UNIT- V

Capital AND CAPITAL BUDGETING

Introduction

Finance is the prerequisite to commence and vary on business. It is rightly said to be thelifeblood of the
business. No growth and expansion of business can take place without sufficient finance. It shows that no
business activity is possible without finance. This is why; every business has to make plans regarding
acquisition and utilization of funds.

However efficient a firm may be in terms of production as well as marketing if it ignores the proper management
of flow of funds it certainly lands in financial crunch and the verysurvival of the firm would be at a stake.

Function of finance

According to B. O. Wheeler, Financial Management is concerned with the acquisition and utiliasation of capital
funds in meeting the financial needs and overall objectives of a business enterprise. Thus the primary function of
finance is to acquire capital funds and put them for proper utilization, with which the firm‟s objectives are
fulfilled. The firm should be able to procure sufficient funds on reasonable terms and conditions and should
exercise proper control in applying them in order to earn a good rate of return, which in turn allows the firm to
reward the sources of funds reasonably, and leaves the firm with good surplus to grow further. These activities
viz. financing, investing and dividend payment are not sequential they are performed simultaneously and
continuously. Thus, the Financial Management can be broken down in to three major decisions or functions of
finance. They are: (i) the investment decision, (ii) the financing decision and (iii) the dividend policy decision.

Investment Decision

The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets as
per their duration of benefits, can be categorized into two groups:
(i) long-term assets which yield a return over a period of time in future (ii) short-term orcurrent assents which in
the normal course of business are convertible into cash usually with in a year. Accordingly, the asset selection
decision of a firm is of two types. The investment in long-term assets is popularly known as capital budgeting
and in short-termassets, working capital management.

1. Capital budgeting: Capital budgeting – the long – term investment decision – is probably the most
crucial financial decision of a firm. It relates to the selection of an assent or investment proposal or
 course of action that benefits are likely to beavailable in future over the lifetime of the project.

The long-term investment may relate to acquisition of new asset or replacement of old assets. Whether an asset
will be accepted or not will depend upon the relative benefits and returns associated with it. The measurement of
the worth of the investment proposalsis, therefore, a major element in the capital budgeting exercise. The second
element of the capital budgeting decision is the analysis of risk and uncertainty as the benefits from the
investment proposals pertain the future, which is uncertain. They have to be estimated under various assumptions
and thus there is an element of risk involved in the exercise. The return from the capital budgeting decision
should, therefore, be evaluated inrelation to the riskassociated with it.

The third and final element is the ascertainment of a certain norm or standard against which the benefits are to be
judged. The norm is known by different names such as cut-offrate, hurdle rate, required rate, minimum rate of
return and so on. This standard is broadly expressed in terms of the cost of capital is, thus, another major aspect of
the capital; budgeting decision. In brief, the main elements of the capital budgeting decision are: (i) The total
assets and their composition (ii) The business risk complexion of the firm, and (iii) concept and measurement of
the cost of capital.

2. Working Capital Management: Working capital management is concerned with the management of
the current assets. As we know, the short-term survival is a pre-requisite to long-term success. The
major thrust of working capital management is the trade-off between profitability and risk (liquidity),
which are inversely related to each other. If a firm does not have adequate working capital itmay not
have the ability to meet its current obligations and thus invite the risk of bankrupt. One the other hand if
the current assets are too large the firm will be loosing the opportunity of making a good return and thus
may not serve the requirements of suppliers of funds. Thus, the profitability and liquidity are the two
major dimensions of working capital management. In addition, the individual current assets should be
efficiently managed so that neither inadequate nor unnecessary funds are locked up.

Finance Decision

The second major decision involved in financial management is the financing decision, which is concerned with
the financing – mix or capital structure of leverage. The term capital structure refers to the combination of debt
(fixed interest sources of financing) andequity capital (variable – dividend securities/source of funds). The
financing decision of a firm relates to the choice of the proportion of these sources to finance the investment
requirements. A higher proportion of debt implies a higher return to the shareholders and also the higher financial
risk and vice versa. A proper balance between debt and equity is a must to ensure a trade – off between risk and
return to the shareholders. A capital structure with a reasonable proportion of debt and equity capital is called the
optimum capital structure.

The second aspect of the financing decision is the determination of an appropriate capital structure, which will
result, is maximum return to the shareholders and in turn maximizesthe worth of the firm. Thus, the financing
decision covers two inter-related aspects: (a) capital structure theory, and (b) capital structure decision.

Dividend Policy decision

The third major decision of financial management is relating to dividend policy. The firm has two alternatives
with regard to management of profits of a firm. They can be either distributed to the shareholder in the form of
dividends or they can be retained in the business or even distribute some portion and retain the remaining. The
course of action tobe followed is a significant element in the dividend decision. The dividend pay out ratio i.
e. the proportion of net profits to be paid out to the shareholders should be in tune with the investment
opportunities available within the firm. The second major aspect of the dividend decision is the study of factors
determining dividend policy of a firm in practice.

Working capital analysis

Finance is required for two purpose viz. for it establishment and to carry out the day-to- day operations of a
business. Funds are required to purchase the fixed assets such as plant, machinery, land, building, furniture, etc,
on long-term basis. Investments in these assets represent that part of firm‟s capital, which is blocked on a
permanent of fixed basisand is called fixed capital. Funds are also needed for short-term purposes such as the
purchase of raw materials, payment of wages and other day-to-day expenses, etc. and these funds are known as
working capital. In simple words working capital refers that partof the firm‟s capital, which is required for
financing short term or current assets such as cash, marketable securities, debtors and inventories. The investment
in these current assets keeps revolving and being constantly converted into cash and which in turn financed to
acquire current assets. Thus the working capital is also known as revolving or circulating capital or short-term
capital.

Concept of working capital

There are two concepts of working capital:

1. Gross working capital

2. Net working capital

Gross working capital:

In the broader sense, the term working capital refers to the gross working capital. The notion of the gross
working capital refers to the capital invested in total current assets ofthe enterprise. Current assets are those
assets, which in the ordinary course of business,can be converted into cash within a short period, normally one
accounting year.
Examples of current assets:

1. Cash in hand and bank balance

2. Bills receivables or Accounts Receivables
3. Sundry Debtors (less provision for bad debts)
4. Short-term loans and advances.
5. Inventories of stocks, such as:
(a) Raw materials
(b) Work – in process
(c) Stores and spares
(d) Finished goods
6. Temporary Investments of surplus funds.
7. Prepaid Expenses
8. Accrued Incomes etc.

Net working capital:

In a narrow sense, the term working capital refers to the net working capital. Networkingcapital represents the
excess of current assets over current liabilities.

Current liabilities are those liabilities, which are intend to be paid in the ordinary course ofbusiness within a short
period, normally one accounting year out of the current assets or the income of the business. Net working capital
may be positive or negative. When the current assets exceed the current liabilities net working capital is positive
and the negativenet working capitalresults when the liabilities are more then the current assets.

Examples of current liabilities:

1. Bills payable
2. Sundry Creditors or Accounts Payable.
3. Accrued or Outstanding Expanses.
4. Short term loans, advances and deposits.
5. Dividends payable
6. Bank overdraft
7. Provision for taxation etc.

Classification or kinds of working capital

Working capital may be classified in two ways:

a. On the basis of concept.

 b. On the basis of time permanency

On the basis of concept, working capital is classified as gross working capital and net working capital is
discussed earlier. This classification is important from the point of viewof the financial manager. On the basis of
time, working capital may be classified as:

1. Permanent or fixed working capital

2. Temporary of variable working capital

1. Permanent or fixed working capital: There is always a minimum level of currentassets, which is
continuously required by the enterprise to carry out its normal business operations and this minimum is
known as permanent of fixed working capital. For example, every firm has to maintain a minimum level
of raw materials, work in process; finished goods and cash balance to run the business operations
smoothly and profitably. This minimum level of current assets is permanently blocked in current assets.
As the business grows, the requirement of permanent working capital also increases due to the increases
in current assets. The permanent working capital can further be classified into regular working capital and
reserve working capital. Regular working capital is the minimum amount of workingcapital required to
ensure circulation of current assets from cash to inventories, from inventories to receivables and from
receivable to cash and so on. Reserve working capital is the excess amount over the requirement for
regular working capital which may be provided for contingencies that may arise at unstated period such

as strikes, rise in prices, depression etc.

2. Temporary or variable working capital: Temporary or variable working capitalis the amount of
working capital, which is required to meet the seasonal demandsand some special exigencies. Thus the
variable working capital can be further classified into seasonal working capital and special working
capital. While seasonalworking capital is required to meet certain seasonal demands, the special
workingcapital is that part of working capital which is required to meet special exigencies such as
launching of extensive marketing campaigns, for conducting research etc.

Temporary working capital differs from permanent working capital in the sense that it is required for short
periods and cannot be permanently employed gainfully in the business.Figures given below illustrate the
different between permanent and temporary working capital.

Importance of working capital

Working capital is refereed to be the lifeblood and nerve center of a business. Working capital is as essential to
maintain the smooth functioning of a business as blood circulationin a human body. No business can run
successfully with out an adequate amount of working capital. The main advantages of maintaining adequate
amount of working capital are as follows:

1. Solvency of the business: Adequate working capital helps in maintainingsolvency of the

business by providing uninterrupted flow of production.
 2. Good will: Sufficient working capital enables a business concern to makeprompt payment
and hence helps in creating and maintaining good will.
3. Easy loans: A concern having adequate working capital, high solvency andgood credit
standing can arrange loans from banks and others on easy andfavorable terms.
4. Cash Discounts: Adequate working capital also enables a concern to availcash discounts on
the purchases and hence it reduces costs.
5. Regular supply of raw materials: Sufficient working capital ensuresregular supply of
raw materials and continuous production.
6. Regular payments of salaries wages and other day to day commitments: A company which
has ample working capital can make regular payment of salaries, wages and other day to day
commitments whichraises the morale of its employees, increases their efficiency, reduces
wastage and cost and enhances production and profits.
7. Exploitation of favorable market conditions: The concerns with adequate working capital
only can exploit favorable market conditions suchas purchasing its requirements in bulk when
the prices are lower.
8. Ability to face crisis: Adequate working capital enables a concern to facebusiness crisis in
emergencies.
9. Quick and regular return on Investments: Every investor wants a quickand regular return on
his investment. Sufficiency of working capital enables a concern to pay quick and regular
dividends to its investors, as there may not be much pressure to plough back profits. This gains
the confidence of itsinvestors and creates a favorable market to raise additional funds in the
future.
10. High morale: Adequacy of working capital creates an environment of security, confidence, and
high morale and creates overall efficiency in a business. Every business concern should have
adequate working capital to run its business operations. It should have neither redundant excess
workingcapital nor inadequate shortage of working capital. Both, excess as well as short working
capital positions are bad for any business. However, out of thetwo, it is the inadequacy of
working capital which is more dangerous from the point of view of the firm.

The need or objectives of working capital

The need for working capital arises mainly due to the time gap between production and realization of cash. The
process of production and sale cannot be done instantaneously and hence the firm needs to hold the current
assets to fill-up the time gaps. There are time gaps in purchase of raw materials and production; production and
sales: and sales and realization of cash. The working capital is needed mainly for the following purposes:

1. For the purchase of raw materials.

2. To pay wages, salaries and other day-to-day expenses and overhead cost such asfuel, power and office
expenses, etc.
3. To meet the selling expenses such as packing, advertising, etc.
4. To provide credit facilities to the customers and
5. To maintain the inventories of raw materials, work-in-progress, stores and sparesand finishes stock etc.
Generally, the level of working capital needed depends upon the time gap (known as operating cycle) and the size
of operations. Greater the size of the business unit generally,larger will be the requirements of working capital.
The amount of working capital needed also goes on increasing with the growth and expansion of business.
Similarly, the larger the operating cycle, the larger the requirement for working capital. There are many other
factors, which influence the need of working capital in a business, and these are discussedbelow in the following
pages.

Factors determining the working capital requirements

There are a large number of factors such as the nature and size of business, the characterof their operations, the
length of production cycle, the rate of stock turnover and the stateof economic situation etc. that decode
requirement of working capital. These factors have different importance and influence on firm differently. In
general following factors generally influence the working capital requirements.

1. Nature or character of business: The working capital requirements of a firm basically depend upon the
nature of its business. Public utility undertakings like electricity, water supply and railways need very
limited working capital as their sales are on cash and are engaged in provision of services only. On the
other hand,trading firms require more investment in inventories, receivables and cash and such they need
large amount of working capital. The manufacturing undertakings also require sizable working capital.
2. Size of business or scale of operations: The working capital requirements of a concern are directly
influenced by the size of its business, which may be measured in terms of scale of operations. Greater the
size of a business unit, generally, largerwill be the requirements of working capital. However, in some
cases, even a smaller concern may need more working capital due to high overhead charges, inefficient
use of available resources and other economic disadvantages of small size.
3. Production policy: If the demand for a given product is subject to wide fluctuations due to seasonal
variations, the requirements of working capital, in suchcases, depend upon the production policy. The
production could be kept either steady by accumulating inventories during stack periods with a view to
meet high demand during the peck season or the production could be curtailed during the slack season
and increased during the peak season. If the policy is to keep the production steady by accumulating
inventories it will require higher working capital.
4. Manufacturing process/Length of production cycle: In manufacturing business, the requirements of
working capital will be in direct proportion to the length of manufacturing process. Longer the process
period of manufacture, largeris the amount of working capital required, as the raw materials and other
supplieshave to be carried for a longer period.
5. Seasonal variations: If the raw material availability is seasonal, they have to bebought in bulk during
the season to ensure an uninterrupted material for the production. A huge amount is, thus, blocked in
the form of material, inventories during such season, which give rise to more working capital
requirements.

Generally, during the busy season, a firm requires larger working capital then in theslack season.
 6. Working capital cycle: In a manufacturing concern, the working capital cycle starts with the purchase
of raw material and ends with the realization of cash fromthe sale of finished products. This cycle
involves purchase of raw materials and stores, its conversion into stocks of finished goods through
work–in progress with progressive increment of labour and service costs, conversion of finished stock
intosales, debtors and receivables and ultimately realization of cash. This cycle continues again from
cash to purchase of raw materials and so on. In general the longer the operating cycle, the larger the
requirement of working capital.
7. Credit policy: The credit policy of a concern in its dealings with debtors and creditors influences
considerably the requirements of working capital. A concern that purchases its requirements on credit
requires lesser amount of working capitalcompared to the firm, which buys on cash. On the other hand, a
concern allowing credit to its customers shall need larger amount of working capital compared to a firm
selling only on cash.
8. Business cycles: Business cycle refers to alternate expansion and contraction in general business
activity. In a period of boom, i.e., when the business is prosperous, there is a need for larger amount of
working capital due to increase in sales. On the contrary, in the times of depression, i.e., when there is a
down swingof the cycle, the business contracts, sales decline, difficulties are faced in collectionfrom
debtors and firms may have to hold large amount of working capital.
9. Rate of growth of business: The working capital requirements of a concern increase with the growth and
expansion of its business activities. The retained profits may provide for a part of working capital but the
fast growing concerns needlarger amount of working capital than the amount of undistributed profits.

Source of finance

Incase of proprietorship business, the individual proprietor generally invests his own savings to start with, and
may borrow money on his personal security or the security of his assets from others. Similarly, the capital of a
partnership from consists partly of fundscontributed by the partners and partly of borrowed funds. But the
company from of organization enables the promoters to raise necessary funds from the public who may
contribute capital and become members (share holders) of the company. In course of its business, the company
can raise loans directly from banks and financial institutions or byissue of securities (debentures) to the public.
Besides, profits earned may also be reinvested instead of being distributed as dividend to the shareholders.

Thus for any business enterprise, there are two sources of finance, viz, funds contributedby owners and funds
available from loans and credits. In other words the financial resources of a business may be own funds and
borrowed funds.

Owner funds or ownership capital:

The ownership capital is also known as „risk capital‟ because every business runs the riskof loss or low profits,
and it is the owner who bears this risk. In the event of low profits they do not have adequate return on their
investment. If losses continue the owners maybe unable to recover even their original investment. However, in
times of prosperity and in the case of a flourishing business the high level of profits earned accrues entirely to the
owners of the business. Thus, after paying interest on loans at a fixed rate, the owners may enjoy a much higher
rate of return on their investment. Owners contribute risk capital also in the hope that the value of the firm will
appreciate as a result of higher earnings and growth in the size of the firm.

The second characteristic of this source of finance is that ownership capital remains permanently invested in the
business. It is not refundable like loans or borrowed capital.Hence a large part of it is generally used for a
acquiring long – lived fixed assets and to finance a part of the working capital which is permanently required to
hold a minimum level of stock of raw materials, a minimum amount of cash, etc.

Another characteristic of ownership capital related to the management of business. It is onthe basis of their
contribution to equity capital that owners can exercise their right of control over the management of the firm.
Managers cannot ignore the owners in the conduct of business affairs. The sole proprietor directly controls his
own business. In a partnership firm, the active partner will take part in the management of business. A company is
managed by directors who are elected by the members (shareholders).

Merits:

Arising out of its characteristics, the advantages of ownership capital may be briefly statedas follows:

1. It provides risk capital

2. It is a source of permanent capital
3. It is the basis on which owners „acquire their right of control over management
4. It does not require security of assets to be offered to raise ownership capital

Limitations:

There are also certain limitations of ownership capital as a source of finance. These are:

The amount of capital, which may be raised as owners fund depends on the number of persons, prepared to
take the risks involved. In a partnership confer, a few persons cannot provide ownership capital beyond a
certain limit and this limitation is more so incase of proprietary form of organization.

A joint stock company can raise large amount by issuing shares to the public. Bus it leadsto an increased number
of people having ownership interest and right of control over management. This may reduce the original
investors‟ power of control over management.Being a permanent source of capital, ownership funds are not
refundable as long as the company is in existence, even when the funds remain idle.

A company may find it difficult to raise additional ownership capital unless it has high profit-earning capacity or
growth prospects. Issue of additional shares is also subject to somany legal and procedural restrictions.

Borrowed funds and borrowed capital: It includes all funds available by way of loans or credit. Business firms
raise loans for specified periods at fixed rates of interest. Thus borrowed funds may serve the purpose of long-
term, medium-term or short-term finance.The borrowing is generally at against the security of assets from banks
and financial institutions. A company to borrow the funds can also issue various types of debentures.

Interest on such borrowed funds is payable at half yearly or yearly but the principal amount is being repaid only at
the end of the period of loan. These interest and principal payments have to be met even if the earnings are low or
there is loss. Lenders and creditors do not have any right of control over the management of the borrowing firm.
But they can sue the firm in a law court if there is default in payment, interest or principalback.

Merits:

From the business point of view, borrowed capital has several merits.
1. It does not affect the owner‟s control over management.
2. Interest is treated as an expense, so it can be charged against income and amountof tax payable thereby
reduced.
3. The amount of borrowing and its timing can be adjusted according to convenienceand needs, and
4. It involves a fixed rate of interest to be paid even when profits are very high, thusowners may enjoy a
much higher rate of return on investment then the lenders.

Limitations:

There are certain limitations, too in case of borrowed capacity. Payment of interest andrepayment of loans
cannot be avoided even if there is a loss. Default in meeting these obligations may create problems for the
business and result in decline of its credit worthiness. Continuing default may even lead to insolvency of firm.

Secondly, it requires adequate security to be offered against loans. Moreover, high rates
of interest may be charged if the firm‟s ability to repay the loan in uncertain.

Source of Company Finance

Based upon the time, the financial resources may be classified into (1) sources of long term (2) sources of short –
term finance. Some of these sources also serve the purpose ofmedium – term finance.

I. The source of long – term finance are:

1. Issue of shares
2. Issue debentures
3. Loan from financial institutions
4. Retained profits and
5. Public deposits
II. Sources of Short-term Finance are:

1. Trade credit
2. Bank loans and advances and
3. Short-term loans from finance companies.

Sources of Long Term Finance

1. Issue of Shares: The amount of capital decided to be raised from members of thepublic is divided into
units of equal value. These units are known as share and the aggregate values of shares are known as
share capital of the company. Those who subscribe to the share capital become members of the company
and are called shareholders. They are the owners of the company. Hence shares are also described as
ownership securities.

2. Issue of Preference Shares: Preference share have three distinct characteristics.Preference shareholders
have the right to claim dividend at a fixed rate, which is decided according to the terms of issue of
shares. Moreover, the preference dividend is to be paid first out of the net profit. The balance, it any, can
be distributed among other shareholders that is, equity shareholders. However, payment of dividend is
not legally compulsory. Only when dividend is declared, preference shareholders have a prior claim over
equity shareholders.

Preference shareholders also have the preferential right of claiming repayment of capital in the event of winding
up of the company. Preference capital has to be repaid out of assets after meeting the loan obligations and claims
of creditors but before any amount isrepaid to equity shareholders.

Holders of preference shares enjoy certain privileges, which cannot be claimed by the equity shareholders. That
is why; they cannot directly take part in matters, which may bediscussed at the general meeting of shareholders,
or in the election of directors.

Depending upon the terms of conditions of issue, different types of preference shares maybe issued by a company
to raises funds. Preference shares may be issued as:

1. Cumulative or Non-cumulative
2. Participating or Non-participating
3. Redeemable or Non-redeemable, or as
4. Convertible or non-convertible preference shares.

In the case of cumulative preference shares, the dividend unpaid if any in previous yearsgets accumulated until
that is paid. No cumulative preference shares have any such provision.
Participatory shareholders are entitled to a further share in the surplus profits after a reasonable divided has been
paid to equity shareholders. Non-participating preference shares do not enjoy such right. Redeemable preference
shares are those, which are repaidafter a specified period, where as the irredeemable preference shares are not
repaid.
However, the company can also redeem these shares after a specified period by givingnotice as per the terms
of issue. Convertible preference shows are those, which are entitled to be converted into equity shares after a
specified period.

Merits:

Many companies due to the following reasons prefer issue of preference shares as asource of finance.
1. It helps to enlarge the sources of funds.
2. Some financial institutions and individuals prefer to invest in preference sharesdue to the assurance
of a fixed return.
3. Dividend is payable only when there are profits.
4. If does not affect the equity shareholders‟ control over management

Limitations:

The limitations of preference shares relates to some of its main features:

1. Dividend paid cannot be charged to the company‟s income as an expense; hence

there is no tax saving as in the case of interest on loans.

2. Even through payment of dividend is not legally compulsory, if it is not paid or

arrears accumulate there is an adverse effect on the company‟s credit.
3. Issue of preference share does not attract many investors, as the return is generally limited and not
exceed the rates of interest on loan. On the other than,there is a risk of no dividend being paid in the
event of falling income.

1. Issue of Equity Shares: The most important source of raising long-term capital for a company is the issue of
equity shares. In the case of equity shares there is no promise to shareholders a fixed dividend. But if the
company is successful and the level profits are high, equity shareholders enjoy very high returns on their
investment. This feature is veryattractive to many investors even through they run the risk of having no return if
the profits are inadequate or there is loss. They have the right of control over the management of the company
and their liability is limited to the value of shares held by them.

From the above it can be said that equity shares have three distinct characteristics:

1. The holders of equity shares are the primary risk bearers. It is the issue of equity shares that mainly
provides „risk capital‟, unlike borrowed capital. Even compared with preference capital, equity
shareholders are to bear ultimate risk.
 2. Equity shares enable much higher return sot be earned by shareholders during prosperity because after
meeting the preference dividend and interest on borrowedcapital at a fixed rate, the entire surplus of
profit goes to equity shareholders only.
3. Holders of equity shares have the right of control over the company. Directors areelected on the vote of
equity shareholders.

Merits:

From the company‟ point of view; there are several merits of issuing equity shares to raise
long-term finance.

1. It is a source of permanent capital without any commitment of a fixed return to theshareholders. The
return on capital depends ultimately on the profitability of business.
2. It facilities a higher rate of return to be earned with the help borrowed funds. This is possible due to two
reasons. Loans carry a relatively lower rate of interest than the average rate of return on total capital.
Secondly, there is tax saving as interestpaid can be charged to income as a expense before tax
calculation.
3. Assets are not required to give as security for raising equity capital. Thus additionalfunds can be raised as
loan against the security of assets.

Limitations:

Although there are several advantages of issuing equity shares to raise long-term capital.

1. The risks of fluctuating returns due to changes in the level of earnings of thecompany do not
attract many people to subscribe to equity capital.
2. The value of shares in the market also fluctuate with changes in businessconditions, this is
another risk, which many investors want to avoid.

2. Issue of Debentures:
When a company decides to raise loans from the public, the amount of loan is dividend into units of equal. These
units are known as debentures. A debenture is the instrument orcertificate issued by a company to acknowledge its
debt. Those who invest money in debentures are known as „debenture holders‟. They are creditors of the company.
Debentures are therefore called „creditor ship‟ securities. The value of each debentures is
generally fixed in multiplies of 10 like Rs. 100 or Rs. 500, or Rs. 1000.

Debentures carry a fixed rate of interest, and generally are repayable after a certain period, which is specified at
the time of issue. Depending upon the terms and conditions ofissue there are different types of debentures. There
are:

a. Secured or unsecured Debentures and

b. Convertible of Non convertible Debentures.
It debentures are issued on the security of all or some specific assets of the company, they are known as
secured debentures. The assets are mortgaged in favor of the debenture holders. Debentures, which are not
secured by a charge or mortgage of any assets, are called unsecured debentures. The holders of these
debentures are treated asordinary creditors.

Sometimes under the terms of issue debenture holders are given an option to covert theirdebentures into equity
shares after a specified period. Or the terms of issue may lay downthat the whole or part of the debentures will be
automatically converted into equity sharesof a specified price after a certain period. Such debentures are known as
convertible debentures. If there is no mention of conversion at the time of issue, the debentures are regarded as
non-convertible debentures.

Merits:
Debentures issue is a widely used method of raising long-term finance by companies, dueto the following
reasons.

1. Interest payable on Debentures can be fixed at low rates than rate of return onequity shares. Thus
Debentures issue is a cheaper source of finance.
2. Interest paid can be deducted from income tax purpose; there by the amount of tax payable is
reduced.
3. Funds raised for the issue of debentures may be used in business to earn a muchhigher rate of return
then the rate of interest. As a result the equity shareholdersearn more.
4. Another advantage of debenture issue is that funds are available from investorswho are not entitled
to have any control over the management of the company.

5. Companies often find it convenient to raise debenture capital from financial institutions, which prefer
to invest in debentures rather than in shares. This is dueto the assurance of a fixed return and repayment
after a specified period.

Limitations:
Debenture issue as a source of finance has certain limitations too.

1. It involves a fixed commitment to pay interest regularly even when the companyhas low earnings or
incurring losses.
2. Debentures issue may not be possible beyond a certain limit due to the inadequacyof assets to be offered
as security.

Methods of Issuing Securities: The firm after deciding the amount to be raised and thetype of securities to be
issued, must adopt suitable methods to offer the securities to potential investors. There are for common methods
followed by companies for the purpose.

When securities are offered to the general public a document known as Prospectus, or a notice, circular or
advertisement is issued inviting the public to subscribe to the securitiesoffered thereby all particulars about the
company and the securities offered are made to the public. Brokers are appointed and one or more banks are
authorized to collect subscription.

Some times the entire issue is subscribed by an organization known as Issue House, whichin turn sells the
securities to the public at a suitable time.

The company may negotiate with large investors of financial institutions who agree to take
over the securities. This is known as „Private Placement‟ of securities.

When an exiting company decides to raise funds by issue of equity shares, it is requiredunder law to offer the
new shares to the existing shareholders. This is described as rightissue of equity shares. But if the existing
shareholders decline, the new shares can be offered to the public.

3. Loans from financial Institutions:

Government with the main object of promoting industrial development has set up a number of financial
institutions. These institutions play an important role as sources of company finance. Besides they also assist
companies to raise funds from other sources.

These institutions provide medium and long-term finance to industrial enterprises at a reason able rate of
interest. Thus companies may obtain direct loan from the financial institutions for expansion or modernization
of existing manufacturing units or for startinga new unit.

Often, the financial institutions subscribe to the industrial debenture issue of companiessome of the institutions
(ICICI) and (IDBI) also subscribe to the share issued by companies.

All such institutions also underwrite the public issue of shares and debentures by companies. Underwriting is an
agreement to take over the securities to the extent there isno public response to the issue. They may guarantee
loans, which may be raised by companies from other sources.

Loans in foreign currency may also be granted for the import of machinery and equipmentwherever necessary
from these institutions, which stand guarantee for re-payments. Apartfrom the national level institutions
mentioned above, there are a number of similar institutions set up in different states of India. The state-level
financial institutions are known as State Financial Corporation, State Industrial Development Corporations,
StateIndustrial Investment Corporation and the like. The objectives of these institutions are similar to those of
the national-level institutions. But they are mainly concerned with the development of medium and small-
scale industrial units. Thus, smaller companies depend on state level institutions as a source of medium and
long-term finance for the expansion and modernization of their enterprise.

4. Retained Profits:
Successful companies do not distribute the whole of their profits as dividend to shareholders but reinvest a part of
the profits. The amount of profit reinvested in the business of a company is known as retained profit. It is shown
as reserve in the accounts.The surplus profits retained and reinvested may be regarded as an internal source of
finance. Hence, this method of financing is known as self-financing. It is also called sloughing back of profits.

Since profits belong to the shareholders, the amount of retained profit is treated as ownership fund. It serves the
purpose of medium and long-term finance. The total amountof ownership capital of a company can be determined
by adding the share capital and accumulated reserves.

Merits:

This source of finance is considered to be better than other sources for the followingreasons.

1. As an internal source, it is more dependable than external sources. It is not

necessary to consider investor‟s preference.
2. Use of retained profit does not involve any cost to be incurred for raising the funds.Expenses on
prospectus, advertising, etc, can be avoided.
3. There is no fixed commitment to pay dividend on the profits reinvested. It is a partof risk capital like
equity share capital.
4. Control over the management of the company remains unaffected, as there is noaddition to the
number of shareholder.
5. It does not require the security of assets, which can be used for raising additionalfunds in the form of
loan.

Limitations:

However, there are certain limitations on the part of retained profit.

1. Only well established companies can be avail of this sources of finance. Even forsuch companies
retained profits cannot be used to an unlimited extent.
2. Accumulation of reserves often attract competition in the market,
3. With the increased earnings, shareholders expect a high rate of dividend to be paid.
4. Growth of companies through internal financing may attract governmentrestrictions as it
leads to concentration of economic power.

5. Public Deposits:
An important source of medium – term finance which companies make use of is public deposits. This requires
advertisement to be issued inviting the general public of deposits. This requires advertisement to be issued
inviting the general public to deposit their savings with the company. The period of deposit may extend up to
three yeas. The rate ofinterest offered is generally higher than the interest on bank deposits. Against the deposit,
the company mentioning the amount, rate of interest, time of repayment and such other information issues a
receipt.

Since the public deposits are unsecured loans, profitable companies enjoying public confidence only can be able
to attract public deposits. Even for such companies there arerules prescribed by government limited its use.

Sources of Short Term Finance

The major sources of short-term finance are discussed below:

1. Trade credit: Trade credit is a common source of short-term finance available to all companies. It refers
to the amount payable to the suppliers of raw materials, goods etc. after an agreed period, which is
generally less than a year. It is customary for all business firms to allow credit facility to their customers
in trade business. Thus, it is an automatic source of finance. With the increase in productionand
corresponding purchases, the amount due to the creditors also increases. Thereby part of the funds
required for increased production is financed by the creditors. The more important advantages of trade
credit as a source of short-termfinance are the following:

It is readily available according to the prevailing customs. There are no special efforts to be made to avail of it.
Trade credit is a flexible source of finance. It can be easily adjustedto the changing needs for purchases.

Where there is an open account for any creditor failure to pay the amounts on time due totemporary difficulties
does not involve any serious consequence Creditors often adjust the time of payment in view of continued
dealings. It is an economical source of finance.

However, the liability on account of trade credit cannot be neglected. Payment has to bemade regularly. If the
company is required to accept a bill of exchange or to issue a promissory note against the credit, payment must
be made on the maturity of the bill ornote. It is a legal commitment and must be honored; otherwise legal action
will follow torecover the dues.

2. Bank loans and advances: Money advanced or granted as loan by commercial banks is known as bank
credit. Companies generally secure bank credit to meet their current operating expenses. The most
common forms are cash credit and overdraft facilities. Under the cash credit arrangement the maximum
limit of creditis fixed in advance on the security of goods and materials in stock or against the personal
security of directors. The total amount drawn is not to exceed the limit fixed. Interest is charged on the
amount actually drawn and outstanding. During the period of credit, the company can draw, repay and
again draw amounts with inthe maximum limit. In the case of overdraft, the company is allowed to
overdraw its current account up to the sanctioned limit. This facility is also allowed either against
 personal security or the security of assets. Interest is charged on the amount actually overdrawn, not on
the sanctioned limit.

The advantage of bank credit as a source of short-term finance is that the amount can beadjusted according to the
changing needs of finance. The rate of interest on bank credit isfairly high. But the burden is no excessive
because it is used for short periods and is compensated by profitable use of the funds.

Commercial banks also advance money by discounting bills of exchange. A company having sold goods on credit
may draw bills of exchange on the customers for their acceptance. A bill is an order in writing requiring the
customer to pay the specified amountafter a certain period (say 60 days or 90 days). After acceptance of the bill,
the company can drawn the amount as an advance from many commercial banks on payment of a discount. The
amount of discount, which is equal to the interest for the period of the bill, and the balance, is available to the
company. Bill discounting is thus another source of short-term finance available from the commercial banks.

3. Short term loans from finance companies: Short-term funds may be availablefrom finance companies
on the security of assets. Some finance companies also provide funds according to the value of bills
receivable or amount due from the customers of the borrowing company, which they take over.

Capital Budgeting

Capital Budgeting: Capital budgeting is the process of making investment decision in long-term assets or courses
of action. Capital expenditure incurred today is expected to bring its benefits over a period of time. These
expenditures are related to the acquisition &improvement of fixes assets.

Capital budgeting is the planning of expenditure and the benefit, which spread over a number of years. It is the
process of deciding whether or not to invest in a particular project, as the investment possibilities may not be
rewarding. The manager has to choosea project, which gives a rate of return, which is more than the cost of
financing the project. For this the manager has to evaluate the worth of the projects in-terms of cost and benefits.
The benefits are the expected cash inflows from the project, which are discounted against a standard, generally
the cost of capital.
Capital Budgeting Process:

The capital budgeting process involves generation of investment, proposal estimation ofcash-flows for the
proposals, evaluation of cash-flows, selection of projects based on acceptance criterion and finally the
continues revaluation of investment after their acceptance the steps involved in capital budgeting process are
as follows.

1. Project generation
2. Project evaluation
3. Project selection
4. Project execution
1. Project generation: In the project generation, the company has to identify the proposal to be undertaken
depending upon its future plans of activity. After identificationof the proposals they can be grouped according
to the following categories:

a. Replacement of equipment: In this case the existing outdated equipmentand machinery may
be replaced by purchasing new and modern equipment.
b. Expansion: The Company can go for increasing additional capacity in theexisting product
line by purchasing additional equipment.

c. Diversification: The Company can diversify its product line by way of producing various
products and entering into different markets. For thispurpose, It has to acquire the fixed
assets to enable producing new products.
d. Research and Development: Where the company can go for installation of research and
development suing by incurring heavy expenditure with a viewto innovate new methods of
production new products etc.,

2. Project evaluation: In involves two steps.

a. Estimation of benefits and costs: These must be measured in terms of cashflows. Benefits to be
received are measured in terms of cash flows. Benefits

to be received are measured in terms of cash in flows, and costs to beincurred are
measured in terms of cash flows.
b. Selection of an appropriate criterion to judge the desirability of the project.

3. Project selection: There is no standard administrative procedure for approving the investment decisions. The
screening and selection procedure would differ from firm to firm. Due to lot of importance of capital budgeting
decision, the final approval of the project may generally rest on the top management of the company. However
the proposals are scrutinized at multiple levels. Some times top management may delegate authority to approve
certain types of investment proposals. The top management may do so by limiting the amount of cash out lay.
Prescribing the selection criteria and holding thelower management levels accountable for the results.

4. Project Execution: In the project execution the top management or the project execution committee is
responsible for effective utilization of funds allocated for the projects. It must see that the funds are spent in
accordance with the appropriation madein the capital budgeting plan. The funds for the purpose of the project
execution must bespent only after obtaining the approval of the finance controller. Further to have an effective
cont. It is necessary to prepare monthly budget reports to show clearly the totalamount appropriated, amount
spent and to amount unspent.
Capital budgeting Techniques:

The capital budgeting appraisal methods are techniques of evaluation of investment proposal will help the
company to decide upon the desirability of an investment proposal depending upon their; relative income
generating capacity and rank them in order of theirdesirability. These methods provide the company a set of
norms on the basis of which either it has to accept or reject the investment proposal. The most widely accepted
techniques used in estimating the cost-returns of investment projects can be grouped under two categories.

1. Traditional methods
2. Discounted Cash flow methods

1. Traditional methods

These methods are based on the principles to determine the desirability of an investment project on the basis of its
useful life and expected returns. These methods depend upon the accounting information available from the books
of accounts of the company. These will not take into account the concept of „time value of money‟, which is a
significant factorto determine the desirability of a project in terms of present value.

A. Pay-back period method: It is the most popular and widely recognized traditional method of evaluating the
investment proposals. It can be defined, as „the number of yearsrequired to recover the original cash out lay
invested in a project‟.

According to Weston & Brigham, “The pay back period is the number of years it takes the
firm to recover its original investment by net returns before depreciation, but after taxes”.

According to James. C. Vanhorne, “The payback period is the number of years required to
recover initial cash investment.

The pay back period is also called payout or payoff period. This period is calculated by dividing the cost of
the project by the annual earnings after tax but before depreciationunder this method the projects are ranked
on the basis of the length of the payback period. A project with the shortest payback period will be given the
highest rank and taken as the best investment. The shorter the payback period, the less risky the investment is
the formula for payback period is

Cash outlay (or) original cost of projectPay-back

period =
Annual cash inflow
Merits:
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.
3. It dose not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available from thebooks.

Demerits:
1. This method fails to take into account the cash flows received by thecompany after the
pay back period.
2. It doesn‟t take into account the interest factor involved in an investment
outlay.
3. It doesn‟t take into account the interest factor involved in an investment
outlay.
4. It is not consistent with the objective of maximizing the market value of
the company‟s share.
5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash inflows.

B. Accounting (or) Average rate of return method (ARR):

It is an accounting method, which uses the accounting information repeated by the financial statements to
measure the probability of an investment proposal. It can be determine by dividing the average income after
taxes by the average investment i.e., theaverage book value after depreciation.
According to „Soloman‟, accounting rate of return on an investment can be calculated as
the ratio of accounting net income to the initial investment, i.e.,

Average net income after taxes

ARR= ] X 100
Average Investment

Total Income after Taxes

Average net income after taxes = -----------------------------
No. Of Years
Total Investment

Average investment = ----------------------

2

On the basis of this method, the company can select all those projects who‟s ARR is higherthan the minimum rate
established by the company. It can reject the projects with an ARRlower than the expected rate of return. This
method can also help the management to rank the proposal on the basis of ARR. A highest rank will be given to a
project with highest ARR, where as a lowest rank to a project with lowest ARR.

Merits:

1. It is very simple to understand and calculate.

2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.

Demerits:

1. It is not based on cash flows generated by a project.

2. This method does not consider the objective of wealth maximization
3. IT ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.

II: Discounted cash flow methods:

The traditional method does not take into consideration the time value of money. They give equal weight age to
the present and future flow of incomes. The DCF methods are based on the concept that a rupee earned today is
more worth than a rupee earned tomorrow. These methods take into consideration the profitability and also
time value ofmoney.

A. Net present value method (NPV)

The NPV takes into consideration the time value of money. The cash flows of different years and valued
differently and made comparable in terms of present values for this thenet cash inflows of various period are
discounted using required rate of return which is predetermined.

According to Ezra Solomon, “It is a present value of future returns, discounted at the
required rate of return minus the present value of the cost of the investment.”

NPV is the difference between the present value of cash inflows of a project and the initialcost of the project.

According the NPV technique, only one project will be selected whose NPV is positive or above zero. If a
project(s) NPV is less than „Zero‟. It gives negative NPV hence. It must berejected. If there are more than one
project with positive NPV‟s the project is selected whose NPV is the highest.
The formula for NPV is

NPV= Present value of cash inflows – investment.

C1 C2 C3 Cn
NPV = + + +
 (1+K)

Co- investment
C1, C2, C3… Cn= cash inflows in different years.
K= Cost of the Capital (or) Discounting rateD= Years.

Merits:

1. It recognizes the time value of money.

2. It is based on the entire cash flows generated during the useful life of the asset.
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for determining thepresent value.

Demerits:

1. It is different to understand and use.

2. The NPV is calculated by using the cost of capital as a discount rate. But theconcept of cost of
capital. If self is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in differentamounts of
investment.
4. It does not give correct answer to a question whether alternative projects or limitedfunds are available
with unequal lines.

B. Internal Rate of Return Method (IRR)

The IRR for an investment proposal is that discount rate which equates the present valueof cash inflows with the
present value of cash out flows of an investment. The IRR is alsoknown as cutoff or handle rate. It is usually the
concern‟s cost of capital.

According to Weston and Brigham “The internal rate is the interest rate that equates the
present value of the expected future receipts to the cost of the investment outlay.

When compared the IRR with the required rate of return (RRR), if the IRR is more than RRR then the project is
accepted else rejected. In case of more than one project with IRRmore than RRR, the one, which gives the
highest IRR, is selected.

The IRR is not a predetermine rate, rather it is to be trial and error method. It implies thatone has to start with a
discounting rate to calculate the present value of cash inflows. If the obtained present value is higher than the
initial cost of the project one has to try with a higher rate. Like wise if the present value of expected cash inflows
obtained is lower than the present value of cash flow. Lower rate is to be taken up. The process is continuedtill the
net present value becomes Zero. As this discount rate is determined internally, thismethod is called internal rate of
return method.

P1 - Q
IRR = L+ --------------- X D
P1 –P2

L- Lower discount rate

P1 - Present value of cash inflows at lower rate. P2 - Present
value of cash inflows at higher rate.Q- Actual investment
D- Difference in Discount rates.
Merits:
1. It consider the time value of money
2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of returnprojects are selected, it
satisfies the investors in terms of the rate of return an capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firm‟s objective of maximum owner‟s welfare.

Demerits:

1. It is very difficult to understand and use.

2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.

C. Probability Index Method (PI)

The method is also called benefit cost ration. This method is obtained cloth a slight modification of the NPV
method. In case of NPV the present value of cash out flows are profitability index (PI), the present value of cash
inflows are divide by the present value ofcash out flows, while NPV is a absolute measure, the PI is a relative
measure.

It the PI is more than one (>1), the proposal is accepted else rejected. If there are more than one investment
proposal with the more than one PI the one with the highest PI will be selected. This method is more useful incase
of projects with different cash outlays cashoutlays and hence is superior to the NPV method.

The formula for PI is

Present Value of Future Cash Inflow

Probability index =
Investment
Merits:
1. It requires less computational work then IRR method
2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of theindex.
4. It is useful to tank the proposals on the basis of the highest/lowest value of theindex.
5. It takes into consideration the entire stream of cash flows generated during theuseful life of the
asset.

Demerits:

1. It is some what difficult to understand

2. Some people may feel no limitation for index number due to several limitationinvolved in their
competitions
3. It is very difficult to understand the analytical part of the decision on the basis ofprobability index.