FMGT

SARANSHLast Mile Referencer for
FINANCIAL
MANAGEMENT
The Institute of Chartered

Accountants of India
(Setup by an Act of Parliament)
Board of Studies (Academic)
www.icai.org | https://boslive.icai.org
Saransh - Last Mile Referencer for Financial Management
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same may be brought to the notice of the Director, BoS. The Council of the Institute is not
responsible in any way for the correctness or otherwise of the matter published herein.
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Published in June 2023 by:

The Institute of Chartered Accountants of India
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BOS (Academic), the student wing of the Institute, does not leave any stone unturned
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PREFACE
the ideal manner of answering questions set at examination also helps students revise
for the forthcoming examination. Mock Test Papers help students assess their level
of preparedness before each examination. BoS (Academic) also conducts live virtual
classes through eminent faculty for its students across the length and breadth of the
country.
To reach out to its students, the BoS (Academic) has also been publishing
subject-specific capsules in its monthly Students’ Journal “The Chartered
Accountant Student” since the year 2017 for facilitating effective revision of concepts
dealt with in different topics of each subject at the Foundation, Intermediate and
Final levels of the chartered accountancy course. Each issue of the journal includes a
capsule relating to specific topic(s) in one subject at each of the three levels. In these
capsules, the concepts and provisions are presented in attractive colours in the form
of tables, diagrams and flow charts for facilitating easy retention and quick revision
of topics.
The BoS (Academic) is now coming out with a comprehensive booklet ”Saransh-Last
Mile Referencer for Financial Management” wherein the significant concepts dealt
with across topics Financial Management are captured by way of diagrams, flow
charts and tables. To sustain and grow their financial standing, organisation across
the world essentially required managers who are competent in various domains of
finance. One of the fundamental domains of finance, financial management deals
with the function relating to how much and which assets are to be acquired, how to
raise capital to acquire the assets and what is to be done to maximize the
shareholder’s wealth. Financial management comprises the processes of planning
and controlling subsystems of funds.
A study in financial management will help the students to understand the functions
of financial managers, providing with an overview of broad issues and problems that
financial managers face in various commercial domains of our economy. This subject
introduces various concepts and theories relating to finance, which are fundamental
to the methodologies and proficiencies offered as aids to understand, identify and
solve the problems of financial managers. Study of financial management will help
the Chartered Accountancy students to develop an acumen, so as to grow
competencies in financing decision, investment decision, dividend decision and
working capital management. This booklet, thus, consolidate all significant Financial
Management at one place, thus, capturing the key points in these subjects. This
would help the reader grasp the essence of the subject as a whole and would also
serve as a ready reckoner.
Happy Reading!
© ICAI BOS(A)
SARANSH
Message of Key ICAI Office Bearers
CA. Aniket S. Talati

President, ICAI
In order to equip students with a robust foundation of knowledge, skills, and professional
values, the Board of Studies (Academic) has been actively engaged in various initiatives
to cater to their learning requirements. In continuation to the earlier publications, namely,
Accounting, Auditing & Cost Management and Strategic Decision Making in this series of
Saransh — Last Mile Referencer, publications for these subjects, Financial Management,
Strategic Management and Company Law have been added. It presents a concise
summary of essential concepts from each chapter, which not only serves as a handy
guide for students but also assists Members in their professional pursuits.
CA. Ranjeet Kumar Agarwal

Vice President, ICAI
ICAI consistently strives to provide exceptional educational content that empowers

students in their pursuit of goals. Saransh — Last Mile Referencer is a meticulously
crafted compilation of booklets, each dedicated to a specific subject of the Chartered
Accountancy Course. These concise capsules serve as a valuable tool for revision of
concepts before examinations in each subject. Whether you are a CA student or a
Member, this series of booklets will serve as a referencer.
CA. Vishal Doshi

Chairman, Board of Studies (Academic)
We are thrilled to introduce the next round of Saransh — Last Mile Referencer, an
invaluable resource for students aspiring to embark on the esteemed path of becoming
a Chartered Accountant. These booklets encapsulate the vital topics of the CA curriculum
across Intermediate, and Final levels. Presented in a condensed format, they effectively
convey the concepts and provisions through tables, diagrams, and flow charts, making
them an indispensable tool for anyone pursuing a career in this field.
CA. Dayaniwas Sharma

Vice-Chairman, Board of Studies (Academic)
For years, the Board has served as the guiding force and mentor to countless aspiring CA
students, offering support in meeting their evolving learning needs. The Saransh — Last
Mile Referencer booklets are an exciting addition to our esteemed collection of insightful
books. These invaluable referencers provide indispensable guidance for students
pursuing the Chartered Accountancy Course. The booklets in concise form will foster
active learning and strengthening students' comprehension and confidence in the
subjects.
© ICAI BOS(A)
INDEX
Topic Pg No.
FINANCIAL MANAGEMENT
Scope and Objective of Financial Market 01
Types of Financing 03
Financial Analysis and Planning - Ratio Analysis 04
Cost of Capital 08
Financing Decisions - Capital Structure 14
Financing Decisions - Leverages 16
Investment Decisions 17
Risk Analysis in Capital Budgeting 20
Dividend Decisions 24
Management of Working Capital 30
© ICAI BOS(A)
SARANSH
© ICAI BOS(A)
SARANSH Financial Management
Financial Management
SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT
Chapter Overview Short- term Finance

Working capital Management (WCM)
Decisions/Function
FINANCIAL MANAGEMENT
Scope of Financial Management

Scope and Objectives of Role and functions of Chief
Determination of size of the enterprise and
Financial Management Finance Officer (CFO)
determination of rate of growth.
Relations of Financial
Profit Maximisation vis-a
Management with other
vis Wealth Maximisation Determining the composition of assets of the enterprise.
disciplines of accounting
Determining the mix of enterprise’s financing i.e., consideration

Meaning of Financial Management of level of debt to equity, etc. and short term functions/decisions
Financial management comprises the forecasting, planning,

organizing, directing, co-ordinating and controlling of all activities Analysis, planning and control of financial
relating to acquisition and application of the financial resources of an affairs of the enterprise.
undertaking in keeping with its financial objective.
Two Basic Aspects of Financial Management Procurement of Funds

There are two basic aspects of financial management viz., Since funds can be obtained from different sources, therefore their
procurement of funds and an effective use of these funds to achieve procurement is always considered as a complex problem by business
business objectives. concerns. Some of the sources for funds for a business enterprise are:
Procurement of funds Debentures and Bonds
Aspects of Financial Management

Utilization of Funds
Owner’s Funds Hire Purchases & Leasing
)LQDQFHIXQFWLRQVÀQDQFHGHFLVLRQ
Commercial Banks Angel Financing
Value of a firm will depend on various finance functions/decisions. (Short, Medium & Long)
It can be expressed as
V = f (I,F,D). Venture Capital
The finance functions are divided into long term and short term
functions/decisions
Effective Utilisation of Funds
Investment The Finance Manager has to point out situations where the funds are
Decisions (I) being kept idle or where proper use of funds is not being made. All
the funds are procured at a certain cost and after entailing a certain
amount of risk.
Long term
Finance
Utilization for Fixed
Function Assets
Decisions
Dividend Financing Utilization for Working

Capital
Decisions(D) Decisions (F)
© ICAI BOS(A) 1
Evolution of Financial Management &RQÁLFWEHWZHHQ3URÀWYHUVXV9DOXHPD[L

The evolution of financial management is divided into three phases.
-misation Principle
Financial Management evolved as a separate field of study at the
beginning of the century. The three stages of its evolution are As a normal tendency, the management may pursue its own personal
goals (profit maximization). But in an organization where there is
a significant outside participation (shareholding, lenders etc.), the
Stages of Evolution of Financial Management management may not be able to exclusively pursue its personal goals
due to the constant supervision of the various stakeholders of the
company-employees, creditors, customers, government, etc.
Traditional Phase Transitional Phase Modern Phase
The below table highlights some of the advantages and disadvantages
of both profit maximisation and wealth maximization goals
2EMHFWLYHVRI)LQDQFLDO0DQDJHPHQW
Goal Objective Advantages Disadvantages
Profit Large (i) Easy to (i) Emphasizes
Profit Maximization amount of calculate the short
Maximisation Wealth / Value profits profits term gains
maximisation (ii) Easy to (ii) Ignores risk
determine or
the link uncertainty
between (iii)Ignores the
financial timing of
decisions and returns
How do we measure the value/wealth of a profits. (iv)Requires
immediate
ÀUP" resources.
Shareholders Highest (i) Emphasizes (i) Offers
Stockholders hire managers to run their firms for them...... Wealth market the long term no clear
Maximisation value of gains relationship
shares (ii) Recognises between
Managers set aside their interest and maximise stock prices... risk or financial
uncertainty decisions and
(iii) Recognises share price.
the timing of (ii) Can lead to
Stockholders wealth is maximised... returns management
(iv) Considers anxiety and
shareholders’ frustration.
Firm value is maximised.... return.
Societal wealth is maximised... 5ROHRI)LQDQFHH[HFXWLYHLQWRGD\·V:RUOG

vis-a-vis in the past
Today, the role of chief financial officer, or CFO, is no longer confined
Value of a firm (V) = Number of Shares (N) × Market price of to accounting, financial reporting and risk management. Some of
shares (MP) the key differences that highlight the changing role of a CFO are as
Or follows
V = Value of equity (Ve) + Value of debt (Vd)
What a CFO used to do? What a CFO now does?
Budgeting Budgeting
Three Important Decisions for Achievement
Forecasting Forecasting
RI:HDOWK0D[LPLVDWLRQ
Accounting Managing M & As
Treasury (cash management) Profitability analysis (for example,
Investment by customer or product)
Decisions Preparing internal financial Pricing analysis
reports for management.
Financing Preparing quarterly, annual Decisions about outsourcing
Decisions filings for investors.
Tax filing Overseeing the IT function.
Tracking accounts payable and Overseeing the HR function.
accounts receivable.
Dividend Travel and entertainment Strategic planning (sometimes
Decisions expense management. overseeing this function).
Regulatory compliance.
Risk management.
© ICAI BOS(A) 2
5HODWLRQVKLSRIÀQDQFLDOPDQDJHPHQWZLWK Decision – Chief focus of an accountant is to

related disciplines making collect data and present the data.
The financial manager’s primary
Financial management is not a totally independent area. It draws responsibility relates to financial
heavily on related disciplines and areas of study namely economics, planning, controlling and decision
accounting, production, marketing and quantitative methods. Even making.
though these disciplines are inter-related, there are key differences
among them.
Financial Management and Other Related
Financial Treatment In accounting, the measurement Disciplines
Management of Funds of funds is based on the accrual
and principle. Financial management also draws on other related disciplines such
Accounting: as marketing, production and quantitative methods apart from
accounting. For instance, financial managers should consider the
The treatment of funds in financial impact of new product development and promotion plans made in
management is based on cash the marketing area since their plans will require capital outlays and
flows. have an impact on the projected cash flows.
TYPES OF FINANCING
Chapter Overview Sources of Finance
Sources of Finance Long-term
Equity Preference Loans 1. Share capital or Equity shares

Share Share Retained Debentures/ from
Earnings Bonds Others 2. Preference shares
Capital Capital Financial
Institution 3. Retained earnings
4. Debentures/Bonds of different types
5. Loans from financial institutions
Classification of Financial Sources 6. Loans from State Financial Corporations
7. Loans from commercial banks
There are mainly two ways of classifying various financial sources
(i) Based on basic Sources (ii) Based on Maturity of repayment period 8. Venture capital funding
9. Asset securitisation
10. International financing like Euro-issues, Foreign currency loans
Sources of Finance based on Basic Sources Medium-term
Based on basic sources of finance, types of financing 1. Preference shares

can be classified as 2. Debentures/Bonds
3. Public deposits/fixed deposits for duration of three years
4. Medium term loans from Commercial banks, Financial Institutions,
State Financial Corporations
5. Lease financing/Hire-Purchase financing
Sources of Finance 6. External commercial borrowings
7. Euro-issues
8. Foreign Currency bonds
Short-term
Internal Sources External Sources
1. Trade credit
2. Accrued expenses and deferred income
3. Short term loans like Working Capital Loans from Commercial banks
4. Fixed deposits for a period of 1 year or less
5. Advances received from customers
Mainly retained Debt or Borrowed Share Capital 6. Various short-term provisions
earnings Capital
Owner’s Capital or Equity Capital:

Loan from A public limited company may raise funds from promoters or from the
Others Financial Debentures Preference Equity
Shares investing public by way of owner’s capital or equity capital by issuing
Institutions Shares ordinary equity shares.
Preference Share Capital:

Sources of Finance based on Maturity of Payment
These are a special kind of shares; the holders of such shares enjoy
Sources of finance based on maturity of payment can be classified as priority, both as regards to the payment of a fixed amount of dividend
and also towards repayment of capital on winding up of the company
© ICAI BOS(A) 3
Debt Securitisation:
Securitization is a process in which illiquid assets are pooled into

marketable securities that can be sold to investors. The process leads
to the creation of financial instruments that represent ownership Bank
interest in, or are secured by a segregated income producing asset or Trade Credit
Advances
pool of assets.
Lease Financing: Accrued

Certificates of Expenses &
Leasing is a general contract between the owner and user of the asset Deposit Deferred
over a specified period of time. The asset is purchased initially by Income
the lessor (leasing company) and thereafter leased to the user (lessee
company) which pays a specified rent at periodical intervals.
Advances
Treasury
from
Bills
Short term Sources of Finance: Customers
There are various sources available to meet short- term needs of Commercial
finance. The different sources are as shown alongside Paper
FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Chapter Overview
Liquidity Ratios*/
RATIO ANALYSIS Short-term Solvency
Ratios
Capital Structure
Application of Ratio Leverage Ratios/ Ratios
Types of Ratio Analysis in dicision Long term Solvency
making Ratios
Coverage Ratios
Types of Ratios
* Liquidity Ratio/Short term Activity Ratios/

Solvency Ratio Efficiency Ratios/
Relation of financial Performance Ratios/
* Leverages Ratio/Long Turnover Ratios* Related to Sales
term Solvency Ratios manegment with other
*Activity Ratio/Efficiency disciplines of accounting.
Related to overall
Ratios/Performance Return on Investment
*Profitability Ratios (Assets/ Capital
Profitability Ratios Employed/ Equity)
Required for analysis

from Owner’s point
5DWLRDQGLWV7\SHV of view
Related to Market/
Valuation/ Investors
Ratio analysis is a comparison of different n umbers f rom t he
balance sheet, income statement, and cash flow statement against
the figures o f p revious y ears, o ther c ompanies, t he i ndustry, o r
even the economy in general for the purpose of financial analysis.
6XPPDU\RI5DWLRV
Types of the Ratios is as given Blongside
Summary of the ratios has been tabulated as under
Ratio Formulae Comments

Liquidity Ratio
Current Ratio Current Assets A simple measure that estimates whether the business can pay
Current Liabilities short term debts. Ideal ratio is 2 : 1.
Quick Ratio Quick Assets It measures the ability to meet current debt immediately. Ideal
Current Liabilities ratio is 1 : 1.
Cash Ratio (Cash and Bank Balances + It measures absolute liquidity of the business.
Marketable Securities )
Current Liabilities
© ICAI BOS(A) 4
Basic Defense Interval Ratio ( Cash and Bank Balances + It measures the ability of the business to meet regular cash
Marketable Securities) expenditures.
Operating Expenses – No. of days

Net Working Capital Ratio Current Assets – Current Liabilities It is a measure of cash flow to determine the ability of business to
survive financial crisis.
Capital Structure Ratio
Equity Ratio Shareholders’ Equity It indicates owner’s fund in companies to total fund invested.
Capital Employed
Debt Ratio Total Outside Liablilities It is an indicator of use of outside funds.
Total Debt + Net Worth

Debt to equity Ratio Total Outside Liabilities It indicates the composition of capital structure in terms of debt
and equity.
Shareholders’ Equity
Debt to Total assets Ratio Total Outside Liabilities It measures how much of total assets is financed by the debt.
Total Assets
Capital Gearing Ratio ( Preference Share Capital + It shows the proportion of fixed interest bearing capital to equity
Debentures shareholders’ fund. It also signifies the advantage of financial
+ Other Borrowed Funds) leverage to the equity shareholder.
( Equity Share Capital +

Reserves & Surplus – Losses)
Proprietary Ratio Prorietary Fund It measures the proportion of total assets financed by
Total Assets shareholders.
Coverage Ratios
Debt Service Coverage Ratio Earnings available for debt service It measures the ability to meet the commitment of various
(DSCR) debt services like interest, installment etc. Ideal ratio is 2.
Interest + Instalments
Interest Coverage Ratio EBIT It measures the ability of the business to meet interest. Ideal ratio
Interest is > 1.
Preference Dividend Coverage Net Profit/Earning after taxes (EAT) It measures the ability to pay the preference shareholders’
Ratio Preference dividend liability dividend. Ideal ratio is > 1.
Fixed Charges Coverage Ratio EBIT + Depreciation This ratio shows how many times the cash flow before interest
Interest + Re-payment of loan and taxes covers all fixed financing charges. The ideal ratio is > 1.
1 – tax rate
Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio
Total Asset Turnover Ratio Sales/COGS A measure of total asset utilisation. It helps to answer the question -
What sales are being generated by each rupee’sXPSUIPGBTTFUT
Average Total Assets
invested in the business?
Fixed Assets Turnover Ratio Sales/COGS This ratio is about fixed asset capacity. A reducing sales or profit
Fixed Assets being generated from each rupee invested in fixed assets may
indicate overcapacity or poorer-performing equipment.
Capital Turnover Ratio Sales/COGS This indicates the firm’s ability to generate sales per rupee of long
Net Assets term investment.
Working Capital Turnover Sales/COGS It measures the efficiency of the firm to use working capital.
Ratio Working Capital
Inventory Turnover Ratio COGS/Sales It measures the efficiency of the firm to manage its inventory.
Average Inventory
Debtors Turnover Ratio Credit Sales It measures the efficiency at which firm is managing its
Average Accounts Receivable receivables.
© ICAI BOS(A) 5
Receivables (Debtors’) Velocity Average Accounts Receivable It measures the velocity of collection of receivables.
Average Daily Credit Sales
Payables Turnover Ratio Annual Net Credit Purchases It measures the velocity of payables payment.
Average Accounts Payables
Profitability Ratios based on Sales
Gross Profit Ratio Gross Profit This ratio tells us something about the business’s ability
x 100
Sales consistently to control its production costs or to manage the
margins it makes on products it buys and sells.
Net Profit Ratio Net Profit It measures the relationship between net profit and sales of the
x 100
Sales business.
Operating Profit Ratio Operating Profit It measures operating performance of business.

x 100
Sales
Expenses Ratio
Cost of Goods Sold (COGS) COGS
x 100
Ratio Sales
Operating Expenses Ratio Administrative exp. +

Selling & Distribution OH
x 100 It measures portion of a particular expenses in comparison to
Sales sales.
Operating Ratio COGS + Operating Expenses x 100
Sales
Financial Expenses Ratio Financial Expenses x 100

Sales
Profitability Ratios related to Overall Return on Assets/ Investments
Return on Investment (ROI) Return/ Profit / Earnings x 100 It measures overall return of the business on investment/ equity
Investments funds/ capital employed/ assets.
Return on Assets (ROA) Net Profit after taxes x 100 It measures net profit per rupee of average total assets/ average
Average Total Assets tangible assets/ average fixed assets.
Return on Capital Employed EBIT It measures overall earnings (either pre-tax or post tax) on total
x 100
ROCE (Pre-tax) Capital Employed capital employed.
8VHUVDQG2EMHFWLYHRI)LQDQFLDO$QDO\VLV$%LUG·V(\HYLHZ
Financial Statement analysis is useful to various shareholders to obtain the derived information about the firm
S.No. Users Objectives Ratios used in general

1. Shareholders Being owners of the organisation they are interested • Mainly Profitability Ratio [In particular
to know about profitability and growth of the Earning per share (EPS), Dividend per
organization share (DPS), Price Earnings (P/E), Dividend
Payout ratio (DP)]
2. Investors They are interested to know overall financial health of • Profitability Ratios
the organisation particularly future perspective of the • Capital structure Ratios
organisations. • Solvency Ratios
• Turnover Ratios
3. Lenders They will keep an eye on the safety perspective of their • Coverage Ratios
money lended to the organisation • Solvency Ratios
• Turnover Ratios
• Profitability Ratios
© ICAI BOS(A) 6
4. Creditors They are interested to know liability position of the • Liquidity Ratios
organisation particularly in short term. Creditors • Short term solvency Ratios/ Liquidity
would like to know whether the organisation will be Ratios
able to pay the amount on due date.
5. Employees They will be interested to know the overall financial • Liquidity Ratios
wealth of the organisation and compare it with • Long terms solvency Ratios
competitor company. • Profitability Ratios
• Return of investment
6. Regulator / Government They will analyse the financial statements to determine Profitability Ratios
taxations and other details payable to the government.
7. Managers:-
(a) Production Managers They are interested to know various data regarding • Input output Ratio
input output, production quantities etc. • Raw material consumption.
(b) Sales Managers Data related to quantities of sales for various years, • Turnover ratios (basically receivable
other associated figures and produced future sales turnover ratio)
figure will be an area of interest for them • Expenses Ratios
(c) Financial Manager They are interested to know various ratios for their • Profitability Ratios (particularly related to
future predictions of financial requirement. Return on investment)
• Turnover ratios
• Capital Structure Ratios
Chief Executive/ General They will try to find the entire perspective of the • All Ratios
Manager company, starting from Sales, Finance, Inventory,
Human resources, Production etc.
8. Different Industry
(a) Telecom • Ratio related to ‘call’
• Revenue and expenses per customer
(b) Bank • Loan to deposit Ratios
Finance Manager /Analyst will calculate ratios of their • Operating expenses and income ratios
(c) Hotel company and compare it with Industry norms. • Room occupancy ratio
• Bed occupancy Ratios
(d) Transport • Passenger -kilometre
• Operating cost - per passenger kilometre.
© ICAI BOS(A) 7
COST OF CAPITAL
Points of Discussion
Cost of
Cost of Debt Equity
Combination
Weighted
Cost of of Cost and
Average Cost
Weight of
Capital of Capital
each sources
Cost of (WACC)
of Capital
Preference Cost of
Share Retained
Earning
Meaning of Cost of Capital TO CALCULATE COST
Identify various cash flows
t Return expected by the providers of capital

Cost of
Capital (i.e. shareholders, lenders and the debt- Like:
holders) t *OnPX PG BNPVOU SFDFJWFE BU UIF CFHJOOJOH
t 0VUnPX PG QBZNFOU PG JOUFSFTU EJWJEFOE
redemption amount etc.
t *OnPX PG UBY CFOFmU PO JOUFSFTU PS 0VUnPX
of payment of dividend tax.
6LJQLÀFDQFHRI&RVWRI&DSLWDO
THEREAFTER, use trial & error method to arrive at a rate
where present value of outflows is equal to present value of
inflows which is basically IRR.
Evaluation of investment options
Financing Decision Cost of LONG-TERM DEBT (Kd)
t %P not confers ownership to the providers

of finance.
Designing of optimum Long-term t %FCU QSPWJEFST EP not participate in the
credit policy Debt affairs of the company.
t ͳFZ get charge on the profit before taxes in
the form of interest
Determination of Cost of Capital Cost of Irredeemable Debt

Cost of long
term Debt
Cost is not the amount which the company plans to pay or Cost of Redeemable Debt
actually pays, rather it is the expectation of stakeholders
“Every problem is a gift—without problems we would not grow.”

- Anthony Robbins
© ICAI BOS(A) 8
Cost of Irredeemable Debentures STEPS TO CALCULATE RELEVANT CASH FLOWS
Kd =
Step-1: Identify the cash flows.
Where,
Kd = Cost of debt after tax Step-2: Calculate NPVs of cash
I = Annual interest payment flows as identified above using two
NP = Net proceeds of debentures* (new debentures) discount rates.
or Current market price (existing debentures)
t = Tax rate
*Net proceeds means issue price less issue expenses or floatation cost Step-3: Calculate IRR
Cost of Redeemable Debentures Step-1: Identify the cash flows.

The relevant cash flows are as follows:
:FBS Cash flows

Using Approximation method 0 Net proceeds in case of new issue/ Current
market price in case of existing debt (NP or P0)
1 to n Interest net of tax [I(1-t)]
#
Kd =
n Redemption value (RV)
Step-2: Calculate NPVs of cash flows as identified above using two

Where, discount rates (guessing) to get each a positive NPV (lower rate) and
I = Interest payment a negative NPV (higher rate).
NP = Net proceeds (new) or Current market price
(existing) Step-3: Calculate IRR.
RV = Redemption value of debentures NPVL
t = Tax rate applicable to the company IRR = L + (H-L)
NPVL-NPVH
n = Remaining life of debentures
#
This formula is used where only interest on debt is tax deductible. Sometime, [Here, H and L stands for higher discount rate and lower discount
debts are issued at discount and/ or redeemed at a premium. If such discount rate respectively. It is to be noted that higher the difference between
on issue and/ or premium on redemption are tax deductible, the following H and L, lower the accuracy of answer.]
formula can be used:
Example: A company issued 10,000, 10% debentures of R100 each

on 01.04.2021 to be matured on 01.04.2026. The company wants to
know the current cost of its existing debt if the market price of the
Kd = debentures is R80, considering 35% tax rate.
Step-1: Identification of relevant cash flows
:FBS Cash flows
0 Current market price (P0) = R80
Using Present value method [Yield to
maturity (YTM) approach] 1 to 5 Interest net of tax [I(1-t)] = 10% of R100 (1-0.35)
= R6.5
5 Redemption value (RV) = Face value i.e. R100
Step- 2: Calculation of NPVs at two discount rates

Year Cash Discount Present Discount Present
:5. "O JOUFSOBM SBUF PG SFUVSO BU XIJDI flows factor @ Value (R) factor @ Value (R)
current price of a debt equals to the (R) 10% (L) 15% (H)
present value of all cash-flows. 0 80 1.000 (80.00) 1.000 (80.00)
1 to 6.5 3.791 24.64 3.352 21.79
5
5 100 0.621 62.10 0.497 49.70
NPV +6.74 -8.51
Step- 3: Calculation of IRR
NPVL 6.74
IRR = L + (H-L) = 10% + (15%-10%)=12.21%
NPVL-NPVH 6.74-(-8.51)
© ICAI BOS(A) 9
Amortisation of Bond Cost of Redeemable Preference Shares
In such a situation,
A bond may be the principal will Kp =
amortised every go down with
year i.e., principal annual payments Cash flows will be
is repaid every and interest will uneven. Where,
year rather than at be computed on
maturity. the outstanding PD = Annual preference dividend
amount. RV = Redemption value of preference shares
NP = Net proceeds from issue of preference shares
n = Remaining life of preference shares
Value of Bond VB =
Cost of EQUITY SHARE CAPITAL (Ke)
VB = t *U JT UIF expectation of equity shareholders.

Equity t Value is performance divided by expectations.
Share t Performance means amount paid by
Capital company to investors, like interest, dividend,
redemption price etc. which is uncertain in
Cost of Convertible Debentures case of equity.
Option to either get the debentures redeemed into

cash or get specified numbers of company’s shares. Dividend Price Approach
While determining redemption value, it is assumed Earning Price Approach

that all the debenture holders will choose the option
which has the higher value i.e. beneficial to the .FUIPET UP
holder. compute Cost
Growth Approach
of Equity
Share Capital
3FBMJ[FE :JFME "QQSPBDI

Cost of PREFERENCE SHARE CAPITAL (Kp)
Capital Asset Pricing
t 1BJE dividend at a specified rate on face .PEFM $"1.
value.
Preference t %JWJEFOE USFBUFE BT BO appropriation of after-
Share
Capital tax profit. Dividend Price Approach
t %PFT not reduce the tax liability of the
company. This approach assumes that the dividend per share is expected
to remain constant forever.
Cost of Irredeemable
Preference Share Capital Ke =
Cost of
Preference
Share Capital Cost of Redeemable Where,
Preference Share Capital D = Expected dividend (also written as D1)
P0 = Market price of equity (ex- dividend)
Earnings Price Approach

Cost of Irredeemable Preference Shares
This approach co-relate the earnings of the company
Kp = with the market price of its share.
Ke =
Where,
PD = Annual preference dividend
Where,
P0 = Net proceeds $ from issue of preference shares
E = Current earnings per share
P = Market price per share
$
Net proceeds means issue price less issue expenses or floatation cost
© ICAI BOS(A) 10
Growth Approach or Gordon’s Model Example: The current dividend (D0) is R16.10 and the dividend 5
year ago was R10. The growth rate in the dividend can found out
as follows:
Rate of dividend growth remains constant. Earnings,
dividends and equity share price all grow at the same rate. Step-I: Divide D0 by Dn i.e. R16.10 ÷ R10 = 1.61
Step-II: Find out the result found at Step-I i.e. 1.61 in corresponding
year’s row i.e. 5th year.
Ke = Step-III: See the interest rate for the corresponding column which
is 10%. Therefore, growth rate (g) is 10%.
Where, JJ (PSEPOT (SPXUI .PEFM

D1 = [D0 (1+ g)] i.e. next expected dividend
P0 = Current Market price per share This model attempts to derive a future growth rate.
g = Constant Growth Rate of Dividend
In case of newly issued equity shares where floatation cost is Growth (g) = b × r
incurred,
Where,
b = earnings retention rate*
Ke = r = rate of return on fund invested
*Proportion of earnings available to equity shareholders which is not
Where, distributed as dividend.
F = Flotation cost per share
Example: A company has paid dividend of R1 per share (of face Realised Yield Approach
value of R10 each) last year and it is expected to grow @ 10% every
year. The market price of share is R55. Average rate of return realised in the past few years historically
regarded as AFYQFDUFE SFUVSO in future.
Ke = = = 0.12 or 12% Computes cost of equity based on the past records of dividends
actually realised.
Example: Mr. X had purchased a share of ABC Limited for R1,000

Estimation of Growth Rate and received dividend for five years @ 10%. At the end of the fifth
year, he sold the share for R1,128. The cost of equity as per realised
yield approach would be as follows:
It would be the discount rate which equates the present value of
Estimation of Growth
Rate the dividends received in the past five years plus the present value
of sale price of R1,128 to the purchase price of R1,000.
The discount rate which equalises these two is 12% (approx..)
Year Dividend Sale Discount Present
(R) Proceeds (R) Factor @ Value (R)
12%
"WFSBHF .FUIPE (PSEPOT (SPXUI
.PEFM 1 100 - 0.893 89.3
2 100 - 0.797 79.7
3 100 - 0.712 71.2
J "WFSBHF .FUIPE
4 100 - 0.636 63.6
Current Dividend (D0) =Dn(1+g)n 5 100 - 0.567 56.7
or
Growth rate = 6 Beginning 1,128 0.567 639.576
1,000.076
Where,
D0 = Current dividend,
Dn = Dividend in n years ago
Capital Asset Pricing Model (CAPM)
Other ways: Approach
t %JWJEF %0 by Dn, find out the result, then refer the FVIF %JWFSTJmBCMF PS 6OTZTUFNBUJD SJTL SFMBUFE XJUI UIF DPNQBOZT
Step-I table. performance) can be eliminated by an investor through
diversification.
t 'JOE PVU UIF SFTVMU GPVOE BU 4UFQ* JO DPSSFTQPOEJOH ZFBST
Step-II row.
However, non-diversifiable or systematic risk (macro-economic

t 4FF UIF JOUFSFTU SBUF GPS UIF DPSSFTQPOEJOH DPMVNO ͳJT JT or market specific risk) is the risk which cannot be eliminated;
Step-III the growth rate. thus, a business should be concerned as per CAPM method, solely
with non-diversifiable risk.
© ICAI BOS(A) 11
$PTUPG&RVJUZVOEFS$"1.3JTLGSFFSBUF 3JTLQSFNJVN Weighted Average Cost Of Capital (WACC)

Required
return
t " DPNQBOZ NBLFT B NJY PG WBSJPVT TPVSDFT PG
finance.
SML WACC
t Cost of total capital will be equal to WA$C of
Ke=Rf + (Rm-Rf) E individual sources of finance.
Risk premium
(Rm - Rf) E
Steps to calculate WACC:
Rf t Calculate the total capital from all the sources of

capital.
Step 1 t &H -POHUFSN EFCU DBQJUBM 1SFG 4IBSF $BQJUBM
Equity Share Capital + Retained Earnings
Risk (E) t Calculate the proportion (or %) of each source of

capital to the total capital.
Step 2 t <&RVJUZ 4IBSF $BQJUBM GPS FYBNQMF 5PUBM $BQJUBM BT
Ke= Rf + ß (Rm − Rf) calculated in Step1 above)]
Where,
t .VMUJQMZ the proportion as calculated in Step 2
Ke = Cost of equity capital
above with the respective cost of capital.
Rf = Risk free rate of return
Step 3 t ,e × Proportion (%) of equity share capital (for
ß = Beta coefficient (represents systematic risk)
example) calculated in Step 2 above)
Rm = Rate of return on market portfolio
(Rm – Rf) = Market risk premium
t Aggregate the cost of capital as calculated in Step 3
Risk Return relationship of various securities above. ͳJT JT UIF 8"$$.
Step 4 t ,e + Kd + Kp + Ks as calculated in Step 3 above)
Choice of Weights
Book Value (BV)
0QFSBUJPOBMMZ easy and .BSLFU 7BMVF .7

convenient.
Reserves such as share .PSF DPSSFDU and represent a firm’s
Example: The risk-free rate of return equals 10%. The company’s premium and retained capital structure.
beta equals 1.75 and the return on the market portfolio equals to profits are included in Preferable to use .7 weights for the
15%. Thus, the cost of equity capital of the company would be: the BV of equity. equity.
Ke = Rf + ß (Rm − Rf)
Reserves such as share premium and
Ke = 0.10 + 1.75 (0.15 − 0.10) = 0.1875 or 18.75% retained profits are ignored as they are
in effect incorporated into the value of
equity.
Cost of Retained Earnings (Kr) /P TFQBSBUF .7 GPS SFUBJOFE FBSOJOHT
Retained t *U JT UIF opportunity cost of dividends Example: The capital structure of the company is as under:
Earnings foregone by shareholders.
(R)
10% Debentures with 10 years maturity (R100 per 5,00,000
Formulas used for calculation of cost of retained earnings are debenture)
same as formulas used for calculation of cost of equity. 5% Preference shares with 10 years maturity (R100 5,00,000
per share)
D
Dividend Price method: Kr = Equity shares (R10 per share) 10,00,000
P
20,00,000
EPS
Earning Price method: Kr = The market prices of these securities are:
P
D1 Debentures R105 per debenture
Growth method: Kr = +g Preference shares R110 per preference share
P0
Equity shares R24 per equity share
For Ke : P = net proceeds realized i.e. issue price less floatation After tax Cost of Capital: Equity = 10%, Debt = 6.89% and
cost. But for Kr : P = current market price. However, sometimes Preference shares = 4.08%
issue price may also be used ignoring Floatation cost.
© ICAI BOS(A) 12
ͳF 8"$$ BQQMZJOH #7 BOE .7 XPVME CF BT GPMMPXT
(a) Calculation of WACC using BV weights

Source of Book Weights After tax WACC
capital Value cost of (Ko)
capital
(R) (a) (b) (c) =
(a)×(b)
10% 5,00,000 0.25 0.0689 0.01723
Debentures
5% 5,00,000 0.25 0.0408 0.0102
Preference
shares
Equity shares 10,00,000 0.50 0.10 0.05000
20,00,000 1.00 0.07743
WACC (Ko PS
C $BMDVMBUJPO PG 8"$$ VTJOH .7 XFJHIUT
Source of .BSLFU Weights After tax WACC
capital Value cost of (Ko)
capital
(R) (a) (b) (c) =
(a)×(b)
10% 5,25,000 0.151 0.0689 0.0104
Debentures
(R105× 5,000)
5% Preference 5,50,000 0.158 0.0408 0.0064
shares
(R110× 5,000)
Equity shares 24,00,000 0.691 0.10 0.0691
(R24×
1,00,000)
34,75,000 1.000
WACC (Ko PS
© ICAI BOS(A) 13
FINANCING DECISIONS-CAPITAL STRUCTURE

Chapter Overview 1HW,QFRPH 1, $SSURDFK
According to this approach, capital structure decision is relevant to the value of the firm.
Capital Structure
Decision An increase in financial leverage will lead to decline in the weighted average cost of capital
(WACC), while the value of the firm as well as market price of ordinary share will increase.
Conversely, a decrease in the leverage will cause an increase in the overall cost of capital
and a consequent decline in the value as well as market price of equity shares
Capital Structure Theories
Capital Structure
• Net Income (NI) Approach Decision
The value of the firm on the basis of Net Income Approach can be ascertained as follows:
• Traditional Approach
• Net Operating Income (NOI) Approach
• Modigliani- Miller (MM) Approach V = Market Value of Equity + Market Value of Debt
• Trade-off Theory EBIT- EPS Analysis
• Pecking Order Theory EBIT
Overall cost of capital =
Value of the Form
Capital Structure decision refers to deciding the forms of financing (which sources to be
tapped); their actual requirements (amount to be funded) and their relative proportions Traditional Approach
(mix) in total capitalisation.
This approach favours that as a result of financial leverage up to some point, cost of capital
Replacement comes down and value of firm increases. However, beyond that point, reverse trends
Capital Budgeting Decision Modernisation emerge. The principle implication of this approach is that the cost of capital is dependent
Expansion on the capital structure and there is an optimal capital structure which minimises cost
Diversification of capital.
Internal funds
Need to Raise Funds
Debt 1HW2SHUDWLQJ,QFRPH$SSURDFK 12,
External equity
Any change in the leverage will not lead to any change in the total value of the firm and
Capital Structure Decision the market price of shares, as the overall cost of capital is independent of the degree of
leverage. As a result, the division between debt and equity is irrelevant.
As per this approach, an increase in the use of debt which is apparently cheaper is offset
by an increase in the equity capitalisation rate. This happens because equity investors
Existing Capital Desired Debt seek higher compensation as they are opposed to greater risk due to the existence of fixed
Payout Policy
Structure Equity Mix return securities in the capital structure.
V= NOI
KO
Where,
Effect of Return Effect of Risk
V = Value of the firm
NOI = Net operating Income
Ko = Cost of Capital
Effect of Cost of
Capital 0RGLJOLDQL0LOOHU$SSURDFK 00
Optimum Cpital
Structure The NOI approach is definitional or co nceptual and la cks be havioral significance. It
does not provide operational justification for i rrelevance o f c apital s tructure. However,
Modigliani-Miller approach provides behavioral justification for constant overall cost
Value of the Firm of capital and therefore, total value of the firm. This approach indicates that the capital
structure is irrelevant because of the arbitrage process which will correct any imbalance
i.e. expectations will chanHe and a stage will be reached where arbitrage is not possible.
Capital Structure Theories

The following approaches explain the relationship between cost of capital, capital Modigliani-Miller (MM)
Approach
structure and value of the firm
Net Income (NI)

Approach
MM Approach MM Approach-
Capital Structure -1958: without
Relevance Theory 1963: with tax
tax
Traditional
Approach
Capital Structure
Theories
Net Operating 7KH7UDGHRII7KHRU\
Income (NOI)
Approach
Capital Structure The trade-off theory of capital structure refers to the idea that a company chooses
Irrelevance Theory how much debt finance and how much equity finance to use by balancing the costs
Modigliani and and benefits.
Miller (MM)
Approach
© ICAI BOS(A) 14
(%,7(36$QDO\VLV
Maximum
Value of firm The basic objective of financial management is to design an
appropriate capital structure which can provide the highest
earnings per share (EPS) over the company’s expected range of
earnings before interest and taxes (EBIT).
Costs of EPS measures a company’s performance for the shareholders.

finanacial The level of EBIT varies from year to year and represents the
distress success of a company’s operations.
PV of interest
tax shield However, The EPS criterion ignores the risk dimension as well
as it is more of a performance measure.
Value of (EBIT-I1) (1-t) (EBIT-I2) (1-t)

=
unlevered
E1 E2
Firm
Where,
EBIT = Indifference point

Optimal Debt E1 = Number of equity shares in Alternative 1
Level E2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
Debt 12 = Interest charges in Alternative 2
level T = Tax-rate
Alternative 1 = All equity finance
Alternative 2 = Debt-equity finance
3HFNLQJRUGHUWKHRU\
This theory is based on Asymmetric information, which

• It is a situation where a firm has
refers to a situation in which different parties have different
more capital than it needs or in
information.
Over- Capitalisation other words assets are worth less
than its issued share capital, and
earnings are insufficient to pay
dividend and interest.
• Debt
• Equity
• It is just reverse of over-

Trade- off capitalisation. It is a state, when
Under Capitalisation its actual capitalisation is lower
Theory
than its proper capitalisation as
warranted by its earning capacity.
Pecking Order Theory
• Internal Financing
• Debt
• Equity
© ICAI BOS(A) 15
FINANCING DECISIONS- LEVERAGES

Chapter Overview Chart Showing Operating Leverage,
)LQDQFLDO/HYHUDJHDQG&RPELQHG/HYHUDJH
Business and Financial
Risk
Profitability Statement
Analysis of Leverage Sales xxx
Types of Leverage Less: Variable Cost (xxx)
(i) Operating Leverage
(ii) Financial Leverages Contribution xxx Operating
(iii) Combined Leverages Leverage
Less: Fixed Cost (xxx)
Operating Profit/ EBIT xxx Combined
In financial analysis, leverage represents the influence of one Leverage
Financial
financial variable over some other related financial variable. These Less: Interest (xxx) Leverage
financial variables may be costs, output, sales revenue, Earnings
Before Interest and Tax (EBIT), Earning per share (EPS) etc. Earnings Before Tax xxx
(EBT)
Less: Tax (xxx)
Business Risk and Financial Risk
Profit After Tax (PAT) xxx
Risk facing the common shareholders is of two types, namely Less: Pref. Dividend (if (xxx)
business risk and financial risk. Therefore, the risk faced by any)
common shareholders is a function of these two risks, i.e.
(Business Risk, Financial Risk). Net Earnings available xxx
to equity shareholders/
PAT
No. Equity shares (N)
Earnings per Share (EPS)
Business Risk Financial Risk = (PAT ÷ N)
• It refers to the risk • It refers to the additional

associated with the firm’s risk placed on the firm’s Operating Leverage
operations. It is the shareholders as a result of
uncertainty about the debt use i.e. the additional
future operating income risk a shareholder bears Operating leverage (OL) maybe defined as the employment of an
(EBIT), i.e. how well can when a company uses asset with a fixed cost in the hope that sufficient revenue will be
the operating incomes be debt in addition to equity generated to cover all the fixed and variable costs.
predicted? financing.
Contribution
Operating leverage =
EBIT
7\SHVRI/HYHUDJH
% change in EBIT
There are three commonly used measures of leverage in financial Degree of Operating Leverage (DOL) =
% change in Sales
analysis. These are
Positive and Negative Operating Leverage
Combined Operating Leverage

Leverage and EBIT
Negative Infinite/ Undefined Positive

Financial
Leverage
Operating at Operating at a
Lower than Operating at break- Higher Level than
break-even point even point break-even point
Operating
Leverage
EBIT= -Ve EBIT = 0 EBIT = +Ve
© ICAI BOS(A) 16
Financial Leverage &RPELQHG/HYHUDJH
Financial leverage (FL) maybe defined as ‘the use of funds with a • It maybe defined as the potential use of fixed
fixed cost in order to increase earnings per share.’ In other words, Combined costs, both operating and financial, which
it is the use of company funds on which it pays a limited return. leverage magnifies the effect of sales volume change
on the earning per share of the firm.
EBIT
Financial leverage = Degree of Combined Leverage = DOL X DFL
EBT
% change in EPS % change in EPS

Degree of Financial Leverage (DFL) = Degree of Combined Leverage (DCL) =
% change in EBIT % change in Sales
Positive and Negative Financial Leverage:
Financial Leverage
Financial Leverage as Financial Leverage as a

‘Trading on Equity’ ‘Double edged Sword’
Positive Infinite/ Undefined Negative • Financial leverage indicates • On one hand when cost of
the use of funds with fixed ‘fixed cost fund’ is less than
cost like long term debts the return on investment
and preference share capital financial leverage will help
EBIT level is more Operating at EBIT level is less along with equity share to increase return on equity
than Fixed Financial Financial break than Fixed capital which is known as and EPS. However, when
Charge even point Financial Charge trading on equity. When cost of debt is more than
the quantity of fixed cost the return it will affect
fund is relatively high return of equity and EPS
EPS: will change in comparison to equity unfavourably. This is why
in the same No Profit no Loss EPS : Negative capital, it is said that the financial leverage is known
direction as EBIT firm is ‘’trading on equity”. as “double edged sword”.
INVESTMENT DECISIONS
Chapter Overview
Investment Decisions
• Identification of investment projects that are
strategic to business overall objectives;
Types of Investment Capital Budgeting Techniques: Capital • Estimating and evaluating post-tax
Decisions • Pay-back period Budgeting incremental cash flows for each of the
• involves investment proposals; and
Accounting RaUe of Return (ARR)
Basic Principles for • Net Present Value (NPV) • Selection of an investment proposal that
measuring Project maximizes the return to the investors
• Profitability Index (NI)
Cash Flows
• Internal Rate of Return (IRR)
Capital Budgeting in • Modified Internal Rate of Return
special cases (MIRR)
• Discounted Pay-back period
Capital Budgeting Process
Planning Evaluation Selection Implementation Control Review
© ICAI BOS(A) 17
Chapter Overview 6. Less: Fixed Cost

(a) Fixed Cash Cost xxx
Generally, capital investment decisions are classified in two (b) Depreciation xxx
ways. One way is to classify them on the basis of firm’s existence.
Another way is to classify them on the basis of decision situation. 7. Earning Before Tax [6 - 7] xxx
8. Less: Tax xxx
9. Earning After Tax [7-8] xxx
Replacement and
Types of Capital Investment Decisions
Modernisation decisions 10. Add: Depreciation xxx
On the basis 11. Cash Inflow After Tax (CFAT) [9 +10] xxx
of firm’s existence Expansion decisions
Diversification decisions
Capital Budgeting Techniques
In order to maximise the return to the shareholders of a company,

MutualMy exclusive decisions it is important that the best or most profitable investment
projects are selected as the results for making a bad long-term
investment decision can be both financially and strategically
On the basis of devastating, particular care needs to be taken with investment
decision situation Accept-Reject decisions
project selection and evaluation.
Contingent decisions
There are a number of techniques available for appraisal of
investment proposals and can be classified as presented below:
(VWLPDWLRQRI3URMHFW&DVK)ORZV
Capital Budgeting analysis considers only incremental cash flows Payback Period
from an investment likely to result due to acceptance of any
project. Therefore, one of the most important tasks in capital
budgeting is estimating future cash flows for a project. Traditional or
Non Discounting Accounting Rate of
Return (ARR)
Calculating Cash Flows
Net Present Value
Particulars No Depreciation is Depreciation is (NPV)
Charged Charged Capital
Budgeting
(RCrore) (RCrore) Techniques Profitability
Total Sales *** *** Index (PI)
Less: Cost of Goods *** *** Time adjusted or

Sold Discounted Cash Internal Rate of
Flows Return (IRR)
*** ***
Less: Depreciation - *** Modified Internal
Rate of Return
Profit before tax *** *** (MIRR)
Tax @ 30% *** *** Discounted
Profit after Tax *** *** Payback Period
Add: Depreciation* - ***

Cash Flow *** ***
3D\EDFN3HULRG
* Being non-cash expenditure, depreciation has been added back
while calculating the cash flow. The payback period of an investment is the length of time required
for the cumulative total net cash flows from the investment to
Statement showing the calculation of Cash equal the total initial cash outlay.
,QÁRZDIWHU7D[ &)$7
Total initial capital investment
Sl. no. (R) Payback period =
Annual expected after-tax net cash flow
1 Total Sales Units xxx
2 Selling Price per unit xxx $FFRXQWLQJ %RRN 5DWHRI5HWXUQ $55
3. Total Sales [1 × 2] xxx
4. Less: Variable Cost xxx The accounting rate of return of an investment measures the
average annual net income of the project (incremental income) as
5. Contribution [3 - 4] xxx a percentage of the investment.
© ICAI BOS(A) 18
Average annual net income Sum of discounted cash inflows

Accounting rate of return = x 100 Profitability Index (PI) =
Investment Initial cash outlay or Total discounted
cash outflow (as the case maybe)
1HW3UHVHQW9DOXH7HFKQLTXH 139
The net present value technique is a discounted cash flow method Decision Rule
that considers the time value of money in evaluating capital
investments.
If PI ≥ 1 Accept the Proposal
If PI ≤ 1 Reject the Proposal
n Ct
NPV = ¦ -I In case of mutually exclusive projects; project with higher PI should
(1+ k) t
t =1
be selected.
Where,
C = Cash flow of various years
K = discount rate
N = Life of the project
,QWHUQDO5DWHRI5HWXUQ0HWKRG ,55
I = Investment
Internal rate of return for an investment proposal is the discount
rate that equates the present value of the expected net cash flows
with the initial cash outflow.
3URÀWDELOLW\,QGH['HVLUDELOLW\)DFWRU
3UHVHQW9DOXH,QGH[0HWKRG 3, NPV at LR
LR + x (HR-LR)
NPV at LR- NPV at HR
In comparing alternative proposal of comparing, we have to
compare a number of proposals each involving different amounts Where,
of cash inflows. One of the methods of comparing such proposals LR = Lower Rate
is to work out what is known as the ‘Desirability factor’, or
‘Profitability index’ or ‘Present Value Index Method’. HR = Higher Rate
6XPPDU\RI'HFLVLRQFULWHULDRI&DSLWDO
Budgeting techniques
Techniques For Independent Project For Mutually Exclusive Projects
Non- Pay Back (i) When Payback period ≤ Maximum Project with least Payback period should be
Discounted Acceptable Payback period: Accepted selected
(ii) When Payback period ≥ Maximum

Acceptable Payback period: Rejected
Accounting (i) When ARR ≥ Minimum Acceptable Rate Project with the maximum ARR should be
Rate of of Return: Accepted selected.
Return (ARR) (ii) When ARR ≤ Minimum Acceptable Rate
of Return: Rejected
Discounted Net Present (i) When NPV > 0: Accepted Project with the highest positive NPV should
Value (NPV) (ii) When NPV < 0: Rejected be selected
Profitability (i) When PI > 1: Accepted When Net Present Value is same, project with
Index(PI) (ii) When PI < 1: Rejected Highest PI should be selected
Internal Rate (i) When IRR > K: Accepted Project with the maximum IRR should be
of Return (ii) When IRR < K: Rejected selected
(IRR)
© ICAI BOS(A) 19
RISK ANALYSIS IN CAPITAL BUDGETING
Points of Discussion Techniques of Risk Analysis
Risk and Uncertainty in capital budgeting Probability
Statistical Variance or Standard

Sources of risks Deviation
Techniques
Coefficient of
Consideration of risks and uncertainities in capital Variation
budgeting
Techniques
of Risk Risk-adjusted
Analysis Conventional discount rate
Techniques used for Analysis of Risks techniques
in Capital
Budgeting Certainty equivalents
Advantages and Limitations of Risk Analysis

Techniques Sensitivity analysis
Others
techniques
Scenario analysis
Risk & Uncertainty and its Measurement Statistical

• PROBABILITY
Technique:
• Risk is the variability of possible

outcomes from the expected one. Probability is a measure about the chances
• Uncertainty is a situation when
probability of cash flows are unknown that an event will occur.
RISK • Risk is measured by the Variance
or Standard Deviation (SD). SD is a
commonly used tool which measures the Event certain to occur
dispersion of possible outcomes around
the mean. • Probability = 1
No Chance of happening an event

• Probability = 0
Sources of Risk Expected cash flows are assigned a probability factor (Pi)
and net cash flows are calculated.
n
Project- Company- Industry- E (R)/ENCF = ∑i=1NCFi×Pi

Market risk Where,
specific risk specific risk specific risk
E (R)/ENCF = Expected Cash flows
Pi = Probability of Cash flow
Risk due to NCFi = Cash flows
Competition International
Economic
risk risk
conditions
“Risk-taking is an inevitable ingredient in investing, and in life, but never take a risk you do
not have to take.”
- Peter Bernstein
© ICAI BOS(A) 20
Example:
The investment
Expectation Cash Flows (R) Probability Expected cash flow (2×3) It enables to For selection
with lower ratio
calculate the between two
(2) (3) (R) of standard
risk borne for projects, a project
deviation
Best guess 3,00,000 0.3 3,00,000×0.3 = 90,000 every unit of which has a
to expected return,
estimated return lower Coefficient
High guess 2,00,000 0.6 2,00,000×0.6 =1,20,000 provides a better
from a particular of Variation is
risk – return trade
Low guess 1,20,000
0.1 1,20,000×0.1 =12,000 investment. selected.
off.
Expected Net cash flow (ENCF) 2,22,000
Statistical Conventional
• VARIANCE
Technique: Technique: • RISK ADJUSTED DISCOUNT RATE (RADR)
It measures the degree of dispersion between numbers A risk adjusted discount rate is a sum of risk
in a data set from its average. free rate and risk premium.
Variance is calculated as below:
+
Risks
Risk free Risk
=
n 2
V2 ¦
j 1
NCFJ ENCF Pj
rate premium
adjusted
discount rate
Where, σ2 = variance in net cash flow;
P = probability and ENCF = expected net cash flow.
The rate of return on Investments that

Risk free bear no risk. For e.g., Government
Variance measures the uncertainty of a value from its average. rate securities yield a return of 6 % and
Thus, variance helps an organization to understand the level of bear no risk. In such case, 6 % is the
risk it might face on investing in a project. risk-free rate.
A variance value of ZERO would indicate that the cash flows that
would be generated over the life of the project would be same.
The rate of return over and above the
risk-free rate, expected by the Investors
Risk as a reward for bearing extra risk.
A LARGE variance indicates that there will be a large variability
Premium For high risk project, the risk premium
between the cash flows of the different years.
will be high and for low risk projects,
the risk premium would be lower.
A SMALL variance would indicate that the cash flows would be
somewhat stable throughout the life of the project.
The required rate of return includes compensation for delay in

consumption plus compensation for inflation equal to risk free
rate of return, plus compensation for any kind of risk taken.
Statistical
• THE COEFFICIENT OF VARIATION
Technique:
If the risk is higher than risk involved in a similar kind of project,
discount rate is adjusted upward in order to compensate this
The Coefficient of Variation calculates the risk borne additional risk borne.
for every percent of expected return.
It is calculated as below:
It is calculated as below:
n
NCF
NPV = ¦ t
-I
Standard Deviation t=0 1+k
Coefficient of variation = Expected Return / Expected Cash Flow
Where, NCFt = Net cash flow; K = Risk adjusted discount
rate; I = Initial Investment
© ICAI BOS(A) 21
Advantages And Limitations Of Risk- Certainty Equivalent Coefficients transform

Adjusted Discount Rate expected values of uncertain flows into their
Certainty Equivalents.
• It is easy to understand.
ADVANTAGES • It incorporates risk premium in the
of RADR Calculation is made as below:
discounting factor.
n αt x NCFt
NPV = ∑t=1 —I
(1+k)t
Where,
• Difficulty in finding risk premium and NCFt = the forecasts of net cash flow for year ‘t’ without
risk-adjusted discount rate. risk-adjustment
LIMITATIONS
of RADR • Though NPV can be calculated but it αt = the risk-adjustment factor or the certainly
is not possible to calculate Standard equivalent coefficient.
Deviation of a given project. Kf = risk-free rate assumed to be constant for all
periods.
I = amount of initial Investment.
Conventional
• CERTAINTY EQUIVALENT (CE)
Technique:
Certainty In industrial
Equivalent situation,
The value of Coefficient 1 cash flows
To deal with risks in a capital budgeting, risky future cash Certainty indicates that are generally
flows are expressed in terms of the certain cashflows as Equivalent the cash flow uncertain and
their equivalent. Decision maker would be indifferent Coefficient lies is certain or managements
between the risky amount and the (lower) riskless amount between 0 & 1. managements are usually risk
considered to be its equivalent. are risk neutral. averse.
STEPS in the Certainty Equivalent (CE)

Method
Advantages and Disadvantages of CE
• Remove risks by substituting equivalent certain Method
cash flows from risky cash flows
Step-1 • Multiply each risky cash flow by the appropriate
αt value (CE coefficient)
• Simple and easy to understand and apply.

ADVANTAGES • It can easily be calculated for different
of CE Method risk levels applicable to different cash
• Discounted value of cash flow is obtained by flows.
Step-2 applying risk less rate of interest
• Capital budgeting methods are applied except

in case of IRR method
Step-3 • IRR is compared with risk free rate of interest • CEs are subjective and vary as per each
rather than the firm’s required rate of return individual’s estimate.
• CEs are decided by the management
DISADVANTAGES based on their perception of risk.
of CE Method
However, the risk perception of the
shareholders who are the money
CE Coefficient (αt) is calculated as below:
lenders for the project is ignored.
Certain cash flow

CE Coefficient (αt) = Risky or expected cash flow t
© ICAI BOS(A) 22
Risk-Adjusted Discount Rate Vs. Certainty- Steps involved in Sensitivity Analysis

Equivalent
Finding variables, which have an influence on
the NPV (or IRR) of the project
Step-1
2. Each year's 3. Despite its
Certainty soundness, it is
Equivalent not preferable
Coefficient is like Risk Adjusted Establishing mathematical relationship between
based on level of Discount Rate the variables.
risk impacting its Method. Step-2
cash flow.
1. Certainty Analysis the effect of the change in each of the

4. It is difficult variables on the NPV (or IRR) of the project.
Equivalent to specify
Method is Risk-adjusted Step-3
Discount a series of
superior to Risk Certainty
Adjusted Discount Rate
Vs. Equivalent
Rate Method as it Coefficients
does not assume Certainty-
Equivalent but simple to
that risk increases
with time at
adjust discount Advantages and Disadvantages of Sensitivity
constant rate.
rates. Analysis
• Critical Issues: This analysis identifies

ADVANTAGES critical factors that impinge on a project’s
Other of Sensitivity
Analysis success or failure.
• SENSITIVITY ANALYSIS
Technique: • Simplicity: It is a simple technique.
A modeling technique used in Capital • Assumption of Independence: This

Sensitivity Budgeting decisions to study the analysis assumes that all variables are
Analysis impact of changes in the variables on independent i.e. they are not related to
DISADVANTAGES
the outcome of the project. of Sensitivity each other, which is unlikely in real life.
Analysis • Ignore probability: This analysis does
not look to the probability of changes in
the variables.
As per CIMA terminology,” A modeling and risk

assessment procedure in which changes are made to
significant variables in order to determine the effect Other
of these changes on the planned outcome. Particular Technique: • SCENARIO ANALYSIS
attention is thereafter paid to variables identifies as being
of special significance”
This analysis brings in the

Scenario probabilities of changes in key
Analysis variables and also allows us to change
more than one variable at a time.
In Sensitivity It is a way of
Analysis, the finding impact
The more
project outcome in the project’s Although sensitivity analysis is probably the most widely
sensitive is the
is studied after NPV (or IRR) for used risk analysis technique, it does have limitations.
NPV, the more
taking into a given change Therefore, we need to extend sensitivity analysis to deal
critical is the
change in only in one of the with the probability distributions of the inputs.
variable.
one variable. variables.
In addition, it would be useful to vary more than one
variable at a time so we could see the combined effects of
changes in the variables.
Scenario analysis provides answer to these situations of
extensions.
© ICAI BOS(A) 23
Examining Risk of Investment through Scenario Analysis
In a nutshell Scenario
Then, go for worst Alternatively scenarios
Scenario analysis analysis examine the
case scenario (low unit analysis is possible
begins with base case risk of investment, to
sales, low sale price, where some factors
or most likely set of analyse the impact of
high variable cost and are changed positively
values for the input alternative combinations
so on) and best case and some factors are
variables. of variables, on the
scenario. changed negatively.
project’s NPV (or IRR).
Sensitivity Analysis Vs. Scenario Analysis
SENSITIVITY analysis calculates the impact of the change of a single

input variable on the outcome of the project viz., NPV or IRR. The
sensitivity analysis thus enables to identify that single critical variable
that can impact the outcome in a huge way and the range of outcomes
of the project given the change in the input variable.
Sensitivity Analysis
Vs
Scenario Analysis
SCENARIO analysis, on the other hand, is based on a scenario. The
scenario may be recession or a boom wherein depending on the
scenario, all input variables change. Scenario Analysis calculates the
outcome of the project considering this scenario where the variables
have changed simultaneously.
DIVIDEND DECISIONS
Points of Discussion 6LJQLÀFDQFHRI'LYLGHQGSROLF\
Meaning of Dividend and its significance Long Term Financing Decision:
Whether to retain or
Forms of Dividend distribute the profit forms
Equity can be raised
externally through issue the basis of the Dividend
of equity shares or can decision. Since payment of
be generated internally cash dividend reduces the
Determinants of Dividend Decisions through retained earnings. amount of funds necessary
But retained earnings are to finance profitable
preferable because they do investment opportunities
not involve floatation costs. thereby restricting it to find
Theories of Dividend other avenues of finance.
Meaning, Advantages and Limitations of Stock split

The decision is based on the
following
0HDQLQJRI'LYLGHQGDQGLWV6LJQLÀFDQFH
Dividend is the part of profit after tax which is distributed to
the shareholders of the company.
Whether the Whether the return on

Distributed Dividend organization has such investment (ROI)
Profit after opportunities in hand will be higher than
tax to invest the amount of the expectations of
Retained profits, if retained? shareholders i.e. Ke?
Retained
Earnings
© ICAI BOS(A) 24
Wealth Maximization Decision: Advantages and Limitations of Stock

Dividend
Because of market imperfections and uncertainty,
shareholders give higher value to near dividends • Policy of paying fixed dividend per share and
than future dividends and capital gains. its continuation increases total cash dividend
of the shareholders in future.
ADVANTAGES • Conservation of cash for meeting profitable
Payment of dividends influences the market price of OF STOCK investment opportunities.
the share. Higher dividends increase value of shares DIVIDEND • Cash deficiency and restrictions imposed by
and low dividends decrease it.
lenders to pay cash dividend.
When the firm increases retained earnings,

shareholders' dividends decrease and consequently
market price is affected. • Stock dividend does not affect the wealth of
shareholders and therefore it has no value for
LIMITATIONS them.
OF STOCK • Stock dividends are more costly to administer
Use of retained earnings to finance profitable DIVIDEND than cash dividend.
investments increases future earnings per share.
On the other hand, increase in dividends may cause the

firm to forego investment opportunities for lack of funds
and thereby decrease the future earnings per share. Determinants of Dividend Decisions
Availability of funds
Thus, management should develop a dividend policy
which divides net earnings into dividends and
retained earnings in an optimum way so as to achieve Cost of capital
the objective of wealth maximization for shareholders.
Capital structure
Stock price
Such policy will be influenced by investment
opportunities available to the firm and value of
dividends as against capital gains to shareholders. Investment opportunities in hand
Factors affecting
Dividend
Decision Internal rate of return
Forms of Dividend
Trend of industry
Forms of Expectation of shareholders

dividend
Legal constraints
Taxation
Cash Stock dividend
dividend (Bonus Shares) Practical Considerations in Dividend Policy
A discussion on internal financing ultimately turns to

When the company practical considerations which determine the dividend
policy of a company.
issues further
Cash here means shares to its existing
cash, cheque, warrant, shareholders without
demand draft, pay consideration, it is called The formulation of dividend policy depends upon
order or directly bonus shares. Such answers to the questions:
through Electronic shares are distributed
Clearing Service (ECS) proportionately thereby Whether there should be a Whether the company should
but not in kind. retaining proportionate stable pattern of dividends treat each dividend decision
ownership of the over the years. completely independent.
company.
© ICAI BOS(A) 25
Theories of Dividend
Theories of Dividend
Irrelevance
Theory Relevance Theory
Other Models
(Dividend is (Dividend is relevant)
ireevelant)
M.M. Walter's Gordon's Dividend Discount Graham & Dodd's Linter's

Approach Model Model Model (DDM) Model Model
Dividend's
• MODIGLIANI and
Advantages and Limitations of MM
Irrelevance MILLER (M.M) HYPOTHESIS Hypothesis
Theory
• This model is logically consistent.

• It provides a satisfactory framework on
According to MM hypothesis, market value of equity shares ADVANTAGES dividend policy with the concept of
of MM Arbitrage process.
depends solely on its earning power and is not influenced by Hypothesis
the manner in which its earnings are split between dividends
and retained earnings.
• Validity of various assumptions is
Market value of equity shares is not affected by dividend size. questionable.
LIMITATIONS • This model may not be valid under
of MM uncertainty.
Hypothesis
Assumptions of MM Hypothesis:
No taxes No Risk of Dividend's

Perfect Fixed
or no tax floatation or uncertainty relevance • WALTER'S MODEL
capital investment
discrimi- transaction does not Theory
markets policy
nation cost exist
As per Walter's Model, in the long run, share prices reflect

Price of shares is calculated as below:
only the present value of expected dividends. Retentions
P1 +D1 influence stock prices only through their effect on further
P0 = 1+K e dividends.
Where,
P0 = Price in the beginning of the period.
P1 = Price at the end of the period. As per Walter's Model, two factors which influence the
D1 = Dividend at the end of the period. market price of a share are (i) Dividend per share and
Ke = Cost of equity/ rate of capitalization/ discount rate. (ii) Relationship between IRR and Ke.
As per MM hypothesis, the value of firm will remain

unchanged due to dividend decision. The relationship between dividend and share price based on
Walter’s formula is shown below:
This can be computed with the help of the following
r
formula: D+ (E - D)
(n + ∆n) P1 - I + E Market Price (P) = Ke
Vf or nP0 = Ke
(1 + Ke )
Where, Where,
Vf = Value of firm in the beginning of the period P = Market Price of the share.
n = number of shares in the beginning of the period E = Earnings per share.
∆n = number of shares issued to raise the funds required D = Dividend per share.
I = Amount required for investment Ke = Cost of equity/ rate of capitalization/ discount rate.
E = total earnings during the period r = Internal rate of return/ return on investment
© ICAI BOS(A) 26
Assumptions of Walter's Model
All investment No taxes

‘r’ rate of No
proposals or no tax The
return & Perfect floatation
are financed discrimination firm has
‘Ke’ cost of capital or
through between perpetual
capital are markets. transaction
retained dividend and life.
constant. cost.
earnings only. capital gain.
Conclusion of Walter’s Model

• The formula does not consider all the factors
Company Condition Correlation between Optimum affecting dividend policy and share prices.
of r vs Ke Size of Dividend dividend payout • Determination of market capitalisation rate is
and Market Price of ratio LIMITATIONS difficult.
share of Walter’s • The formula ignores such factors as taxation,
Model various legal and contractual obligations,
Growth r > Ke Negative Zero
management policy and attitude towards
Constant r = Ke No correlation Every payout dividend policy and so on.
ratio is optimum
Decline r < Ke Positive 100%
Dividend's
• Company is able to invest/utilize the relevance • GORDON'S MODEL
Growth fund in a better manner. Shareholders Theory
Company: can accept low dividend because their
value of share would be higher.
According to Gordon’s model, when IRR is greater than

cost of capital, the price per share increases and dividend
pay-out decreases. On the other hand when IRR is lower
• Company is not in a position to cover than the cost of capital, the price per share decreases and
Decline the cost of capital; shareholders dividend pay-out increases.
would prefer a higher dividend to
Company: utilize their funds in more profitable
opportunities.
The following formula is used by Gordon to find out price
per share:
Advantages and Limitations of Walter’s
Model P0 =
E1(1-b)
Ke -br
• Simple to understand and easy to compute. Where,
• It can envisage different possible market P0 = Price per share
prices in different situations and considers
internal rate of return, market capitalisation E1 = Earnings per share
ADVANTAGES
of Walter’s rate and dividend payout ratio in the b = Retention ratio; (1 - b = Payout ratio)
Model determination of market value of shares. Ke = Cost of capital
r = IRR and br = Growth rate (g)
Assumptions of Gordon's Model
Investment
Retention proposals
Firm is an Growth
IRR will Ke will ratio (b), are financed
all equity rate (g =
remain remains once decide Ke > g through
firm i.e. no br) is also
constant. constant. upon, is retained
debt. constant.
constant. earnings
only.
© ICAI BOS(A) 27
Conclusion of Gordon’s Model
Company Condition of Optimum dividend payout Other • DIVIDEND DISCOUNT MODEL

ratio Models (DDM)
r vs Ke
Growth r > Ke Zero
Constant r = Ke There is no optimum ratio
It is a financial model that values shares at the discounted
Declining r < Ke 100% value of the future dividend payments. Under this model,
the price of a share will be traded is calculated by the PV
of all expected future dividend payment discounted by
The "Bird-in-Hand" Theory an appropriate risk- adjusted rate. The dividend discount
model price is the intrinsic value of the stock.
Myron Gordon revised his dividend model and considered the risk
and uncertainty in his model.
Intrinsic value Sum of PV of future cash flows

Bird-in-hand theory of
Gordon has two arguments
Intrinsic value Sum of PV of PV of Stock Sale

Dividends Price
Investors put a
Investors are premium on certain
D1 D2 Dn RVn
risk averse return and discount on Stock Intrinsic Value = + +.....+ +
(1+Ke)1 (1+Ke)2 (1+Ke)n (1+Ke)n
uncertain return
Gordon argues that what is available at present is preferable to what

may be available in the future. As investors are rational, they want Dividend Discount Model (Possible
to avoid risk and uncertainty. They would prefer to pay a higher situation)
price for shares on which current dividends are paid. Conversely,
they would discount the value of shares of a firm which postpones
dividends. The discount rate would vary with the retention rate.
Dividend Discount
Model
Relationship between Dividend and Share (Possible situation)
Price on the basis of Gordon's formula
ª D0 1+g º
Market price per share(P0) = « »
¬ Ke - g ¼
Where, Constant Variable
Zero Growth
Growth Growth
P0 = Market price per share (ex-dividend)
D0 = Current year dividend
g = Constant annual growth rate of dividends
Ke = Cost of equity capital (expected rate of return).
Zero growth rates: It assumes all dividend paid by a stock
remains same.
Advantages and Limitations of Gordon’s
Model
In this case the stock price would be equal to:
• A useful heuristic model that relates the
present stock price to the present value of its Annual dividend
Stock's intrinsic Value =
ADVANTAGES future cash flows. Requied rate of return
of Gordon’s • Easy to understand.
Model
D
i.e. P0 =
Ke
• Model depends on projections about company
growth rate and future capitalization rates Where,
of the remaining cash flows, which may be D = Annual dividend
LIMITATIONS difficult to calculate accurately. Ke = Cost of capital
of Gordon’s • The true intrinsic value of a stock is difficult
Model P0 = Current Market price of share
to determine realistically.
© ICAI BOS(A) 28
Constant Growth Rate (Gordon’s Growth Model): It assumes

Other
constant growth of dividend. • LINTER's MODEL
Models
The relationship between dividend and share price on the

basis of Gordon’s formula is:
Under Linter’s model, the current year’s dividend is dependent
D0 (1+ g) on current year’s earnings and last year’s dividend.
Market price per share (P) =
Ke - g
Where, Parameters
P = Market price per share (ex-dividend)
D0 = current year dividend The target The spread at which current
g = growth rate of dividends payout ratio dividends adjust to the target
Ke = cost of equity capital/ expected rate of return
The formula is given below:
Notes:
g = b×r D1 = D0 + [(EPS ×Target payout) - D0] × Af
b = proportion of retained earnings or (1- dividend Where,
payout ratio) D1 = Dividend in year 1
D0 = Dividend in year 0 (last year dividend)
Variable growth rate: Variable-growth rate models
EPS = Earnings per share
(multi-stage growth models) can take many forms, even Af = Adjustment factor or Speed of adjustment
assuming the growth rate is different for every year.
The following are the assumptions of Linter’s Model:
However, the most common form is one that assumes 3 different

rates of growth: an initial high rate of growth, a transition to More concern Dividend Managers are
slower growth, and lastly, a sustainable, steady rate of growth. Firm have on changes in changes follow reluctant to
a long term dividends than changes in affect dividend
dividend the absolute long run changes that
payout ratio. amounts of sustainable may have to
Basically, the constant-growth rate model is extended, with each dividends. earnings. be reversed.
phase of growth calculated using the constant-growth method,
but using 3 different growth rates of the 3 phases.
Criticism of Linter’s Model

The present values of each stage are added together CRITICISM of
to derive the intrinsic value of the stock. Linter’s Model
Adjustment factor is an arbitrary

Sometimes, even the capitalization rate, or the required rate of Does not offer a market number and not based on any
return, may be varied if changes in the rate are projected. price for the shares scientific criterion or method
Stock Splits
Other
Models • GRAHAM & DODD's MODEL Splitting one share into many,
Stock Splits say, one share of R500 into
5 shares of R100
The stock market places considerably more weight on Advantages and Limitations of Stock Splits
dividends than on retained earnings.
• Makes the share affordable to small investors.
• Number of shares may increase the number
The formula is given below: ADVANTAGES of shareholders.
of Stock Splits
§ E·
P = m¨D + ¸
© 3¹
• Additional expenditure need to be incurred
Where, on the process of stock split.
• Low share price may attract speculators or
P = Market price per share
LIMITATIONS short term investors, which are generally not
D = Dividend per share of Stock Splits preferred by any company.
E = Earnings per share
m = a multiplier
© ICAI BOS(A) 29
MANAGEMENT OF WORKING CAPITAL

Chapter Overview Receivables Higher Credit Evaluate Cash sales
period attract the credit provide
customers policy; use liquidity but
and increase the services fails to boost
Management of revenue of debt sales and
Working Capital management revenue
(factoring)
agencies.
Cash (Treasury) Pre- Reduces Cost-benefit Improves or
Determinants of Management: payment of uncertainty analysis maintains
Working Capital expenses and profitable required liquidity.
• Functions of Treasury
Department in inflationary
environment.
• Treasury Management
Estimation of Working • Cash Management Cash and Payables are Cash budgets Cash can be
Capital Models Cash honoured and other cash invested in
equivalents in time, management some other
improves the techniques can investment
goodwill and be used avenues
Working Capital helpful in
Cycles getting future
discounts.
Payables Capital can Evaluate the Payables are
Inventory and be used in credit policy honoured in
Management Expenses some other and related time, improves
investment cost. the goodwill
Receivable Management: avenues and helpful in
Payables Management • Factors determining getting future
Credit Policy discounts.
• Financing of Receivables
• Monitoring of Rece
Investment and Financing
Financing of Working
Capital
Working Capital: In accounting term working capital is the Investment in working

difference between the current assets and current liabilities. capital is concerned with
the level of investment in Financing decision
the current assets. concerned with the
Working Capital = Current Assets – Current Liabilities arrangement of funds to
finance the working capital.
6FRSHRI:RUNLQJ&DSLWDO0DQDJHPHQW
Approaches of Working Capital investment
Scope of Working Capital Management
Aggressive Moderate Conservative

Liquidity and Investment and
Profitability Financing
•Here investment in working capital is kept at

Aggressive minimal investment in current assets which means
Liquidity vs Profitability: The trade-off between the the entity does hold lower level of inventory, follow
components of working capital can be summarised as follows: strict credit policy, keeps less cash balance etc.
Component Advantages Trade-off Advantages •In this approach organisation use to invest
of Working of higher side (between of lower side high capital in current assets. Organisations use to
Conservative keep inventory level higher, follows liberal credit
Capital (Profitability) Profitability (Liquidity)
and Liquidity) policies, and cash balance as high as to meet any
current liabilities immediately.
Inventory Fewer Use Lower
stock- outs techniques inventory
increase the like EOQ, JIT requires less •This approach is in between the above two
profitability. etc. to carry capital but approaches. Under this approach a balance
optimum level endangered Moderate
between the risk and return is maintained to gain
of inventory. stock-out and more by using the funds in very efficient manner.
loss of goodwill.
© ICAI BOS(A) 30
7KHYDULRXVFRPSRQHQWVRI2SHUDWLQJ&\FOH
PD\EHFDOFXODWHGDVVKRZQEHORZ
(1) Raw Material Avereage stock of Raw material

=
A Storage Period Average Cost of Raw material
Level of current assets
Consumption per day

Conservative policy
(2) Work-in-Progress Avg Work-in-progress inventory
B holding period =
Average Cost of Production per day
Average policy
(3) Finished Average stock of finished goods
=
c Goods storage Average Cost of Goods Sold per
period day
Aggressive policy
(4) Receivables Average Receivables
(Debtors) =
collection period Average Credit Sales per day
Fixed asset level
Output (5) Credit period Average Payables
allowed by suppliers =
(Creditors) Average Credit Purchases
per day
Operating/ Working Capital Cycle: Working Capital cycle
indicates the length of time between a company’s paying for
materials, entering into stock and receiving the cash from sales
of finished goods. Estimation of Amount of Different Components
RI&XUUHQW$VVHWVDQG&XUUHQW/LDELOLWLHV
:RUNLQJ&DSLWDO&\FOH (i) Raw Materials Inventory:
Estimated Production (units)

× Estimated Cost per unit × Average
12 months / 365 days * raw material storage period
Cash
(ii) Work-in-Progress Inventory:

× Estimated WIP cost per unit ×
12 months / 365 days * Average W-I-P holding period
Receivables Raw Material Labour
Overhead (iii) Finished Goods:
× Estimated Cost of production per
12 months / 365 days * unit × Average storage period
(iv) Receivables (Debtors):
Estimated Credit Sales unit

×Cost of sales (excluding depreciation)
12 months / 365 days * per unit × Average collection period
Stock WIP
(v) Cash and Cash equivalents: Minimum desired Cash and Bank
balance to be maintained
(vi) Trade Payables (Creditors):

In the form of an equation, the operating cycle process can be
expressed as follows:
Estimated credit purchase × Credit period allowed by suppliers
12 months / 365 days *
Operating Cycle = R + W + F + D – C (vii) Direct Wages:

Estimated labour hours x wages
Where, rate per hour
×Average time lag in
12 months / 365 days * payment of wages
R = Raw material storage period
(viii) Overheads (other than depreciation and amortization):
W = Work-in-progress holding period
F = Finished goods storage period Estimated Overheads ×Average time lag in payment of
D = Receivables (Debtors) collection period. 12 months / 360 days * overheads
C = Credit period allowed by suppliers (Creditors).
*Number of days in a year may be taken as 365 or 360 days.
© ICAI BOS(A) 31
(VWLPDWLRQRI:RUNLQJ&DSLWDO5HTXLUHPHQWV (e) Expected Net .…….. ……….. ……… ……….

Profit before Tax
(a-b-c-d)
Amount Amount Amount
(f ) Less: Tax ……... ……….. ………. ………
I. Current Assets:
(g) Expected ..……. ……… ……… ………
Inventories: Profit after Tax
- Raw Materials --- B. Opportunity ..…… ……… ………. ………
Cost of
- Work-in-process --- Investments
- Finished goods --- --- in Receivables
locked up in
Receivables: Collection
Period
- Trade debtors ---
Net Benefits ……… ……… ……… ……….
- Bills --- --- (A – B)
Minimum Cash Balance ---
Gross Working Capital --- --- Statement showing the Evaluation of Credit Policies (based on
Incremental Approach)
II. Current Liabilities:
Trade Payables ---
Particulars Present Proposed Proposed Proposed
Bills Payables --- Policy Policy I Policy II Policy III
days days days days
Wages Payables ---
Payables for overheads --- --- RS RS RS RS
III. Excess of Current Assets --- A. Incremental
over Current Liabilities Expected Profit:
[I – II]
IV. Add: Safety Margin --- Credit Sales ………. …………. ……….. ……….
V. Net Working Capital [III --- (a) Incremental ………. …………. ……….. ……….
+ IV] Credit Sales
(b) Less:
0$1$*(0(172)5(&(,9$%/(6 Incremental
Costs of Credit
Sales
Approaches of Evaluation of Credit Policies
(i) Variable Costs ………. …………. ……….. ……….
There are basically two methods of evaluating the credit policies to be (ii) Fixed Costs ………. …………. ……….. ……….
adopted by a Company – Total Approach and Incremental Approach.
The formats for the two approaches are given as under: (c) Incremental ………. …………. ……….. ……….
Statement showing the Evaluation of Credit Policies (based on Bad Debt Losses
Total Approach)
(d) Incremental ………. …………. ……….. ……….
Cash Discount
Particulars Present Proposed Proposed Proposed
Policy Policy I Policy II Policy III (e) Incremental ………. …………. ……….. ……….
Expected Profit
RS RS RS RS (a-b-c-d)
(f) Less: Tax ………. …………. ……….. ……….

A. Expected
Profit:
(g) Incremental ………. …………. ……….. ……….
(a) Credit Sales ………. …………. ……….. ………. Expected Profit
after Tax
(b) Total Cost
other than Bad ………. …………. ……….. ……….
Debts and Cash
Discount B. Required
Return on
(i) Variable Costs ………. …………. ……….. ………. Incremental
Investments:
(ii) Fixed Costs ………. …………. ……….. ……….
(a) Cost of ………. …………. ……….. ……….
……… ………. ………. ……..
Credit Sales
(c) Bad Debts ………. …………. ……….. ……….
(b) Collection ………. …………. ……….. ……….
(d) Cash discount Period (in days)
© ICAI BOS(A) 32
Financing of Receivables
(c) Investment in ………. …………. ……….. ……….
Receivable (a x
b/365 or 360) (i) Pledging: This refers to the use of a firm’s receivable to secure a
short term loan.
(d) Incremental ………. …………. ……….. ……….
Investment in (ii) Factoring: This refers to outright sale of accounts receivables to a
Receivables factor or a financial agency.
(e) Required Rate of ………. …………. ……….. ………. Factor

Return (in %) Customers send The factor pays
payment to the an agreed-upon
(f) Required Return ………. …………. ……….. ……….
factor percentage of the
on Incremental
Investments accounts receivable
(d x e) to the firm.
Incremental Net ………. …………. ……….. ………. Customer Firm

Benefits (A – B)
Goods
The basic format of evaluating factoring proposal is given as under:

Statement showing the Evaluation of Factoring Proposal
Particulars rs
A. Annual Savings (Benefit) on taking Factoring Service
Cost of Credit Administration saved ………...
Bad Debts avoided …………
Interest saved due to reduction in Average collection period (Wherever applicable) …………
[Cost of Annual Credit Sales × Rate of Interest × (Present Collection Period – New Collection Period)/360* days]
Total ………..
B. Annual Cost of Factoring to the Firm:
Factoring Commission [Annual credit Sales × % of Commission (or calculated annually)] ………..
Interest Charged by Factor on advance (or calculated annually ) ………...
[Amount available for advance or (Annual Credit Sales – Factoring Commission – Factoring Reserve)] ×
[ Collection Period (days)

x Rate of Interest]
360 *
Total ………..
C. Net Annual Benefits/Cost of Factoring to the Firm: ………..
Rate of Effective Cost of Factoring to the Firm
Net Annual cost of Factoring
= x 100 or
Amount available for advance
Net annual Cost of Factoring

x 100
Advances to be paid
Advances to be paid = (Amount available for advance – Interest deducted by factor)
© ICAI BOS(A) 33
SARANSH Last Mile Referencer for
FINANCIAL
MANAGEMENT


The Institute of Chartered Accountants of India
ICAI Bhawan, A-29,
Sector-62, Noida 201 309
E-mail: bosnoida@icai.in
Phone: 0120 - 3045930
https://boslive.icai.org
www.icai.org

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SARANSHLast Mile Referencer for

The Institute of Chartered

Board of Studies (Academic)

© 2023. The Institute of Chartered Accountants of India (Also referred to as ICAI)

Published in June 2023 by:

Message of Key ICAI Office Bearers

CA. Aniket S. Talati

CA. Ranjeet Kumar Agarwal

ICAI consistently strives to provide exceptional educational content that empowers

CA. Vishal Doshi

CA. Dayaniwas Sharma

Scope and Objective of Financial Market 01

Financial Analysis and Planning - Ratio Analysis 04

Financing Decisions - Capital Structure 14

Financing Decisions - Leverages 16

Risk Analysis in Capital Budgeting 20

Management of Working Capital 30

SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT

Chapter Overview Short- term Finance

Scope of Financial Management

Determining the mix of enterprise’s financing i.e., consideration

Financial management comprises the forecasting, planning,

Two Basic Aspects of Financial Management Procurement of Funds

Procurement of funds Debentures and Bonds

Aspects of Financial Management

V = f (I,F,D). Venture Capital

Dividend Financing Utilization for Working

Evolution of Financial Management &RQÁLFWEHWZHHQ3URÀWYHUVXV9DOXHPD[L

Societal wealth is maximised... 5ROHRI)LQDQFHH[HFXWLYHLQWRGD\·V:RUOG

5HODWLRQVKLSRIÀQDQFLDOPDQDJHPHQWZLWK Decision – Chief focus of an accountant is to

Equity Preference Loans 1. Share capital or Equity shares

Sources of Finance based on Basic Sources Medium-term

Based on basic sources of finance, types of financing 1. Preference shares

Owner’s Capital or Equity Capital:

Preference Share Capital:

Securitization is a process in which illiquid assets are pooled into

Lease Financing: Accrued

FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

* Liquidity Ratio/Short term Activity Ratios/

Required for analysis

Ratio Formulae Comments

Operating Expenses – No. of days

Total Debt + Net Worth

( Equity Share Capital +

Operating Profit Ratio Operating Profit It measures operating performance of business.

Operating Expenses Ratio Administrative exp. +

Financial Expenses Ratio Financial Expenses x 100

S.No. Users Objectives Ratios used in general

Meaning of Cost of Capital TO CALCULATE COST

Identify various cash flows

t Return expected by the providers of capital

Financing Decision Cost of LONG-TERM DEBT (Kd)

t %P not confers ownership to the providers

Determination of Cost of Capital Cost of Irredeemable Debt

“Every problem is a gift—without problems we would not grow.”

Cost of Irredeemable Debentures STEPS TO CALCULATE RELEVANT CASH FLOWS

Cost of Redeemable Debentures Step-1: Identify the cash flows.

:FBS Cash flows

Step-2: Calculate NPVs of cash flows as identified above using two

Where, JJ (PSEPOT (SPXUI .PEFM

$PTUPG&RVJUZVOEFS$"1.3JTLGSFFSBUF 3JTLQSFNJVN Weighted Average Cost Of Capital (WACC)

ͳF 8"$$ BQQMZJOH #7 BOE .7 XPVME CF BT GPMMPXT

Less: Cost of Goods * * Time adjusted or