which is a part of
the overall credit policy of the company.
The objective of collection policy is to achieve timely collection of receivables, thereby
releasing funds locked up in receivables for a longer period than they should have been
under the credit terms and to minimize bad debt losses.
The collection program consists of the following:
Monitoring the state of receivables

Despatch of letters to customers whose due date is approaching
Telephonic advice to customers around the due date
Threat of legal action to overdue accounts
Legal action against overdue accounts.
The present sales of Dual Ltd. are Rs.108 lakh, the average collection period 60 days, bad debt
losses 6 percent of sales and collection expenses Rs.1 lakh. The company’s cost of funds is 15
percent.
It is contemplating to increase the collection effort through special programs to reduce the
amount of receivables and the incidence of bad debt losses.
Two separate programs called A and B are under consideration.
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).
Following are the Salient Features of TReDS:

Unified platform for Sellers, Buyers and Financiers
Eliminates Paper
Easy Access to Funds
Transact Online
Competitive Discount Rates
Seamless Data Flow
Standardised Practices
Why TReDS?
Background
MSMEs are the back bone of Indian Economy and despite the important role played by them
in country’s overall economic growth, continue to face constraints in obtaining adequate
finance, particularly in terms of their ability to convert their trade receivables into liquid funds.
The Concept for setting up of electronic bill factoring Exchange was recommended by
Financial Sector Reforms (FSR) Committee in 2008 in their report “Hundred Small Steps”.
Based on the FSR Committee recommendations, SIDBI in collaboration with NSE, had taken
the initiative to set up an E-discounting platform to support financing of MSME receivables.
The platform was named as NTREES (Trade Receivables Engine for E-discounting, Prefix ‘N’
stands for NSE and Suffix ‘S’ stands for SIDBI). The NTRESS platform was based on the
reverse factoring model, where credit exposure was taken by large Purchaser / Corporates, who
offered the invoices drawn by its MSME suppliers for discounting and SIDBI as the Financier
discounted the same and credited the proceeds to MSME bank accounts through RTGS. The
platform was based on the Mexican model (National Financiers – NAFIN) for bidding of
MSME receivables.
TReDS Evolution
RBI on December 3, 2014 issued guidelines on Trade Receivable e-Discounting System
(TReDS). Pursuant to the TReDS guidelines, RBI, on December 2, 2015 granted in-principle
approval to SIDBI and NSICL for setting and operating TReDS as per the said guidelines
issued under the Payment and Settlement System (PSS) Act, 2007. Adhering to the conditions
given in the in-principle letter, separate entity - Receivables Exchange of India Ltd (RXIL) was
incorporated as a joint venture by SIDBI and NSE. The platform was named as “TREDS”.
The following categories of applicants can be registered on TReDS platform of RXIL
subject to such applicant being engaged in business for at least 1 year (except financiers)
prior to the date of registration:
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.
Buyers – Corporates including companies and other buyers including Government

Departments and Public Sector Undertaking and such other entities as may be permitted
by the Reserve Bank of India (“RBI”) from time to time to participate on the TReDS
platform as 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).
2. Who are the participants in TReDS?

Ans. Sellers, buyers and financiers are the participants on a TReDS platform.
3. Who can participate as a seller in TReDS?

Ans. Only MSMEs can participate as sellers in TReDS.
4. Who can participate as a buyer in TReDS?

Ans. Corporates, Government Departments, PSUs and any other entity can
participate as buyers in TReDS.
5. Who can participate as a financier in TReDS?

Ans. Banks, NBFC - Factors and other financial institutions as permitted by the
Reserve Bank of India (RBI), can participate as financiers in TReDS.
6. How does TReDS work?
Ans. Broadly, following steps take place during financing / discounting through
TReDS:
1. Creation of a Factoring Unit (FU) - standard nomenclature used in TReDS for
invoice(s) or bill(s) of exchange - containing details of invoices / bills of exchange
(evidencing sale of goods / services by the MSME sellers to the buyers) on TReDS
platform by the MSME seller (in case of factoring) or the buyer (in case of reverse
factoring);
2. Acceptance of the FU by the counterparty - buyer or the seller, as the case may
be;
3. Bidding by financiers;
4. Selection of best bid by the seller or the buyer, as the case may be;
5. Payment made by the financier (of the selected bid) to the MSME seller at the
agreed rate of financing / discounting;
6. Payment by the buyer to the financier on the due date.
7. What is a Factoring Unit (FU)?

Ans. A Factoring Unit (FU) is a standard nomenclature used in TReDS for
invoice(s) or bill(s) of exchange. Each FU represents a confirmed obligation of the
corporates or other buyers, including Government Departments and PSUs.
8. Who can create an FU?
Ans. In TReDS, FU can be created either by the MSME seller or the buyer. If
MSME seller creates it, the process is called factoring; if the same is created by
corporates or other buyers, it is called as reverse factoring.
9. Whether TReDS could deal with reverse factoring?

Ans. Yes. The TReDS could deal with both receivables factoring as well as reverse
factoring.
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.
11. Whether any authorisation is required to set up and operate a TReDS

platform?
Ans. Yes, authorisation is required to be obtained from RBI under the Payment
and Settlement Systems (PSS) Act, 2007.
12. What is the eligibility criteria for setting up and operating TReDS?
Ans. Eligibility criteria for the purpose of setting up and operating a TReDS
platform is provided in the guidelines (as amended from time to time) for TReDS
issued by RBI. These guidelines are available at the following
path: www.rbi.org.in → “Payment and Settlement Systems” dropdown
→“Guidelines”. RBI’s Press Release dated October 15, 2019 may also be read in
this regard. The same can be accessed at the following web
links: https://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=3504 and https://www
.rbi.org.in/scripts/FS_PressRelease.aspx?prid=48405&fn=9
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
14. Whether TReDS entities undertake KYC (Know Your Customer) of

participants?
Ans. Yes. The KYC process adopted by the TReDS entities shall adhere to the
“Master Direction – Know Your Customer (KYC) Direction, 2016” dated February
25, 2016 (as amended from time to time) issued by RBI.
15. What is a settlement file and who generates it in TReDS?
Ans. A settlement file provides information as to how much amount has to be
debited from and credited to the accounts of participants (sellers, buyers and
financiers), due on a particular date / time. In other words, it indicates how much
a financier has to pay to an MSME seller, and how much a buyer owes to the
financier on a particular date / time. The TReDS entities generate the settlement
file and send the same to existing payment systems (for instance, National
Automated Clearing House) for actual payment of funds. FACTORING
16. Whether defaults on TReDS platform are the responsibility of TReDS

entities?
Ans. No. Default handling is outside the purview of TReDS platforms.
These FAQs are issued by the Reserve Bank of India (hereinafter referred to as
“Bank”) for information and general guidance purposes only. The Bank will not
be held responsible for actions taken and / or decisions made on the basis of the
same. For clarifications or interpretations, if any, one may be guided by the
relevant circulars, guidelines and notifications issued from time to time by the
Bank.
FACTORING
REVERSE FACTORING
Dividend policy and Firm Valuation
Contents
Understanding Dividends
Theories of dividend policy:

Traditional Position
Walter Model
Gordon Model
Miller & Modigliani Position (M&M) Theory of irrelevance
Rational Expectations Model
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.
The following expression, given by traditional approach, establishes the relationship

between market price and dividends using a multiplier
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,
It is assumed that retained earnings are the only sources of finance
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:
Equity capitalization rate (ke) = 15%

Earnings per share (E) = Rs.8
Dividend per share (D) = Rs 0
Return on investments (r) = 12%
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:
Equity capitalization rate (ke) = 12%

Earnings per share (E) = Rs.8
Assumed return on investments (r) are as follows:
i. r = 15%
ii. r = 10%
iii. r = 12%
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.
iii. Firm has an infinite life
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
Dividend payout ratio (1-b) Retention ratio

a. 0% 100%
b. 10% 90%
c. 40% 60%
d. 50% 50%
e. 80% 20%
f. 100% 0%
r > ke (r = 12%; ke = 11%) r = ke (r = 11%; ke = 11%) r < ke (r = 10%; ke = 11%)
E = ₹ 8; DP ratio = 0%; g = br = 1 * 0.12 = 0.12 g = br = 1 * 0.11 = 0.11 g = br = 1 * 0.10 = 0.10

Ret ratio (b) = 100%;
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%;
Ret ratio = 60%;
Ret ratio = 50%;
Ret ratio = 20%;
E = ₹ 8; DP ratio = 100%; g = br = 0 * 0.12 = 0 g = br = 0 * 0.11 = 0 g = br = 0 * 0.10 = 0

Ret ratio = 0%;
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,
The company plans to declare a dividend of ₹ 3 per share.

It also has a new project for which it requires ₹ 5,00,000.
Using MM model, show that dividend payment doesn’t affect the

value of the firm.
The value of firm, when dividends are paid The value of firm, when dividends aren’t paid
Step 1 Price per share at the end
of year 0 i.e (t = 1)
Step 2 Amount to be raised by

the issue of new shares
Step 3 Number of additional

shares to be issued
Step 4 Value of the firm

RATIONAL EXPECTATIONS MODEL
According to the rational expectations model, there would be no impact of the dividend
declaration on the market price of the share as long as it is at the expected rate.
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.
Effect of bonus issue on the equity portion of the balance sheet
Part A: Equity portion before bonus issue

Paid up share capital (1,000,000 shares of ₹ 10 fully paid) 10,000,000
Reserves and surplus 30,00,000
Part B: Equity portion after bonus issue in the ratio 1:1

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
Effect of stock split on the equity portion of the balance sheet.
Part A: Equity portion before stock split

Paid up share capital (500,000 shares of ₹ 10 fully paid) 5,000,000
Part B: Equity portion after stock split in the ratio 5:1

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
A part of reserves is capitalized No capitalization of reserves
The shareholders proportional The shareholders proportional

ownership is unchanged ownership is unchanged
The book value, market value and The book value, market value and
earnings per share decline earnings per share decline
The market price is brought in a more The market price is brought in a

popular trading range more popular trading range
Share buybacks
Also referred to as equity repurchase or stock repurchase is feasible in India after 1998.
In India, the buyback of shares is generally done by either

1. Tender method or
2. Open market purchase method.
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
Excess amount of cash is detrimental (Opportunity cost)

Less amount of cash is detrimental (Reputation)
Huge profit Required cash

Lifeblood of business (
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
SPECULATIVE MOTIVE Opportunity
Objectives of Cash Management

Making short-term forecasts of cash position, finding avenues for
financing during periods when cash deficits are anticipated and
arranging for repayment/ investment during periods when cash
surpluses are anticipated with a view to minimizing idle cash as
far as possible.
Short-term cash forecasting is prepared under the receipts and payments method, showing
the time and magnitude of expected cash receipts and payments. The various items of cash
receipts and payments and the basis for estimating them is listed below:
VRK Industries manufactures razor blades. Its sales figures are given below.
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.
No bad debt losses.
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.
A machine worth Rs.55,000 proposed to be purchased on cash in March.
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
Prompt Billing and Mailing

Collection of Cheques and Remittance of Cash
Centralized Purchases and Payments to Suppliers
Playing the Float
Concept of ‘float’ arises from the practice of banks:
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.
The company is then said to have been playing the float.

Suppose, the opening credit balance of a company with the bank is Rs.10,000. Let
us assume that it deposits cheques daily to the amount of Rs.30,000 and it takes
three days for realization.
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.
A minimum amount of cash can always be maintained with the bank.

Desist from the temptation to use a larger proportion of the net float.
Preferably have an overdraft arrangement with the bank to avoid financial
embarrassment.
Investment of Surplus Cash
Investing surplus cash involves two basic problems:
i. Determining the amount of surplus cash
ii. Determining the channels of investment.

DETERMINATION OF SURPLUS CASH
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.
b. Average daily cash outflows: This is the average amount of disbursements to

be made daily.
The ‘desired days of cash’ and ‘average daily cash outflows’ are to be determined
separately for normal and peak period. Then the safety level of cash can be calculated as
follows:
During Normal Periods

Safety level of cash = Desired days of cash x Average daily cash outflows
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.
The safety level of cash will be Rs.1,05,000 i.e., 7 x 15,000.
During Peak Periods

Safety level of cash = Desired days of cash at the business period x Average of highest
daily cash outflows.
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.
Safety level = 4 x 7,500 = Rs.30,000

Example
From the following data ascertain whether the firm has surplus or deficiency of cash
Normal period Peak period

Desired days of cash 7 5
Average daily outflows 25,000 50,000
Actual cash balance 100,000 250,000
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.
During peak periods:

Cash balance is Rs.2,50,000 and average daily cash outflows Rs.50,000. The firm
has cash available for 5 days which is equal to the required 5 days. Hence the firm is
neither cash deficient nor is cash surplus. It has just sufficient cash.
Determination of Channels of Investment
The Finance Manager can determine the amount of surplus cash, by comparing
the actual amount of cash available with the safety level or minimum level of
cash.
Such surplus cash may be either of a temporary or a permanent nature.
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.
b. Liquidity: This can be ensured by investing money in short-term securities including

short-term fixed deposits with the bank.
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,
(b) Inconvenience costs;
(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)
• Stochastic model (Miller Orr)

Inventory model
If future cash flows are known with certainty, the EOQ model (used in inventory
management) is used for determining the optimal average amount of transaction cash.
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.
Total cost = Transaction cost + Carrying (opportunity) cost
This cost can be expressed as: F (T/C) + I(C/2).
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,
Total cost = Transaction cost + Carrying (opportunity) cost
This cost can be expressed as: F (T/C) + I(C/2).
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.
Substituting these values,
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.
For determining these limits, the Miller-Orr model is used.
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.
The optimal value of return point, z is:
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’.
Consequently, the permanent component needs to be financed from the long-term

sources of finance available to a company such as internal accruals, ordinary
shares, preference shares, debentures and to some extent term loans.
The ‘temporary component’ can be financed from short-term sources such as

accounts payables or trade credit, short-term bank borrowings and public deposits.
The behaviour of current assets influences the pattern of financing to be

adopted by a company.
SPONTANEOUS SOURCES OF
FINANCING CURRENT ASSETS
Accrued expenses
Provisions
Trade credit
Cost of Trade Credit vs. Opportunity Cost of Cash
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.
Factors are usually subsidiaries of banks or private financial companies. Factoring

is a continuous arrangement and not related to a specific transaction. So the factor
handles all the receivables arising out of the credit sales of the seller company and
not just some specific bills or invoices as is done in a bills discounting agreement.
Types of Factoring
1. Recourse Factoring: The factor purchases the receivables on the condition that any
loss arising out of irrecoverable receivables will be borne by the client. The factor
has recourse to the client if the receivables purchased turn out to be irrecoverable.
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.

Sources of Long Term Finance

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Sources of Long Term Finance

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Sources of long term finance

Long term Short term

Capital budgeting Working capital

Bond/debenture; Preference share/Ordinary Term loan; Short term Instruments

Capital market Money market

• Such a mismatch will lead to:

• A liquidity risk with the short-term funds being held

Short term project for 3 years

Issue of securities (Financial securities)

Equity capital or ordinary share

Preference capital or preference share

Debenture capital or bond

• The interest of the debenture holders is usually represented by a trustee

• If the company issues debentures with a maturity period of more than 18

• Fully convertible debentures (FCD)

• Partially convertible debentures (PCD)

1. Appointment of the Lead Manager

2. Preparation of the Prospectus

Exercises his right Sells his right in favour of someone

Total investment 115 Total investment 86.25

Lets his right expire

Market value of 3 shares at the ex rights price (3x28.75) 86.25

Change in wealth 3.75

Ex rights price = (n1*P + n2*S) / (n1+n2)

Value of 5 rights = (Ex rights price - S) = (36.66 - 20) = ₹ 16.66

Value of each right = ₹ 3.33

Exercises his right Sells his right in favour of someone

Total investment 4400 Total investment 3667

Lets his right expire

Market value of shares at the ex rights price (100x36.66) 3667

Change in wealth 333

The company appoints a merchant banker to network with the

The major advantage of privately placing the securities are:

• Easy access to any company

Major advantages of entering into a bought-out deal are:

The interest and the repayment period are negotiated

Bill Rediscounting Scheme, Supplier’s Line of Credit, Seed

Energy applied = Work done

1 unit of energy applied = 1 unit of work done

1 unit of energy applied = more than 1 unit of work done

Energy applied has to change by less than 1% = Amount of work done 1%

To explain further, let X be an independent financial

Operating leverage (Fixed cost) (Revenue and EBIT)

Financial leverage (Interest paid) (EBIT and EPS)

Total leverage or Combined leverage (Revenue and

DOL = 200 / 100 = 2

If the revenue changes by 1 unit, then the EBIT changes by 2 units.

If the revenue increases by 1 unit, then the EBIT increases by 2 units.

For the year 2020

A high degree of operating leverage indicates that a company is likely to experience

The EBIT of the company is zero at the operating break-even point.

It helps in determining how sensitive the profit of the company is to

DFL = 243 / 200 = 1.21

For the year 2020

Year Interest paid Proportion of interest payment DFL

DTL = DOL * DFL

DTL = 243 / 100 = 2.43

For the year 2020

Wants to raise an additional capital of ₹ 1 crore for expansion.

Find the EPS under both the alternatives when EBIT is

Equity financing Debt financing

Equity financing Debt financing

Ex rights price = (n1P + n2S) / (n1+n2)