PUJA KUMARI SRIVASTAVA

PAPER: CC-10- FINANCIAL MANAGEMENT

Unit-1: Financial Management: Meaning, nature and scope of finance; financial goal profit
vs. wealth maximization: Finance functions investments. financing and dividend decisions.
Unit I: Financial Management

Financial Management is a critical aspect of any organization, focusing on the management

of financial resources to achieve the firm's financial goals. This unit covers the meaning,
nature, and scope of finance, the financial goal of profit versus wealth maximization, and the
three main finance functions: investment, financing, and dividend decisions.

1. Meaning, Nature, and Scope of Finance

Meaning of Finance: Finance refers to the management of money and other assets. It
involves the acquisition, allocation, and utilization of resources to achieve an organization’s
objectives. Finance is concerned with investment, financing, and managing resources to
maximize value.

Nature of Finance:

• Interdisciplinary: Combines elements of economics, accounting, and statistics.

• Dynamic: Responds to changes in the economic environment and market conditions.
• Decision-Oriented: Focuses on making informed financial decisions to achieve organizational
goals.
• Forward-Looking: Involves planning and forecasting to ensure the long-term sustainability of
the organization.

Scope of Finance:

• Investment Decisions: Determining where to allocate funds to generate the highest returns.
• Financing Decisions: Deciding the best mix of debt, equity, and internal funds for financing
investments.
• Dividend Decisions: Determining the portion of profits to be distributed to shareholders
versus retained for reinvestment.
• Working Capital Management: Managing short-term assets and liabilities to ensure liquidity.
• Risk Management: Identifying, analyzing, and mitigating financial risks.

2. Financial Goals: Profit Maximization vs. Wealth Maximization

Profit Maximization:

• Focus: Aims to maximize the firm’s earnings in the short term.

• Measurement: Based on accounting profits.
• Limitations: Ignores the timing of returns, risk factors, and long-term sustainability.

Wealth Maximization:

• Focus: Aims to increase the market value of shareholders’ equity over the long term.
 • Measurement: Based on the present value of expected future cash flows.
• Advantages: Considers the timing of returns, risk, and long-term growth, aligning with
shareholders' interests.

Comparison:

• Time Horizon: Profit maximization focuses on short-term gains, while wealth maximization
emphasizes long-term value creation.
• Risk Consideration: Profit maximization often overlooks risk, whereas wealth maximization
incorporates risk assessment.
• Stakeholder Interests: Wealth maximization aligns with broader stakeholder interests,
including shareholders, employees, and customers, while profit maximization may prioritize
immediate financial performance.

3. Finance Functions

A. Investment Decisions: Investment decisions, also known as capital budgeting, involve

determining which long-term investments or projects the firm should undertake. This process
includes:

• Identifying Opportunities: Assessing potential projects or investments that can generate

returns.
• Evaluating Projects: Using techniques such as Net Present Value (NPV), Internal Rate of
Return (IRR), and Payback Period to evaluate the profitability and risk of investments.
• Selecting Projects: Choosing the projects that align with the firm’s strategic goals and offer
the highest returns relative to risk.
• Monitoring Investments: Continuously assessing the performance of investments and
making necessary adjustments.

B. Financing Decisions: Financing decisions involve determining the best sources of funding
for the firm’s investments and operations. Key aspects include:

• Capital Structure: Deciding the optimal mix of debt, equity, and internal financing.
• Cost of Capital: Assessing the cost of various financing options and their impact on the firm’s
overall cost of capital.
• Leverage: Managing the degree of financial leverage to balance potential returns and risks.
• Raising Capital: Choosing methods for raising funds, such as issuing stocks or bonds, taking
loans, or reinvesting profits.

C. Dividend Decisions: Dividend decisions involve determining the portion of profits to be

distributed to shareholders as dividends versus retained for reinvestment in the firm. Key
considerations include:

• Dividend Policy: Establishing a consistent policy that balances shareholder expectations and
the firm’s growth needs.
• Payout Ratio: Deciding the proportion of earnings to be paid out as dividends.
• Retention Ratio: Determining the portion of earnings to be retained for future investments.
• Market Impact: Understanding how dividend decisions affect the firm’s stock price and
investor perceptions.
Unit-II: Capital Budgeting: Nature of investment decisions; Investinent evaluation criteria net
present value, internal rate of return, payback period, accounting relate of return; NPV and
IRP comparison, Risk analysis in capital building.
Unit II: Capital Budgeting

Capital budgeting is the process by which organizations evaluate and select long-term
investments that are consistent with their goal of maximizing shareholder wealth. This unit
covers the nature of investment decisions, various investment evaluation criteria (such as Net
Present Value, Internal Rate of Return, Payback Period, and Accounting Rate of Return), a
comparison of NPV and IRR, and risk analysis in capital budgeting.

1. Nature of Investment Decisions

Investment decisions, also known as capital budgeting decisions, involve the allocation of
significant amounts of capital to long-term assets or projects. These decisions are critical
because they determine the future direction and growth of the organization. The nature of
these decisions includes:

• Long-Term Implications: Investment decisions typically involve long-term commitments and

have far-reaching implications for the organization's future.
• Significant Capital Outlay: These decisions often require substantial amounts of capital,
making it crucial to carefully evaluate their potential returns.
• Irreversibility: Once made, many investment decisions are difficult or costly to reverse
without incurring significant losses.
• Risk and Uncertainty: Investment decisions are subject to various risks and uncertainties,
including market conditions, economic factors, and technological changes.

2. Investment Evaluation Criteria

Several criteria are used to evaluate investment opportunities. The most common methods
include:

A. Net Present Value (NPV):

• Definition: NPV is the sum of the present values of all cash flows associated with an
investment, both inflows and outflows, discounted at the project's required rate of return.
• Formula: NPV=∑(Ct(1+r)t)−C0NPV = \sum \left( \frac{C_t}{(1 + r)^t} \right) -
C_0NPV=∑((1+r)tCt)−C0 where CtC_tCt is the cash flow at time ttt, rrr is the discount rate,
and C0C_0C0 is the initial investment.
• Decision Rule: Accept the project if NPV > 0, as it adds value to the firm.

B. Internal Rate of Return (IRR):

• Definition: IRR is the discount rate at which the NPV of an investment is zero. It represents
the rate of return expected from the project.
• Formula: Solve for rrr in the NPV equation set to zero: 0=∑(Ct(1+r)t)−C00 = \sum \left(
\frac{C_t}{(1 + r)^t} \right) - C_00=∑((1+r)tCt)−C0
• Decision Rule: Accept the project if IRR > required rate of return (cost of capital).
C. Payback Period:

• Definition: The payback period is the time it takes for the initial investment to be recovered
from the net cash inflows generated by the project.
• Formula: Calculate the cumulative cash flows until they equal the initial investment.
• Decision Rule: Accept the project if the payback period is less than the predetermined cutoff
period.

D. Accounting Rate of Return (ARR):

• Definition: ARR is the ratio of the average annual accounting profit to the initial investment.
• Formula: ARR=Average Annual Accounting ProfitInitial InvestmentARR = \frac{\text{Average
Annual Accounting Profit}}{\text{Initial
Investment}}ARR=Initial InvestmentAverage Annual Accounting Profit
• Decision Rule: Accept the project if ARR exceeds the required accounting rate of return.

3. Comparison of NPV and IRR

Net Present Value (NPV):

• Advantages:
o Considers the time value of money.
o Provides a direct measure of the expected increase in value.
o Takes into account all cash flows throughout the project's life.
• Disadvantages:
o Requires an appropriate discount rate.
o Can be difficult to explain to non-financial managers.

Internal Rate of Return (IRR):

• Advantages:
o Considers the time value of money.
o Easy to understand and communicate as a percentage return.
o Useful for comparing projects of different sizes.
• Disadvantages:
o Can result in multiple IRRs for projects with non-conventional cash flows.
o Assumes reinvestment of interim cash flows at the IRR, which may be unrealistic.

Comparison:

• Consistency: NPV provides a more consistent decision rule, particularly when projects have
different sizes or cash flow patterns.
• Reinvestment Assumption: NPV assumes reinvestment at the cost of capital, which is
generally more realistic than the IRR's assumption of reinvestment at the IRR.
• Ranking of Projects: NPV is preferred for ranking mutually exclusive projects, as it measures
absolute value addition, while IRR measures relative profitability.

4. Risk Analysis in Capital Budgeting

Investment decisions involve significant risks due to the uncertainty of future cash flows and
various external factors. Risk analysis helps in understanding and managing these
uncertainties. Common methods include:

A. Sensitivity Analysis:

• Examines how changes in key assumptions (e.g., sales volume, costs, discount rate) affect the
project's NPV or IRR.
• Helps identify critical variables that have the most impact on project outcomes.

B. Scenario Analysis:

• Evaluates the project's performance under different scenarios, such as best-case, worst-case,
and most-likely case.
• Provides insights into potential outcomes and their probabilities.

C. Monte Carlo Simulation:

• Uses computer simulations to model the probability distribution of possible outcomes by

varying multiple uncertain variables simultaneously.
• Provides a range of possible NPVs or IRRs and their associated probabilities.

D. Decision Tree Analysis:

• Graphically represents different decision paths and their possible outcomes, including risks
and rewards.
• Helps in understanding the implications of different choices and the likelihood of various
outcomes.

E. Real Options Analysis:

• Considers the value of flexibility in investment decisions, such as the option to delay, expand,
or abandon a project.
• Uses financial options theory to evaluate the strategic value of these options.

Unit-III: Cost of Capital: Meaning and significance of cost of capital; Calculation of cost of
debt, preference capital, equity capital and earnings, Combined cost of capital (weighted);
Cost of equity and CAPM.
Unit III: Cost of Capital

The cost of capital is a critical concept in financial management that represents the firm's cost
of financing its operations and investments. This unit covers the meaning and significance of
the cost of capital, the calculation of the cost of various components (debt, preference capital,
and equity capital), the combined cost of capital (weighted average cost of capital), and the
cost of equity using the Capital Asset Pricing Model (CAPM).

1. Meaning and Significance of Cost of Capital

Meaning: The cost of capital refers to the rate of return that a company must earn on its
investments to maintain its market value and attract funds. It represents the opportunity cost
of using capital resources in a particular investment rather than in alternative investments.

Significance:

• Investment Decisions: Helps in evaluating the profitability of investment projects. Projects

with returns above the cost of capital increase shareholder value.
• Financing Decisions: Assists in choosing the optimal mix of debt, equity, and other financing
sources to minimize the overall cost of capital.
• Performance Measurement: Acts as a benchmark for measuring financial performance and
value creation.
• Valuation: Plays a critical role in business valuation and determining the value of future cash
flows.

2. Calculation of Cost of Various Components

A. Cost of Debt: The cost of debt is the effective rate that a company pays on its borrowed
funds. It is usually the interest rate paid on the debt adjusted for tax savings since interest
expenses are tax-deductible.

• Formula:

Kd=I×(1−T)K_d = I \times (1 - T)Kd=I×(1−T)

where KdK_dKd is the cost of debt, III is the annual interest expense, and TTT is the
corporate tax rate.

• Example Calculation: If a company issues bonds at an interest rate of 6% and the

corporate tax rate is 30%, the after-tax cost of debt would be:

Kd=6%×(1−0.30)=4.2%K_d = 6\% \times (1 - 0.30) = 4.2\%Kd=6%×(1−0.30)=4.2%

B. Cost of Preference Capital: The cost of preference capital is the dividend expected by
preference shareholders. Since preference dividends are not tax-deductible, the cost of
preference capital is the dividend rate on preference shares.

• Formula:

Kp=DpPpK_p = \frac{D_p}{P_p}Kp=PpDp

where KpK_pKp is the cost of preference capital, DpD_pDp is the annual preference
dividend, and PpP_pPp is the market price of the preference shares.

• Example Calculation: If a company issues preference shares with an annual dividend

of $5 and the market price is $100, the cost of preference capital would be:

Kp=5100=5%K_p = \frac{5}{100} = 5\%Kp=1005=5%

C. Cost of Equity Capital: The cost of equity is the return required by equity investors. It
can be estimated using various methods, including the Dividend Discount Model (DDM) and
the Capital Asset Pricing Model (CAPM).

• Dividend Discount Model (DDM) Formula:

Ke=D1P0+gK_e = \frac{D_1}{P_0} + gKe=P0D1+g

where KeK_eKe is the cost of equity, D1D_1D1 is the expected dividend per share
next year, P0P_0P0 is the current market price of the stock, and ggg is the growth rate
of dividends.

• Example Calculation: If a company expects to pay a dividend of $2 next year, the

current stock price is $40, and the dividend growth rate is 5%, the cost of equity using
DDM would be:

Ke=240+0.05=0.05+0.05=10%K_e = \frac{2}{40} + 0.05 = 0.05 + 0.05 = 10\%Ke=402

+0.05=0.05+0.05=10%

D. Cost of Equity using CAPM: The Capital Asset Pricing Model (CAPM) estimates the
cost of equity based on the risk-free rate, the stock's beta (measure of risk), and the market
risk premium.

• Formula:

Ke=Rf+β(Rm−Rf)K_e = R_f + \beta (R_m - R_f)Ke=Rf+β(Rm−Rf)

where KeK_eKe is the cost of equity, RfR_fRf is the risk-free rate, β\betaβ is the beta
of the stock, and RmR_mRm is the expected return of the market.

• Example Calculation: If the risk-free rate is 3%, the stock’s beta is 1.2, and the
market risk premium is 6%, the cost of equity using CAPM would be:

Ke=3%+1.2×6%=3%+7.2%=10.2%K_e = 3\% + 1.2 \times 6\% = 3\% + 7.2\% = 10.2\%Ke

=3%+1.2×6%=3%+7.2%=10.2%

3. Combined Cost of Capital (Weighted Average Cost of Capital - WACC)

The Weighted Average Cost of Capital (WACC) is the overall cost of capital for the firm,
considering the weighted costs of each component of capital (debt, preference capital, and
equity).

• Formula:

WACC=(EV×Ke)+(DV×Kd×(1−T))+(PV×Kp)WACC = \left( \frac{E}{V} \times K_e \right) + \left(

\frac{D}{V} \times K_d \times (1 - T) \right) + \left( \frac{P}{V} \times K_p \right)WACC=(VE
×Ke)+(VD×Kd×(1−T))+(VP×Kp)
 where EEE is the market value of equity, DDD is the market value of debt, PPP is the
market value of preference capital, VVV is the total market value of the firm's
financing (E + D + P), KeK_eKe is the cost of equity, KdK_dKd is the cost of debt,
and KpK_pKp is the cost of preference capital.

• Example Calculation: Assume a firm has the following capital structure:

o Equity: $500,000 with a cost of 10%
o Debt: $300,000 with an after-tax cost of 4.2%
o Preference capital: $200,000 with a cost of 5%

The WACC would be:

WACC=(500,0001,000,000×10%)+(300,0001,000,000×4.2%)+(200,0001,000,000×5%)WACC =
\left( \frac{500,000}{1,000,000} \times 10\% \right) + \left( \frac{300,000}{1,000,000} \times
4.2\% \right) + \left( \frac{200,000}{1,000,000} \times 5\% \right)WACC=(1,000,000500,000
×10%)+(1,000,000300,000×4.2%)+(1,000,000200,000×5%)
WACC=(0.5×10%)+(0.3×4.2%)+(0.2×5%)=5%+1.26%+1%=7.26%WACC = (0.5 \times 10\%) +
(0.3 \times 4.2\%) + (0.2 \times 5\%) = 5\% + 1.26\% + 1\% =
7.26\%WACC=(0.5×10%)+(0.3×4.2%)+(0.2×5%)=5%+1.26%+1%=7.26%

Unit IV: Capital structure Theories: Determining Capital structure in practice.

Unit IV: Capital Structure Theories

Capital structure refers to the mix of debt and equity that a company uses to finance its
operations and growth. Determining the optimal capital structure is crucial as it can affect a
company’s risk, return, and overall value. This unit explores various capital structure theories
and how companies determine their capital structure in practice.

1. Capital Structure Theories

A. Net Income (NI) Approach:

• Proposed by: David Durand.

• Key Idea: The value of the firm increases with the increase in debt, as debt is cheaper than
equity.
• Assumptions:
o The cost of debt is lower than the cost of equity.
o No taxes.
o Increased leverage (use of debt) leads to lower overall cost of capital.
• Implication: Firms should use as much debt as possible to maximize firm value.

B. Net Operating Income (NOI) Approach:

• Proposed by: David Durand.

• Key Idea: The value of the firm is independent of its capital structure. Changing the mix of
debt and equity does not affect the overall cost of capital.
• Assumptions:
o The cost of equity increases with leverage to offset the benefit of using cheaper
debt.
 o The overall cost of capital remains constant.
• Implication: Capital structure is irrelevant in determining the firm's value.

C. Modigliani and Miller (MM) Theory:

• Proposed by: Franco Modigliani and Merton Miller in 1958.

• Key Idea: In a perfect market (no taxes, bankruptcy costs, or asymmetric information), capital
structure is irrelevant to the firm's value.
• Assumptions:
o No taxes.
o No transaction costs.
o Information is freely available.
o Investors can borrow at the same rate as corporations.
• Implication: The firm's value is determined by its earning power and the risk of its underlying
assets, not by its capital structure.

MM Theory with Taxes:

• Key Idea: When corporate taxes are considered, the value of the firm increases with the use
of debt due to the tax shield on interest payments.
• Implication: Firms should use more debt to take advantage of the tax shield, thus increasing
firm value.

D. Trade-Off Theory:

• Key Idea: Firms balance the tax benefits of debt financing (interest tax shield) against the
costs of financial distress (bankruptcy costs).
• Assumptions:
o There are benefits and costs associated with debt.
o An optimal capital structure exists where the marginal benefit of debt equals the
marginal cost.
• Implication: Firms aim for a target capital structure where they can balance these trade-offs
to maximize firm value.

E. Pecking Order Theory:

• Proposed by: Stewart Myers and Nicolas Majluf.

• Key Idea: Firms prefer to finance new projects using internal funds first, then debt, and issue
equity as a last resort.
• Assumptions:
o Firms have a preference hierarchy for financing sources due to asymmetric
information.
o Internal funds are cheapest, followed by debt, and equity is the most expensive.
• Implication: Firms with higher profitability tend to have less debt, while those with less
profitability rely more on debt financing.

F. Agency Cost Theory:

• Key Idea: Capital structure is influenced by the agency costs arising from conflicts of interest
between managers and shareholders, and between debt holders and shareholders.
• Assumptions:
 o Agency costs include monitoring costs, bonding costs, and residual losses.
o These costs impact the firm's financing decisions.
• Implication: Firms need to design their capital structure to minimize agency costs and align
the interests of managers, shareholders, and debt holders.

2. Determining Capital Structure in Practice

In practice, firms determine their capital structure by considering a variety of factors:

A. Business Risk:

• The inherent risk in the firm's operations. Firms with higher business risk tend to use less
debt to avoid financial distress.

B. Tax Position:

• The potential benefits of the interest tax shield. Firms in higher tax brackets benefit more
from debt financing.

C. Financial Flexibility:

• Firms need to maintain flexibility to raise funds under favorable terms in the future.
Excessive debt can limit this flexibility.

D. Growth Opportunities:

• Firms with high growth opportunities may prefer equity to avoid the constraints of debt
repayments.

E. Market Conditions:

• Prevailing market conditions can influence the cost and availability of different financing
options.

F. Management Style and Preferences:

• Managerial attitudes towards risk and control can impact capital structure decisions.

G. Industry Norms:

• Industry-specific trends and norms also play a role. Firms often look at peer companies when
making capital structure decisions.

H. Legal and Regulatory Environment:

• Regulations and legal frameworks in different countries can influence the preferred mix of
debt and equity.

I. Asset Structure:
 • Firms with tangible assets can borrow more easily as these assets can serve as collateral.

J. Internal Financing:

• Availability of retained earnings or other internal funds can reduce the need for external
financing.

Unit-V: Dividend Policies: Issues in dividend decisions, dividend and uncertainty, relevance
of dividend; dividend policy in practice; Forms of dividend Behavior.
Unit V: Dividend Policies

Dividend policy refers to the strategy a company uses to determine the size and timing of
dividend payments to its shareholders. Understanding the complexities of dividend decisions
is crucial for financial management, as these decisions impact the firm's capital structure,
investor satisfaction, and overall value.

1. Issues in Dividend Decisions

A. Dividend Payout Ratio:

• The proportion of earnings paid out as dividends.

• Balancing reinvestment needs and shareholder expectations.

B. Stability of Dividends:

• Many firms aim for stable or gradually increasing dividends to signal financial health and
predictability.

C. Legal and Contractual Constraints:

• Legal requirements and debt covenants can limit dividend payouts.

D. Availability of Cash:

• Sufficient cash flow is necessary to support dividend payments without compromising

operational needs.

E. Impact on Stock Price:

• Dividend announcements can affect stock prices due to signaling effects and investor
preferences.

F. Tax Considerations:

• Tax treatment of dividends vs. capital gains for shareholders.

G. Investor Preferences:

• Some investors prefer dividends for regular income, while others may prefer capital gains.
2. Dividend and Uncertainty

A. Information Asymmetry:

• Dividends can signal management's confidence in future earnings, reducing information

asymmetry between management and investors.

B. Bird-in-Hand Theory:

• Investors may prefer the certainty of dividends over potential future capital gains, which are
more uncertain.

C. Agency Costs:

• Paying dividends can reduce the funds available to managers, potentially limiting their ability
to invest in projects that may not align with shareholder interests.

3. Relevance of Dividend

A. Dividend Relevance Theories:

I. Walter's Model:

• Proposes that the choice of dividend policies almost always affects the value of the firm.
• The firm's investment policy and dividend policy are interrelated.
• Formula: P=D+E−DN×rkP = \frac{D + \frac{E - D}{N} \times r}{k}P=kD+NE−D×r where PPP is
the market price per share, DDD is the dividend per share, EEE is earnings per share, NNN is
the number of equity shares, rrr is the internal rate of return, and kkk is the cost of capital.

II. Gordon's Model:

• Similar to Walter's Model, emphasizes that dividends are relevant to the value of the firm.
• The model suggests that investors prefer the certainty of dividends over potential future
capital gains.
• Formula: P=E(1−b)k−brP = \frac{E(1 - b)}{k - br}P=k−brE(1−b) where PPP is the market price
per share, EEE is earnings per share, bbb is the retention ratio, rrr is the rate of return on
retained earnings, and kkk is the cost of equity.

B. Dividend Irrelevance Theory:

I. Modigliani and Miller (MM) Hypothesis:

• Proposed by Franco Modigliani and Merton Miller in 1961.

• Asserts that in a perfect market (no taxes, transaction costs, or asymmetric information),
dividend policy is irrelevant to the firm's value.
• Investors can create their own dividend policy by selling a portion of their portfolio if
dividends are not paid.
• Assumptions:
o No taxes.
o No transaction costs.
o No information asymmetry.
 o Investors are rational.

4. Dividend Policy in Practice

A. Residual Dividend Policy:

• Dividends are paid out of residual earnings after all acceptable investment opportunities
have been funded.
• Prioritizes reinvestment needs over dividend payments.

B. Stable Dividend Policy:

• Firms aim to pay a consistent and predictable dividend over time.

• Helps maintain investor confidence and attract income-seeking investors.

C. Hybrid Dividend Policy:

• Combines elements of residual and stable dividend policies.

• Firms may pay a small, stable dividend and supplement it with extra dividends when
earnings are high.

D. Target Payout Ratio:

• Firms aim for a specific payout ratio but may adjust it gradually to avoid volatility in
dividends.

5. Forms of Dividend Behavior

A. Cash Dividends:

• Direct cash payments to shareholders, usually on a regular basis (quarterly, semi-annually, or

annually).

B. Stock Dividends:

• Additional shares are distributed to shareholders instead of cash.

• Increases the number of shares outstanding but does not change the proportionate
ownership.

C. Stock Repurchases:

• Firms buy back their own shares from the market.

• Provides flexibility in returning cash to shareholders and can signal management's
confidence in the firm's value.

D. Special Dividends:

• One-time dividends that are usually larger than regular dividends.

• Typically declared when the firm has excess cash that is not needed for investment or other
purposes.
E. Scrip Dividends:

• Issued when a company does not have sufficient cash to pay dividends.
• Shareholders are given the option to receive dividends in the form of promissory notes
(scrip) which can be converted into cash later.

Unit-VI: Management of Working Capital: Meaning, significance and types of working

capital: Calculating operating cycle period and estimation of working capital requirement:
Financing of working capital and norms of bank finance; Sources of working capital.
Unit VI: Management of Working Capital

Working capital management is critical for maintaining a company's liquidity, operational

efficiency, and financial health. This unit covers the meaning, significance, types of working
capital, methods to calculate the operating cycle, estimation of working capital requirements,
financing working capital, norms of bank finance, and sources of working capital.

1. Meaning, Significance, and Types of Working Capital

A. Meaning: Working capital refers to the funds necessary to manage a company's day-to-
day operations. It is calculated as the difference between current assets and current liabilities.

• Formula: Working Capital=Current Assets−Current Liabilities\text{Working Capital} =

\text{Current Assets} - \text{Current
Liabilities}Working Capital=Current Assets−Current Liabilities

B. Significance:

• Liquidity Management: Ensures the company can meet short-term obligations and operate
without interruptions.
• Operational Efficiency: Maintains smooth production and sales processes by managing
inventory, receivables, and payables effectively.
• Financial Stability: Adequate working capital minimizes financial risk and enhances the firm's
ability to manage unforeseen expenses or downturns.
• Profitability: Efficient working capital management improves profitability by reducing costs
related to inventory holding, receivables management, and financing.

C. Types of Working Capital:

• Gross Working Capital: The total of all current assets.

• Net Working Capital: The difference between current assets and current liabilities.
• Permanent Working Capital: The minimum level of current assets required to sustain the
company's ongoing operations.
• Temporary or Variable Working Capital: Additional working capital needed to meet seasonal
or cyclical variations in business operations.

2. Calculating Operating Cycle Period and Estimation of Working Capital Requirement

A. Operating Cycle: The operating cycle is the time period between the acquisition of
inventory and the collection of cash from receivables. It includes the inventory conversion
period and the receivables conversion period.

• Inventory Conversion Period (ICP): The time taken to convert raw materials into finished
goods and sell them. ICP=Average InventoryCost of Goods Sold×365\text{ICP} =
\frac{\text{Average Inventory}}{\text{Cost of Goods Sold}} \times
365ICP=Cost of Goods SoldAverage Inventory×365
• Receivables Conversion Period (RCP): The time taken to collect payments from customers.
RCP=Average ReceivablesNet Credit Sales×365\text{RCP} = \frac{\text{Average
Receivables}}{\text{Net Credit Sales}} \times 365RCP=Net Credit SalesAverage Receivables
×365
• Payables Deferral Period (PDP): The time period between the purchase of materials and
payment to suppliers. PDP=Average PayablesCost of Goods Sold×365\text{PDP} =
\frac{\text{Average Payables}}{\text{Cost of Goods Sold}} \times
365PDP=Cost of Goods SoldAverage Payables×365
• Operating Cycle (OC): The sum of ICP and RCP minus PDP. OC=ICP+RCP−PDP\text{OC} =
\text{ICP} + \text{RCP} - \text{PDP}OC=ICP+RCP−PDP

B. Estimation of Working Capital Requirement: The estimation involves analyzing the

operating cycle and determining the amount needed to finance the current assets through the
operating cycle.

• Formula:
Working Capital Requirement=Operating Expenses per Day×Operating Cycle in Days\text{Wo
rking Capital Requirement} = \text{Operating Expenses per Day} \times \text{Operating Cycle
in Days}Working Capital Requirement=Operating Expenses per Day×Operating Cycle in Days
where operating expenses per day include costs of raw materials, labor, overheads, and
other operating expenses.

3. Financing of Working Capital and Norms of Bank Finance

A. Financing of Working Capital:

• Internal Financing: Retained earnings and internal cash flows.

• External Financing: Bank loans, trade credit, commercial paper, and factoring.

B. Norms of Bank Finance:

• Tandon Committee Recommendations: Suggests norms for bank financing of working

capital.
o First Method: Maximum permissible bank finance (MPBF) is calculated as 75% of the
working capital gap (current assets minus current liabilities excluding bank finance),
with a minimum of 25% being financed by the firm’s net working capital.
o Second Method: MPBF is 75% of current assets minus current liabilities (excluding
bank borrowings), ensuring that the firm finances a minimum of 25% of total current
assets through net working capital.

4. Sources of Working Capital

A. Short-term Sources:
 • Trade Credit: Credit extended by suppliers, allowing a company to purchase goods or
services and pay for them later.
• Bank Overdraft: A facility allowing a company to withdraw more money than it has in its
bank account up to a specified limit.
• Commercial Paper: An unsecured, short-term debt instrument issued by corporations,
typically used for financing working capital needs.
• Factoring: Selling accounts receivable to a third party (factor) at a discount to obtain
immediate cash.
• Line of Credit: An arrangement with a bank that allows a company to borrow up to a
specified limit as needed.

B. Long-term Sources:

• Equity Financing: Raising capital by selling shares of the company. This does not require
repayment and thus provides long-term funding.
• Long-term Loans: Loans from banks or financial institutions with a maturity of more than
one year.
• Retained Earnings: Profits that are reinvested in the business rather than distributed to
shareholders as dividends.

Unit-VII: Management of cash, receivables and inventory.

Unit VII: Management of Cash, Receivables, and Inventory

Efficient management of cash, receivables, and inventory is essential for maintaining a

company's liquidity and operational efficiency. This unit covers the strategies and practices
for managing these critical components of working capital.

1. Management of Cash

A. Importance of Cash Management:

• Liquidity: Ensures the company can meet its short-term obligations.

• Operational Efficiency: Facilitates smooth day-to-day operations.
• Minimize Risk: Reduces the risk of insolvency.
• Profitability: Maximizes the return on idle cash.

B. Objectives of Cash Management:

• Maintain Optimal Cash Balance: Balance between holding too much and too little cash.
• Efficient Cash Flow: Ensure timely inflows and outflows to meet operational needs.
• Minimize Cost: Reduce costs associated with cash handling and financing.

C. Cash Management Strategies:

• Cash Budgeting: Forecasting cash inflows and outflows to predict cash requirements.
• Cash Collection and Disbursement: Speed up collections (e.g., using lockboxes) and manage
disbursements efficiently.
• Investment of Surplus Cash: Invest excess cash in short-term instruments like treasury bills,
commercial paper, or money market funds.
• Cash Control: Implement controls to prevent fraud and errors in cash handling.
D. Techniques for Cash Management:

• Float Management: Reduce the time taken for checks to clear and funds to be available.
• Zero Balance Account (ZBA): Maintain a zero balance in the account, transferring funds as
needed.
• Electronic Funds Transfer (EFT): Speed up transactions and reduce processing time.

2. Management of Receivables

A. Importance of Receivables Management:

• Liquidity: Improves cash flow by ensuring timely collection of receivables.

• Profitability: Reduces the risk of bad debts and improves profitability.
• Customer Relations: Balances credit policies to maintain good customer relations while
minimizing credit risk.

B. Objectives of Receivables Management:

• Optimize Credit Policy: Balance between extending credit and ensuring timely collections.
• Minimize Bad Debts: Implement policies to reduce the risk of non-payment.
• Efficient Collection: Ensure efficient and timely collection of receivables.

C. Receivables Management Strategies:

• Credit Policy: Define credit terms, credit limits, and credit standards.
• Credit Analysis: Assess the creditworthiness of customers using credit reports and financial
statements.
• Invoicing and Collection: Timely and accurate invoicing, coupled with systematic follow-up
on overdue accounts.
• Aging Schedule: Monitor the age of receivables to identify overdue accounts and take
appropriate actions.

D. Techniques for Receivables Management:

• Factoring: Selling receivables to a third party (factor) to get immediate cash.

• Discounting: Offering discounts for early payment to incentivize timely collections.
• Credit Insurance: Insuring receivables against the risk of non-payment.

3. Management of Inventory

A. Importance of Inventory Management:

• Operational Efficiency: Ensures the availability of raw materials and finished goods for
smooth production and sales.
• Cost Control: Reduces holding costs and minimizes obsolescence and wastage.
• Customer Satisfaction: Ensures timely delivery of products to customers.

B. Objectives of Inventory Management:

• Optimize Inventory Levels: Balance between holding too much and too little inventory.
• Minimize Costs: Reduce costs associated with holding, ordering, and managing inventory.
 • Ensure Availability: Maintain adequate inventory levels to meet production and sales needs.

C. Inventory Management Strategies:

• Economic Order Quantity (EOQ): Determine the optimal order quantity to minimize total
inventory costs.
• Just-In-Time (JIT): Minimize inventory by receiving goods only when needed for production.
• ABC Analysis: Classify inventory items into categories (A, B, and C) based on their value and
manage them accordingly.

D. Techniques for Inventory Management:

• Reorder Point (ROP): Determine the inventory level at which a new order should be placed.
• Safety Stock: Maintain an additional quantity of inventory to guard against uncertainties in
demand and supply.
• Inventory Turnover Ratio: Measure how quickly inventory is sold and replaced over a period.
Inventory Turnover Ratio=Cost of Goods SoldAverage Inventory\text{Inventory Turnover
Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average
Inventory}}Inventory Turnover Ratio=Average InventoryCost of Goods Sold
• Perpetual Inventory System: Continuously track inventory levels through computerized
systems.
• Physical Inventory Counts: Periodically count physical inventory to ensure accuracy.