Financial Management

Financia Management Paper-20 M Com (Fina) Directorate of Distance Education Maharshi Dayanand University ROHTAK 124 001

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Qkhokn 3 CONTENTS Chapter-1: Introduction to Financia Management 5 Chapter-2: Cost of Capita 25 Chapter-3: Operating and Financia Leverage 77 Chapter-4: Capita Budgeting 94 Chapter-5: Capita Budgeting Evauation Techniques 112 Chapter-6: Capita Budgeting under Risk and Uncertainties 130 Chapter-7: Working Capita Management 165 Chapter-8: Cash Management and Marketabe Securities 196 Chapter-9: Management of Receivabes 223 Chapter-10: Inventory Management 244 Chapter-11: Capita Structure Theories 262 Chapter-12: Dividend Decisions 330 Chapter-13: Working Capita Financing 346 Chapter-14: Reguation of Bank Finance 380

4 jktuhfr fokku FINANCIAL MANAGEMENT MCom (Fina) Paper-20 M. Marks : 100 Time : 3 Hrs. Note: There wi be three sections of the question paper. In section A there wi be 10 short answer questions of 2 marks each. A questions of this section are compusory. Section B wi comprise of 10 questions of 5 marks each out of which candidates are required to attempt any seven questions. Section C wi be having 5 questions of 15 marks each out of which candidates are required to attempt any three question. The examiner wi set the questions in a the three sections by covering the entire syabus of the concerned subject. Course Inputs UNIT I UNIT II UNIT III UNIT IV Evauation of Finance, Objectives of the Firm-Profit Max, And Weath Max, Functions of Financia Management, Organisation of the Finance Function, Cost of Capita: Definition and Concepts, Measurement, the weighted average cost of Capita; Leverage: Operating and Financia, Combined Leverage. Capita Budgeting, Meaning, Importance, Rationa of Capita Budget, Nature of Investment Decision, The Administrative framwork, methods of appraisa, Capita Rationing, Infation and Capita Budgeting; Capita budgeting underrisk and Uncertainties. Working Capita Management, Concept, Need, Determinants, Finance mix for working capita, Estimating working capikta needs, Cash management; The Cash Budget, Techniques of cash management and marketabe securities; Management of reseivabes; Objectives, Factors affecting poicies for managing accounts receivabes; Inventory Management; Objectives, Inventory Management techniques. Financing Decisions: Capita Structure Theories, taxation and capita structure; Panning the capita structure, Factors affecting capita structure, E.B.I.T.-E.P.S. ansysis, ROI-ROE anaysis, Assessment of Debt Capacity, Capita Structure Poicies in Practice. Dividend Decision: Theories of Dividends-traditiona position, Gordon Mode, Water mode, M.M. Mode, Radica Mode, Factors affecting dividend poicy, stock dividends and stock spits, Repurchase of stock procedura and ega aspects of dividends. UNIT V Sources of Working Capita Funds: Accuras, trade, credit, commercia banks advances, pubic deposits, Inter corporate deposits, short term oans from financia institution, right debentures for working capita, commercia papers and factoring. Reguation of Bank Finance:-Recommendations of Latest Committee.

Introduction to Financia Management 5 Chapter-1 Introduction to Financia Management Companies do not work in a vacuum, isoated from everything ese. It interacts and transacts with the other entities present in the economic environment. These entities incude Government, Suppiers, Lenders, Banks, Customers, Sharehoders, etc. who dea with the organisation in severa ways. Most of these deaings resut in either money fowing in or fowing out from the company. This fow of money (or funds) has to be managed so as to resut in maximum gains to the company. Managing this fow of funds efficienty is the purview of finance. So we can define finance as the study of the methods which hep us pan, raise and use funds in an efficient manner to achieve corporate objectives. Finance grew out of economics as a specia discipine to dea with a specia set of common probems. The corporate financia objectives coud be to: 1. Provide the ink between the business and the other entities in the environment and 2. Investment and financia decision making Let us first ook at what we mean by investment and financia decision making. 1. Investment Decision: The investment decision, aso referred to as the capita budgeting decision, simpy means the decisions to acquire assets or to invest in a project. Assets are defined as economic resources that are expected to generate future benefits. 2. Financing Decision: The second financia decision is the financing decision, which basicay addresses two questions: a. How much capita shoud be raised to fund the firm's operations (both existing & proposed) b. What is the best mix of financing these assets? Financing coud be through two ways: debt (oans from various sources ike banks, financia institutions, pubic, etc.) and equity (capita put in by the investors who are aso known as owners/ sharehoders). Sharehoders are owners because the shares represent the ownership in the company.

6 Financia Management Funds are raised from financia markets. Financia markets is a generic term used to denote markets where financia securities are teat. These markets incude money markets, debt market and capita markets. We wi understand them in detai ater in the 3rd chapter. Financing and investing decisions are cosey reated because the company is going to raise money to invest in a project or assets. Those who are going to give money to the company (whether enders or investors) need to understand where the company is investing their money and what it hopes to earn from the investments so that they can assure themseves of the safety of their money. The questions that you may thinking about right now are "Why do we need to earn finance? Sha we not eave it to the peope who are going to speciaise in finance? Finance won't hep me in the area that I am going to work in, so why earn?" This is to say that the knowedge of finance does not add any vaue to you. Is it so? Think about it. When you get your pocket money from your parents, you do not go out and bow the whoe ot in one day because if you do, your parents are not going to give you more money to ast through that month. You quicky earn that you need to pan your expenditure so that the money asts throughout the month and you may actuay pan to save some of it. Those who do not get enough to meet their requirements, think about some cever means to raise more money (ike faing sick!). Aternativey if they need more money for the month because of certain specia events (ike Vaentine's day) they can pan to borrow money for a month and repay in the next month. So you pan, raise and efficienty utiise funds that are your disposa (or at east try to). That a business organisation aso needs to do the same can hardy be overemphasised. The scae of operations is much bigger and to efficienty manage funds at this scae, decisions cannot be taken without sound methodoogy. Finance teaches you this terminoogy. For managing these funds the first thing you woud need is information. Externa information has to be coected from the environment and accounting provides interna information about the firm's operations. Accounting can be defined as an information and measurement system that identifies, records, and communicates reevant information about a company's economic activities to peope to hep them make better decisions. You woud now agree that a company needs to manage its own funds efficienty but your question sti remains "Why am I concerned with it?" Further arguing, you say that, "I am going to speciaise in Marketing/ Information Technoogy/ Human Resource Management/ Operations Management and there is no need for me to earn finance. Aso Finance is a separate function in my organisation (or the organisation that I am going to work for) and I am hardy going to use finance to work in my respective department."

Introduction to Financia Management 7 Think again. Everything that you do has an impact on the profitabiity of the company (incuding drinking ten cups of coffee in a day!). So if you want to grow up to be the CEO of the company in a few years from now (which I undoubtedy think that you woud ove to) you shoud take the advice of the top CEOs. 79 per cent of the top CEOs rate Finance skis, as the most required for the CEO of the future. KPMG survey Better take the CEOs advice. But don't get the feeing that ony the CEOs require the Finance Skis, a other functions of management aso cannot do without finance and the financia information. Fieds of Finance The academic discipine of financia management may be viewed as made up of five speciaized fieds. In each fied, the financia manager is deaing with the management of money and caims against money. Distinctions arise because different organizations pursue different objectives and do not face the same basic set of probems. There are five generay recognized areas of finance. 1. Pubic Finance. Centra, state and oca governments hande arge sums of money, which are received from many sources and must be utiized in accordance with detaied poicies and procedures. Governments have the authority to tax and otherwise raise funds, and must dispense funds according to egisative and other imitations. Aso, government do not conduct their activities to achieve the same goas as private organizations. Businesses try to make profits, whereas a government wi attempt to accompish socia or economic objectives. As a resut of these and other differences, a speciaized fied of pubic finance has emerged to dea with government financia matters. 2. Securities and Investment Anaysis. Purchase of stocks, bonds, and other securities invove anaysis and techniques that are highy speciaized. An investor must study the ega and investment characteristics of each type of security, measure the degree of risk invoved with each investment, and forecast probabe performance in the market. Usuay this anaysis occurs without the investor having any direct contro over the firm or institution represented by the form of security. The fied of investment anaysis deas with these matters and attempts to deveop techniques to hep the investor reduce the risk and increase the ikey return from the purchase of seected securities. 3. Internationa Finance. When money crosses internationa boundaries individuas, businesses, and governments must dea with specia kinds of probems. Each country has its own nationa currency; thus a citizen of the United States must convert doars to French francs before being abe to purchase goods or services in Paris. Most governments have imposed restrictions on the exchange of currencies, and these may affect business transactions. Governments may be

8 Financia Management facing financia difficuties, such as baance-of-payments deficits, or may be deaing with economic probems, such as infation or high eves of unempoyment. In these cases, they may require detaied accounting for the fows of funds or may aow ony certain types of internationa transactions. The study of fows of funds between individuas and organizations across nationa borders and the deveopment of methods of handing the fows more efficiency are propery within the scope of internationa finance. 4. Institutiona Finance. A nation s economic structure contains a number of financia institutions, such as banks, insurance companies, pension funds, credit unions. These institutions gather money from individua savers and accumuate sufficient amounts for efficient investment. Without these institutions, funds woud not be readiy avaiabe to finance business transactions, the purchase of private homes and commercia faciities, and the variety of other activities that require organizations that perform the financing function of the economy. 5. Financia Management. Individua businesses face probems deaing with the acquisition of funds to carryon their activities and with the determination of optimum methods of empoying the funds. In a competitive marketpace, businesses and activey manage their funds to achieve their goas. Many toos and techniques have been deveoped to assist financia managers to recommend proper courses of action. These toos hep the manager determine which sources offer the owest cost of funds and which activities wi provide the greatest return on invested capita. Financia management is the fied of greatest concern to the corporate financia officers and wi be the major thrust of the approach we sha use in studying finance. An overview of the five fieds of finance is given in Figure 1.1. Pubic Finance Used in centra, state and oca government. Examines taxes and other revenues. Pursues nonprofit goas. Securities and Investment Anaysis Used by individua and institutiona investors. Measures risk in securities transactions. Measures ikey return. Institutiona Finance Examines banks, insurances companies and pension funds. Studies saving and capita formation. Internationa Finance Studies economic transactions among nations. Concerned with fows among countries. Financia Management Studies financia probems in individua firms. Seeks sources of ow-cost funds. Seeks profitabe business activities. Figure 1.1 Various Fieds of Finance

Introduction to Financia Management 9 Objectives of the Firm - Profit Maximisation and Weath Maximisation To put it simpy, we might say that the goa of any business is to maximise the returns to the owners of the business. So the goa of finance is to hep the business in maximising returns. But if you tak to the companies, you aso hear about many other goas that they are pursuing at the same time. These goas coud incude maximisation of saes, maximisation of market share, maximisation of growth rates of saes, maximisation of the market price of the share (whether rea or specificay pushed up to benefit the owners), etc. Individuay speaking, managers woud be more concerned with the money that they are making from the organisation and the benefits that they are receiving rather than care about what the owners are making! As there coud be many goas for the organisation, we shoud try and summarise the organisationa goas in financia terms so that we can ca them the financia goas. They boi down to two: 1. Maximise profits or 2. Maximise weath Maximise Profits Let us first ook at profit maximisation. Profit (aso caed net income or earnings) can be defined as the amount a business earns after subtracting a expenses necessary for its saes. To put it in an equation form: Saes - Expenses = Profit If you want to maximise profits, there are ony two ways to do it. Either you reduce your expenses (aso caed costs) or you increase the saes (aso caed revenues). Both of these are not easy to achieve. Saes can be increased by seing more products or by increasing the price of the products. Seing more products is difficut because of the competition in the market and you cannot increase the price of the products without adding more features or vaue to it (assuming a competitive market). If you are a competitive company, reducing expenses beyond a certain eve is possibe ony by reducing the investments in advertising, research and deveopment, etc. which utimatey eads to reduction in saes in the ong term and threatens the surviva of the company. Profit maximisation goa assumes that many of the compexities of the rea word do not exist and is, therefore, not acceptabe. Sti, profit maximisation remains one of the key goas for the managers of the company because many managers' compensations are inked to the profits that the company is generating. Owners need to be aware of these goas and understand that it is the ongterm viabiity of their companies that add vaue to them and not the short-term profitabiity.

10 Financia Management Therefore, the ong-term surviva of the company shoud not be sacrificed for the shortterm benefits. Weath Maximisation Sharehoders' weath can be defined as the tota market vaue of a the equity shares of the company. So when we tak about maximising weath we tak about maximising the vaue of each share. How the decisions taken by the organisation affects the vaue of the organisation is refected in the figure 1.1. Figure 1.1: How Financia Decisions affect the Vaue of the Organisation The sharehoders' weath maximisation goa gives us the best resuts because effects of a the decisions taken by the company and its managers are refected in it. In order to empoyee use this goa, we do not have to consider every price change of our shares in the market as an interpretation of the worth of the decisions that the company has taken. What the company needs to focus on is the affect that its decision shoud have on the share price if everything ese was hed constant. This confict of the decisions by the managers and the decisions required by the owners is known as the agency probem. How are companies soving this probem wi be discussed ater. Scope of Financia Management The approach to the scope and functions of financia management is divided, for purposes of exposition, into two broad categories: (a) The Traditiona Approach, and (b) The Modern Approach.

Introduction to Financia Management 11 Traditiona Approach The traditiona approach to the scope of financia management refers to its subjectmatter, in academic iterature in the initia stages of its evoution, as a separate branch of academic study. The term corporation finance was used to describe what is now known in the academic word as financia management. As the name suggests, the concern of corporation finance was with the financing of corporate enterprises. In other words, the scope of the finance function was treated by the traditiona approach in the narrow sense of procurement of funds by corporate enterprise to meet their financing needs. The term procurement was used in a broad sense so as to incude the whoe gamut of raising funds externay. Thus defined, the fied of study deaing with finance was treated as encompassing three interreated aspects of raising and administering resources from outside: (i) the institutiona arrangement in the form of financia institutions which comprise the organization of the capita market; (ii) the financia instruments through which funds are raised from the capita markets and the reated aspects of practices and the procedura, aspects of capita markets; and (iii) the ega and accounting reationships between a firm and its sources of funds. The coverage of corporation finance was, therefore, conceived to describe the rapidy evoving compex of capita market institutions, instruments and practices. A reated aspect was that firms require funds at certain episodic events such as merger, iquidation, reorganization and soon. A detaied description of these major events constituted the second eement of the scope of this fied of academic study. That these were the broad features of the subject-matter of corporation finance is eoquenty refected in the academic writings around the period during which the traditiona approach dominated academic thinking. Thus, the issue to which iterature on finance addressed itsef was how resources coud best be raised from the combination of the avaiabe sources. The traditiona approach to the scope of the finance function evoved during the 1920s and 1930s and dominated academic during the forties and through the eary fifties. It has now been discarded as it suffers from serious imitations. The weaknesses of the traditiona approach fa into two broad categories: (i) those reating to the treatment of various topics and the emphasis attached to them; and (ii) those reating to the basic conceptua and anaytica framework of the definitions and scope of the finance function. The first argument against the traditiona approach was based on its emphasis on issues reating to the procurement of funds by corporate enterprises. This approach was chaenged during the period when the approach dominated the scene itsef. Further, the traditiona treatment of finance was criticised because the finance function was equated with the issues invoved in raising and administering funds, the theme was woven around the viewpoint of the suppiers of funds such as investors, investment bankers and so on, that is, the outsiders. It impies that no consideration was given to the viewpoint of those who had to take interna financia decisions. The traditiona treatment was, in other words, the outsider-ooking-in approach. The imitation was that interna decision making (i.e. insider-ooking out) was competey ignored. The second ground of criticism of the traditiona treatment was that the focus was on financing probems of corporate enterprises. To that extent the scope of financia management was confined ony to a segment of the industria enterprises, as noncorporate organisations ay outside its scope.

12 Financia Management Yet another basis on which the traditiona approach was chaenged was that the treatment was buit too cosey around episodic events, such as promotion, incorporation, merger, consoidation, reorganisation and so on. Financia management was confined to a description of these infrequent happenings in the ife of an enterprise. As a ogica coroary, the day-to-day financia probems of a norma company did not receive much attention. Finay, the traditiona treatment was found to have a acuna to the extent that the focus was on ong-term financing. Its natura impication was that the Issues invoved in working capita management were not in the purview of the finance function. The imitations of the traditiona approach were not entirey based on treatment or emphasis of different aspects. In other words, its weaknesses were more fundamenta. The conceptua and anaytica shortcoming of this approach arose from the fact that it confined financia management to issues invoved in procurement of externa funds, it did not consider the important dimension of aocation of capita. The conceptua framework of the traditiona treatment ignored what Soomon apty describes as the centra issues of financia management. These issues are refected in the foowing fundamenta questions which a finance manager shoud address. Shoud an enterprise commit capita funds to certain purposes do the expected returns meet financia standards of performance? How shoud these standards be set and what is the cost of capita funds to the enterprise? How does the cost vary with the mixture of financing methods used? In the absence of the coverage of these crucia aspects, the traditiona approach impied a very narrow scope for financia management. The modern approach provides a soution to these shortcomings. Modern Approach The modern approach views the term financia management in a broad sense and provides a conceptua and anaytica framework for financia making. According to it, the finance function covers both acquisition of funds as we as their aocations. Thus, apart from the issues invoved in acquiring-externa funds, the main concern of financia management is the efficient and wise aocation of funds to various uses. Defined in a broad sense, it is viewed as an integra part of overa management. The new approach is an anaytica way of viewing the financia probems of a firm. The main contents of this approach are what is the tota voume of funds an enterprise shoud commit? What specific assets shoud an enterprise acquire? How shoud the funds required be financed? Aternativey, the principa contents of the modern approach to financia management can be said to be: (i) How arge shoud an enterprise be, and how fast shoud it grow? (ii) In what form shoud it hod assets? and (iii) What shoud be the composition of its iabiities? The three questions posed above cover between them the major financia probems of a firm. In other words, financia management, according to the new approach, is concerned with the soution of three major probems reating to the financia operations of a firm, corresponding to the three questions of investment, financing and dividend decisions. Thus, financia management, in the modem sense of the term, can be broken down into three major decisions as functions of finance: (i) The investment decision, (ii) The financing decision, and (iii) The dividend poicy decision.

Introduction to Financia Management 13 The investment decision reates to the seection of assets in which funds wi be invested by a firm. The assets which can be acquired fa into two broad group: (i) ongterm assets which yied a return over a period of time in future, (ii) short-term or current assets, defined as those assets which in the norma course of business are convertibe into without diminution in vaue, usuay within a year. The first of these invoving the first category of assets is popuary known in financia iterature as capita budgeting. The aspect of financia decision making with reference to current assets or short-term assets is popuary termed as working capita management. Capita Budgeting is probaby the most financia decision for a firm. It reates to the seection of an asset or investment proposa or course of action whose benefits are ikey to be avaiabe in future over the ifetime of the project. The ong-term assets can be either new or od/existing ones. The first aspect of the capita budgeting decision reates to the choice of the new asset out of the aternatives avaiabe or the reaocation of capita when an existing asset fais to justify the funds committed. Whether an asset wi be accepted or not wi depend upon the reative benefits and returns associated with it. The measurement of the worth of the investment proposas is, therefore, a major eement in the capita budgeting exercise. This impies a discussion of the methods of appraising investment proposas. The second eement of the capita budgeting decision is the anaysis of risk and uncertainty. Since the benefits from the investment proposas extend into the future, their accrua is uncertain. They have to be estimated under various assumptions of the physica voume of sae and the eve of prices. An eement of risk in the sense of uncertainty of future benefits is, thus, invoved in the exercise. The returns from capita budgeting decisions shoud, therefore, be evauated in reation to the risk associated with it. Finay the evauation of the worth of a ong-term project impies a certain norm or standard against which the benefits are to be judged. The requisite norm is known by different names such as cut-off rate, hurde rate, required rate, minimum rate of return and so on. This standard is broady expressed in terms of the cost of capita. The concept and measurement of the cost of capita is, thus, another major aspect of capita budgeting decision. In brief, the main eements of capita budgeting decisions are: (i) the ong-term assets and their composition, (ii) the business risk compexion of the firm, and (iii) concept and measurement of the cost of capita. Working Capita Management is concerned wit the management of current assets. It is an important and integra part of financia management as short-term surviva is a prerequisite for ong-term success. One aspect of working capita management is the trade-off between profitabiity and risk (iquidity). There is a confict between profitabiity and iquidity. If a firm does not have adequate working capita, that is, it does not invest sufficient funds in current assets, it may become iiquid and consequenty may not have the abiity to meet its current obigations and, thus, invite the risk of bankruptcy. If the current assets are too arge, profitabiity is adversey affected. The key strategies and considerations in ensuring a tradeoff between profitabiity and iquidity is one major dimension of working capita management. In addition, the individua current assets shoud be efficienty managed so that neither inadequate nor unnecessary funds are

14 Financia Management ocked up. Thus, the management of working capita has two basic ingredients: (1) an overview of working capita management as a whoe, and (2) efficient management of the individua current assets such as cash, receivabes and inventory. The second major decision invoved in financia management is the financing decision. The investment decision is broady concerned with the asset-mix or the composition of the assets of a firm. The concern of the financing decision is with the financing-mix or capita structure or everage. The term capita structure refers to the proportion of debt (fixed-interest sources of financing) and equity capita (variabe-dividend securities/ source of funds). The financing decision of a firm reates to the choice of the proportion of these sources to finance the investment requirements. There are two aspects of the financing decision. First, the theory of capita structure which shows the theoretica reationship between the empoyment of debt and the return of the sharehoders. The use of debt impies a higher return to the sharehoders as aso the financia risk. A proper baance between debt and equity to ensure a trade-off between risk and return to the sharehoders is necessary. A capita structure with a reasonabe proportion of debt and equity capita is caed the optimum capita structure. Thus, one dimension of the financing decision whether there is an optimum capita structure? And in what proportion shoud funds be raised to maximise the return to the sharehoders? The second aspect of the financing decision is the determination of an appropriate capita structure, given the facts of a particuar case. Thus, the financing decision covers two interreated aspects: (1) capita structure theory, and (2) capita structure decision. The third major decision of financia management is the decision reating to the dividend poicy. The dividend shoud be anaysed in reation to the financing decision of a firm. Two aternatives are avaiabe in deaing with the profits of a firm: they can be distributed to the sharehoders in the form of dividends or they can be retained in the business itsef. The decision as to which course shoud be foowed depends argey on a significant eement in the dividend decision, the dividend payout ratio, that is, what proportion of net profits shoud be paid out to the sharehoders. The fina decision wi depend upon the preference of the sharehoders and investment opportunities avaiabe within the firm. The second major aspect of the dividend decision is the factors determining dividend poicy of a firm in practice. To concude, the traditiona approach had a very narrow perception and was devoid of an integrated conceptua and anaytica framework. It had righty been discarded in current academic iterature. The modern approach has broadened the scope of financia management which invoves the soution of three major decisions, namey, investment, financing and dividend. These are interreated and shoud be jointy taken so that financia decision-making is optima. The conceptua framework for optimum financia decisions is the objective of financia management. In other words, to ensure an optimum decision in respect of these three areas, they shoud be reated to the objectives of financia management.

Introduction to Financia Management 15 Functions of Financia Management The traditiona function of financia management has been imiting the roe of finance to raising and administrating of funds needed by the company to meet their financia needs. It broady covered: 1. Arrangement of funds through financia institutions 2. Arrangement of funds through financia instruments 3. Looking after the ega and accounting reationship between a corporation and its sources of funds This has outived its utiity. With the advent of technoogy and need to tighten ships because of competition, financia management became as much a science as art. Efficient aocation of funds became the imperative. The modern approach is an anaytica way of ooking at the financia probems of a firm with the main concerns ike: 1. What is the tota voume of funds committed 2. What specific assets shoud be acquired or divested 3. How shoud the funds required be financed and from which markets The above questions reate to four broad decision areas, these are: 1. Investment decision: Decisions reating to investment in both capita and current assets. The finance manager has to evauate different capita investment proposas and seect the best keeping in view the overa objective of the enterprise. Capita Budgeting is the typica name given to this decision. 2. Financing Decision: Provision of funds required at the proper time is one of the primary tasks of the finance manager. Identification of the sources, deciding which types of funds to raise (debt or equity), and raising them is one of the crucia tasks. 3. Dividend Decision: Determination of funds requirements and how much of it wi be generated from interna accruas and how much to be sourced from outside is a crucia decision. Equity hoders are the owners and require returns, and how much money to be paid to them is a crucia decision. 4. Working Capita Decision: The investment in current assets is a major activity that a finance manager is engaged in a day to day basis. How much inventory to keep, how much receivabes can be managed, and what is the optimum cash eves, are three of the key questions that are deat with reguary.

16 Financia Management A these decisions interact, investment decision cannot be taken without taking the financing decision, working capita decision aso needs financing, dividend decision is a payout mechanism and has to be taken care of from financing. These tasks are divided and are taken care of by various entities. Objectives of Financia Management To make wise decisions a cear understanding of the objectives which are sought to be achieved in necessary. The objectives provide a framework for optimum financia decision-making. In other words, they are concerned with designing a method of operating the interna investment and financing of a firm. We discuss in this section the aternative approaches in financia iterature. There are two widey-discussed approaches: (i) Profit maximisation approach and (ii) Weath maximisation approach. It shoud be noted at the outset that the term objective is used in the sense of a goa or decision criterion for the three decisions invoved in financia management. It impies that what is reevant is not the overa objective or goa of a business but an operationay usefu criterion by which to judge a specific set of mutuay interreated business decisions, namey, investment, financing and dividend poicy. The second point that shoud be ceary understood to that the term objectives provides a normative framework. That is the focus in financia iterature is on what a firm shoud try to achieve and on poicies that shoud be foowed if certain goas are to be achieve. The impication is that these are not necessariy foowed by firms in actua practice. They are rather empoyed to serve as a basis for theoretica anaysis and do not refect contemporary empirica industry practices. Thus, the term is used in a rather narrow sense of what a firm shoud attempt to achieve with its investment, financing and dividend poicy decisions. Profit Maximisation Decision Ceriterion According to this approach, actions that increase profits shoud be undertaken and those that decrease profits are to be avoided. In specific operationa terms, as appicabe to financia management, the profit maximisation criterion impies that the investment, financing and dividend poicy decisions of a firm shoud be oriented to the maximisation of profits. The term profit can be used in two senses. As a owner-oriented concept it refers to the amount and share of nationa income which is paid to the owners of business, that is, those who suppy equity capita. As a variant it is described as profitabiity. It is an operationa concepts and signifies economic efficiency. In other words, profitabiity refers to a situation where output exceeds input, that is, the vaue created by the use of resources is more than the tota of the input resources. Used in this sense, profitabiity maximisation woud impy that a firm shoud be guided in financia decision making by one test; seect assets, projects and decisions which are profitabe and reject those which are not. In the current financia iterature, there is a genera agreement that profit maximisation is used in the second sense. The rationae & behind profitabiity maximisation, as a guide to financia decision making, is simpe. Profit is a test of economic efficiency. It provides the yardstick by

Introduction to Financia Management 17 which economic performance can be judged. Moreover, it eads to efficient aocation of resources, as resources tend to be directed to uses which in terms of profitabiity are the most desirabe. Finay, it ensures maximum socia wefare. The individua search for maximum profitabiity provides the famous invisibe hand by which tota economic wefare is maximised. Financia management is concerned with the efficient use of an important economic resource (input), namey, capita. It is, therefore, argued that profitabiity maximisation shoud serve as the basic criterion for financia management decisions. The profit maximisation criterion has, however, been questioned and criticized on severa grounds. The reasons for the opposition in academic iterature a into two broad groups: (i) those that are based on misapprehensions about the workabiity and fairness of the private enterprise itsef, and (2) those that arise out of the difficuty of appying this criterion management, refers to an expicit operationa guide for the interna investment and financing of a firm and not the overa goa of business operations. We, therefore, focus on the second type of imitations to profit maximisation as an objective of financia management. The main technica faws of this criterion are ambiguity, timing of benefits, and quaity of benefits. Ambiguity. One practica difficuty with profit maximisation criterion for financia decision making is that the term-profit is a vague and ambiguous concept. It has no precise connotation. It is amenabe to different interpretations by different peope. To iustrate, profit may be short term or ong term; it may be tota profit or rate of profit; it may be before-tax or before-tax or after-tax; it may be return on tota capita empoyed or tota assets or sharehoders equity and so on. If profit maximisation is taken to be the objectives, the question arises, which of these variabe of profit shoud a firm try to maximise? Obviousy, a oose expression ike profit of operationa criterion for financia management. Timing of Benefits. A more important technica objection to profit maximisation, as a guide to financia decision making, is that it ignores the differences in the time pattern of the benefits received from investment proposas or courses of action. Whie working out profitabiity, the bigger the better principe is adopted, as the decision is based on the tota benefits received over the working ife of the asset, irrespective of when they were received. Consider Tabe 1.1 Tabe 1.1 Time-pattern of Benefits (Profits) Aternative A (Rs. Lakhs) Aternative B (Rs. Lakhs) Period I 50 Period II 100 100 Period III 50 100 Tota 200 200 It can be seen from Tabe 1.1 that the tota profits associated with the aternatives, A and B, are identica. If the profit maximisation is the decision criterion, both the aternatives woud be ranked equay. But the returns form both the aternatives differ in one important respect, whie aternative A provides higher returns in earier years,

18 Financia Management the returns from aternative B are arger in ater years. As a resut, the two aternative courses of "action are not stricty identica. This is primariy because a basic dictum of financia panning is the earier the better as benefits received sooner are more voube than benefits'. received ater. The reason for the superiority of benefits now over benefits ater ies in the fact that the former can be reinvested to earn a return. This is referred to as time vaue of money. The profit maximisation criterion does not consider the distinction between returns received in different time periods and treats a benefits irrespective of the timing, as equay vauabe. This not true in actua practice as benefits in eary years shoud be vaued more highy than equivaent benefits in ater years. The assumption of equa vaue is inconsistent with the rea word situation. Quaity of Benefits. Probaby the most important technica imitation of profit maximistion as an operationa objective, is that it ignores the quaity aspect of benefits associated with a financia course of action. The term quaity here refers to the degree of certainty with which benefits can be expected. As a rue, the more certain the expected return, the higher is the quaity of the benefits. Conversey, the more uncertain/ fuctuating is the expected benefits, the ower is the quaity of the benefits. An uncertain and fuctuating return impies risk to the investors. It can be safey assumed that the investors are risk-averters, that is they want to avoid or at east minimise risk. They can, therefore, be reasonaby expected to have a preference for a return which is more certain in the sense that it has smaer variance over the years. The probem of uncertainty renders profit maximisation unsuitabe as an operationa criterion for financia management as it considers ony the size of benefits and gives no weight to the degree of uncertainty of the future benefits. This is iustrated in Tabe 1.2. Tabe 1.2 Uncertainty About Expected Benefits (Profits) State of Economy Aternative A Aternative B Recession (Period I) 9 0 Norma (Period II) 10 10 Boom (Period III) 11 20 Tota 30 30 It is cear from Tabe 1.2 that the tota returns associated with the two aternatives are identica in a norma situation but the range of variations is very wide in case of aternative B, whie it is narrow in respect of aternative A. To put it differenty, the earnings associated with aternative. B are more uncertain (risky) as they fuctuate widey depending on the state. of the economy. Obviousy, aternative A is better in terms of risk and uncertainty, The profit maximisation criterion fais to revea this, To concude, the profit maximisation criterion is inappropriate and unsuitabe as an operationa objective of investment, financing and dividend decisions of a firm. It is not ony vague and time vaue of money. It foows from the above that an appropriate operationa decision criterion for financia management shoud (i) be precise and exact, (ii) be based on the bigger the better principa, (iii) consider both quantity and quantity dimensions of benefits, and (iv) recognise the time vaue of money. The aternative to profit maximisation, that is weath maximisation is one such measure.

Introduction to Financia Management 19 Weath Maximisation Decision Criterion This is aso known as vaue maximisation or net present worth maximisation. In current academic iterature vaue maximisation is amost universay accepted as an appropriate operations decision criterion for financia management decisions as it removes the technica imitations which characterise earier profit maximisation criterion Its operationa features satisfy a the three requirement of a suitabe operation objective of financia courses of action, namey, exactness, quaity of benefits and the time vaue of money. The vaue of an asset shoud be viewed in terms of the benefits it can produce. The worth of a course of action can simiary be judged in terms of the vaue of the benefits it produces ess the cost of undertaking it. A significant eement in computing the vaue of a financia course of action, is the precise estimation of the benefits associated with it. The weath maximisation criterion is based on the measurement of benefits in the case of the profit maximisation criterion. Cash fow is a precise concept with a definite connotation. Measuring benefits in terms of case fow avoids the ambiguity associated with accounting profits. This is the first operationa feature of the net present worth maximisation criterion. The second important feature of the weath maximisation criterion is that it considers is that it considers both the quantity and quaity dimensions of benefit. At the same, it aso incorporates the time vaue of money. The operationa impication of the uncertainty and timing dimensions of the benefits emanating from a financia decision is that adjustment shoud be made in the cash fow pattern, firsty, to incorporate risk and, secondy, to make an aowance for differences in the timing of benefits. The vaue of a course of action must be viewed in teams of its worth to those providing the resources necessary for its undertaking. In appying the vaue maximisation criterion, the term vaue is used in terms of worth to the owners, that is, ordinary sharehoders. The capitaisation (discount) rate that is empoyed is, therefore, the rate that refects the time and risk preferences of the resut of higher risk onger time period. Thus, a stream of case fows that is quite certain might be associated with a rate a 5 per cent, whie a very risky stream may carry a 15 per cent discount rate. For the above reason the net present vaue maximisation is superior to the profits maximisation as an operationa objective. As a decision criterion, it invoves a comparison of vaue to cost. An action that has a discounted vaue refecting both time and risk that exceeds its cost can be said to create vaue. Such actions shoud be undertaking. Conversey, actions, with ees vaue than cost, reduce weath and shoud be aternative with the greatest net present vaue shoud be seected. In the words of Ezra Soomon, The gross present worth of a course of action is equa to the capitaised vaue of the fow of future expected benefit, discounted (or capitaised) at a rate which refects their certainty or uncertainty. Weath or net present worth is the difference between gross present worth and the amount of capita investment required to achieve the benefits being discussed. Any financia action which creates weath or which has a net present worth above zero is a desirabe one and shoud be undertaken. Any financia action which does not meet this test shoud be rejected.

Cost of Capita 25 Chapter-2 Cost of Capita Cost of Capita is the rate that must be earned in order to satisfy the required rate of return of the firm's investors. It can aso be defined as the rate of return on investments at which the price of a firm's equity share wi remain unchanged. Each type of capita used by the firm (debt, preference shares and equity) shoud be incorporated into the cost of capita, with the reative importance of a particuar source being based on the percentage of the financing provided by each source of capita. Using of the cost a singe source of capita as the hurde rate is tempting to management, particuary when an investment is financed entirey by debt. However, doing so is a mistake in ogic and can cause probems. Future Cost and Historica Cost Future cost of capita refers to the expected cost of funds to be raised to finance a project. In contrast, historica cost represents cost incurred in the past in acquiring funds. In financia decisions future cost of capita is reativey more reevant and significant. Whie evauating viabiity of a project, the finance manager compares expected earnings from the project with expected cost of funds to finance the project. Likewise, in taking financing decisions, attempt of the finance manager is to minimise future cost of capita and not the costs aready defrayed. This does not impy that historica cost is not reevant at a. In fact, it may serve as a guideine in predicting future costs and in evauating the past performance of the company. Component Cost and Composite Cost A company may contempate to raise desired amount of funds by means of different sources incuding debentures, preferred stock, and common stocks. These sources constitute components of funds. Each of these components of funds invoves cost to the company. Cost of each component of funds is designated as component or specific cost of capita. When these component costs are combined to determine the overa cost of capita, it is regarded as composite cost of capita, combined cost of capita or weighted cost of capita, The composite cost of capita, thus, represents the average of the costs of each sources of funds empoyed by the company. For capita budgeting decision, composite cost of capita is reativey more reevant even though the firm may finance one proposa with ony one source of funds and another proposa with another source. This is for the fact that it is the overa mix of financing over time which is materiay significant in vauing firm as an ongoing overa entity.

26 Financia Management Average Cost and Margina Cost Average cast represents the weighted average of the costs of each source of funds empoyed by the enterprise, the weights being the reative share of each source of funds in the capita! structure. Margina cost of capita, by contrast refers to incrementa cost associated with new funds raised by the firm. Average cost is the average of the component margina costs, whie the margina cost is the specific concept used to comprise additiona cost of raising new funds. In financia decisions the margina cost concept is most significant. Expicit Cost and Impicit Cost Cost of capita can be either expicit cost or impicit. The expicit cost of any source of capita is the discount rate that equates the present vaue of the cash infows that are incrementa to the taking of the financing opportunity with the present vaue of its incrementa cash outay. Thus, the expicit cost of capita is the interna rate of return of the cash fows of financing opportunity. A series of each fows are associated with a method of financing. At the time of acquisition of capita, cash infow occurs foowed by the subsequent cash outfows in the form, of interest payment, repayment of principa money or payment of dividends. Thus, if a company issues 10 per cent perpetua debentures worth Rs. 10,00,000, there wi be cash infow to the firm of the order of 10,00,00. This wi be foowed by the annua cash outfow of Rs. 1,00,000. The rate of discount, that equates the present vaue of cash infows with the present vaue of cash outfows, woud be the expicit cost of capita. The technique of determination of the expicit cost of capita is simiar to the one used to ascertain IRR, with one difference, in the case of computation of the IRR, the cash outfows occur at the beginning foowed by subsequent cash infows whie in the computation of the IRR, the cash outfows occur at the beginning foowed by subsequent cash infows, whie in the computation of expicit cost of capita, cash infow takes pace at the beginning foowed by a series of cash infow subsequenty. The formua used to compute the expicit cost of capita (C) is: CI 0 = n t CO t...(1) ( 1 C) + t=1 Where, CI 0 = net cash infow in period O. CO t = cash outfow in period under reference C = Expicit cost of capita The expicit cost of an interest bearing debt wi be the discount rate that equates the present vaue of the contractua future payments of interest and principa with the net amount of cash received today. The expicit cost of capita of a gift is minus 100 per cent, since no cash outfow wi occur in future.

Cost of Capita 27 Simiary, expicit cost of retained earnings which invove no future fows to or from the firm is minus 100 per cent. This shoud not tempt one to infer that the retained earnings is cost free. As we sha discuss in the subsequent paragraphs, retained earnings do cost the firm. The cost of retained earnings is the opportunity cost of earning on investment esewhere or in the company itsef. Opportunity cost is technicay termed as impicit cost of capita. It is the rate of return on other investments avaiabe to the firm or the sharehoders in addition to that currenty being considered. Thus, the impicit cost of capita may be defined as the rate of return associated with the best investment opportunity for the firm and its Sharehoders that wi be foregone if the project presenty under consideration by the firm were accepted. In this connection it may be mentioned that expicit costs arise when the firm raises funds for financing the project. It is in this sense that retained earnings has impicit cost. Other forms of capita aso have impicit costs once they are invested, Thus in a sense, expicit costs may aso be viewed as opportunity costs. This impies that a project shoud be rejected if it has a negative present vaue when its cash fows are discounted by the expicit cost of capita. It is cear thus that the cost of capita is the rate of return a firm must earn on its investments for the market vaue of the firm to remain unchanged. Acceptance of projects with a rate of return beow the cost of capita wi decrease the vaue of the firm; acceptance of projects with a rate of return above the cost of capita wi increase the vaue of the firm. The objective of the financia manager is to maximize the weath of the firm s owners. Using the cost of capita as a basis for accepting or rejecting investments is consistent with this goa. Risk A basic assumption of traditiona cost of capita anaysis is that the firm s business and financia risk are unaffected by the acceptance and financing of projects. Business risk is reated to the response of the firm s earnings before interest and taxes, or operating profits, to changes in saes. When the cost of capita is used to evauate investment aternatives, it is assumed that acceptance of the proposed projects wi not affect the firm s business risk. The types of projects accepted by a firm can greaty affect its business risk. If a firm accepts a project that is consideraby more risky than average, suppiers of funds to the firm are quite ikey to raise the cost of funds. This is because of the decreased probabiity of the fund suppiers receiving the expected returns on their money. A ong-term ender wi charge higher interest on oans if the probabiity of receiving periodic interest from the firm and utimatey regaining the principa is decreased. Common stockhoders wi require the firm to increase earnings as compensation for increases in the uncertainty of receiving dividend payments or aby appreciation in the vaue of their stock. In anayzing the cost of capita it is assumed that the business risk of the firm remains unchanged (i.e., that the projects accepted do not affect the variabiity of the firm s saes revenues). This assumption eiminates the need to consider changes in the cost of specific sources of financing resuting from changes in business risk. The definition

28 Financia Management of the cost of capita deveoped in this chapter is vaid ony for projects that do not change the firm s business risk. Financia risk is affected by the mixture of ong-term financing, or the capita structure, of the firm. Firms with high eves of ong-term debt in proportion to their equity are more risky than firms maintaining ower ratios of ong-term debt to equity. It is the contractua fixed-payment obigations associated with debt financing that make a firm financiay risky. The greater the amount of interest and principa (or sinkingfund) payments a firm must make in a given period, the higher the operating profits required to cover these charges. If a firm fais to generate sufficient revenues to cover operating charges, it may be forced into bankruptcy. As a firm s financia structure shifts toward suppiers of funds recognize a more highy evered position the increased financia risk associated with the firm. They compensate for this increased risk by charging higher rates of interest or requiring greater returns, In short they react in much the same way as they woud to increasing business risks. Frequenty the funds suppied to a firm by enders wi change its financia structure, and the charge for the funds wi be based on the changed financia structure. In the anaysis of the cost of capita in this chapter, however, the firm s financia structure is assumed to remain fixed. This assumption is necessary in order to isoate the costs of the various forms of financing. If the firm s capita structure were not hed constant, it woud be quite difficut to find its cost of capita, since the seection of a given source of financing woud change the costs of aternate sources of financing. The assumption of a constant capita structure impies that when a firm raises funds to finance a given project these funds are raised in the same proportions as the firm s existing financing. The awkwardness of this assumption is obvious since in reaity a firm raises funds in umps, it does not raise a mixture of sma amounts of various types of funds. For exampe, in order to raise Rs. miion a firm may se either bonds, preferred stock, or common stock in the amount of Rs. miion; or, it may se Rs. 400,000 worth of bonds, Rs. 100,000 worth of preferred stock, and Rs. 500,000 worth of common stock. Most firms wi use the former strategy, but our anaysis of cost of capita is based on the assumption that the firm wi foow the atter strategy. More sophisticated approaches for measuring the cost of capita when a firm s capita structure is changing rare avaiabe. The key factor affecting financing Costs Since the cost of capita is measured under the assumption that both the firm s asset structure and its capita (financia) structure are fixed, the ony factor that affects the various specific costs of financing is the suppy and demand forces operating in the market for ong-term funds. In other words, as a firm raises ong-term funds at different points in time, the ony factor affecting their cost is the riskess cost of the particuar type of financing. Regardess of the type of financing used, the foowing reationship shoud prevai: where kj = rj + b + f...(2) kj = the specific cost of the various types of ong-term financing, j

Cost of Capita 29 rj = the riskess cost of the given type of financing, j b = the business risk premium f = the financia risk premium Equation 2 indicates that the cost of each specific type of capita depends on he riskess cost of that type of funds, the business risk of the firm, and the financia risk of the firm. Since the firm s business and financia risk are assumed to be constant, the changing cost of each type of capita, j, over time shoud be affected ony by changes in the suppy of and demand for each type of funds, j. The cost of each type of capita to a given firm compared to the cost to another firm (i.e., the inter firm comparison) can differ because of differences in the degree of business and financia risk associated with each firm, since the riskess cost of the given type of funds remains constant. Different business and financia risk premiums are associated. with different eves of business and financia risk. These premiums are a function of the business risk, b, and financia risk, f, of a firm. For intra firm (i.e., time series) comparisons, the ony differentiating factor is the cost of the type of financing, since business and financia risk are assumed to be constant An exampe may hep to carify these points. Exampe The W.T. L. Company s cost of ong-term debt two years ago was 8 percent. This 8 percent was found to represent a 4- percent risk ess cost of ong-term debt, a 2- percent financia risk premium. and a 2- petcent financia risk premium. Currenty, the risk ess cost of ong-term debt is 6 percent. How much woud you expect the W. T. L. s cost of debt to be today, assuming that the risk structure of the firm s assets (business risk) and its capita structure (financia risk) have remained unchanged? The previous business risk premium of 2 percent and financia risk premium of 2 percent wi sti prevai, since neither of these risks has changed in two years. Adding the 4 percent tota risk premiums (i.e., the 2-percent business risk and the 2-percent financia risk premium) to the 6-percent riskess cost of ong-term debt resuts in a cost of ongterm debt to the W. T. L. Company of 10 percent. In this time-series comparison, where business risk and financia risk are assumed to be constant, the cost of the ongterm funds changes ony in response to changes in the riskess cost of a given type of funds. Let us now suppose that there is another company, the Pate Company, for which the risk ess cost of ong-term debt is the same as it is for W. T. L. The Pate Company has a 2-percent business risk premium and a 4-percent financia risk premium because of the high degree of everage in its financia structure. Athough both companies are in the same type of business (and thus have the same business risk premium of 2 percent), the cost of ong-term debt to the Pate Company is 12 percent (i.e., the dpercent riskess cost of money. Athough the reationship between j, b, and t, is presented as inear in Equation A, this is ony for simpicity; the actua reationship is ikey to be much more compex mathematicay. The ony definite concusion that can be drawn is that the cost of a

30 Financia Management specific type of financing for a firm is somehow functionay reated to the riskess cost of that type of financing adjusted for the firm s business and financia risk (i.e., that kj = f(r; b, f). The reader shoud recognize that the riskess cost of each type of financing, I, may differ consideraby. In other words, at a given point in time the riskess cost of debt may be 6 percent whie the riskess cost of common stock may he 9 percent. The riskess cost is expected to be different for each type of financing, j The risk ess cost of different maturities of the same type of debt may differ, since onger-term Issues are generay viewed as more risky. Factors determining the cost of capita There are severa factors that impact the cost of capita of any company. This woud mean that the cost of capita of any two companies woud not be equa. Righty so as these two companies woud not carry the same risk. Genera economic conditions: These incude the demand for and suppy of capita within the economy, and the eve of expected infation. These are refected in the riskess rate of return and is common to most of the companies. Market conditions: The security may not be readiy marketabe when the investor wants to se; or even if a continuous demand for the security does exist, the price may vary significanty. This is company specific. A firm s operating and financing decisions: Risk aso resuts from the decisions made within the company. This risk is generay divided into two casses: n Business risk is the variabiity in returns on assets and is affected by the company's investment decisions. n Financia risk is the increased variabiity in returns to the common stockhoders as a resut of using debt and preferred stock. Amount of financing required: The ast factor determining the company's cost of funds is the amount of financing required, where the cost of capita increases as the financing requirements become arger. This increase may be attributabe to one of the two factors: n As increasingy arger pubic issues are increasingy foated in the market, additiona fotation costs (costs of issuing the security) and underpricing wi affect the percentage cost of the funds to the firm. n As management approaches the market for arge amounts of capita reative to the firm's size, the investors' required rate of return may rise. Suppiers of capita become hesitant to grant reativey arge amounts of funds without evidence of management's capabiity to absorb this capita into the business. Generay, as the eve of risk rises, a arger risk premium must be earned to satisfy company's investors. This, when added to the risk-free rate, equas the firm's cost of capita.

Cost of Capita 31 Significance of the Cost of Capita It shoud be recognized at the outset that the cost of capita is one of the most difficut and disputed topics in the finance theory. Financia experts express conficting opinions as to the way in which the cost of capita can be measured. It shoud be noted that it is a concept of vita importance in the financia decision-making. It is usefu as a standard for: evauating investment decisions, designing a firm s debt poicy, and appraising the financia performance of top management. Investment evauation The primary purpose of measuring the cost of capita is its use as a financia standard evauating the investment projects. In the NPV method, an investment project is accepted if it has a positive NPY. The project s NPV is cacuated by discounting its cash fows by the cost of capita. In this sense, the cost of capita is the discount rate used for evauating the desirabiity of an investment project. In the IRR method, the investment project is accepted if it has an interna rate of return greater than the cost of capita. In this context, the cost of capita is the minimum return on an investment project. It is aso known as the cutoff, or the target, or the hurde rate. An investment project that provides.positive NPV when its cash fows are discounted by the cost of capita makes a net contribution to the weath of sharehoders. If the project has zero NPV, it means that its a return just equa to the cost of capita, and the acceptance or rejection of the project wi not affect the weath of sharehoders The cost of capita is the minimum required rate of return on the investment project that keeps the present weath of sharehoders unchanged. It may be, thus, noted that the cost of capita represents a financia standard for aocating the firm s funds, suppied by owners and creditors, to the various investment projects in the most efficient manner. Designing debt poicy The debt poicy of a firm is significant infuenced by the cost consideration. In designing the financing poicy, that is, the proportion of debt and equity in the capita structure, the firm aims at cost of capita. The reationship between the cost of capita and the capita structure decision is discussed ater on. The cost of capita can aso be usefu in deciding about the methods of financing at a point of time. For exampe, cost may be compared in choosing between easing and borrowing. Of course, equay important considerations are contro and risk. Performance appraisa Further, the cost of capita framework can be used to evuate the financia performance of top management. I Such an evauation wi invove a comparison of actua profitabiity of the investment projects undertaken by the firm with the project overa cost of capita, and the actua cost incurred by management in raising the required funds. The cost of capita aso pays a usefu roe in dividend decision and investment in current assets. The chapters deaing with these decisions show their inkages the methods of financing with the cost of capita.

32 Financia Management Measurement Time Vaue of Money If an individua behaves rationay, then he woud not equate money in hand today with the same vaue a year from now. In fact, he woud prefer to receive today than receive after one year. The reasons sited by him for preferring to have the money today incude: 1. Uncertainty of receiving the money ater. 2. Preference for consumption today. 3. Loss of investment opportunities. 4. Loss in vaue because of infation. The ast two reasons are the most sensibe ones for ooking at the time vaue of money. There is a 'risk free rate of return' (aso caed the time preference rate) which is used to compensate for the oss of not being abe to invest at any other pace. To this a 'risk premium' is added to compensate for the uncertainty of receiving the cash fows. Required rate of return = Risk free rate + Risk premium The risk free rate compensates for opportunity ost and the risk premium compensates for risk. It can aso be caed as the 'opportunity cost of capita' for investments of comparabe risk. To cacuate how the firm is going to benefit from the project we need to cacuate whether the firm is earning the required rate of return or not. But the probem is that the projects woud have different time frames of giving returns. One project may be giving returns in just two months, another may take two years to start yieding returns. If both the projects are offering the same %age of returns when they start giving returns, one which gives the earnings earier is preferred. This is a simpe case and is easy to sove where both the projects require the same capita investment, but what if the projects required different investments and woud give returns over a different period of time? How do we compare them? The soution is not that simpe. What we do in this case is bring down the returns of both the projects to the present vaue and then compare. Before we earn about present vaues, we have to first understand future vaue. Future Vaue If we are getting a return of 10 % in one year what is the return we are going to get in two years? 20 %, right. What about the return on 10 % that you are going to get at the end of one year? If we aso take that into consideration the interest that we get on this 10 % then we get a return of 10 + 1 = 11 % in the second year making for a tota return of 21 %. This is the same as the compound vaue cacuations that you must have earned earier

Cost of Capita 33 Future Vaue = (Investment or Present Vaue) * (1 + Interest) No. of time Periods The compound vaues can be cacuated on a yeary basis, or on a haf-yeary basis, or on a monthy basis or on continuous basis or on any other basis you may so desire. This is because the formua takes into consideration a specific time period and the interest rate for that time period ony. To cacuate these vaues woud be very tedious and woud require scientific cacuators. To ease our jobs there are tabes deveoped which can take care of the interest factor cacuations so that our formuas can be written as: Future Vaue = (Investment or Present Vaue) * (Future Vaue Interest Factor n,i) where n = no of time periods and i = is the interest rate. Let us ook at an exampe of how we cacuate the future vaue: Exampe Rs 7000 are invested at 5% per annum compound interest compounded annuay. What wi be the amount after 20 years? Soution Here i = 0.05, P = 7000, and n = 20. Putting it in the formua we get: FV = 7000 x (1+0.05)20 FV = 7000 x 2.6533 = Rs 18573.1 We have taken a shortcut here. We ooked at the future vaue of Rs 1 at the end of 20 years at 5% interest in the Future Vaue Interest Factor Tabe given at the end of this book (i.e. find the vaue of Future Vaue Interest Factor n,i)and found the figure to be 2.6533 and then substituted the figure here to get the answer. Another way of doing it woud be to use a scientific cacuator and cacuate the vaue that comes out to be the same. A third way of doing this woud be even more simpe. Use a spreadsheet program. Let us see how we use Microsoft Exce to do the same. Step 1: Go to the Insert menu and choose function. You get a screen that ooks ike this:

34 Financia Management Step 2: In the financia function category choose FV (it stands for Future Vaue) and press OK. Step 3: You woud get a screen that woud ook ike this:

Cost of Capita 35 Step 4: Insert the vaues as given in the exampe. Here r = I = 0.05, Nper is the number of periods = 20, Pmt is the periodic annuity (how to use it we wi see a itte ater) = 0 in this case as there is no annua payment except the first one. Pv is the present vaue = Rs 7000 in this case and Type is a vaue representing the timing of the payment = 0 in this case as the investment is done at the end of the period 0 or at the start of the period 1. This aso means that we get the returns at the end of the period 20 simutaneousy when we make the ast payment. Putting these vaues we get the foowing screen. Note that the resut of the figures that you input is shown in the formua resut section where it is Rs 18,573.08. Compare this with the figure that you get from using the vaue from the tabe, a difference of Rs 0.02. Negigibe. What if the money was payabe at the start of the period rather than at the end of the period? Here it does not matter as there is ony one investment and that is aso at the start of the first period. It woud matter when we ook at the future vaue of the annuity. But what is an annuity anyway?

36 Financia Management Future Vaue of an Annuity Annuity is defined as periodic payment every period for a number of periods. This periodic payment is the same every year ony then it coud be caed an annuity. The compound vaue (future vaue) of this annuity can be cacuated using a different formua: Future Vaue = [(1 + i) A i n 1] Here A is the constant periodic cash fow (annuity), i is the rate of return for one period and n is the number of time periods. The term within the brackets is the compound vaue factor of an annuity. We can aso use the tabes given at the end of the text book to cacuate the compound vaues of the cash fows and the formua woud change to: Future Vaue = Annuity * (Future Vaue Annuity Factor n,i ) Extending the same exampe we used above, if we were going to pay Rs 7000 every year for the next 20 years what is the vaue at the end of 20 years if the interest rate was 5 % compounded annuay. Exampe An annua payment of Rs 7000 is invested at 5% per annum compounded annuay. What wi be the amount after 20 years? Soution Here i = 0.05, P = 7000, and n = 20. Putting it in the formua we get: [(1 + 0.005) Fugure Vaue = 7000 0.05 FV = 7000 x 33.066 = Rs 2,31,462 20 1] We have taken a shortcut here. We ooked at the future vaue of Rs 1 at the end of 20 years at 5% interest in the Future Vaue Annuity Factor Tabe given at the end of this book (i.e. find the vaue of Future Vaue Annuity Factor n,i)and found the figure to be 33.066 (try finding the figure yoursef) and then substituted the figure here to get the answer. Another way of doing it woud be to use a scientific cacuator and cacuate the vaue that comes out to be the same. Let us see how we use Microsoft Exce to do the same. Insert the vaues as given in the exampe. Here r = I = 0.05, Nper is the number of periods = 20, Pmt is the periodic annuity = 7000. Pv is the present vaue = 0 in this case as it an annuity and Type is a vaue representing the timing of the payment = 0 in this case as the first investment is

Cost of Capita 37 done at the end of the period 1. Note that in the earier case this aso means that we get the returns at the end of the period 20 simutaneousy when we make the ast payment. Putting these vaues we get the foowing screen. Can you find the answer? Yes, it is Rs 231,461.68 a difference of Rs 0.32 from the answer we got using the tabe above. A variation on this woud be that the payment made at the start of the period instead of the end of the period. This means that you earn extra interest for one year. The formua is sighty different in that the whoe vaue is mutipied by (1+i) resuting in the foowing formua: n [(1 + i) 1] Future Vaue = A (1 + i) i In the exce spreadsheet we just have to change the type to 1 to get the desired resut. The resut now comes to Rs 243,034.76, which is nothing but the earier figure of The resut now comes to Rs 2,43,034.76, which is nothing but the earier figure of Rs 2,31,461.68 mutipied by 1.05 (i.e. 1+i).

38 Financia Management Sti this eaves one probem unanswered: If the projects have different time spans (which coud be as far apart as 50 years or more) how do we use the resuts that we get from here to compare. It becomes very difficut. Aso we cannot be too sure of the discounting rates and cash fows so getting comparabe vaues woud be difficut to say the east. To sove this probem we sove for the present vaue. Present Vaue When we sove for the present vaue, instead of compounding the cash fows to the future, we discount the future cash fows to the present vaue to match with the investments that we are making today. Bringing the vaues to present serves two purposes: 1. The comparison between the projects become easier as the vaues of returns of both are as of today, and 2. We can compare the earnings from the future with the investment we are making today to get an idea of whether we are making any profit from the investment or not. For cacuating the present vaue we need two things, one, the discount rate (or the opportunity cost of capita) and two, the formua. The present vaue of a ump sum is just the reverse of the formua of the compound vaue of the ump sum: FutureVaue Pr esentvaue = n (1 + i) Or to use the tabes the change woud be: Present Vaue = Future Vaue * (Present Vaue Interest Factor n,i) where n = no of time periods and i is the interest rate. Let us ook at an exampe of how we cacuate the future vaue: Exampe Rs.2,00,000 is the amount that you require after 20 years for your retirement. How much shoud you invest now at 5% per annum compounded annuay? Soution Here i = 0.05, FV = 2,00,000, and n = 20. Putting it in the formua we get: Pr esentvaue = 200000 (1 + 0.05) 20

Cost of Capita 39 Sove this or use the present vaue tabe. Using the present vaue interest factor tabe we find that present vaue of Rs 1 of 20 years from now at 5% interest is 0.3769. Mutipying it with the future vaue Rs 2,00,000 we get: PV = 2,00,000 x 0.3769 = Rs 75,380 Let us see how we use Microsoft Exce to do the same. Step 1: Go to the Insert menu and choose function. In the financia function category choose PV (it stands for Present Vaue) and press OK. Step 3: You woud get a seen that woud ook ike this:

40 Financia Management Step 4: Insert the vaues as given in the exampe. Here r = I = 0.05, Nper is the number of periods = 20, Pmt is the periodic annuity (how to use it we wi see a itte ater) = 0 in this case as there is no annua payment except the first one. Fv is the future vaue = Rs 2,00,000 in this case and Type is a vaue representing the timing of the payment = 0 in this case. Putting these vaues we get the foowing screen. Note that the resut of the figures that you input is shown in the formua resut section where it is Rs 75,377.89. Compare this with the figure that you get from using the vaue from the tabe, a difference of Rs 2.11. Negigibe, but sti higher than the differences we used to get in the future vaue. Can you te why? This is because of the fact that whie dividing you require numbers more than four digits to get accuracy. What if the money was payabe at the start of the period rather than at the end of the period? Here it does not matter as there is ony one future vaue and that is aso at the start of the first period. It woud matter when we ook at the present vaue of the annuity. Present Vaue of an Annuity The present vaue of an annuity can be cacuated by: Pr esentvaue n [(1 + i) 1] A i(1 + i) = n Or to use the tabes the change woud be: Present Vaue = Annuity * (Present Vaue Annuity Factor n,i) Let us see an exampe Exampe You have been promised an annua grant of Rs 7000 every year for the next 20 years

Cost of Capita 41 If you can invest the amount at 5% per annum compounded annuay what wi be the amount you woud require today to and up with the same position? Soution Here i = 0.05, A = 7000, and n = 20. Putting it in the formua we get: Using the shortcut from the tabe we get: Pr esentvaue 20 [(1 + 0.05) 1] 7000 0.05(1 + 0.05) = 20 PV = 7000 x 12.4622 = Rs 87,235.4 We ooked at the present vaue of an annuity of Rs 1 for 20 years at 5% interest in the Present Vaue Annuity Factor Tabe given at the end of this book (i.e. find the vaue of Present Vaue Annuity Factor n,i)and found the figure to be 12.4622 (try finding the figure yoursef) and then substituted the figure here to get the answer. Another way of doing it woud be to use a scientific cacuator and cacuate the vaue that comes out to be the same. Let us see how we use Microsoft Exce to do the same. Insert the vaues as given in the exampe. Here r = I = 0.05, Nper is the number of periods = 20, Pmt is the periodic annuity = 7000 in this case. Fv is the future vaue = 0 in this case as it is an annuity and Type is a vaue representing the timing of the payment = 0 in this case as the first investment is done at the end of the period 1. Putting these vaues we get the foowing screen. Can you find the answer? Yes, it is Rs 87,235.47 a difference of Rs 0.07 from the answer we got using the tabe above. A variation on this woud be that the payment made at the start of the period instead of the end of the period. This means that you earn extra interest for one year. The formua is sighty different in that the whoe vaue is mutipied by (1+i) resuting in the foowing formua:

42 Financia Management Pr esentvaue = n [(1 + i) 1] A (1 + i) n i(1 + i) In the exce spreadsheet we just have to change the type to 1 to get the desired resut. The resut now comes to Rs 91,597.25, which is nothing but the earier figure of Rs 87,235.47 mutipied by 1.05 (i.e. 1+i). Perpetuity If the annuity is expected to go on forever then it is caed a perpetuity and then the above formua reduces to: Pr esentvaue = A i Perpetuities are not very common in financia decision making as no project is expected to ast forever but there coud be a few instances where the returns are expected to be for a ong indeterminabe period. Especiay when cacuating the cost of equity perpetuity concept is very usefu. For a growing perpetuity the formua changes to: A Pr esentvaue = i g A these cacuations take into consideration that the cash fow is coming at the end of the period. Vauing Securities The objective of any investor is to maximise expected returns from his investments,

Cost of Capita 43 subject to various constraints, primariy risk. Return is the motivating force, inspiring the investor in the form of rewards, for undertaking the investment. The importance of returns in any investment decision can be traced to the foowing factors: It enabes investors to compare aternative investments in terms of what they have to offer the investor. Measurement of past returns enabes the investors to assess how we they have done. Measurement of historica returns aso heps in estimation of future returns. Why are we discussing the return so much? The vaue of the security to an investor is directy proportiona to the return that he is expected to get from that security. Higher the return expected, higher is the vaue. But what are we going to do with the vaue of the security? We, vaue of the security is the price that you are going to pay for that security. This means that the present vaue of the security is that vaue which is dependent on the return from the security and the risk profie of that security. Now et us go further on return. The Components of Return Return is basicay made up of two components: The periodic cash receipts or income on the investment in the form of interest, dividends, etc. The term yied is often used in connection with the component of return. Yied refers to the income derived from a security in reation to its price, usuay its purchase price. The appreciation (depreciation) in the price of the asset is referred to as capita gain (oss). This is the difference between the purchase price and the price at which the asset can be, or is, sod. Measuring the Rate of Return The rate of return is the tota return the investor receives during the hoding period (the period when the security is owned or hed by the investor) stated as a %age of the purchase price of the investment at the beginning of the hoding period. In other words it is the income from the security in the form of cash fows and the difference in price of the security between and the end of the hoding period expressed as a %age of the purchase price of the security at the beginning of the hoding period. Hence, tota return can be defined as: Cash Payment received + Price change over the period Tota Returns = Purchase price of the asset

44 Financia Management The price change over the period, is the difference between the beginning (or purchase) price and the ending (or saes) price. This can be either positive (saes price exceeds purchase price) or negative (purchase price exceeds saes price). The genera equation for cacuating the rate of return for one year is shown beow: K = [D t + (P t - P t-1 )] P t-1 where K = Rate of Return P t = Price of the security at time "t" i.e. at the end of the hoding period. P t-1 = Price of the security at time "t-1" i.e. at the beginning of the hoding period or purchase price. D t = Income or cash fows receivabe from the security at time "t". Vauing Debt Securities Securities that promise to pay its investors a stated rate of interest and return the principa amount at the maturity date are known as debt securities. The maturity period is typicay more than one year which is the key differentiating factor between them and the money market securities. Debt securities are usuay secured. Debt securities differ according to their provisions for payment of interest and principa, assets pedged as a security and other technica aspects. In the case of bankruptcy of the corporation, the aw requires that the debt hoders shoud be paid off before the equity investors. A ega agreement, caed a trust deed, is drawn between the security hoders and the company issuing the debt securities. Every security issued under it has the same right and protection. Trust deed is a compicated ega document containing restrictions on the company, pedges made by the company, and severa other detais. The trustee, usuay a arge bank or a financia institution, ensures that the issuing corporation keeps its promises and obeys the restrictions of the contract. The trustee is the watchdog for the debt securities hoders because it is impossibe for the individua hoders to keep an eye on the functioning of the company. Debt securities are different from term oans provided by the financia institutions and the banks to the company. Term oans are ong term debt contracts under which a borrower agrees to make a series of interest and principa payments on specific dates to the ender. Whie this is true for debt securities aso, term oans differ in one significant aspect that they are generay sod to one (or few) enders especiay financia institutions and banks, whie debt securities (terms 'debentures' and 'bonds' wi be used interchangeaby for debt securities) are typicay offered to the pubic. Another significant difference is that principa repayments in term oans are made aong with the interest

Cost of Capita 45 payments but in debt securities it is usuay a ump sum payment at the end of the period (or a series of payments). Terms Associated with Debt Securities There are severa terms which are used when we tak about debt securities. Before we take a ook at different kinds of debt securities avaiabe in the Indian market, et us first understand these terms. Face Vaue/ Par Vaue Vaue of the security as mentioned on the certificate of the security. Face vaues and par vaues are two terms which are used interchangeaby. Corporate debentures are usuay issued with Rs.100 face vaues and Government bonds with Rs.1 ac face vaues. Athough the vaue of the debenture (or the Government bond) wi fuctuate in price from the time they are issued unti redemption, they are usuay redeemed at maturity at their face vaue (uness a premium is to be given on redemption). The face vaue is the amount on which the interest is cacuated. Thus, a 15 per cent debenture with a face vaue of Rs.100 wi pay debenture hoders Rs.15 per debenture per year. Coupon Rate The coupon rate is the stipuated interest rate to be paid on the face vaue of a bond. It represents a fixed rupee amount that is paid periodicay as ong as the debtor is sovent. The period coud be monthy, quartery, semi-annuay or annuay. Zero-coupon bonds (discussed ater) are aso common. The coupon rate coud be a fixed rate or a foating rate. The foating rate is normay pegged to a base rate (e.g. 1 per cent above bank rate) and fuctuates with the fuctuation in the base rate. The coupon rate is fixed after the issuing corporation's merchant banker has weighed the risk of defaut, the credit rating of the issuer, options attached with the issue, the investment position of the industry, the security backing of the debenture, and the appropriate market rate of interest for the firm's industry, size, and risk cass. The goa is to pick a coupon rate that is just high enough to attract investors. Interest payments Debenture interest is usuay paid semi-annuay, though annua payments are not uncommon. In India we normay have registered debentures on which the interest is payabe to the debenture hoder whose name appears on the register when the payment is made. In deveoped countries, coupon bonds are aso avaiabe which have a series of attached coupons that are cipped off at the appropriate times and sent to a bank for coection of the interest. Of course, now with the Eectronic Cearing System, the interest can be directy deposited in the bank account of the bond hoder.

46 Financia Management Maturities Debentures are sometimes grouped by the ength of time unti maturity that existed on the date the debenture was first issued. Money Market Securities mature in 364 days or ess. Short-term debentures are those maturing within 1 to 3 years. Medium term debentures mature between 5 to 8 years and ong term debentures are the ones who have a maturity ife of 10 years or more. Redemption Redemption is the repayment of the debt security at or before maturity. Redemption coud at par or at a premium to face vaue. A debt security wi be redeemed before maturity if the issuer fees that he can borrow the same amount at a ower rate of interest or he does not require the funds any onger. If there is a premature redemption (redemption before the maturity date), a premium is usuay paid to the debenture hoders. Ca/ Put Options Provision A ca/ put option provision aow both the issuing company and the investor to redeem the bonds at a specified amount before the maturity date. Long term bonds (10 years or more) usuay have a ca/ put option is attached to the bond which is (usuay) exercisabe after every 5 year intervas. In this case the issuing company has a ca option that it can ca back the bonds and repay to the investors the principa and interest due ti that date. If the issuer exercises his ca option the investor has no recourse but to submit his bonds and get the money. Simiary the investor has a put option, in which case he has an option to return the bonds and get the principa and interest ti that date. As in earier case if the investor exercises his option, the company has no recourse but to pay the investor. Issuing corporation wi use the provision if the interest rates fa substantiay beow the coupon rates offered on the security and the investor wi use the put option if he can get better returns esewhere. For bonds with ca/ put options the yieds are cacuated to the nearest year at which the ca/ put option is exercisabe. This yied is known as yied to ca (YTC) which is different from the yied to maturity (YTM). Sinking Fund A provision that requires the corporation to set aside a fixed amount each year to hep provide for the ordery repayment of the debt issue. Credit Rating It is mandatory for the issuing companies to get the credit rating done on debt securities issues. Credit ratings are aso mandatory for Commercia Paper and Fixed Deposits issues of the companies. Ratings refect the probabiity of the companies going into defaut. The higher the rating, the ower the risk of defaut that is associated with the

Cost of Capita 47 issue. This aso has an effect on the rate of interest offered on the issue. The methodoogy and the rating symbos remain the same as in money market securities. Types of Debt Securities There are severa types of debt securities avaiabe in the market. The range incudes Government Securities, debentures, deep discount bonds, zero coupon bonds, etc. Government Securities Government is one of the biggest borrowers from the capita and the money market. We have aready taken a ook at the money market securities offered by the Government as aso the schemes run by it through the post office. Government Securities is the generic term appied to various kinds of debentures and bonds offered by the Government (centre or state) and quasi-governmenta agencies. The maturities of the Government securities range between 1-20 years and the return on the securities range between 5 to 7 per cent. The rates have significanty come down from the high yieds of 14 per cent registered in 1996. Most of the Government Securities are bought by the banks, financia institutions, provident fund trusts, insurance companies. There are two types of Government Securities that are offered: Government of India Foating Rate Bonds Bonds which pay a foating rate depending upon the base rate announced by the RBI. Government Securities Reguar debentures which pay a fixed rate of return and the principa amount is returned on maturity. The ast issue of government stock paid a coupon rate of 6.50 per cent. The present yied on Government Securities is in the range of 5.50-7.00 per cent depending on the maturity. Non-Convertibe Debentures (NCDs) NCDs are pain debenture securities issued by corporations. They are normay medium term in nature, maturing between 1 to 8 years and generay have a repayment schedue staggered over two to three years. They are secured by a coatera backing and credit rated. Interest rate offered on medium term NCDs is usuay ower than the market rate so many times the companies offer a sop of equity warrants aong with NCDs to sweeten the issue. Interest rate on the short term NCDs is in ine with the market rate and depends upon the quaity of the issuer. Deep Discount Bond (DDB) Usuay ong term with maturities exceeding 10 years, deep discount bonds are normay issued by bue chip corporations or financia institutions. Like money market securities, these bonds are issued at a discount to their face vaues. Because of ong maturity

48 Financia Management periods the discount is aso higher, hence the term deep discount. Athough ong term maturity is the norm, short maturities are not uncommon, for exampe GE Capita had an issue of DDBs with a maturity period of 17 months and 29 days. The first issue of DDBs was made by Sma Industries Deveopment Bank of India (SIDBI). Each DDB, with a face vaue of Rs.1,00,000, was issued at a discounted price of Rs.2,500 with a maturity period of 25 years from the date of aotment. Both the investors and SIDBI have an option of withdrawing or redeeming the bond (ca & put options) respectivey at the end of 5th, 9th, 12th, 15th, or 20th year from the date of aotment at the deemed vaue of Rs.5,300, Rs.9,600, Rs.15,300, Rs.25,000 and Rs.50,000 respectivey. After the success of the SIDBI issue, a the prominent financia institutions ike IDBI, ICICI, etc. came out with the issues of DDBs. A these issues, however, were caed by the institutions as the interest rates fe. Zero Interest Bonds (ZIBs) Very much aike DDBs, the ony crucia difference is that these are issued at face vaues (DDBs are issued at a discount to face vaue) and the redemption is at a premium. Tax treatment of both is the same. Secured Premium Notes (SPNs) SPNs are bonds issued by corporations which are medium term in nature, maturing between 3 to 8 years. The advantage is the fexibiity it offers in giving the returns as premium or interest payments depend upon the preferences of the hoders. The ony issuer of SPNs in the Indian markets ti now is TISCO Ltd. It issued SPNs of Rs.300 each. The repayment started after three years, and there was no payment of interest in between. The repayment went on for four years starting from the fourth year to seventh year. Every year there wi be a payment of Rs.150 (totaing Rs.150*4=Rs.600 in four years). Rs.75 in this woud be accounted for as principa repayment and the rest Rs.75 coud be taken as a mixture of interest and premium at the option of the investor. (Rs.25 as interest + Rs.50 as premium; Rs.37.50 interest + Rs.37.50 premium; Rs.50 interest + Rs.25 premium). The advantage of this was easier tax panning for the investor, but the tax authorities were not happy with this kind of an arrangement. TISCO aso attached an equity warrant which was convertibe into equity at a price which was at considerabe discount to the market price prevaiing at that time. Foating Rate Bonds (FRBs) Bonds whose interest payments fuctuate with changes in the genera eve of interest rates and are tied to a basic rate (known as the reference rate). The first issue in India

Cost of Capita 49 was from State Bank of India (SBI). It issued unsecured, redeemabe, subordinated, foating interest rate bonds in the nature of promissory notes carrying a coupon rate of 3 per cent per annum above the bank's maximum term deposit rate. Pass Through Certificates (PTCs) Pass Through Certificates (PTCs) are debt securities that pass through income from debtors through intermediaries to investors. Primariy banks who have a strong retai oan portfoio are the intermediaries who issue these certificates. The most common form if pass through is mortgage backed security, in which the principa and and interest payment from the home oan (or car oan) takers are passed from the banks or savings agencies that poo and repackage them in the form of securities, to investors. The bank that coects the payments from debtors charges a fee fro its services, which is deducted from the income passed on to investors. These securities are credit rated and the interest payment is according to the rating. The rating (i.e. P1+) is foowed by (So) to denote the transaction is that of securitization. Rate of return of a Bond In case of bonds, instead of dividends, the investor is entited to payments of interest annuay or semi-annuay. The investor aso benefits if there is an appreciation in the vaue of bond, otherwise there is the redemption of the bond at par vaue or at premium. Using the present vaue formua deveoped above we can say that: Present Vaue of a Bond n = t= 1 Interest Amount t (1+ i) Principa Amount + n (1 + i) Here interest amount is individuay brought to its present vaue or we can appy the annuity factor tabe to get its present vaue. The principa amount is brought to its present vaue when it is due. Or to use the tabes the change woud be: Present Vaue = Interest Amount * (Present Vaue Annuity Factor n,i ) + Principa Amount * (Present Vaue Interest Factor n,i ) Exampe A bond is paying 10 % interest per annum and is going to mature in the next two years At maturity it wi pay its principa amount of Rs 100. If the expected return on bonds today are (i) 7 %, (ii) 10 % and (iii) 15 %, what vaue woud you pay for the bond today. Soution Using the above formua for situation 2), we can say that

50 Financia Management Present Vaue of a Bond 2 = t= 1 10 Present Vaue of a Bond = (1.1) Interest Amount Principa Amount + t 2 (1.1) (1.1) 1 + 10 (1.1) 2 100 + (1.1) 2 Or to use the tabes the change woud be: Present Vaue = 10 * (PVAF2,0.1) + 100 * (PVIF2,0.1) Substituting the vaues we find that Present Vaue = 100 This is no magic. When you are getting a 10 % return and aso expect a 10 % return, the price you woud pay woud equa the par vaue of the bond. This means that if we expect higher return i.e. 15% in situation (iii) above, the price that we woud be wiing to pay for a bond returning ony 10 % woud be ess than the par vaue. Simiary, if we expect ower return, i.e., 7% in situation (i) above, the price that we woud be wiing to pay for a bond returning 10 % woud be higher than the par vaue. Can you find out the vaues for these two cases? There are five variabes in this case: (1) present vaue, (2) future vaue, (3) interest amount paid, (4) return expected and (5) time period. Properties of mathematics say that if any four of these five variabes are given, you can aways find the vaue of the fifth variabe. You can attempt that yoursef or turn over to soved exampes to ook at a simiar case. Vauing Equity Securities Unike debt and money market instruments, equity instruments represent the ownership interest in the company. As owners must put in their money in the venture before anybody woud end to them, equity is aways issued before debt is reeased by the institutions. In fact the incorporation of the company requires that the promoters must pick up some shares in the company, ony then the company can be incorporated. As equity represents the owners it is but ogica that a the debt hoders must be paid off before owners can caim any returns from the company. So the equity has the owestpriority caim on earnings. Equity aso has the ast caim on the assets in case the company is iquidated (cosed down). This means that the equity carries the highest risk. Not without reason. The fip side of the coin is that the equity owners are aso the owners of a the profits that remain after a the debt hoders are paid their interest. The interest payment is fixed whie there is no imit on the eves of profits that can accrue to the equity hoders. Vice Versa does not appy here, the iabiity of the equity hoders is imited to the eve of investments that

Cost of Capita 51 they have put in into the company and not unimited. Unimited profit sharing means that equity shares have an unimited potentia for dividend payments and price appreciation. Which is why investing in equity is so exciting and fu of opportunities. At the same time the risk is aso high because there is nothing fixed about earnings which can fuctuate widey depending upon the business environment. This is aso the reason why this book wi devote much more time to equity than on debt. Sharehoders, being the owners of the company, eect the board of directors and vote on major issues that affect the functioning and ong term pans of the company. Major sharehoders take up seats on the board of directors and infuence the decisions that are taken. Sma sharehoders cannot exercise the same eve of contro so when they do not ike the way the company is being run they simpy se their shares and invest their money somewhere ese. A sharehoder, by virtue of being an owner, is normay entited to four basic rights of ownership: 1. caim on a share of the company's undivided assets in proportion to number of shares hed (this is not to say that he can return the shares and get a part of the assets, he wi not get it), 2. proportionate voting power in the eection of Directors and other business conducted at annua genera meeting which can be exercised either by attending of the meeting or by Proxy, 3. dividends, when earned and decared by the Board of Directors, as aso a proportionate share in the residua earnings which the company retains, and 4. pre-emptive right to subscribe to additiona share offerings before they are offered to genera investors uness a specia resoution has been passed in the annua genera meeting to the contrary. The piece of paper which testifies the ownership position of the sharehoder in a company is caed a share certificate. The number of shares, their par vaue, the certificate number, distinctive numbers, the date of issue and the owner's name are mentioned on the share certificate. Terms Associated with Equity Securities Let us ook at some of key terms that are associated with equity shares: Stock Ownership of a company represented by shares that are a caim on the company's earnings and assets. Share

52 Financia Management Unit of equity ownership in a company or in a mutua fund. This ownership is represented by a share certificate, which names the company and the sharehoder. Face Vaue/ Par Vaue The vaue of one share as given on the share certificate of the company. The face vaue today can be either Rs.10 or beow that number (but in mutipes of Rs. 1) as specified by the Securities Law governing pubic imited companies. You wi find many companies with a face vaue of ess than Rs. 10, for exampe Rs. 5 (E.g Infosys Technoogies, Maruti Udyog), Rs. 4 (igate Goba Soutions), Rs.2 (Satyam Computers) and even Rs.1 (e.g. Tata Consutancy Services, Hindustan Lever). Earier Rs 100 and Rs 50 were the typica face vaues and you wi sti find shares with these face vaues, e.g. Dawn Mis has Rs 50 face vaue and Shri Dinesh Mis has Rs 100 face vaue per share. The face vaue is the amount on which the dividend is cacuated. Thus, a 15 per cent dividend on a share with a face vaue of Rs.10 wi pay the share hoder Rs.1.5 per share. This means that any dividend percentage has different meaning in Rupee terms as the face vaue changes. For exampe 100% dividend on 1 share of Rs 100 face vaue wi get you Rs 100 but the same dividend percentage on 1 share of Rs 1 face vaue woud get you ony Rs 1. Authorised and Paid-up Share Capita Number of shares of stock provided for in the Artices of Association of a company is the authorized share capita. This figure is usuay indicated in the Share Capita section of the Baance Sheet. Paid-up share capita is the capita that has been issued and subscribed by the sharehoders. Authorised capita is usuay we in excess of the paid-up capita and a company cannot egay issue more shares than authorized. The number of authorized shares can be changed ony by amendment to the Artices of Association for which a specia resoution needs to be passed in the Annua Genera Meeting. Figure 2.1 shows the Schedue 'A' of the Cosco India baance sheet, which gives us detais on the authorized and paid-up capita of the company. Figure 2.1: Authorised and Paid-up Share Capita

Cost of Capita 53 The second part in the figure taks about 'Issued & Subscribed Capita'. Issued Share Capita is that portion of the authorised capita that has been actuay offered for subscription. Subscribed share capita is that portion of issued share capita, which has actuay been subscribed and aotted. Paid-up share capita is that part of the subscribed capita for which consideration in cash or otherwise has been received. Therefore, subscribed share capita can be ess than or equa to the issued share capita. Simiary paid-up share capita can be ess than or equa to subscribed share capita. A these types of share capita aso incude the bonus shares that have been aotted by the organisation. There is another term 'caed-up share capita' which you may find in some of the baance sheets. It refers to that part of the subscribed capita, which sharehoders have been required or demanded to pay but have not paid as yet. This comes in the case where the company has issued party paid up shares and some sharehoders have not paid the entire amount to make the shares fuy paid up. Book Vaue The book vaue is cacuated by adding reserves to the equity capita of the company, mutipied by the face vaue and divided by the equity capita of the company. Book vaue tes us how much each share is worth in the books of the company. So if a company has a face vaue of Rs.10, equity capita of Rs.10 crores and reserves of Rs.20 crores, then the book vaue of each Rs.10 share wi be: Book Vaue = ( Rs. 10cr + Rs. 20cr ) Rs. 10 = Rs. 30 Rs. 10cr The true worth of the share coud be very different from the book vaue so cacuated even when we are not taking the market price into consideration. Why this is so we wi see ater. Book and market vaues wi usuay be equa on the day the shares in a new corporation are issued, but after that ony coincidence wi ever make them equa at any given moment. Earnings Per Share (EPS) EPS can be defined as the company's profit aocated to each outstanding equity share. For instance, a company that earned Rs.10 crore ast year and has 1 crore shares outstanding (with a face vaue of Rs.10 each) wi report a EPS of EPS = Rs. 10 cr 1cr = Rs. 10 The profits that are used to cacuate EPS are the profits that are eft after paying interest to debt hoders, taxes and dividend on preference shares. EPS is considered to be a key figure (and aso miseading) in evauating a share's outook.

54 Financia Management Stock Price Quotations If you pick up any of the major newspapers (financia or non financia), they carry at east some of the quotations of the ast day's trading on the major stock exchanges, be it Nationa Stock Exchange (NSE), Bombay Stock Exchange (BSE), or any other stock exchange. The usua format in a financia newspaper is to carry four prices (open, high, ow, cose) aong with voumes of shares traded and number of trades. Price/ Earning Ratio (P/E) and market capitaization is aso carried. They aso carry the cosing share price of the previous trading day in a bracket before starting with yesterday's prices as aso carry the previous 52 week (one year) high/ow prices for that share. The prices mentioned are for one share of the company. Figure 2.2 shows two sampes taken from the Business Standard and The Economic Times. See the reporting differences. The Business Standard carries more information on top 200 companies and different information is carried every day of the week. Types of Equity Instruments There are basicay two types of equity instruments: equity shares and preference shares. What we have been discussing ti now in equity instruments appies as it is to equity shares. Preference shares are different. Preference Shares Sandwiched between debt hoders and equity share hoders, preference share hoders have the promise of an assured dividend from the company and therefore assume ess risk than that borne by equity share hoders. They do not have any voting rights in the company. When a company fais to pay the dividend to them for two years in a row, then these shares get a voting right. The preference shares are issued by ony those companies who are paying a very ow eve of tax. Why? This is because athough the returns desired by the preference share hoders is at par with the returns offered by the fixed deposits, the cost to the company is after tax in case of preference shares whie the interest paid on fixed deposits is tax deductibe. So a company which is paying 10 per cent dividend on preference shares ends up paying 11 per cent (incuding 10 per cent dividend tax). If the company pays no income tax [as in the case of a 100 per cent Export Oriented Unit (EOU)] then this is the cost to the company. If the company pays tax at the rate of 35 per cent then the before tax cost shoots above 14 per cent. Compared with a debt cost of 7 to 12 per cent for estabished companies, it is not a viabe aternative at a to go in for preference shares if the tax iabiities are high. Therefore, preference shares woud ony be issued if the company requires a more permanent source of capita.

Cost of Capita 55 For the investor the biggest benefit of investing in a preference share is that the dividends are tax free in their hands. Which means if you are getting a dividend of 10 per cent from a preference share and you are in 30 per cent tax bracket, your net return is sti 10 per cent which is equivaent to receiving an interest income of 13 per cent from fixed deposits or any other interest bearing source. American / Goba Depository Receipts (ADRs/ GDRs) Equity shares that are offered in the internationa markets to internationa investors are issued in the form of Depository Receipts (DRs). If these DRs are issued for US investors in the US markets, then they are known as American Depository Receipts (ADRs). They can be isted on New York Stock Exchange (NYSE) or Nationa Association of Securities Deaers Automated Quotations (NASDAQ) Exchange. If they are issued for internationa investors to be isted on Luxemborg Stock Exchange in Europe then they are caed Goba Depository Receipts (GDRs). What goes in the hands of the investors is not a share certificate but a 'receipt' of a share certificate which is ying with the depository. The benefits of keeping the shares in the depository incude: ease of transfer, no bad deiveries, ess registrar & book keeping probems, etc. DRs entite the hoders to get both dividend and capita gains. ADRs/ GDRs can be converted into equity shares any time as they represent equity shares anyway and the reverse conversion of equity shares into ADRs/ GDRs is aowed to the extent of the first conversion. ADRs/ GDRs give an opportunity to foreign investors to buy the equity shares in Indian companies with the added benefits of trading in their own exchanges and without registering in India for buying and seing securities. Equity and Debt: A Comparison 1. Equity shares do not carry any fixed charges on them. If the company does not generate positive earnings, it does not have to pay equity shares any dividends. This is very much in contrast to interest on debt, which must be paid regardess of the eve of earnings. 2. Equity shares have no maturity date - it is permanent capita that does not have to be "paid back". Whie debt has a fixed maturity date and the debt taken has to be paid pack on that date. 3. Equity shares can, at times, be easier to se than debt. It appeas to many investor groups because (1) equity shares typicay carry a higher expected return than does preference shares or debentures, (2) equity shares provide investors with a better hedge against infation than debentures, and (3) returns from capita gains on equity shares are not taxed unti the gains are reaised whereas the interest income on debentures is taxed reguary. 4. The sae of new equity shares gives voting rights, or even contro if the stake is high enough, to the additiona new share owners who are brought into the company.

56 Financia Management Whie the debt and preference share owners do not have any voting rights (except in specia conditions). For this reason, debt is preferred over additiona equity financing. Equity financing is often avoided by sma companies, whose owner managers are not wiing to share contro. 5. The use of debt enabes the firm to acquire funds at a fixed cost, whereas the use of equity shares means that more sharehoders wi share in the firm's net profits. 6. The costs of underwriting and seing equity shares are usuay higher than the costs of underwriting and seing preferred shares or debt, which puts additiona burden on the companies raising resources. But the ife and permanency of the equity shares more than compensates for the additiona expenses in initia foatation. Share Capita Figure 2.2 shows the Schedue 'A' of the Cosco India baance sheet. Figure 2.2: Share Capita The first heading is 'Authorised', which means authorised share capita. Authorised share capita is the tota amount of shares that a company is authorised to se. 'Memorandum and Artices of Association' of the company provides the information about the number of shares that the company is authorised to se and their par vaue. Par Vaue is the vaue per share estabished at the time of authorisation. Par vaue of the share estabishes the minimum ega capita for the company and the sharehoder must invest assets equa to that amount (whether in cash or by transferring the assets to the company). Par vaue mutipied by the number of authorised shares form the authorised capita. Cosco India Ltd is authorised to se 10,000,000 equity shares (10 miion or 1 crore shares) of Rs 10 each. Here the par vaue is Rs 10 per share and the tota number of shares that the company can se is 1 crore. Therefore the tota authorised capita is Rs 10 crore. The authorised capita is not fixed forever and can be changed depending upon the requirements. To change the authorised capita, first the company has to take permission

Cost of Capita 57 from the sharehoders by passing a resoution in the annua genera meeting to modify the authorised capita figure in the 'Memorandum and Artices of Association' of the company. This change is then notified to the 'Registrar of Companies' (Government) and then incorporated in the baance sheet. No forma entry is required for authorised share capita in the books of accounts. Can you expain why? This is because of the reason that there is no transaction of the authorised share capita. The second part taks about 'Issued, Subscribed and Paid-up Capita'. Issued Share Capita is that portion of the authorised capita that has been actuay offered for subscription. Subscribed share capita is that portion of issued share capita, which has actuay been subscribed and aotted. Paid-up share capita is that part of the subscribed capita for which consideration in cash or otherwise has been received. Therefore, subscribed share capita can be ess than or equa to the issued share capita. Simiary paid-up share capita can be ess than or equa to subscribed share capita. A these types of share capita aso incude the bonus shares that have been aotted by the organisation. There is another term 'caed-up share capita' which you may find in some of the baance sheets. It refers to that part of the subscribed capita, which sharehoders have been required or demanded to pay but have not paid as yet. This comes in the case where the company has issued party paid up shares and some sharehoders have not paid the entire amount to make the shares fuy paid up. As you can see in the figure 5.4, Cosco has an 'Issued and Subscribed' share capita of 41,60,000 shares of Rs 10/- each amounting to Rs 41,610,000. The figure was the same ast year meaning that the company has not issued any new shares in the ast one year. In brackets it aso says that the figure incudes 19,20,000 equity shares aotted as fuy paid up bonus shares by capitaisation of Rs 192 acs from Genera Reserve. This means that Rs 192 acs have been transferred from genera reserves to the share capita. As both of them beong to the sharehoders, it is merey a book entry and does not represent a fow of cash. As Cosco India Ltd is a isted company, this means that the company woud have issued shares to the pubic. The issue of new shares can be in five different ways: 1. It can se shares directy to the pubic. 2. It can se shares directy to seected investors. 3. It can se shares ony to its existing sharehoders. 4. It can issue shares without any consideration to existing sharehoders. 5. It can issue shares as exchange for assets from other entities.

58 Financia Management The first four woud resut in money or assets fowing in and the ast one woud resut in no additiona asset as it is merey a book entry. Seing Shares Directy to Pubic: Pubic Issue Seing shares directy to the pubic is known as 'pubic issue'. You woud have seen companies issuing advertisements for sae of its equity shares in the newspapers and other media targeted at potentia buyers. The company has to get its issue managed by a merchant banker (finance intermediaries speciaising in raising money for the companies). Certain norms specified by the Securities and Exchange Board of India (SEBI) appy to the companies who want to raise money from the pubic. Additionay there is a 'isting agreement' (specified by the stock exchanges where the company wants to ist its shares for trading), which the company has to adhere to. Cosco India Ltd is isted on Bombay Stock Exchange and Dehi Stock Exchange, which means that it woud have signed the isting agreement with both the stock exchanges separatey. Both the isting agreements woud neary be the same with very minor differences. Can you ook at the newspapers and find out what is the rate that one share of Cosco is quoting at on these stock exchanges? This rate is known as the market price of the share. Market price of the share is infuenced by a variety of factors, incuding expected future earnings, dividends, growth and other company specific and economic events. Market vaue of frequenty traded shares are reported daiy in newspapers such as The Business Standard, The Times of India, etc. and are avaiabe on the internet. Can you ocate two web sites that give you the atest price information on Indian isted companies? Seing Shares Directy to Seect Investors: Private Pacement Seing shares directy to seected investors is known as 'private pacement'. For making private pacements the companies do not issue advertisements in the newspapers but offer shares directy to seected institutiona investors ike mutua funds and foreign institutiona investors, etc. There is no obigation for the company to get its issue managed by a merchant banker but many of them empoy financia intermediaries to hep them se the issue. Certain norms specified by the Securities and Exchange Board of India (SEBI) appy to the companies who want to raise money this way so as to protect the rights of existing sharehoders. For exampe, the companies cannot issue shares beow the average market price of the ast six months. Of course, these guideines appy to ony those companies, which are isted on the stock exchange. Cosey hed companies can se new shares to whomsoever they want and at whatever price per share that is mutuay acceptabe to the company and the buyers. However, this price cannot be ess than the par vaue of the share. Seing Shares ony to existing Sharehoders: Right Issue The main difference between a pubic issue and a rights issue is that the rights issue is

Cost of Capita 59 ony meant for the existing sharehoders of the company. This means that the genera pubic cannot subscribe to the issue. The right issue is made to sharehoders in a ratio of their existing hodings. This means that if the sharehoder hods 100 shares and the company want to offer right shares in the ratio of 1:1, the sharehoder wi get a right to subscribe to 100 shares. The sharehoder can waive his right to subscribe to these shares and can pass it on or se it to any other person who is interested in buying it. Issuing shares without any consideration to existing sharehoders: Bonus Issue The first three types discussed issues that raise money. A company can aso issue new shares without any consideration to its existing sharehoders. This type of an issue is caed 'bonus issue.' As in the rights issue, the company offers additiona shares to its existing sharehoders in a particuar ratio of their existing sharehoding. How can it do that when the company has a vaue attached to each share? The company transfer the money from reserves & surpus (a part of sharehoder's money) to share capita, in other words, simpy a book entry where the tota funds avaiabe to the company does not change. The money for the bonus issue of shares comes from 'Reserves & Surpus', which means that the tota sharehoders funds remain constant. Issuing shares as exchange for assets from other entities When a company takes over the assets of another company or merges that company with it, it usuay issues shares instead of paying the other company or its sharehoders. The consideration paid for acquisition is usuay more than the book vaue of the assets transferred (Can you expain why?). It coud be due to the fact the goodwi of the assets of the company is aso transferred or it coud be because of the fact that the assets are in working condition and add significanty add to the vaue of the company. There are severa methods of vauation of the future benefits that accrue from the assets, but these are outside of the purview of this book. These methods are discussed in detai in any good vauation book. Issuing Shares at Par or at Premium The consideration that the company gets by seing its shares does not necessariy have to be the face vaue (par vaue) per share. The company can issue shares 'at par' or 'at premium'. At par means that the company wi charge ony the par vaue for every share issued. This means that if Cosco issues shares at par, what wi be the amount it wi get per share? (Ans: Rs 10). At premium means that the company can charge an amount per share which is more than the par vaue per share. This additiona amount is caed the share premium and is shown as a separate head in the 'Reserves & Surpus' category.

60 Financia Management Reserves & Surpus Genera Reserves is the name given to the aggregate amount of corporate earning that has been reinvested in the business. There is another reserve caed share premium reserve, which represents the premium charged when the company issued shares. The third is the surpus that comes from the profit and oss account. A these together constitute 'Reserves and Surpus'. The reserve and surpus as a whoe increases each year by the net income that is retained in the company and decreases by osses. You shoud note that the reserves and surpus does not mean cash. In fact, the company can have arge reserves and surpus position and be without cash or it can have a ot of cash and a very sma reserves and surpus baance. Athough both cash and reserves & surpus usuay increase when a company earns, the amount by which each one increases is usuay different. Two reasons can be attributed for this difference. 1. The net profit of the company is cacuated on accrua basis and not on a cash basis. Therefore, reserves & surpus woud show increase on an accrua basis as against cash, which wi ony show increase if there is rea infow of cash. 2. The cash generated from the net profit can be invested in assets, can be used to pay off oans or spend in any number of ways, both of which woud not affect net income or reserves and surpus. For exampe, if a Managing Director buys a Mercedes car for himsef on company's account, he is basicay making an expense that woud not be refected in the net income or reserves and surpus but woud be refected in the cash position of the company. To summarise cash is an asset and retained earning is one of the sources of financing (aong with share issues and oans) that a company can use for its business purposes. In the figure 2.3 beow, you can see the reserves and surpus figures of Cosco. Figure 2.3: Reserves & Surpus There are three items that you can notice in the figure. Let us discuss each one of them one by one. The share premium account shows a baance of Rs 31,230,000 which is unchanged from the ast year cosing baance. This means that company did not issue

Cost of Capita 61 any new shares in the ast one year. It aso means that the company woud have issued shares at a premium somewhere in the past. When these shares were issued cannot be interpreted from the information given and no other information on that is avaiabe in this annua report. Searching information from other resources, we come to know that a company had issued shares at a premium of Rs 30 per share. Can you cacuate, how many new shares has the company issued? Simpe cacuations woud te you that the company issued 1,041,000 shares (31,230,000 divided by 30). Coming to the second item, we see the genera reserve has an addition of Rs.7,921,724 in the ast year's figure to bring the tota to Rs.72,699,057. Now this addition has come again from the same head appropriations in the profit and oss account where it says 'transfer to genera reserve' and the same figure is mentioned. There was a different amount transferred to the baance sheet ast year. There is no stipuation that a particuar amount shoud be transferred, it ony depends on the company's requirements. Why did it not transfer more money can be traced to the fact that profits have been ower this year as compared to ast year. The third item shows the profit and oss account heading. But most of the companies report it under the heading 'Reserves & Surpus' as it beongs to the sharehoders. Here aso the figure has remained unchanged from the ast year. This means that the next profit was appropriated fuy and no extra surpus from the profit and oss account was carried to the baance sheet this time. If you ook at the profit and oss account in Annexure I, you see an item in appropriations at the end of the profit and oss account n which says baance Dividend carried Amount to baance Expected sheet. This Future confirms Vaue of that theno Share Present Vaue of a Share profit was carried = + t n to baance sheet t= 1 from (1profit + i) and oss account this (1 year. + i) For the ast year, it shows the figure of Rs.3,500,000/- which woud now be a part of the figure of 8,500,000 that is shown now. At the end of reserves & surpus, where it shows previous year figures, the additions work out to Rs 14,980,907 which is exacty the sum that you get when you add the two amounts that were transferred ast year to the baance sheet under their respective heads. A stocks rate of return In case of shares the first component is "Dt" which is nothing but the income in cash from dividends and the second component is the price change (appreciation and depreciation). This means that the price you are wiing to pay for a share today is a function of the dividends that you expect to receive and the present vaue of the expected future share price.

62 Financia Management But what if you are going to hod the share to maturity and not se. Then your ony return is the dividend amount. This means that this perpetua dividend is what you woud use to vaue the share. So you simpy use the perpetuity formuas mentioned above for constant or growing dividends. Finding out the present vaue of the share seems easy-doesn't it! Now comes the tedious question, what return do you expect from the security? Now every security has a different risk profie and you being a rationa human being woud expect a return that is commensurate with the risk that you are going to bear. So et us devote some time to understand the nature of risk and then how do we use this knowedge to reach the desired rate of return on the share. Risk Risk and return go hand in hand in investments and finance. One cannot tak about returns without taking about risk, because, investment decisions aways invove a trade - off between risk and return. Risk can be defined as the chance that the actua outcome from an investment wi differ from the expected return. This means that, the more variabe the possibe outcomes that can occur (i.e. the broader the range of possibe outcomes), the greater the risk. Risk and Expected Rate of Return The width of a probabiity distribution of rates of return is a measure of risk. The wider the probabiity distribution, the greater the risk or the greater the variabiity of return or greater the variance. An investor cannot expect greater returns without being wiing to assume greater risks. Sources of Risk Interest Rate Risk. It is the variabiity in a security's return from changes in the eve of interest rates. Market Risk. Market risk refers to the variabiity of returns due to fuctuations in the securities market. Infation Risk. With rise in infation there is reduction of purchasing power, hence this is aso referred to as purchasing power risk and affects a securities. Business Risk. This refers to the risk of doing business in a particuar industry or environment and it gets transferred to the investors who invest in the business or company. It may be caused by a variety of factors ike heightened competition, emergence of new technoogies, deveopment of substitute products, shifts in consumer preferences, etc. Financia Risk. Financia risk arises when companies resort to financia everage or the use of debt financing. The more the company resorts to debt financing, the

Cost of Capita 63 greater is the financia risk as it creates fixed interest payments due to debt or fixed dividend payments on preference stock thereby causing the amount of residua earnings avaiabe for common stock dividends to be more variabe than if no interest payments were required. It is avoidabe to the extent that management have the freedom to decide to borrow or not to borrow funds. Liquidity Risk. This risk is associated with the secondary market which the particuar security is traded in. A security which can be bought or sod quicky without significant price concession is considered iquid. The greater the uncertainty about the true eement and the price concession, the greater the iquidity risk. Securities that have ready markets ike treasury bis have esser iquidity risk. Measurement of Tota Risk Risk is associated with the dispersion in the ikey outcomes. Dispersion refers to variabiity. If an asset's return has no variabiity, it has no risk. An investor anaysing a series of returns on an investment over a period of years needs to know something about the variabiity of its returns or in other words the asset's tota risk. There are different ways to measure variabiity of returns. The range from the highest possibe to owest possibe rate of return is one measure, but the range is based ony on two extreme vaues. A more popuar way of measuring variabiity of returns is standard deviation. The standard deviation is simpy the square root of the variance of the rates of return. σ = n 2 [ Pi ( ki k ) ] i= 1 where, s = standard deviation Pi = probabiity associated with the ith possibe outcome ki = rate of return from the ith possibe outcome k = expected rate of return n = number of outcomes Portfoios and Risk An investment portfoio refers to the group of assets that is owned by an investor. When an investor invests a his funds in a singe security, it is more in the nature of specuation than of an investment, because the returns to the investor are based on the future of the singe asset, making it a very risky proposition. Generay, in order to reduce risk, investors hod on to a diversified portfoio which might contain equity capita,

64 Financia Management bonds, rea estate, savings accounts and various other assets. In other words, the investor does not put a his eggs into one basket. Diversifiabe and Non-diversifiabe Risk The fact that returns on stocks do not move in perfect tandem means that risk can be reduced by diversification. But the fact that there is some positive correation means that in practice risk can never be reduced to zero. So there is a imit on the amount of risk that can be reduced through diversification. The ower the degree of positive correation, the greater is the amount of risk reduction that is possibe. The amount of risk reduction achieved by diversification aso depends on the number of stocks in the portfoio. As the number of stocks in the portfoio increases, the diversifying effect of each additiona stock diminishes. As you can see that the major benefits of diversification are obtained with the first 10 to 12 stocks, provided they are drawn from industries that are not cosey reated. Increases beyond this point continue to reduce the tota risk but the benefits are margina. It is aso apparent that it is the diversifiabe risk that is being reduced unike the nondiversifiabe risk which remains constant whatever your portfoio is.

Cost of Capita 65 Nondiversifiabe risk is that part of tota risk (from various sources ike interest rate risk, infation risk, financia risk, etc.) that is reated to the genera economy or the stock market as a whoe and hence cannot be eiminated by diversification. Nondiversifiabe risk is aso referred to as market risk or systematic risk. Diversifiabe risk on the other hand, is that part of tota risk that is margina to the company or industry and hence can be reduced by diversification. Diversifiabe risk is aso caed unsystematic risk or specific risk. Risk of Stocks in a Portfoio A portfoio's standard deviation is a good indicator of the risk of a portfoio, to the extent that if adding a stock to the portfoio increases the portfoio's standard deviation, the stock adds risk to the portfoio. But the risk that a stock adds to a portfoio wi depend not ony on the stock's tota risk, its standard deviation, but on how that risk breaks down into diversifiabe and nondiversifiabe risk. If an investor hods ony one stock, there is no question of diversification, and this risk is therefore the standard deviation of the stock. For a diversified investor, the risk of a stock is ony that portion of tota risk that cannot be diversified or its nondiversifiabe risk. The nondiversifiabe risk is generay measured by Beta coefficient. Beta measures the reative risk associated with any individua portfoio as measured in reation to the risk of market portfoio. The market portfoio represents the most diversified portfoio of risky assets an investor coud buy since it incudes a risky assets. The reative risk can be expressed as: Non - diversifiabe risk of asset or potfoio β = risk of market portfoio Thus, the Beta coefficient is a measure of the non-diversifiabe or systematic risk of an asset reative to that of the market portfoio. A Beta of 1.0 indicates an asset of average risk. A Beta coefficient greater than 1.0 indicates above-average risk - stocks whose returns tend to be more risky than the market. A Beta coefficient ess than 1.0 indicates beow-average risk, i.e., ess riskier than market portfoio. In case of market portfoio a the diversification possibe has been done-thus the risk of market is a non-diversifiabe which an investor cannot avoid. Simiary, as ong as the asset's returns are not perfecty positivey with returns from other assets, there wi be some way to diversify away its unsystematic risk. As a resut beta depends ony on non-diversifiabe risks. The beta of a portfoio is nothing but the weighted average of betas of the securities

66 Financia Management that constitute the portfoio, the weights being the proportions of investments in respective securities. Measurement of Beta The systematic reationship between the return on the security or a portfoio and the return on the market can be described using a simpe inear regression, identifying the return on a security or portfoio as the dependent variabe Kj and the return on market portfoio as the independent variabe Km, in the singe-index mode or market mode deveoped by Wiiam Sharpe. This can be expressed as: K = α + β K + e j j j m j The Beta parameter bj in the mode represents the sope of the above regression reationship and measures the responsiveness of the security or portfoio to the genera market and indicates how extensivey the return of the portfoio or security wi vary with changes in the market return. The Beta coefficient of a security is defined as the ratio of the security's covariance of return with the market to the variance of the market. This can be cacuated as foows: The Apha parameter "a" is the intercept of the fitted ine and indicates what the return of the security or portfoio wi be when the market return is zero. For exampe, a security with an a of +2 per cent woud earn 2 percent even when the market return was zero and woud earn an additiona 2 percent at a eves of market return. The converse is true if a security has a of -2 percent. The positive a thus represents a sort of bonus return and woud be a highy desirabe aspect of a portfoio or security whie a negative a represents a penaty to the investor. β The third term ej is the unexpected return resuting from infuences not identified by the mode. Frequenty referred to as random or residua return, it may take on any vaue but is generay found to average out to zero. The Capita Asset Pricing Mode (CAPM) The CAPM deveoped by Wiiam F Sharpe, John Linter and Jan Mossin is one of the major deveopments in financia theory. The CAPM estabishes a inear reationship between the required rate of return of a security and its systematic or undiversifiabe risk or beta. This reationship as defined by CAPM can be used to vaue an equity share.

Cost of Capita 67 Mathematicay the reationship between the share's return and the market return can be depicted by the foowing formua: Here R s stands for return expected on the security, R f stands for risk-free return, R m stands for return from the market portfoio and β stands for beta. This reationship means that if the market goes up by 10 % and the security price aso goes up by 10 %, and vice versa, the beta is said to be 1.00, i.e., there is a perfect correation between return from the security and return from the market. If the beta is 2.00 the security price woud up or down by twice the %age of change of the market. If the beta is 0.00 then no correation exists between the market movement and the security price movement. It is easy to see that the required return for a given security increases with increases in its beta. Assumptions The CAPM is based on a ist of critica assumptions, some of which are as foows : Investors are risk-averse and use the expected rate of return and standard deviation of return as appropriate measures of risk and return for their portfoio. In other words, the greater the perceived risk of a portfoio, the risk-averse investor expects a higher return to compensate the risk. Investors make their investment decisions based on a singe-period horizon, i.e., the next immediate time period. Transaction costs in financia markets are ow enough to ignore and assets can be bought and sod in any unit desired. The investor is imited ony by his weath and the price of the asset. Taxes do not affect the choice of buying assets. A individuas assume that they can buy assets at the going market price and they a agree on the nature of the return and risk associated with each investment. In the CAPM, the expected rate of return can aso be thought of as a required rate of return because the market is assumed to be in equiibrium. The expected return is the return from an asset that investors anticipate or expect to earn over some future period. The required rate of return for a security is defined as the minimum expected rate of return needed to induce an investor to purchase it.

68 Financia Management Investors can earn a riskess rate of return by investing in riskess assets ike treasury bis. This risk free rate of return is designated Rf and the minimum return expected by the investors. In addition to this, because investors are risk-averse, they wi expect a risk premium to compensate them for the additiona risk assumed in investing in a risky asset. Required Rate of Return = Risk-free rate + Risk premium The CAPM provides an expicit measure of the risk premium. It is the product of the Beta for a particuar security j and the market risk premium K m - R f. Risk premium = b j (K m -R f ) This Beta co-efficient 'bj' is the non-diversifiabe risk of the asset reative to the risk of the market. If the risk of the asset is greater than the market risk, i.e., b exceeds 1.0, the investor assigns a higher risk premium to asset j, than to the market. The Security Market Line The pot of reationship between the required rate of return (kj) and non-diversifiabe risk(beta) as expressed in CAPM wi produce a graph of the SML as shown beow! " #$% & As per the CAPM assumptions any individua security's expected return and beta statistics shoud ie on the SML. The SML intersects the vertica axis at the risk-free

Cost of Capita 69 rate of return Rf and km - Rf is the sope of the SML. Since a securities are expected to pot aong the SML, the ine provides a direct and convenient way of determining the expected/required return of a security if we know the Beta of the securities. The SML can aso be used to cassify securities. Those with betas greater than 1.00 and potting on the upper part of the SML are cassified as aggressive securities whie those with betas ess than 1.00 and potting on the ower part of the SML can be cassified as defensive securities which earn beow-average returns. Asset pricing impications of the SML One of the major assumptions of the CAPM is that the market is in equiibrium and that the expected rate of return is equa to the required rate of return for a given eve of market risk or beta. In other words, the SML provides a framework for evauating whether high-risk stocks are offering returns more or ess in proportion to their risk and vice versa. Once a security's expected rate of return and beta have been computed they may be potted with reference to the SML. If the security's required rate of return, the security may be over or under priced and may fa beow or above the SML. ' ()! #( * + & #$%#$(#$, From the figure we see that Rf = 6% and km = 12%. Two securities X and Y have been shown in the figure. Both X and Y shoud have been on the SML but obviousy are not. Taking the case of X first, the expected rate of return from X is around 25%. But at a beta of around 1.2, using the SML we see that the required rate of return need be ony around 13%. This tes us that security X is undervaued or priced too ow because its average rate of return is inappropriatey high for the eve of risk it bears. X

70 Financia Management On the other hand, Security Y with a beta of around 1.7 requires a rate of return of around 16% but its expected return is ony about 7%. This tes us that the asset is overvaued or overpriced and hence unattractive because it is expected to produce a return ower than stocks with simiar betas. These two assets shoud move toward their equiibrium - required return positions on the SML (i.e., expected rate of return shoud be equa to required rate of return and correspond to their respective betas). To reach equiibrium and their required rate of return positions on the SML both stocks have to go through a temporary price adjustment. In order to reach equiibrium, assuming betas remain the same, the expected return of X has to be brought down to be equa to the required rate of return and be potted on the SML. To accompish this, the purchase price has to be sufficienty increased. Simiary, for security Y, the purchase price has to be sufficienty reduced so that the expected return rises to be the same eve as the required rate of return. In practice, investors wi be interested in purchasing security X because it offers more than proportionate returns in comparison to the risk. This demand wi push up the price of X as more of it is purchased and correspondingy bring down the returns. This process wi continue ti it reaches the equiibrium price and the expected returns are the same as the required returns. In the case of security Y, investors wi be tempted to se as it offers ess than the required rate of return. This increase in the suppy of Y wi drive down its price and correspondingy increase the return unti the expected return rises enough to reach the SML and the security is once again in equiibrium. Thus, the CAPM provides many usefu insights for the finance manager to maximise the vaue of the firm. It shows the type of risk for which sharehoders require compensation in the form of higher risk premium, and hence higher returns. Because finance managers aso perform the investment function on behaf of sharehoders, they must keep sight of the returns sharehoders expect for taking risks. Now et us ook at another part of the investment decision, i.e., what cash fows to incude and what cash fows to excude. Cash Fow In considering investment decisions, it does not matter whether outays are termed 'capita' or 'revenue' nor whether infows are turned 'profit', 'depreciation', 'tax aowance', or whatever. A outays and income must be taken into account. Cash fows in this context is not the same as the cash fow through a bank account, nor is it identica to accounting profit, since changes in the ater can occur without any change taking pace in the cash fow.

Cost of Capita 71 For purposes of investment appraisa, the cash fow is the incrementa cash receipts ess the incrementa expenditures soey attributabe to the investment in question. The future costs and revenues associated with each investment aternative are: 1. Capita costs: These cover (a) the ong-term capita outays necessary to finance a project, and (b) working capita. Typicay additiona working capita wi be required to cover a higher inventory, or a arger number of debtors, and to be worth whie the project must earn a turn on this capita as we as on the ong-term capita. 2. Operating costs: Running costs of the operations that are required to generate income. These incude both the variabe and the fixed costs. 3. Revenue: Reaisations from the sae of goods produced as we as other income which is not directy attributabe to operations but contributes to the profitabiity of the operations. 4. Depreciation: In the case of the discounting methods of appraisa, the recovery of capita is automaticay aowed for from the net cash fow, so depreciation need not be incuded as an accounting provision. This has the important advantage that the discounting profitabiity assessment is not affected by the pattern of accounting depreciation chosen. 5. Residua vaue: As with working capita, the residua assets of the project may have a vaue. This residua vaue shoud be incuded with the net cash fow. An investment decision impies the choice of an objective, a technique or appraisa, and ength of service-the project's ife. The objective and technique must be reated to definite period of time. No matter how good a company's maintenance poicy, its technoogica forecasting abiity, or its demand forecasting abiity, uncertainty wi aways be present because of the difficuty of predicting the ength of project's ife. The actua assessment of a project's profitabiity is a team exercise in which the expertise of economist, the market researcher, the engineer, and the controer must a be brought together. The outcome of their coaboration wi be a forecast of the cash fow over a period of years If this period is incorrecty estimated, the whoe anaysis wi be wrong or at east grossy inaccurate. As a rue, in investment appraisa, one of two assumptions is adopted-either the cash fow is assumed to be known with certainty, or the best estimate is used. The assumption of certainty is generay unacceptabe, so aowance must be made for the risk inherent in the proposed adoption of the 'best' estimate. To the expected outcome, probabiities can be attached to saes, costs, and other eements of the investment proposa to aow for risk.

72 Financia Management The appication of risk anaysis enabes management to answer the foowing questions: (1) What is the profitabiity resuting from given estimates of costs and revenues from the project, if they are achieved? and (2) What is the ikeihood of such estimates being achieved? This then enabes top management to concentrate on those factors that are critica to the financia success of the project, such as seing price, saes voume, capita cost, and so forth. Measuring cash fows is not a very tedious job if they exist, but aways remember you are taking about future projections in these cash fows and projections are perceptions that change with each person. The Weighted Average Cost of Capita Assumptions of the cost of capita mode A. Constant business risk: We assume that any investment being considered wi not significanty change the firm's business risk. Therefore the overa cost of capita woud not change with the changing nature of investments in different markets. B. Constant financia risk: Management is assumed to use the same financia mix as it used in the past with the same combination of debt and equity. C. Constant dividend poicy: 1. For ease of computation, it is generay assumed that the firm's dividends are increasing at a constant annua growth rate. Aso, this growth is assumed to be a function of the firm's earning capabiities and not merey the resut of paying out a arger percentage of the company's earnings. 2. We aso impicity assume that the dividend payout ratio (dividend/net income) is constant. Computing the weighted cost of capita A firm's weighted cost of capita is a function of () the individua costs of capita, (2) the capita structure mix, and (3) the eve of financing necessary to make the investment. The individua costs of capita heps in deciding the weigtage that has to be given to the different modes of financing. The capita structure mix decides eve of the debt that the company woud take up. The eve of financing heps in working out the amount that the company coud she out of its own and deciding whether and how much to finance from outside sources.

Cost of Capita 73 Determining individua costs of capita a) Cost of Debt: As we discussed in the ast chapter the before-tax cost of debt is found by tria-and-error by soving for kd in PV = PV 0 Interest n t = + t= 1 d 1 Pr incipa t ( 1+ k ) ( + k ) n d where PV = the market price of the debt, ess fotation costs, Interestt = Principa = the annua interest paid to the investor each year, the maturity vaue of the debt kd = before-tax cost of the debt (before-tax required rate of return on debt) n = the number of years to maturity. The after-tax cost of debt equas = kd(1 - T). b) Cost of preference share (required rate of return on preference share), kps, equas the dividend yied based upon the net price (market price ess fotation costs) or k ps = dividend net price = D NP o c) Cost of equity share: There are three measurement techniques to obtain the required rate of return on equity shares as discussed in the ast chapter. The first is the perpetuity growth mode, aso known as the dividend growth mode. A variation on the same is to ook at the foatation of a new equity share and incude the foatation costs when determining the cost of capita. The second one is the CAPM mode. The third one derives its vaue from the vaue of the debt of the company. i) Dividend growth mode a. Cost of internay generated common equity, ks k s = dividend in yea r 1 market price annua growth + in dividends k s = D 1 + g P o b. Cost of new equity share, k ns k ns = D 1 NP + g o

74 Financia Management where NP o = the market price of the equity share ess fotation costs incurred in issuing new shares. ii) Capita asset pricing mode: As discussed in the ast chapter the expected cost of equity share is dependent on the risk profie of the share versus the market as a whoe. k s = k f + b(k m - k f ) where k s k f b k m = the cost of equity share = the risk-free rate = beta, measure of the stock's systematic risk = the expected rate of return on the market iii) Risk-Premium Approach: A these modes are very usefu for companies that have their shares isted in the market or about to get them isted. What about the companies that are privatey owned. The best way to do it for these companies is to find the genera risk premium and take the company specific cost of debt (which is supposed to incude the risk premium of the company) and then add the two to find out the equity cost of the company. k s where k s k d RP s = k d + RP s = cost of equity share = cost of debt = risk-premium of equity share 2. Determining capita structure mix 3. The individua costs of capita wi be different for each source of capita in the firm's capita structure. If the company uses debt to the eve of fifty percent of its investment, then the cost of debt shoud get 50% weightage in the capita structure. To use the cost of capita in investment anayses, we must compute a weighted or overa cost of capita. 3. Leve of financing and the weighted average cost of capita The weighted margina cost of capita specifies the composite cost for each additiona rupee of financing. The firm shoud continue to invest up to the point where the margina interna rate of return earned on a new investment (IRR) equas the margina cost of new capita. Effect of additiona financing on the cost of capita woud be threefod.

Cost of Capita 75 a. Issuing new equity share wi increase the firm's weighted cost of capita because externa equity capita has a higher cost than internay generated common equity. b. As we use additiona debt and preference shares, their cost may increase, which wi resut in an increase in the weighted cost of capita. c. The increase in the firm's weighted margina cost of capita curve wi occur at the tota rupee financing eve when a the cheaper funding wi be consumed by the firm's investments, given the targeted debt- equity ratio. The increase in the weighted cost of capita wi occur when the tota financing from a sources equas: Procedure for determining the weighted margina cost of capita curve is given beow for ready reference. 1. Determine financia mix to be used. 2. Cacuate the eve of tota financing at which the cost of equity capita increases. 3. Cacuate the costs of each source of capita. 4. Compute the weighted margina costs of capita at different eves of tota financing. 5. Construct a graph that compares the interna rates of return of avaiabe investment projects with the weighted margina costs of capita. Cacuation of Weighted average cost of capita WACC basic computation is given by the formua given beow E k o = k s D + E D + k d [1-T] D + E where: k o k s k d = the weighted average cost of capita = the cost of equity capita = the before-tax cost of debt capita T = the margina tax rate E/(D+E) = percentage of financing from equity D/(D+E) = percentage of financing from debt (D+E) = Tota capita empoyed by the firm In the formua above we are assuming that the capita has two components ony, debt

76 Financia Management and equity. If the preference capita is aso there then it is simpy added to it the way other two are denoted. The cost of capita and cash fows are then utiised to evauate a project by using an evauation method.

Operating and Financia Leverage 77 Chapter-3 Operating and Financia Leverage One of the most important of the various financia decisions is how much everage a firm shoud empoy. A fundamenta decision made by any business is the degree to which it incurs fixed costs. A fixed cost is one that remains the same regardess of the eve of operations. As saes increase, fixed costs don't increase in the same proportion. Some fixed costs do not increase at a ti a particuar point. As a resut, profits can rise faster during good times. On the other hand, during bad times fixed costs don't decine, so profits fa more rapidy than saes do. The degree to which a firm ocks itsef into fixed costs is referred to as its everage position. The more highy everaged a firm, the riskier it is because of the obigations reated to fixed costs that must be met whether the firm is having a good year or not. At the same time, the more highy everaged the greater the profits during good times. This presents a cassic probem of making a decision where there is a trade-off between risk and return. There are two major types of everage - financia and operating. Financia everage is specificay the extent to which a firm gets its cash resources from borrowing (debt) as opposed to issuance of additiona shares of (equity). The greater the debt compared to equity, the more highy everaged the firm because debt egay obigates the firm to interest payments. These interest payments represent a fixed cost. Operating everage is concerned with the extent to which a firm commits itsef to high eves of fixed costs other than interest payments. A firm that rents property using canceabe eases has ess everage than a firm that commits itsef to a ong-term noncanceabe ease does. A firm that has substantia vertica integration has created a highy everaged situation. Consider what happens if a company verticay integrates by acquiring its raw materias' suppier. Raw materias wi now cost the company ess, because it doesn't have to buy them from an outside firm. But when times are bad, the firm wi have to bear the fixed costs associated with the suppier subsidiary. Had there sti been two separate companies, the big company coud have simpy sowed its purchases of raw materias from suppier without having to bear its fixed costs. In the cases of both financia and operating everage, the crucia question is how much everage is appropriate. We can't answer that question in absoute terms, but we wi

78 Financia Management hep you understand the topic. This understanding shoud make it simper to make appropriate choices or to understand what went into making the choices your firm has aready made. Operating Leverage Whie decisions about financia everage is stricty the domain of the firm's highest eves of management, operating everage is an issue that directy affects the ine managers of the firm. The eve of operating everage a firm seects shoud not be made without input from the managers directy invoved in the production process. For exampe, one of the most significant operating everage issues is the choice of technoogy eves. Seection of the highest eve of technoogy avaiabe is not aways in the best interests of the business. Suppose that we are opening a chain of copy centres. Each centre wi provide a fu service operation. Customers can drop work off in the morning and pick it up ater in the day or the week. The empoyees wi do the actua photocopying. We are faced with the choice of renting a reativey sow copy machine, or the newest technoogy machine, which is consideraby faster. The faster machine is aso consideraby more expensive to ease. It wi generay be the case that newer technoogy has a higher fixed cost and ower variabe cost than the oder technoogy. Variabe costs are those that vary directy with voume. If we doube the number of copies made, we doube the amount of paper, printing ink toner, and abour time needed for making the copies. One of the principe functions of new technoogy is to reduce the variabe costs of production. It may turn out that a machine that can reduce the variabe costs is more expensive to make, and thus has a higher purchase or ease price than the oder generation machine. However, even if it doesn't cost more to make, its manufacturer wi charge more for the new machine than for the oder machine. Intuitivey, if the new machine is in some respect better than the od machine (that is, it owers the variabe cost without reducing quaity), and doesn't cost more to buy, then no one wi buy the oder machine. Thus, anytime we see two technoogies being sod side by side, such as sow and fast copy machines, we can expect the faster machine to have a higher renta fee or purchase price, and therefore a higher fixed cost. Let's assume that we coud ease the sower, oder technoogy copy machine for Rs 10,000 per year, or a faster, newer technoogy copy machine for Rs 15,000 per year. Both produce photocopies of equa quaity. Both use the same quantities of paper and ink toner, but the faster machine requires ess operating time. Therefore, the abour cost is much ower for the faster machine. As a resut, the variabe cost of copies on the sow machine is 30 paise each, whie the variabe cost of copies from the fast machine is ony 25 paise each. Is the faster machine the better bet?

Operating and Financia Leverage 79 That depends. Suppose we se each copy for 50 paise. Then, for each copy we se we receive 50 paise and spend extra 30 paise or 25 paise (depending on our choice of machine) for the variabe costs. The difference between the price and the variabe costs is referred to as the contribution margin. This margin represents the amount of money avaiabe to be used to pay fixed costs and provide the firm with a profit. If we use the sower machine, we receive 50 paise and spend 30 paise, eaving 20 paise to be used toward paying the rent on the copy machine. If we se enough copies, there wi be enough individua contributions of 20 paise a piece to pay the fu Rs 10,000 rent and eave some receipts for a profit. So in operating everage the decision bois down to the production eves that we have or we anticipate and on that basis we decide the amount of fixed costs that we are wiing to bear. A this eads itsef to breakeven anaysis or cost-voume-profit anaysis that you have earned earier. Financia Leverage Let's start our discussion of financia everage with an exampe. Assume you were to buy a sma buiding as a piece of investment property. You buy the buiding for Rs 1,00,000 and pay the fu amount in cash. Suppose that an year ater you se the buiding for Rs 1,30,000. Your pre-tax profit is Rs 30,000. This is a 30% pre-tax return on your origina investment of Rs 1,00,000. As an aternative to paying the fu Rs 1,00,000 cash for the investment, you might have to put Rs 10,000 cash down and borrow Rs 90,000 from the bank at 15% interest. This time when you se the property for Rs 1,30,000 you repay Rs 90,000 to the bank, aong with Rs 13,500 interest. After deducting your origina Rs 10,000 investment, Rs 16,500 is eft as a pre-tax profit. This is a pre-tax return of 165% on your Rs 10,000 investment. Compare the 30% we cacuated earier to this rate of return of 165%. That's financia everage for you! Note that we had a net profit of Rs 30,000 without everage, but ony Rs 16,500 in the everaged case. Athough we earned a higher return, we had ess profit. That's because in the uneveraged case we had invested Rs 1,00,000 of our money, but in the everaged case we had invested ony Rs 10,000. If we have additiona investment opportunities avaiabe to us, we coud have invested our fu Rs 1,00,000, borrowed Rs 900,000, and had a pre-tax profit of Rs 165,000 on the same investment that yieds Rs 30,000 in the uneveraged situation. Financia everage can not ony increase your yied from investments, but can aso aow you to consider projects that are much arger than what woud be feasibe without borrowing.

80 Financia Management Suppose, however, that the property were sod after one year for Rs 70,000 rather than Rs 1,30,000. On Rs 1,00,000 uneveraged investment, the oss woud be Rs 30,000 before taxes. This woud be a 30% oss on our origina Rs 1,00,000 investment. In the everaged case, the oss wi be magnified. We woud have to repay the bank the Rs 90,000 oan pus Rs 13,500 of interest. These payments tota to Rs 1,03,500, which is Rs 33,500 greater than the Rs 70,000 proceeds from the sae. Further, we've ost our initia Rs 10,000 investment. The tota oss is Rs 43,500 before taxes. On our initia investment of Rs 10,000, this constitutes a oss of 435 percent. That's financia everage too! Let us put that into a tabe so as to see the effect of financia everage more ceary. Origina investment Amount Borrowed Profit/ (Loss) Profit/ (Loss) as percentage of origina investment 1,00,000-30,000 30 % 10,000 90,000 30,000 1,65 % 1,00,000 - (30,000) (30 %) 10,000 90,000 (30,000) 4,35 % Ceary when the firm is going to accept this eve of everage it must decide if the 165% possibe gain is worth the risk of a 435% oss. Whether it is or not depends on the ikeihood of the increase in vaue versus the probabiity of a decine. Of course it can accept a ower eve of everage but sti the interpay of debt and equity woud be there and a study of its effects in both the good times and the bad times woud be important. If the project reay was a sure thing, everage woud certainy make sense but projects are rarey sure things. Yet, managers shoud try to decide how confident they are of the success of a project, and weigh that confidence against the impications for the firm if the project does indeed fai. Not a managers rate the same project as being equay ikey to succeed. Some managers fee a particuar project is great, whie others may not think as highy of it. Further, even if a managers agreed on how ikey a project were to succeed, they woud not a make the same decision about financia everage. Some managers and firms tend to be more averse to risk than others. There are gambers and conservatives. Usuay sharehoders aign themseves with a firm that they fee does things the way they want them done. A person dependent on a steady eve of income from share dividends might prefer to buy the share of a firm that shuns everage and prefers a steady, if esser income. A person ooking for arge potentia appreciation in share price might prefer the share of a firm that is highy everaged.

Operating and Financia Leverage 81 How Much Financia Leverage Is Enough In practice, the everage decision is based on firm poicy. Some firms raise amost a of their funds from issuing share to sharehoders and from earnings retained in the firm. Other firms borrow as much as they possiby can and raise additiona money from sharehoders ony when they can no onger raise any additiona money by borrowing. Most firms are somewhere in the midde. In the exampe that we discussed above, you didn't have to borrow Rs 90,000 or nothing; you coud have chosen to borrow some amount in between the two. Likewise, some firms maintain one-fourth as much debt as equity, some firms equa amounts of debt and equity, and some firms more debt than equity. The firm's top corporate managers and the board of directors make this decision. Generay, project managers evauating the potentia of individua projects do not make the decision of issuing share or borrowing money. Debt or Equity? In making a decision regarding whether additiona funds shoud be raised from issuing debt or equity, there are severa factors to be considered. The first rue of financia everage is that it ony pays to borrow if the interest rate is ess than the rate of return on the money borrowed. If your firm can borrow money and invest it at a high enough rate so that the oan can be repaid with interest and sti eave some after-tax profit for your sharehoders, then your sharehoders have profited. They have made extra profit with no extra investment. This greaty magnifies the rate of return on the amount they invested. Why are enders so generousy aowing you to benefit at their expense? How can there be a system where a firm can increase profits to its sharehoders without extra investment from them? The key is risk. The sharehoders of your company don't increase their investment, but they do increase their risk. The ender may not reap a of the possibe profits from the use of his money. But the ender does earn a contractuay guaranteed rate of return. The ender gets back his money pus a set amount of interest, whether we make a fortune or ose our shirts. The amount that enders et you borrow depends argey on your avaiabe coatera. Merey desiring to be highy everaged doesn't guarantee that you can borrow enough to be highy everaged. Because the ender isn't a partner if you strike it rich, he doesn't want to be a partner if you go bankrupt. Assuming that you have enough coatera to borrow as much as you might want, what factors shoud you consider in trying to arrive at a reasonabe eve of everage? To a great degree, your desired everage position depends on the degree to which your saes and profits fuctuate. The greater the fuctuation in saes and profits, the ess everage you can afford. If your firm is a stabe, noncycica firm that makes money in good times and bad, then use of debt wi hep improve the rate of return earned by your sharehoders. If cycica factors in your industry or the economy at arge tend to cause your business to have both good and bad years, then debt entais a greater risk.

82 Financia Management For exampe, the petrochemicas industry, with its huge capita requirements has traditionay been highy everaged. The resuts have been very arge profits during the good years, but substantia osses during periods when petrochemica prices fas. Cycica factors shoudn't scare companies away from having any debt at a. The key is to accumuate no more interest and principa repayment obigations than can reasonaby be met in bad times as we as good. Utimatey, considering the variabiity of your profit stream, a decision must be made regarding the eve of extra risk you are wiing to take to achieve a higher potentia rate of return on sharehoder investments. Impact of Financia Leverage Financia everage acts as a ever to magnify the infuence of fuctuations. Any fuctuation in earnings before interest and taxes (EBIT) is magnified on the earnings per share. (EPS) by operation of everage. The greater the degree of everage, the wider the variation in EPS given any change in EBIT. The foowing iustration woud expain how everage technique works. Iustration Pramia company is capitaised with Rs. 10,00,000 divided in 1,000 common shares of Rs. 1,000 each. The management wishes to raise another Rs. 10,00,000 to finance a major programme of expansion through one of our possibe financing pans. The management may finance the company with : (I) (II) (III) (IV) a common stock, Rs. 5 akhs in common stock and Rs. 5 akhs in debt at 5 per cent interest, or a debt at 6 per cent interest or Rs. 5 akhs in common stock and Rs. 5 akhs in preferred stock with 5 per dividend. The company s existing earnings before interest and taxes (EBIT) amounted to Rs. 1,20,000. Corporation tax is assumed to be 50 percent. Soution: Impact of financia everage, as observed earier, wi be refected in earnings per share avaiabe to common stockhoders. To cacuate, the EPS in each of the four aternative EBIT has to be first of a cacuated: Proposa Proposa Proposa Propsa A B C D Rs. Rs. Rs. Rs. EBIT 120000 120000 120000 120000 Less Interest - 25000 60000 - EBT 120000 95000 60000 120000 Less Taxes @ 50% 60000 475000 30000 60000 EAT 60000 475000 30000 60000 Preferred Dividend - - - 25000 Earnings Avaiabe to Common stock hoders 60000 47000 30000 35000 No of Equity Shares 20000 15000 10000 15000 EPS 3.0 3.67 3.0 2.33

Operating and Financia Leverage 83 Thus, when EBIT is Rs. 1,20,000, proposa B invoving a tota capitaisation of 75 percent common stock and 25 per cent debt woud be the most favorabe with respect to earnings per share. It may further be noted that proposition of common stock in tota capitaisation is the same in both the proposas Band D but EPS is atogether different because of induction of preferred stock. Whie preferred stock dividend is subject to taxes where as interest on debt is tax-deductibe expenditure resuting in variation in EPS in proposas B and D. With a 50 percent tax rate the expicit cost of preferred stock is twice the cost of debt. We have so far assumed that eve of earnings woud remain the same even after the expansion of funds. Now assume that eve of earnings before interest and taxes doubes the present eve in correspondence with increase in capitaisation, changes in earnings per share to common stockhoders under different aternatives woud be as foows: Iustration Proposa Proposa Proposa Propsa A B C D Rs. Rs. Rs. Rs. EBIT 2,40,000 2,40,000 2,40,000 2,40,000 Less Interest - 2,5000 60,000 - EBT 2,40,000 2,15,000 1,80,000 2,40,000 Less Taxes @ 50% 1,20,000 1,07,000 90,000 1,20,000 EAT 1,20,000 1,07,000 90,000 1,20,000 Less: Preferred Dividend - - - 25000 Earnings Avaiabe to Common stock hoders 1,20,000 1,07,000 90,000 1,20,000 No of Equity Shares 20,000 15,000 10,000 15,000 EPS 6 7.17 9 6.33 EPS before Additiona Issue 3 3 3 3 It is evident from iustration that increase in earnings before interest and taxes is magnified on the earnings per share where debt has been inducted. Thus, in proposa Band d where debt comprises a portion of tota capitaisation, EPS woud increase by more than twice the existing eve whie in proposa A EPS has improved exacty in proportion to increase in earnings before interest and taxes. Since dividend in preferred stock is a fixed obigation and is ess than the increase in earnings, EPS in proposa D aso increases more than twice the rise in earning. Another important concusion that coud be drawn from the above iustration is that the arger the ratio of debt to equity, the greater the return to equity. Thus, in proposa C where debt represents 50 per cent of the tota capitaisation, EPS is magnified three times over the existing eve whie in proposa B where debt has furnished one-third

84 Financia Management of the tota funds, increase in EPS is itte more than doube the earier eve. This voatiity of earning operates during contraction of income as we as during an expansion. Likewise, financia everage magnifies a osses sustained by the company. Assume that the Rekha Company expects to sustain a toss of Rs. 60,000 before interest and taxes, oss per share under the different aternatives woud be: Ihrstration Proposa Proposa Proposa Propsa A B C D Rs. Rs. Rs. Rs. Loss before interest and Taxes 60,000 60,000 60,000 60,000 Add: Interest - 25,000 60,000 - Loss Per Share 3 5.67 12 4 Thus oss per share is highest under aternative C where proportion of debt is, as high as 50 per cent of the tota capitaisation and the owest in proposa A where everage is zero. This is why the phrase financia everage magnifies both profits and oss is very often quoted to expain magic of the financia everage. Thus, the financia everage is usefu as ong as the borrowed capita can be made to pay the company more than what it costs. Naturay it wi become source of decrease in profit rates when it costs more than what it earns. To what extent debt capita shoud be used in order to improve earnings of the company is a major financing probem facing a finance manager. It shoud be remembered here that the financia everage offers financia advantages ony up to a point. Beyond that point debt financing may be detrimenta to the company. For instance, as we expand the use of debt in our capita structure, enders wi perceive a greater financia risk for the company. For that reason, they may raise the average interest rate we pay, and pace certain restrictions on the company. Furthermore, concerned equity stockhoders may drive down the price of the stock forcing the management away from the company s main objectives of maximizing overa vaue of the company in the market. Thus, before using the financia everage as a technique of improving net earnings of the company, its impact on EPS must carefuy weighed. A graphica presentation of a financing pan A financing pan that consisted of Rs.40,000 of 5-percent bonds, 500 shares of Rs. 4 preferred stock, and 1,000 shares of common stock was used to iustrate financia everage in Tabe 3.1. This financing pan can be iustrated graphicay; ike a pans of this type, it can be potted as a straight ine. This is because it is affected ony by the deduction of certain fixed rupees costs. Potting two vaues of EBIT Rs.10,000 and Rs.14,000-and associated earnings per share of Rs. 2 and Rs. 4 gives us the ine in Figure 3.1.

Operating and Financia Leverage 85 This ine shows the earnings per share associated with each eve of EBIT. It is interesting to note that the ine intersects the EBIT axis at Rs.6,000. This vaue of EBIT represents the eve at which the firm s earnings per share are equa to zero. This zero intercept can be verified by ooking at Case 2 in Tabe 3.1. At eves of EBIT beow Rs.6,000, the firm woud have negative EPS. This portion of the graph has not been incuded. A graphica iustration of different degrees of financia everage The type of graphica presentation in Figure 3.7 can be used to iustrate differences in financia everage. Suppose we want to compare the financing pan in the preceding exampe with an aternate pan. The aternate pan invoves Rs. 20,000 of 5-percent debt, 250 shares of Rs. 4 preferred stock, Financing Pan EPS (Rs.) Rs. 3,500 = Rs.1.75/ sh 2,000 EBIT(Rs) Figure 3.1: A Graphica presentation of a financing pan and 2,000 shares of common stock. The annua interest payment wi be Rs.1,000 (.05 Rs.20,000) and the annua preferred dividend payment wi be Rs.1,000 (Rs.4/sh. 250 sh.). in order to graph this pan, two sets of EBIT -EPS coordinates are required. The EPS associated with EBIT vaues of Rs.10,000 and Rs.14,000 are cacuated beow. 40% Rs. Rs. EBIT 10,000 14,000 I 1,000 1,000 EBT 9,000 13,000 T (50%) 4,500 6,500 P 1,000 1,000 EPC 3,500 3,500 EPS Rs. 5,500 = Rs. 2.75/ sh 2,000 +56%

86 Financia Management A 40-percent increase in the firm s EBIT wi resut in a 56-percent increase in EPS. Appying Equation 3.6 to these vaues yieds + 56% = 1.4 + 40% The vaue of 1.4, when compared to the financia everage vaue of 2.5 cacuated earier indicates that this pan has a ower degree presented initiay. Each of these pans is graphed m Figure 3.8, The origina pan, first graphed in Figure 3.1, is abeed pan A; the current pan is abeed pan B. Pan A Pan B EPS (Rs.) EBIT(Rs) Figure 3.2: A graphica comparison of differing financing pans As Figure 3.8 iustrates, the sope of pan A is steeper than that of pan B This indicates that pan A has more financia everage than pan B This resut is as expected, since the ratio of the change in EPS for a given change in EBIT is 2.5 for pan A and 1.4 for pan B. The higher this ratio is, the more everage a pan has. The reader shoud recognize from Figure 3 8 that financing pans with higher degrees of everage have steeper sopes when potted on EBIT -EPS axes. The point of intersection of each pan with the EBIT axis represents the amount of earnings before interest and taxes necessary for the firm to cover its fixed financia charges, that is, the point at which EPS = 0. This point of intersection can be thought of a financia break-even point since it represents the eve of EBIT necessary for the firm to break even on its fixed financia charges. The break-even EBIT for pan A is Rs. 6,000, and for pan B it is Rs. 3,000 In other words, earnings before interest and taxes of ess than Rs.6,000 with pan A or ess than Rs.3,000 with pan B wi resut in a oss, or negative EPS. The point abeed X in Figure 3.2 represents, the point of intersection between pan A oss, or negative EPS. and pan B It indicates that at a eve of EBIT of Rs.9,000, EPS of Rs. 1.50 woud resut under either pan. At eves of EBIT beow Rs.9,000, pan

Operating and Financia Leverage 87 B resuts in higher eves of EPS; whie at eves of EBIT above Rs,9,COO, pan- A resuts in higher eves of EPS. The usefuness of this type of anaysis is discussed in Chapter on Capita Structure whie discussing methods of evauating financing pans. Combined Leverage The operating everage has its effects on operating risk and is measure by the percentage change in EBIT due to percentage change in saes. The financia everage has its effects on financia risk and is measured by rthe percentage change in EPS due t percentage change in EBIT. Since both these everages are cosey concerned with ascertaining the abiity to cover fixed charges (fixed-operating costs in the case of operating everage and fixed-financia costs in the case of financia everage), if they are combined, the resut is tota everage and the risk associated with combined everage is known as tota risk. Symboicay, DCL = DOL X DFL (14.11) Where DCL = Degree of combined everage DOL = Degree of operating everage DFL = Degree of financia everage Substituting the vaues of DOL and DFL, we have: % change in EBIT % change in EPS % change in saes % change in DCL = EBIT DCL = % change in EBIT % change in saes DCL = Contribution EBIT EBIT EBIT -1 Contribution EBIT -1 Thus, the DCL measures the percentage change in EPS due to percentage change in saes. If the degree of operating everage of a firm is 6 and its financia everage is 2.5, the combined everage of this a firm woud be 15(6 X 2.5). That is, 1 per cent change in saes woud bring about 15 per cent change in EPS in the direction of the change in saes. The combined everage can work in either direction. It wi be favourabe if saes increase and unfavourabe when saes decrease because changes in saes wi resut in more than proportionate returns in the form of EPS. The usefuness of DCL ies in the fact that it indicates the effect that saes changes wi have on EPS. Its potentia is aso great in the area of choosing financia pans for new investments. If, for exampe, a firm begins to invest heaviy in more risky assets than usua, the operating everage wi obviousy increase. If it does not change its financing

88 Financia Management poicy, that is, the capita structure remains constant, there woud be no change in its financia everage. As a resut, the combined everages woud increase causing an increase in its tota risk. The firm, in order to keep its risk constant, may ike to ower its financia everage. This coud be done if the new investments are financed with more equity than the firm has used in the past. This woud ower the financia everage and compensate for the increased operating everage caused by investment in more risky investments. If the operating everage has decreased due to ow fixed costs, the firm can afford to have a more evered financia pan to keep the tota risk constant at the same time having the same prospects of magnifying effects on EPS due to change in saes. Soved Probems 1. B Corporation is considering a new project which wi require the purchase of a new machine at a cost of 250,000. The project wi aso require use of a machine which has been fuy depreciated but which coud be sod today for 30,000. In addition, the firm expects an increase in net working capita investment of 60,000 in the first year of the project. What is the incrementa net investment at the outset of this project? How much of this incrementa net investment wi the firm be abe to depreciate? Soution The incrementa investment incudes both the cash required to purchase the new machine and the after-tax disposa vaue of the od machine, which is cacuated as foows: Gain on sae = Market vaue - Book vaue = 30,000-0 = 30,000. Taxes on gain = Gain Tax rate = (30,000)(0.40) = 12,000 Thus the firm's incrementa investment fows are: Cost of new machine : 250,000 Increase in net working capita 60,000 Market vaue of od machine -30,000 Tax on gain of sae of od machine : 12,000 Incrementa investment outay 292,000 The firm's depreciabe vaue for tax purposes wi be ony the 250,000 cost of the new machine. (If the od machine had remaining book vaue, the incrementa tax basis woud be reduced by the oss of this book vaue.) 2. The Stupid Company is considering a project requiring the purchase of a new machine costing Rs 200,000. The machine wi be depreciated on a straight-ine

Operating and Financia Leverage 89 basis over its economic ife of five years. The project, however, has ony a threeyear ife and the machine wi be sod after three years for an estimated Rs 30,000. In addition, the firm wi be abe to recover Rs 6,000 of working capita investment. What is the after-tax cash fow in year 3 from the sae of this machine and the recovery of the working capita investment? Assume that the firm's margina tax rate is 40 percent. Soution The net cash fow in the fina year are after-tax cash fows, incuding the tax effect of any asset sae. Note that there is no tax effect on the recovery of working capita investment since the recovery invoves the coection of accounts receivabe and the sae of inventory which has no tax effect (other than those represented by revenues and expenses). Gain or oss on asset sae : Market vaue of asset 30,000 Less : Book vaue of aset [200-(3)(40)] 80,000 Loss of sae of asset 50,000 Cacuating year 3 after-tax cash fows : Taxes saved due to oss on sae [(50)(0.40)] 20,000 Decreases in working capita investmen 6,000 Net after-tax cash fow in year 3 56,000 3. The foowing figures reate to two companies: (Rs akhs) P Ltd. Q Ltd. Saes 500 1,000 Variabe costs 200 300 Contribution 300 700 Fixed costs 150 400 150 300 Interest 50 d 100 Profit before Tax 100 200 You are required to: (i) Cacuate the operating, financia and combined everages for the two companies; and (ii) Comment on the reative risk position of them.

90 Financia Management Soution: Cacuation of everage : Contributi on Operating everage = Earning before Interest & Tax P Ltd = Q Ltd = Rs. 300akhs Rs.150akhs Rs.700akhs Rs.300akhs = 2 = 2.33 Financia everage = Earning before Interest & Tax Profit before Tax P Ltd = Q Ltd = Rs.150akhs Rs.100akhs Rs. 300akhs Rs.200akhs = 1.5 = 1.5 Contributi on Combined everage = Earning before Tax (i.e., Operating everage Financia everage) P Ltd = Q Ltd = Rs. 300akhs Rs.100akhs Rs.700akhs Rs.200akhs = 3 = 3.5 Comment on the reative risk position of P Ltd. and Q Ltd. (a) (b) Operating Leverage: The operating everage of Q Ltd. is higher than P Ltd.' and hence Q Ltd. is exposed to higher business risk than P Ltd. A firm wi face business risk when the EBIT does not vary in direct proportion with the change in saes. Financia Leverage: The financia everage of both the companies is same i.e., 1.5. (c) Combined Leverage: When we study the overa risk of the companies, is carrying higher risk than P Ltd. 4. (i) Find the operating everage from the foowing data: Saes Rs. 50,000 Variabe Costs 60% Fixed costs Rs. 12,000

Operating and Financia Leverage 91 (ii) Find the financia everage from the foowing data: Net Worth Rs. 25,00,000 Debt/Equity 3/1 interest rate 12% Soution: (i) Cacuation of Operating eve rage: Particuars (Rs.) Saes 50,000 Less: Variabe Costs (60% of Saes) 30,000 Contribution 20,000 ess: Fixed Costs 12,000 Operating Profit 8,000 d Operating everage = Contribution/Operating profit = Rs. 20,000/Rs. 8,000 = 2.5 (ii) Cacuation of Financia Leverage Working Notes: Cacuation of debt and interest thereon: (a) Debt =Rs. 25,00,000 3 = Rs. 75,00,000 (b) Interest on debt = Rs. 75,00,000 12/100 = Rs. 9,00,000 Rs. Operating Profit 20,00,000 Less: Interest on debt 9,00,000 d Profit before tax 11,00,000 Financia Leverage = Operating profit/profit before tax = Rs. 20,00,000/Rs. 11,00,000 = 1.82 5. Cacuate the operating everage, financia everage and combined everage from the foowing data under Situations I and II and Financia Pans A and B: Instaed capacity Actua Porduction and saes Seing Price 4,00 unit 75% of the Capacity Rs. 30 per Unit

92 Financia Management Variabe Cost Rs. 15 per Unit Fixed cost: Under Situation I Rs. 15, 000 Under Situation II Rs. 20,000 Capita structure: Rs. Financia Pan A B Equity 10,000 15,000 Debt (rate of Interest at 20%) 10,000 5,000 d 20,000 20,000 Soution: (i) Cacuation of Operating Leverage Operating Leverage = (Contribution/operating profit) Rs. Situation I Situation II Saes 90,000 90,000 Less: variabe cost 45,000 45,000 (3,00 unit@ Rs. 30 per unit) Contribution 45,000 45,000 Less: Fixed Costs 15,000 20,000 R R Operating profit (EBIT) 30,000 25,000 Operating Leverage = Rs. 45,000 Rs. 30,000 (ii) Cacuation of financia everage Financia everage = Operating profit Profit before tax = 1.5 Rs. 45,000 Rs. 25,000 =1.8 Financia pan A B Situation I 30,000 30,000 Operation profit Less: Interest on debt 2,000 1,000 profit before tax PBT 28,000 29,000 Financia everage = = Rs. 30, 000 Rs. 29, 000 = 1.07 = 1.04

Operating and Financia Leverage 93 Financia pan A B Situation II 25,000 25,000 Operation profit 2,000 1,000 Less: Interest on debt 23,000 24,000 PBT Financia everage = Rs. 25,000 Rs. 23, 000 = Rs. 25,000 Rs. 24, 000 = 1.04 = 1.09 (iii) Cacuation of combined everages Combined everage = Operating Leverage Financia Leverage Financia pan A B Situation I (1.5 1.07) (1.5 1.04) Situation II (1.8 1.09) (1.8 1.04) = 1.96 = 1.87

94 Financia Management Chapter-4 Capita Budgeting Meaning, Importance, rationae of capita budgeting, nature of investment decision, the administrative framework, Methods of Appraisa, Capita Rationing, Infation and capita budgeting, Capita Budgeting under Risk and Uncertainties Meaning, Importance & Rationae of Capita Budgeting A firm conducts its business in a rapidy changing and highy competitive environment. The changing environment poses both opportunities and threats for the company. For exampe, change in Government poicy may cause change in prices of inputs and outputs, demand and suppy of products/services. Simiary, technoogy change may cause the production cost change. Aso the cash infows and outfows cannot be ascertained with accuracy. Therefore, evauation of investment projects under uncertainty and risk become important. Characteristicay, a capita budgeting decision invoves argey irreversibe commitment of resources that is generay subject to a significant degree of risk. Such decisions have far reaching effects on a company's profitabiity and fexibiity over the ong-term, thus requiring that they be part of a carefuy deveoped strategy that is based on reiabe forecasting procedures. Capita Budgeting Capita budgeting may be defined as the decision-making process by which, firms evauate the purchase of major fixed assets, incuding buidings, machinery, and equipment It aso covers decisions to acquire other firms, either through the purchase of their common stock or groups of assets that can be used to conduct an ongoing business. Capita budgeting scribes the firm s forma panning process for the acquisition and investment of capita and resuts in a capita budget that is the firm s forma pan for the expenditure of money to purchased assets. A capita-budgeting decision is a two-sided process. First, the anayst must evauate a proposed project to cacuate the ikey or expected return from the project. This cacuation generay begins with expenditure of the project s service ife and a stream of cash fowing into the firm over the ife of the project. The cacuation of expected, turn may be done by two methods: a interna rate of return, or (b) net present vaue, These two methods are discussed ater in this unit.

Capita Budgeting 95 The second side of a capita-budgeting decision is to determine the required return from a project. We may cacuate the ikey return to be 12 percent but the question is whether this is good enough for the proposa to be accepted. In order to determine whether the return is adequate, the auayst must evauate the degree of risk in the project and then must cacuate the, required return for the given risk eve. Two techniques may be used to perform this anaysis. The weighted-average cost of capita is used when the new proposa is assumed to have the same degree of risk as the firm s existing activities. The capita asset pricing mode is used if the risk in the project is viewed as different from the firm s current risk eve. Capita budgeting is important for the future we-being of the firm; it is aso a compex, conceptuay difficut topic. A, we sha see ater in this chapter, the optimum capita budget-the eve of investment that maximizes the present vaue of the firm is simutaneousy determined by the interaction of suppy and demand forces under conditions of uncertainty. Suppy forces refer to the suppy of capita, the firm or its cost of capita schedue. Demand forces reate to the investmen opportunities open to the firm, as measured by the stream of revenues that wi resut from an investment decision Uncertainty enters the decision because it is impossibe to know exacty either the cost of capita or the stream of revenues that wi be derived from a project. Significane of Capita Budgeting A number of factors cornbine to make capita budgeting perhaps the most important decision with which financia management is invoved. Further, a departments Of a firm-production, marketing, and so on, are vitay affected by the capita budgeting decisions, so a executives, no matter what their primary responsibiity, must be aware of how capita budgeting decisions are made, These points are discussed in this section. Long Term Effects First and foremost, the fact that the resuts continue over an extended period means that the decision maker oses some of his fexibiity. He must make a commitment into the future. For exampe, the purchase of an asset with an economic ife of ten years requires a ong period of waiting before the fina resuts of the action can be known. The decision maker must commit funds for this period, and, thus, he becomes a hostage of future events. Asset expansion is fundamentay reated to expected future saes. A decision to buy or to construct a fixed asset that is expected to ast five years invoves an impicit fiveyear saes forecast. Indeed, the economic ife of a purchased asset represents an impicit forecast for the duration of the economic ife of the asset. Hence, faiure to forecast accuratey wi resut in over investment or under investmnent in fixed assets. An erroneous forecast of asset requirements can resut in serious consequences. If the firm has invested too much in assets, it wi incur unnecessariy heavy expenses. If it

96 Financia Management has not spent enough on fixed assets, two serious probems may arise. First, the firm s equipment may not be sufficienty modern to enabe it to produce competitivey. Second, if it has inadequate capacity, it may ose a portion of its share of the market to riva firms. To regain ost customers typicay requires heavy seing expenses, price reduction, product improvements, and so forth. Timing the Avaiabiity of Capita Assets Another probem is to phase propery the avaiabiity of capita assets in order to have them. come on stream at the correct time. For exampe, the executive vice-president of a decorative tie company gave the authors an iustration of the importance of capita budgeting. His firm tried to operate near capacity most of the time. For about four years there had been intermittent spurts in the demand for its product; when these spurts occurred, the firm had to turn away orders. After a sharp increase in demand, the firm woud add capacity by renting an additiona buiding, then purchasing and instaing the appropriate equipment. It woud take six to eight months to have the additiona capacity ready. At this point the company frequenty found that there was no demand for its increased output-other firms had aready expanded their operations and had taken an increased share of the market, with the resut that demand for this firm had eveed off. If the firm had propery forecast demand and had panned its increase in capacity six months or one year in advance, it woud have been abe to maintain its market-indeed, to obtain a arger share of the market. Quaity of Capita Assets Good capita budgeting wi aso improve the timing of asset acquisitions and the quaity of assets purchased. This situation foows from the nature of capita goods and their producers. Firms do not order capita goods unti they see that saes are beginning to press on capacity. Such occasions occur simutaneousy for many firms. When the heavy orders come in, the producers of capita goods go from a situation of ide capacity to one where they cannot meet a the orders that have been paced. Consequenty, arge backogs accumuate. Since the production of capita goods invoves a reativey ong work-in-process period, a year or more of waiting may be invoved before the additiona capita goods are avaiabe. This factor has obvious impications for purchasing agents and pant managers. Asset expansion is fundamentay reated to expected future saes. A decision to buy or to construct a fixed asset that is expected to ast five years invoves an impicit fiveyear saes forecast. Indeed, the economic ife of a purchased asset represents an impicit forecast for the duration of the economic ife of the asset. Hence, faiure to forecast accuratey wi resut in over investment or under investmnent in fixed assets. An erroneous forecast of asset requirements can resut in serious consequences. If the firm has invested too much in assets, it wi incur unnecessariy heavy expenses. If it has not spent enough on fixed assets, two serious probems may arise. First, the firm s

Capita Budgeting 97 equipment may not be sufficienty modern to enabe it to produce competitivey. Second, if it has inadequate capacity, it may ose a portion of its share of the market to riva firms. To regain ost customers typicay requires heavy seing expenses, price reduction, product improvements, and so forth. Timing the Avaiabiity of Capita Assets Another probem is to phase propery the avaiabiity of capita assets in order to have them. come on stream at the correct time. For exampe, the executive vice-president of a decorative tie company gave the authors an iustration of the importance of capita budgeting. His firm tried to operate near capacity most of the time. For about four years there had been intermittent spurts in the demand for its product; when these spurts occurred, the firm had to turn away orders. After a sharp increase in demand, the firm woud add capacity by renting an additiona buiding, then purchasing and instaing the appropriate equipment. It woud take six to eight months to have the additiona capacity ready. At this point the company frequenty found that there was no demand for its increased output-other firms had aready expanded their operations and had taken an increased share of the market, with the resut that demand for this firm had eveed off. If the firm had propery forecast demand and had panned its increase in capacity six months or one year in advance, it woud have been abe to maintain its market-indeed, to obtain a arger share of the market. Quaity of Capita Assets Good capita budgeting wi aso improve the timing of asset acquisitions and the quaity of assets purchased. This situation foows from the nature of capita goods and their producers. Firms do not order capita goods unti they see that saes are beginning to press on capacity. Such occasions occur simutaneousy for many firms. When the heavy orders come in, the producers of capita goods go from a situation of ide capacity to one where they cannot meet a the orders that have been paced. Consequenty, arge backogs accumuate. Since the production of capita goods invoves a reativey ong work-in-process period, a year or more of waiting may be invoved before the additiona capita goods are avaiabe. This factor has obvious impications for purchasing agents and pant managers. Raising Funds Another reason for the importance of capita budgeting is that asset expansion typicay invoves substantia expenditures Before a firm spends a arge amount of money, it must make the proper pans-arge amounts of fund are not avaiabe automaticay. A firm contempating, major capita expenditure program may need to arrange its financing severa years in advance to be sure of having the funds required for the expansion. Raising Funds Another reason for the importance of capita budgeting is that asset expansion typicay invoves substantia expenditures Before a firm spends a arge

98 Financia Management amount of money, it must make the proper pans-arge amounts of fund are not avaiabe automaticay. A firm contempating, major capita expenditure program may need to arrange its financing severa years in advance to be sure of having the funds required for the expansion. Abiity to Compete Finay, it has been said with a great dea of truth that many firms fai, not because they have too much capita equipment but because they have too itte. Whie the conservative approach of having a sma amount of capita equipment may be appropriate at times, such an approach may aso be fata if a firm s competitors insta modern, automated equipmen that permits them to produce a better product and se it at a ower price. The same thing aso hods true for nations: If United States firms fai to modernize but those of other nations do, then the u.s. wi not be abe to compete in word markets Thus, an understanding of business investment behavior and of factors that motivate firms to undertake investment programs is vita for congressiona eaders and others invoved in governmenta poicy making. Appication of the Concept At the appied eve, the capita budgeting process is much more compex than what it ooks. Projects do not just appear, a continuing stream of good investment opportunities resuts from hard thinking, carefu panning, and, often, arge outays for research and deveopment Moreover, some very difficut measurement probems are invoved: the saes and costs associated with particuar projects must be estimated, frequenty many years into the future, in the face of great uncertainty. Finay, some difficut conceptua and empirica probems arise over the methods of cacuating rates of return and the cost of capita. Businessmen are required to take action, however, even in the face of the kinds of probems described; this requirement has ed to the deveopment of procedures that assist in making optima investment decisions. Difficuties in Capita Budgeting Whie capita expenditure decisions are extremey important, they aso pose difficuties, which stem from three principa sources: Measurement Probems Identifying and measuring the costs end benefits of a capita expenditure proposa tends to be difficut. This is more so when a capita expenditure has a bearing on some other activities of the firm (ike cutting into the saes of some existing product) or has some intangibe consequences (ike improving the morae of workers). Uncertainty A capita expenditure decision invoves costs and benefits that extend far into future. It is impossibe to predict exacty what wi happen in future. Hence, there is usuay a great dea of uncertainty characterizing the costs and benefits of a capita expenditure decision.

Capita Budgeting 99 Tempora Spread The costs and benefits associated with a capita expenditure decision are spread out over a ong period of time, usuay years for industria projects and 20-50 years for infrastructura projects Such a tempora spread creates some probems in estimating discount rates and estabishing equivaences. Project Cassification Project anaysis entais time and effort. The costs incurred in this exercise must be justified by the benefits from it. Certain projects, given their compexity and magnitude, may warrant a detaied anaysis whie others may ca for a reativey simpe anaysis. Hence firms normay cassify projects into different categories. Each category is then anaysed somewhat differenty. Whie the system of cassification may vary from one firm to another, the foowing categories are found in most cassifications. Mandatory Investment These are expenditures required to compy with statutory requirements. exampes of such investments are poution contro equipment, medica dispensary, fire fitting equipment, cr5che in factory premises, and so on. These are often non-revenue producing investments. In anayzing such investments the focus is mainy on finding the most cost-effective way of fufiing a given statutory need. Repacement Projects Firms routiney invest in equipments meant to repace Obsoete and inefficient equipments, even though they may be in a serviceabe condition. The objective of such investments is to reduce costs (of abor, raw materia, and power), increase yied, and improve quaity. Repacement projects can be evauated in a fairy straightforward manner, though at times the anaysis may be quite detaied. Expansion Projects These investments are meant to increase capacity and/or widen the diistribution network. Such investments ca for an expicit forecast of growth. Since this can be risky and compex, expansion projects normay warrant more carefu anaysis than repacement projects Decision reating to such projects are taken by the top management. Diversification Projects These investments are aimed at producing new products or Services or entirey new geographica areas. Often diversiftcation projects entai substantia risks, invove arge outays, and require considerabe manageria effort and attention. Given their strategic importance, such projects ca for a very thorough evauation, both quantitative and quaitative. Further, they require a significant invovement of the board of directors. Research and Deveopment Projects R&D projects absorbed a very Sma proportion of capita budget in most Indian companies. Things, however, are changing. Companies are now aocating mote funds to R&D projects, more so in knowedge-intensive

100 Financia Management industries. R&D projects are characterized by numerous uncertainties and typicay invove sequentia decision-making. Hence the standard DCF anaysis is not appicabe to them. Such projects are decided on the basis of manageria judgment. Firms, which rey more on quantitative methods, use decision tree anaysis and option anaysis to evauate R&D projects. Misceaneous Projects This is a catch-a category that incudes items ike interior Decoration, recreationa faciities, executive aircrafts, andscaped gardens, and so on. There is no standard approach for evauating these projects and decisions regarding them are based on persona preferences of top management. Rationae The rationae underying the capita budgeting decision is efficiency. Thus, a firm must repace worn and obsoete pants and machinery, acquire fixed assets for current and new products and make strategic investment decisions. This wi enabe the firm to achieve its objective of maximizing profits either by way of increased revenues or cost reductions. The quaity of these decisions is improved by capita budgeting. Capita budgeting decision can be of two types: (i) those which expand revenues, and (ii) those which reduce costs. Investment Decision Affecting Revenues. Such investment decisions are expected to bring in additiona revenue, thereby raising the size of the firm s tota revenue. They can be the resut of either expansion of present operations or the deveopment of new product ines. Both types of investment decisions invove acquisition of new fixed assets and are income-expansionary in nature in the case of manufacturing firms. Investment Decisions Reducing Costs Such decisions, by reducing costs, add to the earnings of firm. A cassic exampe of such investment decisions is the repacement proposas when an asset wears out or becomes outdated. The firm must decide whether to continue with the existing assets or repace them. The firm evauates the benefits from the new machine in terms of ower operating cost and the outay that woud be needed to repace the machine. An expenditure on a new machine may be quite justifiabe in the ight of the tota cost savings that resut. A fundamenta difference between the above two categories of investment decision ies in the fact that cost-reduction investment decisions are subject to ess uncertainty in comparison to the revenue-affecting investment decisions. This is so because the firm has a better fee for potentia cost savings as it can examine past production and cost data. However, it is difficut to precisey estimate the revenues and costs resuting from a new product ine, particuary when the firm, knows reativey itte about the same.

Capita Budgeting 101 Nature of Investment Decision Typica exampes of capita budgeting decisions are: expansion projects; repacement projects; seection among aternatives; and buy or ease decisions. Good capita budgeting decisions, based on sound investment appraisa procedures, shoud improve the timing of capita acquisitions as we as the quaity of capita acquisitions. Investment in expansion/ modernisation is one of the main sources of economic growth, since it is required not ony to increase the tota capita stock of equipment and buidings, but aso to empoy abour in increasingy productive jobs as od pant is repaced by new. The Administrative Framework Successfu administration of capita investments by a company invoves 1. Generation of investment proposas 2. Estimation of cash fows for the proposas 3. Evauation of cash fows 4. Seection of projects based upon an acceptance criterion 5. Continua reevauation of investment projects after their acceptance Depending upon the firm invoved, investment proposas can emanate from various sources. For purposes of anaysis, projects may be cassified into one of five categories. 1. New products or expansion of existing products 2. Repacement of equipment or buidings 3. Research and deveopment 4. Exporation 5. Others The fifth category comprises misceaneous items such as the expenditure of funds to compy with certain heath standards or the acquisition of a poution-contro device. For a new product, the proposa usuay originates in the marketing department. On the other hand a proposa to repace a piece of equipment with a more sophisticated mode usuay emanates from the production area of the firm, in each case, efficient administrative procedures are needed for channeing in- Most firms screen proposas at mutipe eves of authority. For a proposa originating in the production area, the hierarchy of authority might run from (1) section chiefs to

102 Financia Management (2) pant managers to (3) the vice-president for operations to (4) a capita expenditures committee under the financia manager to (5) the president to (6) the board of directors. How high a proposa must go before it is finay approved usuay depends upon its size. The greater the capita outay, the greater the number of screens usuay required. Pant managers may be abe to approve moderate-sized projects on their own, but ony higher eves of authority approve arger ones. Because the administrative procedures for screening investment proposas vary greaty from firm to firm, it is not possibe to generaize. The best procedure wi depend upon the circumstances. The eve and type of capita expenditure appear to be important to investors, as they convey information about the expected future growth of earnings. John J. McConne and Chris J. Muscareia test this notion with respect to the eve of expenditures of a company. They find that an increase in capita-expenditure intentions, reative to prior expectations, resuts in increased stock returns around the time of the announcement, and vice versa for an unexpected decrease. Investment Ideas: Who Generates? Investment opportunities have to be identified or created; they do not occur automaticay? Investment proposas of various types may originate at different eves within a firm. Most proposas, in the nature of cost reduction or repacement or process or product improvement take pace at pant eve. The contribution of top management in generating investment ideas is generay confined to expansion or diversification projects. The proposas may originate systematicay or haphazardy in a firm. The proposa for adding a new product may emanate from the marketing department or from the pant manager who thinks of a better way of utiizing ide capacity. Suggestions for repacing an od machine or improving the production techniques may arise at the factory eve. In view of the fact that enough investment proposas shoud be generated to empoy the firm s funds fuy we and efficienty, a systematic procedure for generating proposas may be evoved by a firm. In a number of Indian companies, more than 50 per cent of the investment ideas are generated at the pant eve. The contribution of the board in idea generation is reativey insignificant. However, some companies depend on the board for certain investment ideas. Other companies depend on research centers for investment ideas. Is the investment idea generation primariy a bottom-up process in India? In UK, both bottom up as we as top-down processes exist.4 The Indian practice is more ike that in USA. Petty and Scott s study (1981) showed that project initiation was a bottomup process in USA, with about 82 per cent of investment proposas coming from divisiona management and pant personne. 5 However, it is to be noted that the sma number of ideas generated at the top may represent a high percentage in terms of investment vaue, so that what ooks to be an entirey bottom-up process may not be reay so.

Capita Budgeting 103 Indian companies use a variety of methods to encourage idea generation. The most common methods used are: (a) management sponsored studies for project identification, (b) forma suggestion schemes, and (c) consuting advice. Most companies use a combination of methods. The offer of financia incentives for generating investment idea is not a popuar practice. Other efforts empoyed by companies in searching investment ideas are: (a) review of researches done in the country or abroad, (b) conducting market surveys, and (c) deputing executives to internationa trade fairs for identifying new products/technoogy. Once the investment proposas have been identified, they coud be submitted for scrutiny any time. However, some companies do specify a submission time. Deveoping Cash Fow Estimation Estimation of cash fows is a difficut task because the future is uncertain. Operating managers with the hep of finance executives shoud deveop cash now estimates. The risk associated with cash nows shoud aso be property handed and shoud be taken into account in the decision process. Estimation of cash nows requires coection and anaysis of a quaitative and quantitative data, both financia and non-financia in nature. Large companies woud have a management information system providing such data. Executives in practice do not aways have carity about estimating cash fows. A arge number of companies do not incude additiona working capita whie estimating the investment project cash fows. A number of companies aso mix up financia fows with operating fows. Athough the companies caim to estimate cash fows on incrementa basis, some of them make no adjustment for sae proceeds of existing assets whie computing the project s initia cost. Most Indian companies choose an arbitrary period of 5 or 10 years for forecasting cash fows. This was because companies in India argey depended on government-owned financia institutions for financing their projects, and these institutions required 5 to 10 years forecasts of the project Cash fows. Evauation The evauation of projects shoud be performed by a group of experts who have no are to grind. Far exampe, the production peope may be generay interested in having the most modem type of equipments and increased production even if productivity is expected to be ow and goods cannot be sod. This attitude can bias their estimates of cash nows of the proposed projects. Simiary, marketing executives may be too optimistic about the saes prospects of goods manufactured, and overestimate the benefits of a proposed new product. It is therefore, necessary to ensure that an impartia group scrutinizes projects and that objectivity is maintained in the evauation process.

104 Financia Management A company in practice shoud take a care in seecting a method or methods of investment evauation. The criterion or criteria seected shoud be a true measure of evauating if the investment is profitabe (in terms of cash fows), and it shoud ead to the net increase in the company s weath (that is, its benefits shoud exceed its cost adjusted for time vaue and risk). It shoud aso be seen that the evauation criteria do not discriminate between the investment proposas. They shoud be capabe of ranking projects correcty in terms of profitabiity. The net present vaue method is theoreticay the most desirabe criterion as it is a true measure of profitabiity; it generay ranks projects correcty and is consistent with the weath maximisation criterion. In practice, however, managers choice may be governed by other practica considerations aso. A forma financia evauation of proposed capita expenditures has become a common practice among companies in India. A number of companies have a forma financia evauation of amost three-fourths of their investment rojects. Most companies subject more than 50 per cent of the projects to some kind of forma evauation. However, projects, such as repacement or worn-out equipment, wefare and statutoriy required projects beow certain imits, sma vaue items ike office equipment or furniture, repacement of assets of immediate requirements, etc., are not often formay evauated. Methods of Evauation As regards the use of evauation methods, most Indian companies, use payback criterion. In addition to payback and/or other methods, some companies aso use interna rate of return (IRR) and net present (NPV) methods. A few companies use accounting rate of return (ARR) method. IRR is the second most popuar technique in India. The major reason for DCF techniques not being as popuar as payback is the ack of famiiarity with DCF on the part of executives. Other factors are ack of technica peope and sometimes unwiingness of top management to use the DCF techniques. One arge manufacturing and marketing organisation, for exampe, thinks that conditions of its business are such that the DCF techniques are not needed. By business conditions the company perhaps means its marketing nature, and its products being in seer s markets. Another company fees that repacement projects are very frequent in the company, and therefore, it is not necessary to use DCF techniques for such projects. The practice of companies in India regarding the use of evauation criteria is simiar to that in USA. A study by Scha, Sundem and Geijsbeak (1978) showed that whereas 86 per cent of the firms used either the interna rate of return or net present vaue modes, ony 16 per cent used such discounting techniques without using the payback period or average rate of return methods. The tendency of US firms to use naive techniques as suppementary toos has aso been reported in other studies. However, firms in USA have come to depend increasingy on the DCF techniques, particuary IRR. According to Rockey s study (1973X the British companies use both DCF

Capita Budgeting 105 techniques and return on capita, sometimes in combination and sometimes soey, in their investment evauation; the use of payback is wide-spread. A recent study by Pike shows that the use of the DCF methods has significanty increased in UK in 1992, and NPV is more popuar than IRR. However, this increase has not reduced the importance of the traditiona methods such as payback and return on investment. Payback continues to be empoyed by amost a companies. One significant difference between practices in India and USA is that payback is used in India as a primary method and IRRJNPV as a secondary method, whie it is just the reverse in USA. Indian managers fee that payback is a convenient method of communicating an investment s desirabiity, and it best protects the recovery of capitaa scarce commodity in the deveoping countries. Cut-off Rate In the impementation of a sophisticated evauation system, the use of a minimum required rate of return is necessary. The required rate of return or the opportunity cost of capita shoud be based on the riskiness of cash fows of the investment proposa; it is compensation to investors for bearing the risk in suppying capit81 to finance investment proposas. Not a companies in India specify the minimum acceptabe rate of return. Some of them compute the weighted average cost of capita (WACC) as the discount rate. WACC is defined either as: (i) after-tax cost of debt x weight + after-tax cost of equity x weight (cost of equity is taken as 25 per cent (a judgmenta number) and weights are in proportion to the sources of capita used by a specific project); (ii) (after tax cost of borrowing borrowings + dividend rate equity) dividend by tota capita. Business executives in India are becoming increasingy aware of the Importance of the cost of capita, but they perhaps ack carity among them about its computation. Arbitrary judgment of management aso seems to pays roe in the assessment of the cost of capita. The faacious tendency of equating borrowing rate with minimum rate of return aso persists in the case of some companies. In USA, a itte mom than 50 per cent companies have been found using WACC as cut-off rate. In UK, ony 14 per cent firms were found to attempt any cacuation of the cost of capita. As in USA and UK, companies in India have a tendency to equate the minimum rate with interest rate or cost of specific source of finance. The phenomenon of depending on management judgement for the assessment of the cost of capita is prevaent as much in USA and UK as in India. Recognition of Risk The assessment of risk is an important aspect of an investment evauation. In theory, a number of techniques are suggested to hande risk. Some of them, such as the computer simuation technique are not ony quite invoved but are aso expensive to use. How do companies hande risk in practice?

106 Financia Management Companies in India consider the foowing as the four most important contributors of investment risk: seing price, product deman4 technoogica changes and government poicies. India is fast changing from seers market to buyers market as competition is intensifying in a arge number of products; hence uncertainty of seing price and product demand are being reaised as important risk factors. Uncertain government poicies (in areas such as custom and excise duty and import poicy), of course,, a continuous source of investment risk in deveoping countries ike India. Sensitivity anaysis and conservative forecasts are two equay important and widey used methods of handing investment risk in India. Each of these techniques is used by a number of Indian companies with other methods whie many other companies use either sensitivity anaysis or conservative forecasts with other methods. Some companies aso use shorter payback and infated discount rates (risk-adjusted discount rates). In US4 risk adjusted discount rate is used by 90 per cent companies whie ony 10 per cent use payback and sensitivity anaysis. This is aso confirmed by another US study by Petty and Scott (1981). In Rockey s survey of the British companies ony one firm out of 69 used sensitivity anaysis.3 The contrasts in risk evauation practices in India, on the one hand, and USA and UK, on the other, are sharp and significant. Given the compex nature of risk factors in deveoping countries, risk evauation cannot be handed through a singe number such as NPV cacuation based on conservative forecasts or risk-adjusted discount rate. Managers must know the impact on project profitabiity of the fu range of critica variabes. Hastie, an American businessman, strongy advocates the use of sensitivity anaysis for risk handing and casts doubt on the survey resuts in USA. He states: there appear to be more corporations using sensitivity anaysis than surveys indicate. In some cases firms may not know that what they are undertaking is caed sensitivity anaysis, and it probaby is not in the sophisticated, computer oriented sense...typicay, anaysts or midde managers eiminate the aternative assumptions and soutions in order to simpify the decision making process for higher management Capita Rationing Indian companies, by and arge, do not have to reject profitabe investment opportunities for ack of funds, despite the capita markets not being so we deveoped. This may be due to the existence of the government-owned financia system which is aways ready to finance profitabe projects. Indian companies do not use any mathematica technique to aocate resources under capita shortage which may sometimes arise on account of internay imposed restrictions or management s reuctance to raise capita from outside. Priorities for aocating resources are determined by management, based on the strategic need for and profitabiity of projects.

Capita Budgeting 107 Authorization It may not be feasibe in practice to specify standard administrative procedures for approving investment proposas. Screening and seection procedures may differ from one company to another. When arge sums of capita expenditures are invoved, the authority for the fina approva may rest with top management. The approva authority may be deegated for certain types of investment projects. Deegation may be affected subject to the amount of outay, prescribing the seection criteria and hoding the authorized person accountabe for resuts. Funds are appropriated for capita expenditures after the fina seection of investment proposas. The forma pan for the appropriation of funds is caed the capita budget. Generay, the senior management tighty contros the capita expenditures. Budgetary contros may be rigidy exercised, particuary when a company is facing iquidity probem. The expected expenditure shoud become a part of the annua capita budget, integrated with the overa budgetary system. Top management shoud ensure that funds are spent in accordance with appropriations made in the capita budget. Funds for the purpose of project impementation shoud be spent ony after seeking forma permission from the financia manager or any other authorized person. In India, as in UK, the power to commit a company to specific capita expenditure and to examine proposas is imited to a few top corporate officias. However, the duties of processing the examination and evauation of a proposa are somewhat spread throughout the corporate management staff in case of a few companies. Senior management tighty contro capita spending. Budgetary contro is aso exercised rigidy. The expected capita expenditure proposas invariaby become a part of the annua capita budget in a companies. Some companies aso have forma ong-range pans covering a period of 3 to 5 years. Some companies fee that ong-range pans have a significant infuence on the evauation and I funding of capita expenditure proposas. Quaitative Factors and Judgement In theory, the use of sophisticated techniques is emphasized since they maximise vaue to sharehoders. In practice, however, companies, athough tending to shift to the forma methods of evauation, give considerabe importance to quaitative factors. Most companies in India are guided, one time or other, by three quaitative factors: urgency, strategy, and environment. A companies think that urgency is the most important consideration whie a arge number thinks that strategy pays a significant roe. Some companies aso consider intuition, security and socia considerations as important quaitative factors. Quaitative factors ike empoyees moras and safety, investor and

108 Financia Management customer image, or companies in USA consider ega matters important in investment anaysis. Due to the significance of quaitative factors, judgment seems to pay an important roe. Some typica responses of companies about the roe of judgment are: Vision of judgment of the future pays an important roe. Factors ike market potentia, possibiity of technoogy change, trend of government poicies etc., which are judgmenta, pay important roe. The opportunities and constraints of seecting a project, its evauation of quaitative and quantitative factors, and the weightage on every bit of pros and cons, cost-benefit anaysis, etc., are essentia eements of judgment. Thus, it is inevitabe for any management decision. Judgment and intuition shoud definitey be used when a decision of choice has to be made between two or more, cosey beneficia projects, or when it invoves changing the ong-term strategy of the company. For routine matters, iquidity and profits shoud be preferred over judgment. It (judgment) pays a very important roe in determining the reiabiity of figures with the hep of quaitative methods as we as other known financia matters affecting the projects. We fee that what businessmen ca intuition or (simpy) judgment is in fact informed judgment based on experience. A firm growing in a favourabe economic environment wi be abe to identify profitabe opportunities without making NPV or IRR computation. Businessmen often act more inteigenty than they tak. Strategic Aspects of Investment Decision Recenty, a ot of emphasis has been paced on the view that a business firm facing a compex and changing environment wi benefit immensey in terms of improved quaity of decision-making if capita budgeting decisions are taken in the context of its overa strategy. This approach provides the decision-maker with a centra theme or a big picture to keep in mind at a times as a guideine for effectivey aocating corporate financia resources. As argued by a chief financia officer: Aocating resources to investments without a sound concept of divisiona and corporate strategy is a ot ike throwing darts in a dark room. A businessman argues as foows: We have erred too ong by exaggerating the improvement in decisionmaking that might resut from the adoption of DCF or other refined evauation techniques. What is needed are approximate answers to the precise probems rather than precise answer to the approximate probems

Capita Budgeting 109 There is itte vaue in refining an anaysis that does not consider tire most appropriate aternative and does not utiise sound. Management shoud spend its time improving the quaity of assumptions and assuring that a the strategic questions have been asked rather than impementing and using more refined evauation techniques. (Emphasis added). In fact a cose inkage between capita expenditure, at east major ones, and strategic positioning exists which has ed some searchers to concude that the set of probems companies refer to as capita budgeting is a task for genera management rather than financia anayst Some recent empirica works ampy support the practitioners concern for strategic considerations in capita expenditure panning and contro. It is therefore B myopic point of view to ignore strategic dimensions or to assume that they are separabe from the probem of efficient resource aocations addressed by capita budgeting theory. Most companies in India consider strategy as an important factor in investment evauation. What are the specific experiences of the companies in India in this regard? Exampes of six companies showing how they defined their corporate strategy are given as foows: To remain market eader by highest quaity and remunerative prices. This company undertook the production of a new range of product (which was marginay profitabe) for competitive reasons. To have moderate growth for saving taxes and to set up pants for forward and backward integration. Our strategy is to grow, diversify and expand in reated fieds of technoogy ony. Any project, which is within the strategy and satisfied profitabiity yardsticks, is accepted. This company found a ow-profit chemica production proposa acceptabe since it came within its technoogica capabiities. Strategy invoves anaysis of the company s present position, nature of its reationship with the environmenta forces, company s evauation of company s strong and weak points. To take up new projects for expansion in the fieds which are coser to present project/technoogy. This company rejected a profitabe project (of deep sea fishing and ship budding) whie it accepted a marginay profitabe project (of paint systems) since it was very cose to its current heat transfer technoogy. To stay in industria intermediate and capita goods ine, and in the process to achieve threefod profits in rea terms over a 5-year period. This company rejected a highy profitabe project (of manufacturing mopeds) since it was a consumer durabe and accepted a margina project.

110 Financia Management One more exampe is that of an Indian subsidiary of a giant mutinationa that ooks for projects in high technoogy, priority sector. This company even sod one of its profitabe non-priority sector division to a sister concern to maintain is high-tech priority sector profie. Strategic management has emerged as a systematic approach in propery positioning companies in the compex environment by baancing mutipe objectives. In practice, therefore, a comprehensive capita expenditure panning and contro system wi not simpy focus on profitabiity, as assumed by modern finance theory, but aso on growth, competition, baance of products, tota risk diversification, and manageria capabiity. There are umpteen exampes in the deveoping countries Like India where unprofitabe ventures are not divested even by the private sector companies because of their desirabiity from the point of view of consumer and empoyees, in particuar and society, in genera. Such considerations are not at a ess important than profitabiity since the utimate egitimating and surviva of companies (and certainy that of management) hinges on them. One must appreciate the dynamics of compex forces infuencing resource aocation in practice; it is not simpy the use of the most refined DCF techniques. Certain other practica considerations are as foows: Apart from the profitabiity of the project, other features ike its (project s) critica utiity in the production of the main product, strategic importance of capturing the new product first, adapting to the changing market environments, have a definite bearing on investment decisions. Technoogica deveopments pays critica roe in guiding investment decisions. Government poicies and concessions aso have a bearing on these. Investment in production equipment is given top priority among the existing products and the new project. Capita investment for expansion in existing ines where market potentia is proved is given first priority. Capita investment in new projects is given the next priority. Capita investment for buidings, furniture, cars, office equipments etc., is done on the basis of avaiabiity of funds and immediate needs. These statements reinforce the need for a strategic framework for probem- soving under compexities and the reevance of strategic considerations in investment panning. It aso impies that resource aocation is not simpy a matter of choosing most profitabe new projects. What is being stressed is that the strategic framework provides a higher eve screening and an integrating perspective to the whoe system of capita expenditure panning and contro. Once strategic questions have been answered, investment proposas may be subjected to DCF evauation.

Capita Budgeting 111 Capita Budgeting Decision-making eves For panning and contro purposes, three eves of decision-making have been identified: operating administrative, and strategic. Capita budgeting coud be categorized into those three eves. Openrting capita budgeting may incude routine minor expenditures, such as on office equipment, and ower eve management can easiy hande it. Strategic capita budgeting invoves arge investments such as acquisition of new business or expansion in a new ine of business. Strategic investment are unique and unstructured, and they cast a significant infuence on the direction of the business. Top management therefore, generay handes such investments. Administrative capita budgeting fas in-between these two eves. It invoves medium-size investments such as expenditure on expansion of existing ine of business. Administrative capita budgeting decisions are semi-structured in nature, and can be handed by midde management. Keeping in view the different decision-making eves, capita expenditures coud be cassified in a way which woud refect the appropriate manageria efforts to be paced in panning and controing them.! One usefu cassification (i) strategic projects, (ii) expansion in the new ine of business, (iii) genera repacement projects, (iv) expansion in the existing ine of business, and (v) statutory required and wefare projects. Further, each of these categories coud be sub-cassified according to funds required by the projects.

112 Financia Management Chapter-5 Capita Budgeting Evauation Techniques Methods of Appraisa Investment appraisa methods can be divided into two basic areas. One in which no time vaue of money is taken into consideration and one in which it is. Using time vaue of money whie evauating projects is known as discounting. A. Non-Discounting Methods Urgency Payback Period Accounting Rate of Return Debt Service Coverage Ratio B. Discounting Methods Net Present Vaue Profitabiity Index Interna Rate of Return C. Economic Vaue Added (EVA) charm as a Performance Measure Urgency Non-discounting Methods According to this critera, projects which are deemed to be more urgent get priority over projects which are regarded as ess urgent. The probem with this criterion is: How can the degree of urgency be determined? In certain situations, of course, it may not be difficut to identify highy urgent investments. For exampe, some minor equipment may have to be repaced immediatey due to faiure, to ensure continuity of production. Non-repacement of such equipment may mean considerabe osses arising from stoppage in production. It may be futie in such a case to go into detaied anaysis and deay decision. In view of these imitations of the urgency criterion, we suggest that in genera it shoud not be used for investment decision making. In exceptiona cases, where genuine urgency exists, it may be used provided investment outays are not significant.

Capita Budgeting Evauation Techniques 113 Payback Period Payback period is the most widey used technique and can be defined as the number of years required to recover the cost of the investment. This is easy to cacuate, but is often cacuated before tax, and aways after accounting depreciation. By definition, the payback period ignores income beyond this period, and it can thus be seen to be more as a measure of iquidity than of profitabiity. The payback period is the ength of time required to recover the initia cash outay on the project. For exampe, if a project invoves a cash outay of Rs 6,00,000 and generates cash infows of Rs 1,00,000, Rs 1,50,000, Rs 1,50,000 and Rs 2,00,000 in the first, second, third and fourth years respectivey, it payback period is four years because the sum of cash infows during four years is equa to the initia outay. When the annua cash infow is a constant sum, the payback period is simpy the initia outay divided by the annua cash infow. For exampe, a project which has an initia cash outay of Rs 10,00,000 and constant annua cash infow of Rs 3,00,000 has a payback period of Rs. 10,00,000/Rs 3,00,000 = 3.1/3 years. According the payback criteria, the shorter the payback period, the more desirabe the project. Firms using this criterian, generay specify the maximum acceptabe payback period. If this is n years, projects with a payback period of n years or ess are deemed worthwhie, and projects with a payback period exceeding n years are considered unworthy. Projects with ong payback periods are characteristicay those invoved in ong range panning, and which determine a firm's future. However, they may not yied their highest returns for a number of years and the resut is that the payback method is biased against the very investments that are most important to ong term success. Evauation A widey used investment criterion, the payback period seems to offer the foowing advantages. It is simpe, both in concept and appication. It does not use comex concepts and tedious cacuations and has few hidden assumptions. It is a rough and ready method for deaing with risk. It favours projects which generate substantia cash infows in earier years and discriminates against projects which bring substantia cash infows in ater years but not in earier years. Now, if risk tends to increase with futurity - in genera, this may be true - the payback criterion may be hepfu in weeding out risky projects. Since it emphasises earier cash infows, it may be a sensibe criterion when the firm is pressed with probems of iquidity.

114 Financia Management The imitations of the payback criteria, however, are very serious: It fais to consider the time vaue of money. Cash infows, in the payback cacuation, are simpy added without suitabe discounting. This vioates the most basic principe of financia anaysis which stipuates that cash fows occurring at different points of time can be added or subtracted ony after suitabe compounding / discounting. It ignores cash fows beyond the payback period. This eads to discrimination against projects which generate substantia cash infows in ater years. To iustrate, consider the cash fows of two projects, A and B: Year Cash fow of A Cash fow of B 0-1,00,000-1,00,000 1 50,000 20,000 2 30,000 20,000 3 20,000 20,000 4 10,000 40,000 5 10,000 50,000 6 60,000 The payback criteria prefers A, which has a payback period of 3 years, in comparison to B, which has a payback period of 4 years, even though B has very substantia cash infows in years 5 and 6. Since the payback period is a measure of a projects' capita recovery, it may divert attention from profitabiity. Payback has harshy, but not unfairy, been described as the "fish bait test since effectivey it concentrates on the recovery of the bait (the capita outay) paying not attention to the size of the fish (the utimate profitabiity), if any." Though it measures a project's iquidity, it does not indicates the iquidity position of the firm as a whoe, which is more important. Accounting Rate of Return The accounting rate of return, aso referred to as the average rate of return or the simpe rate, is a measure of profitabiity which reates income to investment, both measured in accounting terms. Since income and investment can be measured variousy, there can be a very arge number of measures for accounting rate of return. The measures that are empoyed commony in practice are: Average income after tax A : ------------------------------- Initia investment

Capita Budgeting Evauation Techniques 115 Average income after tax B : -------------------------------- Average investment Average income after tax but before interest C : ------------------------------------------------------ Initia investment Average income after tax but before interest D : ------------------------------------------------------ Average investment Average income before income and taxes E : --------------------------------------------------- Initia investment Average income before income and taxes F : --------------------------------------------------- Average investment Tota income after tax but before depreciation - Initia investment Initia investment G : ------------------------------------------------------------------------------- Yrs. This method is superior to the payback period, but is fundamentay unsound. Whie it does take account of the earnings over the entire economic ife of a project, it fais to take account of the time vaue of money. This weakness is made worse by the faiure to specify adequatey the reative attractiveness of aternative proposas. It is biased against short term projects in the same way that payback is biased against onger term ones. Evauation Traditionay as a popuar investment appraisa criterion, the accounting rate of return has the foowing virtues: It is simpe to cacuate. 2 It is based on accounting information which is readiy avaiabe and famiiar to businessmen. It considers benefits over the entire ife of the project. Since it is based on accounting measures, which can be readiy obtained from the financia accounting system of the firm, it faciitates post-auditing of capita expenditures. Whie income data for the entire ife of the project is normay required for cacuating the accounting rate of return one can make do even if compete income date is not avaiabe. For exampe, when due to indeterminacy of project ife a compete forecast of income cannot be obtained, the accounting rate of return can be cacuated on the basis of income for some typica year or income for the first three to five years.

116 Financia Management The shortcomings of the accounting rate of return criterion seem to be considerabe: It is based upon accounting profit, not cash fow. It does not take into account the time vaue of money. To iustrate this point, consider two investment proposas X and Y, each requiring an outay of Rs 1,00,000. Both the proposas have an expected ife of four years after which their vaue woud be ni. Reevant detais of these proposas are given beow: PROPOSAL X Year Book Vaue Depreciation Profit Cash after tax 0 1,00,000 0 0 1,00,000 1 75,000 25,000 40,000 65,000 2 52,000 25,000 30,000 55,000 3 50,000 25,000 20,000 45,000 4 0 25,000 10,000 35,000 PROPOSAL Y Year Book Vaue Depreciation Profit Cash after tax 0 (1,00,000) 0 0 (1,00,000) 1 70,000 25,000 10,000 35,000 2 50,000 25,000 20,000 45,000 3 25,000 25,000 30,000 55,000 4 0 25,000 40,000 65,000 Both the proposas, with an accounting rate of return (measure A) of 50% ook aike from the accounting rate of return point of view, though project X, because it provides benefits earier, is much more desirabe. Whie the payback period criterion gives no weight to more distant benefits, the accounting rate of return criteria seems to give them too much weight. There are, as we have seen, numerous measures of accounting rate of return. This can create controversy, confusion and more confusion, and probems in interpretation. Accounting income (whatever particuar measure of income we choose) is not uniquey defined because it is infuenced by the methods of depreciation, inventory vauation, and aocation of certain costs. Working with the same basic accounting data, different accountants are ikey to produce different income figures. A simiar probem, though ess severe, exists with respect to investment. The argument that the accounting rate of return measure faciitates post-auditing of capita expenditure is not very vaid. The financia accounting system of a firm

Capita Budgeting Evauation Techniques 117 is designed to report events with respect to accounting periods and for profit centres but not for individua investment. Debt Service Coverage Ratio Financia institutions, which provide the buk of ong-term finance for industria projects, evauate the financia viabiity of a project primariy in terms of the interna rate of return and the debt service coverage ratio. DSCR n i= 1 = n (PAT + D i= 1 i i i + I ) (I + LTI ) Debt service coverage ratio (DSCR) is defined as where PAT i = Profit after tax for year i D i = depreciation for year i I i = interest on ong-term oans of financia institutions for year i LRI i = oan repayment instament for year i. n = period over which the oan has be repaid. i i Looking at the debt service coverage ratio we find the numerator consists of a mixture of post-tax and pre-tax figures (profit after tax is a post tax figure and interest is a pretax figure). Likewise, the denominator consists of mixture of post-tax and pre-tax figures (oan repayment instaation is a post-tax figure and interest is a pre-tax figure). It is difficut to interpret a ratio which is based on a mixture of post-tax and pre-tax figures. In view of this difficuty, we suggest two aternatives : Aternative 1: Earnings before depreciation interest and taxes DSCR = ---------------------------------------------------------- Interest + Loan repayment instament --------------------------------------------- 1 - Tax rate Aternative 2: Profit after tax + Depreciation DSCR = -------------------------------------- Loan repayment instament Whie aternative 1 is based on pre-tax figures, aternative 2 is based on post-tax figures.

118 Financia Management There is one more difference. Aternative 1, assumes that the interest and oan repayment obigations are of the same order and focuses on the abiity of the firm to meet these obigations jointy. Aternative 2 assumes that the interest burden is of a higher priority, and focuses on the abiity of the firm to meet the principa repayment obigation, once the interest obigation is fuy met. These traditiona methods of investment appraisa are miseading to a dangerous extent. A means of measuring cash that aows for the importance of time is needed. This is provided by the discounting methods of appraisa, of which there are basicay two methods, both of which meet the objections to the payback period and the average rate of return methods. Net Present Vaue Discounting Methods of Appraisa The net present vaue of a project is equa to the sum of the present vaue of a the cash fows associated with the project. One of the most important concepts originating from the time vaue of money, NPV is cacuated by subtracting the present vaue of the cash outfows (investment) from the present vaue of the cash infows (income). Suppose you are making an investment of Rs 1 ac today and are expecting that you wi get Rs 1.1 acs one year from now. You wi ony invest if the present vaue of Rs 1.1 ac that you are getting one year hence is more than Rs 1 ac you have invested today. Using the tabe for present vaue of Rs 1, the mutipying factor for one year at 10% is 0.909. If we mutipy Rs 1.1 ac with.909 we get approx. Rs 1 ac. This means that we are getting a return of 10% from the project. If you again ook at the same tabe, the vaue gets owered as the interest rate increases, which means that for an interest rate of more than 10% we wi be getting a present vaue which wi be ower than the investment we are making. So if we are expecting a return of 15% for one year, we wi not invest as the present vaue of Rs 1.1 ac at 15% discount rate is ower than the investment of Rs 1 ac we are making today. The formua for cacuating the NPV is: where NPV CF t C0 t = net present vaue = cash fow occurring at the end of year = Initia cash out fow or investment = (t = 0...n), A cash infow has a positive sign, whereas a cash outfow has a negative sign

Capita Budgeting Evauation Techniques 119 n k = ife of the project = cost of capita used as the discount rate Here C0 is the initia investment we are making into the project and the rest is the present vaue of the cash fows we are expecting in the future. So NPV is the difference between the two at the expected rate of return. With NPV the acceptance rue is NPV > 0 Accept = 0 Indifferent < 0 Reject If the NPV is greater than zero we accept the project because we are getting a rate of return which exceeds our desired rate of return, if it is equa to zero we may or may not accept the project as we are getting a return which is exacty equa to our desired rate of return, and if it is ess than zero we reject the project proposa because the rate of return we are getting is ess than our desired rate of return. Features of Net Present Vaue Two features of the net present vaue method to be emphasised : 1. The NPV method is based on the assumption that the intermediate cash infow of the project is reinvested at a rate of return equa to the firm's cost of capita. 2. The NPV of a simpe project monotonicay decreases as the discount rate increases; the decrease in NPV, however, is at a decreasing rate. Evauation Conceptuay sound, the net present vaue criterion has considerabe merits: It takes into account the time vaue of money. It considers the cash fow stream in its entirety. It squares neaty with the financia objective of maximisation of the weath of stockhoder. The net present vaue represents the contribution to the weath of stockhoders. The net present vaue of various projects, measured as they are in today's rupees, can be added. For exampe, the present vaue of package consisting of two projects A and B, wi simpy be the sum of the net present vaue of these projects individuay: NPV (A+B) = NPV (A) + NPV (B) The additivity property of net present vaue ensures that a poor project (one which has

120 Financia Management a negative net present vaue) wi not be accepted just because it is combined with a good project (which has a positive net present vaue ). The imitations of the net present vaue criteria are: The ranking of projects on the net present vaue dimension is infuenced by the discount rate. To iustrate, consider two mutuay excusive projects - A and B which have the foowing cash fow streams : Year A B 0-3,00,000-3,00,000 1 60,000 1,30,000 2 1,00,000 1,00,000 3 1,20,000 80,000 4 1,50,000 60,000 The net present vaue of A and B for various rate of discounts is given beow. Discount rate NPV (A) NPV (B) 10% 36,622 29,180 12 20,390 17,658 14 5,318 6,828 15-1,826 1,654 16-8,702-3,350 Looking at the behaviour of net present vaue, we find that : (i)when the discount rate is 12 per cent, the net present vaue of A is greater than the net present vaue of B; and (ii) when the discount rate is 14 per cent the net present vaue of B is greater than the net present vaue of A. The net present vaue measure, an absoute measure, does not appear very meaningfu to businessmen who want to think in term of rate of return measures. Profitabiity Index (PI) Profitabiity Index reates the present vaue of benefits to the initia investment. It is aso known as Benefit-Cost Ratio (BCR) PVCF PI = ------- I where, PI = Profitabiity Index PVB = present vaue of cash fows I = initia investment To iustrate the cacuation of these measures, et us consider a project which is being evauated by a firm that has a cost of capita of 12 per cent.

Capita Budgeting Evauation Techniques 121 Initia investment : Rs. 1,00,000 Year 1 25,000 Year 2 40,000 Year 3 40,000 Year 4 50,000 The profitabiity index for this project is: 25,000 40,000 40,000 50,000 ---------- + --------- + --------- + --------- (1.12)1 (1.12)2 (1.12)3 (1.12)4 PI = ---------------------------------------------------------- = 1.145 1,00,000 With PI the acceptance rue is PI > 1 Accept = 1 Indifferent < 1 Reject If PI is greater than one we accept the project because we are getting a rate of return which exceeds our desired rate of return. If it is equa to one we may or may not accept the project as we are getting a return which is exacty equa to our desired rate of return. If it is ess than one we reject the project proposa because the rate of return we are getting is ess than our desired rate of return. Putting it simpy PI is an adaptation of the NPV rue because through it uses the same figures it ony heps in ranking of the project. Evauation The proponents of profitabiity index argue that since this criterion measures net present vaue per rupee of outay it can discriminate better between arge and sma investments and hence is preferabe to the net present vaue criterion. How vaid is this argument? Theoreticay, it can be very easiy verified that: (i) (ii) (iii) Under unconstrained conditions, the PI criteria wi accept and reject the same projects as the net present vaue criteria. When the capita budget is imited in the current period, the benefit cost ratio criteria may rank projects correcty in the order of decreasingy efficient use of capita. However, its use is not recommended because it provides no means for aggregating severa smaer projects into a package that can be compared with a arge project. When cash outfows occur beyond the current period, PI criteria is unsuitabe as a seection criteria.

122 Financia Management Interna Rate of Return When the present vaue of cash infows are exacty equa to the present vaue of cash outfows we are getting a rate of return which is equa to our discounting rate. In this case the rate of return we are getting is the actua return on the project. This rate is caed the IRR. NPV = n i= 1 CF t (1 + k) t C 0 Using the same formua as given in the NPV above, IRR wi be the return when the NPV is equa to zero as ony then the present vaue of cash infows wi be equa to the present vaue of the cash outfows. CF NPV = (1 + r) n i= 1 C = t t 0 0 n i= 1 CF t (1 + r) t = C 0 here CFt = cash fow at the end of year t r = discount rate n = ife of the project In the net present vaue cacuation we assume that the discount rate (cost of capita) is known and determine the net present vaue of the project. In the interna rate of return cacuation, we set the net present vaue equa to zero and determine the discount rate (interna rate of return) which satisfies this condition. Both the discounting methods NPV and IRR reate the estimates of the annua cash outays on the investment to the annua net of tax cash receipt generated by the investment. As a genera rue, the net of tax cash fow wi be composed of revenue ess taxes, pus depreciation. Since discounting techniques automaticay aow for the recovery of the capita outay in computing time-adjusted rates of return, it foows that depreciation provisions impicity form part of the cash infow. Interna rate of return method consists of finding that rate of discount that reduces the present vaue of cash fows (both infows and outfows attributabe to an investment project to zero. In other words, this true rate is that which exacty equaises the net cash proceeds over a project's ife with the initia investment outay. If the IRR exceeds the financia standard (i.e. cost of capita), then the project is prima facie acceptabe. Instead of being computed on the basis of the average or initia investment, the IRR is based on the funds in use from period to period.

Capita Budgeting Evauation Techniques 123 The actua cacuation of the rate is a hit-and-miss exercise because the rate is unknown at the outset, but tabes of present vaues are avaiabe to aid the anayst. These tabes show the present vaue of future sums at various rates of discount and are prepared for both singe sums and recurring annua payments. What Does IRR Mean? There are two possibe economic interpretations of interna rate of return: (i) Interna rate of return represents the rate of return on the unrecovered investment baance in the project. (ii) Interna rate of return is the rate of return earned on the initia investment made in the project. Evauation A popuar discounted cash fow method, the interna rate of return criteria has severa virtues : It takes into account the time vaue of money. It considers the cash fow stream in its entirety. It makes sense to businessmen who want to think in terms of rate of return and find an absoute quantity, ike net present vaue, somewhat difficut to work with. The interna rate of return criteria, however, has its own imitations. It may not be uniquey defined. If the cash fow stream of a project has more than one change in sign, there is a possibiity that there are mutipe rates of return. The interna rate of return figure cannot distinguish between ending and borrowing and hence a high interna rate of return need not necessariy be a desirabe feature. The interna rate of return criterion can be miseading when choosing between mutuay excusive projects that have substantiay different outays. Consider projects P and Q. Cash Fows Interna rate Net present vaue -------------- of return (%) (assuming k = 12%) Period 0 1 P - 10,000 + 20,000 100 7,857 Q - 50,000 + 75,000 50 16,964 Both the projects are good, but Q, with its higher net present vaue, contributes more to the weath of the stockhoders. Yet from an interna rate of return point of view P ooks better than Q. Hence, the interna rate of return criterion seems unsuitabe for ranking projects of different scae.

124 Financia Management Comparison of Discounting Methods In ordinary circumstances, the two discounting approaches wi resut in identica investment decisions. However, there are differences between them that can resut in conficting answers in terms of ranking projects according to their profitabiity. In forma accept/reject decisions, both methods ead to the same decision, since a projects having a yied in excess of the cost of capita wi aso have a positive net present vaue. Exampe Project A and B both require an outay of Rs 1000 now to obtain a return of Rs 1150 as the end of year 1 in the case of A, and 1405 at the end of year 3 in the case of B. The cost of capita is 8%. Interna rate of return A = 15% B = 12% Net present vaue A = (1150 x 0.926) - 1000 = Rs.65 B = (1405 x 0.794) - 1000 = Rs.115 Both project have rates of return in excess of 8% and positive net present vaue; but on the basis of the interna rate of return method, project A is superior, whie on the basis of the net present vaue method, project B is superior. Confusion arises because the projects have different engths of the ife, and if ony one of the projects is to be undertaken, the interna rate of return can be seen to be unabe to discriminate satisfactoriy between them. As with any rate of return, there is no indication of either the amount of capita invoved or the duration of the investment. The choice must be made either on the basis of net present vaues, or on the return on the incrementa investment between projects. The two methods make different impicit assumptions about the reinvesting of funds received from projects-particuary during the "gaps" between the end of one and the end of another. The net present vaue approach assumes that cash receipts can be reinvested at the company's cost of capita, thereby giving a bias in favour of ong-ived projects. In contrast, the interna rate of return approach assumes that cash receipts are reinvested at the same rate, giving a bias in favour of short-ived projects. It foows that the comparison of aternatives by either method must be made over a common time period, with expicit assumptions being made about what happens to funds between their receipt and the common termina date.

Capita Budgeting Evauation Techniques 125 Capita Rationing In terms of financing investment projects, three essentia questions must be asked: 1. How much money is needed for capita expenditure in the forthcoming panning period? 2. How much money is avaiabe for investment? 3. How are funds to be assigned when the acceptabe proposas require more money than is avaiabe? The first and third questions are resoved by reference to the discounted return on the various proposas, since it wi be known which are acceptabe, and in which order of preference. The second question is answered by a reference to the capita budget. The eve of this budget wi tend to depend on the quaity of the investment proposas submitted to top management. In addition, it wi aso tend to depend on: top management's phiosophy towards capita spending (e.g., is it growth - minded or cautious:)? the outook for future investment opportunities that may be unavaiabe if extensive current commitments are undertaken; the funds provided by current operations; and the feasibiity of acquiring additiona capita through borrowing or equity issues. It is not aways necessary, of course, to imit the spending on projects to internay generated funds. Theoreticay, projects shoud be undertaken to the point where the return is just equa to the cost of financing these projects. If safety and the maintaining of, say, famiy contro are considered to be more important than additiona profits, there may be a marked unwiingness to engage in externa financing and hence a imit wi be paced on the amounts avaiabe for investment. Even though the firm may wish to raise externa finance for its investment programme, there are many reasons why it may be unabe to do this. Exampes incude: a) The firm's past record and its present capita structure may make it impossibe or extremey costy to raise additiona debt capita. b) The firm's record may make it impossibe to raise new equity capita because of ow yieds or even no yied. c) Covenants in existing oan agreements may restrict future borrowing. Furthermore, in the typica company, one woud expect capita rationing to be argey sef-imposed. Each major project shoud be foowed up to ensure that it conforms to the conditions on

126 Financia Management which it was accepted, as we as being subject to cost contro procedures. Infation and Capita Budgeting One of the major mistakes is improper treatment of infation in capita budgeting decisions. The capita budgeting resuts woud be unreaistic if the impact of infation is not correcty factored in the anaysis as the cash fow estimates wi not refect the rea purchasing power. In other words, cash fows woud be shown at infated sums and, to that extent, cause distortion in capita budgeting decisions. Therefore, cash fows shoud be adjusted to accommodate the infation factor so that the capita budgeting decisions refect the 'true' picture. This Section dwes on the procedure for adjusting data for infation. Consider Exampe 2.2 An investment proposa P requires an initia capita outay of Rs. 2,00,000, with no savage vaue, and wi be depreciated on a straight ine basis for tax purposes. The earnings before depreciation and taxes (EBDT) during its 5 year ife are: Year 1 2 3 4 5 EBDT (Rs.) 70,000 76,000 80,000 60,000 52,000 Exampe 2.2 The corporate tax rate is 35 per cent and the company evauates its investment projects at 12 per cent cost of capita. Advice the company whether the project shoud be accepted. (i) when there is no infation and (ii) when there is infation at the rate of 15 per cent per annum, and the stated gross earnings are aso expected to grow at this rate of infation. Soution Determination of NPV (No Infation situation) Year PBDT Depre- ciation (200/5) Taxabe Income Profit After (Amount in rupees thousand) Since the net present vaue is positive, the project is worth accepting in a non-infationary scenario. Tax (Inc.x0.65) Cash Fow After Tax (PAT+Dep) PV Factor Present Vaue 1 70 40 30 19.5 59.5 0.893 53.13 2 76 40 36 23.4 63.4 0.797 50.53 3 80 40 40 26.0 66.0 0.712 46.99 4 60 40 20 13.0 53.0 0.636 33.71 5 52 40 12 7.8 47.8 0.567 27.10 Gross present vaue Less: Cash outfows 211.46 200.00 Net present vaue 11.46

Capita Budgeting Evauation Techniques 127 In an infationary situation, PBDT are expected to grow at 15 per cent. PBDT can be determined (refecting 15 per cent compound rate of growth) using the tabe. As amount of depreciation remains unchanged, taxabe profits as we as taxes woud go up as exhibited beow: Year PBDT Compo- unding Factor At 0.15 Revised PBDT (PBDT X Com. Fac.) Depreciation Taxabe Income PAT CFAT 1 70 1.150 80.50 40 40.50 26.32 66.32 2 76 1.322 100.47 40 60.47 39.31 79.31 3 80 1.521 121.68 40 81.68 53.09 93.09 4 60 1.749 104.94 40 64.94 42.21 82.21 5 52 2.011 104.57 40 64.57 41.97 81.97 Since CFAT are infated sums, they are to be defated at the rate of infation (15 per cent) to determine rea cash fows. The reevant cacuations are as foows: Determination of Rea Cash Fows (Amount in thousand rupees) Year CFAT Discount/ defated factor at 0.15 Rea cash infows (CFAT) 1 66.32 1/1.15 = 0.870 57.50 2 79.31 1/(1.15) 2 = 0.756 59.96 3 93.09 1/(1.15) 3 = 0.658 61.25 4 82.21 1/(1.15) 4 = 0.572 47.02 5 81.97 1/(1.15) 5 = 0.497 40.74 The rea cash fows are substantiay ower than nomina cash fows. This is due to the fact that increased income (as depreciation charges do not change) is subject to higher amount of taxes. The corporate tax rate is more than twice (35 per cent) the infation rate (15 per cent). The NPV and rea cash infows are shown in the foowing tabes. NPV Cacuations (Amount in thousand rupees) Year Rea CF PV factor at 12% Present Vaue 1 57.70 0.893 51.53 2 59.96 0.797 47.79 3 61.25 0.712 43.61 4 47.02 0.636 29.90 5 40.74 0.567 23.10 Gross present vaue Less: Cash outfows 195.93 200.00 Net present vaue (4.07) Since the NPV is negative under infationary situations, the investment proposa is not acceptabe. Thus, infation resuts both in ower cash fows and ower rea rates of

128 Financia Management return. Exampe 2.2 highights that firms (conscious of protecting the rea purchasing power of their owners) may go for unprofitabe investment projects, affecting the sharehoders weath adversey. It underines the significance of incorporating the infation factor in evauating capita budgeting decisions, in particuar for business firms interested in rea returns. Consistency warrants that the rea cost of capita shoud be used to discount rea cash infows after taxes and the nomina cost of capita shoud be empoyed for nomina CFAT. This point is iustrated in Exampe 2.3. The investment data of Rajiv Company Ltd. Launching a new product and with 12 per cent cost of capita, is as foows: Particuar Amount Investment Rs.7,00,000 CFAT: Year 1 5,00,000 2 4,00,000 3 2,00,000 4 1,00,000 5 1,00,000 Exampe 2.3 Assuming an infation rate of 5 per cent, determine NPV of the project by using both the nomina rate of discount and the rea rate of discount. Soution NPV Using Nomina Rate of Discount Year CFAT (Rs.) PV factor at 0.12 Tota PV (Rs.) 1 5,00,000 0.893 4,46,500 2 4,00,000 0.797 3,18,800 3 2,00,000 0.712 1,42,400 4 1,00,000 0.636 63,600 5 1,00,000 0.567 56,700 Gross present vaue Less: Cash outfows 10,28,000 7,00,000 Net present vaue 3,28,000 The nomina rate of discount (n) is obtained by compounding the rea rate (r) and infation rate (i). In equations terms, it is ( + n) = (1 + r) ( + i) ( + r) = (1 + n) ( + i) or

Capita Budgeting Evauation Techniques 129 substituting the vaues, ( + r) = 1.12/1.05 = 1.0667 r = 0.0667 or 6.67 per cent. or Since the discount rate now to be used is the rea discount rate, the CFAT shoud aso be adjusted for infation so that they too are expressed in rea terms. In operationa terms, CFAT wi be defated by the infation rate (5 per cent). Whie Tabe 5.1 shows rea/ defeted CFAT, NPV of rea CFAT is provided in Tabe 5.2 Rea Cash Fows Year CFAT (Rs.) Defation factor at 0.05 Rea CFAT (Rs.) 1 5,00,000 1/(1.05) = 0.952 4,76,00 2 4,00,000 1/(1.15) 2 = 0.907 3,62,800 3 2,00,000 1/(1.15) 3 = 0.864 1,72,800 4 1,00,000 1/(1.15) 4 = 0.823 82,300 5 1,00,000 1/(1.15) 5 = 0.784 78,400 Tabe 5.1 NPV Using Rea Rate of Discount Year Rea CFAT PV factor at 6.67% Tota PV 1 4,76,000 0.938 4,46,488 2 3,62,800 0.879 3,18,901 3 1,72,800 0.824 1,42,387 4 82,300 0.772 63,536 5 78,400 0.724 56,761 Gross present vaue Less: Cash outfows Net present vaue 10,28,073 7,00,000 3,28,073 Tabe 5.2 Pease note that 'rea cash fows discounted at the 'rea' discount rate yied an identica amount of NPV that is obtained by discounting 'nomina' cash fows by the 'nomina' discount rate. When estimates of CFAT and cost of capita incude infation, they are said to be expressed in nomina terms; when such estimates excude the impact of infation, they are said to be shown in rea terms. For correct anaysis, these estimates shoud either be stated in nomina or rea terms. It impies that capita budgeting decisions shoud either reckon the infation factor in CFAT, as we as the cost of capita, or excude it competey.

130 Financia Management Chapter-6 Capita Budgeting under Risk and Uncertainties Risk is used to describe the type of situation in which there are a number of possibe states of nature, hence outcomes, but in which the decision maker can reasonaby assess the probabiity of occurrence of each. Thus risk can be expressed in quantitative terms. Under conditions of uncertainty, in contrast, it is recognised that severa out-comes are possibe, but the decision-maker is unabe to attach probabiities to the various states of nature. The iabiity is usuay due to a ack of data on which to base a probabiity estimate. For instance, in aunching a new product, the marketing manager may have an idea of what the saes in year 1 are ikey to be, but he must accept that the actua eve wi be one of many possibe eves. However, the marketing manager may be unabe to specify the probabiity of each eve being achieved, making it an uncertainty situation. There is aso, of course, the situation of compete certainty. This reates to a decision over which the decision-maker has compete contro, and is thus ikey to be confined to the production sphere. This is so because the existence of externa agents in marketing and distribution means that knowedge is incompete, and the creative aspect of R & D means that outcomes are unknown in advance. If a finance manager fees he knows exacty what the outcomes of a project woud be and is wiing to act as if no aternative were in existence, he wi be presumaby acting under conditions of certainty. Thus, certainty is a state of nature, which arises when outcomes are known and determinate. In this state each action is known to ead invariaby to a.specific outcome. For exampe, if one invests Rs. 20,000 in five yeary centra government bonds which is expected to yied 7 per cent tax free return, then the return on the investment @ 7 per cent can be estimated quite precisey. This is so because we assume the Government of India to be one of the most stabe forces in this country. Thus, the outcome is known to have a probabiity of 1. Since we know how things are or wi be, the decision strategy is deterministic, we simpy evauate aternative actions and seect the best one. Risk invoves situations in which the probabiities of an event occurring are known and these probabiities are objectivey or subjectivey determinabe. The main attribute of

Capita Budgeting under Risk and Uncertainties 131 risk situation is that the event is repetitive in nature and possesses a frequency distribution. It is the inabiity to predict with perfect knowedge the course of future events that introduces risk. As events become more predictabe, risk is reduced. Conversey, as events become ess predictabe, risk is increased. Thus, if Rs. 10 akhs is invested in stock of a company organised to extract coa from a mine, and then the probabe return cannot be predicted with 100 per cent certainty. The rate of return on the above investment coud vary from minus 100 per cent to some extremey high figure and because of this high variabiity; the project is regarded as reativey risky. Risk is then associated with project variabiity - the more variabe the expected future returns from the project, the riskier the investment. In contrast, when an event is not repetitive and unique in character and the finance manager is not sure about probabiities themseves, uncertainty is said to prevai. Uncertainty is a subjective phenomenon. In such situation no observation can be drawn from frequency distributions. We have no knowedge about the probabiities of the possibe outcomes. It foows that if the probabiities are competey unknown or are not even meaningfuy known the expected vaue of any decisions cannot be determined. Practicay no generay accepted methods coud so far be evoved to dea with situation of uncertainty whie there are a number of techniques to dea with risk. In view of this, the term risk and uncertainty wi be used interchangeaby in the foowing discussion. With the introduction of risk no company can remain indifferent between two investment projects with varying probabiity distributions as shown in Figure 6.1 Athough each investment infows of Rs. 5,000 in its three-year ife. Proposa A Probabiity Occurance Proposa B 3000 0 3000 5000 7000 9000 11000 Figure: 6.1 : Comparison of Probabiity Distribution

132 Financia Management A ook at the Figure 6.1 wi make it crysta cear that dispersion of the probabiity distribution of expected cash fows for proposa B is greater than that for proposa A. Since the task is associated with the deviation of actua outcome from that which was expected, proposa B is the riskier investment. This is why risk factor shoud be given due importance in investment anaysis. Sources of Risk The first step in risk anaysis is to uncover the major factors that contribute to the risk of the investment. Four main factors that contribute to the variabiity of resuts of a particuar investment are cost of project, investment of cash fows, variabiity of cash fows and ife of the project. 1. Size of the Investment A arge project invoving greater investments entais more risk than the sma project because in case of faiure of the arge project the company wi have to suffer consideraby greater oss and it may be forced to iquidation. Furthermore, cost of a project in many cases is known in advance. There is aways the chance that the actua cost wi vary from the origina estimate. One can never foresee exacty what the construction, debugging, design and deveopmenta costs wi be. Rather than being satisfied with a singe estimate, it seems more reaistic to specify a range of costs and the probabiity of occurrence of each vaue within the range. The ess confidence the decision maker has in his estimate, the wider wi be the range. 2. Reinvestment of Cash Fows Whether a company shoud accept a project that offers a 20 per cent return for 2 years or one that offers a 16 per cent return for 3 years woud depend upon the rate of return avaiabe for reinvesting the proceeds from the 20 per cent, 2-year period. The danger that the company wi not be abe to reinvest funds as they become avaiabe is a continuing risk in managing fixed assets and cash fows. 3. Variabiity of Cash Fows It may not be an easy job to forecast the ikey returns from a project. Instead of basing investment decision on a singe estimate of cash fow it woud be desirabe to have range of estimates. 4. Life of the Project Life of a project can never be determined precisey. The production manager shoud base the investment decision on the range of ife of the project. Techniques for Handing Risk and Uncertainty Risk anaysis is one of the most compex and sippery aspects of capita budgeting. Many different techniques have been suggested and no singe technique can be deemed

Capita Budgeting under Risk and Uncertainties 133 as best in a situations. The variety of techniques suggested to hande risk in capita budgeting fa into two broad categories: (i) Approaches that consider the stand-aone risk of a project; (ii) Approaches that consider the risk of a project in the context of the firm or in the context of the market. Exhibit 6.2 cassifies various techniques into these two broad categories. This chapter discusses different techniques of risk anaysis (except market risk anaysis which is covered in the chapter on Cost of Capita), expores various approaches to project seection under risk, and describes risk anaysis in practice. It is divided into nine sections as foows: Sensitivity anaysis Scenario anaysis Break-even anaysis Hiier mode Simuation anaysis Decision tree anaysis Corporate risk anaysis Project seection under risk. Risk anaysis in practice. Techniques of Risk Anaysis Anaysis of Stand aone Risk Anaysis of Contextua Risk Sensiivity Anaysis Scenario Anaysis Corporate Risk Anaysis Market Risk Anaysis Break Even Anaysis Hiier Mode Simuation Anaysis Decision Tree Anaysis Sensitivity Anaysis Figure 6.2: Techniques of Risk Anaysis Since future is uncertain, you may ike to know what happens to the viabiity of a project when some variabe ike saes or investment deviates from its expected vaue. In other words, you woud ike to do sensitivity anaysis. Aso caed what if anaysis it answers questions ike: What happens to net present vaue (or some other criterion of merit) if saes are ony 60,000 units rather than the expected 75,000 units9 What happens to net present vaue if the ife or the project turns out to be ony 8 years, rather than the expected 10 years?

134 Financia Management Procedure Fairy simpe, sensitivity anaysis consists of the foowing steps: 1. Set up the reationship between the basic underying factors (ike the quantity sod, unit seing price, ife of the project, etc.) and net present vaue (or some other criterion of merit). 2. Estimate the range of variation and the most ikey vaue of each of the basic underying factors. 3. Study the effect on net present vaue of variations in the basic variabes. (Typicay one factor is varied at time.) Iustration Anischit Enterprises is anaysing an investment proposa. The foowing net present vaue reationship has been set up: NPV = n t= 1 [ Q( P V) F D]( 1 T) + D S + t ( 1 + r) ( 1 + r) n 1...(8.1) where NPV = net present vaue of the project Q = number of units sod annuay P = seing price per unit V = variabe cost per unit F = tota fixed cost, excuding deprecation and interest D = annua depreciation charge T = income tax rate r = cost of capita n = project ife in years S = net savage vaue I = initia cost. The range and most ikey vaue of each of the basic variabes are given in Tabe 6.3 Tabe 6.3: Range and Most Likey Vaue of Basic Variabes Variabes Range Most Likey Vaue Rs. Rs. Q 1,000-2,000 1,600 P 600-1,000 750 V 300-500 400 F 120,000-120,000 120,000 D 160,000-160,000 160,000 T 0.60-0.60 0.60 r 0.08-0.11 0.10 n 5-5 5 S 400,000-400,000 400,000 I 1,200,000-1,200,000 1,200,000

Capita Budgeting under Risk and Uncertainties 135 Given the range and most ikey vaue of basic variabes, we can study the impact of variation in each variabe on net present vaue, hoding other variabes constant at their most ikey eves. To iustrate the nature of this anaysis we sha ook at the reationship between (i) r and NPV, and (iii) P and NPV. r and NPV The retionship between r and NPV given the most ikey vaues of other variabes is NPV = 5 t= 1 [ 1, 600( 750 400) 120, 000 160, 000]( 1 0. 6) + 160, 000 400, 000 + 120, 000 5 ( 1 + r) ( 1 + ) r t = 5 272, 000 400, 000 + 120, 000 5 ( 1 + r t ) ( 1 + r ) t= 1 The net present vaue for various vaues of r is shown beow. The same reationship is shown graphicay in Tabe 6.4 r 8% 9% 10% 11% NPV Rs. 158.080 118.080 79,552 42,700 NPV ( 000) 150 100 50 8 9 10 11 r (Per cent) Figure 6.4: Reationship between r and NPV P and NPV The reationship between P and NPV, given the most ikey vaues of other factors, is: NPV = 5 t= 1 [ 1, 600( P 400) 120, 000 160, 000]( 1 0. 6) + 160, 000 400, 000 + 1, 200, 000 t 5 ( 110. ) ( 110. ) = 5 640P t ( 110. ) = 1 t 5 208, 000 400, 000 + 1, 200, 000 t 5 ( 110. ) ( 110. ) t= 1 the net present vaue for various vaues of P is shown beow: P 600 700 750 800 990 1,000 NPV Rs. 284,384-41,769 79,552 200,864 443,488 686,112

136 Financia Management The same reationship is shown graphicay in Tabe 6.4 Composite Picture A usefu way of presenting the resuts of sensitivity anaysis is to shown how net present vaue behaves for different percentages of unfavorabe changes (from their most ikey vaues) in the basic variabes. The behavior of net present vaue when there is 5 per cent, 10 percent, 15 per cent, and 20 per cent unfavorabe change in r, other factors remaining unchanged at their most ikey eves, is shown as foows: 700 600 500 400 300 200 100-100 -200-300 600 700 800 900 1000 P Figure 6.5: Reationship Between P and NPV Percentage unfavourabe variation Vaue of r Net present vaue 5 10.5 60,418 10 11.0 42,700 15 11.5 24,681 20 12.0 7,525 The behaviour of net present vaue when there is 5 percent, 10 percent, 15 percent and 20 percent unfavourabe variation in P is shown as foows: Percentage unfavourbe variation Vaueof P Net present vaue 5.713 (10, 308) 10.575 (102,500) 15.638 (192,267) 20.600 (284,384) Exhibit 6.5 shows graphicay the behaviour of net present vaue for various unfavourabe percentage variations of r and P. Such a visua presentation is hepfu in identifying variabes, which are crucia for the success of the project.

Capita Budgeting under Risk and Uncertainties 137 Evauation Sensitivity anaysis, a popuar method for assessing risk, has certain merits: It forces management to identify the underying variabes and their inter-reationships. It shows how robust or vunerabe a project it to changes in the underying variabes. It indicates the need for further work. If the net present vaue or interna rate of return is highy sensitive to changes in some variabe, it is desirabe to gather further information about that variabe. NPV ( 000) 60 40 20 20 40 60 80 100 120 140 160 180 200 220 240 260 280 300 5 10 15 20 P Percentage unfavourabe variation Figure 6.6: Behaviour of NPV for Unfavourabe Percentage Variations of r and P Sensitivity anaysis, however, suffers from severe imitations: It may fai to provide eads-if sensitivity anaysis merey presents a compicated set of switching vaues it may not shed ight on the risk characteristics of the project. The study of the impact of variation is one factor at a time, hoding other factors constant, may not be very meaningfu when the underying factors are ikey to be interreated. What sense does it make to consider the effect of variation in price whie hoding quantity (which is ikey to be cosey reated to price) unchanged?

138 Financia Management Scenario Anaysis In sensitivity anaysis, typicay one variabe is varied at a time. If variabes are interreated as they are most ikey to be, it is hepfu to ook at some pausibe scenarios, each scenario representing a consistent combination of variabes. Procedure The steps invoved in scenario anaysis are as foows: 1. Seect the factor around which scenarios wi be buit. The factor chosen must be the argest source of uncertainty for the success of the project. It may be the state of the economy or interest rate or technoogica deveopment or response of the market, costs. 2. Estimate the vaues of each of the variabes in investment anaysis (investment outay, revenues, cost, project ife, and so on) for each scenario. 3. Cacuate the net present vaue and/or interna rate of return under each scenario. Iustration Zen Enterprises is evauating a project for introducing a new product. Depending on the response of the market-the factor which is the argest source of uncertainty for the success of the project-the management of the firm has identified three scenarios: Scenario 1: The product wi have a moderate appea to customers across the board at a modest price. Scenario 2: The product wi strongy appea to a arge segment of the market which is highy price-sensitive. Scenario 3: The product wi appea to a sma segment of the market which wi be wiing to pay a high price. (Rs. in miion) Scenario 1 Scenario 2 Scenario 3 Initia investment 200 200 200 Unit seing price (in rupees) 25 15 40 Demand (in units) 20 40 10 Revenues 500 600 400 Variabe costs 240 480 120 Fixed costs 50 50 50 Deprciation 20 20 20 Pre-tax profit 190 50 210 Profit after tax 95 25 105 Annua cash fow 95 25 105 Project ife 115 45 125 Savage vaue 10 years 10 years 10 years Net present vaue 0 0 0 377.2 25.9 427.4 (at a discount rate of 15 per cent) Figure 6.7: Present Vaue Cacuation for Three Scenarios

Capita Budgeting under Risk and Uncertainties 139 Best and Worst Case Anaysis In the above iustration, an attempt was made to deveop scenarios in which the vaues of variabes were internay consistent. For exampe, high seing price and ow demand typicay go hand in hand. Firms often do another kind of scenario anaysis caed the best case and worst case anaysis. In this kind of anaysis the considered: Best Scenario Norma Scenario Worst Scenario High demand, high seing price, ow variabe cost, and so on. Average demand, average seing price average variabe cost, and so on. Low demand, ow seing price, high variabe cost and so on. The objective of such scenario anaysis is to get a fee of what happens under the most favourabe or the most adverse configuration of key variabes, without bothering much about the interna consistency of such configurations. Evauation Scenario anaysis may be regarded as an improvement over sensitivity anaysis because it considers variations in severa variabes together. However, scenario anaysis has its own imitations: It is based on the assumption that there are few we-deineated scenarios. This may not be true in many cases. For exampe, the economy does not necessariy ie in three discrete states, viz., recession, stabiity, and boom. It can in fact be anywhere on the continuum between the extremes. When a continuum is converted into three discrete states some information is ost. Scenario anaysis expands the concept of estimating the expected vaues. Thus, in a case where there are 10 inputs the anayst has to estimate 30 expected vaues (3 10) to do the scenario anaysis. Break-even Anaysis In sensitivity anaysis we ask what wi happen to the project if saes decine or costs increase or something ese happens. As a finance manager, you wi aso be interested in knowing how much shoud be produced and sod at a minimum to ensure that the project does not ose money. Such an exercise is caed breakeven anaysis and the minimum quantity at which oss is avoided is caed the break-even point. The break-even point may be defined in accounting terms or financia terms. Accounting Break-even Anaysis Suppose you are the finance manager of Naveen Four Mis. Naveen is considering

140 Financia Management setting up a new four mi near Bangaore. Based on Naveen s previous experience, the project staff of Naveen has deveoped the figures shown in Exhibit 6.8 1. Investment (20,000) ( 000) Year 0 Years 1-10 2. Saes 18,000 3. Variabe costs (66+% of saes) 12,000 4. Fixed costs 1,000 5. Depreciation 2,000 6. Pre-tax profit 3,000 7. Taxes 1,0000 8. Profit after taxes 2,000 9. Cash fow from operation 4,000 10. Net cash fow (20,000) 4,000 Figure 6.8: Cash Fow Forecast for Naveen s Four Mi Project Note that the ratio of variabe costs to saes is 0.667 (12/18). This means that every rupee of saes makes a contribution of Rs 0.333. Put differenty, the contribution margin ratio is 0.333. Hence the break-even eve of saes wi be: Fixed Costs + Depreciation Contribution are in Ratio 1 = + 2 = 0. 333 Rs. 9 miion By way of confirmation, you can verify that the break-even eve of saes is indeed Rs 9 miion. Rs. in Miion Saes 9 Variabe Costs 6 Fixed Costs 1 Depreciation 2 Profit Before Tax 0 Tax 0 Profit After Tax 0 A project that breaks even in accounting terms is ike a stock that gives you a return of zero per cent. In both the cases you get back your origina investment but you are not compensated for the time vaue of money or the risk that you bear. Put differenty, you forego the opportunity cost of your capita. Hence a project that merey breaks even in accounting terms wi have a negative NPV. Financia Break-even Anaysis The focus of financia break-even anaysis is on NPV and not accounting profit. At

Capita Budgeting under Risk and Uncertainties 141 what eve of saes wi the project have a zero NPV? To iustrate how the financia break-even eve of saes is cacuated, et us go back to the four mi project. The annua cash fow of the project depends on saes as foows: 1. Variabe costs : 66.67% of saes 2. Contribution : 33.33% of saes 3. Fixed costs : Rs. 1 miion 4. Depreciation : Rs. 2 miion 5. Pre-tax profit : (0.333 Saes) Rs. 3 miion 6. Tax (at 33.3%) : 0.333 (0.333 Saes Rs. 3 miion) 7. Profit after tax : 0.667 (0.333 Saes Rs. 3 miion) 8. Cash fow (4 + 7) : Rs. 2 miion + 0.067 (0.333 Saes Rs. 3 miion) = 0.222 Saes Since the cash fow asts for 10 years, its present vaue at a discount rate of 12 per cent is: PV(cash fows) = 0.222 Saes x PVIFA (10 years, 12%) = 0.222 Saes x 5.650 = 1.255 Saes The project breaks even in NPV terms when the present vaue of these cash fows equas the initia investment of Rs 20 miion. Hence, the financia break-even occurs when PV (cash fows) = Investment 1.255 Saes = Rs. 20 miion Saes = Rs. 15.94 miion Thus, the saes for the four mi must be Rs 15.94 miion per year for the investment to have a zero NPV. Note that this is significanty higher than Rs 9 miion which represents the accounting break-even saes. Hiier Mode Under certain circumstances, the expected net present vaue and the standard deviation of net present vaue may be obtained through anaytica derivation. Two cases of such anaysis are discussed here: (i) no correation among cash fows and (ii) perfect correation among cash fows. Uncorreated Cash Fows When the cash fows of different years are uncorreated, the cash fow for year t is

142 Financia Management independent of the cash fow for year i-r. Put differenty, there is no reationship between cash fows from one period to another. In this case the expected net present vaue and the standard deviation of net present vaue are defined as foows: n Ai NPV = 1 ( 1 t + i )...(8.2) t = 1 where σ =...(8.3) = σ + NPV = expected net present vaue A t = expected cash fow for year t i = risk-free interest rate t = initia outay σ(npv) = standard deviation of net present vaue σ 1 = standard deviation of the cash fow for year t. Note that in the above formuae the discount rate is the risk-free interest rate because we try to separate the time vaue of money and the risk factor. This risk of the project, refected in σ (NPV) is considered in conjunction with NPV computed with the riskfree discount rate. If is computed using a risk-adjusted discount rate and then if this is viewed aong with σ (NPV), the risk factor woud be doubed counted. Exampe: A project invoving in outay of Rs. 10,000 has the foowing benefits associated with it. Year 1 Year 2 Year 3 Net cash fow Probabiity Net Cash fow Probabiity Net Cash fow Probabity Rs. Rs. Rs. Rs. Rs. Rs. 3,000 0.3 2,000 0.2 3,000 0.3 5,000 0.4 4,000 0.6 5,000 0.4 7,000 0.36 6,000 0.2 7,000 0.3 N Cacuate and σ (NPV), assuming that i = 6 per cent I = 5, 000 4, 000 5, 000 + + = 10, 000 = 2, 475 2 3 ( 106. ) ( 106. ) ( 106. ) σ = σ = = +

Capita Budgeting under Risk and Uncertainties 143 = L NM 1/ 2 O 2, 400, 000 1, 600, 000 2, 400, 000 + +. 2, 258 2 4 6 ( 106. ) ( 106. ) ( 106. ) QP = Rs Perfecty Correated Cash Fows If cash fows are perfecty correated, the behaviour of cash fows in a periods is aike. This means that if the actua cash fow in one year is a standard deviations to the eft of its expected vaue, cash fows in other years wi aso be a standard deviations to the eft of their respective expected vaues. Put in other words, cash fows of a years are ineary reated to one another. The expected vaue and the standard deviation of net present vaue, when cash fows are perfecty correated, are as foows: NPV = σ σ(npv) = = +...(8.3)...(8.4) n A t ( 1 i) t= 1 + t 1 Exampe: An investment project invoves a current outay of Rs 10,000. The mean and Standard Deviation of cash fows which are perfecty correated, are as foows: Year 1 5000 1500 2 3000 1000 3 4000 2000 4 3000 1200 σ t Cacuate and σ(npv), assuming a risk-free interest rate of 6 per cent. 4 A i NPV = 1 t I ( 1 + i ) t= 1 = 5, 000 4, 000 5, 000 3000 + + + = 10, 000 = 3121 2 3 4 ( 106. ) ( 106. ) ( 106. ) ( 106. ) α = σ(npv) = + = = + + + = Standardising the Distribution Knowedge of NPV and σ(npv) is very usefu for evauating the risk characteristics of a project. If the NPV of a project is approximatey normay distributed, we can cacuate the probabiity of NPV being ess than or more than a certain specified vaue.

144 Financia Management This probabiity is obtained by finding the area under the probabiity distribution curve to the eft or right of the specified vaue. Suppose the probabiity distribution of NPV is as shown in Figure 6.9. If we want to cacuate the probabiity distribution curve to the eft of 0, this is indicated by the shaded region on the eft. If we are interested in finding the probabiity that NPV exceeds a certain vaue, say Rs. 4 miion, we cacuate the area under the probabiity distribution curve to the right of Rs. 4 miion-this area is shown as the shaded region on the right. Probabiity 0 2 4 NPV (Rs. in miion) Figure 6.9: Area Under a Norma Distribution Curve How can we cacuate the area to the eft or right of a specified point? To cacuate the area to the eft or right of a specified point, we use the foowing procedure. Step 1 Standardise the difference between the specified point and NPV. To do this the difference between the specified point and NPV is divided by a(npv). The standardised difference may be referred to as Z. The purpose of standardisation is to transform the actua distribution of NPV into a standard norma distribution. The standard norma distribution has a mean of 0 and standard deviation of 1. Figure 6.10 shows the standard norma distribution. Probabiity -2-1 0 +1 +2 Vaue Figure 6.10: Standard Norma Distribution

Capita Budgeting under Risk and Uncertainties 145 Step 2 Refer to the standard norma distribution tabe and find the probabiity to the eft (or right depending on our interest) of the Z vaue obtained in step 1. To iustrate the above procedure suppose that a project s NPV and σ(npv) are Rs 96,000 and Rs 60,000 respectivey and we want to find the probabiity that NPV wi be ess than 0. This may be done as foows: Step 1 The standardised difference between the specified point (NPV = 0) and NPV = 96,000 is Step 2 The cumuative probabiity up to Z = -1.6 as seen from the standard norma distribution given in Appendix A is 0.55. This means that there is a 5.5 per cent chance that NPV wi be equa to or ess than 0. Simuation Anaysis Sensitivity anaysis indicates the sensitivity of the criterion of merit (NPV, IRR, or any other) to variations in basic factors and provides information of the foowing type: If the quantity produced and sod decreases by 1 per cent, other things being equa, the NPV fas by 6 per cent. Such information, though usefu, may not be adequate for 0 96000 decision making. The decision maker woud aso ike to know the ikeihood of such = 16. 6000 occurrences. This information can be generated by simuation anaysis which may be used for deveoping the probabiity profie of a criterion of merit by randomy combining vaues of variabes which have a bearing on the chosen criterion. Procedure The steps invoved in simuation anaysis are as foows: 1. Mode the project. The mode of the project shows how the net present vaue is reated to the parameters and the exogenous variabes. (Parameters are input variabes specified by the decision maker and hed constant over a simuation runs. Exogenous variabe s are input variabes which are stochastic in nature and outside the contro of the decision maker). 2. Specify the vaues of parameters and the probabiity distributions of the exogenous variabes. 3. Seect a vaue, at random, from the probabiity distributions of each of the exogenous 4. Determine the net present exogenous variabes and pre-specified parameter vaues. 5. Repeat steps (3) and (4) a number of times to get a arge number of simuated net present vaues. 6. Pot the frequency distribution of the net present vaue.

146 Financia Management Iustration In rea ife situations, simuation is done ony on the computer because of the computationa medium invoved. However, to give you a favour of what goes on in simuation, we wi work with a simpe exampe where simuation has been done manuay. Zenith Chemicas is evauating an investment project whose net present vaue has been modeed as foows: NPV = n t= 1 Annua Cost Fow Initia Investment...(8.5) ( + Risk Free Rate) In the NPV mode embodied in Eq. (8.5), the risk-free rate and the initia investment are parameters with the foowing vaues: risk-free rate = 10 per cent and initia investment = Rs 13,000. The annua cash fow and the ife (n) are stochastic exogenous variabes with the foowing distributions: Annua Cash Fow Project Life Vaue Probabiity Vaue Probabiity Rs. 1,000 0.02 3 years 0.05 1,500 0.03 4 0.10 2, 000 0.15 5 0.30 2,500 0.15 6 0.25 3,000 0.30 7 0.15 3,500 0.20 8 0.10 4,000 0.15 9 0.03 10 0.02 The firm wants to perform 10 manua simuation runs for this project. To perform the simuation runs, we have to generate vaues, at random, for the two exogenous variabes: annua cash fow and project ife. For this purpose, we have to (i) set up the correspondence between the vaues of exogenous variabes and random numbers, and (ii) choose some random number generating device. Exhibit 8.10 shows the correspondence between various variabes and two digit random numbers. Exhibit 8.11 presents a tabe of random digits that wi be used for obtaining two digit random numbers. Now we are ready for simuation. In order to obtain random numbers from Exhibit 8.11 we may begin anywhere at random in the tabe and read any pair of adjacent coumns (since we are interested in a two-digit random number) and read coumn-wise or rowwise. For our exampe, et us use the first two coumns of Exhibit 8.11. Starting 8.11. Starting from the top, we wi read down the coumn. For the first simuation run we need two-

Capita Budgeting under Risk and Uncertainties 147 digit random numbers, one for the annua cash fow and the other for the project ife. These number are 53 and 97 and the corresponding vaues for annua cash fow and project ife are Rs. 3,000 and 9 years respectivey. We go further in this manner. Tabe 6.11 shows the random numbers so obtained and the resuts of simuation. Annua Cash Fow Project Life Vaue Probabiity Cumuative Two digit Vaue Probabiity Cumuative Two digit Probabiity random probabiity random numbers numbers As Years 1,000 0.02 0.02 00 to 01 3 0.05 0.05 00 to 04 1,500 0.03 0.05 02 to 04 4 0.10 0.15 05 to 14 2,000 0.15 0.20 05 to 19 5 0.30 0.45 15 to 44 2,500 0.15 0.35 20 to 34 6 0.25 0.70 45 to 69 3,000 0.30 0.65 35 to 64 7 0.15 0.85 70 to 89 3,500 0.20 0.85 65 to 84 8 0.10 0.95 85 to 94 4,000 0.15 1.00 86 to 99 9 0.03 0.98 95 to 97 10 0.02 1.00 98 to 99 Figure 6.11: Correspondence between Vaues of Exogenous Variabes and Two-Digit Random Numbers 53479 81115 98036 12217 59526 97344 70328 58116 91964 26240 66023 38277 74523 71118 84892 99776 75723 03172 43112 83086 30176 48979 92153 38416 42436 81874 83339 14988 99937 13213 19839 90630 71863 95053 55532 09337 33435 53869 52769 18801 31151 58925 40823 41330 21093 67619 52515 03037 81699 17106 Annua Cash Fow Tabe 6.12: Random Numbers Project Life Run Random Corresponding Random Corresponding Net present number vaue of annua number vaue of vaue fow project fie 1. 53 3,000 97 9 4277 2. 66 3,500 99 10 8506 3. 30 2,500 81 7 (829) 4. 19 2,000 09 4 (7660) 5. 31 2,500 67 6 (2112) 6. 81 3,500 70 7 4039 7. 38 3,000 75 7 1605 8. 48 3,000 83 7 1605 9. 90 4,000 33 5 2163 10. 58 3,000 52 6 66 Figure 6.13: Simuation Resuts

148 Financia Management Evauation An increasingy popuar too of risk anaysis, simuation offers certain advantages: Its principa strength ies in its versatiity. It can hande probems characterised by (i) numerous exogenous variabes foowing any kind of distribution, and (ii) compex interreationships among parameters, exogenous variabes, and endogenous variabes. Such probems often defy the capabiities of anaytica methods. It compes the decision maker to expicity consider the interdependencies and uncertainties characterising the project. Simuation, however, is a controversia too which suffers from severa shortcomings. It is difficut to mode the project and specify the probabiity distributions of exogenous variabes. Simuation is inherenty imprecise. It provides a rough approximation of the probabiity distribution of net present vaue (or any other criterion of merit). Due to its imprecision, the simuated probabiity distribution may be miseading when a tai of the distribution is critica. A reaistic simuation mode, ikey to be compex, woud most probaby be constructed by a management scientist, not the decision maker. The decision maker, acking understanding of the mode, may not use it. To determine the net present vaue in a simuation run the risk-free discount rate is used. This is done to avoid prejudging risk which is supposed to be refected in the dispersion of the distribution of net present vaue. Thus the measure of net present vaue takes a meaning, very different from its usua one, that is difficut to interpret. Decision Tree Anaysis The scientists at Vigyanik have come up with an eectric moped. The firm is ready for piot production which is estimated to cost Rs 8 miion and take one year. If the resuts of piot production are encouraging the next step woud be to test market the product. This wi cost Rs 3 miion and take two months. Based on the outcome of the test marketing, a manufacturing decision may be taken. The firm may, however, skip the test marketing phase and take a decision whether it shoud manufacture the product or not. If the firm decides to manufacture the product commerciay it is confronted with two options: a sma pant or a arge pant. This decision hinges mainy on the size of the market. Whie the eve of demand in the short run may be gauged by the resuts of the test market, the demand in the ong run woud depend on how satisfied the initia users are. If the firm buids a arge pant initiay it can cater to the needs of the market when demand growth is favourabe. However, if the demand turns out to be weak, the pant woud operate at a ow eve of capacity utiisation. If the firm buids a sma pant, to

Capita Budgeting under Risk and Uncertainties 149 begin with, it need not worry about a weak market and the consequent ow eve capacity utiisation. However, if the market turns out to be strong it wi have to buid another pant soon (and thereby incur a higher tota outay) in order to save itsef from competitive encroachment. To anayse situations of this kind where sequentia decision making in the face of risk is invoved, decision tree anaysis is a usefu too. This section discusses the technique of decision tree anaysis. Steps in Decision Tree Anaysis The key steps in decision tree anaysis are: 1. Identifying the probem and aternatives 2. Deineating the decision tree 3. Specifying probabiities and monetary outcomes 4. Evauating various decision aternatives. Identifying the Probem and Aternatives To understand the probem and deveop aternatives, information from different sources-marketing research, engineering studies, economic forecasting, financia anaysis, etc.-has to be tapped. Imaginative effort must be made to identify the nature of aternatives that may arise as the decision situation unfods itsef and assess the kinds of uncertainties that ie ahead with respect to market size, market share, prices, cost structure, avaiabiity of raw materia and power, technoogica changes, competitive action, and governmenta reguation. Recognising that risk and uncertainty are inherent characteristics of investment projects, persons invoved in anaysing the situation must be encouraged to express freey their doubts, uncertainties, and reservations and motivated to suggest contingency pans and identify promising opportunities in the emerging environment. Deineating the Decision Tree The decision tree, exhibiting the anatomy of the decision situation, shows: The decision points (aso caed decision forks) and the aternative options avaiabe for experimentation and action at these decision points. The chance points (aso caed chance forks) where outcomes are dependent on a chance process and the and ikey outcomes at these points. The decision tree refects in a diagrammatic form the nature of the decision situation in terms of aternative courses of action and chance outcomes which have been identified in the first step of the anaysis. A decision tree can easiy become very compex and cumbersome if an attempt is made to consider the myriad possibe future events and decisions. Such a decision tree, however, is not ikey to be a very usefu too of anaysis. Over-eaborate, It may obfuscate the critica issues. Hence an effort shoud be made to keep the decision tree somewhat simpe so that the decision makers can focus their attention on major future aternatives without being drowned in a mass of trivia. One must remember the advice

150 Financia Management of Breaey and Myers. Decision trees are ike grapevines; they are productive ony if vigorousy pruned. Specifying Probabiities and Monetary Vaues for Outcomes: Once the decision tree is deineated, the foowing data have to be gathered: Probabiities associated with each of the possibe outcomes at various chance forks. Monetary vaue of each combination of decision aternative and chance outcome. The probabiities of various outcomes may sometimes be defined objectivey. For exampe, the probabiity of a good monsoon may be based on objective, historica data. More often, however, the possibe outcomes encountered in rea ife are such that objective probabiities for them cannot be obtained. How can you, for exampe, define objectivey the probabiity that a new product ike an eectric moped wi be successfu in the market? In such cases, probabiities have to be necessariy defined subjectivey. This does not, however, mean that they are drawn from a hat. To be usefu they have to be based on the experience, judgement, intuition, and understanding of informed and knowedgeabe executives. Assessing the cash fows associated with various possibe outcomes, too, is a difficut task. Again, the judgement of experts pay an important roe. Evauating the Atmnatives: Once the decision tree is deineated and data about probabiities and monetary vaues gathered, decision aternatives may be evauated as foows: 1. Start at the right-hand end of the tree and cacuate the expected monetary vaue at various cance points that come first as we proceed eftward. 2. Given the expected monetary vaues of chance points in step 1, evauate the aternatives at the fina stage decision points in terms of their expected monetary vaues. 3. At each of the fina stage decision points, seect the aternative which has the highest expected monetary vaue and truncate the other aternatives. Each decision point is assigned a vaue equa to the expected monetary vaue of the aternative seected at that decision point. 4. Proceed backward (eftward) in the same manner, cacuating the expected monetary vaue at chance points, seecting the decision aternative which has the highest expected monetary vaue at various decision points, truncating inferior decision aternatives, and assigning vaues to decision points, ti the first decision point is reached. Iustration The technique of decision tree anaysis may be expained with the hep of an iustration A widcatter, evauating a particuar basin, is considering three aternatives: (i) He may dri. (ii) He may conduct a seismic experiment costing Rs 20,000 to find the nature of the underying soi structure and decide on that basis. (iii) He may not do anything. If he dris, he is ikey to find one of the foowing oi-bearing states: dry, wet, or soaking. A dry we hardy yieds anything; a wet we provides a moderate quantity of oi; a soaking we generates a substantia quantity of oi.

Capita Budgeting under Risk and Uncertainties 151 If he conducts a seismic experiment, he can earn about the underying soi structure before deciding whether to dri or not. The underying soi structure in this case may be one of the foowing types: no structure, open structure, or cosed structure. If no structure is discovered, the prospects of finding oi are beak, if open structure is found the prospects of finding oi are fair, and if cosed structure is discovered the prospects of finding oi are bright. The decision tree corresponding to this situation is shown in Exhibit 6.13. It may be noted that, as a convention, a decision fork is represented by a square and chance fork by a circe. The decision tree deineated, the next phase of anaysis cas for gathering information about probabiities and monetary vaues associated with various outcomes in the decision tree. The widcatter reviews his experiences, anayses statistics reating to oi discoveries, and consuts geoogica experts. He comes up with the foowing information: Probabiity for Various Oi Bearing States: If he dris without conducting seismic experiments probabiities for various oi bearing states are: Oi bearing state Probabiity Dry 0.50 Wet 0.25 Soaking 0.25 Probabiities for Various Soi Structures: If he conducts a seismic experiment he is ikey to find the underying geoogica structures with probabiities mentioned against them: Geoogica structure Probabiity No structure (NS) 0.40 Open structure (OS) 0.30 Cosed structure (CS) 0.30 Reationship between the Underying Structures and Oi Bearing States The reationship between the underying geoogica structures and oi-bearing states expressed in terms of joint probabiities is as foows: Underying Geoogica Structure Oi Bearing State No Open Cosed Margina Structure Structure Structure Probabiity of State Dry 0.32 0.15 0.03 0.50 Wet 0.04 0.10 0.11 0.25 Margina 0.04 0.05 0.16 0.25 Probabiity of geoogica structure 0.40 0.30 0.30 1.00

152 Financia Management C 11 C 1 Dry C 12 Wet C 13 Soaking D 2 C 21 Dri D 22 C 3 C 31 Dry C 32 Wet C 33 Soaking D 1 D 12 Conduct Siesmic D 12 No structure C 2 Cosed structure C 21 C 22 Open C 23 D 3 D 4 Do not dri C 21 Dri D 32 Do not dri C 41 Dri D 42 Do not dri C 4 C 5 C 41 Dry C 42 Wet C 43 Soaking C 51 Dry C 52 Wet C 53 Soaking Do nothing Figure 6.14: Decision Tree Monetary Vaues of Outcomes The net present vaue of cash fows, cacuated at 12 per cent discount rate, associated with the three states for five years (which is the maximum duration of oi driing) is given beow: State Net present vaue (Rs. in miion) Dry -0.6 Wet 0.8 Soaking 2.4 Exhibit 6.15 shows the decision tree incorporating information regarding probabiities and monetary vaues of outcomes discussed above. With this decision tree we evauate the aternative courses of action as foows:

Capita Budgeting under Risk and Uncertainties 153 D 11 Dri C 1 Rs. in miion C 11 (Dry) -0.6 p = 1/2 C 12 (Wet) p = 1/4-0.8 C 13 (Soaking) p = 1/4-2.4 D 1 D 32 Conduct Siesmic experiments D 12 C 2 Do nothing p = 1/10 C 21 (No structure) C 23 (Cosed structure) C 22 (Open structure) p = 3/10 D 2 D 3 D 4 C 21 Dri D 22 Do not dri C 21 Dri D 32 Do not dri C 41 Dri D 42 Do not dri C 3 C 4 C 5 C 31 (Dry) p = 4/6 C 32 (Wet) p = 1/10 C 33 (Soaking) p = 1/10 C 41 (Dry) p = 1/2 C 42 (Wet) p = 1/3 C 43 (Soaking) p = 1/6 C 51 (Dry) p = 1/10 C 52 (Wet) p = 11/30 C 53 (Soaking) p = 16/30-0.6-0.8-2.4 0-0.6-0.8-2.4 0-0.6-0.8-2.4 0 0 Figure 6.15: Decision Tree 1. Starting at the right-hand end of the tree, the expected monetary vaues (EMVs) at chance forks C 1, C 3, C 4 and C 5, which come first at we proceed eftwards, are determined: EVM (C 1 ) = Rs. 0.5 miion EMV (C 3 ) = Rs. 0.16 miion EMV (C 4 ) = Rs. 0.367 miion EMV (C 5 ) = Rs. 1.513 miion 2. Given the expected monetary vaues the aternatives at the ast stage decision points and their expected monetary vaues are defined as foows: Decision point Aternatives Expected monetary vaue (Rs. in miion) D 2 D 21 (Dri) -0.16 D 22 (Do not Dri) 0 D 31 (Dri) 0.367 D 3 D 32 (Do not Dri) 0 D 41 (Dri) 1.513 D 4 D 42 (Do not Dri) 0

154 Financia Management 3. On the basis of the above information, the aternatives seected at the decision points D 2, D 3 and D 4 are D 2 (do not dri), D 31 (dri), and D 41 (dri) respectivey. The vaues assigned to the decision points D 2, D 31 and D 4 are 0, Rs. 0.367 miion, and Rs. 1.513 miion respectivey. 4. Proceeding eftward the expected monetary vaue at chance fork C 2 is cacuated Expected monetary vaue at C 2. = 0.4 b + 0.3 3.67 + 0.3 + 15.13 = Rs. 0.564 miion 5. Moving eftwards the first-state decision point is reached. The aternatives and their expected monetary vaues, at this decision point, are: Aternatives Expected Monetary Vaue (Rs. in miion) D 11 (Dri) 0.5 D 12 (conduct seismic experiments) 0.544 D 13 (Do Nothing) 0 Looking at the expected monetary vaues as find that D 12 (conduct seismic experiments) is the most desirabe aternative at the first stage decision point. Figure 6.16 shows the decision tree with expected vaues at chance points and decision points. Based on the above evauation of aternatives we find that the optima decision strategy is as foows: Choose D 12 (conduct seismic experiment) at decision point D 1 and wait for the outcome at chance point C 2. If the outcome at C 2 is C 21 (no structure), then choose C 22 (do not dri); if the outcome at C 2 is C 22 (open structure), then choose D 31 (dri), if the outcome at C 2 is C 23 (cosed structure), then choose D 41 (dri).

Capita Budgeting under Risk and Uncertainties 155 D 11 Dri C 1 500 Rs. in miion C 11 (Dry) -0.6 p = 1/2 C 12 (Wet) p = 1/4-0.8 C 13 (Soaking) p = 1/4-2.4 D 1 544 D 32 Conduct Siesmic experiments -0.2 D 12 Do nothing p = 1/10 C 21 (No structure) C 2 564 C 23 (Cosed structure) C 22 (Open structure) p = 3/10 p = 3/10 D 2 0 D 3 367 D 4 1513 C 21 Dri D 22 Do not dri C 31 Dri D 32 Do not dri C 41 Dri D 42 Do not dri C 2-16 C 4 367 C 5 1513 C 31 (Dry) p = 4/5 C 32 (Wet) p = 1/10 C 33 (Soaking) p = 1/10 C 41 (Dry) p = 1/2 C 42 (Wet) p = 1/3 C 43 (Soaking) p = 1/6 C 51 (Dry) p = 1/10 C 52 (Wet) p = 11/30 C 53 (Soaking) p = 16/30-0.6-0.8-2.4 0-0.6-0.8-2.4 0-0.6-0.8-2.4 0 0 Figure 6.16: Decision Tree Foowing the above decision strategy, the decision maker, may, depending on the outcome at chance points, traverse paths as shown in Figure 6.17. Path Probabiity Net present vaue (Rs.) D 12 C 21 D 22 0.40-20,000 D 12 C 22 D 31 D 41 0.15-620,000 D 12 C 22 D 31 D 42 0.10 780,000 D 12 C 22 D 31 D 43 0.05 2,380,000 D 12 C 23 D 41 D 51 0.03 620,000 D 12 C 23 D 41 D 52 0.11 780,000 D 12 C 23 D 41 D 53 0.16-2,380,000 Evauation Figure 6.17: Paths, Possibiities, and Net Present Vaues Decision trees are usefu for anaysing a project that has the characteristics: Decision on continuing the project are made in we-defined stages. The outcomes at each stage fa into few broad casses.

156 Financia Management The probabiities and the cash fows associated with various outcomes can be specified at the beginning of the project. This means that the firm has experience of doing simiar projects in the past. Obviousy, decision tree anaysis requires enormous information before it can be appied. The oi driing project is one case where the required information may be avaiabe. However, it may be much more difficut to appy decision tree anaysis to a project where the product or service is new and the firm has very itte information on how the market wi respond to it. Decision trees are not easy to when investments are graduay made over a period of time rather than in a few we-defined stages. Corporate Risk Ansysis A project s corporate risk is its contribution to the overa risk of the firm. Put differenty, it refects the impact of the project on the risk profie of the firm s tota cash fows. We know that the contribution of a security to portfoio risk depends on (i) the standard deviation of its returns and (ii) the correation of its returns with the returns on the other securities incuded in the portfoio. In the same way, the corporate risk of a project depends on (i) the standard deviation of its returns and (ii) the correation of its returns with the returns on the other projects of the firm. On a stand-aone basis a project may be very risky but if its returns are not highy correated or, even better, negativey correated with the returns on the other projects of the firm, its corporate risk tends to be ow. Aware of the benefits of portfoio diversification, many firms consciousy pursue a strategy of diversification. Hindustan Lever Limited, for exampe, has a diversified portfoio comprising, in the main, the foowing businesses: soaps and detergents, persona care products, edibe oi, and tea. The proponents of diversification argue that it heps in reducing the firm s overa risk exposure. As most businesses are characterised by cycicaity it seems desirabe that there are at east two to three different ines of business in a firm s portfoio. As someone put it vividy. If you have three egs to your firm, you enjoy a reasonabe degree of stabiity. This is simpy another way of saying that don t put a your eggs in the same basket. The ogic of corporate diversification for reducing risk, however, has been questioned. Why shoud a firm diversify when sharehoders can reduce risk through persona diversification. A that they have to do is to hod a diversified portfoio of securities or participate in a mutua fund scheme. Indeed, they can do it more efficienty. There does not seem to be an easy answer. Athough sharehoders, can reduce risk through persona diversification there are some other benefits from corporate

Capita Budgeting under Risk and Uncertainties 157 diversification. Stabe earnings and cash fows enabe a firm to attract taent, to secure greater commitment from various stakehoders, to expoit tax sheters fuy, and to check adverse manageria incentives. Hence most firms do ook at the impact of investment proposas, particuary the major ones, on the overa risk profie of the firm. Project Seection Under Risk Once information about expected return (measured as net present vaue, or interna rate of return or some other criterion of merit) and variabiity of return (measured in terms of range or standard deviation or some other risk index) has been gathered, the next question is: Shoud the project be accepted or rejected? There are severa ways of incorporating risk in the decision process: judgementa evauation, payback period requirement, risk profie method, certainty equivaent method, and risk adjusted discount rate method. Judgementa Evauation Often managers ook at risk and return characteristic of a project and decide judgementay whether the project shoud be accepted or rejected, without using any forma method for incorporating risk in the decision making process. The decision may be based on the coective view of some group group ike the capita budgeting committee, or the executive committee, or the board of directors. If judgementa decision making appears highy subjective or haphazard, consider how most of us make important decisions in our persona ife. We rarey use forma seection methods or quantitative techniques for choosing a career or a spouse or an empoyer. Instead, we rey on our judgement. Payback Period Requirement In many situations companies use NPV or IRR as the principa seection criterion, but appy a payback period requirement to contro for risk. Typicay, if an investment is considered more risky, a shorter payback is required even if the NPV is positive or IRR exceeds the hurde rate. This approach assumes that risk is a function of time. Ordinariy it is true that the further a benefit ies in future the more uncertain it is ikey to be because economic and competitive conditions tend to change over time. However, risk is infuenced by things other than the mere passage of time. Hence the payback period requirement may not be an adequate method for risk adjustment or contro. Risk Profie Method To use this method, we first transform the probabiity distribution of net present vaue, an absoute measure, into the profitabiity distribution of profitabiity index, a reative measure. To iustrate this transformation, et us consider the profitabiity distribution of the net present vaue of a project, which invoves an investment outay Rs. 100,000

158 Financia Management shown in Exhibit 6.17. Since profitabiity index is a inear transformation of net present vaue, the shape of its profitabiity distribution is identica to that of the probabiity distribution of net present vaue. The profitabiity distribution of profitabiity index for our project is shown in Exhibit 6.18. It shoud be noted that the x-axis of this exhibit shows the profitabiity index vaues corresponding to the net present vaues shown on the axis of Exhibit 6.18. Probabiity 0 20,000 40,000 Net present Vaue Figure 6.18: Probabiity Distribution of Net Present Vaue Probabiity B A' 1.0 1.2 1.4 Probabiity index Figure 6.19: Probabiity Distribution of Probabiity Index Having transformed the probabiity distribution of net present vaue into the probabiity distribution of profitabiity index, we compare the dispersion of the profitabiity index of the project with the maximum risk profie acceptabe to management for the expected profitabiity index of the project. Suppose the maximum risk profie acceptabe to management when the expected profitabiity index 1.20 is as shown by curve B in Exhibit 6.18. comparing the dispersion of the profitabiity distributions A and B shown in Exhibit 6.18 we find the risk of the project is ess than the maxima risk acceptabe to management for the given eve of expected profitabiity index. Hence the project is deemed worthwie. Note that the higher the expected vaue of profitabiity index, the greater the dispersion

Capita Budgeting under Risk and Uncertainties 159 that is acceptabe to management. This is quite understandabe. If the profitabiity index is high, one profitabiity that the net present vaue is negative (profitabiity index is ess than 1) is negigibe even if the dispersion is wide. Risk Adjusted Discount Rate Method The risk adjusted discount rate method cas for adjusting the discount rate to refect project risk. If the risk of the project is equa to the risk of the existing investments of the firm, the discount rate used is the average cost of capita of the firm, if the risk of the project is greater than the risk of the existing investments of the firm, the discount rate used is higher than the average cost of capita of the firm; if the risk of the project is ess than the risk of the existing investment of the firm the discount rate used is ess than the average cost of capita of the firm. The risk adjusted discount rate is : rk = i + n + dk where rk = risk-adjusted discount rate for project k i = risk-free rate of interest n = adjustment for the firm s norma risk dk = adjustment for the differentia risk of project k It may be noted that (1 + n) measures the firm s cost of capita dk may be positive or negative depending on how the risk of the project under consideration compares with the existing risk of the firm. The adjustment for the differentia risk of project, k quite understandaby, depends on management s perception of the project risk and management s attitude towards towards risk (risk return preference). A arge pharmaceutica concern, for exampe, uses the foowing riskadjusted discount for various types of investments. Investment category Risk-adjusted discount rate Repacement investments Cost of capita Expansion investments Cost of capita + 3% Investment in reated ines Cost of capita + 6% Investment in new ines Cost of capita + 10% Once the project s risk-adjusted discount rate (rk) is specified, the project is accepted if its net present vaue, cacuated as foows, is positive. NPV = n A t 1 t I...(8.7) ( 1 rk) t= 1 + where NPV = net present vaue of project k

160 Financia Management A t = expected cash fow for year t rk = risk adjusted discount rate for project k Exampe The expected cash fows of a project, which invoves an investment outay of Rs. 1,000,000, are as foows: Year Cash fow Rs. 1. 200,000 2 300,000 3. 400.000 4. 500.000 5. 200,000 The risk-adjusted discount rate for this project is 18 per cent. Is the project worthwhie? The net present vaue of the project, using the risk-adjusted discount rate is: NPV = 200, 000 300, 000 400, 000 300, 000 200, 000 + + + + 1, 000, 000 2 3 4 5 ( 118. ) ( 118. ) ( 118. ) ( 114. ) ( 118. ) = -Rs. 129,440 Since the net present vaue is negative the project is not worthwhie. The risk-adjusted discount rate is commony empoyed in practice. Firms use different discount rates, presumaby reated to the factor risk, for different types of investment projects. The discount rate is generay ow for routine repacement investments, moderate for expansion investments, and high for new investments. Despite its popuarity, the risk-adjusted discount rate method suffers from two serious imitations: (i) It is difficut to estimate dk consistenty-often it is determined in an extremey ad hoc and arbitrary manner. (ii) This method assumes that risk increases with time at a constant rate. This assumption may not be very vaid. Certainty Equivaent Method Before describing the certainty equivaent method et us understand the concept of certainty equivaent coefficient. Suppose someone presents you with a ottery the outcome of which has the foowing probabiity distribution. Outcome Probabiity Rs. Rs. 1,000 0.3 5,000 0.7 You are further asked: How much of a certain amount woud you accept in ieu of this ottery? Let us say that your repy is: Rs. 3,000. This amount, Rs. 3,000 represents the certainty equivaent of the above ottery which has a expected vaue of Rs. 3,800 (Rs. 1,000 0.3 + Rs 5,000 0.7) and a given distribution. The factor 3,000/3,800 (=0.79)

Capita Budgeting under Risk and Uncertainties 161 is caed the certainty coefficient. It refects primariy two things: variabiity of outcomes and your attitude towards risk. Certainty equivaent coefficients transform expected vaues of uncertain fows into their certainty equivaents. Under the certainty equivaent method, the net present vaue is cacuated as foows: α NPV = + =...(8.8) where NPV = net present vaue A t = expected cash fow for the year t α 1 = certainty equivaent coefficient for the cash fow of year t i = risk free interest rate I = initia investment (about which it is assumed that there is no uncertainty) Exampe: Vazeer Hydrauics Limited is considering an investment proposa invoving an outay of Rs. 4,500,000. The expected cash fows and certainty equivaent coefficients are: Year Expected Cash Fow Certainty Equivaent Coefficient (Rs.) 1 1000000 0.90 2 1500000 0.85 3 2000000 0.82 4 2500000 0.78 The risk-free interest rate is 5 per cent. Cacuate the net present vaue of the proposa. The net present vaue is equa to: 100000 1500000( 0. 85) 2000000( 0. 82) 2500000 + + + 4500000 2 3 4 ( 105. ) ( 105. ) ( 105. ) ( 105. ) = Rs. 534570 The vaue of the certainty equivaent coefficient usuay ranges between 0.5 and 1. A vaue of 1 impies that the cash fow is certain or the management is risk neutra. In industria situations, however, cash fows are generay uncertain and managements usuay risk-adverse. Hence the certainty equivaent coefficients are typicay ess than 1. An iustrative tabe of certainty equivaent coefficients for different types of investments is shown here. Certainty Equivaent Coefficient Year 1 Year 2 Year 3 Year 4 Repacement Investments 0.92 0.87 0.84 0.80 Expansion Investment 0.89 0.85 0.80 0.75 New Product Investment 0.85 0.80 0.74 0.68 R & D Investment 0.75 0.70 0.64 0.58

162 Financia Management Repacement investments Expansion investments New product investments Research and deveopment investments. The certainty equivaent method is conceptuay superior to the risk-adjusted discount rate method because it does not assume that risk increases with time at a constant rate. Each year s certainty equivaent coefficient is based on the eve of risk characterising its cash fow. Despite its conceptua soundness it is not as popuar as the risk-adjusted discount rate method. This is perhaps because it is inconvenient and difficut to specify a series of certainty equivaent coefficient but seemingy simpy to adjust the discount rate. Notwithstanding this practica difficuty, the merits of the certainty equivaent method must not be ignored. Anaysis of Non Financia Aspects Investment decisions are based on appraisa and evauation techniques. Apart from technica and financia viabiity the project's economic and socio-poitica costs aso matter. Economic Aspects Institutions and banks consider various economic factors before deciding to invest in a project. Various anaytica toos exist to assist the decision maker in deaing with this situation. Among these toos are: cost-benefit anaysis, risk-benefit anaysis, risk-cost benefit anaysis, project economic viabiity, opportunity cost and insurabiity imits. It is not suggested that these methods give exact resuts, but ony that they revea something of the nature of the underying vauation. For a competey satisfactory assessment of the cost and benefit aspects of the acceptabiity of risk, the assessment has to incude evauation of the foowing: 1. The tota costs associated with each option. 2. The benefits in money terms associated with each option. It must be recognised that, at east initiay, a the benefits may not be expressed directy in quantitative terms and there may be probems in converting quaitative statements about benefits into quantitative statements. 3. The costs in quantitative terms associated with the direct and indirect risks inherent in each option. 4. The errors and uncertainties associated with the estimates of costs and benefits. 5. The overa economic impications of the options considered. Given the doubts about the feasibiity of finding universa criteria for assessing the ranking that economic factors justify, it is suggested that for many cases ranking of acceptabiity of the economic factors coud be made on the basis of the ife cost and benefits, the cacuation taking into account a direct and indirect costs and benefits. It

Voting It is the most comprehensive Not appropriate for a projects If the resut is cear it gives the Capita Budgeting under Risk and Uncertainties 163 aso has to be accepted that the cacuation has to incude a factor to aow for the risk of the project not being competed. Such a factor may be a compound factor, which incudes aowance for a the features of the economic environment that may cause a project to fai. It shoud be recognised that simpy postuating a ranking criteria does not resove the mora question of how the costs of benefits shoud be distributed, answer questions about the macro-economic significance of the proposa, or expain how the cacuation shoud be made. The mora question is party answered by assessing pubic reaction to a proposa and this point is discussed next under the heading of socio-poitica factors. Socio-Poitica Aspects When these decisions are considered from the point of view of society, they go beyond finding out cash infows and outfows, the benefits to society are aso worked out. For exampe, whenever a new capita intensive project is undertaken, its impact on the heath of the society is seen in terms of environmenta poution, noise poution, empoyment generation, etc. Because of the nature of socio-poitica factors the probems invoved in assessing their significance in decision making are quite different to the probems of assessing technica and economic factors. Socio-poitica aspects of a decision are concerned with what ought to be, and such decisions are quite different from technica judgements which are concerned with what can be done. There are four methods for assessing acceptabiity of socio-poitica factors: Method Strengths Limitation Comment Epidemioogica Reates what has aready been Past experience may not be such studies identify past areas studies accepted to environment of reevant to the future. Does not of concern, but do not predict decision being considered represent a commitment by present or future concerns or pubic invoved reaction to nove proposas Consutation Quick, provided appropriate Those consuted may not The success of this method machinery for consutation represent the views of the depends upon those consuted aready exists. Can give a whoe community affected by being fuy aware of the views permanent form of contact the proposa in question. May of the community concerned between the pubic and the be difficut to organise when and understanding the issues project and the decision nationa boundaries have to be invoved. Sometimes it can makers crossed. Does not represent a take two or three years to commitment by the pubic arrive at a view invoved Samping A sampe survey can provide Does not give every-one a The sampe surveyed must be structured evidence about chance to express their views taken directy from the views on acceptabiity about what is acceptabe. Does popuation affected by the not represent a commitment by decision and for the resuts of the pubic invoved the samping process to Contd... reay hep the decision maker the popuation samped must understand the issue invoved

164 Financia Management the pubic invoved the samping process to reay hep the decision maker the popuation samped must understand the issue invoved Voting It is the most comprehensive Not appropriate for a projects If the resut is cear it gives the way of estabishing the views particuary sma ones. decision maker positive and wishes of a particuar Expensive and sow to arrange. guidance on the action the popuation Uness some form of popuation consider shoud be compusion is used not taken. If the verdict is margina everyone wi vote. Not the issue is not efficienty necessariy binding on either resoved for the decision party invoved maker There are four methods for assessing acceptabiity of socio-poitica factors: The concusions that can be made about the probems of assessing socio-poitica factors are: 1. The socio-poitica factors reated to compex decisions can be evauated by carefuy designed surveys. 2. Changes in opinion that take pace over a period as short as two years can be detected by conventiona survey methods. 3. Variations in views can be detected over a reativey sma geographica area. 4. For an effective survey to be made the nature of the risk must be expained to the popuation being surveyed. 5. A sampe opinion survey does not represent any kind of commitment by the peope being surveyed, whereas voting procedures may be binding. 6. For the decision maker considering a major pubic project there may be considerabe uncertainty about the viabiity of the assessment of pubic acceptabiity uness it is based on the resuts of a voting procedure. 7. For sma non-conventiona projects' surveys of the pubic's view of the acceptabiity of a proposa may not be justified.

Working Capita Management 165 Chapter-7 Working Capita Management Concept, Need & Determinants Working capita coud be defined as the portion of assets used in current operations. The movement of funds from working capita to income and profits and back to working capita is one of the most important characteristics of business. This cycica operation is concerned with utiisation of funds with the hope that they wi return with an additiona amount caed Income. If the operations of a company are to run smoothy, a proper reationship between fixed capita and current capita has to be maintained. Sufficient iquidity is important and must be achieved and maintained to provide the funds to pay off obigations as they arise or mature. The adequacy of cash and other current assets together with their efficient handing, virtuay determine the surviva or demise of the company. A businessman shoud be abe to judge the accurate requirement of working capita and shoud be quick enough to raise the required funds to finance the working capita needs. Working capita is often cassified as Gross Working Capita and Net Working Capita. The former refers to the tota of a Current Assets and the atter refers to the difference between Current Assets and Current Liabiities. The maintenance of a sound Working Capita position is an important function of the Finance Department of the organisation. With the magnitude of business rising with gobaisation, the quantum of working capita to be managed is on the increase. No wonder, working capita management is taked about more today than ever before. Long-term investment decisions (capita budgeting) and ong-term financing decisions are characterized by the facts that they (a) generay invove arge amounts of money, and (b) are reativey infrequent occurrences. Decisions that come under the heading short-term finance are equay important, because, whie typica decisions often don t invove as much money, decisions are much more frequent. This is suggested in the resuts of a recent survey of CFOs. Ranked Greatest Importance Average Time Aocated Financia Panning 59% 35% Working Capita Mgmt 27% 32% Capita Budgeting 9% 19% Long-Term Financing 5% 14% Tota 100% 100%

166 Financia Management In defining short term finance, we focus on the cash fows connected with the operations of a company. Because the cash infows and cash outfows are not synchronised, a company needs a temporary parking pace for cash, which we can ca a iquidity portfoio. This iquidity portfoio may consist of cash and marketabe securities. Since cash fows for a company are uncertain, both in amount and timing, the amount of cash in temporary storage may not be adequate for a time periods. Thus, it is necessary to provide some backup iquidity for periods when the norma store of iquidity is insufficient. Aso there is a need to move cash from one point to another within a company. We need to have interna cash fows to connect these various infows, outfows and sources of iquidity. The cash system of a company is the mechanism that provides the inkage between cash fows. The financia manager of the company has the responsibiity, at east in part, to deveop and maintain the poicies and procedures necessary to achieve an efficient fow of cash for the company s operations. Short term financia management thus encompasses decisions about activities that affect cash infows, cash outfows, iquidity, backup iquidity, and interna cash fows. Many decisions of a company have a short term financia management aspect. For exampe, the decision to se a bond issue in order to raise funds to finance an expansion in pant and equipment is ceary a ong term decision. However, the decision on how to invest the proceeds from the bond issue unti they are needed to pay for the construction is a short term financia decision. The use of a 1-year time horizon to separate short term and ong term decisions is arbitrary and, in some cases, ambiguous. To refine the definition of short term finance, it is hepfu to examine the differences and interreationships between the decisions that are cassified as short term finance and those that are considered ong term finance. Decisions usuay cassified as ong term are difficut to reverse and essentiay determine the basic nature of the business and how it wi be carried out. Short term financia poicies take the resuts of these decisions as a starting point and concentrate on how they can be efficienty and economicay carried out. We can think of short term decisions as being more operationa. Once impemented they are easier to change Importance of Working Capita Management Working capita management incudes a number of aspects that make it an important topic for study, and we wi now consider some of them. Surveys indicate that the argest portion of a financia manager s time is devoted to the day by- day interna operation of the firm; this may be appropriatey subsumed under the heading working capita management. since so much time is spent on working capita decisions, it is appropriate that the subject be covered carefuy in manageria finance courses.

Working Capita Management 167 Characteristicay, current assets represent more than haf the tota as-sets of a business firm. Because they represent a arge investment and because this investment tends to be reativey voatie, current assets are worthy of the financia manager s carefu attention. Working capita management is particuary important for sma firms. A sma firm may minimize its investment in fixed assets by renting or easing pant and equipment, but there is no way it can avoid an investment in cash, receivabes, and inventories. Therefore, current assets are particuary significant for the financia manager of a sma firm. Further, because a sma firm has reativey imited access to the ong term capita markets, it must necessariy rey heaviy on trade credit by increasing current iabiities. Reationship between Saes, Growth and current Assets The reationship between saes growth and the need to finance current assets is cose and direct. For exampe, if the firm s average coection period is 40 days and if its credit saes are 1,000 a day it wi have an investment of 40,000 in accounts receivabe. If saes rise to 2,000 a day the investment in accounts receivabe wi rise to 80,000. Saes increases produce simiar immediate needs for additiona inventories and, perhaps, for cash baances. A such needs must be financed, and since they arise so quicky, it is imperative that the financia manager keep himsef aware of deveopments in the working capita segment of the firm. of course, continued saes increases wi require additiona ong- term assets, whie must aso be financed. However, fixed assetinvestments, whie criticay important to the firm in a strategic, ong run sense do not generay have the same urgency as do current asset investment Origina Concept of Working Capita The term working capita originated at a time when most industries were cosey reated to agricuture. Processors woud buy crops in the fa, process them, se the finished product, and end up just before the next harvest with reativey ow inventories. Bank oans with maximum maturities of one year were used to finance both the purchase and the processing costs, and these oans were retired with the proceeds from the sae of the finished products. The situation is depicted in Figure 1. There fixed assets are shown to be growing steadiy over time, Whie current assets jumps at harvest season, then decine during the year, ending atzero just before the next crop is harvested. Short-term credit is used to finance current assets, and fixed assets are financed with ong-term funds. Thus the top segment of the graph deas with working capita.

168 Financia Management The figure represents, of course, an ideaized situation- current assets buid up graduay as crops are purchased and processed, inventories are drawn down ess reguary, and ending inventory baances do not decine to zero. Nevertheess, the exampe does iustrate the genera nature of the production and financing process, and working capita management consists of decisions reating to the top section of the graphmanaging current assets and arranging the short-term credit used to finance them. Doars Current assets Short-term credit Long-term debt pus equity capita 0 1 2 3 4 Figure 1: Fixed and Current Assets and Their Financing Extending The Working Capita Concept As the economy became ess oriented toward agricuture, the production and financing cyces of typica business changed. Athought seasona patterns sti existed, and business cyces aso caused asset requirements to fuctuate, it became apparent that current assets rarey, if ever, dropped to zero. This reaization ed to the deveopment of the idea of permanent current assets, diagrammed in Figure 2. As the figure is drawn, it maintains the traditiona notion that permanent assets shoud be financed with ong term capita, whie temporary assets shoud be financed with short-term credit. The pattern shown in Figures -1 and -2 was considered to be desirabe because it minimizes the risk that the firm maybe unabe to pay off its maturing obigations To iustrate, suppose a firm borrows on a one-year basis and uses the funds obtained to buid and equip a pant. Cash fows from the pant (profit pus deprecation) are not sufficient to pay of one at the end of the year. So the oan, then the firm has probems had the pant been financed with ong term debt, however, cash fows woud have been sufficient to retire the oan, and the probem of renewa woud not have arisen.thus, if a firm finances ong-term assets with permanent capita and short-term assets with temporary capita, its financia risk is ower than it woud be if ong-term assets were financed with short-term debt.

Working Capita Management 169 Doars Fuctuating current assets Short-term financing Tota permanent assets Permanent current assets Fixed assets 1 2 3 4 5 6 7 8 Time Period Long-term debt pus equity capita Figure 2: Fuctuating versus Permanent Assets At the imit, a firm can attempt to match the maturity structure of its assets iabiities exacty. A machine expected to ast for five years coud be financed by a five-year oan ;a 20-year buiding coud be financed by a 20-year mortgage bond; inventory expected to be sod in 20 days coud be financed by a 20-day bank oan ;and so forth. Actuay, of course, uncertainty about the ives of assets prevents this exact maturity matching. We wi examine this point in the foowing sections. Figure-2 shows the situation for a firm that attempts to match asset and iabiity maturity exacty. Such a poicy coud be foowed, but firms may foow other maturitymatching poicies if they desire. Figure-3, for exampe, iustrates the situation for a firm that finances a its fixed assets with term capita but part of its permanent current assets with short-term credit. Doars Fuctuating current assets Short-term financing Permanent current assets Fixed assets Long-term debt pus equity capita 1 2 3 4 5 6 7 8 Time Period Figure 3: Fuctuating versus Permanent Assets

170 Financia Management The dashed ine coud have even been drawn beow the ine designating fixed assets, indicating that a the current assets and part of the fixed assets are financed with short-term credit ; this woud be a highy aggressive, non-conservative position, and the firm woud be very much subject to potentia renewa probems. Doars Mrketabe securities Permanent current assets Short-term financing requirements Short-term financing Fixed assets Long-term debt pus equity capita 1 2 3 4 5 6 7 8 Time Period Figure 4: Fuctuating versus Permanent Assets and Liabiities Aternativey, as in Figure-4, the dashed ine coud be drawn above the ien designating permanent current assets, indicating that permanent capita is being used to meet seasona demands. In this case, the firm used a sma amount of short-term credit to meet its peak seasona requirements, but it aso meets a part of its seasona needs by storing iquidity in the form of marketabe securities during the off-season. The humps above the dashed ine represent short-term financing, the troughs beow the dashed ine represent short term security hodings. Longer term versus Short-term Debt The arger the percentage of funds obtained from ong-term sources, the more conservative the firm s working capita poicy. The reason for this, of course, is that during times of stress the firm may not abe to renew its short-term debt. This begin so, why firms ever use short term. Concepts of Working Capita There are two concepts of working capita- gross and net. Gross working capita refers to the firm s investment in current assets. Current assets are the assets which can be converted into cash within an accounting year (or operating cyce) and incude cash, short-term securities, debtors, (accounts receivabe or book debts) bis receivabe and stock (inventory). Net working capita refers to the difference between current assets and current

Working Capita Management 171 iabiities. Current iabiities are those caims which are expected to mature for payment within an accounting year and incude creditors (accounts payabe), bis payabe, and outstanding expenses. Net working capita can be positive or negative. A positive net working capita wi arise when current assets. The two concepts of working capita- gross and net are not excusive, rather they have equa significance from the management viewpoint The gross working capita concept focuses attention on two aspects of current assets management; (a) How to optimise investment in current assets? (b) How shoud current be financed? The consideration of the eve of investment in current assets shoud avoid two dangers points- excessive and inadequate investment in current assets. Investment in current assets shoud be just adequate, not more not ess, to the needs of the business firm. Excessive investment in current assets shoud be avoided because it impairs the firm s profitabiity, as ide investment earns nothing. On the other hand, inadequate amount of working capita can threaten sovency of the firm because of its inabiity to meet its current obigation. It shoud be reaised that the working capita needs of the firm may be fuctuating with changing business activity. This may cause excess or shortage of working capita frequenty. The management shoud be prompt to initiate an action and correct imbaances. Another aspect of the gross working capita points to the need of arranging founds to finance current assets. Whenever a need of working capita funds arises due to the increasing eve of business activity, or for any others reason, financing arrangement shoud be made quicky. Simiary, if suddeny, some surpus funds arise they shoud be aowed to remain ide, but shoud be invested in short-term securities. Thus the financia manager shoud have a knowedge of the sources of working capita funds as we as investment avenues where ide funds may be temporariy invested. Net working capita is a quaitative concept. It indicates the iquidity position of firm and suggests the extent to which working capita needs may be financed by permanent sources of funds. Current assets shoud be sufficienty in excess of current iabiities to constitute a margin or buffer for maturing obigations within the ordinary operating cyce of a business. In order to protect their interests, short-term creditors aways ike a company to maintain current assets at a higher eve than current iabiities. It is a conventiona rue to maintain the eve of current assets twice the eve of current iabiities. However, the quaity of current assets shoud be considered in determining the eve of current assets vis -a-vis current iabiities. A weak iquidity position poses a threat to the sovency of the company and makes it unsafe and unsound. A negative working capita means a negative iquidity, and may prove to be harmfu for the company s reputation. Excessive iquidity is aso bad. It may be due to mismanagement of current assets. Therefore, prompt and timey action shoud be taken by management improve and correct the imbaances in the iquidity position of the firm.

172 Financia Management Net working capita concept aso covers the question of judicious mix of ong-term and short-term funds for financing current assets. For every firm, there is a minimum amount of net working capita which is permanent. Therefore, a portion of the working capita shoud be financed with the permanent sorces of funds such as equity share capita, debentures, ong-term debt, preference share capita or retained earnings. Management must, therefore, decide the extent to which current assets shoud be financed with equity capita and/or borrowed capita. In summary, it may be emphasised that both gross and net concepts of working capita are equay important for the efficient management of working capita. There is no precise way to determine the exact amount of gross, or net working capita for any firm. The data and probems of each company shoud be anaysed to determine the amount of working capita. There is no specific rue as to how current assets shoud be financed. It is not feasibe in practice to finance current assets by short-term source ony. Keeping in view the constraints of the individua company, a judicious mix of ong and short-term finances shoud be invested in current assets. Since current assets invove cost of funds, they shoud be put to productive use. The common definition and its impications The most common definition of net working capita is the difference between a firm s current assets and current iabiities. As ong as firm s current assets exceed its current iabiities, it has net working capita. Most firm must operate with some amount of net working capita; now much depends argey on the industry. Firms with very predictabe cash fows, such as eectric utiities, can operate with negative net working capita; however, most firms must maintain positive eves of net working capita. The theoretica underpinning for the use of net working capita to measure a firm s iquidity is the beief that the greater the margin by which a firm s current assets cover its short-term obigations (current iabiities) the more abe it wi be to pay its bi as they come due. However, a probem arises because each current asset and current iabiity has a different degree of iquidity associated with it. Athough the firm s current assets may not be converted into cash at precisey the point in time when it is needed the greater the amount of current assets present the more ikey it is that some current asset wi be converted into cash in order to pay a debt that is due. It is the nonsynchronous nature of a firm s cash fows that makes net working capita necessary. The firm s cash outfows resuting from payment of current iabiities are reativey predictabe. It generay earns when bis are due when an obigation is incurred. For instance, when merchandise is purchased on credit, the credit terms extended to the firm require payment at a known point in time. The same predictabiity is associated with notes payabe and accruas, which have stated payment dates. What is difficut to predict are the firm s cash infows. Predicting when current assets other

Working Capita Management 173 than cash and marketabe securities wi be converted into cash is quite difficut. The more predictabe these cash infows are the ess net working capita a firm requires. It is because an eectric utiity has a very predictabe pattern of cash infows that it can operate with itte or no net working capita. Firms with more uncertain cash infows must maintain eves of current assets adequate to cover current iabiities. It is the inabiity of most firms to match cash receipts and cash disbursements that makes sources of cash receipts, (current assets) that wi more than cover current iabiities necessary. For exampe, if the GHI Company has the current position given in Tabe 1, the foowing situation may exist. A $600 of the firm s accounts payabe, pus $200 of its notes payabe and $100 in accruas, are due at the end of the current period. That this $900 in outays must be made is certain; how the firm wi cover these outays is not certain,. The firm can be sure that $700 wi be avaiabe since it has $500 in cash and $200 in marketabe securities, which can be easiy converted into cash. The remaining $200 must come from the coection of an account receivabe and/or the sae of inventory for cash. The firm cannot be sure when either a cash sae or the coection of an account receivabe wi occur. More uncertainty is associated with the coection of accounts receivabe than with a cash sae. Athough customers who have purchased goods on credit are expected to pay for them by the date specified in the credit arrangement, quite often they wi not pay unti a ater date. Thus the cash fows associated with the purchases wi not occur at the point in time they were expected. Tabe 1: The current position of the GHI Company Current assets Current iabiities Cash $500 Accounts payabe $600 Marketabe securities 200 Notes payabe 800 Accounts receivabe 800 Accruas 200 Inventory 1,200 Tota $1,600 Tota $2,700 Of course, some soution to this diemma must exist. In order to have a higher probabiity of having sufficient cash to pay its bis, a firm shoud attempt to make saes, since in many cases they wi resut in the immediate receipt of cash and in other cases they wi resut in accounts receivabe which wi eventuay be converted into cash. A eve of f inventory adequate to satisfy the probabe demand for the firm s products shoud be maintained. As ong as the firm is generating saes and coecting receivabes as they come due, sufficient cash shoud be forthcoming to satisfy its cash payment obigations. The GHI Company can increase the probabiity of its being abe to satisfy its obigations by maintaining of some of these items into cash. The more accounts receivabe and inventories there are on hand, the greater the probabiity that some of these items wi be turned into cash. As a rue a certain eve of net working capita

174 Financia Management is often recommended in order to ensure that a firm wi be abe to pay bis. The GHI Company has $1,100 of net working capita ($2,700-$1,600) which wi most ikey be sufficient to cover a its bis. Its current ratio of 1.69 ($2,700/$1,600), shoud provide sufficient iquidity as ong as its accounts receivabe and inventories are reativey iquid. An aternate definition of net working capita An aternate definition of net working capita is that portion of a firm s current assets financed with ong-term funds. This definition can best be iustrated by a specia type of baance sheet, ike that for the GHI Company presented in Figure 5. The vertica axis of the baance sheet is a doar scae on which a the major items on the firm s baance sheet are indicated. Assets Liabiities and Equities Current Assets Net Working Capita UVW 1,000 1,600 Current Liabiities 2,000 2,700 3,000 4,000 Long Term Debt Long Term Funds 5,000 Tota Assets 6,000 7,000 Tota Liabiities & Equities Figure 5: A specia baance sheet for the GHI Company Figure 5 shows that the firm has current assets of $2,700, fixed assets of 4,300 and tota assets of $7,000. It is aso shows that the firm has current iabiities of $1,600, ongterm debts of $2,400 ($4,000-$1,600), and stockhoders equity of $3,000 ($7,000- $4,000). A firm s ong-term debt pus its stockhoders equity represents its sources of ong-term funds; the GHI Company s ong-term funds equa $5,400. The portion of the firm current assets that was financed with ong-term funds has been abeed net working capita in Figure 5. Anaysis of this figure shoud enabe the reader to better understand why a firm s net working capita can be thought of as the portion of current assets financed with ong-term funds. Since current exceed current iabiities the amount of the excess must be financed with onger-term funds. The usefuness of this aternate definition wi become more apparent in a ater section of the chapter.

Working Capita Management 175 The Trade-off between Profitabiity and Risk A trade-off exists between a firm s profitabiity and risk. Profitabiity, in this context, is measured by profits after expenses, whie risk is measured by the probabiity that a firm wi become technicay insovent (i.e., unabe to pay bis as they come due). A firm s profits can be increased in two ways: (1) by increasing saes or (2) by decreasing costs. Both methods are discussed in the foowing pages. Costs can be reduced by paying ess for an item or a service or by using existing resources more efficienty. Any reduction in costs shoud increase a firm s profits. Profits can aso be increased by investing in more profitabe, assets, which are capabe of generating higher eves of saes. An understanding of how profits are increased and reduced is critica to grasping the idea of a profitabiity-risk trade-off. The risk of becoming technicay insovent is most commony measured using either the amount of net working capita or the current ratio. In this chapter the amount of net working capita is used as a measure. It is assumed that the greater the amount of net working capita a firm has, the ess risky the firm is. In other words, the more net working capita the more iquid the firm and, therefore, the ess ikey it is to become technicay insovent. The opposite is aso considered to be true; ower eves of iquidity (i.e., net working capita) are associated with increasing eves of risk on the part of the business firm. The reationship between iquidity, net working capita, and risk is such that if either net working capita of iquidity increases the firm s risk decreases. Some basic assumptions In taking about a profitabiity-risk trade-off, a number of basic assumptions, which are generay true, must be made. The first concerns the nature of the firm being anayzed, the second concerns the basic differences in the earning power of assets, and the third concerns differences in the cost of various methods of financing. Each of these assumptions wi be discussed separatey. The nature of the firm: The kind of firm we are taking about in this chapter is a manufacturing firm, not some type of merchandising or service organization. As we stated earier in the text, the emphasis in this book is generay on manufacturing firms since they provide the best aboratory for investigating most of the basic principes of manageria finance. The earning power of assets: A manufacturing firm is expected to be abe to earn more on its fixed assets than on its current assets. Fixed assets represent the true earning assets of the firm. Pants, machines, and warehouses a enabe the firm to generate finished products that can utimatey be sod for a profit. The firm s current assets, except for marketabe securities, are not generay earning assets. Rather, they provide a buffer that aows the firm to make saes and extend credit. The importance

176 Financia Management of current assets to the firm s operation was indicated in the preceding section; but without fixed assets to generate finished products that can be converted into cash, marketabe securities, accounts receivabe, and inventory, the firm coud not operate. If the firm coud earn more money by purchasing its inventory than by producing it or by investing its money in marketabe securities then it shoud not be in the manufacturing business. In other words, if a firm cannot make more on fixed-asset investments than it makes on current-asset investments, it shoud se a its fixed assets and use the proceeds to purchase current assets. In the foowing discussion it is assumed that the firm can earn more on fixed assets than current assets. The cost of financing: The firm can obtain its required financing from either of two source: (1) current iabiities or (2) ong-term funds. Current iabiities are sources of short-term funds; ong-term debts and equity are sources of ong-term funds. Since current iabiities generay consist of accounts payabe, notes payabe, and accruas, they are typicay a cheap source of funds. Of the basic current iabiities, ony notes payabe normay have a stated cost. This is because notes payabe represent the ony negotiated form of borrowing. Accounts payabe and accruas are cheaper sources of funds than notes payabe since they do not normay have any type of interest payment associated with them. Historicay, in genera, short-term funds cost ess than ong-term funds. In the recent past, interest rates have been increasing and peope have expected higher interest rates in the future. Lenders with such expectations wi typicay provide short-term funds at rates beow those charged for onger-term funds. They do this because short-term oans mature in ess than a year, and they wi get their money back in time to reend it at higher rates if interest rates do increase over the year. If interest rates are expected to increase in the future, a ender wi charge a high enough rate of interest on a onger-term oan to compensate himsef for tying up his money for a ong period and osing future opportunities to end money at increased rates. Whenever enders beieve that future interest rates wi rise, short-term borrowing rates are ess than ong-term rates. When future rates are expected to decine from a currenty high rate, ong-term rates are most often beow short-term rates. Since increasing interest rates have prevaied in the most recent past, it is assumed in the foowing discussion that short-term funds are cheaper than onger-term funds. The fact that short-term sources of funds incude not ony notes payabe but aso accounts payabe and accruas makes it much easier to accept this assumption, since accounts payabe and accruas are virtuay interest-free. The cheapest form of financing for the business firm is, therefore, short-term funds. The nature of the trade-off between risk and profitabiity If a firm wants to increase its profitabiity, it must aso increase its risk. If it wants to

Working Capita Management 177 decrease risk, it must decrease profitabiity. The trade-off between these variabes is such that regardess of how the firm increases its profitabiity through the manipuation of working capita the consequence is a corresponding increase in risk as measured by the eve of net working capita. The effects of changing current assets and changing current iabiities on the firm s profitabiity-risk trade-off wi be discussed separatey prior to integrating them into an overa theory of working capita management. Current assets The effects of the firm s eve of current assets on its profitabiityrisk trade-off can be iustrated using a simpe ratio the ratio of the firm s current assets to its tota assets. This ratio indicates what percentage of the firm s tota assets are current. It may increase or decrease. Effects of an increase As the ratio of current assets to tota assets increases, both the firm s profitabiity and its risk decrease. Its profitabiity decreases because current assets are ess profitabe than fixed assets. The risk of technica insovency decreases because, assuming that the firm s current iabiities do not change, the increase in current assets wi increase its net working capita. Effects of a decrease A decrease in the ratio of current assets to tota assets wi resut in an increase in the firm s profitabiity since the firm s fixed assets, which There have been periods when short-term rates have exceeded ong-term rates, but these periods have been exceptions rather than the norm. The second quarter of 1974 through the first quarter of 1975 was a period during which the short-term were above ong-term rates increase, generate higher returns than current assets. However, risk wi aso increase since the firm s net working capita wi decrease with- the decrease in current assets. The consequences of a decrease in the ratio of current to tota assets are exacty the opposite of the resuts of an increase in the ratio. Exampe The baance sheet for the GHI Company presented in Figure 5 indicated the foowing eves of assets, iabiities, and equity: Assets Liabiities and equity Current assets $2,700 Current iabiities $1,600 Fixed assets 4,300 Long-term debts 2,400 Tota $7,000 Equity 3,000 tota $7,000 If the GHI Company earns approximatey 2 percent on its current assets and 12 percent on its fixed assets, the current baance sheet configuration wi aow it to earn approximate $570 [(2%. $2,700) + (12%. $4,300)1 on its tota assets. The firm s net working capita is currenty $1,100 ($2,700 - $1,600). Its ratio of current assets to tota assets is approximatey.386 ($2,700 $7,000). If the firm decreases this ratio by investing $309 more in fixed assets (and thus $300 ess in current assets), the new ratio of current to tota assets is.343 ($2,400 s $7,000). The firm s profits on its tota assets wi then be $600, [2% ($2,400)+ 12% ($4,600)].

178 Financia Management Its net working capita wi be-$800, ($2,400 $1,600). These resuts are tabuated in Tabe 2. Tabe 2: The effects of a change in GHI s current assets Initia vaue Vaue after change Ratio of current to tota assets.386.343 Profits on tota assets $570 $600 Net working capita $1,100 $800 As Tabe 2 indicates, as the firm s ratio of current to tota assets decreases from.386 to.343 its profits on its tota assets increase from $570 to $600. Its risk, measured by the amount of net working capita, increases since its net working capita, and thus its iquidity, is reduced. This supports our earier concusions concerning the profitabiityrisk trade-off as reated to the firm s current assets. Current iabiities The effects of changing the eve of a firm s current iabiities on its profitabiity-risk trade-off can aso be demonstrated using a simpe ratio in this case, the ratio of the firm s current iabiities to its tota assets. This ratio indicates the percentage of the firm s tota assets that have been financed by current iabiities. It can either increase or decrease. Effects of an increase As the ratio of current iabiities to tota assets increases, the firm s profitabiity increases; but so does its risk. Profitabiity increases due to the decreased costs associated with using more short-term financing and ess ong-term financing. Since short-term financing invoving accounts payabe, notes payabe, and accruas is ess expensive than ong-term financing, the firm s costs decrease, driving its profits higher. Assuming that the firm s current assets remain unchanged, its net working capita wi decrease as its current iabiities increase. A decrease in net working capita means an increase in overa risk. Effects of a decrease A decrease in the ratio of current iabiities to tota assets wi decrease the profitabiity of the firm, since a arger amount of financing must be raised using the more expensive ong-term instruments. There wi be a corresponding decrease in risk due to the decreased eve of current iabiities, which wi cause an increase in the firm s net working capita. The consequences of a decrease in the ratio of current iabiities to tota assets are exacty the opposite of the resuts of an increase in this ratio. Exampe The baance sheet for the GHI Company in the preceding section can be used to show the effects of an increase in the firm s current iabiities. Initiay the ratio of current iabiities to tota assets is.229 (%1,600 $7,000). Assume that the firm s current iabiities cost approximatey 3 per cent to maintain whie the average cost of its ions-

Working Capita Management 179 term funds is 8 percent. Ignoring the changes made in the preceding exampe, the effect of shifting $300 from ong-term funds into current iabiities wi increase current iabiities to $1,900 ($1,600 + $300) and decrease ong-term funds to $5,100 ($5,00 $300). The new ratio of current iabiities to tota assets wi be.271 ($1,900 $7,000). The resut of this change wi be a decrease in costs from the current eve of $480 [(3% $1,600) + (8% $5,400)1 to $465 [(3% %1,600) + (8% $5,100)]. The firm s net working capita wi decrease from the initia eve of $1,100 to $800 ($2,700 $1,900). These resuts of the increase in the ratio of current iabiities to tota assets are tabuated in Tabe.3. Tabe 3: The effects of a change In GH s current iabiities Initia vaue Vaue after change Ratio of current iabiities to tota assets.229.271 Cost of finanace a $480 $465 Net working capita $1,100 $800 a A decrease in any of the firm s costs is equivaent to an increase in profitabiity by the same amount. Tabe 3 iustrates that as the firm s ratio of current iabiities to tota assets increases from.229 to.271, the firm s profits increase by $15 (since its costs drop from $480 to $465). Meanwhie, the firm s risk, measured by the eve of net working capita, increases since its net working capita, or iquidity, decreases. This exampe iustrates ony the effects of an increase in the ratio of current iabiities to tota assets; a decrease woud have an opposite effect. Combined effects The combined effects of changes in current assets and changes in current iabiities can be measured by considering them simutaneousy. In the preceding two exampes, the effects of a decrease in the ratio of current to tota assets and the effects of an increase in the ratio of current iabiities to tota assets were iustrated. Both changes, considered independenty, were shown to increase the firm s profitabiity whie increasing its risk. Logicay, then, the combined effect of these actions shoud be to increase profits and risk and decrease net working capita. Tabe 4 iustrates the effects of combining the changes in current assets and current iabiities presented in Tabes 2 and 3. Tabe 4: The combined effects of changer in GH s current assets and iabiities Change in profits Change in net working capita Decrease in ratio of current to tota assets + $30 -$300 Increase in ratio of current iabiities to tota assets +$15 -$300 Net Effect +$45 -$600

180 Financia Management The vaue in Tabe 4 iustrate that the net effect of the two changes iustrated earier is an increase in profits of $45 and a decrease in net working capita (iquidity) of $600. The trade-off here is obvious; the firm has increased its profitabiity by increasing its risk. Tabe 4 shows that the firm s net working capita has been reduced from its initia eve of $1,100 to $500. The firm s initia net profit can be thought of as the difference between the initia profits on tota assets and the initia cost of financing. The initia profit on tota assets was $570, and the initia cost of financing was $480. The initia net profit was therefore $90 ($570 $480). After the changes in current assets and current iabiities, the firm s profits on its tota assets increased to $600 whie the cost of financing decreased to $465. Its net profits, therefore, increased to $135 ($600 $465).. Finance Mix for working capita The finance mix for workng capita is as foows: Current Assets ( in descending order of iquidity): 1. Cash 2. Bank Baance 3. Short term investments 4. Trade Debtors 5. Inventory Finished Goods Work in process Raw materias Stores & Spares 6. Pre-payments (Insurance, advances etc.) Current Liabiities: 1. Trade Creditors 2. Bank Overdraft or Cash Credit 3. Short Term Borrowings 4. Provision for taxes 5. Provision for dividends If current assets is the source from which current iabiities are to be met (as and when they fa due) during the course of business operations, then their strengths or weaknesses

Working Capita Management 181 wi have significant bearing on the short run iquidity of the company. The importance of preserving this short term iquidity need not be emphasised and hence the need to manage the working capita. Working parameters of a company infuence the composition mix of various components of working capita. Whether the company is singe product or mutipe product? Whether the company does made-to-order work or it keeps stock in inventory? Whether it is a manufacturing company or a trading company? Whether it extends credit to its customers or does not? Whether it gets credit from its suppiers or does not? These are some of the questions that the company has to answer before it can reay decide what eves of working capita that the company needs. Singe product companies normay operate with a ower quantum of working capita than a muti-product or muti-process companies. Trading operations, which get the payments in cash everyday, wi necessariy have to manage their funds in a different way than a defence contractor who gets his payment after six months of the competion of the job. The management of funds wi be atogether different for an infrastructure contractor whose payment terms are divided over a number of years. Estimating working capita needs The size of the company s investment in current assets is determined by its short-term financia poicies. There are three types of poicies that the company can use: 1) Fexibe poicy, 2) Restrictive poicy and 3) A compromise poicy that ies between the two. 1) A company keeping a fexibe working capita poicy means that the company is very ibera in its trade terms and has invested a arge amount of funds in its operations. Fexibe poicy actions incude: Keeping arge cash and securities baances Keeping arge amounts of inventory Granting ibera credit terms 2) A company keeping a restrictive working capita poicy is basicay investing the owest amount possibe in the operations. for Restrictive poicy actions incude: Keeping ow cash and securities baances Keeping sma amounts of inventory Aowing few or no credit saes 3) A company keeping a compromise working capita poicy is reaisticay investing the money in the operations, neither has very arge amount of cash nor runs aways short of it ike the restrictive poicy does.

182 Financia Management The three types of poicies are shown in figure 6: Figure 6: Types of Financing Poicies As you can see in the figure 18.1, a company that keeps a fexibe poicy keeps enough iquid assets that are sufficient to finance its peak requirements of working capita. This means that the company invests the excess money that it has when there is ess than the peak demand. A company with a restrictive poicy keeps enough iquid assets that are sufficient to meet the owest eve of working capita requirements. This means that the company borrows as the seasona needs grow to fund its working capita needs. With a compromise poicy, the firm keeps a reserve of iquidity which it uses to initiay finance seasona variations in current asset needs. Short-term borrowing is used when the reserve is exhausted. A restrictive poicy is associated with higher risk and higher expected profitabiity. A conservative poicy ensures higher iquidity and cover risk but is aways accompanied by ower profitabiity. The poicy to be adopted is based on managements perception of the risk with a view to maximise the utiity vaue of the funds used in the working capita management. This means that the risk-return trade-off is to be kept in mind whie formuating the WC poicy. R Fexibe poicy means that the company is carrying excess cash and hence bearing higher carrying costs than the other two poicies. Restrictive poicy means that the company is out of cash many times and hence carries shortage costs ike oss of orders, etc. This is depicted in the figure 3.2 beow: Figure 7: Carrying Costs and Shortage Costs

Working Capita Management 183 As the eve of working capita increases, shortage costs go down whie the carrying costs increase. This means that there woud be a point where the sum tota of carrying costs and the shortage costs woud be the owest. This is the optimum eve of current assets that the company shoud keep. In addition to the working parameters pecuiar to a company that determine the quantum of required working capita, the foowing factors are aso equay important: 1. Profit eves: A company earning huge amounts of profits can add to the working capita poo a arger quantum of funds. Such companies shoud, however, guard against the temptation of expanding beyond necessity and tying up the funds in unproductive capita expenditure or aow unnecessary increase in overheads. Generay it is seen that companies with high profit eves become ax in management of funds and usuay mismanage by bocking funds excessivey in stocks or debtors. 2. Tax Leves and Panning: Income Tax aws provide for payment of advanced tax in instaments. Excise and saes tax are payabe at time of despatch of goods from the factory premises and the point of saes respectivey. Any working capita management must make adequate and timey provision for the same as a of them invove cash outays. 3. Dividend Poicies and Retained Earnings: Dividend poicy and retained earnings are directy reated. There has to be a proper baance between the need to preserve cash resources and the obigation to satisfy sharehoder expectations. Sometimes reserves are sacrificed for consistent dividends. Dividends once decared become a short time iabiity which has to be paid for in cash and this impact shoud be recognised in the working capita budget. On the other hand, it woud be of itte satisfaction to the genera body of the sharehoders to enjoy a ibera dividend at the expense of poughing back the same for the growth of the company. Reserves in the form of retained earnings is a very important source of augmenting working capita. 4. Depreciation Poicy: The extent to which depreciation provision is made during the course of making the financia statements has a direct bearing on the dividend poicy and retained earnings. This so because a higher quantum of depreciation woud eave esser profits resuting in reduced retained earnings and dividends. The quantum of depreciation can be made to vary by choosing different methods to provide for the use of assets. As provisions for depreciation are actuay ony book entries and represent no cash fow at that time, they wi have no bearing on working capita except to the extent they may hod back distribution of dividends. 5. Expansion/Diversification Pans: Addition of fixed assets to produce new

184 Financia Management products, resorting to mutipe shifts, or marginay adding to the pant and machinery are some of the common known ways to expand or diversify. Either of them represent an increase in production which cas for a higher quantum of spending of current assets, e.g., you buy more raw materia when you produce more and so on. In such situations, it is unwise to strain the interna resources for avoiding externa funding. 6. Price eve changes in raw materia and finished goods: Infation has got a direct bearing on the working capita. It depends to a arge extent on the companies abiity to readjust its own prices to cover the increase in the cost. In case the product or service requires government approva or is administered as far as the price is concerned, infation may have a very significant bearing on the working capita needs. Infation coud be either recessive or expensive. During recessive infation the companies are unabe to se more products due to ack of demand which resuts in the reduction of production. Inventories pie up and fixed expenses need a drastic reduction. 7. Operating Efficiency of the company: Operating efficiency of a company pays a major roe in working capita management. An efficient company wi have a shorter manufacturing period, ong credit terms avaiabe from suppiers and minima customers credit outstanding. If this is achieved then the quantum of working capita required wi be naturay reduced. The Working Capita Cyce The Working Capita Cyce (or operating cyce) is the ength of time between a company s paying for materia entering into stock and receiving the infow of cash from saes. The movements in the cyce are different for different types of companies and are dependent on the nature of the company. Inventory purchased Inventory period Accounts payabe period Inventory sod Cash paid for inventory Accounts receivabe period Cash received Time Operating cyce Cash cyce Figure 8: Operating and Cash Cyces

Working Capita Management 185 The operating cyce is the time period from inventory purchase unti the receipt of cash. (Sometimes the operating cyce does not incude the time from pacement of the order unti the arriva of stock.) The cash cyce is the time period from when cash is paid out, to when cash is received. Computation of Working Capita The two components of working capita (WC) are current assets (CA) and current iabiities (CL). They have a bearing on the cash operating cyce. In order to cacuate the working capita needs, what is required is the hoding period of various types of inventories, the credit coection period and the credit payment period. Working capita aso depends on the budgeted eve of activity in terms of production/ saes. The cacuation of WC is based on the assumption that the production/saes is carried on eveny throughout the year and a costs accrue simiary. As the working capita requirements are reated to the cost excuding depreciation and not to the sat price, WC is computed with reference to cash cost. The cash cost approach is comprehensive and superior to the operating cyce approach based on hoding period of debtors and inventories and payment period of creditors. Some probems have been soved, however, using the operating cyce approach aso. The steps invoved in estimating the different items of CA and CL are as foows: Estimation of Current Assets Raw Materias Inventory The investment in raw materias inventory is estimated on the basis of Eq.. Budgeted Cost of raw Average inventory production materia(s) hoding period (in units) per unit (months/days) 12 months/365 days (1) Work-in-Process (W/P) Inventory The reevant costs to determine work-in-process inventory i are the proportionate share of cost of raw materias and conversion costs (abour and manufacturing overhead costs excuding depreciation). In case, fu unit of raw materia is required in the beginning, the unit cost of work-in-process woud be higher, that is, cost of fu unit + 50 per cent of conversion cost, compared to the raw materia requirement throughout the production cyce; W/P is normay equivaent to 50 per cent of tota cost of production. Symboicay, Budgeted Estimated work Average time span production in-process cost of work-in-progress (In units) per unit inventory (months/days) 12 months/365 days (2)

186 Financia Management Finished Goods Inventory Working capita required to finance the finished goods inventory is given by factors summed up in Eq. 3. Budgeted Cost of goods produced Finished goods production per unit (excuding hoding period (in units) depreciation) (months/days) 12 months/365 days (3) Debtors The WC tied up in debtors shoud be estimated in reation to tota cost price (excuding depreciation, Symboicay, Budgeted Cast of saes per Average debt credit saes unit excuding coection period (in units) depreciation (months/days) 12 months/365 days (4) Cash and Bank Baances Apart from WC needs far financing inventories and debtors, firms aso find it usefu to have some minimum cash baances with them. It is difficut to ay down the exact procedure B of determining such an amount. This woud primariy be based on the motives for hoding cash baances of the business firm, attitude of management toward risk, the access to the borrowing sources in times of need and past experience, and so on. Estimation of Current Liabiities The working capita needs of business firms are ower to the that extent such needs are met through the current iabiities (other than bank credit) arising in the ordinary course of business. The important current iabiities (CL), in this context are, tradecreditors, wages and overheads: Trade Creditors Budgeted yeary Raw materia Credit period production x requirement x aowed by creditors (in units) per unit (months/days) 12 months/365 days (5) Note: Proportiona adjustment shoud be made to cash purchases of raw materias. Direct Wages Budgeted yeary Direct abour Average time-ag in production cost per unit payment of wages (in units) (months/days) 12 months/365 days (6) The average credit period for the payment of wages approximates to a haf-a-month in the case of monthy wage payment: The first days monthy wages are paid on the 30th day of the month, extending. credit for 29 days, the second day s wages are, again,

Working Capita Management 187 paid on the 30th, extending credit for 28 days, and so on. Average credit period approximates to haf a month. Overheads (Other than Depreciation and Amortisation) Budgeted yeary Overhead cost Average time-ag in production per unit payment of overheads (in units) (months/days) 12 months/365 days (7) The amount of overheads may be separatey cacuated for different types of overheads. In the case of seing overheads, the reevant item woud be saes voume instead of production voume. The computation of working capita is summarised in foowing format (I) Estimation of Current Assets: (a) (b) (c) Format 7: Determination of Working Capita Minimum desired cash and bank baances Inventories Raw materia work-in-process Finished Goods Debtors Tota Current Liabiities: (II) Estimation of Current Liabiities: (a) (b) (c) Creditors** Wages Overheads Tota Current Liabiities (III) Net Working Capita (I-II) Add margin for contingency (IV) Net Working Capita Required * If payment is received in advance, the Item woud be isted in CL. Amount ** If advance payment is to be made to creditors, the item woud appear under CA. The same woud be the treatment for advance payment of wages and overheads. Exampes 1. X & Y Ltd is desirous to purchase a business and has consuted you, and one point on which you are asked advise them. is the average amount of working capita which wi be required in the first year s working. You are given the foowing estimates and are instructed to add 10 per cent to your computed figure to aow for contingencies.

188 Financia Management Amount for the year (i) Average amount backed up for stocks: Stocks of finished product Rs 5,000 Stocks of stores and materias 8,000 (ii) Average credit given: Inand saes, 6 weeks credit 3,12,000 Export saes, 1.5 weeks credit 78,000 (iii) Average time ag in payment of wages and other outgoings: Wages, 1.5 weeks 2,60,000 Stocks and materias, 1.5 months 48,000 Rent and royaties, 6 months 10,000 Cerica staff, 0.5 month 62,400 Manager, 0.5 month 4,800 Misceaneous expenses, 1.5 months 48,000 (iv) Payment in advance: Sundry expenses (paid quartery in advance) 8,000 Undrawn profits on an average throughout the year 11,000 Set up your cacuations for the average amount of working capita required. Soution Statement to determine Net Working Capita for X a Y Ltd (a) Current assets: (i) Stock of finished product Rs 5,000 (ii) Stock of stores and materias 8,000 (iii) Debtors: Inand saes (Rs 3,12,000 6/52) 36,000 Export saes, (Rs 78,000 3/104) 2,250 (iv) Advance payment of sundry expenses (Rs 8,000 1/4) 2,000 Tota investment in current assets 53,250 (b) Current iabiities: (i) Wages (Rs 2,60,000 3/104) 7,500 (ii) Stocks/materias, (Rs 48,000 3/24) 6,000 (iii) Rent, royaties, (Rs 10,000 6/12) 5,000 (iv) Cerica staff (Rs 62,400 1/24) 2,600

Working Capita Management 189 (v) Manager (Rs 4,800 1/24) 200 (vi) Misceaneous expenses (Rs 48,000 3/24) 6,000 Tota estimate of current iabiities 27,300 (c) Net working capita: (i) Current assets-current iabiities (A-B) 25,950 (ii) Add 10 per cent contingency aowance 2,595 Average amount of working capita required 28,545 Assumptions (i) (ii) (iii) A time period of 52 weeks/12 months has been assumed in year. Undrawn profit has been ignored in the working capita computation for the foowing reasons: (a) (b) For the purpose of determining working capita provided by net profit, it is necessary to adjust the net profit for income tax and dividends/drawings, and so on. Profit need not aways be a source of financing working capita. It may be used for other purposes ike purchase of fixed assets, repayment of ongterm oans, and so on; Since the firm does not seem to have such uses, Rs 11,000 may be treated as source of working capita. But the WC wi not change. Actua working capita requirement woud be more than what is estimated here as the cash component of current assets is not known. 2. A Proforma cost sheet of a company provides the foowing particuars: Eements of cost: Amount per unit Raw materias Rs 80 Direct abour 30 Overhead 60 Tota cost 170 Profit 30 Seing price 200 The foowing further particuars are avaiabe: Raw materias in stock, on average, one month; Materias in process (competion stage, 50 per cent), on average, haf a month; Finished goods in stock, on average, one month. Credit aowed by suppiers is one month; Credit aowed to debtors is two months;

190 Financia Management Average time-ag in payment of wages is 1.5 weeks and one month in overhead expenses; one-fourth of the output is sod against cash; cash in hand and at bank is desired to be, maintained at Rs 3,65,000. You are required to prepare a statement showing the working capita needed to finance a eve of activity of 1,04,00 units of production. You may assume that production is carried on eveny throughout the year, and wages and overheads accrue simiary. Soution Statement showing Determination of Net Working Capita (A) Current assets: (i) Stock of materias for 1 month: (1,04,000 x Rs 80 4/52) Rs 6,40,000 (ii) Work-in-progress for 0.5 month: (a) Materia (1,04,000 x Rs 80 2/52) 0.50 1,60,000 (b) Labour (1,04,000 x Rs 30 2/52) 0.50 60,000 (c) Overheads (1,04,000 x Rs 60 2/52) 0.50 1,20,000 (iii) Finished goods for 1 month: (1,04,000 Rs 170 4/52) 13,60,000 (iv) Debtors for 2 months (78,000 Rs 170 8/52) 20,40,000 (v) Cash in hand and at bank 3,65,000 Tota investments in current assets 47,45,000 (B) Current iabiities: (i) Creditor8, 1 month s purchase of raw materias, (i.e. 1,04,000 x Rs.80 x 4/ 52) 6,40,000 (ii) Average time-ag in payment of expenses (a) Overheads (1,04,000 Rs 80 4/52) 4,80,000 (b) Labour (1,04,000 Rs 30 3/104) 90,000 Tota estimate of current iabiities 12,10,000 (C) Net working capita = Current; assets - Current iabiities(a-b) 35,36,000 Working notes and assumptions (i) 26,000 units have been sod for cash. Therefore, credit saes pertain to 78,000 units ony. (ii) (iii) Year has 52 weeks. A overheads are assumed to be variabe. Presence of depreciation eement in overheads wi ower the working capita requirement. 3. Whie preparing a project report on behaf of a cient you have coected the foowing facts. Estimate the net working capita required for that project. Add 10 per cent to your compacted figure to aow contingencies:

Working Capita Management 191 Estimated cost per unit of production is: Amount per unit Raw materia Rs 80 Direct abour 30 Overheads (excusive of depreciation, Rs 10 per unit) 60 Tota cash cost 170 Additiona information: Seing price, Rs 200 per unit Leve of activity, 1,04,000 units of production per annum Raw materias in stock, average 4 weeks Work in progress (assume 50 per cent competion stage in respect of conversion costs and 100 per cent competion in respect of materias), average 2 weeks Finished goods in stock, average 4 weeks Credit aowed by suppiers, average 4 weeks Credit aowed to debtors, average 8 weeks Lag in payment of wages, average 1.5 weeks Cash at bank is expected to be, Rs 25,000. You may assume that production is carried on eveny throughout the year (52 weeks) and wages and overheads accrue simiary. A saes are on credit basis ony. Soution (A) Current assets: Net Working Capita Estimate of a Project (i) Raw materias in stock, (1,04,000 Rs 80 4/52) 6,40,000 (ii) Work-in-progress (a) Raw materia (1,041000 Rs 80 2/52) 3,20,000 (b) Direct Labour (1,04,000 Rs 15 2/52) 60,000 (c) Overheads (1,04,000 Rs 30 2/52) 1,20,000 (iii) Finished goods stock: (1,04,000 Rs 170 4/52) 13,60,000 (iv) Debtors: (1,04,000 Rs 170 8/52) 27,20,000 (v) Cash at bank 25,000 Tota investment in current assets 52,45,000

192 Financia Management (B) Current iabiities: (i) Creditors, average 4 weeks: (1,04,000 Rs 80 4/52) 6,40,000 (ii) Lag in payment of wages (1,04,000 Rs 30 3/104) 90,000 Tota current iabiities 7,30,000 (C) Net working capita: Current assets - Current iabiities 45,15,000 Add 10 per cent contingencies 4,51,000 Working notes Rs 49,66,500 A fu unit of raw materia is required at the beginning of the manufacturing process and, therefore, tota cost of the materia, that is, Rs 80 per unit has been taken into consideration, whie in the case of expenses, viz. direct abour and overheads, the unit has been finished ony to the extent of 50 pet cent. Accordingy, Rs 15 and Rs 30 have been charged for direct abour and overheads respectivey in vauing work-in-process. 4. A newy formed company has appied for a oan to a commercia bank for financing its working capita requirements. You are requested by the bank to prepare an estimate of the requirements of the working capita for the company. Add 10 per cent to your estimated figure to cover unforeseen contingencies. The information about the projected profit and oss account of this company is as under: Saes Rs 21,00,000 Cost of goads sod 5,30,000 Gross profit 5,70,000 Administrative expenses Rs 1,40,000 Seing expenses 1,30,000 2,70,000 Profit before tax 3,00,000 Provision for tax 1,00,000 Note: Cost of goods sod has been derived as foows: Materias used 8,40,000 Wages and manufacturing expenses 6,25,000 Depreciation 2,35,000 17,00,000 Less stock of finished goods (10 per cent-nor yet sod) 1,70,000 15,30,000

Working Capita Management 193 The figures given above reate ony to the goods that have been finished and not to work in progress goods equa to 15 per cent of the year s production (in terms of physica units) are in progress on an average, requiring fu materias but ony 40 per cent of other expenses. The company beieves in keeping two months consumption of materia in stock; Desired cash baance, Rs 40,000. Average time-ag in payment of a expenses is 1 month; suppiers of materias extend 1.5 months credit; saes are 20 per cent cash; rest ate at two months credit; 70 per cent of the income tax has to be paid in advance in quartery instaents. You can make such other assumptions as you deem necessary for estimating working capita requirements. Soution (A) Current assets: Net Working Capita Estimate of a Company (i) Raw materia in stock =: (Rs 8,40,000 2/12) Rs 1,40,000 (ii) (iii) (iv) Work-in-progress: (a) Raw materia (Rs 8,40,000 15/100) 1,26,000 (b) Wages and manufacturing expenses =: (Rs 6,25,000 0.4 15/100) 37,500 Stock of finished goods: [Rs 1,70,000 - Rs 23,500 (0.10 Rs 2,35,000, depreciation) 1,46,500 Debtors (a) Cost of goods sod Rs 15,30,000 Less depreciation (Rs 2,35,000 0.9) 2,11,500 13,18,500 (b) Administrative expenses 1,40,000 (c) Seing expenses 1,30,000 Tota 15,88,500 Credit saes (4/5 of Rs 15,88,500) = Rs 12,70,800 (12,70,800 2/12) 2,11,800 (v) Cash required 40,000 Tota investment in current assets 7,01,800 (B) Current iabiities: (i) Average time-ag in payment of expenses: (a) Wages and manufacturing expenses 6,25,000

194 Financia Management (b) Administrative expenses 1,40,000 (c) Seing expenses 1,30,000 8,95,000/12 74,583 (ii) Creditors (Rs 8,40,000 3/24) 1,05,000 Tota current iabiities 1,79,583 (c) Net working capita: Current assets Current iabiities (A-B) 5,22,217 Add 10 per cent contingencies 52,222 Assumptions and working notes (i) (ii) 5,74,439 Depreciation is not a cash expense and, therefore, excuded from cost of goods sod for the purpose of determining work-in-progress, finished goods and investment in debtors. Since profit is not taken into consideration in our cacuation as a source of working capita, income tax has been 5. From the foowing projections of XYZ & Ltd for the next year, you are required to determine the working capita required by the company. Annua saes, Rs 14,40,000 Cost of production (incuding depreciation of Rs 1.20,000), Rs 12,00,000 Raw materia purchases, Rs 7,05,000 Monthy expenditure, Rs 30,000 Estimated opening stock of raw materias, Rs 140,000 Estimated cosing stock of raw materias, Rs 1,25,000 Inventory norms: Raw materias, 2 months Work-in-process, 1/2 month Finished goods, 1 month The firm enjoys a credit of haf-a-month on its purchases and aows one month credit on its suppies. On saes orders, the company receives an advance of Rs 15,000. You may assume that production is carried out eveny throughout the year and minimum cash baance desired to be maintained is Rs 35,000.

Working Capita Management 195 Soution Statement showing determination of net working capita (A) Current assets: Cash baance Rs 35,000 Inventories: Raw materias: Opening stock Rs 1,40,000 Add purchases 7 05,000 Less cosing stock 1,25,00 Annua consumption 7,20,000 Two months requirement: (Rs 7,20,000 2/12) 1,20,000 Work-in-process: (Rs 10,80,000 1/24) 45,000 Finished goods: (Rs 10,80,000 1/12) 90,000 Debtors: (Rs 10,80,000 1/12) 90,000@ Tota current assets 3,80,000 (B) Current iabiities: Trade creditors: (Rs 7,05,000 1/24) 29,375 Advance received from debtors 15,000 Tota current iabiities 44,375 (C) Net working capita (A-B) 3,35,625 @ It is assumed that there is neither opening nor cosing stock of finished stock and, therefore, cost of saes is Rs 10,80,000 excuding depreciation. Monthy expenditure is excuded as the cost of production incudes it (Rs 7.2 akh, raw materias + Rs 3.6 akh, other expenses @ Rs 30,000 per month).

196 Financia Management Chapter-8 Cash Management and Marketabe Securities A thorough understanding of why and how a firm hods cash requires an accurate conception of how cash fows into and through the enterprise. Figure depicts the process of cash generation and disposition in a typica manufacturing setting. The arrows in the Jinge show the fow is, whether the cash baance is being increased or decreased. The firm experiences irreguar increases in its cash hodings from severa externa sources. Funds can be obtained in the financia markets from the sae of securities, such as bonds, preference shous and equity shares or through debt contracts with enders such as commercia banks. These irreguar cash infows do not occur on a daiy basis. They tend to be episodic, in that the financing arrangements that give rise to them are effected at wide intervas. The reason is that externa financing contracts usuay invove huge sums of money stemming from a major need identified by the company s management, and these needs do not occur every day. For exampe, a new product might be in the process of aunched, or a pant expansion might be required to provide added productive capacity. In most organisations the financia officer responsibe for cash management aso contros the transactions that affect the firm s investment in marketabe, securities. As excess cash becomes temporariy avaiabe, marketabe securities wi be purchased. When cash is in short suppy, a portion of the marketabe securities portfoio wi be iquidated. Whereas the irreguar cash infows are from externa sources, the other main sources of cash to the firm arise from interna operations and occur on a more reguar basis. Over ong periods the argest receipts wi come from accounts receivabe coections and to a esser extent from direct cash saes of finished goods. Many manufacturing concerns aso generate cash on a reguar basis through the iquidation of scrap or obsoete inventory. In the automobie industry arge and costy machines caed chip cruisers grind waste meta fine scrap that brings considerabe revenue to the major producers. At various times fixed assets may aso be sod, thereby generating some cash infow. This is not a arge source of funds except in unusua situations where, for instance, a compete pant renovation may be taking pace. Apart from the investment of excess cash in near-cash assets, the cash baance wi experience reductions for three key reasons. First, on an irreguar basis withdrawas wi be made to (1) pay cash dividends on preferred and common shares, (2) meet

Cash Management and Marketabe Securities 197 interest requirements on debt, (3) repay the principa borrowed from creditors, (4) buy the firm s own shares in the financia markets for use in executive compensation pans or as an aternative to paying a cash dividend, and (5) pay tax. Again, by an irreguar basis we mean items not occurring on a daiy or highy frequent schedue. Second, the company s capita expenditure program wi designate that fixed assets be acquired at various intervas. Third, inventories wi be purchased on a rather reguar basis to ensure a steady fow of finished goods off the production ine. Note that the investment in fixed assets with the inventory account does invove depreciation. This indicates that a portion of the cost of fixed assets in charged against the product coming of the assemby fine. This cost is subsequenty recovered through the sae finished goods inventory, as the product seing price wi be set by management to cover a of the costs of production, incuding depreciation. The variety of infuences we have mentioned that constanty affect the cash baance hed by the firm can be synthesized in terms of the cassic motives for hoding cash, as identified in the iterature of economic theory. Motives for Hoding Cash In a cassic economic treatise John Maynard Keynes segmented the firm s or any economic units demand for cash into three categories: (1) the transactions motive, (2) the precautionary motive, and (3) the specuative motive. Transactions Motive Baances hed for transactions purposes aow the firm to dispense with cash needs that arise in the ordinary course of doing business. Transactions baances woud be used to meet the irreguar outfows as we as the panned acquisition of fixed assets and inventories. The reative amount of transactions cash hed with be significanty affected by the industry in which the firm operates. If revenues can be forecast to fa within a tight range of outcomes, then the ratio of cash and near cash to tota assets wi be ess for the firm than if the prospective cash in fows might be expected to very over a wide range. In this regard, it is we known that utiity concerns can forecast cash receipts quite accuratey, owing demand for their services arising from their quasi-monopoy status. This enabes them to stagger their biings throughout the month and to time to coincide with their panned expenditures. Infows and outfows of cash are thereby synchronised. Thus, we woud expect the cash hodings of utiity firms reative to saes or assets to be ess than those associated with a major retai chain that ses groceries. The concern experiences a arge number of transactions each day, amost a of which invove an exchange of cash.

198 Financia Management The Precautionary Motive Precautionary baances are a buffer stock of iquid assets. This motive for hoding cash reated to the maintenance of baance to be used to satisfy possibe, but as yet indefinite, needs. In our discussion of transactions baances we saw that cash fow predictabiity coud affect a firm s cash hodings through synchronisation of receipts and disbursements. Cash fow predictabiity aso has a materia infuence on the firm s demand for cash through the precautionary motive. The airine industry provides a typica iustration. Air passenger carriers are pagued with a very high degree of cash fow uncertainty. The weather, rising fue costs, and continua strikes by operating personne make cash forecasting a most difficut activity for any airine company. The up short of this probem is that because of a the things that might happen, the minimum cash baances desired by the management of the air carriers tend to be arge. In addition to cash fow predictabiity the precautionary motive for hoding cash is affected by the firm s access to externa funds. Especiay important are those cash sources that can be tapped on short on short notice. Book banding reationships and estabished ines of credit can reduce the firm s need to keep cash on hand. This unused borrowing power wi obviate somewhat the need to invest in precautionary baances. In actua business practice the precautionary motive to a arge extend by the hoding of a portfoio of iquid assets, not just cash. In arge corporate organisation, funds may fow either into or out of the marketabe securities portfoio on a daiy basis. Because actua rate of return can be earned on the near-cash assets, compared with a zero rate of return avaiabe on cash hoding, it is ogica that the precautionary motive wi be met in part by investment in marketabe securities. The Specuative Motive Cash is hed for specuative purposes in order to take advantage of hoped for, profit making situations. Construction firms that erect private dweings wi at times accumuate cash in anticipation of a significant drop in umber costs. If the price of buiding suppies does drop, the companies that buid up their cash baances stand to profit by purchasing materias in arge quantities. This wi reduce their cost of goods sod and increase their net profit margin. Generay, the specuative motive is the east important component of a firm s preference for iquidity. The transactions and precautionary motive account for most of the reasons why a company hods cash baances. Decisions that concern the amounts of iquid assets to hod rest with the financia officer responsibe for cash management. A number of factors that can be expected to infuence the financia officer s investment in cash and near cash have just been reviewed. Not

Cash Management and Marketabe Securities 199 a of these factors affect every firm. Moreover, factors that do affect many companies wi do so in differing degrees. Since the executives responsibe for the utimate cash management choices wi have different risk-bearing preferences, we might expect that iquid asset hoding among firms woud exhibit considerabe variation. Cash Management Objectives and Decisions Risk Return Trade off A company wide cash management must be concerned with minimising the firm s risk of insovency. In the context of cash management the term insovency is used to describe the situation where the firm is unabe its maturing iabiities on time in case the company is technicay insovent in that it acks the necessary iquidity to make prompt payment on its current debt obigations. This probem coud be met quite easiy by carrying arge cash baances to pay the bis that come due. Production, after a, woud soon come to hat shoud payments for raw materia purchases be continuay ate or omitted entirey. The firm s suppiers woud cut off further shipments. In fact, the fear of irritating a key suppier by being past due on the payment of a trade payabe does cause some financia managers to invest in too much iquidity. The management of the company s cash position, though, is one of those major probem areas where you are criticized if you don t and criticized if you do. True, the production process wi eventuay be hated shoud too itte cash be avaiabe to pay bis. If excessive cash baances are carried, however, the vaue of the enterprise in the financia marketpace wi be suppressed of the arge cost of Income forgone. The expicit return earned on ide cash baances is zero. The financia manager must strike an acceptabe baance between hoding too much cash and too itte cash. This is the foca point of the risk-return tradeoff. A arge cash investment minimises the chances of insovency but penaises company profitabiity. A sma cash investment frees excess baances for investment in both marketabe securities and onger-ived assets; this enhances company profitabiity and thereby the vaue of the firm s common shares but increases the chances of running out of cash. Objectives The risk-return tradeoff can be reduced to two prime objectives for the firm s management system: 1. Enough cash must be on hand to dispense effectivey with the disbursa needs that arise in the course of doing business. 2. The firm s investment in ide cash baances must be reduced to a minimum.

200 Financia Management Evauation of these operationa objective, and a conscious attempt on the part of management to meet them, gives rise to the needs for some typica cash management decisions. Decisions Two conditions woud aow the firm to operate for extended periods with cash baances near a eve of zero: (1) a competey accurate forecast of net cash fows over the paning horizon and (2) perfect synchronisation of cash receipts and disbursements. Cash fow forecasting is the initia step in any effective cash management programme. This is usuay accompished by the finance function s evauation of data suppied by the marketing and production functions in the company. The device used to forecast the cash fows over the panning period is the cash budget. Cash-budgeting procedure are expained in the atter part of new chapter it is emphasized though, that the net cash fows pinpointed in the forma cash budget are mere estimates, subject to considerabe variation. Thus, a totay accurate cash fow projection is ony an idea, net a reaity. Our discussion of the cash fow process depicted in Figure 1 showed that cash infows and outfows are not synchronised. Some infows and outfows are irreguar; other are more continua. Some finished goods are sod directy for cash but more ikey the saes wi be on account. The receivabes, then wi have to be coected before a cash infow is reaised raw materias have to be purchased, but severa suppiers are probaby used, and each may have its own payment date further, no aw of doing business coections to coincide with raw materia payments dates. So the second criterion that woud permit operation of the firm with extremey ow cash baances is not met in actua practice either. Given that the wi as a matter, of necessity, invest in some cash baances, certain types of decisions reated to the size of those baances dominate the cash management process. These incude formuation of answers to the foowing questions: 1. What can be done to speed up cash coections and show down or better contro cash outfows? 2. What shoud be the composition of our marketabe securities portfoio? 3. How shoud our investment in iquid assets be spit between actua cash hodings and marketabe securities? Cash Forecasting One objective of cash management is ceary to ensure that the business does not run short of cash. There must aways be enough cash avaiabe to meet iabiities as they fa due. Equay the business shoud not have much more cash than what it requires. The financia manager must be aert for opportunities to make use of any cash temporariy in excess of current needs.

Cash Management and Marketabe Securities 201 To ensure that these aims are met, it is necessary to know in advance as accuratey as possibe when cash shortages or cash surpuses are ikey to occur, so that action can be panned to dea with these eventuaities. Cash management depends on cash forecasting. The most convenient type of cash forecast for this purpose is the receipts and payment forecast, because it buit up in the same form as that used for recording actua transactions in the books of account. A typica form of receipts and payment forecast is iustrated beow, and it covers a period of three months with monthy rests. The first item, coection of debts, is derived from two sources: The outstanding debtors ist at the commencement of the forecast period. Such ists shoud be under continuous review as part of the company s credit contro procedure, and it shoud be possibe to enter the expected coections under the various future months; Estimates of saes invoicing over the next three months. The invoice estimates wi be converted into coection estimates using the company s norma credit period, with adjustments for any major items to which specia credit terms appy, or where deays may be anticipated. The coaboration of the saes department is needed in deveoping these forecasts. Other cash receipts may incude cash saes (probaby extrapoated from past experience), interest receivabe at known due dates, and dividends receivabe so far as these can be forecast. A major item of cash outfow wi be payments to suppiers. It wi be convenient for contro if a items that are deat with through the purchase edger are grouped together, though various managers wi be invoved in forecasting transactions of different types. Basicay the purchasie manager must be required to prepare a forecast of purchase orders due to be paced month by month.

202 Financia Management FORM OF RECEIPTS AND PAYMENTS FORECAST Company. (figures in Rs. thousands) Quarter Tota 1 st Receipt and Payment Forecast One Year..19. 2 nd 3 rd Month Month Month Coection of Debt Due Now Future Invoicing by Quarter Other Income Tota Income Payments Creditors Now Future Purchases by Quarter Quartery Payro Petty Cash Payments Periodic Payments Bank Charges Other Payments Tota Outstandings Bank Overdraft Opening -- Cosing Simiar to the debtors forecast, the payments to creditors forecast wi start with a ist of accounts payabe outstanding at the commencement of the forecast period. This and the purchases forecast wi have to be converted into a forecast of payment due dates, using the credit terms agreed by the purchasing manager. The remaining payments wi be forecast under the headings most suitabe for comparison with source documents, for exampe: net wages and saaries for comparison with payros; petty cash items in tota for comparison with the petty cash book; specia cheque payments and bank standing orders (anaysed by type of expense to ensure the none is forgotten), which wi probaby be compared with anaysis coumn in the main cash book.

Cash Management and Marketabe Securities 203 Each month the net cash fow inwards or outwards is cacuated and adjusted on the previous month s cash baance to give the new month-end baance. It is thus possibe to see whether at any time surpus funds wi be avaiabe. If, on the other hand, the forecast shows excess demands which cannot be met from the avaiabe cash overdraft faciities, then it wi be necessary to review the forecast and to make pans for modifying the timing of particuar cash fows so as to restore an acceptabe baance. A monthy contro report shoud be prepared. This wi have the same ine anaysis as the forecast, and wi set out the forecast and actua cash movements on each ine and the variances between them. These variances must be anaysed by cause and responsibe factors so that action can be taken to improve cash contro for the future. The Cash Budget When a cash forecast shows unsatisfactory cash baance throughout, it wi probaby be necessary to consider ways of obtaining additiona capita. But as cash shortages are forecast ony as short-term features within a genera satisfactory trend, each item in the forecast shoud be scrutinised for possibe modification to either: a) timing: or b) amount. The possibiity of changes in amount shoud be deat with first, because an improvement in tota coectibes or a reduction in tota payabes is of greater benefit to the business than the mere shifting of an item from one time period to another. In reation to saes income, forecast saes quantities and prices coud be reviewed, but care must be taken that this eads to a new figure which is genuiney expected to occur, and is not just a change from a moderate to an optimistic forecast. Because of the variety of possibiities (and often their reativey sma amounts), misceaneous receivabes may have been ignored by and it is possibe that in tota they coud have a significant effect on the cash position. Three particuar exampes are: Saes of scrap, possiby after sorting and ceaning; Disposas of underutiised fixed assets; Saes of surpus stock. In each case the potentia saes proceeds have to be compared with the opportunity cost of reinquishing the assets. In attempting to reduce the amount of proposed expenditure a good starting point is to cassify the various items between those that are essentia to current operations and those that are discretionary. Discretionary expenses may incude such items as

204 Financia Management subscriptions and donations, books and pubications, advertising and pubicity. Such expenditure can be reduced without causing short-term damage to the business. There is nothing ike shortage of cash (rea or induced) to get every manager reviewing the effectiveness of his expenditure (though there must be strong centra co-ordination to ensure that short-term savings do not ead to onger-term osses): Ensuring that responsibiities have been aocated for rigorous progress action on over-due or disputed customer accounts, and that the cash forecast incorporates the coection of such items at target dates; Scheduing the essentia payments in such a way that the cash baance is preserved with the east impairment of good reations with the creditors. Once we have the cash back, we have to manage it too ti the time it is utiised in paying for the purchases and other expenses. The primary purpose of cash in business is to make possibe those transactions necessary to set up the business and run it day by day. Before discussing the contro of cash, therefore, it is hepfu to ook at the various transactions in respect of which cash wi be received or disbursed. We sha refer to this severa times, but for our immediate purpose the important features are as foows: The tota cash avaiabe in hand or in the bank at any time is represented by the arge box eft-centre of the diagram; The cash baance with which the business was first estabished wi have been obtained by an injection of capita as shown in the top eft-hand corner of the chart; During the course of the norma trading, manufacturing or service operations of the business, cash wi be paid out for the purchase of goods, materias and suppies, for wages and saaries, and for various other expenses such as traveing, postage, insurance and so on; The marketabe items or services emerging from this expenditure wi be sod to customers who wi pay for them and thus reinstate the cash baance; If this cyce of events happened instantaneousy, then so far as operating transactions were concerned there woud never be any shortage of cash.

Cash Management and Marketabe Securities 205 Business Cash Fows Fresh Capita Saes, Profit Stocks Debtors Overdraft Cash Creditors Purchases Cash credit Cash Receivabes Wages Expenses Dividends & Capita Tax Interest Expenditure The net effect of these deays wi have been mitigated because one must hope that saes vaues wi have been in excess of the reevant outays; i.e., they wi have a markup for profit. This profit, however, has to cover three further items, isted beow: The majority of businesses wi require fixed assets-and, buiding, pant, machinery, motor vehices, etc. (The outay on these is shown at the bottom right of the chart as capita expenditure.) This disbursement has to be made before profits can be earned, and wi ony be recouped over a proonged of time, the recovery being represented by a depreciation charge in arriving at the profit mark-up. Athough it is not shown on the chart it is possibe to impose a deay factor on acquisition of fixed assets in various ways. Profit, after aowances for capita expenditure, wi give rise to demand for tax. The tax payment wi probaby occur sometime after a profit has been earned, but wi be eventuay be a compete oss to the cash system of the business; The suppiers of capita to the business must be remunerated. Interest payments wi be required periodicay and reguary, athough dividend payments wi be made ony if the profits are considered sufficient to justify them. But both types of payments wi again be osses to the cash system. Cash fows wi be managed, therefore, by controing: 1. Working capita the contro of debtors, stock and creditors 2. Profit margins; 3. Capita expenditure 4. Taxation - tax management is a highy speciaised subject outside the scope of this study

206 Financia Management 5. Interest and dividends dependent on the capita structure of the company. The first and the biggest component of cash management is the eve of cash which is supposed to come in. Cash forecasting was discussed earier. Its importance in cash management cannot be undermined. Once we have forecasted the eve of cash that is supposed to come in over the next few periods, then we can ook at what is the base eve we need for our operations. Managing Coections and Disbursements The size up our probem of cash management et us examine the fow of cash through a firm s accounts. It is usefu to think of the process as cyce in which cash is used to purchase materias, from which are produced goods, which are then sod to customers, who ater pay their bis. The firm receives cash from its customers and the cyce repeats. Opportunities to improve efficiency in coecting and disbursing funds centre on fows through the current section of the baance sheet. Let us assume that XYZ Corporation orders raw materias at point A and receives them 14 days ater at B. Terms of 2/10, net 30 are offered, so the firm pays the invoice 10 days ater C. However, it takes 2 days for the cheque to cear, and XYZ s bank account is not changed unti point D. XYZ turns its inventory six times per year, so 60 days after the materias are received, the product is sod and the customer is bied, the coection period is 30 days, 28 for the customer to pay and 2 for the cheque to arrive by mai(g). XYZ processes the payment and deposit it 2 days ater at H. Another 2 days eapses whie XYZ s bank coects the funds from the customer s bank. The firm s tota financing requirements is affected by the tota time ag from point B to point J. The firm itsef can contro some factors that determine the various ags, but some it cannot. Some of the ags affect the cash baance, whie others affect other components of working capita such as accounts receivabe and inventory. In addressing ourseves to Cash management, we are concerned with time periods BCD and FGHJ. Time period AB is beyond the firm s contro and does not directy affect its financia statements, athough it may affect production schedues. Time period DE is determined by the firm s production process and inventory poicy, and affects the tota investment in inventory. Time period EF is determined by the firm s credit terms and the payment poicies of its customers, and affect the tota investment in accounts receivabe we wi examine the management of inventory and accounts receivabe in the next chapter. Our present task is to examine what can be done to improve the efficiency of a firm s cash management. We wi focus on three areas: concentrating working baances speeding coections, and controing disbursements.

Cash Management and Marketabe Securities 207 Concentrating Banking Many firms need ony a singe bank account. Larger firms that operate over wide geographica areas usuay need more than one, sometimes dozens. Where many accounts are needed, concentration accounts can be used to minimise the tota requirement for working baances. Suppose a company has a number of branch offices, each with a oca bank account. Branches coect accounts receivabe and make deposits in their oca accounts. Each days, funds above a certain predetermined minimum are transferred to a centra concentration account, usuay at the firm s headquarters. The daiy transfer of funds can be made either by a depository transfer check or by wire transfer; the atter is faster but more expensive. The funds transferred to the concentration account are avaiabe for disbursement for other purpose. As we wi see ater, the more variabe a firm s cash fows, the higher the requirement for working cash baances. By pooing its funds for disbursement in singe account, the aggregate requirement for working baances is ower than it woud be if baances were maintained at each branch office. Concentration in short, permits the firm to store its cash more efficienty. Speeding Coections Another means of conserving cash is to reduce the ag between the time the customer mais the cheque and the time the funds become coected, that is, from points F to J of the 6 days ag, 2 days are due to mai time, 2 days are due to processing time within XYZ Corporation, and 2 days are due to coection time within bank. We wi have more to say ater about coection within the banking system. Let us now focus on the 4 days ag from F to H. Sma firms that operate in imited geographica areas often can do itte to reduce mai time. However, improvements often can be made in processing time within the firm. Suppose XYZ Corporation has credit saes of Rs 5 crore per year. With approximatey 250 working days per year, XYZ s coections average Rs 20,000 per working day. If XYZ coud reduce it by Rs 20,000, (XYZ s borrowing cost was 9 per cent) saving of about Rs 1,800 per year woud be reaised. These potentia saving coud be compared to the cost of faster processing to determine whether the change in processing shoud be made. We can concude that interna processing shoud be speeded up to the point at which the costs of further improvement exceed the savings. A second step that may be advantageous is to estabish a ock-box system, which often can reduce mai and processing time sti further. The firm first estabishes a number of coection points, taking account of customer ocations and mai schedues. At each ocation, the firm rents a post office box and instruments its customers to remit to the

208 Financia Management box. The firm s oca bank is authorised to pick up mai directy from the box. The bank does so, perhaps severa times a day and deposits the cheque in the firm s account. The bank made a record of names and amounts and other data needed by the firm for interna accounting purpose, and immediatey enters the cheques for coections. The ock-box system resuts in two benefits to the firm: First, the bank performs the cerica tasks of handing the remittances prior to deposit, services which the bank may be abe to perform at ower cost. Second, and often more important, the process of coection through the banking system begins immediatey upon receipt of the remittance and does not have to wait unti the firm competes its processing for interna accounting purpose. In the activity represented by HJ now takes pace simutaneousy with GH. The firms processes remittances for interna accounting purpose using data suppied by the bank and can schedue this processing at any time without deaying coection. Using a ock-box system as much as 4 days in maiing and processing time can be reduced. Banks change for their services in connection with a ock-box pan either via fees or compensating baance requirements. Whether the savings wi outweigh the costs for a particuar company depends mainy on the geographica dispersion of customers the rupee amount of the average remittance, the firm s cost of financing. We see that a major advantage of speeding coections is the free cash and thereby reduce the firm s tota financing requirement. There are other advantages as we. By transferring cerica functions to the bank, the firm may reduce its costs, improve interna contro, and reduce the possibiity of fraud. By getting cheque to banks on which they are written sooner, the incidence of cheques dishonoured for insufficient funds may be reduced. Coection Time in the Banking System We have made severa references to the time required to coect a cheque through the banking system but we have made no proposas to shorten it. Let us be more specific about what is invoved. Suppose a customer in New Dehi, purchases eectronics equipment from a firm in Mumbai, and remits with a cheque drawn on a New Dehi Bank. The seer deposit the cheque in a bank in Mumbai, but the funds are not avaiabe for use unti the cheque has been presented physicay to the New Dehi bank, a process that depends on mai service between the two cities and may take severa days. A very extensive cearing network has been estabished in India that invoves the commercia banks and the RBI. In the majority of cases, cearing times has been reduced to 2 days or ess using the faciities of the direct inter-bank cearing. In the matter of cheque cearing, the banks are the experts, and firms usuay can rey on their banks to minimise the time requirements.

Cash Management and Marketabe Securities 209 Controing Disbursements Just as speeding coections turns accounts receivabe into cash and thereby reduces the firm s financing requirements. Sowing disbursements does the same. In earier chapter, we discussed trade credit as a source of funds. There we concude that the proper poicy was to pay within the terms agreed upon taking cash discounts when offered. We concude aso that is no point in paying sooner than agreed. By waiting as ong as possibe, the firm maximises the extent to which accounts payabe are used as a source of funds, a source which requires no interest payment. Firms with expense-generating activities that over a wide area often find it advantageous to make disbursements from a singe centra account. In that way, schedues can be tighty controed and disbursements can be made on exacty the right day. An aternate arrangement is to disburse from decentraised ocations, but to wire transfer the exact amount needed in each oca account for a disbursement schedued that day. Some firms find it advantageous to expoit the cheque book foat, which is the time between the writing of a cheque and its presentation for coection, represented by CD. If this ag can be expoited, it offsets at east partiay the ag in the other direction in coecting cheques from customer (HJ). Because of ag CD, a firm s baance on the bank s books is higher than in its own cheque book. Knowing this, a firm may be abe to reduce its working cash requirements. Banks understand cheque book foat aso, and can be expected to set compensating baances and fees based on baances on their (the banks) books. If a firm expoits cheque book foat too far, it increases the ikeihood of cheques being dishonoured for insufficient funds and the accompanying dispeasure of both bank and payee. Determining the Appropriate Working Cash Baance Let us assume the firm now is coecting, and disbursing its cash as efficienty as possibe. Given its ong-term financia structure fixed assets ong-term iabiities, and equity its tota cash position at any time is determined by its operating pan. Suppose tota cash is more than the firm needs for operating purposes, if disbursements are made according to pan. The Neptune Company projected a tota cash baance as high as Rs 4,89,000 in November. Shoud a these funds be kept in Neptune s current account? Since current accounts earn no interest, it is to Neptune s advantage to eave ony the amount necessary to operate, and to invest the remainder temporariy in interest-bearing iquid assets unti needed. Our probem, then, is to determine how much cash a firm shoud maintain in its current account as a working baance. We wi address this question here, and in the next section discuss the investment of amounts above the working baance.

210 Financia Management The working baance is maintained for transaction purposes for paying bis and coecting payments on accounts receivabe. If the firm maintains too sma a working baance, it runs out of cash. It then must iquidate marketabe securities if avaiabe, or borrow. Liquidating marketabe securities and borrowing both invove transaction costs. If, on the other hand, the firm maintains too high a working baance, it foregoes the opportunity to earn interest on marketabe securities, that is, it incurs what economists refer to as an opportunity cost. Thus, the answer we seek is the optima working baance, rather than the minimum. Finding the optimum invoves a tradeoff of transaction costs against opportunity costs. If a firm tries to keep its working baances ow, it wi find itsef seing securities (and ater repurchasing securities) more often than if it aims at a higher eve of working baances, that is, transaction costs fa as the working baance eve rises. Opportunity costs, on the other hand, rise as the eve of working baances rises. There is one point where the sum of the two costs is at a minimum. This is the point efficient management shoud try to find. Compensating Baance Requirements If a firm uses bank credit as a source of financing, the question of the optima current account baance may have a simpe answer: it may be dictated by its compensating baance requirements to compensate for various services such as processing cheques and standby commitments to end. In some cases, a firm may determine with very itte anaysis that it optima working baance is beow the bank s compensating baance requirement. In such cases, the atter figure becomes the firm s minimum current account baance. In other cases, where the answer is not so cear or where compensating baances are not required. We must put penci to paper to determine the appropriate working baance. Finding the Optima Working Baance Having done a we can to improve our coection and disbursement procedures, et us now take the pattern of receipts and disbursement as given. Over any time period, a firm s beginning and ending cash baances are reated as foows: Ending baance = Beginning baance + Receipts Disbursement If receipts and disbursements we constant each day, we woud know with certainty what each woud be each day and our probem woud be simpe. Since receipt aways woud exceed disbursements by the same amount, we count withdraw the ending baance each day and use it for other purposes. In practice, we have two probems: variabiity

Cash Management and Marketabe Securities 211 and uncertainty. In most firms, receipts and disbursements vary both over the month and over the year. Over a month, receipts and disbursements for current operating expenses are ikey to show some variation, perhaps in a reguar pattern. In seasona firm, the amounts aso wi vary over the year ess frequent outays. Such as those for capita expenditure, taxes, and dividends, introduce sti more variabiity. Some of this variabiity may be predictabe, but some probabe is not. Let us examine these two probems variabiity and uncertainty separatey. Variabiity Suppose receipts and disbursements both vary and are not synchronised, but the variations are competey predictabe. Determining the appropriate working baance in the face of non-synchronous but predictabe cash fows is a probem of minimising tota costs. If we set the baance too ow, we incur high transaction costs; one might say we make too many trips to the bank. If we set the baance too high, we ose too much interest on marketabe securities. The determination of the optima working baance under conditions of certainty can be viewed as an inventory probem in which we baance the costs of too itte cash (transaction costs) against the costs of too much cash (opportunity costs). If the cash shortage becomes severe enough, we may begin to forego cash discounts on purchases, adding another eement of opportunity cost. Forma modes of the cash baance probem have been deveoped using inventory theory. Inputs to such a mode are the tota net cash outfow over the period of time in question, the transaction costs of repenishing the cash baance by seing securities or borrowing, and the interest rate that can be earned on securities. The answer given by the mode tes us how often and in what amounts funds shoud be transferred to the checking account from other sources. Uncertainty Receipt and disbursements are very sedom competey predictabe. If we go to the opposite extreme and assume receipts and disbursements for the difference between them) to be competey random, a different kind of mode can be deveoped using the technique of contro theory. In addition to information on transaction costs and interest rates on securities, we need a measure of the variabiity of net cash fows. Using these data, we can determine the optima maximum and minimum baances in the firm s checking account, denoted by eves X and Y. In the firm s working cash baance fuctuates randomy in response to random infows and outfows. At time t 1, the baance reaches the upper contro imit Y. At that

212 Financia Management point, (Y X) money is transferred out of the cash account and into marketabe securities. The baance continues to fuctuate, faing to zero at t 2, at which time X vaue of marketabe securities are sod and the proceeds transferred to the working baance. The contro imit mode thus gives an answer in terms of maximum and minimum baances and provides a decision rue, rather than a fixed schedue of transfers as did the simpe inventory mode. One of the important insight of the contro imit mode is that, where cash fows are uncertain, the greater the variabiity the higher the minimum baance. Using Mathematica Modes Forma mathematica modes such as those mentioned above are usefu for increasing our understanding of the cash management probem and providing insights and quaitative guidance. The modes te us which factors are important and make the tradeoffs expicit. We see, for exampe, that transaction costs pay a centra roe. If transaction costs were zero, the firm woud require no working cash baance at a; it simpy woud se securities or borrow to pay every bi. Are forma mathematica modes aso usefu for quantitative appications? In practice, the cash fow patterns of most firms are party predictabe and party random. Neither the inventory mode nor the contro imit mode is stricty appicabe. By combining the insights from forma modes with the techniques of cash budgeting and pro forma anaysis, many firms can arrive at reasonabe answers by experience and experiment. In deciding how far to go in anaysing the probem, we must consider the cost of the anaysis. Except in the case of very arge firms, quantitative soutions to the cash baance probem using forma mathematica modes are ikey to be uneconomica. Often, the cost of obtaining the necessary input data and operating the mode exceeds the savings over soutions that can be attained by experience and experiment. As aways, we must keep an eye on the cost of our anaytica techniques as we as on the benefits. Panning Cash Requirement In most cases, to search for the optima working cash baance probaby overstates our capabiities; we must be content to get reasonaby cose. Perhaps we shoud substitute the word appropriate for optima. The current account baance that the firm shoud maintain is the compensating baance requirement, or the optima working baance. Whichever is greater. Some firms, especiay those with seasona saes patterns, may find that the appropriate working baance varies somewhat over the year. As a firm grows, the appropriate working cash baance aso wi grow, athough probaby not proportionay. Once we have setted on the appropriate baance to be maintained in the current account,

Cash Management and Marketabe Securities 213 we can integrate cash management into the financia panning process. The projected current account baance goes into the pro forma baance sheet. Any excess cash over that figure then may be invested in interest-bearing assets. Investing Ide Cash Cash in excess of requirements for working baances normay is invested in interest bearing assets that can be converted readiy to cash. A firm might hod excess cash for two principa reasons; First, the firm s working capita requirement may very over the year, perhaps in a fairy predictabe manner if the variation is due to recurring seasona factors. From the pro forma baance sheet, it was apparent that excess cash woud buid up during seasona ows in accounts receivabe and inventory, and woud be needed ater to finance a re-expansion of receivabes and inventory during the next seasona high. We can view the excess cash as a part of the firm s transaction baances. Even though the cash is temporariy ide, there is a predictabe requirement for it ater. Second, excess cash may be hed to cover unpredictabe financing requirements. In a word of uncertainty, cash fows can never be predicted with compete accuracy. Competitors act, technoogy changes, products fai, strikes occur, and economic conditions vary. On the positive side, attractive investment opportunities may suddeny appear. A firm may choose to hod excess cash to finance such needs if and when they occur. We noted earier that cash hed for such purposes is referred to as a precautionary baance and usuay in invested in interest-bearing assets unti needed. An aternative exists to the hoding of excess cash for either of the two purposes described above. The firm can simpy borrow short-term to finance variabe requirements as they arise. Under such a poicy, the firm woud never hod excess cash. A firm s choice between short-term borrowing versus iquid assets as a means of financing variabe requirements wi depend on poicy decisions with respect to the firm s ongterm financia structure, particuary the mix of short-term and ong-term funds. We wi discuss overa financia structure and the reationship between maturity structure and iquidity ater. Here, we take as given the ong-term structure and the amount avaiabe for investment in interest-bearing assets. Investment Criteria A firm might invest excess cash in many types of interest-bearing assets. To choose among the aternatives, we must estabish criteria based on our reasons for investing excess cash in the first pace. We are investing either temporary transaction baances or precautionary baance or both. When we need the cash, we want to be abe to obtain it-a of it-quicky. Given these objectives, we can rue out equity share and other investments with returns that are not contractua and with prices that often vary widey.

214 Financia Management Debt securities, with a contractua obigation to pay, are our best candidates. In seecting among debt securities, there are three principa characteristics we shoud examine: defaut risk, maturity and marketabiity. Defaut risk refers to the possibiity that interest or principa might not be paid on time and in the amount promised. If the financia markets suddeny perceive a significant risk of defaut on a particuar secuar security. The price of the security is ikey to fa substantiay, even though defaut may not actuay have occurred. Investors in genera are averse to risk, and the possibiity of defaut is sufficient to depress the price. Given our purposes in investing excess cash, we want to steer cear of securities that stand any significant chance of defauting. In an uncertain word, there is no guarantee that is absoutey certain. With its capacity to create money. However, there are securities avaiabe with defaut risk that is sufficienty ow to be amost negigibe. In seecting securities, we must keep in mind that risk and return are reated, and that ow-risk securities provide the owest returns. We must give up some return in order to purchase safety. Maturity refers to the time period over which interest and principa payments are to be made. A 20 years bond might promise interest semiannuay and principa at the end of the twentieth year. A 6-month bank certificate of deposit woud promise interest and principa at the end of the sixth month. When interest rates vary, the prices of fixed-income securities vary. A rise in market rates produces a fa in price, and vice versa. Because of this reationship, debt securities are subject to a second type of risk. Interest rate risk, in addition to defaut risk. A government bond, though free of defaut risk, is not immune to interest rate risk. The onger the maturity of a security, the more sensitive its price is to interest rate changes and the greater its exposure is to interest rate risk. For this reason, short maturities are generay best for investing excess cash. Marketabiity refers to the ease with which an asset can be converted to cash. With reference to financia assets, the terms marketabiity and iquidity often are used synonymousy. Marketabiity has two principa dimensions-price and time-that are interreated. If an asset can be sod quicky in arge amounts at a price that can be determined in advance within narrow imits, the asset is said to be highy marketabe or highy iquid. Perhaps the most iquid of a financia assets are Treasury Bis. On the other hand, if the price that can be reaised depends significanty on the time avaiabe to se the asset, the asset is said to be iiquid. The more independent the price is of time, the more iquid the asset. Besides price and time, a third attribute of marketabiity is ow transaction costs.

Cash Management and Marketabe Securities 215 Yieds A the characteristics we discussed above-defaut risk, maturity, and marketabiityaffect yied. In genera, the ower the defaut risk and the better the marketabiity, the ower the yied. Securities with these desirabe characteristics have higher prices, and since price and yied are inversey reated, ower yieds. The reationship between maturity and yieds is more compex and changes over time. On an average, short maturities yieds ess, other factors being equa, because they are subject to ess interest rate risk. Rates on short maturities, however, are more voatie than those on onger maturities, and at times exceed the atter. At any point in time, rates on the major types of money-market securities discussed above are fairy cose to one another. For equa maturities, the differentias usuay are sma and are due to sma differences in defaut risk and marketabiity. Over time, the entire structure of short-term rates varies significanty. Such variations are reated to the business and monetary cyces, the demand for funds by individuas and firms, and the credit poicies of the RBI. Coection & Disbursement Systems Primary objective of a coection system is to receive vaue from the buyer as quicky as possibe. Secondary objective is to receive and process information associated with the payment. The onger the deays the more the funds that wi be tied up in it. If we define the system in terms of the inear programming mode, the objective function that we need to minimise is: Objective function: Minimise Cost of coection foat Vaue of payment information Vaue of reationship with payers + Coection system costs + Cost of osses through theft/ fraud + means that the function is to go with the objective (i.e., here to minimise) and - means that it has to go against the stated objective (i.e., to maximise rather than minimise in this case) What is a foat? Foat coud be defined as the amount of funds represented by checks that have been issued but not yet coected. OR

216 Financia Management It coud be defined as the time between the deposit of checks in bank and its payment. Due to the time difference, many firms are abe to pay the foat, that is, to write checks against money not presenty in the firm s bank account. There are different kinds of foats that the firm has to encounter. These incude: Coection Foat Time taken to reaise the money after the company has received the cheque from the debtors. Mai Foat Time that eapses from the maiing of the cheque unti its receipt. Processing Foat Processing time after the cheque is received and before it is deposited with the bank. Avaiabiity Foat Time taken from the deposit of the cheque to the funds being avaiabe in the bank. The ast two items together make up deposit foat and a the three items make up the coection foat. Foat measurement Foat is usuay measured in rupee-days, which are cacuated by mutipying the time ag in days by the rupee amount being deayed. Foat can be measured either on each item that is processed or on an average daiy basis. Cost of Coection Foat The cost is determined by the foowing formua: money in foat * no. of days * daiy interest rate * frequency of payment Vaue of Payment Information Matching payments to accounts in a timey and accurate manner. The biggest utiisation is to update the systems so that actua positions of funds in the accounts are avaiabe. Vaue of Reationship with Payee Deays in posting may send wrong information to customers. Coud aso cause deays

Cash Management and Marketabe Securities 217 in shipments as you may be withhoding shipments for the payments. Coection System Costs Costs of receiving the money from the customers ti the time the payments reach the office and the cost of processing in the office. Cost of osses from Fraud and Theft Cash coection coud invove frauds and thefts which coud negate the effect of exceent coection systems. Techniques of Cash Management and Marketabe Securities Cash Concentration Systems There are three basic tasks of the cash concentration systems: 1. Receive Deposits 2. Transfer funds to disbursa banks 3. Serve as foca point of short term investments and credit transactions Objective function Minimise Opportunity cost of excess baance Disbursement Systems + Transaction costs - Savings on dua baances + Administration costs + Contro costs Many times the cash is coected from severa paces where the customers are there but is disbursed from the factory premises or the corporate headquarters. So the objective function woud be to maximise the disbursement foats avaiabe without straining the reationships with the suppiers. Objective function: Maximise + Vaue of disbursement foat - Loss of discounts for eary payment - Cost of excess baances in disbursement accounts - Transaction costs + Vaue of payee reations + Vaue from dua baances

218 Financia Management Required Cash Baance - Administration, information and contro costs The question may be designed as whether it is possibe to define the amount of cash which out to be hed at any time? Cash is needed for three reasons: 1. To finance transactions (which was the main theme of the previous paragraphs): 2. As a precaution - a safeguard against the inaccuracies in cash forecasts - bearing in mind that every forecast, by its very nature, wi be inaccurate. 3. For specuative purposes - to take advantage of any profitabe opportunities that arise. What average cash baance then shoud be hed to finance norma transaction, incuding any necessary margin of safety? The word norma is important because it may be assumed that sma deviation from the norm wi be covered by overdraft faciities. This is a question cosey akin to one we sha be asking about stockhodings in the next unit. Attempts are sometimes made to estabish a equation based on: The hoding cost of cash (i.e., the opportunity cost of keeping the cash uninvested; The procurement cost of cash (.i.e., the transaction cost of converting securities into cash, or otherwise obtaining new funds). The estimates used in such cacuations are ikey to be suspected, and the mode to which they give rise is ony appicabe when the demand for cash is reasonaby consistent from period to period. There are two modes used. The first one is Baumo Mode which works exacty on the ines of inventory mode and that is its biggest shortcoming. The second one is Mier- Orr mode which specifies a minimum and a maximum eve of cash in the system and expects the cash eves to move between the two. Let us ook at Mier-Orr mode in sighty more detai. Figure beow gives you the basic functioning of Mier-Orr mode. We can see that The company has estabished upper and ower imits within which it aows the cash eves to operate. If the cash eve touches the upper eve, the company converts extra cash into securities so as to bring it to the target cash baance. It foows the same procedure for the ower imit where it ses securities instead of buying it. This makes it easy for the company to manage cash as the eves of cash is difficut to predict very accuratey. Note that the target cash baance point is at one-third of the distance between the ower and upper eve, from the ower eve instead of haf-way between the two because

Cash Management and Marketabe Securities 219 the company wants to minimise the cash it is hoding. Their studies have shown that this eve is the optimum eve. Cash U* C* X U* is the upper contro imit. L is the ower contro imit. The target cash baance is C* [which is 1/3(U*-L) +L]. As ong as cash is between L and U*, no transaction is made. Y L Tim e Figure: The Mier-Orr Mode Other mathematica modes, too, have been suggested by various authors, but they tend to be mainy of academic interest ony. A simper approach to the definition of the required cash baance is by the use of ratios. One such measure is the ratio between the saes of a period and the opening cash baance: Saes for period Cash turnover = Initia cash baance This is sometimes caed the cash veocity. (The resembance to the stock turnover ratio wi be obvious.) As with a management ratios one is ooking for consistency period by period within the company, or a trend of improvement which, in this case, woud be higher saes per unit of cash hed. If, for exampe, the cash veocity ast period was: Rs.18,000 Cash turnover = = 20x Rs. 9,0000 Then an increase of saes to Rs.2,25,000 without a change in cash hoding woud increase the veocity to 25x. In other words, the cash baance woud have been kept to Rs.9,000 instead of rising to Rs.2,25,000/20 = Rs.11,250, so there woud be saving of interest or a gain at the opportunity cost rate into Rs.2,250. Again, ike other ratios this ratio cannot be used in isoation. An increase in saes without an increase in cash baance might mean that the company had become ess abe to pay its debts as they fe due, possiby signifying that it was over-trading. It might be possibe

220 Financia Management to use this ratio for comparison with an average for the industry, but probaby not with individua firms within the industry, since specia factors might affect the baance hed by a particuar firm at its year-end date (especiay if the businesses were seasona, or if the firm under review were accumuating cash for a specific project). A second ratio quite often found is that between the cash baance and the tota current assets: Pr oporation of cash hed = Cash baance Cash Assets A wide range of figures between different industries wi be found. Based on transaction anaysis or past trends, the company coud set a minimum proportion of cash hodings to current assets with the objective not of using this as an absoute imit but as an opportunity for reviewing the reasons for any deviation from the norm. In genera the use of simpe ratios has a imited vaue in cash panning. There is no adequate substitute for detaied cash forecasts, possiby inked with a financia mode of the business as a whoe. For an outside observer, and to some extent for the board of a company, usefu information can be derived from a trend of iquidity ratios incorporating not merey cash but aso those eements of working capita which are readiy convertibe into cash. This concept of iquidity was buit into the source and appication of funds statement described above. Investing Surpus Funds If the cash forecast for a business shows surpus funds becoming avaiabe, then pans shoud be made for putting them to use. However, the surpuses may be transitory, either because they are being accumuated deiberatey for some purpose such as the purchase of pant or the payment of taxes, or because the business is seasona and the funds wi eventuay be required to finance off-peak activities. It is important to schedue in detai, with frequent reviews, how much money wi be avaiabe for various period of times, so that it can be put to the best possibe use. Sma amounts which are required to be kept iquid are probaby best paced on deposit with a cearing bank or other finance house. The rate of interest wi be ow, but ony short notice is required for withdrawa. When arge sums are avaiabe there is a greater range of investment aternatives. Loans to oca authorities or merchant banks or oca authority bonds, have various terms from days upto five years, so they can be matched to the avaiabiity of funds, however, they are not readiy negotiabe. Negotiabe certificates of deposit issued by the commercia banks overcome this disadvantage, offer a higher rate of interest and can cover a wide range of maturities from three months upwards.

Cash Management and Marketabe Securities 221 The purpose of this type of investment is to squeeze extra profit out of money which is normay in use in the operations of the business. It does not give fu scope for portfoio panning, which is essentia when funds are avaiabe for investment over a ong period. The main principe invoved in panning the investment of short-term cash surpuses is to match investment maturities with cash needs. Before considering investment, therefore, it is necessary to have reiabe cash movements forecast, so that one knows with reasonabe certainty how much cash wi be spare for what period of time. The second principe is to invest for as ong as possibe, because interest rates are higher for ong periods. Opposed to this principe is the need to have a margin of safety, this may be a bank overdraft faciity or may take the form of sighty more iquidity in the investment portfoio than the forecast stricty requires. The size of the fund avaiabe for investment wi have an effect on how profitaby it can be used, both because arge funds can bear the cost of a professiona investment manager and because such funds can be paced directy on the money market rather than through the company s bank. Cost of Hoding Cash Trading costs are increased when the firm must se securities to estabish a cash baance. Opportunity costs are increased when there is a cash baance because there is no return to cash. The tradeoff between the two resuts in an optimum point of hoding cash, which becomes their target cash baance as depicted in figure. Figure: Cost of Hoding Cash

222 Financia Management Cash Management in a Group of Companies Within a group of companies it is often considered desirabe for cash to be managed by a centra department which wi: Gather in a surpus funds from the various companies and redistribute them in accordance with the investment opportunities which best serve the group objectives; Dictate the dividend distributions of the subsidiary companies to ensure that funds are retained where they are needed within the group; Arrange the investment outside the business of funds which are temporariy surpus to group needs; Negotiate centray any bank overdraft faciities, and the raising of new ong-term capita. With regard to interna investment it sometimes appears that priority is given to projects from those companies which are aready profitabe (since they are abe to show better incrementa returns than those which are currenty ess successfu); and it is argued that the oss-making companies may we have the greater need for operations. In reation to overdraft faciities, the argument for Group centra negotiation is that ony one banker (or a ead banker) wi be invoved who wi be we informed on the whoe of the group s activities, and that a the resources of the group wi be avaiabe as security. This does, however, put the whoe group at risk if credit faciities are reduced. If the various companies have a good oca reationship with the banks they have used individuay in the past, it can happen that the tota of ocay negotiated overdrafts is greater than coud have been obtained centray. Whie the withdrawa of one faciity sti eaves the other companies untouched. The payment of creditor accounts centray is easier to arrange, though it may invove deays in payment if invoves first to be approved by oca offices. Whether centraised purchasing is beneficia wi depend on whether the advantages of standardised specifications and the negotiation of buid discounts are offset by a oss of speciaised purchasing skis for a diverse range of products and by deays in the procurement of urgenty needed suppies. The majority of the foregoing comments wi appy equay to a singe company having divisiona profit centre in scattered ocations.

Management of Receivabes 223 Chapter-9 Management of Receivabes If we are getting trade credit to fund our needs, we aso have to extend trade credit to our customers. A company grants trade credit to protect its saes from the competitors and to attract the potentia customers to buy its products at favourabe terms. Extending trade credit creates receivabes or book debts which the company expects to coect in the near future. The book debts or receivabes arising out of trade credit has three characteristics: 1. It invoves an eement of risk: This shoud be carefuy anaysed. Cash saes are riskess, but not the credit saes as the cash is yet to be received. 2. It is based on economic vaue: To the buyer, the economic vaue in goods or services passes immediatey at the time of sae, whie the seer expects an equivaent amount of vaue to be received ater on. 3. It impies futurity: The cash payment for the goods or services received by the buyer wi be made by him in a future period. The customers from whom receivabes or book debts are due are caed debtors and represent the company s caim or asset. Let us take up an exampe to iustrate the benefit of providing trade credit. Exampe A company is panning to extend credit to its customers. The choice is between one month and two month s credit. The first year s resuts under the three aternatives, of providing no credit and one & two months credit, are tabuated beow. Note that we have not shown an interest charge on the increased working capita because in due course the increase in stocks and debtors wi in effect be financed out of the improved profits, and no specific borrowing may be needed. However, regardess of how the working capita is financed it must sti produce the required rate of return. The exampe makes the fairy obvious points that giving credit invoves cost, incuding the opportunity cost of additiona capita empoyed. In some cases these costs wi cance out or outweigh any gains from increased business ike in the second aternative above. In some cases the granting of credit may not increase the saes of the business but may be justified because it wi prevent a oss of saes to a competitor.

224 Financia Management (Rupees) No credit One month s credit Two month s credit Saes 120,000 160,000 240,000 Debtors 13,333 40,000 Stocks (ess creditors (Say, 1/12 of saes vaue) 10,000 13,333 20,000 Tota 10,000 26,666 60,000 Increase in working capita through granting 16,666 50,000 credit Margina contribution 30,000 40,000 60,000 Less: Cost of: Credit contro (6,000) (6,000) Bad debts (1,600) (4,800) Reevant comparabe profits 30,000 32,400 49,000 Increase in profits 2,400 19,200 But the company requires a return of15% on 2,500 7,500 the increase in capita empoyed; i.e. The net advantage (or disadvantage) of the proposed changes in credit poicy is therefore (Rs.100) Rs.11,700 There are two costs that we can associate with extending credit as: i) credit costs and ii) opportunity costs. Credit costs are the cash fows that must be incurred when credit is granted. They are positivey reated to the amount of credit extended. Opportunity costs are the ost saes from refusing credit. These costs go down when credit is granted. This means that there is a point where the sum tota of these two costs are minimum for the company. This point depicts the optimum credit poicy that the company must foow. Cost in rupees of hoding cash Tota costs of hoding cash Opportunity costs Trading costs C* Optima size of cash baance Size of cash baance (C) Figure 9.1: The Costs of Granting Credit

Management of Receivabes 225 The above discussion wi suggest three ways of management contro in connection with credit poicy: (a) Debtors expressed in reationship to saes - either as a percentage or as a number of weeks saes. This provides an overa confirmation that the business is effective in carrying out its own credit poicy. With a seasona business, however, these cacuations coud be miseading. Another disadvantage of averages is that they may concea the fact that some ong-overdue debts are being compensated by quicker coections from other customers. For management contro there is no substitute for a compete isting of debtor accounts, anaysed by age, compied every month. (b) (c) Bad debts as a percentage of saes vaue, or reported otherwise in detai. Credit contro costs. This means that credit contro invoves three types of action: (a) (b) (c) (a) deciding the norma credit period to be aowed; estabishing credit imits for individua customers; impementing the system (that is to say, ensuring that credit imits and the credit period are not exceeded). Deciding the Credit Period: If a business is offering a unique product or service, or one for which demand exceeds suppy, there may be no need to offer credit terms at a. In other cases the starting point in deciding credit poicy is a review of the credit terms offered by competitors, and from this basis the credit terms of the particuar business wi be deveoped. Other factors that affect the ength of the credit period are the foowing: Buyer's inventory and operating cyce Perishabiity and coatera vaue Consumer demand Cost, profitabiity and standardisation Credit risk The size of the account Competition Customer type Long credit period may be offered to the customers if this wi enabe the business to capture a arger share of the avaiabe market, or the break into a new market. The

226 Financia Management initia effect of granting ong credit periods may be adverse because of the extra costs invoved but profits from increased voumes shoud more than offset the osses. If it does not there is no use in extending onger credit periods. Even otherwise it is necessary to ook to the onger term where, among other possibiities, seing prices may be increased because smaer competitors have been eiminated in the 'credit war'. Shorter credit may be imposed if demand is ineastic, so that the quantity sod wi not be affected simpy by changes in credit terms. Infuence of Credit Poicy Credit poicy wi directy infuence saes, investment eves, bad-debt osses, and coection costs. Saes: Saes vary directy with the extent to which credit terms are iberaised. The demand for a firm's product is greaty infuenced by the ease with which the products can be purchased on credit. Saes wi be at their owest eve if they are stricty for cash. Those who want to buy on credit wi patronise other manufacturers who extend credit. Saes wi start increasing as credit terms are iberaised. Saes wi be at their maximum eve when the firm does not screen buyers for credit worthiness. Rather, credit is extended to a who want to buy the firm's products. Investment Leves: Saes on credit resut in accounts receivabe. As discussed above, saes are directy reated to the iberaity of credit terms. As credit terms are iberaised, saes increase and to service this increased eve of saes propery, the firm needs to increase its investments in cash and inventories. Finay, if saes increase sufficienty, the firm may have to increase its productive capacity. As credit terms are made more ibera, the firm's investment in cash accounts receivabe, inventories, and perhaps physica equipment increases in a compimentary fashion. Bad-Debt Losses: Without credit saes the firm wi not incur any bad-debt osses. With a very conservative credit poicy, bed-debt osses wi be nonexistent or minima. As credit terms are iberaised, the firm begins to give credit to marginay ess-creditworthy cients. The iberaisation of credit terms resut in increases in bad-debt osses. Coection Costs: Coection costs are the cerica and administrative costs associated with granting credit and managing accounts receivabe. When credit is not granted, coection costs are minima. As credit terms iberaised, the firm's voume of accounts receivabe increases. The cerica and administrative costs of invoicing, coecting, and book keeping aso increase as credit terms are iberaised. A second type of coection cost is the one reated to efforts to coect on deinquent accounts. As credit terms are iberaised, deinquent accounts increase and the costs of efforts to coect on these accounts aso increases.

Management of Receivabes 227 Credit Terms As discussed previousy, credit poicy has a direct infuence on saes, investment eves, bad-debt osses, and coection costs. From a manageria view-point and ooking stricty at the reationship between credit poicy and saes, one coud concude that a very ibera credit poicy is highy desirabe. However, the reationship between credit poicy and investment eves, bad-debt osses, and coection costs impies that a very conservative credit poicy is desirabe. An appropriate credit poicy baances profits from increased saes due to more ibera credit terms with increased costs due to increased investments, bad-debt osses, and coection costs. The idea credit poicy aows for the iberaisation of credit terms to the point where the margina revenues from a new category of credit accounts is exacty equa to the margina costs of seing and servicing accounts. In practice it is not feasibe to estabish the idea credit poicy. However, firms do consider aternative credit terms to see what infuence they have on profits. Our focus here wi be to ook at certain specific credit terms and see how they might affect profits and what guideines a firm coud use to enhance its profitabiity. The three specific components of credit terms are credit period, credit discount, and discount period. Credit Period: The credit terms are specified on the invoices sent out by firms. A typica credit term may state: 2/10, net 30. The first number "2" is the credit discount and indicates that a 2 per cent discount may be taken if the invoice is paid within the number of days specified by the second term, or 10 days. The second term "10" is the discount period and indicates the number of days during which the credit discount can be taken. The ast number "30" indicates the credit period. The credit period specifies the number of days that a firm can take to pay the invoice without being considered to be deinquent. With terms of 2/10, net 30 the credit period is 30 days and the fu amount of the invoice is due within 30 days. One way to iberaise credit terms is to increase the credit period. Conversey, credit terms can be tightened by shortening the credit period. Mitsui Corporation is currenty seing on credit terms of 2/10, net 30. Its annua gross saes are at the Rs 36 crore eve currenty. A saes are for credit. Fifty per cent of its cients take the 2 per cent discount and pay on the tenth day. The other 50 per cent, who do not take the discount, on the average pay after 30 days. The saes voume between discount takers and non-discount takers is eveny divided. The company's management is considering two aternative credit pans: pan A woud change the credit terms 2/10, net 45; pan B woud extend the credit period even further, making the terms 2/10, net 60. pan A is expected to increase saes by 5 per cent from current eves, whereas pan B woud increase saes by 7 per cent. Mitsui's margins on saes before credit-reated costs and taxes are 20 per cent. Investments in accounts receivabe carry a 12 per cent before tax cost. In trying to decide whether to keep the present credit pan or switch to either of pans A or B, management recognises that an occasiona resut of extending the credit period

228 Financia Management wi be that more customers wi take the discount. However, they fee that with the present pans there wi be no change in the rupee voume of saes on which the discount is taken. That is, a incrementa saes wi be paid for after the 10-day discount period. In addition, management fees that 1 per cent of a incrementa saes under pan A and 2 per cent under pan B wi prove to be uncoectibe. No additiona credit costs wi be invoved in cerica or administrative functions. Which credit period poicy appears to be the most desirabe? The variabes to be considered in deciding between the present credit terms and pans A and B are profits on increased saes, increases in accounts receivabes, increases in the cost of financing the additiona receivabes, and increased in bad-debt osses. The effects of the three credit terms on these variabes are summarized in Tabe 1. The anaytica approach is incrementa. that is, given the existing credit terms we focus on the incrementa profits and costs of pans A and B. Under pan A saes increase by 5 per cent or 0.05 per cent Rs 36 crore = Rs 1.8 crore. Saes woud increase by Rs 2.52 crore under pan B. Margina profits before taxes and credit-reated expenses are 0.2%. Rs 1.8 crore = Rs 3,60,000 for pan A and Rs 504,000 for pan B. Increases in accounts receivabe cannot be cacuated by just ooking at incrementa saes. The reason is that when the credit period is extended, the existing buyers who are not taking the discount and are paying after 30 days wi aso take advantage of the extended credit period and not pay for 45 days. Incrementa investment in receivabes is estimated by cacuating tota receivabes first. For present credit terms, 50 per cent of saes are paid for in 10 days, the other 50 per cent in 30 days. The average sae is outstanding for 0.5(10) + 0.5(30) = 20 days. Daiy saes are Rs 36 crore / 360 days = Rs 100,000. Tota accounts receivabe equa 20 days Rs 100,000 = Rs 2 crore. 1 Tabe 1: Anaysis of credit terms changing credit periods for Mitsui Corporation Present Pan A Pan B (d) Increase in saes (%) 0 % 5 % 7 % (e) Increase in saes (Rs=1 Rs 36 crore) Rs 0 Rs 1,800,000 Rs 2,520,000 (f) Margin on saes (%) 20% 20% 20% (g) Margina profits (Rs = 2 3) a Rs 0 Rs 360,000 Rs 504,000 (h) Average saes outstanding 20 days 28.34 days 36.65 days (i) Daiy saes Rs 100,000 Rs 105,000 Rs 107,000 (j) Tota receivabes (5 6) Rs 2,000,000 Rs 2,975,000 Rs 3,921,600 (k) Increase in receivabes 0 975,700 1,921,600 () Increase in investment costs (8 12 %) 0 117,084 230,592 (m) Increase in bad debt osses (2 x%) 0 18,000 50,400 (n) Increase in costs (9+10) 0 135,084 280,992 (o) Increase in profits (4 11) 0 224,916 223,008

Management of Receivabes 229 Under pan A tota saes are Rs 36 crore + 1.8 crore = Rs 37.8 crore. The rupee amount subject to payment by the tenth day remains at Rs 18 crore or Rs 18 crore / Rs 37.8 crore = 47.6 per cent. The other 52.4 per cent now take 45 days to pay. The average sae wi be outstanding for 0.476 (10 days) + 0.524 (45 days) = 28.34 days. Daiy saes are Rs 37.8 crore/360 days = Rs 105,000. Tota receivabes are Rs 105,000 28.34 days = Rs 2,975,700. Under pan B tota saes Rs 38.52 crore. The percentage of discount takers is Rs 18 crore Rs 38.52 crore= 46.7 per cent. The average saes is outstanding for 0.467 (10 days) + 0.533 (60 days) = 36.65 days. Daiy saes are Rs 38.52 crore / 360 days = Rs 107,000 and receivabes are Rs 107,000 36.65 days = Rs 3,921,600. Incrementa receivabes for pan A are Rs 2,975,700 - Rs 2,000,000 = Rs 975,700 and are Rs 1,921,600 for pan B. The before-tax cost of financing these receivabes is 12 per cent. Therefore, the increase in investment costs for pan A is Rs 975,700 0.12 = Rs 117,084 and is Rs 1,921,600 0.12 = Rs 230,000 for pan A and 0.02 Rs 2.52 crore = Rs 50,400 for pan B. The tota incrementa credit associated costs for pan A are Rs 117,084 + Rs 18,000 = Rs 135,084 and are Rs 280,992 for pan B. The incrementa profits after adjusting for credit costs are Rs 224,916 for pan A and Rs 223,008 for pan B. Both pans are superior to the present pan. However, pan A is sighty preferabe to pan B. Credit Discount: The credit discount is offered as an inducement for the credit buyer to pay prompty. The credit buyer's opportunity cost of not taking the discount is given by: 360 days credit discount credit period discount period For terms of 2/10, net 30 the opportunity cost of not taking the discount is 360 days 2 per cent / (30 10) = 36 per cent. Obviousy, this opportunity cost has to be high enough to motivate a financiay strong credit buyer to take the discount. For exampe, terms of 1/10, net 70 impy an opportunity cost of 6 per cent. At this cost firms wi prefer to use trade credit rather than borrow from banks and the credit discount is no onger a viabe credit poicy instrument. Athough changing the credit discount has some infuence on demand, its most visibe impact is on reducing the average coection period and the eve of accounts receivabe. Assume that Mitsui is considering changing its credit terms from 2/10, net 30 to 2.5/10, net 30 in pan C or 3/10, net 30 in pan D. Either of the new pans woud not affect the saes voume. However, under pan C, 70 per cent of the credit buyers woud take the credit discount and, under pan D, 90 per cent woud take the discount. Shoud Mitsui switch to either pan C or D if the previousy given information on investments cost is appicabe here?

(g (h (i (j (k ( (m 230 Financia Management The anaysis here woud be simiar to the one done for the credit period. Gross saes voume under either the present credit terms or pan C or D remain at Rs 36 crore. Saes for which discounts are taken are 50 per cent or Rs 18 crore for the present pan, and Rs 25.2 crore and Rs 32.4 crore for pan C and D, respectivey (see Tabe 2). The credit discount for the present pan is 2 per cent or 0.02 Rs 18 crore = Rs 360.000. For pan C it is 0.025 Rs 25.2 crore = Rs 630,000 and is Rs 972,000 for pan D. The incrementa cost of going to a more ibera credit discount under pan C is Rs 630,000 - Rs 360,000 = Rs 270,000 and is Rs 612,000 for pan D. The increase in credit costs due to giving a arger credit discount reduces the eve of investments in accounts receivabe. Tota receivabes under the present pan were cacuated to be Rs 2 crore in Tabe 1. Under pan C the average coection period is 0.7 (10 days) + 0.3 (30 days) = 16 days. Since daiy saes are Rs 100,000, tota receivabes are Rs 1.6 crore. Under pan D tota receivabes are [0.9 (10 days)] Rs 100,000 = Rs 1.2 crore. Under pan C, receivabes decrease by Rs 2.0 crore - Rs 1.6 crore = Rs 400,000. The decrease in investments under pan D is Rs 2.0 crore - Rs 1.2 crore = Rs 800,000. The cost of investments in receivabes is 12 per cent. Cost savings are Rs 400,000 0.12 = Rs 48,000 for pan C and Rs 96,000 for pan D. Cost savings ess increase in discount costs give increase in profits before taxes. As Tabe 2 shows, neither pan C nor pan D resuts in increasing profits over the present eves. Consequenty, Mitsui shoud not impement either pan C or pan D. Tabe 2: Anaysis of Credit Terms Changing Credit Discounts for the Mitsui Corporation. (d (e (f a Before credit reated costs and taxes. 1 Saes are assumed to be reasonaby equay distributed among buyers. Aso, it is assumed that the daiy saes voume is constant.

Management of Receivabes 231 Discount Period: The anaysis of changing discount periods is very simiar to the anaysis for changing credit discounts. As the discount period is increased, the opportunity cost of not taking a discount increases. Therefore, it becomes more attractive for a credit buyer to take the discount. However, as the discount period is extended the existing discount takers take advantage of the iberaised credit terms and deay making their payments unti the end of the new discount period. Whether extending the discount period is desirabe is dependent on whether tota receivabes increase or decrease. Continuing the Mitsui exampe, the firm can change credit terms to 2/12, net 30 or 2/15, net 30 under pans E and F, respectivey. The per cent of saes subject to the discount woud be 60 per cent in pan E and 80 per cent in pan F. Shoud Mitsui switch to either pan E or pan F? Gross saes woud not be affected by these aternative pans. Tabe 3: Anaysis of Credit Terms Changing Discount periods for Mitsui Corporation Present Pan E Pan F (d) Gross saes voume Rs 36,000,000 Rs 36,000,000 Rs 36,000,000 (e) Saes with discounts (%) 50% 60% 80% (f) Saes with discounts (1 2) Rs 18,000,000 Rs 21,600,000 Rs 28,800,000 (g) Credit discounts (Rs = 3 2%) Rs 360,000 Rs 432,000 Rs 576,000 (h) Increase in discounts 0 Rs 72,000 Rs 216,000 (i) Tota receivabes Rs 2,000,000 Rs 1,800,000 Rs 1,400,000 (j) Decrease in receivabes 0 Rs 200,000 Rs 600,000 (k) Decrease in investment costs (7 12%) 0 Rs 24,000 Rs 72,000 () Increase in profits (8 5) 0 (Rs 48,000) (Rs 144,000) Saes subject to discounts woud be Rs 18 crore, Rs 21.6 crore, and Rs 28.8 crore, for the present terms, pan E, and pan F, respectivey. Credit discount at 2 per cent woud be Rs 360,000 for the present pan and Rs 432,000 and Rs 576,000 for pans E and F, respectivey. The increase in discounts for pan E woud be Rs 72,000 and woud be Rs 216,000 for pan F (Tabe 3). The tota receivabes under pan E woud be [0.6 (10 days) + 0.4 (30 days)] Rs 100,000 = 1.8 crore. The same entry woud be [0.8 (10 days) + 0.2 (30 days)] Rs 100,000 Rs 1.4 crore for pan F. A decrease in investment costs due to a decrease in receivabes is Rs 24,000 for pan E and Rs 72,000 for pan F. Taking into consideration the increased discounts being given, we find that neither of the two new pans is acceptabe. Simutaneous Changes in Credit Terms Most firms, from a practica standpoint, wi consider changes in a credit terms

232 Financia Management simutaneousy. For exampe, the Mitsui Corporation may seek to evauate new credit terms in which the credit period, credit discount, and discount period a change simutaneousy. As we have seen previousy, extending the credit period infuences saes most strongy, whereas changing the other two credit terms has a strong impact on the eve of receivabes outstanding. A firm considering changing a credit terms needs to carefuy examine the potentia impact of the changes on incrementa profits. Assume that Mitsui is considering changing from terms of 2/10, net 30 either to 2/15, net 45 in pan G or 2.5/15, net 60 in pan H. Under pan G saes are expected to increases by 5 per cent, whereas with pan H saes woud have a potentia of increasing by 10 per cent. Margina returns before credit-adjusted costs and taxes woud be 20 per cent of saes. Under the present credit terms, the average coection period is 20 days (as shown in Tabe 1). Under pan G, 45 per cent of saes woud invove the discount. Those who take the discount woud pay at the end of the discount woud, on the average, pay by the end of the credit period. Bad-debt osses woud increase by 1 per cent of incrementa saes for pan G and 2 per cent of incrementa saes for pan H. Coection costs woud increase by Rs 10,000 and Rs 30,000 under pans G and H, respectivey which credit term pan appears to be best for Mitsui. Under pan G saes and margina profits woud increase by Rs 1.8 crore and Rs 360,000, respectivey. For pan H saes woud increase by Rs 3.6 crore and profits by Rs 720,000. These margina profits are before credit adjusted costs and need to be adjusted for changes in the investment eves in receivabes and in discount taken. Given credit terms of 2/15, net 45, average coection period for pan G is 0.45 (15 days) + 0.55 (45 days) = 31.5 days. Since daiy saes are Rs 37.8 crore/360 days = Rs 105,000. Tota receivabes for pan G woud be 31.5 days Rs 105,000 = Rs 3,307,500. Simiary, tota receivabes for pan H woud be [0.40 (15 days) + 0.6 (60 days)] = 42 days 39.6 crore/360 = Rs 4,620,000 (see Tabe 4). For pan G bad debt osses woud be Rs 1.8 crore 0.01 = Rs 15,000 and Rs 72,000 for pan H. Cost of giving discounts and increased coection costs are shown in Tabe 4. Given the tota credit reated cost increases of Rs 165,100 for pan G, its profitabiity before taxes is Rs 360,000 Rs 165,000 = Rs 194,900. Simiary, pan H woud increase pretax profits by Rs 267,600. Of these two pans, H is the better one. Pan H is aso the best pan among a eight pans discussed in this section. From tota receivabes we can cacuate incrementa receivabes and the cost of increased investments in receivabes, as shown in Tabe 4.

Management of Receivabes 233 Tabe 4: Anaysis of Credit Terms Changing Credit Terms for Mitsui Corporation. Present Pan G Pan H (d) Increase in saes (%) 0% 5% 10% (e) Increase in saes (Rs = 1 Rs 36 crore) 0 Rs 1,800,000 Rs 3,600,000 (f) Margin on saes (%) 20% 20% 20% (g) Margina profits (Rs = 2 3) a 0 Rs 3,60,000 Rs 720,000 (h) Average coection period 20 days 31.5 days 42 days (i) Daiy saes Rs 100,000 Rs 105,000 Rs 110,000 (j) Tota receivabe Rs 2,000,000 Rs 3,307,500 Rs 4,620,000 (k) Increase in receivabe 0 Rs 1,307,500 Rs 2,620,000 () Increase in investment costs (8 12%) 0 Rs 156,900 Rs 314,400 (m) Increase in bad debt osses (2 x%) 0 Rs 18,000 Rs 72,000 (n) Saes with discount (Rs) 18,000,000 17,010,000 15,840,000 (o) Credit discounts (%) 2% 2.5% 2.5% (p) Credit discounts (Rs = 11 12) 360,000 340,000 396,000 (q) Increase in discounts 0 19,800 36,000 (r) Increase in coection costs 0 10,000 30,000 (s) Increase in credit costs (9 + 10 + 14 + 15) 0 165,100 452,400 (t) Increase in profit (4 16) 0 194,900 267,600 a Before credit-reated costs and taxes. Coection Poicy When an account becomes deinquent, a firm can resort to a series of actions to try to coect on the account. These actions incude writing a etter, caing on the phone, caing in person, using a coection agency, and ega action. The particuar coection procedures foowed have a direct impact on bad-debt osses and the average coection period. The firm has an obvious interest in reducing both bad-debt osses and the average coection period, which ower tota receivabes and average coection period, which ower tota receivabes and investment in receivabes. In genera, the more the firm spends on coection, the ower its deinquency costs (bad-debt osses) and the cost of maintaining excess receivabes. However, the margina productivity of coection expenditures decine as the firm expends more and more. The discussion on coection poicy has assumed that saes are independent of coection poicy. Most firms recognise that instituting a very aggressive coection poicy may be very irritating for some customers who are frequenty sow in paying. An aggressive coection poicy may therefore adversey affect saes. A second resut of an aggressive coection poicy may be to force more customers to prefer taking the discounts. These

234 Financia Management two factors need to be recognised before a firm impements a coection poicy that equates margina coection expenditures with margina reductions in deinquency costs. Estabishing Credit Limits The fact that the business has a credit poicy does not mean that credit terms wi be granted to every customer. It is not aways easy to decide whether a particuar customer is credit worthy in the sense that he has both the abiity and the incination to pay at the due date. Many companies require cash with order from new customers unti their creditworthiness have been estabished. Five Cs of Credit that a bank ooks at are the ones that you shoud aso ook at whie granting credit: Character: Wiingness to pay back the credit Capacity: Abiity to pay back Capita: Financia reserves incuding cash Coatera: What assets coud be pedged or are pedged to others that hinder payments Conditions: Reevant economic conditions That means that in assessing the creditworthiness of a customer two things are absoutey necessary: (a) (b) Facts about his business, in particuar whether it is profitabe, whether it is generating or has access to sufficient cash to met its iabiities, and whether it has suitabe assets avaiabe to cover the caims of unsecured creditors in the event of winding up. In brief, it is necessary to anayse the accounts of the business. It is hepfu aso if the customer wi suppement these with the sort of information they do not give; e.g., the current order book, any pans for future deveopment, and the condition and market vaue of the assets owned by his business. Opinions about the business and the peope running it, formed from either persona contacts (director eve, or at any reiabe and knowegeabe eve) or obtained from third parties such as business associates, mutua acquaintances or empoyees changing jobs. There are other sources from which we can have information about the company as we as the industry that it is operating in: (a) (b) Reports from the reevant trade protection association, if one exists; Trade references from other companies with which the customer does business;

Management of Receivabes 235 (c) (d) Bank references - these may not give a ot of information but they tend to use a series of standardised repies, and experience of these wi indicate the reative credit grading of the customer in question; Reports pubished in trade journas or the financia press deaing either with the customer company or with the type of business in which it is engaged. In assessing the creditworthiness of overseas customers, reports from bankers are an important source of information. It is aso necessary to weigh up the risks of the customer being prevented from paying either through poitica or exchange contro restrictions. On a these matters the Export Credits Guarantee Department can usuay give guidance. If the customer s creditworthiness appears to be estabished, the next stage is to decide the amount of credit to be given. Theoreticay there are three possibe ways of doing this: (a) (b) (c) The income or cash fow method, which requires knowedge of the amounts of cash becoming avaiabe to the customer, and how he proposes spending them, thus indicating his abiity to pay the suppier s invoices - this method is possibe between a bank manager and his cient seeking an overdraft or oan, but sedom in business ife; The capita structure method, under which the vaue of uncharged assets in the customer s ast baance sheet is estabished, and the credit imit wi be a percentage of this vaue. This is a necessary cacuation when the proposed vaue of future transactions wi invove a major increase in the customer s tota indebtedness, but it is not an indicator of iquidity, and is not particuary reevant to sma transactions in the ordinary course of trade; The requirement method, which is amost aways used in practice. If the customer is creditworthy then we shoud be abe to rey on him to pay any amounts arising from the ordinary course of business. The amount of credit granted, therefore, is based on the vaue of business which the customer expects to pace with the suppier each month. The forecast monthy saes to the customer are mutipied by a number of months credit aid down as company poicy to give that customer s credit imit. If, for exampe, a customer proposed pacing orders totaing Rs.1,500 per month with a suppier whose credit terms required payment by the end of the month foowing the date of invoice (say, two month s credit) the credit imit granted him might be 2xRs.1,500 = Rs.3,000 outstanding on the edger accounts at any time. For customers of internationa repute it may be decided that no imitation of credit is necessary, but the financia difficuties faced by severa major companies in recent

236 Financia Management years must be a warning against the automatic granting of unimited credit. Vetting Incoming Orders The amount appearing on the customer s edger account at any time wi, of course, resut from invoicing the orders he has paced, so that if the vaue of orders in any period were to exceed the origina forecast this might not become apparent unti after invoicing. At that time the outstanding baance on the edger woud suddeny be found to be in excess of the agreed imit. To safeguard against this possibiity an order register may be kept for each customer, showing the vaue of orders paced for deivery in particuar months. Each incoming order wi then be checked against the register to confirm that it wi not cause the credit imit to be exceeded. This coud be a cumbersome procedure, and normay it woud ony be used in respect of: (a) (b) New customers whose compiance with credit imits has not been estabished; Customers who had consistenty faied to adhere to their credit imits in the past. (It might be better in such cases to withdraw credit faciities competey). A incoming orders shoud be checked to ensure that are paced on the customer s officia order form and authorised by somebody purporting to have the power to pace that type of order. Computerisation has made this task very easy. Saes Invoicing So far as the customer is concerned, the company s credit period does not begin unti he receives an invoice. Even then his accounting procedures probaby invove a monthy cut off date for the receipt of invoices, so that any invoice received after, say, the 28th day of the month wi be treated as beonging to the succeeding month. It is important, therefore, that deays in invoicing be kept to a minimum. The causes of deay are neary a within the contro of the company, and may incude: (a) (b) (c) (d) An infexibe routine in the saes invoicing department (perhaps invoices are issued ony on certain days in the month); A requirement for approva or signature of saes invoices by members of the saes staff who are often away from the office; Faiure to agree prices for specia work; and For job work, and in other cases where prices are inked with costs, excessivey sow procedures for cacuating costs.

Management of Receivabes 237 Debt Coection There must be no sackness in pursuing the coection of debts. In most business purey forma reminders are ineffective, and therefore a waste of money, when an account has passed its due date there shoud be eary persona contact with the customer either by teephone or a saesman s visit or by a etter addressed to a named person in the customer company. If necessary, there may be a foow up at the higher eve of authority. And this shoud be foowed by a threat to cut off suppies. The vaue of ega action against debtors needs to be assessed. When this stage is reached, the ikeihood of the customer s paying is sharpy reduced, and additiona ega costs may never be recouped. On the other hand, the action may deter potentia future defauters. From the point of view of the saesman every customer is vauabe. From the financia director s standpoint the margina contribution from goods sod to a ate payer wi be more profitabe without saes to that particuar customer. Overdue debts shoud be the subject of forma discussion between the saes and financia managers. The reasons for deayed payment shoud be noted, and decisions shoud be minuted on the action to be taken in each case and the peope responsibe for taking it. Athough the saesman s job is not compete unti his customer has paid the money due, it is often advantageous for the more rigorous coection procedures to be handed by finance staff, eaving the saesman free to exercise his persuasive infuence with the customer s buying department. Credit and Coection Procedures In the previous section we considered the firm s overa credit and coection poicies. In this section we sha discuss how these poicies can be appied to individua accounts. In this section we sha first discuss sources of information and then the decision to grant credit. Finay, we sha ook at specific procedures that coud be utiised to coect deinquent accounts. Sources of Information An individua or firm is requesting credit. What sources of information are avaiabe to judge the credit worthiness of the appicant? Sources that can be utiised are financing statements, bank references, and credit bureaus. Financia Statements: A vita source of information is the appicant s financia statements. An appicant who is in a financiay sound position woud have no hesitation in making avaiabe his or her financia statements. Interim reports, if avaiabe, are more desirabe than annua reports. Audited and CPA certified reports are preferred to

238 Financia Management unaudited reports. The financia statements are usefu for cacuating various iquidity, everage, efficiency, and profitabiity ratios that may be used in evauating credit risk. If the firm is using a credit scoring mode (discussed ater) or if the appicant is requesting a arge amount of credit, financia statements are essentia. Credit Bureaus: Credit bureaus speciaise in consoidating the experiences of other firms with the appicant. Credit bureaus compie a history of the appicant s credit payment performance as reported by the credit-granted firms. Financia information on a credit appicant may be obtained by credit bureau member firms who agree to provide credit bureaus with information on their cients. In addition to these information sources, a firm may try to compie its own information. It may have its saes personne prepare a report on the credit appicant. Aternativey, if the credit request is arge enough, it may send a credit department empoyee to visit personay with the credit appicant and garner as much financia information as possibe. Credit Anaysis and Credit Limit A firm reviewing a request for credit needs to judge the credit appicant s wiingness and abiity to pay. If either of these two factors is missing, the firm woud increase its chances of suffering osses on credit extended to the appicant. Wiingness to pay is judged by the firm s past financia performance. Its abiity to pay is judged by the strength of its financia statements in reation to the amount of credit desired. Either heuristic or statistica procedures coud be utiised in credit anaysis. Heuristic Approach: The heuristic approach described here is based on a manufacturing company s actua experience. The formua or procedure described here has the weight of manageria experience and intuition behind it and therefore is heuristic in nature. There are eight factors that need to be considered in the decision to estabish a credit imit and grant credit. The credit imit is the maximum amount of credit purchases aowed the credit appicant at any one time and is stated as a per cent of tangibe net worth. The ower imit is minus 15 per cent and is tantamount to denying new credit to the appicant. The upper imit is 80 per cent and is equivaent to the sum of the maximum percentage points on the eight credit-granting factors. Credit Requirements; The first factors is appicant credit requirements, (C). This factor is a measure of the appicant s dependency on the creditor. If the appicant pans to buy ess than 25 per cent of his requirements from the creditor, he gets 0 perm cent toward his credit ine. If he pans to buy between 25 and 50 per cent, he gets a 5 per cent aowance. If the pans to buy over 50 per cent he gets a 10 per cent aowance (see Tabe 5). Pay Habits: The second factor is pay habits (P) and is a measure of the wiingness

Management of Receivabes 239 and abiity to pay. Payments during the discount period rate 10 per cent. Payments during the credit period are worth 5 per cent. Habituay ate payments rate minus 5 per cent. Years in Business: The third factor is years in business (Y) and is a measure of the abiity of the firm to pay. Being in business ess than 3 years has no effect on increasing the imits. If Y is between 3 and 10 years, the imit is increased by 5 per cent. If the firm has been in existence for more than 10 years, it rates 10 per cent. Tabe 5: Heuristic Approach to Estabishing the Credit Limit CONTRIBUTING FACTOR Rating Contribution to Credit Limit : Per cent of Net Worth Appicant credit requirements (C) C < 25% 0 25 < C < 50% 5 C > 50% 10 Pay habits (P) Take discount 10 Pays on time 5 Pays ate -5 Years in Business (Y) Y < 3 years 0 3 < Y < 10 5 Y > 10 10 Profit Margin (M) M < 5% 0 Profit Margin. The fourth M% < measures M < 14% is the profit margin 5 (M). If margins are ess than 5 per cent, 0 per cent is M contributed > 14% to the credit imit. Margins 10 in excess of 14 per cent contribute 10 per cent to the credit imit. Current Ratio (R) R > 2.2:1 10 1.5 < R < 2.2 5 Current Ratios. The fifth R < measure 1.5 is the current ratio (R). 0 A current ratio of over 2.2 to 1 is considered to be a good indication of abiity to pay and heps contribute 10 per cent 0.5 < T < 0.3 5 toward the credit imit. A current ratio of ess than 1.5:1 is considered to be reativey T < 0.5-5 weak and does not hep increase the credit imit. Tota debt tota assets (T) T < 1.3 10 Inventory Turnover (I) I < 10 10 Tota Debt to Asset Ratio. 5 < I The < 10 sixth measure is the ratio of 5 tota debt to tota assets (T) I > 5 0 and represents the abiity to pay. If T is ess than 30 per cent, the appicant is viewed to be conservativey everaged and adds 10 per cent to the credit imit. Quaitative (Q) Q = high 10 Q = average 5 Q = ow -5 On the other hand, a T of over 50 per cent impies increased financia riskiness and rates a minus 5 per cent toward the credit imit.

240 Financia Management Inventory Turnover. The seventh factor is the inventory turnover (I). A higher inventory turnover impies high efficiency; I can hep contribute anywhere from 0 per cent to 10 per cent toward the credit imit, as shown in Tabe 5. Quaitative Factor. The ast factor is a quaitative factor (Q) and ets the credit manager use discretion in subjective evauation of the credit appicant's wiingness and abiity to pay. It shoud be kept in mind that the factors mentioned here and their contribution to the credit imit are based on a particuar firm's actua experience. The factors and their contributions to the credit imit may vary from accounts payabe, and the economic environment woud aso be considered in deveoping a heuristic credit evauation decision mode. As an exampe we an appy the heuristic mode presented here to evauate Kartik Meta. Assume that Kartik is requesting a credit ine to buy ess than 25 per cent of its raw materias requirements. What is the maximum credit ine to estabish for Kartik? The contributions of the various factors to the credit imit are shown in Tabe 6. The ast factor, Q, is rated average. Tabe 6: Appication of the Credit Limit Mode Kartik Meta Products Factor Kartik s Rating Contribution to Credit Limit (per cent) 1. Kartik s requirement (C) C < 25 % 0 2. Pay habits (P) Takes discount 10 3. Years in business (Y) Y > 10 10 4. Profit margins (M) M = 4.6 % < 5 % 0 5. Current ratio (R) R = 2.89 > 2.5 10 6. Tota debt to tota assets (T) T = 0.28 < 0.3 10 7. Inventory turnover (I) a I = 12 > 10 10 8. Quantitative (Q) Average 5 Tota Contribution 55 a Based on saes; Rs 177, 250/Rs14, 619 = 12 Kartik s credit imit = Rs 42,961 0.55 = Rs 23,600. Additiona credit for Kartik = Rs 23,00 Rs 7500 = Rs 16,100. because of Kartik s dependence on ony 12 customers. Tota contribution of the eight factors to the credit imit is 55 per cent of tangibe net worth, or Rs 42,961 0.55 = Rs 23,600. Since the existing credit ines tota Rs 3,000 + Rs 2,500 = Rs 7,500. Kartik can be extended additiona credit up to Rs 23,600 Rs 7,500 = Rs 16,100. Statistica Approach. In quantitative approaches to credit anaysis, the firm reies on financia information as we as on the payment records of firms it granted credit in the

Management of Receivabes 241 past. Past customers can be readiy cassified into good risk and bad risk categories. The financia information on customers is used in conjunction with a statistica procedure caed mutipe discriminant anaysis to deveop a statistica credit scoring mode. Discriminant anaysis first of a provides an indication of those measures which are most important in distinguishing between good risk and bad risk customers. That is, the firm may start out by using 30 ratios and variabes in its anaysis. Discriminant anaysis might indicate that ony five of these ratios and variabes are important in characterising good risk and bad risk customers. Second, discriminant anaysis wi deveop weights for each ratio or variabe to form a discriminant function that may ook ike: discriminant score = 3.5 (current ratio) + 1.7 (profit margins) + 7.1 (debt to assets) + 0.3 (inventory turnover) + 1.9 (quick ratio) The 3.5, 1.7, and so forth, are weights deveoped by discriminant anaysis. Current ratio, profit margins, and so forth, are discriminant variabes identified as important by the mode. The sum of the products of the weights and the variabes is the discriminant score. The anaysis seects weights such that discrimination between good risk and bad risk accounts is maximised. A perfect set of weights woud create a discriminant score such that a bad risk firms woud have scores on one side of the discriminant score. Once the discriminant credit scoring mode has been deveoped, it can be appied to credit appicants. The weights can be used to cacuate a score for the credit appicant. The credit appicant s score can be compared with the discriminant score to see whether the appicant fas in the good risk or bad risk category. If the appicant fas in the good risk category, a simiar type of procedure to that described here can be used to estabish a credit imit for the appicant. A variety of coection procedures can be utiised by the firm in its efforts to coect on deinquent accounts. The initia efforts shoud be very ow key and shoud become more strict as per the response from debtors. If payment is not received within a few days, one or more foow up etters shoud be sent demanding payment. Teephone Ca. If etters are unsuccessfu, a credit department empoyee, preferaby the manager, shoud ca the deinquent debtor and ask for prompt payment. The credit manager may aso wish to communicate that ega action may be taken if payment is not forthcoming. Persona Ca. Some firms have either coection personne or saes representatives visit deinquent debtors. The firms fee that a face-to-face confrontation with a deinquent debtor provides them with an edge over other creditors. Coection Agency. If the preceding measures are unsuccessfu, the firm may consider the services of a coection agency. The coection agency fee is typicay high-usuay

242 Financia Management 50 per cent of the amount coected. For sma deinquent accounts this may be the ony feasibe aternative. Lega Action. Lega action is usuay costy and there is no guarantee of a payment. If a firm is in a very weak financia position, ega action wi force it into bankruptcy. The firm may choose to use ega action as a negotiating too to dea with arge deinquent accounts. With a very arge deinquent account, the firm may use the threat of ega action to appoint more competent management. Cost of Credit Contro The costs of credit contro incude the cost of: assessing and reviewing creditworthiness; checking incoming orders; saes edger keeping, and invoicing debt coection. These costs may occur in various departments of the business, but there shoud be some means of identifying them and coecting the tota cost, which wi have to be taken into account in reviewing the benefits of the credit poicy. Cash Discount An aternative or suppement of a forma credit poicy is to offer discount for prompt payment. In considering this possibiity it is important to bear in mind that: (a) (b) customers who normay pay prompty wi now become entited to discount, athough there wi be no improvement in the timing of their payments. some ate payers wi nevertheess deduct discount from their settements, and there may be some practica difficuty in recovering these incorrect deductions. There are various other ways in which a business can speed up its coection of cash without requiring the customer to pay any earier. The most common exampes are by using bis discounting or factoring both of which have been mentioned earier. Persona Guarantees An aternative form of protection against bad debts is to take a persona guarantee in support of the customer s account. The vaue of persona guarantees varies consideraby and they are ikey to present two probems. it may be more difficut to assess the creditworthiness of an individua guarantor than of the trade customer;

Management of Receivabes 243 the guarantor does not normay expect to be caed upon to pay, and there may be difficuties in obtaining money from him when the need arises. These probems do not occur to the same extent when the guarantor is another company, often the parent company in the customer s group. So the objective of the receivabes management remains as the most effective way to receive the cash back without sacrificing the saes and future prospects of the company. Factors affecting poicies for managing accounts receivabes There are severa affects of extending credit to the customers on various operating parameters of the company. These incude: 1. Revenue effects: As the customers are extended credit, payment for goods is received ater giving the customers time to generate saes from the goods and pay back the company. This may aow the company to charge a higher price and aso the quantity sod may increase. 2. Cost effects: Extending credit means that the company has to maintain a credit department. This invoves costs. Aso coecting receivabes has its own costs associated with it. 3. The cost of debt: If the company has to extend credit it must finance these receivabes from its own money or from borrowings. Both of these methods invove costs. 4. The probabiity of nonpayment: The company aways gets paid if it ses for cash but if it extends credit there is a probabiity that the customer may not pay. This means that the company may not get its payments resuting in a oss to the company. 5. The cash discount: The cash discount affects payment patterns and amounts that the company recieves eary. If the cash discount is high then there is higher probabiity that the company wi get more cash upfront and vice versa.

244 Financia Management Chapter-10 Inventory Management The financia decisions reating to stockhoding have certain specia features, but ooking first at saeabe stocks (finished goods) we can postuate that the object of hoding stocks is to increase saes, and that the object of increasing saes is to increase profit. We can then create a simpe mode simiar to that for debtors. Exampe The Retai Company Ltd makes cash saes from stock and obtains an average rate of margina contribution of 25% on saes vaue. When it hods stocks equivaent to one month s cost of saes it achieves saes of Rs.10,000 per annum. It is estimated that by doubing the stock avaiabe an increase of 25% in saes vaue coud be achieved; aternativey, if three months stocks were hed then saes coud be increased by 35% from the present eve. The effect on profits of these two aternatives, incuding any reevant changes in costs, is iustrated on the foowing page. This somewhat exaggerated exampe draws attention to three points which are reevant to any further discussion of the financia impications of stockhoding poicy: Rs. No credit One month s Credit Two month s Credit Saes 120,000 160,000 240,000 Debtors 13,333 40,000 Stocks (ess creditors (Say, 1/12 of saes vaue) 10,000 13,333 20,000 Tota 10,000 26,666 60,000 Increase in working capita through granting credit 16,666 50,000 Margina contribution 30,000 40,000 60,000 Less: Cost of: Credit contro (6,000) (6,000) Bad debts (1,600) (4,800) Reevant comparabe profits 30,000 32,400 49,000 Increase in profits 2,400 19,200 But the company requires a return of 15% on the increase in capita empoyed; i.e. 2,500 7,500 The net advantage (or disadvantage) of the proposed changes in credit poicy is therefore (Rs.100) Rs.11,700 There are some points that you need to note here: There may be a point beyond which further increase in stock wi not give rise to sufficient additiona saes and gross profit to justify the additiona costs invoved.

Inventory Management 245 Purchase order processing costs per unit or Rs. vaue of purchases ( and possiby even in tota as shown) are ikey to diminish as stock hodings are increased, because instead of having to frequent orders for the renewa of stocks, the company is now pacing ess frequent buk orders i.e. one negotiation, one order and one progress action cover a arge quantity of any particuar item; Stock hoding costs naturay increase with the size of stockhodings because: 1. stocks occupy space which has to be purchased, rented or converted from some other use - that space has to be equipped with racks or containers; 2. peope are required to put the stocks into the warehouse, to withdraw them when needed (picking and packing), to record them, check their conditions and ensure they are not ost; 3. stocks ose vaue if they deteriorate, are wasted in handing, pifered, destroyed or aowed to become obsoete - it may be desirabe to insure against some of these risks; 4. stocks tie up money, invoving interest charges or opportunity costs. Why shoud increased stocks give rise to increased saes? One reason woud be that the business may offer a wider range of goods and it diversifies its range. Another coud be that with the existing range the business was offering a better eve of service; i.e. it was ess frequenty out of stock of an item when it was required. Stock Service Leves In deciding on an inventory poicy it is necessary to define the eve of service to be offered to the customer, in the sense of the percentage of order which can be satisfied immediatey from stock. This wi depend on the nature of the business. In some cases the company may be the monopoy suppier of certain goods, or may offer particuar advantages of quaity, reputation., reiabiity or after-saes services. Where such distinguishing features exist, it is possibe that the customers wi be prepared to endure occasiona deays in meeting their requirements, and it woud not be necessary to hod sufficient stocks to ensure immediate deivery. In other cases quick deivery may be an essentia feature of success in achieving saes. This woud be the case, for exampe, if there was strong competition for a imited market, or if the faiure to suppy a spare part for instaed equipment woud cause significant oss to the customer whie the equipment was out of use. When the required eve of service has been defined, the next probem is to decide how much stock is needed to meet that requirement. This wi be the minimum hoding, and

246 Financia Management not the average hoding which wi be infuenced by the stockhoding costs iustrated in the previous paragraph. Pattern of Procurement and Stockhoding Assuming that an item is in constant demand there are no difficuties in obtaining suppies, it woud be norma to take a suppy into stock and then use it up steadiy unti it was exhausted, when a new suppy woud be obtained. Taking the exampe from the paragraph on contro of stock where saes were to be Rs.1,35,000 per annum, assume, that this represents 1,35,000 units of an item of stock at Rs.1 each. If demand is steady, the monthy usage of this item woud be 11,250 units. Now it woud be possibe to buy a 1,35,000 units at the beginning of the year and to use them progressivey as shown in the foowing diagram: Quantity 140000 120000 100000 80000 60000 40000 20000 0 Avg. Stockhoding 67,500 0 3 6 9 12 Months If this was done then: there woud be ony one purchase, so the reated costs in the buying department woud be ow; the average stock hoding woud be 62,500 units, so there woud be 62,500x12 = 7,50,000 unit-months to infuence the costs of stock-hoding. An aternative action woud be to buy twice during the year, as shown in the next diagram. This woud doube the procurement costs, but woud reduce the average stockhoding to 31,250 units so that stockhoding costs woud be determined by ony haf the previous number of unit-months. Quantity 70000 60000 50000 40000 30000 20000 10000 0 Avg. Stockhoding 33,750 0 3 6 9 12 Months

Inventory Management 247 There is obviousy a very arge choice of procurement and stockhoding patterns; what is needed is to find that pattern which keeps tota procurement and hoding costs at the owest possibe eve. Figure 18.5: Costs of Hoding Inventory Cost in rupees of hoding inventory Tota costs of hoding inventory Carrying costs Restocking costs Size of inventory Q* orders (Q) Optima size of inventory order Figure : Costs of Hoding Inventory This means that carrying costs increase with the quantity of inventory on hand and as the inventory go down the carrying costs aso go down. But with the decining amount of inventory hed restocking costs go up as there are more number of orders and more number of receipts of orders. As tota costs are the sum of the carrying and restocking costs we need to find a eve where it is minimum. This is depicted graphicay in the figure above. Tota Restocking Costs = Fixed Costs per order Number of restocking times Mathematicay speaking carrying costs are given by: S TRC = FC Tota Carrying Costs = Interest Q Costs Cost per unit Average Inventory Q TCC = I P 2 Here Q/2 is the average inventory, I the interest rate and P the price per unit. Simiary Restocking Costs are given by Here S = tota quantity consumed in a year. As we know that tota costs are a sum of these two individua costs. We can say Tota Costs = Carrying Costs Restocking Costs TC = TOC + TRC Q TC = I P + FC 2 S Q

248 Financia Management But this doesn't give us the optimum size of the inventory order. For finding the minimum costs we need to find the 'economic order quantity' for the particuar item of stock under review. The effect of the combination of the various items of stock into the tota business inventory wi be discussed ater. Inventory Management Techniques Economic Order Quantity (EOQ) The economic order quantity is defined as a point where the tota costs of restocking and carrying costs are the owest. EOQ is usuay cacuated by a formua based on differentia cacuus. Though we wi not derive the formua we need to understand its working. EOQ = 2 FC S I P There are four assumptions that we make in the EOQ mode: 1. Saes can be forecasted perfecty, 2. Saes are eveny distributed throughout the year, and 3. Orders are received as soon as they are paced. This set of assumptions mean is pretty restrictive and we wi reax these assumptions sowy. Before we reax these assumptions there are two important things to note about the EOQ: 1. Athough a mathematicay precise EOQ can be cacuated, in practice there is ikey to be a range of order quantities within which tota costs remain at a ow eve. The choice of order quantity within this ow-cost range may not significanty affect the overa financia pan. 2. The key factor in the cacuations is usuay the cost of capita (interest on stockhodings). In times of high interest rates this is ikey to outweigh a the other variabes. The inventory hoding costs wi go up very steepy, and one's concusion wi be that stockhodings shoud be kept to the owest figure possibe having regard to any practica difficuties in obtaining frequent repacement suppies. Optimum Order Quantity (OOQ) The ast comment above is a reminder that suppiers do not ike handing sma orders. The purchase price per unit, therefore, may vary with the size of the purchase order, and this wi require a modification to our EOQ cacuation.

Inventory Management 249 The suppier might, for exampe, impose a 'minimum order vaue' so that for quantities beow this imit the cost per unit woud, in effect, be higher than norma. This woud either impose a ower cut-off imit on the size of order paced, or woud introduce an upward curve at the ower end of the hoding cost ine on the EOQ chart, since insurance and interest charges per unit woud be reativey high unti the sma order imit was reached. For arger orders, on the contrary, there might be quantity discounts, and these woud cause one or more downward steps at those points on the hoding cost ine where they began to operate. This possibiity can resut in minimum tota cost which differs from the position of the EOQ as originay cacuated. This point is sometimes distinguished as the 'optimum order quantity'. Safety Margins in Stockhoding So far we have assumed that a company wi he pacing purchase orders at reguar intervas of time for a fixed quantity (the economic or optima order quantity) of any particuar item. The possibiity of doing this depends on demand remaining constant from period to period and on suppies being avaiabe as and when required. Saes demand, however, coud show fuctuations around the norma eve, so that in a period of high demand the avaiabe stock coud be used up before fresh suppies are due. Simiary, in some periods deiveries from suppiers coud be deayed so that even the norma saes demand coud not be satisfied. Against both these contingencies, it is necessary to hod a safety margin of stock. If it were necessary to hod a safety margin sufficienty arge to cover the simutaneous occurrence of a peak in demand and a deay in suppies, then the minimum stockhoding woud form the greater part of the tota stockhoding. Very itte can be done to correct for random deays in suppy, but it may be possibe to anticipate changes in the trend of demand and to modify the purchasing procedure to meet them in one of the foowing ways: to order in economic order quantities but at varying time intervas according to the rate of demand currenty being experienced, or anticipated in the near future - this is known as the fixed order quantity or re-order eve system (for reasons which wi be expained beow); to order at reguar intervas but in varying quantities determined by the current rate of demand - this is the fixed interva, or periodic review system.

250 Financia Management Modified Ordering Systems The re-order eve system invoves deciding a eve of stockhoding at which new purchase orders sha be paced. This wi be decided in reation to the norma rate of issues during the norma purchasing ead time. The quantity to be ordered is constant, and an order for that quantity wi be paced whenever stock fas to the pre-determined order eve. The system thus responds quicky to variations in demand though there is a danger that in doing so it may refect purey short term or random fuctuations in saes. The operation of re-order eve system incude the use of: A maximum stock eve. This woud correspond to the norma peak hoding under stabe conditions. If the stockhoding exceeds the peak eve this provides a warning that demand has been running beow the rate expected when the EOQ was fixed. The stock controer shoud then review the correctness of his standard purchase order quantity a minimum stock eve which, as suggested above, is probaby the amount of the safety margin. The minimum stock eve provides a warning of a potentia out-of-stock position. When a stockhoding fas to that eve the stock controer wi review his outstanding purchase orders and their due dates, and aso the current trend of demand, and can then decide whether additiona emergency procurement is necessary. Under the periodic review system purchase orders are paced at fixed intervas of time but the quantity ordered can be modified to meet the rate of demand indicated by current experience. This gives an opportunity for anaysing the trend of demand, and various techniques such as 'exponentia smoothing' can be used in forecasting this trend. The system does not respond rapidy to immediate needs, and it may therefore necessitate a arger safety margin than the re-order eve system. Inventory (units) Reorder point Deivery time Deivery time Minimum inventory eve Time By combining safety stocks and reorder points, the firm maintains a buffer against unforeseen events. Figure : Safety Stocks and Reorder Points

Inventory Management 251 It is, in fact, a common experience that the re-order eve system gives sighty ower average stock eves, and it is sometimes thought to be the cheaper system to operate because reordering is triggered automaticay at the re-order eves, however, requires reviewing in the ight of changes in the rate of demand. Any system can appear cheap in the short run if it is operated in a soveny manner. Infrequent and Seasona Demand In most inventories it wi be necessary to carry items which are sow moving in the sense that units of demand are separated by significant intervas of time. These items may have high individua vaue but because they are demanded infrequenty they wi probaby contribute ony a sma percentage of the tota annua vaue of saes. The norma distribution of stockhodings woud show that about 20% of the ine items carried woud contribute 80% of the tota annua usage, though this reationship wi vary between different types of business. It may be decided not to hod stocks of some sow-moving items, but to procure them as and when they are required. If a stock is needed however the amount hed wi probaby be imited to the quantity most ikey to be next demanded, the occurrence of the demand being the signa for further procurement action. The quantity hed may, however, be increased if the purchase price per unit is sufficienty ower for arge quantities so as to offset any increase in hoding costs for a arger stock hoding. This coud occur for exampe when the suppier imposed a minimum order vaue. There shoud be a reguar review of sow-moving items to identify stocks which have become technicay obsoete or for which the demand has diminished to the point where stock hoding is no onger justified. In some businesses (for exampe, adies fashion wear), it is necessary to pace orders for the fu seasona requirement we in advance of the demand occurring, with a high probabiity that repeat orders wi not be obtainabe. In such instances the purchase and sae of each batch wi be a separate project or venture dependent heaviy on accurate forecasting of demand quantities and seing prices. In this case, the evauation procedure appicabe to stock hoding for continuous demand wi not appy. Of a simiar nature wi be decisions ike the foowing: to purchase goods in buk in advance of demand arising in order to protect the business against anticipated price rises or shortages of suppy; to purchase commodities forward at a fixed price for future deivery; to combine forward purchase options with forward saes options, so as to imit osses arising from price changes (incuding changes in currency exchange rates);

252 Financia Management to purchase foreign currency forward against specific overseas purchases, so as to minimise the effect of changes in exchange rates. These are financia decisions quite separate from the routine probems of inventory contro, and woud be evauated as investment projects. The Tota Inventory The techniques described in the foregoing paragraphs a reate to singe ine items of stock; the assumption has been made that if each item is hed at its own economic eve then the overa hoding of stock wi be correcty baanced. This woud be true provided that two conditions were satisfied. that there was enough space avaiabe to hod a the stocks required; and that enough money coud be found to finance them. Neither condition is ikey to be fufied in practice, so some form of mathematica programme might be used to constrain the idea unit quantities within the imiting factors. There are, however, a number of simpe pragmatic approaches to inventory reduction, and these incude: modifying the service eve offered, either generay or in reation to seected items; etting the company's suppiers act as stockhoders (possiby by pacing buk orders with schedues of ca-off dates inked to saes demand); discontinuing those items which are the east profitabe having regard to their margina contribution and reevant fixed costs per unit of the imiting factor. Raw Materia Stocks and Work-In-Progress So far, in considering inventory contro we have been discussing saeabe stocks, but the same principes appy to stocks of raw materias. The main difference is that demand for raw materias is not direct from the outside customers but indirect through the production pans of the factory using the raw materias. In considering the scheduing of production the 'Economic Batch Quantity' (EBQ) corresponds to the EOQ for purchased items. Manufacture in sma batches wi be more costy than in arger batches because there wi be greater repetition of panning and progress actions and of the setting up and breaking-down of machine tooing, and aso because there wi be ess opportunity for an efficient momentum of work to be estabished. However, these batch processing costs (ike procurement costs of stocks) wi change inversey to the hoding costs of the work-in-progress (foor space, insurance, interest on capita, etc.).

Inventory Management 253 A big probem with work-in-progress is that work passes in sequence through a series of operations. What is an economic batch for athe work may not be economic for driing, miing or assemby operations. Appying EBQ cacuation to one operation in isoation can cause bottenecks in the fow or production - creating excessive hodings of party-competed work because it coud be produced cheapy in a arge batch, even though there wi be no demand for that work for some time ahead. A simiar probem is that of keeping skied work peope steadiy occupied, since their wages are basicay fixed in reation to time, even though outside customer demand may be seasona or erratic. Because these probems are concerned with the uneven timing of cash fows they are best soved by the use of discounted cash fow techniques. If, however, there is a capabiity of a rate of production which is in excess of a steady rate of demand (interna or externa) then the probem is to decide what is the economic ength of a production run, the faciities then being switched to other work unti the next run is required. As the number of items coud be very arge in case of raw materias it is necessary to find ways to seectivey pay attention to those items that represent the highest vaue. A categorisation method known as ABC anaysis is used for the same purpose. The idea behind ABC anaysis is that attention is focussed on the highest vaue items that are usuay sma in number categorised as A-category items and the owest vaue items are categorised as C and are ordered in more quantities so that ess attention is required there. For exampe in the figure 3.6 beow, the A category items represent ony 10 % of tota inventory items but represent 57 % of the tota vaue. Whie C category items represent 50 % of the tota items but ony 16 % of the vaue. By concentrating more on the A category items the company is abe to manage its raw materia inventory better. Percent of inventory vaue 100 80 60 40 20 0 A Group 57% B Group 27% C Group 16% 20 40 10% 40% 50% 60 Percent of inventory items 80 100 Figure: ABC Inventory Anaysis

254 Financia Management Integrated Working Capita Panning Short-term financia panning is concerned with the management of the company's short-term, or current assets and iabiities. The most important current assets are cash, marketabe securities, inventories and accounts receivabe. The most important current iabiities are bank oans and accounts payabe. Current assets and iabiities are turned over much more rapidy than the other items on the baance sheet. Short-term financing and investment decisions are more quicky and easiy reversed than ong term decisions. Consequenty, the financia manager does not need to ook too far into the future when making them. The nature of company's short term financia panning probem is determined by the amount of ong term capita it raises. A company that issues arge amounts of ong term debt or equity, or which retains a arge part of its earnings, may find that it has permanent excess cash. In such cases there is never any probem paying bis, and short term financia panning consists of managing the company's portfoio of marketabe securities. Companies with permanent excess cash shoud ook at the cost of funds and pay them out to the sharehoders if they are earning ess than the cost of funds. Other companies raise reativey itte ong term capita and end up as permanent short term debtors. Most companies attempt to find a goden mean by financing a fixed assets and part of current assets with equity and ong term debt. This may even be required by the bank to be so. Such companies may invest cash surpuses during part of the year and borrow during the rest of the year. The starting point for short term financia panning is an understanding of sources and uses of cash. Companies forecast their net cash requirements by forecasting coections on accounts receivabe, adding other cash infows, and subtracting a forecasted cash outays. If the forecasted cash baance is insufficient to cover day-to-day operations and to provide a buffer against contingencies, you wi need to find additiona finance. It may make sense to raise ong term finance if the deficiency is permanent and arge. Otherwise you may choose from a variety of sources of short term finance. In addition to the expicit costs of short term financing, there are often impicit costs. The financia manager must choose the financing package that has owest tota cost (expicit and impicit costs combined) and yet eaves the company with sufficient fexibiity to cover contingencies. Short Term Financia Panning Mode Working out a consistent short term pan requires burdensome cacuations. Fortunatey much of the arithmetic can be deegated to a computer. Many arge companies have

Inventory Management 255 buit modes to do this. Smaer companies do not face so much detai and compexity and find it easier to work with a spreadsheet programme on a persona computer. In either case the financia manager specifies forecasted cash requirements or surpuses, interest rates, credit imits, etc. and the mode grinds out a pan. The computer aso produces baance sheets, income statements, and whatever specia reports the financia manager may require. Smaer companies that do not want custom buit modes can buy genera purpose modes offered by accounting companies, management consutants or speciaised computer software companies. Most of these modes are simuation programmes. They simpy work out the consequences of the assumptions and poicies specified by the financia manager. Optimisation modes for short term financia panning are aso avaiabe. These modes are usuay inear programming modes. They search for the best pan from a range of aternative poicies identified by the financia manager. Optimisation heps when the company faces compex probems with many interdependent aternatives and restrictions for which tria and error might never identify the best combination of aternatives. Of course the best pan for one set of assumptions may prove disastrous if the assumptions are wrong. Thus, the financia manager has to expore the impications of aternative assumptions about future cash fows, interest rates and so on. Linear programming can hep identify good strategies, but even with an optimisation mode the financia pan is sti sought by tria and error. Soved Probems 1. The Cassic Company offers trade credit to its customers of net 30. Credit saes average Rs 620,000 per day on which the company earns a contribution margin of 20 percent. The average accounts receivabe coection period is 50 days. The appropriate after-tax discount rate for evauating accounts receivabe poicy changes is 9 percent and the company's margina tax rate is 40 percent. a. What is the average baance in accounts receivabe? What is the average investment in accounts receivabe? What are the annua financing costs associated with the investment in receivabes? b. The saes manager beieves she can impement a credit poicy change that wi reduce the average coection period by four days without affecting the eve of saes. If this poicy works as expected, what wi be the company's investment in accounts receivabe? What wi be the net annua after-tax advantage to the company of adopting this poicy?

256 Financia Management Soution c. Suppose the credit poicy change wi aso reduce saes by Rs 5,000 per day. What woud be the company's investment in accounts receivabe? What wi be the expected effect of this poicy change on the company's after-tax net income? a. The average baance of accounts receivabe is: Average A/R baance = (Rs 620,000/day) (50 days) = Rs 31,000,000 Average investment in A/R =(Rs 31,000,000) (0.80) = Rs 24,800,000 The cost of financing the investment in receivabes is: Cost of financing A/R = (Rs 24,800,000) (.09) = Rs 2,232,000 Note: The financing cost of carrying receivabes is based on the cost of saes since the cost of saes represents the cash paid out in advance of coections. The cash paid out creates a financing need. b. Reducing the coection period by 4 days wi free up: Cash freed up = (4days) (Rs 620,000 per day) (0.80) = Rs 1,984,000 The net advantage is reduced financing cost of the cash freed up: Reduced financing cost = (Rs 1,984,000) (0.09) = Rs 178,560 per year c. If saes decrease and the average coection period is reduced, New investment in A/R=(Rs 615,000)(0.80)(46) Rs 22,632,000 New financing cost of A/R=(Rs 22,632,000)(0.09) = Rs 2,036,880 There are two effects on saes: Financing cost of A/R=(Rs 2,232,000-Rs 2,036,880) Rs 195,120 Net Profit from ower saes=(-rs 5,000/day)(365)(0.20)(0.60) 219,000 NIAT -Rs 23,880 Note: Here D means additiona Given the expected effects, the poicy change woud not be profitabe. 2. Rupesh Goe, credit manager of Kapana Company, is considering a change in the company's credit terms from net 60 to net 30. Kapana has daiy credit saes of Rs 50,000 and its variabe cost ratio is 15 percent. Tightening credit standards woud reduce the average coection period from 75 days to 40 days, reduce daiy saes by Rs 2,000, and ower bad debts from 5 percent of saes to 3 percent of saes. The company's margina tax rate is 40 percent and it uses an after-tax

Inventory Management 257 Soution discount rate of 12 percent to evauate accounts receivabe poicy changes. How woud the change in credit terms affect Kapana's after-tax income? To answer, first cacuate the new and od investment in A/R Od investment in A/R=(75 days)(rs 50,000/day)(0.85) = Rs 3,187,500 New investment in A/R=(40 days)(rs 48,000/day)(0.85) 1,632,000 Investment in A/R Rs 1,555,500 There are three expected changes in after-tax net income: Financing cost of A/R investment = (Rs 1,555,500)(0.20) Rs 186,660 Bad debt expense [(0.05)(Rs 50,000)(365)-(0.03)(Rs 48,000)(365)](0.60) 232,140 Profit on saes = (Rs 2000)(365)(0.15)(0.60) (65,700) Net Profit Rs 353,100 3. The Dryden Company currenty offers trade credit to its customers on terms of net 30. Daiy credit saes average Rs 250,000 on which the company earns a contribution margin of 25 percent. The average coection period of 45 days. The company's margina tax rate is 30 percent and its after-tax discount rate for anayzing credit poicy changes is 8 percent. Soution a. Under the current poicies, what is the company's investment in accounts receivabe? What is the annua after-tax financing cost associated with the investment in account receivabe? b. The company is considering offering credit terms of 2/10, net 30. If the discount is offered, an estimated 85 percent of the company's customers wi choose to take the discount and the average coection period wi fa to 18 days. Assuming the change in credit poicy has no effect on daiy saes, what wi be the effects on the company's after-tax net income? c. Suppose the change in credit terms aso reduces daiy saes by Rs 4,000, owers bad debt expenses from 5 percent to 2 percent of saes, and saves Rs 60,000 per year in credit department expenses. Wi it be profitabe to change the credit terms? a. Under current poicies: Investment in A/R=(Rs 250,000)(0.75)(45 days) = Rs 8,437,500 Cost of financing A/R = (Rs 8,437,500)(0.08) = Rs 675,000

258 Financia Management b. The new investment in accounts receivabe wi be Investment in A/R = (Rs 250,000)(0.75)(45-18) = Rs 5,062,500 The changes in after-tax income are: Cost of financing A/R=(Rs 5,062,500)(0.08) Rs 405,000 Discounts accepted (0.02)(Rs 250,000)(0.85)(365)(0.60) (930,750) NIAT (Rs 525,750) The proposed poicy changes woud be unprofitabe. c. The change in the investment in A/R is: New investment in A/R=(18)(Rs 246,000)(0.75) Rs 3,321,000 Investment in A/R = (Rs 3,321,000-8,437,500) - Rs 5,116,500 The changes in after-tax income are: Cost of financing A/R = (-5,116,500)(0.08) Rs 409,320 Lower profit on saes = (Rs 4000)(365)(0.25)(0.60) (219,000) Discounts accepted = (0.02)(246,000)(365)(0.60) (1,077,480) Bad debt expense =[(0.05)(250,000)(365)-(0.02)(246,000)(365)](0.60) 1,660,020 Credit department expenses = (0.60)(Rs 60,000) 36,000 Net Profit Rs 808,860 The change in credit poicies woud be profitabe. 4. The Superb Company is evauating its credit standards. The company's variabe cost ratio is 78 percent of saes and its margina tax rate is 40 percent. The appropriate after-tax discount rate for evauating credit poicies is 9 percent. Superb cassifies customers into severa credit casses depending on the risk of defaut. Based on the information given in the tabe, woud Superb be better off not granting credit to the two customers in risk casses 4 and 5? (Evauate the profitabiity of granting credit to each risk cass separatey.) Risk Average Annua saes Bad debts as Additiona annua credit Cass Coection percentage of saes department expenses period 4 50 days 730,000 7% Rs 35,000 5 65 days 580,000 12 62,000

Inventory Management 259 Soution For each risk cass, the net advantage of granting credit is: Risk cass 4: Profit on saes = (Rs 730,000)(0.22)(0.60) Rs 96,360 Bad debt expense = (Rs 730,000)(0.07)(0.60) (30,660) Cost of financing A/R=(Rs 730,000/365)(50 days)(0.09) (9,000) Extra credit department costs (Rs 35,000)(0.60) (21,000) NIAT Rs 35,700 Risk cass 5 : Profit on saes = (Rs 580.000)(0.22)(0.60) Rs 76,560 Bad debt expense = (Rs 580,000)(0.12)(0.60) (41,760) Cost of financing A/R=(Rs 580,000/365)(65 days)(0.09) (9,296) Extra credit department costs (Rs 62,000)(0.60) (37,200) Net Profit -Rs 11,696 Extending credit to risk cass 5 appears unprofitabe. 5. The Sunit Company currenty carries Rs 12 miion of inventory. The finance manager proposes a reduction in inventory to Rs 10 miion. The saes and production managers estimate that the poicy change wi increase stockouts, costing the company saes of Rs 600,000 per year. Storage and spoiage costs shoud decrease by Rs 25,000 per year and the company's investment in accounts receivabe wi decrease by Rs 120,000. The variabe cost ratio is 75 percent of saes. The company's margina corporate tax rate is 30 percent and the appropriate after-tax discount rate for evauating inventory poicy changes if 8 percent. Soution a. What are the financing costs to the company of its current inventory poicies? b. If the new poicy is adopted, what wi be the annua change in after-tax income? a. Financing cost of inventory = (12 miion)(0.08)=rs 960,000 per year. b. The poicy changes wi have the foowing effects on annua income. Financing of inventory = (Rs 2,000,000)(0.08) Rs 160,000 Stockout and spoiing cost = (Rs 25,000)(0.60) 15,000 Financing of A/R = (Rs 120,000)(0.08) 9,600 Profit on saes = (Rs 600,000)(0.25)(0.60) (90,000) Net Profit Rs 94,600

260 Financia Management 6. The Storage Corporation currenty carries Rs 25 miion of inventory. The finance manager is considering whether to recommend a reduction in inventory costs at the foowing information about inventory costs at various eves. The company's after-tax discount rate that is used to evauate current asset poicies is 6 percent. The company earns a contribution margin of 20 percent on saes. Storage costs Spoiage costs Daiy saes Rs 25 miion Rs 23 miion Rs 21 miion 750,000 725,000 710,000 400,000 375,000 367,000 120,000 119,000 114,500 Soution a. Woud it be profitabe for the company to reduce its inventory from Rs 25 miion to Rs 23 miion? (Cacuate the change in after-tax income.) b. Woud it be profitabe for the company to reduce its inventory to Rs 21 miion? (Cacuate the change in after-tax income.) a. Reducing inventory from Rs 25 to Rs 23 miion causes net income to: Storage cost = (Rs 750,000 - Rs 725,000)(0.60) Rs 15,000 Spoiage cost = (Rs 400,000 - Rs 375,000)(0.60) 15,000 Financing cost = (Rs 2,000,000)(0.06) 120,000 Profit on saes = (Rs 120,000-119,000)(365)(0.20)(0.60) (43,800) Net Profit Rs 106,200 b. To determine if it is profitabe to reduce inventory to Rs 21 miion, determine the change in profits associated with reducing from Rs 23 miion. That is, you know that Rs 23 miion is better than Rs 25 miion and the decision is now whether to reduce further to Rs 21 miion. Remember that decisions depend on incrementa costs and benefits. Reducing inventory from Rs 23 to Rs 21 miion causes net income to: Storage cost = (Rs 725,000 - Rs 710,000)(0.60) Rs 9,000 Spoiage cost = (Rs 375,000 - Rs 367,000)(0.60) 4,800 Financing cost = (Rs 2,000,000)(0.06) 120,000 Profit on saes = (Rs 119,000-114,500)(365)(0.20)(0.60) (197,100) Net Profit (Rs 63,300) Given the choices, Rs 23 miion is the most profitabe eve of inventory. 7. The Phi Company expects to se 30,000 amps per month or 360,000 amps per year. The carrying cost is Rs 1.20 per amp and the fixed reorder cost is Rs 375.

Inventory Management 261 Soution a. What is the annua before-tax cost of the current inventory poicy? b. What is the optima reorder quantity according to the EOQ mode? c. If the company changes its reorder poicy to conform with the EOQ mode, what wi be the net savings? (Round the number of reorders to the nearest integer.) a. The annua before-tax cost of the current poicy are : Annua cost = Ordering cost + Carrying cost = (12)(Rs 375) + (30,000)(1.20)/2 = Rs 4,500 + Rs 18,000 = Rs 22,500 b. The optima reorder quantity according to the EOQ mode is: 2(375)(360,000) Q* = = 15, 000 1.20 c. To conform with the EOQ mode, the company wi pace 24 orders per year [=(360,000)/15,000)]. The average eve of inventory wi be 7,500 [=15,000/2] Thus the annua inventory costs wi be: Annua cost = Ordering cost + Carrying cost = (24)(Rs 375) + (7,500)(1.20) = Rs 9,000 + Rs 9,000 = Rs 18,000 The annua before-tax saving of foowing the EOQ mode is Rs 4,500 [=Rs 22,500-18,000].

262 Financia Management Chapter-11 Capita Structure Theories There are basicay three approaches to capita structure decision: Net income Approach Net Operating Income approach Modigiani Mier Approach Net Income Approach According to this approach, the cost of debt capita, Kd and the cost of equity capita Ke remains unchanged when D/S, the degree of everage, varies. Here S stands for tota capita empoyed = D+E). The constancy of Kd and Ke with respect to the degree of everage means that Ko, the average cost of capita, measured by the foowing formua decines as the degree of everage increases. K o = k d D * + k ( D + E) e E * ( D + E) This happens because when the degree of everage increases, Kd which is ower than Ke, receives a higher weight in the cacuation of Ko. This can aso be iustrated by a graph shown in Figure 11.1. K e Cost of Capita K d K o Degree of Leverage D/S Figure 11.1 : Net Income Approach Graph

Capita Structure Theories 263 As our assumption is that the cost of debt and equity capita woud not change with the change in the eve of everage, Ko is seen to go down with the increasing proportion of debt in the capita. Note that we are taking about the market vaue of debt and the market vaue of equity. Many times we confuse it with the book vaues of debt and equity, a measure that aways eads to probems in measuring the true costs of debt and equity. Let us take a company that has an investment of Rs 1,00,000 and an net operating income of Rs 10,000. It is considering two scenarios: 1) no debt and 2) equa eves of debt and equity of Rs 50,000 each. Let us say that the company finds out that the cost of equity is 10% and the cost of debt is 6%. Cacuations show that equity earnings woud be Rs 10,000 and Rs 7,000 respectivey in the two scenarios as shown beow. As the return expected on equity is 10%, we can say that this profit is 10% and therefore the market vaue of equity woud be such that this return becomes 10% on the same. This means that the market vaue of equity woud be Rs 1,00,000 and Rs 70,000 respectivey in the two scenarios. Adding the market vaue of debt and the market vaue of equity gives us the tota vaue of the firm in the market. Scenario A Scenario B Equity 1,00,000 50,000 Debt 0 50,000 Cost of equity 10% 10% Cost of debt 6% 6% Net operating income 10,000 10,000 Interest on debt 0 3,000 Equity earnings 10,000 7,000 Market vaue of equity 1,00,000 70,000 Market vaue of debt 0 50,000 Tota vaue of firm 1,00,000 1,20,000 Average cost of capita: Scenario A: 6% * (0 / 100000) + 10% *(100000 / 100000) = 10 % Scenario B: 6% * (50000/120000) + 10% * (70000 / 100000) = 8.33% There are three points to be noted here. 1. As the cost of capita decreases the vaue of the firm woud go up as it is dependent upon the return expected and the cost of capita. Inverse reationship exists between the vaue of the firm and cost of capita for any given eve of return.

264 Financia Management 2. This means that as we increase the eve of debt in the company, the vaue of the firm woud go up even further. This woud mean that the companies woud ike to empoy as much debt as possibe. Something that doesn't happen in the rea word. 3. Note that we have not considered the effect of taxes. If we consider the same, the vaue of the firm woud go up even further because of the interest tax shied, an effect that we consider ater. Net Operating Income Approach Taking an opposite view from the view taken in the net income approach, this approach states that the cost of capita for the whoe firm remains constant, irrespective of the everage empoyed in the firm. With the cost of debt and the cost of capita constant, we can say that the cost of equity capita changes with the everage to compensate for the additiona eve of risk. Putting it simpy, according to the net operating income approach; for a degrees of everage, Overa capitaisation rate remains constant The cost of debt remains same Given this, and manipuating the equation of the firm's tota cost of capita, we can express the cost of equity as: K e ( Ko kd ) * D = Ko + ( D + E) This is iustrated beow in Figure 11.2. Figure 11.2: Graph of Net Opearting Income Approach

Capita Structure Theories 265 Let us repeat the exampe we discussed earier in net income approach. Let us take a company that has an investment of Rs 1,00,000 and an net operating income of Rs 10,000. It is considering two scenarios: 1) no debt and 2) equa eves of debt and equity of Rs 50,000 each. Let us say that the company finds out that the overa cost of capita is 8% and the cost of debt is 6%. Cacuations show that equity earnings woud be Rs 10,000 and Rs 7,000 respectivey in the two scenarios as shown beow. As the return expected on tota capita is 8 per cent, therefore the market vaue of tota capita woud be such that this return becomes 8 per cent on the same. This means that the market vaue of capita woud be Rs 1,25,000 in both the scenarios as our assumption in this case is that the tota market vaue remains constant. Aso the vaue of debt woud aso remain constant as the cost of debt remains constant. This means that the equity capitaisation can be cacuated by subtracting the market vaue of debt from the tota market vaue of the firm. Then the return on equity divided by the market capitaisation of equity woud give us the cost of equity. Scenario A Scenario B Equity 1,00,000 50,000 Debt 0 50,000 Cost of debt 6% 6% Net Operating income 10,000 10,000 Overa capitaisation rate 8 % 8 % Tota market vaue 1,25,000 1,25,000 Interest on debt 0 3000 Debt capitaisation rate 0.06 0.06 The equity capitaisation rates of scenario A and B are as foows : Market vaue of debt 0 50,000 Scenario A Equity earnings = 10,000 = 0.08 = 8 % Market vaue of equity Market vaue of equity 1,25,000 1,25,000 75,000 Degree of everage 0.0 Scenario B : Equity earnings = 7,000 = 0.0933 = 9.33% Market vaue of equity 75,000

266 Financia Management There are three points to be noted here. 1. As the cost of tota capita and debt is constant, the cost of equity woud go up or down with increasing or decreasing everage, i.e., the amount of debt in the equity. 2. This means that as we increase the eve of debt in the company, the vaue of the firm doesn't change and the company does not benefit by taking on debt. This woud mean that the companies woud ike to empoy as much equity as possibe so as to reduce the risk of the company. Something that doesn't happen in the rea word again, companies do benefit from taking on debt. 3. Note that we have sti not considered the effect of taxes. With these two scenarios in mind et us ook at what one of the most surprising theories of finance say about the capita structure. Modigiani Mier Approach In 1958, Franco Modigiani and Merton Mier (MM) pubished one of the most surprising theories of the modern financia management - they concuded that the vaue of a firm depends soey on its future earnings stream, and hence its vaue is unaffected by its debt / equity mix. In short, they concuded that a firm's vaue stems from its assets, regardess of how those assets are financed. In other words, a variant of the net operating income approach discussed above. This finding had such widespread impications that the artice was judged by the members of the Financia Management Association to have had more impact on financia management than any other pubished work. In their paper, MM began with a very restrictive set of assumptions, incuding perfect capita markets (which impies zero taxes). And then they used an arbitrage proof to demonstrate that capita structure is irreevant. Under their assumptions, if debt financing resuted in a higher vaue for the firm than equity financing, then investors who owned shares in a everaged (debt-financed) firm coud increase their income by seing those shares and using the proceeds, pus borrowed funds, to buy shares in an uneveraged (a equity-financed) firm. The simutaneous seing of shares in the everaged firm and buying of shares in the uneveraged firm woud drive the prices of the stocks to the point where the vaues of the two firms woud be identica. Thus, according to MM Hypothesis, a firm's stock price is not reated to its mix of debt and equity financing. Modigiani and Mier have restated and ampified the net operating income position in terms of three basic propositions. These are as foows: Proposition I The tota market vaue of a firm is equa to its expected operating income (EBIT when Tax = 0) divided by the discount rate appropriate to its risk cass. It is independent of the degree of everage.

Capita Structure Theories 267 V L = V U = EBIT = k o,l EBIT k e,l Here the subscript L is used to denote Leveraged firm and subscript U is used to denote Uneveraged firm. Since the V (Vaue of the firm) as estabished by the above equation is a constant, then under the MM mode, when there are no taxes, the vaue of the firm is independent of its everage. This impies that the weighted average cost of capita to any firm is competey independent of its capita structure and the WACC for any firm, regardess of the amount of debt it uses, is equa to the cost of equity of uneveraged firm empoying no debt. Proposition II The expected yied on equity, Ke is equa to Ko pus a premium. This premium is equa to the debt-equity ratio times the difference between Ko and the yied on debt, Kd. This means that as the firm's use of debt increases, its cost of equity aso rises, and in a mathematicay precise manner. Proposition III The cut-off rate for investment decision making for a firm in a given risk cass is not affected by the manner in which the investment is financed. It emphasises the point that investment and financing decisions are independent because the average cost of capita is not affected by the financing decision. Exampe Let us take the case of two firms X and Y, simiar in a respects except in their capita structure. Firm X is financed by equity ony; firm Y is financed by a mixture of equity and debt. The financia parameters of the two firms are as foows : Financia particuars of Firms X and Y Firm X Firm Y Tota Capita Empoyed(Rs.) 1,000,000 1,000,000 Equity Capita(Rs.) 1,000,000 600,000 Debt (Rs.) ni 400,000 Net operating Income (Rs.) 100,000 100,000 Debt Interest (Rs.) 0 20,000 Market Vaue of Debt (Rs.) 0 400,000 (Debt Capitaisation is 5%) Equity earnings (Rs.) 100,000 80,000 Equity capitaisation rate 10% 12% Market vaue of equity (Rs.) 1,000,000 666,667

268 Financia Management Firm X Firm Y Debt Interest (Rs.) 0 20,000 Market Vaue of debt (Rs.) 0 400,000 (Debt capitaisation rate is 5%) Equity earnings (Rs.) 100,000 80,000 Equity capitaisation rate 8% 12% Market vaue of equity (Rs.) 1,250,000 666,667 Tota Market vaue (Rs.) 1,200,000 1,066,667 From the above particuars, it can be seen that the vaue of everaged firm Y is higher than that of the uneveraged firm. According to Modigiani Mier approach, such a situation cannot persist because equity investors woud do we to se their equity investment in firm Y and invest in the equity of firm X with persona everage. For exampe, an equity investor who owns 1 % equity in firm Y woud do we to: Se his equity in firm Y for Rs. 6,667 Borrow Rs. 4,000 at 5% interest on persona account and Buy 1.0667% of the equity of firm X with the amount of Rs 10,667 that he has. Such an action wi resut in the foowing income : (Rs.) Income on investment in firm X 1066.7 Less Interest (4000 x 0.5) 200.0 Net Income 866.7 This net income of Rs. 866.7 is higher than a net income of Rs.800 foregone by seing 1 percent equity of firm Y and the everage ratio is the same in both the cases. When investors se their equity in firm Y and buy the equity in firm X with persona everage, the market vaue of equity of firm Y tends to decine and the market vaue of equity of firm X tends to rise. This process continues unti the net market vaues of both the firms become equa because ony then the possibiity of earning a higher income for a given eve of investment and everage by arbitraging is eiminated. As a resut of this the cost of capita for both the firms is the same. The above exampe expained that due to the arbitrage mechanism the vaue of a everaged firm cannot be higher than that of an uneveraged firm, other things being equa. It can aso be proved that the vaue of an uneveraged firm cannot be higher than that of everaged firm, other things being equa.

Capita Structure Theories 269 Let us assume the vauation of the two firms X and Y is the other way around and is as foows: Firm X Firm Y Debt Interest (Rs.) 0 20,000 Market Vaue of debt (Rs.) (Debt capitaisation rate is 5%) 0 400,000 Equity earnings (Rs.) 100,000 80,000 Equity capitaisation rate 8% 12% Market vaue of equity (Rs.) 1,250,000 666,667 Tota Market vaue (Rs.) 1,200,000 1,066,667 If a situation ike this arises, equity investors in firm X woud do we to se the equity in firm X and use the proceeds party for investment in the equity of firm Y and party for investment in the debt of firm Y. For exampe, an equity investor who owns 1 percent equity in firm X woud do we to : Se his 1 % equity in firm X for Rs 12,500 Buy 1.01 % of equity and debt in firm Y invoving an outay of Rs 12,500. Such an action wi resut in an increase of income by Rs 172 without changing the risk shoudered by the investor. When investors resort to such a change, the market vaue of the equity of firm X tends to decine and the market vaue of the equity of firm Y tends to rise. This process continues unti the tota market vaue of both the firms becomes equa. Criticism of MM Hypothesis The arbitrage process is the behavioura foundation for the M-M thesis. The shortcomings of this thesis ie in the assumption of perfect capita market in which arbitrage is expected to work. Due to the existence of imperfections in the capita market, arbitrage may fai to work and may give rise to discrepancy between the market vaues of evered and unevered firms. The arbitrage process may fai to bring equiibrium in the capita market for the foowing reasons: Lending and borrowing rates discrepancy The assumption that firms and individuas can borrow and end at the same rate of interest does not hod good in practice. Because of the substantia hoding of fixed assets, firms have a higher credit standing. As a resut, they are abe to borrow at ower rates of interest than individuas. If the cost of borrowings to an investor is more than the firm s borrowing rate, then the equaisation process wi fa short of competion. If the cost of debt paid by the firm is ess than that paid by the investor, then the vaue of the evered firm, V t, must exceed

270 Financia Management the vaue of the unevered firm, V1, for tota return to be equa. For exampe, if the investors can borrow at 9 per cent, his returns after switching wi be ony Rs 550. Consequenty, it does not foow that market opportunities and forces wi ead V t into equaity with V u. Non-substitutabiity of persona and corporate everages It is incorrect to assume that persona (home-made) everage is a perfect substitute for corporate everage. The existence of imited iabiity of firms in contrast with unimited iabiity of individuas ceary paces individuas and firms on a different footing in the capita markets. If a evered firm goes bankrupt, a investors stand to ose to the extent of the amount of the purchase price of their shares. But, if an investor creates persona everage, then in the event of the firm s insovency, he woud ose not ony his principa in the shares of the unevered company, but wi aso be iabe to return the amount of his persona oan. Thus, if the investor keeps his investment in the evered firm, his oss in the event of bankruptcy wi be Rs 6,000. But if he engages in the arbitrage transactions and invests in the unevered firm, he can ose his principa investment of Rs 5,000 and wi aso be iabe to return Rs 5,000 borrowed by him on the persona account. Thus, it is more risky to create persona everage and invest in the unevered firm than investing directy in the evered firm. Transaction costs The existence of transaction costs aso interferes with the working of arbitrage. Because of the costs invoved in the buying and seing securities, it woud become necessary to invest a greater amount in order to earn the same return. As a resut, the evered firm wi have a higher market vaue. Institutiona restrictions Institutiona restrictions aso impede the working of arbitrage. Durand points out that home-made everage is not practicay feasibe as a number of institutiona investors woud not be abe to substitute persona everage for corporate everage, simpy because they are not aowed to engage in the home-made everage. Existence of corporate tax The incorporation of the corporate income taxes wi aso frustrate M-M s concusions. Interest charges are tax deductibe. This, in fact, means that the cost of borrowing funds to the firm is ess than the contractua rate of interest. The very existence of interest charges gives the firm a tax advantage, which aows it to return to its equity and debt hoders a arger stream of income than it otherwise coud have. For exampe, suppose X = Rs 10,000, k d = 0.06 and D t = Rs 20,000. Let the corporate income tax rate equa 50 per cent. Thus, the unevered firm wi have Rs 5000 [= Rs 10,000 (1 0.50)] for distribution to its equity share-hoders. The evered firm must pay a tota tax of Rs 4,400 [= 0.50 (10,000 - Rs 1,200)] which eaves it Rs 5,600 to distribute to its equity and debt-hoders (i.e., Rs 4,400 to equityhoders and Rs 1,200 to debt-hoders). Thus, the tota returns to debt and equity-hoders from the unevered firm are ess than that of evered firm. Hence, the tota market

Capita Structure Theories 271 vaue of a evered firm shoud tend to exceed that of the unevered firm for this very reason. This point is eaborated further in the foowing section. Reevance of Capita Structure: The MM-Hypothesis under corporate Taxes M-M s hypothesis that the vaue of the firm is independent of its debt poicy is based on the critica assumption that corporate income taxes do not exist. In reaity, corporate income taxes exist, and interest paid to debt hoders is treated as a deductibe expense. Dividends paid to sharehoders; on the other hand, are not tax-deductibe. Thus, unike dividends, the return to debt-hoders is not subject to the taxation at the corporate eve. This makes debt financing advantageous. In their 1963 artice, M-M show that the vaue of the firm wi increase with debt due to the deductibiity of interest charges for tax computation, and the vaue of the evered firm wi be higher than of the unevered firm. Consider an exampe. Iusration 6: Suppose two firms L and U are identica in a respects except the use of debt firm U is an a-equity financed firm with Rs 10,000 equity capita whie firm L empoys Rs 5,000 equity and Rs 5,000 debt at a 14 per cent rate of interest. Both firms have an expected earning before interest and taxes of Rs 2,500, pay corporate tax at 50 per cent and distribute 100 per cent earnings as dividends to sharehoders. The; after-tax earnings accruing to investors is shown in Tabe given beow. X Note in Tabe that the iabiity of firm L is Rs 350 ess than that of firm U. The tota income of investors of firm L is more by that amount. This amount is the interest tax shied provided by the debt of firm L: 0.5 0.14 5,000 = 0.5 700 = Rs 350. Thus Interest tax shied = Tax rate Interest INTS = T INT = T (k d D)...(11) where k, is the cost of debt and D is the amount of debt. Tabe: Income of investors of evered and Unevered firm s under corporate income tax Income Firm U Firm L 1. EBIT, X 2,500 2,500 2. Interest, INT = k d D 0 700 3. Profit before tax, ( X -k d D) 2,500 1,800 4. Tax, T= 0.5, T( -k d, D) 1,250 900 5. Profit after tax, ( - k, D) - T ( - k d D) = ( -k d D) (I - T) 1,250 900 6. Dividends to sharehoders, ( - k d D) (I - T) 1,250 900 7. Interest to debt hoders, k d D 0 700 8. Tota income to investors, ( k d D) (I - T) + k d D = (1-T) + Tk d D 1,250 1,600 9. Interest tax shied. Tk d D 0 350

272 Financia Management Interest tax shied (INTS) is an infow to the firm and therefore, it is vauabe. Suppose that firm L wi empoy debt of Rs 5,000 forever. If firm L s debt of Rs 5,000 is permanent, then the interest tax shied of Rs 350 is a perpetuity. What is the vaue of this perpetuity? For this, we need a discount rate which refects the riskiness of those cash fows. The evered firm s after-tax earnings consist of operating income and interest tax shied as given beow: After-tax earnings of a investors = After-tax operating income + Intemst tax shied = (1 - T)+ Tk d D In case of the unevered firm, the after-tax earnings are simpy: (1-T) The cash fows arising on account of interest tax shied are ess risky than the operating income which is subject to business risk. Interest tax shied depends on the corporate tax rate and the firm s abiity to earn enough profit to cover the interest payments. The corporate tax rates do not change very frequenty, Firm L can be assumed to earn at east equa to the interest payabe otherwise it woud not ike to borrow, Thus the cash infows from interest tax shied can be considered ess risky, and they shoud be discounted at a ower discount rate. It wi be reasonabe to assume that the risk of interest tax shied is the same as that of the interest payments generating them. Thus, the discount rate is 14 per cent, the rate of return required by debt-hoders. The present vaue of firm L s perpetua interest tax shied of Rs 350 is: PV of interest tax shied = = Rs 2,500 X T3 0. Note that the government, through its fisca poicy, assumes 50 per cent (the corporate tax rate) of 0.14 firm L s Rs 5,000 debt obigation. Under the assumption of the permanent debt, we can determine the present vaue of the interest tax shied as foows: PV of interest tax shied = PVINTS =...(12) Thus the present vaue of the interest tax shieds (PVINTS) is independent of the cost of debt it is simpy the corporate tax rate times the amount of permanent debt (TD). What is the tota vaue of firm L (that is, the evered firm)? It is the sum of the present vaue of the after-tax operating income and interest tax shied. The operating income, R (1 - T), of the evered firm is equa to the after-tax earnings of the pure-equity (that is, unevered) firm U. The equity- capitaisation rate (the opportunity cost of equity) of a pure-equity firm, k u, shoud be used to discount the stream of operating income. Thus

Capita Structure Theories 273 the vaue of firm L (the evered firm) is equa to the vaue of the unevered firm pus the present vaue of the interest tax shied as shown in Equation beow: Vaue of evered firm = Vaue of unevered firm + PV of tax shied V t = v u + TD...(13) We can write Equation (13) in its expanded form as foows: V t = +...(14) where V t is the vaue of the firm with debt, X (I - T) is perpetua operating income stream of the pure-equity firm, k u is the pure-equity capitaisation rate, k d is the expected rate of return on debt, D is debt and D is the corporate tax rate. Equation (13) impies that when the corporate tax rate, T, is positive (T > 0), the vaue of the evered firm wi increase continuousy with debt. Thus, theoreticay the vaue of the firm wi be maximum when it empoys 100 per cent debt. This is shown in Figure 8. V 1 V 1 Vu TD = + V V V Vaue V u V u Cost k d k 1 k d o Leverage D/V o Leverage D/V Figure 8: Vaue of evered firm Figure 9: Cost of capita of the evered firm V = V + TD u Vu 1 = + V TL (setting D/V = L) V Vu = Thus, for T > 0, V 1 TL wi be maximum when L = 1.0. Under the assumption of the M-M hypothesis with corporate taxes, the evered firm s cost of capita is given by the foowing formua: k = k u (1 TL)...(15) where k, is the evered firm s cost of capita, k u is the pure-equity capitaisation rate,

274 Financia Management T is the corporate tax rate and L is debt ratio. The evered firm s cost of capita is shown in Figure. The M-M s tax-corrected view suggests that, because of the tax deductibiity of interest charges, a firm can increase its vaue or ower its cost of capita continuousy with everage. Thus the optimum capita structure is reached when the firm empoys 100 per cent debt. But the observed experience does not entirey support this view. In practice, firms do not empoy arge amounts of debt, nor are enders ready to end beyond certain imits. M-M suggest that firms woud adopt a target debt ratio so as not to vioate the imits of the debt eve imposed by enders. They state:... existence of a tax advantage for debt financing does not necessariy mean that corporations shoud at a times seek to use the maximum possibe amount of debt in their capita structures... (T) here are, as we pointed out, imitations imposed by enders, as we as many other dimensions in rea-word probems of financia strategy which are not fuy comprehended within the framework of static equiibrium modes... These additiona considerations, which are typicay grouped under the ruberic of the need for preserving fexibiity, wi normay impy the maintenance by the corporation of a substantia reserve of untapped borrowing power. Why do companies not empoy extreme eve of debt in practice? There coud be two possibiities: First, we need to consider the impact of both corporate and persona taxes for corporate borrowing. Persona income tax may offset the advantage of the interest tax shied. Second, borrowing may invove extra costs (in addition to contractua interest cost)-costs of financia distress which may aso offset the advantage of the interest shied. Let us examine these points in the foowing section. Economy-wide Optimum Capita Structure: Mier s Hypothesis with Corporate and Persona Taxes Investors are required to pay persona taxes on the income earned by them. Therefore, from investor s point of view, taxis wi incude both corporate and persona taxes. A firm shoud thus aim at minimising the tota taxes (both corporate and persona) whie deciding about borrowing. How do persona income taxes change investor s return and vaue? It depends on the corporate tax rate and the difference in the persona income tax rates of investors. Consider an exampe. In Iustration 6 of firms L and U, et us add information about the persona taxes. Assume that both sharehoders and enders are required to pay 40 per cent tax on their income respectivey dividends and interest. The after-tax income accuring to investors is shown in Tabe

Capita Structure Theories 275 1. EBIT, Tabe: Income of Investors of Unevered and Levered Firms: Income Income Firm U Firm L 2,500 2,500 2. Interest, INT = k d I) 0 700 3. Profit before tax, 4. Tax,T( 5. Profit after tax ( - k d D 2,500 1,800 -k d D) 1,250 900 - k d D)- T ( 6. Dividends to sharehoders, ( 7. Persona taxes on dividends, Tp [( 8. Dividends after persona taxes, ( - k d D) = ( - k d D) (1 - T) 1,250 900 - k d D) (I - T) 1,250 900 - k d D) (I - T)] 500 360 - k d D) (I - T) (I - T p ) 750 540 9. Interest to debt-hoders, k d D 0 700 10. Persona taxes on interest, Tp (k d D) 0 280 11. Interest after persona taxes, (k d D - Tp k d D) = k d D (I - T p ) 0 420 12. Tota income to investors, (8 + 11) ( - k d D) (I - T) (I - T p ) + k d D (1 - T p ) 750 960 13. Interest tax shied after persona taxes, k d DT - k d DT T p (I = T p ) k d DT - 210 Note that the after-tax income avaiabe to both sharehoders and debt hoders is ess by 40 per cent on account of persona taxes. Further, you aso notice that the interest tax shied after persona tax has reduced to: Rs 350 (1-0.4) = Rs 210. What is the present vaue of this perpetua stream? We sha have to adjust the discount rate for X the persona taxes. This is done because the cash fows arising from the interest tax = shied are computed after persona taxes. The debt hoders of firm L can obtain 14 per cent before tax, but ony 0.14 (1-0.4) = 0.08 or 8.4 per cent after persona tax. Thus, the present vaue of interest tax shied is: PVINTS = Rs 2,500 This present vaue is same as obtained earier when the persona taxes were ignored. It is because both cash fows and discount rate have been reduced by the persona tax rate of 40 per cent. Thus PVINTS = Corporate tax rate Interest ( 1 Persona tax rate) Cost of debt ( 1 Persona tax rate) = =...(16) The vaue of the evered firm is sti given by the foowing formua: V t = V u + TD In reaity, however, dividends are treated differenty from interest income for tax

276 Financia Management purpose. In India, for exampe interest income is tax exempt upto Rs 7,000 for individuas. After this, they are required to pay tax at a margina rate which can be as high as 30 per cent. Dividends in the hands of sharehoders are tax exempt, and capita gains are treated more favouraby for tax purposes. The tax rate on capita gains is 20 per cent. Tax on capita gains is paid ony when they are reaised. Thus, an individua can defer paying tax on capita gains for a ong period if he does not reaise them and thus, his tax on equity income wi be zero. Interest income, whether received or accrued, is taxed in the hands of individuas, athough it is exempted from tax at the corporate eve. Dividends are taxed at the corporate eve whie it is possibe to avoid tax on capita gains at the persona eve and pay no tax on the current dividends. We may concude that, in genera, interest income is taxed at a higher rate than equity income at the persona eve. Consider an exampe. In our earier iustration, et us assume that interest income is taxed at 40 per cent and equity income is not taxed at the persona eve. The aftertax earnings of investors are shown in Tabe. It can be seen that corporate borrowing is sti advantageous since an interest tax shied after persona taxes of Rs 70 is generated. Note that the interest tax shied is reduced by the persona tax on interest income (i.e. k d DT - k d DT pb ). But it is substantiay ess than the case where equity income was taxed at 40 per cent. Tabe: Income of Investors of Unevered and Levered Firms: Corporate Tax at 50% Equity Income Tax Zero and Interest Income Tax at 40$ Income Firm U Firm L 1. EBIT,X 2,500 2,500 2. Interest, INT = k, I) 0 700 X 3. Profit before tax, X - k d D 2,500 1,800 4. Tax,T(X-kdD) 1,250 900 5. Profit after tax ( - k d D)- T ( - k d D) = ( - k d D) (1 - T) 1,250 900 6. Dividends to sharehoders, ( - k d D) (I - T) 1,250 900 7. Persona taxes on dividends, Tp [( - k d D) (I - T)] 0 0 8. Dividends after persona taxes, ( - k d D) (I - T) (I - T p ) 1,250 900 9. Interest to debt-hoders, k d D 0 700 10. Persona taxes on interest, Tp (k d D) 0 280 11. Interest after persona taxes, (k d D - Tp k d D) = k d D (I - T p ) 0 420 12. Tota income to investors, (8 + 11) (X - k d D) (I - T) (I - T p ) + k d D (1 - T p ) 1,250 1,320 13. Interest tax shied after persona taxes, k d DT - k d DT T p (I = T p ) k d DT - 70 The present vaue of this perpetua stream of interest tax shied is:

Capita Structure Theories 277 PVINTS = Thus the formua for PVINTS in the case of a positive persona tax rate for enders and no persona tax rate for sharehoders can be written as foows: PVINTS = Corporate tax rate Lender' s Persona tax rate) Interest Cost of debt ( 1 Lender' s Persona tax rate) = =...(17) The tota earnings of a firm wi be distributed either as interest income or equity income. The persona tax rate on interest income is T pb and on equity income T pe. T pe is unikey to be equa to T pb. mosty it wi be ess than T pb, and in extreme cases it wi be equa to zero. Comparing the income tax shieds in Tabes we can see that corporate borrowings is advantageous if (1 - T pb ) > (1 - T pe )( - T) Thus a firm shoud stop borrowing when (1 - T pb ) becomes equa to (1 - T pe ) (1 - T). In practice, the finance manager wi find it difficut to arrive at the numerica vaues of T pb and T pe since the firm wi have a arge number of sharehoders and debt hoders in different tax brackets. = How does everage affect the firm vaue when the persona tax rates of sharehoders = and debt-hoders differ? We have aready shown that the vaue of the firm wi be reduced when the persona tax rate of enders is higher than that of sharehoders. Mier has provided a forma answer to this question. As we know, the interest tax shied (INTS) which is the gain from everage is the difference between the vaue of the evered and unevered firm, and is aso given by the product of the corporate tax rate and the amount of debt under the assumption of perpetua debt and no persona taxes: INTS = k d DT PVINTS = k d DTk d PVINTS = V t V u = TD...(18) Mier introduced persona taxes in the mode and modified it. In the unevered firm where equity income is taxed at T pe persona tax rate, the sharehoder s earnings wi be: X (1-T) (1-T pe )...(19) and when we discount these earnings at the pure-equity capitaisation rate, k~, the vaue of the unevered firm wi be:...(20)

278 Financia Management In case of the evered firm, the sharehoder s earnings wi be: ( X - k d D)( - T)(1 - T pe )...(21) and the debt-hoders earnings after persona taxes at a rate equa to T pb Wi be: k d D(1 - T pb )...(22) The tota income of both types of investors (sharehoders and debt-hoders) wi be: ( - k d D)( - T)(1 - T pe ) +k d D(1 - T pb ) (1 - T)(1 - T pe ) - k d D(1 - T)(1 - T pe ) + k d D(1 - T pb )...(23) Note that the first term of Equation (23) is equa to the sharehoder s earnings of an unevered firm and therefore, it can be discounted at k. The remaining terms have the Same risk as the interest payments, and therefore, they can be discounted at k,( - T pb ). Thus the vaue of the evered firm is: = +...(24) The second term of Equation (24) is the gain from everage (viz. the present vaue of the interest tax shied): PVINTS =...(25) X Appying Equation (25) to data in Tabe 18.8, we obtain: PVINTS = = = and when appied to data of Tabe we obtain: PVINTS = = = = We can generaise the foowing from Equation (25) If T pe = T pb = 0, then the present vaue of the interest tax shied is equa to: TD (corporate tax rate T times the amount of debt, D). If T pb > T pe which is a reasonabe assumption given the persona tax aws in India, then the present vaue of the interest tax shied wi be ess than TD: PVINTS < TD. If (1 - T pb ) = (1-T) (1 - T pe ), then the advantageous of everage wi be competey ost.

Capita Structure Theories 279 In terms of the corporate borrowing, Mier s mode [Equation (25)] indicates the foowing. If the persona tax rate on equity income is zero, except the tax-exempt debthoders, nobody woud be interested in ending to the firm. But, from the firm s point, there is a strong incentive to borrow as the corporate taxes are reduced. Therefore, to induce debt-hoders to end to the firm, the firm wi have to offer a higher beforetax interest rate. This impies that if the rate on the debt of tax-exempt investors is, say, I, then debt-hoders with a persona tax rate of T pb, wi have to be at east offered a rate of interest equa to i 0 /(1 - T pb ), otherwise they wi not end. The persona income tax system is generay progressive. Therefore, the firms wi have to keep the interest rate rising to attract investors in high tax brackets. Firms wi be motivated to keep the interest rate rising if the corporate tax saving is greater than the persona tux oss. They wi stop borrowing once the-corporate tax rate, T, equas the persona tax rate, T pb. Thus, in the equiibrium, the interest rate shoud be equa to: i 0 /(-T). Let us verify this point. Assume that the persona tax rate on equity income is zero: T pe = 0, then Equation (25) can be written as foows: PVINTS = =...(26) The advantage from everage wi become zero once the interest rate offered (i.e., the suppy rate) becomes equa to tax exempt rate grossed up for taxes, i s = i 0 (1-T). The suppy rate i s is equa to the demand rate i d, in equiibrium: = = =...(27) and consequenty, (1 - T) = (1 - T pb ), and PVINTS = 0. If i s < i 0 ( - T), the PVINTS > 0 and firms wi attempt to reach 100 per cent debt in their capita structures. This is shown in Figure 11.3. Mier s mode has two important impications: There is an optimum amount of debt in the economy which is determined by the corporate and persona tax rates. In other words, there is an optimum debtequity ratio for a firms in the economy. There is no optimum debt-equity ratio For a singe firm. There are hundreds of firms which have aready induced tax-exempt and ow ax bracket investors. Therefore, a singe firm can-not gain or ose by borrowing more or ess. Mier s mode has certain imitations: It impies that tax-exempt persons/institutions wi invest ony in debt securities and high-tax bracket investors in equities.in practice, investors hod portfoio of debt and equity securities.

280 Financia Management i d = i 0 /(1-T pb ) i s /(1-T) Suppy i s = i 0 /(1-T) i 0 Demand o Amount of borrowing Figure 11.3: Aggregate suppy and demand for borrowoing The persona tax rate on equity income is not zero. Firms do pay dividends. If T pe is positive, more investors can be induced to hod debt securities. Assume T = 0.25 and T = 0.5. Then the tota tax on equity income is: 0.5 + 0.25 (1-0.5) = 0.625 or 62.5 per cent. More debt can be raised unti investors in 62.5 per cent tax brackets are covered. Investors in high-tax brackets can be Induced to invest in debt securities indirecty. They can invest in those institutions wherefrom income is tax exempt. These institutions, in turn, can invest in the corporate bonds. We can summarise our discussion of M-M s and Mier s modes as foows. Under M- M s mode, the existence of the corporate taxes provide a strong incentive to borrow. In fact, it is idea for a firm to have 100 per cent debt in its capita structure. They ignore persona taxes. Mier s mode considers both the corporate as we as the persona taxes. It concudes that the advantage of corporate borrowing is reduced by the persona tax oss. The important impication of the mode is that there is no optimum capita structure for a singe firm, athough for the economy as a whoe, there does exist equiibrium amount of aggregate debt. From a singe firm s point of view, therefore, the capita structure does not matter. Mier s mode is based on some controversia assumptions, and therefore, most peope sti beieve that in baance, there is a tax advantage to corporate borrowing. Financia Distress We have argued earier that it is difficut to beieve that a firm shoud have 100 per cent debt because of tax advantage. Why don t firms in practice borrow 100 per cent? What are the offsetting disadvantages of debt? The offsetting disadvantages are grouped under the term financia distress. A firm exposeh to higher business risk faces a greater chance of financia distress. The business risk of a firm depends on operating risk, intensity of competition, price easticity, economic conditions, the size of the firm,

Capita Structure Theories 281 extent of diversification etc. Financia distress occurs when the firm finds it difficut to honour the obigations of creditors. The extreme form of financia distress is insovency. Insovency coud be very expensive. It invoves ega costs. The firm may have to se its assets at distress prices. More important consideration is the infexibiity of raising funds when needed if the firm has aready used heavy amount of debt. Non-avaiabiity of funds on acceptabe terms coud adversey affect the operating performance of the firm. Financia distress has many indirect costs as we. It has a great effect on the attitude of management. The sharehoders may ike the management to invest in risky, margina projects so that debt hoder s weath is transferred. Management may aso avoid investment in profitabe projects since, under an insovency or financia distress, debt hoders are ikey to benefit more from such investments. Creditors ose their patience when a firm faces financia probems. They force the firm into iquidation to reaise their caims. A financiay distressed firm aso has a tendency to emphasise short-term profitabiity at the cost of ong-term sustainabiity and profitabiity. Financia distress reduces the vaue of the firm. Thus, the vaue of a evered firm is given as Vaue of evered firm = Vaue of unevered firm + PV of tax shied - PV of financia distress V t = v u + TD PVFD..(28) V Leverage Market Vaue V u Leverage V u o Leverage Optimum ratio Figure 11.4: Vaue of evered firm under corporate taxes and financia distress Figure 11.4 shows the capita structure of the firm is determined as a resut of the tax benefits and the costs of financia distress. The present vaue of the interest tax shied increases with borrowing but so does the present vaue of the costs of financia distress. However, the costs of financia distress are quite insignificant with moderate eve of debt, and therefore, the vaue of the firm increases with debt. With more and more debt, the costs of financia distress increases and therefore, the tax benefit

282 Financia Management shrinks. The optimum point is reached when the present vaue of the tax benefit becomes equa to the present vaue of the costs of financia distress. The vaue of the firm is maximum at this point. CAMP and Capita Structure Leverage causes variabiity in the sharehoder return (EPS or ROE). This adds financia risk. As a consequence, the beta of a firm s equity wi increase as it introduces debt in its capita structure. We know that a portfoio consists of individua securities. Each security has its beta, and the beta of the portfoio is the weighted average beta of individua securities in the portfoio. Simiary, a firm is a portfoio of assets, and therefore, the asset beta of a firm, P~I, is the weighted average of betas of individua assets. Thus, β a = β 1 ω 1 + β 2 ω 2 + β 3 ω 3 +... β a = β ϖ...(29) = where β a is the weighted average beta of assets, Pi is the beta of ith asset and... is the weight of ith asset. A firm s assets are financed by debt and equity. Therefore, a firm s asset beta wi aso equa to the weighted average of the firm s equity beta and debt beta. Assuming no corporate tax, the beta of assets wi be as foows: β a = β e ω e + β d ω d...(30) where... is equity beta, We is weight of equity,... is debt beta and w, is weight of debt. Weight of equity is equa to the market vaue of equity (S) divided by the tota vaue of the firm (V) and the weight of debt wi be equa to the market vaue of debt (D) divided by the tota vaue of the firm (V). Thus, β a = β e + β...(31) + + What is beta of equity for a evered firm? We can derive equity beta from Equation (31) as foows: β e + = + β β + β e = β + a β + +

Capita Structure Theories 283 = β a + = β + β β...(32) We can observe from Equation (32) that the equity beta increases ineary with everage (D/S) since it adds financia risk to the sharehoder s return. Iustration 1: Unevered Firm has no corporate tax. The observed beta on its equity is 1.20. The beta of debt is 0.20. The company has a debt-equity ratio of 0.40. Cacuate the company s asset beta. β e = β a + (β d β e )D/S 1.20 = β a + (β a 0.20)0.40 β e + 0.4β a = 1.20 + 0.08 β a = 1.28/1.4 = 0.914 Debt has ow risk. If we assume that debt is risk-free, then β d = 0. If β d =0, then β a (asset beta) is given as foows: β e = β a + (β d β d )D/S β e = β a + β a D/S (since β d = 0) β β a = +! β #! " β $ = β = β = Corporate + β #! " $ Tax and Interest Tax Shied...(33) Firms in practice pay taxes, and interest paid on debt is tax deductibe. The asset beta shoud be adjusted for the tax effect. The adjustment factors wi be the tax rate and the firm s everage (debt ratio). The adjusted beta wi be as foows: where V is tota market vaue of debt and equity (i.e. S + D)....(34) As we have stated earier, the risk of debt hoders is quite ow. If they have no risk, they wi earn risk-free rate and β d wi be zero. Thus, Equation (34) can be expressed as foows: β a = β #! " (since β d = 0)...(35) where L is D/V. From Equation (35), we can express β e as foows:

284 Financia Management $ β e = β a $...(36) Iustration 2: Nicoe Pubishing Companys market vaue of shares and debt is Rs 50 crore and Rs 15 crore respectivey. The beta of the company s share is 1.32. The expected corporate tax rate for the company is 35 percent. Cacuate Nicoe s asset beta. Tota vaue of the firm, V = 50 + 15 = Rs 65 crore Vaue of shares, S = Rs 50 crore Vaue of debt, L) = Rs 15 crore Debt ratio, D/V = L = 15/65 = 0.23 β a = β $ = = $ %% = It is not difficut to appreciate that for an unevered firm (a firm without any debt), the asset and equity bet wi be the same. For a evered firm, the cost of equity under CAPM wi be as foows: k e = r f 3- (r m - r f ) β e...(37) = r f + (r m - r f )β a...(38) where β a is the asset beta of an unevered firm. Iustration 3: Chemicas has an equity beta of 1.25 and debt ratio of 0.5. The riskfree rate is 9 per cent and the expected market rate of return is 20 per cent. The corporate tax rate is 35 percent. What is Desai chemica s required rate of return on equity? β If we use Equation (37), we obtain: k e = 0.09 + (0.20-0.09)1.25 = 0.09 + 0.1375 = 0.2475 or 24.75% The asset beta is: β a = Using Equation (37), we obtain: k e = 0.09 + (0.20-0.09)0.758 = 0.09 + (0.20 0.09)0.758 1.65 = 0.09 + (0.20-0.09)1.25 = 0.2475 or 24.75%

Capita Structure Theories 285 Cost of Equity and Beta of a Division It has been argued that in evauating a division s investment, its cost of capita shoud be used as the discount rate. The risk of the division may not be the same as the risk of the firm. The beta of the division may, therefore, be higher or ower than the firm s beta. We aso expained that in practice, a division s beta may be approximated by finding out the betas of the comparabe firms in the same industry to which division beongs. However, the comparabe firms may have different eves of debt. Before using the beta of a comparabe firm (or weighted average betas of the comparabe firms) to a division, adjustment for everage shoud be made. The foowing steps are invoved: Identify comparabe firms in the same industry as the division. Cacuate the betas of the comparabe firm. Estimate the comparabe firms asset betas by adjusting them for everage and tax. (This process is caed unevering the beta), Cacuate the average beta from the comparabe firms asset betas that can be used as the beta for the division, Iustration 10: A arge engineering company wants to diversify into fertiiser business organise it as a new division. The company found a comparabe fertiiser company that has an equity beta of 1.35, and debt ratio of 0.72. The corporate tax rate is 35 per cent. $ = The engineering company wi have a debt ratio of 0.50 for proposed fertiiser business. $ = Cacuate the beta for the proposed new division. First, we sha unever the equity beta (that is, cacuate the asset beta) of the comparabe firm: β a = β e Second, se can now ever the equity beta for the division by incorporating its debt ratio: $ β e = β = = a = $ The equity beta for the division is ower than that of the comparabe firm since it wi empoy ess debt. Adjusted Present Vaue Equation (14) gives the vaue of a evered firm: V = V u + TD = +...(14)

286 Financia Management Reca that k U is the cost of capita of an a-equity (unevered) firm, it X (1-T) is perpetua after-tax cash fows (net operating income) of an a-equity firm and Tk d D is a perpetua stream of interest tax shied, Equation (14) impies the foowing required rate of return for a evered firm: k t = V u (1-TL) where k, is the cost of capita of the evered firm and L is debt ratio (D/V). We can use k, as the discount rate for those investment projects that generate perpetua cash fows (perpetua after-tax a-equity cash fows and perpetua interest tax shieds). In practice, it not common to find projects with perpetua cash fows. Projects have finite ife, and firms are abe to raise funds from financia institutions or pubic which are tied to specific projects. This is more so under project financing Thus, the amounts of interest and principa repayments are predetermined, and they are accounted for within the ife of the project. Such projects have their unique capita structure. How can we evauate the net present vaue of projects that are not prepetua investments and that do not have constant capita structure? It is not possibe to estimate the weighted cost of capita for such projects We can use the adjusted present vaue (APV) method for evauating such investments. We can rewrite Equation (14) for vauing an investment project with finite cash fows as foows: APV = =...(39) In practice, a project may get many other benefits (or invove penaties) in addition to the interest tax shied. Equation (39) can be extended to incorporate the vaue of such benefits (or costs). There is no method avaiabe to adjust such items in estimating the weighted average cost of capita. Iustration 4: Gujarat Engineering Company is considering a new project to manufacture stee tubes. The estimated project outay is Rs 64 crore which wi be raised by issuing equity of Rs 40 crore and borrowing a 15 per cent oan of Rs 24 crore from a financia institution for eight years. The oan wi be repaid in three equa instaments at the end of years 6, 7 and 8. The project is expected to generate an annua after-tax cash fow of Rs 12 crores over the eight-year ife of the project. The aequity required rate of return is 18 per cent. The corporate tax rate is 35 percent. The termina vaue of the project is assumed to be zero. Shoud the company make investment to manufacture stee tube? We can use APV method for evauating the project. The project is expected to generate an after-tax annuity of Rs 12 crore for 8 years. The interest tax shied is cacuated as foows:

Capita Structure Theories 287 Year Loan at the Interest Principa Loan at Interest Beginning Repayment the End Tax Shied 0 - - - 24-1 24 3.60-24 1.26 2 24 3.60-24 1.26 3 24 3.60-24 1.26 4 24 3.60-24 1.26 5 24 3.60-24 1.26 6 24 3.60 8 16 1.26 7 16 2.40 8 8 0.84 8 8 1.20 8 0 0.42 The project s APV can be cacuated by using Equation (40): APV = 8 i= 1 12 ( 118. )t L N 6 M i= 1 126. + + ( 115. )t = (12 4.0776) + [1.26 3.7845 + 0.84 0.3759 + 0.42 0.3269] = 48.93 + [4.77 + 0.32 + 0.141 = 48.93 + 5.23 = Rs 54.16 The adjusted net present vaue (ANPV) is: ANPV = APV - Initia Cost = 54.16-64 = - Rs 9.84 Since ANPV is negative, the project shoud not be accepted. What wi happen to the project s ANPV if the company is abe to negotiate oan of Rs 24 crore at concessiona interest rate of 10 per cent from the government if it agrees to start the project in a backward area? If the market interest rate is assumed to be 15 per cent, the project gets a subsidy of 5 percent. Aso, it wi get interest tax shied. The interest subsidy and interest tax shieds are cacuated as foows (assuming that oan is repaid in equa instaments at the end of years 6, 7 and 8): Year Interest Interest Tax Subsidy Shied 1. (0.15-0.10) 24 = 1.20 0.35 0.10 24 = 0.84 2. (0.15-0.10) 24 = 1.20 0.35 0.10 24 = 0.84 3. (0.15-0.10) 24 = 1.20 0.35 0.10 24 = 0.84 4. (0.15-0.10) 24 = 1.20 0.35 0.10 24 = 0.84 5. (0.15-0.10) 24 = 1.20 0.35 0.10 24 = 0.84 6. (0.15-0.10) 24 = 1.20 0.35 0.10 24 = 0.84 7. (0.15-0.10) 16 = 1.20 0.35 0.10 16 = 0.84 8. (0.15-0.10) 8 = 1.20 0.35 0.10 8 = 0.84 The project APV wi be:

288 Financia Management APV = + + + + + + = = = = 48.93 + [3.18 + 0.21 + 0.09] + [4.54 + 0.3P + 0.13] = 48.93 3-3.48 + 4.97-57.38 The project s ANPV is: ANPV = 57.38-64 The project, in spite of the benefit of interest subsidy, is sti unattractive. Iustrative Probems Probem 1: Keey Manufacturing Co. has a tota capitaisation of Rs 10,00.000, and it normay earns Rs 1,00,000 (before interest and taxes). The Financia manager of the firm wants to take a decision regarding the capita structure. After a study of the capita market, he gathers the foowing data: Amount of Debt Interest Rate Equity Capitaisation Rate Rs. % (at given eve of debt) % 0-10.00 1,00,000 4.0 10.50 2,00,000 4.0 11.00 3,00,000 4.5 11.60 4,00,000 5.0 12.40 5,00,000 5.5 13.50 6,00,000 6.0 16.00 7,00,000 8.0 20.00 (a) (b) What amount of debt shoud be empoyed by the firm if the traditiona approach is hed vaid? If the Modigiani-Mier approach is foowed, what shoud be the equity capitaisation rate? Assume that corporate taxes do not exist, and that the firm aways maintains its capita structure at book vaues. Soution (a) As per the traditiona approach, optimum capita structure exists when the weighted average cost of capita is minimum. The weighted average cost of capita cacuations at book vaue weighs are as foows:

Capita Structure Theories 289 k e W e k d W d k e W e k d W d k 0 (1) (2) (3) (4) (5) (6) (7)=(5)+(6) 0.100 1.0 - - 0.100-0.1000 0.105 0.9 0.040 0.1 0.095 0.0040 0.0985 0.110 0.8 0.040 0.2 0.080 0.0080 0.0960 0.116 0.7 0.045 0.3 0.082 0.0135 0.0947 0.124 0.6 0.050 0.4 0.074 0.0200 0.0944 0.135 0.5 0.055 0.5 0.065 0.0275 0.0950 0.160 0.4 0.060 0.6 0.060 0.0360 0.1000 0.200 0.3 0.080 0.7 0.060 0.0560 0.1160 The firm shoud empoy debt of Re 4,00,000 as the weighted average cost of capita is minimum at this eve of debt. (b) According to the M-M approach, the cost of capita is a constant, and the cost of euqity increases ineary with debt. The equiibrium cost of capita is assumed to be equa to pure equity capitaisation rate, which is 10 per cent in the present probem. The equity capitaisation rate is given by the foowing formua: k e = k 0 + (k 0 - k d ) )* The equity capitaisation rates wi be: Debt k d k 0 (k 0 k d ) Debt/Equity k e Rs 0-0.10 + (0.10-0.000) 0 = 0.1000 1,00,000 0.040 0.10 + (0.10-0.040) 1,00,000/9,00,000 = 0.1067 2,00,000 0.040 0.10 + (0.10-0.040) 2,00,000/8,00,000 = 0.1150 3,00,000 0.040 0.10 + (0.10-0.045) 3,00,000/7,00,000 = 0.1236 4,00,000 0.050 0.10 + (0.10-0.050) 4,00,000/6,00,000 = 0.1333 5,00,000 0.050 0.10 + (0.10-0.055) 5,00,000/5,00,000 = 0.1450 6,00,000 0.060 0.10 + (0.10-0.060) 6,00,000/4,00,000 = 0.1600 7,00,000 0.080 0.10 + (0.10-0.080) 7,00,000/3,00,000 = 0.1467 Probem 2: The Levered Company and the Unevered Company are indentica in every respect except that the Levered Company has 6 per cent Rs 2,00,000 debt outstanding. As per the NI approach, the vauation of the two firms is as foows:

290 Financia Management Unevered Co. Levered Co. Rs Rs Net operating income, X 60,000 60,000 Tota cost of debt, k d D 0 12,000 Net earnings, NI 60,000 48,000 Equity capitaisation rate, k e 0.100 0.111 Market vaue of shares, S 6,00,000 4,32,000 Market vaue of debt, D 0 2,00,000 Tota vaue of the firm, V 6,00,000 6,32,000 Mr X hods Rs 2,000 worth of the Levered Company s shares. Is it possibe for Mr X to reduce his outay to earn same return through the use of arbitrage? Iustrate. Soution Through arbitrage it is possibe for Mr X to reduce his outay and earn the same return. 1. Mr X woud se his shares in the Levered Company for Rs 2,000. 2. He woud create a persona everage equa to his share of debt in the Levered Company by borrowing Rs 926 (= Rs 2,000 x Rs 2,00,000/Rs 4,32,000). 3. He woud buy Rs 2,778 (= Rs 6,00,000 x Rs 2,000/Rs 4.32,0001 of the Unevered Company s shares His return is: Return on the Unevered Co. s shares: Rs 2,778 10% Rs 2,77.80 Less: Interest, Rs 926 6% 55.56 Net return Rs 2,22,24 His return from the Levered Co. is Rs 2,000 x 11.1% = Rs 222.22, same as in the Unevered Co. However, the funds invoved in the Unevered Co are Rs 2,778 - Rs 926 = Rs 1,852 which is ess than Rs 2,000 cash outay invoved in the Levered Company. Probem 3: Firms A and B are simiar except that A is unevered, whie B has Rs 2,00,000 of 5 per cent debentures outstanding. Assume that the tax rate is 40 per cent; NOI is Rs 40,OM) and the cost of equity is 10 per cent. (i) Cacuate the vaue of the firms, if the M - M assumptions are met. (in Suppose V B = Rs 3,60,000. According to M-M. do these represent equiibrium vaues? How wi equiibrium be set? Expain. Soution (i) The vaue of the unevered firm is: V A = = = The vaue of the evered firm is: V B = V A + TD = Rs 2,40,000 + 0.4 of Rs 2,00,000 = Rs 2,40,000 + Rs 80,000 = Rs 3,20,000

Capita Structure Theories 291 X (ii) These do not represent the equiibrium vaues. Firm B is overvaued by Rs 40,000 (= Rs 3,60,000 - Rs 3,20,000). The arbitrage process with taxes wi work as foows to restore equiibrium Assume an investor owns and return is 0 per cent of B Co. s shares. His invstment is: and return is 0.10 (Rs 3,60,000 - Rs 2,00,000) = 0.10 Rs 1,60,000 Rs 16,000 0.10 [(Rs 40,000 Rs 10,000) (1-0.4)] = 0.10 Rs 13,000 = Rs 1,800 The investor can get the same income by shifting his investment to A Co. He woud se his hidings in B Co. for Rs 16,000 and borrow on persona account Rs. 12,000, which is his percentage hodings in B Co. s debt i.e., 0.10 (1-0.4) Rs 2,00,000 = Rs 12,000. He woud then, purchase 10 per cent of A Co. s share: 0.10 Rs 2,40,000 = 24,000. His return and outay woud be: Return 0.10 (1-0.4) 40.000 24,000 Less: cost of persona debt 0.05 x Rs 12,000 600 Net return 1,800 Tota funds avaiabe at his disposa: From sae of B Co. s shares 16,000 Borrowed funds 12,000 Rs 28,000 Tota cash outay in A Co. s shares 24,000 Uncommitted funds 4,000 Through arbitrage and the substitution of persona for corporate everage, the investor can switch from B Company to A Company, earn the same tota return of Rs 1,800, and have funds eft over to invest esewhere. This process woud continue ti the equiibrium is restored. Probem 4: The foowing are the costs and vaues for the firms A and B according to the traditiona approach: Tota vaue of firm, V 50,00 60,000 Market vaue of debt. D 0 30,000 Market vaue of equity, S 50,000 30,000 Expected net operating income, X 5,000 5,000 Cost of debt, INT = k d D 0 1,800 Net income, Cost of equity, k e = ( A Rs B Rs - k d D 5,000 5,000 -k d D)/S 10.00% 10.70% Debt-equity ratio, D/S 0 0.5 Average cost of capita, k 0 10.00% 8.33%

292 Financia Management Compute the equiibrium vaue for Firms A and B in accordance with the M-M thesis. Asume that (i) taxes do not exist and (ii) the equiibrium vaue of k 0 is 9.09 per cent. Soution The equiibrium vaues are shown beow: for Firms A and B in accordance with the M-M thesis. Assume that (i) taxes do not exist and (ii) the equiibrium vaue of k 0 is 0.09 per cent. Expected net operating income, A Rs A Rs 5,000 5,000 Tota cost of debt, INT = k d D 0 1,800 Net income, -k d D 5,000 3,200 Average cost of capita, k 0 0.909 0.909 Tota vaue of firm, V = /k 0 55,000 55,000 Market vaue of debt, D 0 30,000 Market vaue of shares, S = V- D 55,000 25,000 Cost of equity, k e = ( X-k d D)/S 0.909 0.128 Asymmetric Information Theory Aso caed the pecking order theory, this theory is based on the assumption that managers have better information than investors, postuates that there is a preferred "pecking order" of financing: first use retained earnings (and depreciation), then debt, and, finay, as a ast resort ony, issue new common stock. This theory eads to the concusion that firms shoud maintain a borrowing capacity reserve so that they can aways issue debt on reasonabe terms rather than have to issue new stock at the wrong time. X Another important point that needs to be remembered is that the optima capita structure is structured by the managers in terms of book vaue rather than market vaue terms. As book vaues refect the historica costs of the assets, these have itte to do with the abiity to produce cash fows and debt servicing capabiity. As the main focus of anaysing capita structure is to find a structure which maximises the firm's market vaue, and hence its stock prices, so it can ony be anaysed by an anaysis of the market vaues. But the probem with using the market vaues is that they are unpredictabe, so managers tend to use book vaues which are far easier to predict. Another point that is not considered is of the growth of the firm. Growth rates have impications on the marketing approach, investments, organisation size, structure and capita requirements. When the projected growth is rapid, the capita structure has to be fexibe enough to vary within a certain range of debt and equity ratio to accommodate funds requirements for the future growth of the firm. A contracting market for the company's products may indicate a need to move away from debt. This is because in case of reduced saes and hence ower profits, the risk of the firm defauting on debt

Capita Structure Theories 293 servicing is high so the interest rates charged by the creditors increase to refect the changing risk profie of the company. Sometimes promoters having management capabiity and experience in high growth potentia areas are acking in financia strength. These companies, if they have to raise funds in the market wi have to financiay everage their meagre capita contribution by a high incidence of debt. Here, the need to retain management contro imits the amount of equity that can be raised and subsequenty the debt that can be raised, too. Taxation and capita structure In 1963, MM added corporate taxes to their mode. With corporate taxes considered, a firm's stock price was shown to be directy reated to its use of debt financing -- higher the percentage of debt financing, the higher the stock price. Under the MM with tax theory, firms shoud use virtuay 100% debt financing. The reason for this resut is the corporate tax structure - returns to stockhoders come from after-tax earnings, but returns to creditors are paid before tax. The effect of this tax treatment is that more of a company's operating income is eft for investors when more debt financing is used. Modigiani and Mier basic propositions with corporate taxes are as foows: Proposition I The tota market vaue of a everaged firm is equa to (1) the vaue of an uneveraged EBIT (1 T) firm in the same risk cass pus (2) the gain from Deverage, k which is the vaue of the tax e,l = k k e,u + Risk Premium = k e,u + (k e,u - k d )(1- T) o,l savings due to debt financing and which equas the E corporate tax rate times the amount debt the firm uses. V L = V U + T D With zero debt the vaue of the uneveraged firm is equa to the vaue of its equity E = VU = Proposition II The cost of equity of a everaged firm is equa to (1) the cost of equity of an uneveraged firm in the same risk cass pus (2) a risk premium, whose size depends on the differentia between the costs of equity and debt to an uneveraged firm, the amount of financia everage and the corporate tax rate. This means that as the firm's use of debt increases, its cost of equity aso rises but at a sower rate now because of the effect of (1-T) which is ess than 1. Empirica Evidence Against MM Hypothesis In spite of the MM arguments, firms do not usuay use anywhere cose to 100% debt

294 Financia Management financing. In an attempt to modify MM's mode to make it more consistent with actua behaviour, many of their assumptions were reaxed in papers by other authors. In particuar, the possibiity of financia distress drasticay changed the MM resuts. In the modified mode, tax savings cause the vaue of a firm to rise as more and more debt is used, but at some point (the optima structure), the vaue of the firm begins to fa with additiona debt because the tax benefits are more than offset by the increasing costs of potentia financia distress. The MM mode as modified to incude financia distress suggests to managers that a certain amount of debt is good that too much debt is bad, and that there is an optima amount of debt for every firm. Thus, the modified MM theory, which is caed the trade-off theory of capita structure, provides usefu insights into the factors that affect a firm's optima capita structure. Here the margina costs and benefits of debt financing are baanced against one another, and the resut is an optima capita structure that fa somewhere between zero and 100% debt. Tax Perspective Both Debt or Equity require the company to service the same. Interest is paid on debt and dividends on equity. Interest, which is 100% deductibe for Income Tax purposes, provides the company a tax shied for the amount of interest being charged. Let us take an exampe to compare two modes of financing: Case 1 Case 2 Company ABC Ltd. XYZ Ltd. Equity (Rs. Mn) 10 30 Debt (Rs. Mn) 20 ni Turnover (Rs. Mn) 100 100 Cost of Goods sod (Rs. Mn) 50 50 Other Expenses (Rs. Mn) 40 40 Interest (Rs. Mn) 2 Ni Profit Before Tax (Rs. Mn) 8 10 Tax (Rs. Mn) 2.4 3.0 PAT (Rs. Mn) 5.6 7.0

Capita Structure Theories 295 Company XYZ enjoys a tax shied of Rs 0.6mn. Assuming that the above capita structure remains unchanged for 3 years, then at the current eve of profitabiity, after 3 years company ABC woud have paid Rs 6mn as interest whereas the company XYZ woud have paid Rs 4.2 mn thus saving Rs 1.8mn in taxes in 3 years. However, a major drawback with debt is that it entais a iabiity for the company for a particuar period of time and thus might act as a drawback in improving profitabiity during the ean phase of business. However, equity doesn't have the above mentioned disadvantage. During stabe market conditions, debt is perhaps the cheapest mode of raising capita from externa sources. But in voatie market conditions, equity is perhaps the safest mode. Normay a company wishes to raise capita by way of both equity and debt because of the severa constraints mentioned beow. To make the task easier in deciding what to raise and how much to raise, we use a technique known as EBIT-EPS anaysis. This anaysis heps us to understand how sensitive is EPS to changes in EBIT under different financing aternatives. It is aso possibe to cacuate the break even EBIT eve (for two aternative financing pans), i.e., the eve of EBIT for which the EPS is the same. The EBIT indifference point between the two aternative pans can be obtained mathematicay by soving the foowing equation for EBIT: Where, (EBIT - I 1 ) ( 1 - t) = (EBIT - I 2 ) ( 1 - t) -------------------------- ------------------------- n 1 n 2 EBIT = indifference point between the two aternative financing pans I 1, I 2 = interest expenses before taxes under financing pans 1 and 2 t n 1, n 2 = income tax rate = number of equity shares outstanding after adopting financing pans 1 and 2. Beow this eve of EBIT it woud be usefu to raise money from equity ony and above this eve of EBIT, raising money from debt woud be a suitabe aternative. Assessment of Debt Capacity & Panning The Capita Structure At the optimum capita structure the vaue of an equity share is the maximum and the average cost of capita is the minimum. A capita structure is considered to be appropriate if the foowing conditions are met: 1. Profitabiity: The capita structure shoud resut in maximum profitabiity.

296 Financia Management 2. Sovency: Company shoud not run the risk of insovency because of the increased debt in the baance sheet. 3. Fexibiity: The capita structure shoud provide enough fexibiity to the company to raise additiona funds whenever required without constraints. 4. Contro: Contro of the company shoud not be ost because of the high diution of equity. This means that the finance manager has to make a compromise between the best capita structure and the pecuiar needs of the company. Factors Infuencing Capita Structure In the rea word taking decisions on capita structure is not so easy as it is made out ti now. In deciding the capita structure of a company, the foowing points need to be considered: Corporate Strategy Corporate strategy is the main factor determining the financia structure of a company. The market growth rates form a basis for defining the Organisation structure, Investment in Assets and Overa Capita Intensity (Debt/Equity Financing). The fact that the company has to source funds from the markets, makes it imperative to factor in the market responsiveness to the company's ca for funds. Capabiity to service the funds, both debt and equity and the growth phase of the business have to be considered in tandem. Other strategic decisions ike management contro eve, risk averseness or risk taking nature of the management, etc. have aso to be considered. Utimatey, the most appropriate capita structure wi be the one, which most cosey supports the strategic direction of the business with the east cost and at a reasonaby acceptabe risk eve. Nature of the Industry The nature of the industry pays an important roe in capita structure decisions. Capita Intensity: Capita structure shoud factor in the type of the assets being financed. Capita intensive firms rey mosty on ong term debt and equity. Generay speaking, ong term assets shoud be financed by a baance between term debt and equity and short term assets shoud be financed ess by ong term sources (ike term debt and equity) and more by short term debt. The terms current (short term) and fixed (ong term) assets are determined by the nature of the industry and the business itsef. For exampe, a rapidy growing non-seasona and non-cycica business may regard part of its investments in short term assets ike inventories and accounts receivabe, as permanent

Capita Structure Theories 297 investments and fund it by ong term sources. If on the other hand, the business is seasona in nature, the seasona peaks fund requirements may have to be funded by short term debt. Cycica Business: In businesses ike construction, capita and higher consumer goods their voumes, and hence requirements of funds, are affected by the changes in the nationa and goba scene. Businesses subject to such variations need a capita structure that can buffer the risks associated with such swings. Again manoeuvrabiity of capita structure, is at a premium during times of contraction. Competition: The degree of competition is aso a major factor to be considered in deciding the capita structure. In highy competitive industry with ow entry barriers, companies with deep pockets can ony survive in the ong run. Product or business ife cyce: During the initia phase of the growth curve of a business/product the risk is high. Debt is hard to come by due to the riskiness of the venture and funding has to be through the venture capita equity. Financia everage is ow, which coud be increased as the product/business estabishes itsef. As the business matures, increased cash fows may reduce the need for debt funds. Current and Past capita Structure Current capita structure of a company is determined argey by past decisions. Investment decisions of the past, acquisitions, take-overs, financing poicy, dividends etc. go into forming the current capita structure which is difficut to change overnight. Atering current capita structure can be done by raising capita, retiring debts, buying back shares, taking on debt, atering dividend payout poicies, ateration in earning capacity, etc. Aso, as past decisions decide current capita structure, current changes in the capita structure decide the future capita structure. Hence, utmost care has to be exercised in decision and impementation of changes in the capita structure. Whie making the capita structure decisions, the company has to consider the different ife cyce stages which are : the pioneering stage the expansion stage the stagnation/stabiisation stage The pioneering stage is one of rapid increase in demand for the products/services of the company. The risk is highest at this stage of the ife cyce of the company and the efficient companies are the ones to survive. The financia cost of borrowing is very high at this stage, due to the risk perception about the company. To survive this the capita structure shoud orient more towards equity and if avaiabe utiise soft oans from the government.

298 Financia Management The expansion stage is the next stage, during which the strong companies survive the competitive strugge and aim to expand their market share and voumes. During this stage, huge investments are made to expand production/service capacity. Requirement of funds is high during this stage. Subject to the corporate strategy of funding projects and the market conditions, the company may raise capita at the owest possibe cost. As the earnings stabiise, the company wi be in a position to weather any sma variations in business, then it can seek to financiay everage itsef within a pre-fixed ceiing, by bank oans or financia institutiona oans. It is during this stage that companies are typicay expected to reward their investors with dividend and stock dividend/spits. Stabiisation/stagnation stage is the ast and fina stage. A dynamic management wi aways be on the ookout for expansion/diversification into new projects. It coud, again depending on corporate strategy, go in for green-fied projects or take over existing units, seek mergers, acquisitions and strategic aiances, etc. Usuay a recession in economy opens up a vast number of such opportunities which cash rich companies can take advantage of. In case of ack of such opportunities, the company coud reduce the financia everage and save on interest and if possibe down size the equity by buy back of shares. Buy back of shares acts to boost investor confidence in the company and aso makes equity serviceabe during recession. EBIT - EPS Anaysis & ROI - ROE Anaysis As a method to study the effect of everage on capita structure, EBIT - EPS anaysis essentiay invoves the comparison of aternative methods of financing under various assumptions of EBIT. A firm has the choice to raise funds for financing its investment proposas from different sources in different proportions. For instance, it can (i) excusivey use equity capita (ii) excusivey use debt, (iii) excusivey use preference capita, (iv) use a combination of (i) and (ii) in different proportions; (v) a combination of (i), (ii) and (iii) in different proportions, (vi) a combination of (i) and (iii) in different proportions, and so on. The choice of the combination of the various sources woud be one which, given the eve of earnings before interest and taxes, woud ensure the argest EPS. Consider Exampe 4.3. Suppose a company has a capita structure excusivey comprising of equity shares amounting to Rs.10,00,000. The firm now wishes to raise additiona Rs. 10,00,000 for expansion. The firm has various aternatives, three of them are given beow: (A) It can raise the entire amount in the form of equity capita. (B) (C) It can raise 50 per cent as equity capita and 50 per cent as 5% debentures. It can raise the entire amount as 6% debentures. Further assume that the existing EBIT is Rs.1,20,000, the tax rate is 35 per cent, outstanding shares 10,000 and the market price per share is Rs.100 under a the three aternatives.

Capita Structure Theories 299 Which financing pan shoud the firm seect? Soution EPS Under Various Financia Pans Particuars EBIT Less: Interest Earnings before taxes Taxes Earnings after taxes Less: Preference dividend Earnings avaiabe to ordinary sharehoders Number of shares Earnings per share (EPS) Financing Pans A B C Rs 1,20,000 ------- Rs 1,20,000 25,000 Rs 1,20,000 60,000 1,20,000 42,000 95,000 33,250 60,000 21,000 78,000 ------ 61,750 ------ 39,000 ------ 78,000 61,750 39,000 20,000 15,000 10,000 3.9 4.1 3.9 The cacuations in Tabe revea that given a eve of EBIT of Rs.1,20,000, the financing aternative B, which invoves 50 per cent ordinary shares and 50 per cent debt, is the most favourabe with respect to EPS. Tabe aso indicates that the annua before-tax costs of the various financing pans are: 1. Financing Pan B Rs.25,000 2. Financing Pan C 60,000 Financing pan A invoves no cost as there is no fixed financia charge. That the financing pan invoves a specific amount of cost, is another way of saying that an equa amount of earnings before interest and taxes is necessary to cover the fixed financia charges. Earnings per share woud be zero for pans B, C for the EBIT eve of Rs.25,000, Rs.60,000 respectivey. This eve of EBIT may be termed as financia break even (BEP) eve of earnings before interest and taxes because it represents the eve of EBIT necessary for the firm to break even on its fixed financia charge. In other words, it is the eve of EBIT at which the firm can satisfy a fixed financia charges (i.e. interest and preference dividend). EBIT ess than this eve wi resut in negative EPS. The financia break-even point can be determined by Eq. 1+ Dp Financia break-even point = 1 t where I = Annua interest charges DP = Preference dividend T = Tax rate

300 Financia Management Equation gives before - tax earnings necessary to cover the firm's fixed financia obigations. As fixed financia charges are added, the break-even point for zero EPS is increased by the amount of the additiona fixed cost. Beyond the financia break-even point, increase in EPS is more than the proportionate increase in EBIT. This is iustrated in Tabe, which presents the EBIT-EPS reationship for the data in Exampe under the various EBIT assumptions given in the box (i) (ii) (iii) (iv) (v) Rs.80,000 (4 per cent return on tota assets) Rs.1,00,000 (5 per cent return on tota assets) Rs.1,30,000 (4 per cent return on tota assets) Rs.1,60,000 (4 per cent return on tota assets) Rs.2,00,000 (4 per cent return on tota assets) EBIT-EPS Anaysis under Various EBIT Assumptions for the three financing Pans of Exampe (i) EBIT = Rs. 80,000 (4 percent return on investments) Particuars EBIT Less: Interest EBIT Less: Taxes EAT Less: Preference dividend EAT for equity-hoders Financing Pans A B C 80,000 ------- 80,000 25,000 80,000 55,000 28,000 19,250 52,000 35,750 ------ ------ 52,000 35,750 80,000 60,000 20,000 7,000 13,000 ------ 13,000 EPS 2.6 2.38 1.3 (ii) EBIT = Rs. 1,00,000 (5 percent return ) Particuars EBIT Less: Interest EBIT Less: Taxes EAT Less: Preference dividend EAT for equity-hoders Financing Pans A B C 1,00,000 ------- 1,00,000 25,000 1,00,000 75,000 35,000 26,250 65,000 48,750 ------ ------ 65,000 48,750 1,00,000 60,000 40,000 14,000 26,000 ------ 26,000 EPS 3.25 3.25 2.6

Capita Structure Theories 301 (iii) EBIT = Rs. 1,30,000 (6.5 percent return ) Particuars EBIT Less: Interest EBIT Less: Taxes EAT Less: Preference dividend EAT for equity-hoders EPS Financing Pans A B C 1,30,000 ------- 1,30,000 25,000 1,30,000 60,000 1,30,000 45,500 1,05,000 36,750 70,000 24,500 84,500 ------ 68,250 ------ 45,500 ------ 84,500 68,250 45,500 4.55 4.22 4.55 (iv) EBIT = Rs. 1,60,000 (8 percent return ) Particuars EBIT Less: Interest EBIT Less: Taxes EAT Less: Preference dividend EAT for equity-hoders Financing Pans A B C 1,60,000 ------- 1,60,000 25,000 1,60,000 60,000 1,60,000 56,000 1,35,000 47,250 1,00,000 35,000 1,04,500 ------ 87,750 ------ 65,000 ------ 1,04,500 87,750 65,000 EPS 5.2 5.8 6.5 (v) EBIT = Rs. 2,00,000 (10 percent return ) Particuars EBIT Less: Interest EBIT Less: Taxes EAT Less: Preference dividend EAT for equity-hoders Financing Pans A B C 2,00,000 ------- 2,00,000 25,000 2,00,000 60,000 2,00,000 70,000 1,75,000 61,250 1,40,000 49,000 1,30,000 ------ 1,13,750 ------ 91,500 ------ 1,30,000 1,13,750 91,500 EPS 6.5 7.6 9.1 Tabe shows that when the EBIT eve exceeds the financia break-even eve (Rs.25,000, Rs.60,000 for financing aternatives, B, C respectivey) EPS increases. The percentage increase in EPS is the greatest when EBIT is nearest the break-even point. Thus, in

302 Financia Management Pan C, an increase of 25 per cent in EBIT (from Rs.80,000 to Rs.1,00,000) resuts in a 100 per cent increase in EPS (from Re 1.3 to Rs.2.6), whereas the percentage increase in EPS is ony 40 per cent (from Rs.6.5 to Rs.9.1) as a resut of the change in EBIT at higher eves from Rs.1,60,000 to Rs.2,00,000 (i.e. 25 per cent increase). Tabes show that the EPS for different financing pans at a given eve of EBIT is equa. At EBIT eves above or beow the given eves, the EPS is higher or ower. Thus, for aternatives A and C at the EBIT eve of Rs.1,20,000 the EPS is the same, that is, Rs. 3.9. If EBIT is beow this eve, aternative A (ordinary shares) wi provide higher EPS; above this eve, the debt aternative (C) is better from the viewpoint of EPS. The earnings per share (EPS) in aternatives A and B are the same at EBIT eve of Rs.1,00,000. Above this, B pan woud ead to higher EPS; at eves ower than this, financing pan A woud provide higher EPS. The debt aternative (B) gives higher EPS; at eves ower that this, financing pan A woud provide higher EPS. Operating Conditions and Business Risk One very important factor on which the variabiity of EPS depends is the growth and stabiity of saes. As you may reca that EPS wi fuctuate with fuctuations in saes. The magnitude of the EPS variabiity with saes wi depend on the degrees of operating and financia everages empoyed by the company. Firms with stabe saes and favourabe cost price structure and successfu operating strategy wi have stabe earnings and cash fows and thus, can empoy a high degree of everage as they wi not face difficuty in meeting their fixed commitments The ikey fuctuations in saes increase the business risk. A sma change in saes can ead to a dramatic change in the earnings of a company when its fixed costs and debt are high. As a resut, the sharehoders perceive a high degree of financia risk if debt is empoyed by such companies. A company wi get into a debt trap if operating conditions become unfavourabe and if it acks in focussed strategy: Exhibit DEBT TRAP: Case of Hindustan Shipyard The fuctuating raw materias and component prices cause ups and downs in the revenues and profits of a ship-buiding company. With the right operating strategy and appropriate prudent financing, a company can manage to sai safey Hindustan Shipyard Limited (HSL), however, is finding it quite difficut to come out of the troubed waters due to huge borrowings It has a tota outstanding of Rs 554 crore: working capita oan Rs 138 crore, deveopment oan for modernisation Rs 69 crore, and outstanding interest on these oans ns 160 crore; cash credit Rs 62 crore, outstanding interest, cash credit Rs 65 crore and pena interest Rs 60 crore. How did this hppen?hsl's troube began when, between 1981 and 1982, Japanese and South Korean shipbuiders started offering "heaviy subsidised rates" against the rates fixed by the Indian

Capita Structure Theories 303 government; based on internationa parity price In effect, buiding ships turned out to be unviabe for the yard. Further, HSL's overtime bi soared up, being a highy overstaffed company. It had 11,000 workers in 1990. A ack of strategy paved way for unchecked downfa. Orders continued decining, and became amost ni by 1988 and 1989. To tide over this, company borrowed funds, and since operating performance did not improve, the company fe deeper and deeper into debt trap.hsl is technicay insovent. The capita restructuring pan are on to put the company back on its feet. Source: Messias Lione, Hindustan Shipyard: A Dead Weight Debt, The Economic Times, 15 Feb, 1994. Saes of the consumer goods industries show wide fuctuations; therefore. they do not empoy a arge amount of debt. On the other hand, the saes of pubic utiities are quite stabe and predictabe. Pubic utiities, therefore, empoy a arge amount of debt to finance their assets. The expected growth in saes aso affects the degree of everage. The greater the expectation of growth, the greater the amount of externa financing needed since it may not be possibe for the firm to cope up with growth through internay generated funds. A number of managers consider debt to be chapter and easy to raise. The growth firms, therefore, may usuay empoy a high degree of everage. Companies with decining saes shoud not empoy debt in their capita structures as they woud find difficuty in meeting their fixed obigations. Non-payment of fixed charges can force a company into iquidation. It may be noted that saes growth and stabiity is just one factor in the everage decision; many other factors woud dictate the decision. There are instances of a arge number of high growth firms empoying no or sma amount of debt. Cost of Capita and Vauation Approach The cost of a source of finance is the minimum return expected by its suppiers. The expected return depends on the degree of risk assumed by investors. A high degree of risk is assumed by sharehoders than debt-hoders. In the case of debt-hoders, the rate of interest is fixed and the company is egay bound to pay interest whether it makes profits or not. For ordinary sharehoders, the rate of dividends is not fixed and the board of directors has no ega obigation to pay dividends eiren if the profits are made by the company. The oan of debt-hoders is returned within a prescribed period, whie sharehoders wi have to share the residue ony when the company is wound up. This eads one to concude that debt is a cheaper source of funds than equity. This is generay the case even when taxes are not considered. The tax deductibiity of interest charges further reduces the cost of debt. The preference share capita is aso cheaper than equity capita, but not as cheap as debt. Thus, using the component, or specific, cost of capita as a criterion for financing decisions and ignoring risk, a firm woud aways ike to empoy debt since it is the cheapest source of funds.

304 Financia Management Pecking Order Hypothesis The cost of equity incudes the cost of new issue of shares and the cost of retained earnings. The cost of debt is cheaper than the costs of both these sources of equity funds. Considering the cost of new issue and retained earnings, the atter is cheaper because persona taxes have to be paid by sharehoders on distributed earnings whie no taxes are paid on retained earnings as aso no foatation costs are incurred when the earnings are retained. As a resut, between the two sources of equity funds, retained earnings are preferred it has been found in practice that firms prefer interna finance. If the interna funds are not sufficient to meet the investment. outays, firms go for externa finance, issuing the safest security first. They start with debt, then possiby hybrid securities such as convertibe debentures, then perhaps equity as a ast resort. Myers has caed it the pecking order theory since there is not a we-defined debt-equity target and there are two kinds of equity, interna and externa, one at the top of the pecking order and one at the bottom. Trade-off Theory The specific cost of capita criterion does not consider the entire issue. It ignores risk and the impact on equity vaue and cost. The impact of financing decision on the overa cost of capita shoud be evauated and the criterion' shoud be to minimise the overa cost of capita, or to maximise the vaue of the firm. If we consider the tax shied advantage of debt (on account of interest tax deductibiity), then debt woud have a favourabe impact on vaue and woud hep to reduce the overa cost of capita. It shoud, however, be reaised that a company cannot continuousy minimise its overa cost of capita by empoying debt. A point or range is reached beyond which debt becomes more expensive because of the increased risk (financia distress) of excessive debt to creditors as we to sharehoders. When the degree of everage increases, the risk of creditors increases, and they demand a higher interest rate and do not grant oan to the company at a, once its debt has reached a particuar eve. Further, the excessive amount of debt makes the sharehoders' position very risky. This has the effect of increasing the cast of equity. Thus, up to a point the overa cost of capita decreases with debt, but beyond that point the cost of capita woud start increasing and, therefore, it woud not be advantageous to empoy debt further. So, there is a combination of debt and equity which minimises the fimr's average cost of capita and maximises the market vaue per share. In practice, there is generay a range of debt-equity ratio wihin which the cost of capita is minimum or the vaue is maximum. As stated earier in this chapter, for individua companies, this range can be found out empiricay and the firm can operate safey within that range.

Capita Structure Theories 305 The vauation framework makes it cear that excessive debt wi reduce the share: price (or increase the cost of equity) and thereby ower the overa return to sharehoders, despite the increase in EPS. The return of sharehoders is made of dividends and appreciation in share prices, not of EPS. Thus, the impact of debt - equity ratio shoud be evauated in terms of vaue, rather than EPS. The difficuty with the vauation framework is that managers find it difficut to put into practice. It is not possibe for them to quantify a variabes. Aso, the operations of the financia markets are so compicated that it is not easy to understand them. But this kind of anaysis does provide insights and quaitative guidance to the decision maker. The trade-off between cost of capita and EPS set the maximum imit to the use of debt. However, other factors shoud aso be evauated to determine the appropriate capita structure for a company. Cash Fow Approach One of the features of a sound capita structure is conservatism. Conservatism does not mean empoying no debt or sma amount of debt. Conservatism is reated to the fixed charges created by the use of debt or preference capita in the capita structure and the firm's abiity to generate cash to meet these fixed charges. In practice, the question of the optimum (appropriate) debt-equity mix bois down to the firm's abiity to service debt without any threat of insovency and operating infexibiity. A firm is considered prudenty financed if it is abe to service its Fixed charges undet any reasonaby predictabe adverse conditions. The fixed charges of a company incude payment of interest, preference dividends and principa, and they depend on both the amount of oan securities and the terms of payment. The amount of fixed charges wi be high if the company empoys a arge amount of debt or preference capita with short-term maturity. Whenever a company thinks of raising additiona debt, it shoud anayse its expected future cash fows to meet the fixed charges. It is mandatory to pay interest and return the principa amount of debt. If a company is not abe to generate enough cash to meet its fixed obigation, it may have to face financia insovency. The companies expecting arger and stabe cash infows in the future can empoy a arge amount of debt in their capita structure. It is quite risky to empoy fixed charge sources of finance by those companies whose cash infows are unstabe and unpredictabe. It is possibe for a high growth, profitabe company to suffer from cash shortage if its iquidity (working capita) management is poor. We have exampes of companies ike BHEL, NTPC etc., whose debtors are very sticky and they continuousy face iquidity probem in spite of being profitabe. Servicing debt is very burdensome for them. One important ratio which shoud be examined at the time of panning the capita structure

306 Financia Management is the mtio of net cash infows to fixed charges (debt-servicing ratio). It indicates the number of times the fixed financia obigations are covered by the net cash infows generated by the company. The greater the coverage, the greater is the amount of debt a company can use. However, a company with a sma coverage can aso empoy a arge amount of debt if there are not significant yeary variance in its cash infows and a sma probabiity of the cash infows being consideraby ess to meet fixed charges in a given period. Thus, it is not the average cash infows but the yeary cash infows which are important to determine the debt capacity of a company. Fixed financia obigations must be met when due, not on an average or in most years but, aways.' This requires a fu cash fow anaysis. Debt Capacity The technique of cash fow anaysis is hepfu in determining the firm's debt capacity. Debt capacity is the amount which a firm can service easiy even under adverse conditions; it is the amount that the firm shoud empoy. There may be enders who are prepared to end to you. But you shoud borrow ony if you can service debt without any probem. A firm can avoid the risk of financia distress if it can maintain its abiity to meet contractua obigation of interest and principa payments. Debt capacity, therefore, shoud be thought in terms of cash fows rather than debt ratios. A high debt ratio is not necessariy bad. If you can service high debt without any risk, it wi increase sharehoders' weath. On the other hand, a ow debt ratio can prove to be burdensome for a firm which has iquidity probem. A firm faces financia distress (or even insovency) when it has cash fow probem. It is dangerous to finance a capita intensive project out of borrowings which has buit in uncertainty about the earnings and cash fows. Nationa Auminium Company is an exampe of a wrong initia choice of capita structure, without anaysing the company's debt servicing abiity. Exhibit 2: Debt Burden Under Cash Crunch Situation: Case of NALCO Nationa Auminium Company (NALCO), started in 1981, is the argest integrated auminium compex in Asia of tota investment of Rs 2,408;crore, borrowings from a consortium of European banks financed to the extent of $ 830 miion or Rs 1,119 crore (46.5 per cent). The oan was repayabe by 1995. Auminium is an eectricity-intensive business; each tonne of auminium needs over 15,000 kw of eectricity. Since its commissioning in 1988, Naco has exported substantia portion of its production since the domestic demand has been very ow than what the company had projected at its inception. The faing internationa prices in ast few years have eroded the company's profitabiity. The net profit of Rs 172 crore in 1989 dropped to Rs 14 crore in 1991-92. The he 1,119 crore Eurodoar oan has appreciated to Re 2,667 crore inspite of having repaid Rs 644 crore. Due to profitabiity and iqu:,dity probem and hit by the depreciating rupee and the iberaised exchange mechanism, the company is

Capita Structure Theories 307 forced to reschedue repayments of its debt by the year 2003 instead of 1995. Naco's debtequity ratio has increased from 1 : 1 to 2.7 : 1.The reasons for Naco's pight is its decision to go for the production of auminium which consumes heavy eectricity in addition to aumina. The probem of power shortage ed to the setting up of power pant which is proving very costy to the company. The overcapacity of auminium production word wide and highy competitive prices have added to Naco's woes. Naco is trying to get out of its probems by attempting to diversify into vaue-added products.naco's fate can change if the domestic demand for auminium picks up and internationa prices rise. The mounting debt of the company poses a question: Shoud you use heavy dose of debt (since it is avaiabe from certain sources) to finance investments in a business ike auminium which has wordwide over capacity, fuctuating internationa prices and expensive and short suppy of eectricity in the country in which it is set up? Debt woud accentuate the financia crises when a company has buit-in operating uncertainties Source: Based on an artice by Sudipt Dutta, NALCO: under a Debt Mountain, Business India, August 17-30, 1992, pp. 77-78. Components of Cash Fows The cash fows shoud be anaysed over a ong period of time, which can cover the various adverse phases, for determining the firm's debt poicy.' The cash fow anaysis can be carried out by preparing profoma cash fow statements to show the firm's financia conditions under adverse conditions such as a recession. The expected cash fows can be categorised into three groups. Operating cash fows Non-operating cash fows Financia fows. Operating cash fows reate to the operations of the firm and can be determined from the projected profit and oss statements The behaviour of saes voume, output price and input price over the period of anaysis shoud be examined and predicted. Non-operating cash fows generay incude capita expenditures and working capita changes. During a recessionary period, the firm may have to speciay spend for the promotion of the product. Such expenditures shoud be incuded in the non-operating cash fows. Certain types of capita expenditure cannot be avoided even during most adverse conditions. They are riecessary to maintain the minimum operating efficiency. Such irreduciabe, minimum capita expenditure shoud be, ceary identified. Financia fows incude interest, dividends, ease nentas, repayment of debt etc. They are further divided into: contractua obigations and poicy obigations. Contractua obigations incude those financia obigations, ike interest, ease rentas and principa

308 Financia Management payments, that are matters of contract and shoud not be defauted Poicy obigations consist of those financia obigations, ike dividends, that are at the discretion of the board of directors. Poicy obigations are aso caed discretionary obigations. The cash fow anaysis may indicate that a decine: in saes, resuting in profit decine or osses, discretionary obigations. may not necessariy cause cash inadequacy This may be so because cash may be reaised from permanent inventory and receivabe Aso, some of the pemranent current iabiities may decine with fa in saes and profits. On the other hand, when saes and profits are growing, the firm may face cash inadequacy as arge amount of cash is needed to finance growing inventory and receivabe. If the profits decine due to increase in expenses or faing output prices, instead of the decine in the number of units sod, the firm may face cash inadequacy because its funds in inventory and receivabe wi not be reeased The point to be emphasised is that a firm shoud carry out cash fow anaysis to get a cear picture of its abiity to service debt obigations even under the adverse conditions, and thus, decide about the proper amount of debt in the capita structure This can be done by examining the impact of aternative debt poicies on the firm's cash fow abiity. The firm shoud then choose the debt poiicy which it can service. Cash Fow Anaysis Versus EBIT-EPS Anaysis Is cash fow anaysis superior to EBIT-EPS anaysis? How does it incorporate the insights of the finance theory? The cash fow anaysis has the foowing. It focuses on the iquidity and sovency of the firm over a ong-period of time, even encomyassing adverse circumstances Thus. it evauates the firm's abiity to meet fixed obigations.it goes beyond the anaysis of profit and oss statement and aso considers changes in the baance sheet items. It identifies discretionary cash fows. The firm can thus prepare an action pan to face adverse situations. It provides a ist of potentia financia fows which can be utiised under emergency. It is a ong-term dynamic anaysis and does not remain confined to a singe period anaysis. The most significant advantage of the cash fow anaysis is that it provides a practica way of incorporating the insights of the finance theory. As per the theory, debt financing has tax advantage. But it aso invoves risk of financia distress. Therefore, the optimum amount of debt depends on the trade-off between tax advantage of debt and risk of financia distress, financia distress occurs when the firm is not in a position to meet its cont,actua obigations. The cash fow anaysis indicates when the firm wi find it difficut to service its debt. Therefore, it is usefu in providing good insights to determine the debt capacity which heps to maximise the market vaue of the firm.

Capita Structure Theories 309 Cash Fow Anaysis Versus Debt-Equity Ratio The cash fow anaysis ceary reveas that a higher debt-equity ratio is not risky if the company has the abiity of generating substantia cash infows in the future to meet its fixed financia obigations. Financia risk in this sense is indicated by the company's cash-fow abiity, not by the debt-equity ratio. To quote Van Home;...the anaysis of debt-to-equity ratios aone can be deceiving, and anaysis of the magnitude and stabiity of cash-fows reative to fixed charges is extremey important in determining the appropriate capita structure for the firm. To the extent that creditors and investors anayse a firm's cash-fow abiity to service debt, and management's risk preferences correspond to those of investors, capita structure decisions made in this basis shoud tend to maximise share price. The cash fow anaysis does have its imitations It is difficut to predict a possibe factors which May infuence the firm's cash fows. Therefore, it is not a foo-proof technique to determine the firm's debt poicy. EBIT-EPS Anaysis The EBIT-EPS anaysis, as a method to study the effect of everage, essentiay invoves the comparison of aternative methods of financing under various assumptions of EBIT. A firm has the choice to raise funds for financing its investment proposas from different sources in different proportions. For instance, it can (i) excusivey use equity capita (ii) excusivey use debt, (iii) excusivey use preference capita, (iv) use a combination of (i) and (ii) in different proportions; (v) a combination of (i), Oi and (iii) in different proportions, (vi) a combination of (i) and (iii) in different proportions, and so on. The choice of the combination of the various sources woud he one which, given the eve of earnings before interest and taxes, woud ensure the argest EPS. Consider Exampe 2. Exampe 2: Suppose a firm has a capita structure excusivey comprising of ordinary shares amounting to Re 10,00,000. The firm now wishes to raise additiona Rs 10,00,000 for expansion. The firm has four aternative financia pans: (A) (B) (C) It con raise the entire amount in the form of equity capita. It can raise 50 per cent as equity capita and 50 per cent as 5% debentures. It can raise the entire amount as 6% debentures. (D) It can raise 50 per cent as equity capita and 50 per cent as 5% preference capita.

310 Financia Management Further assume that the existing EBIT are Rs 120, 000, the tax rate is 35 per cent, outstanding ordinary shares' 10,000 and the market price per share is Rs 100 under a the four aternatives. Which financing pan shoud the firm seect? Soution EPS under Various Financia Pans EBIT Less Interest Earnings before taxes Taxes Earning after taxes Less preference dividend Earnings avaiabe to ordinary sharehoders Number of Shares Earnings per share (EPS) Financing pans A B C D 1,20,000 1,20,000 1,20,000 1,20,000-25,000 60,000-1,20,000 95,000 60,000 1,20,000 42,000 33,250 21,000 42,000 78,000 61,750 39,000 78,000 - - - 25,000 78,000 61,750 39,000 53,000 20,000 15,000 10,000 15,000 3.9 4.1 3.9 3.5 The cacuations in above tabe reveas that given a eve of EBIT of Rs 1,20,000, the financing aternative B, which invoves 75 per cent ordinary shares and 25 per cent debt, is the most favourabe with respect to EPS. Another discosure of the tabe is that athough the proiortion of ordinary shares in the tota capitaization under the financing pan D is aso 75 per cent, that is, equa to pan B, EPS is consideraby different (owest). The difference in the pans B and D is due to the fact that interest on debt is taxdeductibe whie the dividend on preference shares is not. With 35 per cent income tax, the expicit cost of preference shares woud be higher than the cost of debt. Tabe aso indicates that the annua before-tax costs of the various financing pans are: 1. Financing Pan B Rs 25,000 2. Financing Pan C 60,000 3. Financing Pan D 38,426 Financing pan A invoves no cost as there is no fixed financia charge. That the financing pan invoves a specific amount of cost, is another way of saying that an equa amount of earnings before interest and taxes is necessary to cover the fixed financia charges. Since preference dividend is not tax-deductibe, we must divide the tota dividends by one, minus the tax rate, in order to obtain the EBIT necessary to cover these dividends as a financia charge. Assuming a 35 per cent tax rate, preference dividend of Rs 25,000 can be paid on EBIT of Rs 38,462. The fixed financia charge woud, therefore, be higher. Earnings per share woud be zero for pans B, C and D for the EBIT eve of

Capita Structure Theories 311 Rs 25,000, Rs 60,000 and Rs 38,462 respectivey. This eve of EBIT may be termed as financia break even eve of earnings before interest and tares because it represents the eve of EBIT necessary for the firm to break even on its fixed financia charge. In other words, it is the eve of EBIT at which the firm can satisfy a fixed financia charges (i.e. interest and preference dividend). EBIT ess than this eve wi resut in negative EPS. The financia break-even point can be determined by Eq. Financia break-even point = +, + where I = Annua interest charges PD = Preference dividend t = Tax rate Equation gives before-tax earnings necessary to cover the firm's fixed financia obigations. As fixed financia charges are added, the break-even point for zero EPS is increased by the amount of the additiona fixed cost. Beyond the financia break-even point, increase in EPS is more than the proportionate increase in EBIT. (i) (ii) (iii) (iv) (v) Rs 80,000 (4 per cent return on tota assets) 1,00,000 (5 per cent return on tota assets) 1,30,000 (6.5 per cent return on tota assets) 1,60,000 (8 per cent return on tota assets) 2,00,000 (10 per cent return on tota assets) Tabe: EBIT-EPS Anaysis under Various EBIT Assumptions for the four Financing Pans (i) EBTT a Re 80,000 (4 per cent return on investments) Financing Pans A B C D EBIT 80,000 80,000 80,000 80,000 Less interest - 25,000 60,000 - EBT 80,000 55,000 20,000 80,000 Less taxes 28,000 19,250 7,000 28,000 EAT 52,000 35,750 13,000 52,000 Less preference dividend - - - 25,000 Ear for equity number 52,000 35,750 13,000 27,000 EPS 2.6 2.38 1.3 1.8

312 Financia Management (ii) EBIT = Rs 1,00,000 (5 per cent return) EBIT 1,00,000 1,00,000 1,00,000 1,00,000 Less interest - 25,000 60,000 - EBT 1,00,000 75,000 40,000 35,000 Less taxes 35,000 26,250 14,000 35,000 EAT 65,000 48,750 26,000 65,000 Less preference dividend - - - 25,000 EAT for equity hoders 65,000 48,750 26,000 40,000 EPS 3.25 3.25 2.6 2.67 (iii) EBIT = Rs 1,30,000 (6.5 per cent return) EBIT 1,30,000 1,30,000 1,30,000 1,30,000 Less interest - 25,000 60,000 - EBT 1,30,000 1,05,000 70,000 1,30,000 Less taxes 45,500 36,750 24,500 45,500 EAT 84,500 68,250 45,500 84,500 Less preference dividend - - - 25,000 EAT for equity hoders 84,500 68,250 45,500 59,500 EPS 4.22 4.55 4.55 3.97 (iv) EBIT a Rs 1,60,000 (8 per cent return) EBIT 1,60,000 1,60,000 1,60,000 1,60,000 Less interest - 25,000 60,000 - EBT 1,60,000 1,35,000 1,00,000 1,60,000 Less taxes 56,000 47,250 35,000 56,000 EAT 1,04,000 87,750 65,000 1,04,000 Less preference dividend - - - 25,000 EAT for equity hoders 1,04,000 87,750 65,000 79,000 EPS 5.2 5.8 6.5 5.3 (v) EBIT = Rs 2,00,000 (10 per cent return) EBIT 2,00,000 2,00,000 2,00,000 2,00,000 Less interest - 25,000 60,000 - EBT 2,00,000 1,75,000 1,40,000 2,00,000 Less taxes 70,000 61,250 49,000 70,000 EAT 1,30,000 1,13,750 91,000 1,30,000 Less preference dividend - - - 25,000 EAT for equity hoders 1,30,000 1,13,750 91,000 1,05,000 EPS 6.5 7.6 9.1 7

Capita Structure Theories 313 It can be seen from above Tabe that when the EBIT eve exceeds the financia breakeven eve (Rs 25,000, Rs 60,000 and Rs 38,462 for financing aternatives, B, C and D' respectivey) EPS increases. The percentage increase in EPS is the greatest when EBIT is nearest the break-even point. Thus, in Pan C an increase of 25 per cent in EBIT (from Rs 80,000 to Rs 1,00,000) resuts in a 100 per cent increase in EPS (from Re 1.3 to Rs 2.6), whereas the percentage increase in EPS is ony 40 per cent (from Rs 6.5 to Rs 9.1) as a resut of the change in EBIT at higher eves from Rs 1,60,000 to Rs 2,00,000 (i.e. 25 per cent increase). We can aso see from Tabes that the EPS for different financing pans at a given eve of EBIT is equa. At EBIT eves above or beow the given eve, the EPS is higher or ower. Thus, for aternatives A and C at the EBIT eve of Rs 1,20,000 the EPS is the same, that is, Rs 3.9. If EBIT is beow this eve, aternative A (ordinary shares) wi provide higher EPS; above this eve, the 1 debt aternative (C) is better from the viewpoint of EPS. Between preference share (D) and ordinary share (A) aternatives, the EPS is equa (Rs 5.2) at Rs 1,60,000 EBIT eve. above this eve aternative D wi give better EPS; whie beow it, aternative A. The earnings per share (EPS) in aternatives A and B are the same at EBIT eve of Re 1,00,000. Above B woud provide higher EPS. The debt aternative (B) gives higher EPS for a eves of EBIT as compared to the preference share aternative (D). Indifference Point The EBIT eve at which the EPS is the same for two aternative financia pans is referred to as the indifference point/eve. The indifference point may be defined as the eve of EBIT beyond which the benefits of financia everage begin To operate with respect to earnings per share (EPS). In operationa terms, if the expected eve is to exceed the indifference eve of EBIT, the use of fixed-charge source of funds (debt) woud be advantageous from the viewpoint of EPS, that is, financia everage wi be favourabe and ead to an increase in the EPS avaiabe to the sharehoders. The capita structure shoud incude debt. If, however, the expected eve of the EBIT is ess than the indifference point, the advantage of EPS woud be avaiabe from the use of equity capita. The indifference point between two methods of financing can be obtained mathematicay (agebraic approach) as we as graphicay. Agebraic Approach Mathematicay, the indifference point can be obtained by using the foowing symbos: X = earnings before interest and taxes (EBIT) at the indifference point

314 Financia Management N 1 = number of equity shares outstanding if ony equity shares are issued N 2 = number of equity shares outstanding if both debentures and equity shares are issued N 3 = number of equity shares outstanding if both preference and equity shares are issued N 4 = number of equity shares outstanding if both preference shares and debentures are issued I = the amount of interest on debentures P = the amount of dividend on preference shares t = corporate income tax rate Dt = tax on preferance dividend For a New Company The indifference point can be determined by using the foowing equations: (i) Equity shares versus debentures: = & & (a) (ii) Equity shares versus preference shares: - (b) (iii) Equity shares versus preference (c) (iv) Equity shares versus preference shares and debentures: (d) For and Existing Company If the debentures are aready outstanding, et us assume i, = interest paid on existing debt, and I2 = interest payabe on additiona debt, then the indifference point woud be determined by Equation (e) (e)

Capita Structure Theories 315 Exampe 3: The financia manager of a company has formuated various financia pans to finance Rs 30,00,000 required to impement various capita budgeting projects: (i) Either equity capita of Rs 30,00,000 or Rs 15,00,000 108 debentures and Rs 15,00,000 equity; (ii) Either equity capita of Rs 30,00,000 or 13% preference shares of Rs 10,00,000 and Rs 20,00,000 (iii) Either equity capita of Rs 30,00,00 or 13% preference capita of Rs 10,00,000, (subject to dividend tax of 10 per cent), Rs 10,00,000 1046 debentures and Rs 10,00,000 equity; and (iv) Either equity share capita of Rs 20,00,000 and 104b debentures of Rs 10,00,000 or 13% preference capita of Re 10,00,000. 10% debentures of Rs 8,00,000 and Rs 12,00,000 equity. You are required to detetmine the indifference point for each financia pan, assuming 35 per cent corporate tax rate and the face vaue of equity shares, as Rs 100. Soution TABLE: Determination of Indifference Point -, % = = & & (i) or or or 0.65X = 1.3X - Rs 1,95,000 or -0.65X = - Rs 1,95,000 % = =

316 Financia Management Confirmation tabe Equity financingequity + debt financing EBIT Rs 3,00,000 Rs 3,00,000 Less interest - 1,50,000 Earning before taxes 3,00,000 1,50,000 Less taxes 1,05,000 52,500 Earnings for equity hoders 1,95,000 97,500 Number of equity shares 30,000 15,000 EPS 6.5 6.5 (iii) = &, & or or or X = Rs 6,00,000 Confirmation Tabe Equity financing Equity+Preference financing EBIT Rs 6,00,000 Rs 6,00,000 Less taxes 2,10,000 2,10,000 Earning after taxes 3,90,000 3,90,000 Less dividends on preference shares - 1,30,000 Earnings for equity hoders 3,90,000 2,60,0000 Number of equity shares 30,000 20,000 EPS 13 13 (iii) -, + + = & & or

Capita Structure Theories 317 or X = Rs 4,80,000 Confirmation tabe Equity financing Equity+debt+ Preference financing EBIT Rs 4,80,000 Rs 4,80,000 Less interest - 1,00,000 Earning before taxes 4,80,000 3,80,000 Less taxes 1,68,000 1,33,000 Earnings after tax 3,12,000 2,47,000 Less dividends incuding dividend tax on preference shares - 1,43,000 Earnings avaiabe for equity hoders 3,12,000 1,04,000 Number of equity shares 30,000 10,000 = = EPS 10.4 10.4 (iv), -, + = & & or or X = Rs 5,50,000 Confirmation tabe Equity financing Equity + Preference + Debentures financing EBIT Rs 5,50,000 Rs 5,50,000 Less interest 1,00,000 80,000 Earning before taxes 4,50,000 4,70,000 Less taxes 1,57,500 1,64,500 Earnings after tax 2,92,500 3,05,500

318 Financia Management Less dividends preference shares - 1,30,000 Earnings for equity hoders 2,92,500 1,75,500 Number of equity shares 20,000 12,000 EPS 14.625 14.625 Graphic Approach The indifference point can aso be determined graphicay. Figures 1 and 2 portray the graphic representation of financia pans (i) and (ii) of Exampe 7. The horizonta X-axis represents EBIT whie EPS is represented on the Y-axis. In order to graph the financia pan, two sets of EBIT-EPS coordinates are required. The EPS vaues associated with EBIT vaues of Rs 2,00,000 and Rs 6,00,000 are cacuated and potted on the graph paper under each financia pan in case of Figure 1. It may noted that 100 per cent equity inancing pan starts from origin (O) because EPS woud be zero if EBIT is zero. However, EBIT required to have the vaue of the EPS as zero is Rs 1,50,000, that is, the interest charges payabe on 105 debentures of Rs 15,00,000. Therefore, the starting point of 50 per cent equity financing pan is away from the point of the origin (i.e. it starts from Rs 1.5 akh). The point at which the two ines intersect is the indifference point (IP). When we draw a perpendicuar to the X- axis from the point of intersection, we have EBIT required for the IF. A ine drawn from the point of intersection and joined with the Y-axis determines the EPS at the indifference point - Figure 1: EBIT-EPS Anaysis An important point to be remembered in reation to the drawing of 33 per cent preference share financia pan (Fig. 2) is that EPS woud not be zero if the firm's EBIT is Rs 1,30,000, because dividend payabe on preference share is not tax-deductibe. The firm must earn so much more than Rs 1,30,000 that it is eft with Rs 1.30,000 after paying taxes. This amount can be cacuated dividing by (1- t). The required amount Is Rs 2,00,000 (Rs 1,30,000)

Capita Structure Theories 319 (1-0.35). Thus, the starting point of preference share financia pan woud be Rs 2 akh. The indifference points of Figs. 1 and 2 correspond to what we have determined through the agebraic approach. But the utiity of the EBIT-EPS chart ies in its being more informative regarding the EBIT-EPS reationship. It gives a bird's eye view of EPS at various Leves of EBIT. The EPS vaue at the estimated eve of EBIT can be prompty ascertained. Moreover, it more easiy expains why an equity financing pan is better than other pans requiring debenture and/or preference shares for the EBIT eve beow the BEP. For instance, Fig 2. indicates that for a EBIT eves beow Rs d akh, the EPS under equity aternative is greater than 33 per cent preference share financing pan and for a EBIT eves above Rs 6 akh, the EPS is greater under 33 per cent financing pan than 100 per cent equity financing. The IP can be compared with the most ikey eve of EBIT. If the ikey eve of EBIT is more than the IF, the use of fixed cost financing pan may be recommended, otherwise equity pan woud be more suitabe. To sum up, the greater the ikey eve of EBIT than the indifference point, the stronger is the case for using evered financia EPS (Rs) 32.5 26 19.5 13 6.5 Equity Advantage Equity + Preference Aternative Equity + Preference Advantage Equity Aternative Indifference point 0 1 2 3 4 5 6 7 8 9 10 11 12 EBIT (Rs in akhs) Figure 2: EBIT-EPS Anaysis pans to maximise the EPS. Conversey, the ower the ikey eve of EBIT in reation to the indifference point. the more usefu the unevered financia pan woud be froni the view point of EPS. In other words, financia everage wi be favourabe and sharehoders wi get higher EPS if the return on tota investment is more than the fixed cost (interest and preference dividend). If the return is ess than the fixed financia charge, the EPS wi decine with the use of debt and the everage wi be unfavourabe. The financia everage wi have no effect on EPS in case the return on investment is exacty equa to the fixed financia costs. The indifference point may be computed in another way using narket vaue as the basis. Since the operationa objective of financia management is the maximisation of share prices, the market price of shares of a firm with two different financia pans

320 Financia Management shoud be identica. Thus, on the basis of eve of EBIT which ensures identica market price for aternative financia pans, the indifference point can be symboicay computed by foowing Equation. +!) = +!) & - / & where PEI = P/E ratio of evered pan and P/E2 = P/E ratio of unevered pan. Determine the indifference point at which market price of equity shares of a corporate firm wi be the same frdm the foowing data: 1. Funds required, Rs 50,000. 2. Existing number of equity shares outstanding, 5,000 @ Rs 10 per share. 3. Existing 10% debt, Rs 20,000 4. Funds required can be raised either by (a) issue of 2,000 equity shares, netting Rs 25 per share or (b) new 15 per cent debt. 5. The P/E ratio wi be 7 times in equity aternative and 6 times in debt aternative. 6. Corporate tax rate, 35 per cent. Soution -, +!) = +!) & - +, & - = - % or - - = or 5(4.55x - Rs 9,100) = 7(3.9 Rs 37,050) or 4.55x = Rs 2,13,850, i.e. = Rs 47,000 Confirmation tabe 15% Debt issue Equity issue EBIT Rs 47,000 Rs 47,000 Less interest 9,500 2,000 Earning before taxes 37,500 45,000

Capita Structure Theories 321 Less taxes 13,125 15,750 Earnings after tax 24,375 29,250 Number of equity shares 5,000 7,000 Earnings per share 4.875 4.18 P/E ratio (times) 6 7 Market price of the share 29.25 29.25 ROI-ROE Anaysis In the preceding section we ooked at the reationship between EBIT and EPS under aternative financing pans. Pursuing a simiar ine of anaysis, we may ook at the reationship between the return on investment (ROI) and the return on equity (ROE) for different eves of financia everage. 2.0 A 1.0 B Exhibit 2: Probabiity Distributions of EBIT EBIT (Rs. in miion) 1.0 2.0 3.0 4.0 5.0 6.0 7.0 Suppose a firm, Korex Limited, which requires an investment outay of Rs 100 miion, is considering two capita structures: Capita Structure A (Rs in miion) Capita Structure B (Rs in miion) Equity 100 Equity 50 Debt 0 Debt 50 Whie the average cost of debt is fixed at e~per cent, the ROI (defined as EBIT divided by tota assets) may vary widey. The tax rate of the firm is 50 per cent. Based on the above information, the reationship between ROI and ROE (defined as equity earnings divided by net worth) under the two capita structures, A and 8, woud be as shown in Exhibit graphicay the reationship is shown in Exhibit

322 Financia Management Exhibit 3: Reation between ROI and ROE Under Capita Structures A and B Capita Structure A Capita Structure B ROI 5% 10% 15% 20% 25% 5% 10% 15% 20% 25% EBIT (Rs in miion) 5 10 15 20 25 5 10 15 20 25 Interest 0 0 0 0 0 5 5 5 5 5 Profit after tax 5 10 15 20 25 0 5 10 15 20 Tax 2.5 5 7.5 10 12.5 0 2.5 5 7.5 10 Profit after tax 2.5 5 7 5 10 12.5 0 2.5 5 7.5 10 Return an equity 2.5% 5% 7.5% 10% 12.5% 0% 5% 10% 15% 20% Reationship between ROI and ROE Under Aternative Capita Structure 20 ROE 15 B A 10 5 ROI Exhibit 4: Reationship between ROI and ROE Under Aternative Capita Structure Looking at' the reationship between ROI and ROE we find that: 1. The ROE under capita structure A is higher than the ROE under capita structure B when ROI is ess than the cost of debt. 2. The ROE under the two capita structures is the same when ROI is equa to the cost of debt. Hence the indifference (or breakeven) vaue of ROI is equa to the cost of debt. 3. The ROE under capita structure B is higher than the ROE under capita structure A when ROI is more than the cost of debt. Mathematica Reationship The infuence of ROI and financia everage on ROE is mathematicay as foows: ROE = [ROI + (ROI - r) D/E] (1 - t) where ROE = return on equity ROI = return on investment

Capita Structure Theories 323 r = cost of debt D/E = debt-equity ratio t = tax rate Appying the above equation to Korex Limited when its D/E ratio is 1, we may cacuate the vaue of ROE for two vaues of ROI, namey, 15 per cent and 20 per cent. ROI= 15% ROE = 115 + (15-10) 1] (0.5)= 12 5% ROI = 20 per cent ROE = [20 + (20-10) 1] (Q.5) = 15.0% These resuts, as expected, are in conformity with our earier anaysis. Assessment of Debt Capacity Empoyment of debt capita entais two kinds of burden: interest payment and principa repayment. To assess a firm's debt capacity we ode at its abiity to meet these committed paymens. This may be judged in terms of: Coverage ratios Coverage Ratios ROE 20 15 10 Inventory of resources Coverage Ratios B A coverage ratio shows the reationship between a committed payment and the source; for that payment. The coverage ratios commony used are: interest coverage ratio, A cash fow coverage ratio, and debt service coverage ratio. 5 5 10 15 20 25 30 ROI Fig. 3: Reationship between ROI and ROE Under Aternative Capita Structure

324 Financia Management Interest Coverage Ratio The interest coverage ratio (aso referred to as the times interest earned ratio) is simpy defined as: )/210// -,/ 0 To iustrate, suppose the most recent earnings before interest and taxes (EBIT) for Vitrex Company were Rs. 120 miion and the interest burden on a debt obigations were Rs. 20 miion. The interest coverage ratio, therefore, woud be 120/20 = 6. What does it impy? It means that even if EBIT drops by 83'h per cent, the earnings of Vitrex Company cover its interest payment. Though somewhat commony used, the interest coverage ratio has severa deficiencies: (i) It concerns itsef ony with the interest burden, ignoring the principa repayment obigation. (ii) It is based on a measure of earnings, not a measure of cash fow. (iii) It is difficut to estabish a norm for this ratio. How can we say that an interest coverage ratio of 2, 3, 4, or any other is adequate? Cash Fow Coverage Ratio This may be defined as: ), + /40 + 65/ 0 4545/2 $0/3.3,/ 0 + -/ To iustrate, consider a firm: Dcpreciation Rs. 20 akhs EBIT Rs. 120 akhs Interest on debt Rs. 20 akhs Tax rate 50% Loan repayment instament Rs. 20 akhs The cash fow coverage ratio for this firm is: It may be noted that in cacuating the cash fow coverage ratio the oan repayment amount in the denominator is adjusted upward for this tax factor because the oan repayment amount, unike the interest, is not a tax-deductibe payment. The cash fow coverage ratio is a distinct improvement over the interest coverage ratio in measuring the debt capacity; it covers the debt' service burden fuy and it focuses on

Capita Structure Theories 325 cash fows. However, it too is characterised by the probem of estabishing a suitabe norm for judging its adequacy. Debt Service Coverage Ratio Financia institutions which provide the buk of ong-term debt finance judge the debt capacity of a firm in terms of its debt service coverage ratio. This is defined as: DSCR = where DSCR = debt service coverage ratio, PAT, = profit after tax for year i DEPi, = depreciation for year i INTi = interest on ions-term oan for year i LRIi = oan repayment instament for year i n = period of the oan To iustrate the cacuarion of debt service coverage ratio, consider a project with the foowing financia characteristics. (Rs. in akhs) Year 1 2 3 4 5 6 7 8 9 10 Profit after tax -2.0 10.0 20.0 25.0 30.0 40.0 40.0 50.0 55.0 55.0 +7 + )+ +,& Depreciation! 12.0 10.8 9.72 8.75 7.87 7.09 6.38 5.74 5.17 4.65, + $ Interest on ongterm oan 17.6 17.6 17.05 14.85 12.65 10.45 8.25 6.05 3.85 1.65 Loam repayment Instament - - 20 20 20 20 20 20 20 20 DSCR = = +7 + )+ +,&! = %!,& + $, = % Normay, financia institutions regard a debt service coverage ratio of 2 as satisfactory. If this ratio is significanty ess than 2 and the project is otherwise desirabe, a term oan of a onger maturity may be provided. By the same token, if this ratio is significanty more than 2, the maturity period of the oan may he shortened. Probabiity of Cash Insovency In assessing the debt capacity of a firm the key question is whether the probabiity of cash insovency associated with a certain eve of debt is acceptabe to the management and not so much whether a particuar coverage norm is satisfied. Gordon Donadson, advocating the use of such an approach, has suggested that the anaysis of debt capacity may broady invove the foowing steps:

326 Financia Management 1. Determination of the toerance imit on the probabiity of cash insovency. 2. Specification of the probabiity distribution of cash fows under adverse conditions (recessionary conditions). 3. Cacuation of the fixed charges associated with various eves of debt, 4. Estimation of the debt capacity of the firm as the highest eve of debt which is acceptabe, given the toerance imit, the probabiity distribution, and the fixed charges defined above, This kind of anaysis may be iustrated with the hep of information for Phoenix Limited which is given beow: Toerance Limit The management of the company does not want the ikeihood of cash insovency to exceed 5 per cent even in adverse (recessionry) conditions. Probabiity Distribution Under adverse (recessionry) conditions the company woud have an expected cash infow of Rs. 50 miion with a standard deviation of Rs, 30 miion. The cash infow woud be normay distributed. The initia cash baance of the company is Rs. 1.26 miion. Fixed Charges The annua fixed charges associated with various eves of debt woud be as foows: Leve of Debt Up to Rs. 5 miion Between Rs. 5 miion and Rs. 10 miion Between Rs. 10 miion and Rs. 15 miion Annua Fixed Charges Rs 0.25 miion for every Rs 1 miion of debt Rs 0.26 miion for every Rs. 1 miion debt Rs 0.27 miion for every Rs. 1 miion of debt. Debt Capacity Given the above information the debt capacity may be estabished as foows: 1. Since the cash infow is normay distributed the foowing variabe has a standard norma distribution (Z distribution): Cash infow - Mean vaue of cash infow Stan dard deviation of cash infow 2. The Z vaue corresponding to 5 per cent cumuative probabiity (which refects the risk toerance of the management) is - 1.653 3. Since m = Rs. 50 miion, s = Rs. 30 miion, and the Z vaue corresponding to the risk toerance imit is --1.645, the cash avaiabe from the operations of the firm to service the debt is equa to X: which is defined as:

Capita Structure Theories 327 = This means X = Rs. 0.65 miion 4. The tota cash avaiabe for servicing the debt wi be equa to: Rs 0.65 miion (cash avaiabe from operations) Rs. 1.26 miion (initia cash baance) = Rs. 1.91 miion. 5. The eve of debt that can be serviced with Rs. 1.91 miion is as foows: Amount Annua fixed charges Rs. 5.00 miion Rs. 2.54 miion Rs. 7.54 miion 0.25 5.00 = Rs. 1.25 miion 0.26 2.54 = Rs 0.06 miion Rs. 1.91 miion Inventory of Resources Normay, when a firm's debt capacity is being assessed, certain coverage ratios, as discussed above, are ooked into. In addition, firms resorting to more sophisticated anaysis try to estimate the ikeihood of cash insovency (or cash inadequacy under recessionary conditions for different eves of debt for estabishing their? debt, capacity it woud be hepfu to suppement such anayses by estimating potentia sources of iquidity avaiabe to the firm to meet possibe cash drains. These sources, as suggested by Gordon Donadson, may be divided into three categories: Uncommitted Reserves These are reserves maintained primariy as an insurance against adverse deveopments and not earmarked for any specific purpose. Usuay these reserves can be tapped at a reativey short notice. Reduction of Panned Outays Resources may be made avaiabe by effecting reductions and cuts in proposed outays and disbursements. Typicay such reductions and cuts, whie they reease resources, tend to impair the profitabiity Liquidation of Assets In order to tide over an unmanageabe drain of cash, the firm may raise resources by iiquidat;ng some of its assets. Foowing Tabe drawn from an artice written by Gordon Donadson' shows the above mentioned categories aong, with their subcassifications.

R U In S T 328 Financia Management Tabe: Inventory of Resources Capita Structure Poicies in Practice There is ceary some vaue to debt financing, and firms use different amounts of debt depending on their tax rates, their asset structures, and their inherent riskiness. Unfortunatey, capita structure theory does not provide neat, cean answers to the question of the optima capita structure. Thus, many factors must be considered when actuay choosing a firm's target capita structure, and the fina decision wi be based on both anaysis and judgement. If a firm has perpetua cash fows, then a reativey simpe mode can be used to vaue the firm at different capita structures. In theory, this mode can be used to find the capita structure that maximises the firm's stock price. However, the inputs to the mode are very difficut, if not impossibe, to estimate. Further, most firms are growing, so they do not have constant cash fows. N Is R S D L

Capita Structure Theories 329 Since one cannot use ony quantitative modes to determine the optima capita structure, managers must aso consider such quaitative factors as ong-run viabiity, manageria conservatism, ender institutions attitudes, reserve borrowing capacity, manageria constraints, contro, asset structures, profitabiity and taxes. Wide variations in capita structure exist, both across industries and among individua firms within industries. The variations across industries can be expained to a arge extent by the economic fundamentas of the industry and the variations across companies in the same industry by their operating fundamentas and management decisions. Indian corporates empoy substantia amount of debt in their capita structure in terms of the debt-equity ratio as we as tota debt to tota assets ratio. Nonetheess, the foreign controed companies in India use ess debt than the domestic companies. The dependence of the Indian corporate sector on debt as a source of finance has over the years decined particuary since the mid-nineties. The corporate enterprises in India seem to prefer ong-term borrowings over short-term borrowings. Over the years, they seem to have substituted short-term debt for ong-term debt. The foreign controed companies use more ong-term oans reativey to the domestic companies. As a resut of debt-dominated capita structure, the Indian corporates are exposed to a very high degree of tota risk as refected in high degree of operating everage and financia everage and, consequenty, are subject to a high cost of financia distress which incudes a broad spectrum of probems ranging from reativey minor iquidity shortages to extreme cases of bankruptcy. The foreign controed companies, however, are exposed to ower overa risk as we as financia risk. The debnt service capacity of the sizeabe segment of the corporate borrower as measure by (i) interest coverage ratio and (ii) debt service coverage ratio is inadequate and unsatisfactory. Retained earnings are the most favoured source of finance. There is significant difference in the use of internay generated funds by the highy profitabe corporates reative to the ow profitabe firms. The ow profitabe firms use different form of debt funds more than the highy profitabe firms. Loan from financia institutions and private pacement of debt are the next most widey used source of finance. The arge firms are more ikey to issue bonds in the market than sma corporates. The hybrid securities is the east popuar source of finance amongst corporate India. They are more ikey to be used by ow growth firms. Preference shares are used more by pubic sectors units and ow growth corporates.

330 Financia Management Chapter-12 Dividend Decisions Once a company has been formed and continues in operation, it shoud have earnings to retain or to distribute to the owners. This disposition of these earnings is a fundamenta probem of financia management. In organisations, which are cosey hed, the probem is not there because the sharehoders run the organisation themseves and can dictate the terms. In arge organisations, however, the situation is different. Here the poicy concerning the distribution of earnings is normay deegated to the directors of the company by the sharehoders. However, they retain the fina approva authority and the dividend is paid ony after fina approva of the sharehoders in the Annua Genera Meeting. Once it is approved in the AGM, the dividend cheque is sent to the sharehoders within a month and is normay payabe in the city of residence of the sharehoder so as to expedite the payment to him. The management of an enterprise has an important financia decision to decide about the disposition of income eft after meeting a business expenses. Generay, of the tota business profits, a portion is retained for reinvestment in the business and rest is distributed to sharehoders as dividend. Organisations finance a arge portion of their needs internay, that is, from retained earnings and from non-cash charges, such as depreciation, to the extent that they are covered by earnings. To the extent that the organisations are dependent on interna funds to meet their capita and other requirements, there coud be a concern that the funds retained may not be used as productivey as they might be esewhere. In a sma concern (especiay proprietership/ partnership) the owners are very ikey to compare the return to be gained from retained earnings in the business and the return that they might make from some other investment of equivaent risk. Because they do not participate directy in formuating dividend poicy, sharehoders in arge companies do not have the chance to make this direct comparison. Thus earnings that are retained in many companies have not met a "market test" and therefore we may not be sure that they shoud have been retained. The objective of the dividend poicies shoud be to divert funds from the ess productive operations to more productive ones. But it is very difficut for the directors and the management to accept the fate of a decining company and to aow the gradua iquidation of their company, as woud be suggested by economic thought. If the management

Dividend Decisions 331 finds itsef in a decining industry, they want to retain more funds for the business operations and pay out ess so as to conserve the funds. Something that is not beneficia for the sharehoders. They aso try to retain more to fund other more profitabe investments so the continuity of the corporation can be maintained. The important issue is to decide the portion of profit to decare for dividend pay out and for retaining in business. The dividend poicy decision invoves two questions: What fraction of earnings shoud be paid out, on average, over time? and Shoud the firm maintain a steady, stabe dividend growth rate? Before we try and answer these questions, et us ook at the theories reated to dividend decisions. After that we wi ook at the empirica evidence of the same. Traditiona Position: MM Mode Theories of Dividends Dividend Irreevance: Mier and Modigiani Mier and Modigiani deveoped the dividend irreevance theory, which hods that a firm's dividend poicy has no effect either on the vaue of the firm or on its cost of capita (Do you remember the capita structure theories?). MM used the same five assumptions as they used in the debt poicy: 1. There are no persona or corporate income taxes. 2. There are no share foatation or transaction costs. 3. Investors are indifferent between a rupee of dividends and a rupee of capita gains. 4. The firm's capita investment poicy is independent of its dividend poicy. 5. Investors and managers have the same set of information (symmetric information) regarding future investment opportunities. The above assumptions that give us MM1 actuay yied a far more powerfu resut than just the irreevancy of debt poicy. They impy that the entire financia poicy foowed by the organisation is irreevant for its vauation; a that matters is the organisation's portfoio of investment projects. Hence, capita structure, dividend poicy and risk management activities (among other things) are a ineffectua in atering organisation's vaue. Consider a firm that has fixed its investment poicy. In each period, it is eft with a net cash fow, which is simpy the difference between operating income and investment costs. A straightforward corporate dividend poicy woud just be to pay out this net

332 Financia Management cash fow to the hoders of the equity. However, consider a firm that desires to pay a dividend in excess its cash fow. In order to do this, the firm can raise funds by issuing new equity. Aternativey, the firm coud borrow money, which assuming perfect capita markets is a transaction with the NPV of zero. Conversey, a firm wishing to pay a smaer dividend might spend the baance of its net cash fow on repurchasing equity. The key idea here is that a firm can choose whatever pay-out poicy it desires, funding the poicy through share issues/ repurchases; hence; dividend poicy is irreevant. In other words, they reasoned that the vaue of a firm is determined by its basic earning power and its risk cass, and, therefore, that a firm's vaue depends on its asset investment poicy rather than on how earnings are spit between dividends and retained earnings. MM demonstrated, under the ight of above mentioned assumptions, that if a firm pays higher dividends, then it must se more shares to new investors, and the vaue of the shares given to the new investors is exacty equa to the dividends paid out. From the individua investor's point of view we can show that the dividend poicy is irreevant too. To do this we can use a simiar argument to that empoyed when we said that sharehoders are indifferent to capita structure changes; sharehoders are indifferent to dividend poicy as, through appropriate purchases or saes of shares, they can repicate any dividend poicy they wish. Hence, investors wi not vaue a firm paying a particuar dividend poicy different to any other firm such that firm vaue does not depend on dividends. The MM assumptions are not reaistic, and they obviousy do not hod precisey. Firms and investors do pay income taxes, firms do incur foatation costs, and investors do incur transaction costs. Further, managers often have better information than outside investors. Thus, MM's theoretica concusions on dividend irreevance may not be vaid under rea-word conditions. Radica Modes Bird-in-the-hand Theory: Gordon and Lintner Gordon and Lintner argue that the cost of equity increases as the dividend payout is reduced, because investors can be more sure of receiving dividends than the capita gains that are expected to resut from retained earnings. Therefore, the theory hods that the vaue of the firm wi be maximised by a high dividend payout ratio, because investors regard actua dividends as being ess risky than potentia capita gains. This means that this theory is in direct contrast with MM theory of dividend irreevance.

Dividend Decisions 333 Tax Preference Theory: Litzenberger and Ramaswamy If a firm retains its earnings then the share gains in vaue in the market which resuts in capita gains for the sharehoder. If the company pays out dividend the share vaue does not increase but the sharehoder gains cash. In case of getting dividends the sharehoder has effectivey paid ony 10% tax whie in the case of capita gains he woud be in the 20% tax bracket. This means that he woud prefer to get dividends rather than get capita gains but if the capita gains are disproportionate he woud prefer capita gains rather than dividends. The tax preference theory hods that the vaue of the firm wi be maximised by a ow dividend payout, because investors pay ower effective taxes on capita gains than on dividends internationay. In India the situation is different and the sharehoder woud prefer dividends rather than capita gains. The above anaysis suggests that there is a preference for current dividends - that, in fact, there is a direct reationship between the dividend poicy of a firm and market vaue. The argument goes on the ines that investors are generay risk averse and therefore attach ess risk to current as opposed to future dividends or capita gains. In the words of John E. Kirshmann "Of two stocks with identica earnings, records and prospects but the one paying a arger dividend than the other, the former wi undoubtedy command a higher price merey because sharehoder's prefer present to future vaues. Myopic vision pays a part in the price-making process. Stockhoders often act upon the principe that a bird in hand is work two in the bush and for this reason are wiing to pay a premium for the stock with the higher dividend rate, just as they discount the one with the ower dividend rate." Benjamin Graham and David L. Todd, authors of the we-known security vauation book 'Security Anaysis' aso say that "The typica investor woud most certainy prefer to have his dividend today and et tomorrow take care of itsef. No instances are on record in which the withhoding of dividends for the sake of future profits has been haied with such enthusiasm as to advance the price of the stock. The direct opposite has invariaby been true. Given two companies in the same genera position and with the same earnings power, the one paying the arger dividend wi aways se at the higher prices." These observations are supported by the share vauation modes that have been deveoped using the dividend payouts. Water's mode (which is actuay an adaptation of the Gordon's mode) are given beow. Water s Mode Water's mode is one of the eariest dividend modes is adapted from the Gordon's mode for vauation of an equity share.

334 Financia Management Gordon's mode gives us the cost of internay generated common equity, ks ks = dividend in yea r 1 annua growth + market price in dividends ks = D 1 + g P o which can aso be written as: P 0 D K 1 = s g Hence the dividend growth rate can be subtracted from the cost of equity capita to get the present vaue of the share price which shoud be the market price according to the formua. Water adjusted the above formua to refect the earnings retention and rewrote the equation as: P 0 D K 1 = s rb Here, b is the percentage of earnings retained, and r is the expected rate of profitabiity from the retained earnings. It foows from the formua that if the earnings retained gives you a higher return than the cost of capita, you woud get a positive return and the share price woud go up and otherwise the share price woud come down because of the higher earnings retained. Water's formua highights the return on retained earnings reative to the average market rate of return on investment (market capitaisation rate) as the critica determinant of dividend poicy. A high rate of return on retained earnings indicates a ow payout ratio, whereas a ow rate reative to the market average indicates the desirabiity of a high payout ratio to increase the price of the equity shares. Therefore to increase the share vauation a company may go in for a higher payout in the form of a dividend. But this reduces the growth rate of the dividends (keeping a other things constant) bringing it back to square one.

Dividend Decisions 335 Aso a high dividend poicy may force the firm to go to the capita markets more often. In practice, most firms try to foow a poicy of paying a steadiy increasing dividend. This poicy provides investors with stabe, dependabe income, and if the signaing theory is correct, it aso gives investors information about management's expectations for earnings growth. Most firms use the residua dividend mode to set a ong run target payout ratio which permits the firm to satisfy its equity requirements with retained earnings. Factors Affecting Dividend Poicies Fund Requirements: Generay, the firms that have substantia investment opportunities and consequenty considerabe funding needs to keep their payout ratio rather ow to conserve resources for growth. On the other hand, firms which have rather imited investment avenues usuay pursue a more generous payout poicy. Bond indentures: Debt contracts often restrict dividend payments to earnings generated after the oan was granted. Aso, debt contracts frequenty stipuate that no dividends can be paid uness the current ratio, the interest coverage ratio, and other safety ratios exceed stated minimum vaues. Preference share restrictions: Typicay, equity dividends cannot be paid if the company has omitted (not paid) dividend on its preference shares. The preference dividends arrears must be paid before equity dividends can be resumed. Avaiabiity of cash: Cash dividends can ony be paid with cash. Thus, a shortage of cash in the bank can restrict dividend payments. However, unused borrowing capacity can offset this factor. Contro: If the management is concerned about maintaining contro, it may be reuctant to se new shares, hence it may retain more earnings than it otherwise woud. This factor is especiay important for sma, cosey hed firms. Differences in the cost of Externa equity and Retained Earnings: Cost of externa equity is obviousy more than the cost of retained earnings due to the foatation costs of raising the former. Therefore, if the company has some expansion pans which invoves capita expenditure it is very ikey that it woud prefer a ow dividend payout ratio. Signaing: As we have noted earier, managers can and do use dividends to signa the firm's situation. For exampe, if management thinks that investors do not fuy understand how we the firm is doing, and how good its prospects are, it may increase the dividend by more than that was anticipated in an effort to boost the stock price.

336 Financia Management Sharehoder Preference: When equity sharehoders have greater interest in current dividend vis-a-vis capita gains, the firm may be incined to foow a ibera dividend payout poicy. Whie the preference of equity sharehoders has some infuence over the dividend poicy of the firm, the dividend poicy may have a greater impact on the kind of sharehoders who are attracted towards it. Each firm is ikey to draw itsef a "cientee" which finds its payout poicy attractive. As mentioned above certain forma and casua empirica observations point in the opposite direction. Perhaps the most famous set of resuts on actua dividend poicy was compied and presented by John Lintner. Lintner interviewed the management of a sampe of US corporations in order to determine what ay behind their dividend-setting decisions. His research ed to the four foowing styised facts: Managers seem to have a target dividend pay-out eve. This pay-out eve is determined as a proportion of ong run (i.e. sutainabe) earnings of the firm. Managers are more concerned with changes in dividends rather than the actua eve of dividends. Managers prefer not to make dividend changes that might need to be reversed (e.g. cutting dividends after having raised them in the previous period). As the second fact impies, it is not current but ong-run earnings that matter in setting dividends such that dividends can be seen to be smoothed reative to earnings. There are three basic types of dividend poicies that are used by the companies. They are 1. Stabe dividends 2. Target Payout Ratio and 3. Reguar and extra dividends 1. Stabe dividends: A company foowing this type of a poicy maintains a constant dividend rate irrespective of the actua earnings eve and the company tries to maintain it even when during the recession the earnings go down beow the actua dividends pay, trying to signa to the investor that this is a temporary phase and earnings wi be back up when the economy revives. Companies expect that the investors wi pace a premium on the shares of a company which pays stabe dividends and ony increases its dividend payment when it beieves that increase can be maintained. A stabe dividend poicy

Dividend Decisions 337 irrespective of fuctuating earnings aso is beneficia because many institutions take decisions based on the actua payout by the companies. Signaing effect of this type has aready been mentioned above. This is the most favoured type of dividend poicies adopted by the companies the word over. 2. Target Payout Ratio: Athough there is a reason to beieve that stabe dividends have a positive effect on a company's share price, many firms set a bench-mark target payout ratio (or range). They ony deviate from this target to achieve reativey stabe dividends or stabe and occasionay increasing ones. Lintner contents that companies seek to maintain a target dividend payout ratio over the ong run, but ony with a ag. For exampe, a company may decide that it wi pay around 40 per cent of its earnings as dividends and ony increase it when this ratio fas to 30 per cent of the earnings that the company is reasonaby sure of. This is especiay appicabe in case of companies with stabe earnings and earnings growth for ony they can sustain a target payout ratio in the ong run. 3. Reguar and extra dividends: Especiay when a company earns above average earnings because of any reason but which is non-recurring in nature, it proposes a extra dividend over and above the reguar dividend it pays. This extra earnings coud be due to divestment of a pant or business operations and the company has no possibe utiisation of the same. In ine with the recommendations that investors ike to receive the money back from the company rather than the company utiising that money in non-business activities, the companies usuay return the money back to the sharehoders. This abeing of extra dividends or one-time dividends is given to hep the investors appreciate the fact that extra dividends are non-recurring in nature and this is the ony year this is being paid. There are other ways of returning cash to sharehoders and one of the biggest ones is gaining ground in India recenty. This is share buyback. Stock Dividends and Stock Spits An integra part of dividend poicy of a firm is the use of bonus shares and stock spits. Both invove issuing new shares on a pro rata basis to the current sharehoders whie the firm's assets, its earnings, the risk being assumed and the investors percentage ownership in the company remain unchanged. The ony definite resut from either a bonus share or share spit is the increase in the number of shares outstanding. Tabe iustrates their effect on the capitaization of the firm. Part one of the tabe shows the equity of the baance sheet before the bonus issue and part two after the issue. The effect of share spits is shown in part three.

338 Financia Management 1. Equity portion before the bonus issue: Equity share capita (30,000 shares of Rs.100 each) Share premium (@ Rs.25 per share) Retained earnings Tota equity 2. Equity portion after the bonus issue (1 : 2 ratio): Equity share capita (45,000 shares of Rs.100 each) Share premium (45,000 shares X Rs.25) Retained earnings (Rs.62,50,000 15,000 shares Rs.125) Tota equity 3. Equity portion before the share spits (10 : 1 ratio): Equity share capita (3,00,000 shares of Rs.10 each) Share premium Retained earnings Tota equity Rs. 30,00,000 7,50,000 62,50,000 1,00,00,000 45,00,000 11,25,000 43,75,000 1,00,00,000 30,00,000 7,50,000 62,50,000 1,00,00,000 TABLE Effect of Bonus Shares and Shares Spits From Tabe it is cear that a share spit is simiar to bonus issue from the economic point of view though there are some difference from the accounting point of view. In the equity portion of the firm, a bonus issue reduces the retained earnings and correspondingy increases paid-up equity and share premium, if any, whereas stock/share spit has no such effect. The economic effect of both is to increase the number of equity shares outstanding. As pointed out earier, no major economic benefit resuts from bonus shares and share spits. Yes, certain advantages are associated with them. In the first pace, the issue of bonus shares / share spits woud have the effect of bringing the market price of shares within more popuar range as a resut of arger number of shares outstanding. The arger number of outstanding shares wi aso promote more active trading in the shares due to avaiabiity of foating stock. Yet another advantage might reate to the informationa content of bonus/spit announcement. The announcement is perceived as favourabe news by the investors in that with growing earnings, the company has bright prospects and the investors can reasonaby ook for increase in future dividends. Moreover, it enabes the conservation of corporate cash. If the bonus share is an effort to conserve cash for profitabe investment opportunities, the share prices wi tend to rise and the sharehoders benefit. However, if the move to conserve cash reates to financia difficuties within the firm, the market price wi most ikey react adversey. Finay, bonus / spit announcements improve the prospect of raising additiona funds particuary through the issue of convertibe debentures. Repurchase of Stock As an aternative to paying cash dividends, a company may distribute income to its

Dividend Decisions 339 sharehoders by repurchasing its own shares. Assuming that the repurchase does not adversey affect the firm's earnings, the earnings per share on the remaining shares wi increase, resuting in a higher market price per share, which means that the capita gains wi have been substituted for dividends. A repurchase that is part of capita restructuring is different from a reguar repurchase mentioned above. In a capita restructuring repurchase pan asset saes and issuance of debt are used to bring in additiona capita and then this capita is distributed to sharehoders through a major, one-time share repurchase. Disadvantages/ Advantages of Share Repurchases 1. Repurchase announcements are viewed as positive signas by investors because the repurchase is often motivated by management's beief that the firm's shares are undervaued. 2. The sharehoders have a choice to se or not to se in share repurchase situation. So those who prefer capita appreciation can get the same and those who prefer cash can se the shares. 3. Repurchase can hep reduce the suppy of shares in the market, thereby increasing the vaue of the share. 4. Management disikes increasing cash dividend as it sends positive signas about future profitabiity and if the company cannot maintain the same in the future it may resut in a sharp fa in the share price. Therefore, if the earnings increase is ony temporary then the management may prefer to make the distribution in the form of a share repurchase. 5. It can hep in drasticay changing the capita structure of the company, which is otherwise very difficut. There are certain disadvantages too: 1. The sharehoder may benefit more from cash dividends than share repurchase if the market discounts the earnings more than a given eve. 2. The seing sharehoder may ose because of the share repurchase pan as he woud get the ong term benefit of share repurchase. 3. The company may pay too high a price for share repurchase, resuting in a reduction in vaue for existing sharehoders. A this means that share repurchases on a systematic, dependabe basis is probaby not a good idea. However, it can be given carefu consideration if the market is not discounting the share in a proper manner and the company has extra cash that it can utiise for the same. Repurchases can be especiay vauabe to a firm that wants to make a arge shift in its capita structure within a short period of time.

340 Financia Management Procedura and Lega Aspects of Dividends The amount of dividend that can be egay distributed is governed by company aw, judicia pronouncements in eading cases, and contractua restrictions. The important provisions of company aw pertaining to dividends are described beow. 1. Companies can pay ony cash dividends (with the exception of bonus shares). Apart from cash, dividend may aso be remitted by cheque or by warrant. The same may aso be transmitted eectronicay to sharehoders after obtaining their consent in this regard to the bank account number specified by them. The step has been proposed by the Department of Company Affairs to avoid deay in the remittance of dividend. 2. Dividends can be paid ony out of the profits earned during the financia year after providing for depreciation and after transferring to reserves such percentage of profits as prescribed by aw. The Companies (Transfer to Reserve) Rues, 1975, provide that before dividend decaration, a percentage of profit as specified beow shoud be transferred to the reserves of the company. a. Where the dividend proposed is up to 10 per cent of the paid up capita, no amount of the current profits need to be transferred. b. Where the dividend proposed exceeds 10 per cent but not 12.5 per cent of the paid-up capita, the amount to be transferred to the reserves shoud not be ess than 2.5 per cent of the current profits. c. Where the dividend proposed exceeds 12.5 per cent but not 15 per cent, the amount to be transferred to reserves shoud not be ess than 5 per cent of the current profits. d. Where the dividend proposed exceeds 15 per cent but not 20 per cent, the amount to be transferred to reserves shoud not be ess than 7.5 per cent of the current profits. e. Where the dividend proposed exceeds 20 per cent, the amount to be transferred to reserve shoud not be ess 10 per cent. f. A company may vountariy transfer a percentage higher than 10 per cent of the current profits to reserves in any financia year provided the foowing conditions are satisfied: (i) (ii) It ensures that the dividend decared in that financia year is sufficient to maintain average rate of dividend decared by it over three years immediatey preceding the financia year. In case, it has issued bonus shares in the year in which dividend is decared or in the three years immediatey preceding the financia year, it maintains the amount of dividend equa to the average amount of

Dividend Decisions 341 dividend decared over the three years immediatey preceding the financia year. However, maintenance of such minimum rate or quantum of dividend is not necessary if the net profits after tax in a financia years are ower by 20 per cent or more than the average profits after tax of the two immediatey preceding financia years. g. A newy incorporated company is prohibited from transferring more than then percent of its profits to reserves. The 'current profit' for the purpose of transfer to reserves wi be profits after providing for statutory transfer to the Deveopment Rebate Reserve and arrears of depreciation if any. 3. Due to inadequacy or absence of profits in any year, dividend may be paid out of the accumuated profits of previous years. In this context, the foowing conditions, as stipuated by the companies (Decaration of Dividend out of Reserves) Rues, 1975, have to be satisfied. a. The rate of the decared dividend shoud not exceed the average of the rates at which dividend was decare by the company in 5 years immediatey preceding that year or 10 per cent of its paid-up capita, whichever is ess. b. The tota amount to be drawn from the accumuated profits earned in previous years and transferred to the reserves shoud not exceed an amount equa to one-tenth of the sum of its paid-up capita and free reserves and the amount so drawn shoud first be utiized to set off the osses incurred in the financia year before any dividend in respect of preference or equity shares is decared. c. The baance of reserves after such drawa shoud not fa beow 10 per cent of its paid-up capita. 4. Dividends cannot be decared for past years for which accounts have been adopted by the sharehoders in the annua genera meeting. 5. Dividend decared, interim or fina, shoud be deposited in separate bank account within 5 days from the date of decaration and dividend wi be paid within 30 days from such a date. 6. Dividend incuding interim dividend once decared becomes a debt. Whie the payment of interim dividend cannot be revoked, the payment of fina dividend can be revoked with the consent of the sharehoders. Procedura Aspects The important events and dates in the dividend payment procedure are: 1. Board Resoution: The dividend decision is the prerogative of the board of

342 Financia Management directors. Hence, the board of directors shoud in a forma meeting resove to pay the dividend. 2. Sharehoder Approva: The resoution of the board of directors to pay the dividend has to be approved by the sharehoders in the annua genera meeting. However, their approva is not required in the case of decaration of interim dividend. Further, it shoud be noted that the sharehoders in the annua genera meeting have neither the power to decare the dividends (if the Board of Directors do not recommend it) nor to increase the amount or dividend. However, they can reduce the amount of the proposed dividend. 3. Record Date: The dividend is payabe to sharehoders whose names appear in the register of members as on the record date. 4. Dividend Payment: Once a dividend decaration has been made, dividend warrant must be posted within 30 days. Within a period of 7 days, after the expiry of 30 days, unpaid dividends must be transferred to a specia account opened with a schedued bank. In case the company fais to transfer the unpaid dividend to the 'unpaid dividend account' within 37 days of the decaration of dividend, an interest of 12 per cent per annum on the unpaid amount is to be paid by the company. The interest so accruing is to be paid to the sharehoders in the proportion of the dividend amount remaining unpaid to them. The dividend wi be paid to the registered sharehoder or to his order or to his banker or in case a share warrant has been issued to the bearer of such a share warrant. In the case of joint-hoders, the dividends shoud be paid to the first jointhoder. Further, as per the notification issued by the Department of Company Affairs, the payment of dividend to the sharehoders invoving the fraction of 50 paise and above be rounded off to the rupee and the fraction of ess than 50 paise may be ignored. In the case of demateriaized shares (i.e., the shares hed in eectronic form), the corporate firms are required to coect the ist of members hodings shares in the depository and pay them the dividend. 5. Unpaid dividend: If the money transferred to the 'unpaid dividend account' in the schedued bank remains unpaid / uncaimed for a period of 7 years from the date of such transfer, the company is required to transfer the same to the 'Investor, Education and Protection Fund' estabished for the purpose.

Dividend Decisions 343 Dividend Poicies in Practice To earn about the dividend poicies of business firms, the author asked the chief finance executives of 20 arge-sized business undertakings, representing a wide cross-section of industries, the foowing question: What is your dividend poicy? The responses obtained are reproduced beow (the engthier ones have been paraphrased). Nature of Industry Response Eectrica Chemicas Tea Fertiiser Toothpaste Auminium Chemica Automobie Shipping Leasing "We try to maintain a ten per cent dividend rate. That is what the government expects from us." "Dividend poicy is concerned primariy with the wefare of sharehoders. When earnings position permits we decare good dividends. Otherwise, we don't. We don't think of accumuating surpus and decaring bonus shares." "In the ast ten years the parent company has not been insisting on any dividend rate. Whatever has been paid out is accepted. Our payout has been 30 to 50 per cent." "Though we are a joint sector project, our dividend poicy is governed by commercia considerations. Of course, we are a bit conservative." "We beieve in rewarding sharehoders generousy - both in dividends and bonus shares. Our payout has been very high. 'We pay dividend whenever we can afford it. When performance or iquidity unsatisfactory we skip dividend to preserve strength our financia strength." "Our dividend poicy is to pay a fixed rate of dividend and issue bonus shares when we are eigibe to. The purpose is to ensure that sharehoders retain shares to enjoy capita gains." "We ike to maintain a dividend rate of 15 per cent. This seems to be a fair return to investors." "In the past when the going was good, we paid good dividends and issued bonus shares periodicay. The ast few years were rough. We had to suspend dividend for some time. We are now recovering. We wi try to foow the past poicies, provided business conditions are good." "We woud ike to decare as high a dividend as we can. If share prices rise due to that, we can raise reativey easiy more funds by issuing convertibe debentures."

344 Financia Management Diversified Diversfied Truck Pharmaceuticas Diversified Texties Storage Diversified "We regard sharehoders as partners. They deserve handsome returns. We give good dividends and periodic bonus issues." "We have a very conservative dividend poicy. Our dividend rate which used to be 10 per cent four years ago has now been raised to 15 per cent. We won't probaby consider a change for the next few years. "The company foows a conservative dividend poicy which aims at protecting the interests of the sharehoders and the company by (a) providing a consistent and reasonabe return to the (b) sharehoders, and (c) poughing back profits to take care of contingencies and to improve the equity base. "We distribute about 30 per cent of our earnings. We maintain our dividend around 18 per cent. When the reserves position permits and the earnings potentia justifies, we issue bonus shares." "We don't have a specific dividend poicy. When the profits are good and iquidity satisfactory we give 12 per cent to 15 per cent as dividends. "Due to drop in profits we have skipped dividends. We wi try to restore it-when I don't know." "We have been paying steadiy about 20 per cent as dividends." "Of course, our bonus record is poor. In the foreseeabe future there may be very itte change." "The investor is the king. Uness he is rewarded, we can't get the funds for our growth. So, we try to benefit him by dividends, bonus issues, and rights issue." Consumer Eectronics "We paid good dividends a profits were high. We wi try to maintain the same. Of course, profitabiity wi be the key factor." Diversified "We have, if you permit me to say, an obsession with 20 per cent dividend rate. We don't want to raise it to 25 or 30 per cent as this connotes super profits--but we woud ike to decare bonus shares. Our panning revoves around this compeing goa-dominant Some Types On the basis of the above responses we find that most of the firms pursue three types of poicies:

Dividend Decisions 345 Generous Dividend and Bonus Poicy Firms which foow this poicy reward sharehoders generousy by stepping up tota dividend payment over time. Typicay, these firms maintain the dividend rate at a certain eve (15 to 25 per cent) and issue bonus shares when the reserves position and earnings potentia permit. Such firms naturay have a strong share hoder orientation. More or Less Fixed Dividend Poicy Some firms have a target dividend rate which is usuay in the range 10 per cent to 20 per cent which they consider as a reasonabe compensation to equity sharehoders. Such firms normay do not issue bonus shares frequenty, may be once in few years, the dividend rate may be raised sighty to provide somewhat higher compensation to equity sharehoders to match the higher returns from other forms of investment. Erratic Dividend Poicy Firms which foow this dividend poicy seem to be indifferent to the wefare of equity sharehoders. Dividends are paid erraticay whenever the management beieves that it wi not strain its resources. Tax Aspects With effect from financia year 2003-4, dividend income from domestic companies and mutua funds is exempt from tax in the hands of the sharehoders / investors / unithoders. However, the domestic companies wi be iabe to pay dividend distribution tax at the rate of 12.5 per cent (pus surcharge) on dividends paid after Apri 1, 2003.

346 Financia Management Chapter-13 Working Capita Financing Accruas, trade credit, commercia Banks advances, pubic deposits, Inter Corporate Deposits, Short Term Loans from Financia Institutions, Debentures for working capita, Commercia Paper, Factoring, Reguation of Bank Finance Recommendation of Latest Committee. This chapter discusses sources of financing. By convention a sources of financing that must be repaid within one year are considered to be short term, those that must be repaid in one to five years are intermediate term, and a sources with maturities onger than five years are cassified ong term. Two major issues are invoved in managing the firm s use of short-term financing: (1) How much short-term financing shoud the firm use? and (2) What specific sources of short-term financing shoud be seected? The earier chapter used the bedging principe of working capita management to answer the first of these two questions. Basicay, that invoved an attempt to match temporary needs for funds with short-term sources of financing and permanent needs with ong term sources. 1 The objective of this chapter wi be to answer the second of the above questions: How shoud the financia manager seect a source of short-term credit? In genera, three basic factors shoud be considered in seecting a source of short-term credit: (1) the effective cost of credit, (2) the avaiabiity of credit in the amount needed and for the period of time when financing is required, and (3) the infuence of the use of a particuar credit source on the cost and avaiabiity of other sources. We discuss the probem of estimating the cost of short-term credit before. Introducing the various sources of credit, as the procedure used is the same for a. The second and third factors isted above are each discussed as they pertain to the individua sources of short-term credit. Estimating the Cost of Short-Term Credit 1 Temporary needs for funds arise in response to a temporary need for current assets. These incude current assets that the firm does not pan to hod throughout the indefinite future. Permanent needs for funds arise in conjunction with a permanent need for certain assets. These assets consist of fixed assets pus the firm s minimum eve of investment in current assets. Thus, when discussing working-capita management we abandoned the current-fixed assets cassification in favour of the more usefu concept of temporary and permanent assets.

Working Capita Financing 347 Approximate Cost-of-Credit Formua The procedure used in estimating the cost of short-term credit is a very simpe one and reies on the basic interest equation. (8-1) Interest = principe rate time Where interest is the amount of interest on a principa that is borrowed at some annua rate for a fraction of a year (represented by time). For exampe, a six-month oan for Rs 1000 at 8 per cent interest woud require interest payments of Rs 40: Interest = Rs 1000.08 1/2 = Rs 40. The probem faced in assessing the cost of a source of short-term financing, generay invoves estimating the annua effective rate (RATE) where the interest amount, the principa sum, and the time for which financing wi be needed are known. Thus, soving the basic interest equation for RATE produces Interest (8-2) Rate = Principa Time or Interest Rate = Principa 1 Time Exampe: The SKC Corporation pans to borrow Rs 1000 for a 90-day period. At maturity the firm wi repay the Rs 1000 principa amount pus Rs 30 interest. The effective annua rate of interest for the oan can be estimated using the RATE equation as foows: Rs 30 Rate = Rs 1000 1 90/360 360 =. 03 =.12, 90 or 12 per cent The effective annua cost of funds provided by the oan is therefore 12 per cent. The Annua Percentage Rate Formua Compound interest was not considered in the simpe RATE cacuation. To consider the infuence of compounding we can use the foowing equation: (3-3) APR = (1 + r/m)m 1 Where APR is the annua percentage rate, r is the nomina rate of interest per year (12 per cent in the above exampe) and m is the number of compounding periods within a year (m = 1/TIME = 1/(90/360) = 4 in the exampe above. Thus, the effective rate of interest on the exampe probem, considering compounding, is APR = (1 +.12 / 4) 4 1=.126, or 12.6 per cent

348 Financia Management The effect of compounding is to raise the effective cost of short-term credit. Since the differences between the two methods for periods ess than one year are usuay sma, the simpe interest version of RATE discussed above wi be used. Sources of Short-Term Credit Short-term credit sources can be cassified into two basic groups: unsecured and secured. Unsecured oans incude a those sources that have as their security ony the ender s faith in the abiity of the borrower to repay the funds when due. There are three major sources of unsecured short-term credit: trade credit, unsecured bank oans, and commercia paper. Secured oans invove the pedge of specific assets as coatera in the event the borrower defauts in payment of principa or interest. The principa suppiers of secured credit incude commercia banks, finance companies, and factors. The primary sources of coatera incude accounts receivabe and inventories. Accruas Interna accruas is one of the major sources of funds for most companies and is derived from the retained earnings. Profits eft after paying dividends are primariy used for working capita financing. Trade credit In any norma business practice, buyers are not generay required to pay cash on deivery for the goods and services they order. Instead, the seers invoice, or bi the buyers on deivery according to the terms of the particuar trade or ine of business. That is, seers extend credit to buyers, and this extension of credit provides a temporary source of funds to the buyer in the form of accounts payabe. Because suppiers are generay more ibera in extending credit than banks are, trade credit has become the most important source of short-term business funds in terms of tota voume of credit suppied. Forms of Trade Credit There are three avenues of trade credit extension: (1) the open account, which is by far the most common; (2) the promissory note; (3) the trade acceptance. Open-account credit is ordinariy extended ony after the seer conducts a fairy extensibe investigation of the buyer s credit standing and reputation. The open account derives its name from the fact that the buyer does not sign a forma debt instrument evidencing the amount he owes the seer, as woud be the case if he appied for and obtained bank credit. The ony evidence the seer has that credit has been extended is the buyer s purchase order, a copy of the invoice showing that merchandise was shipped,

Working Capita Financing 349 and an entry in his accounts receivabe edger. It is indicative of the extent to which a credit economy has deveoped in this country that, when most trade credit is arranged, this is a that is done and a that is required to be done to estabish ega evidence of indebtedness. In some situations, however, a promissory note may be used in the transaction. A promissory note is written promise by one person to another to pay on demand or at a fixed or determinabe future time a certain sum of money to order of bearer. The promissory note is generay an interest-bearing instrument. Buyers are required to sign such notes most often in cases where their open accounts have become deinquent and the seer wishes to obtain a forma acknowedgement of the debt, a definite maturity date, and, at times, a return in the form of interest on the funds thus committed. Promissory notes appear on the seer s baance sheet as notes receivabe of course. In some ines of business, trade acceptances are used in pace of the open account. A trade acceptance is generated when a seer, after receiving a purchase order from a customer, draws a time draft on that customer in the amount of the order. A time draft is an unconditiona order to pay a certain sum of money at a fixed or determinabe future time. The seer then sends the draft through his own bank, together with an order bi of ading from the carrier by which the goods are shipped, for presentation to and acceptance by the customer. An order bi of ading must be presented to the carrier to secure the reease of the goods shipped at their destination. The seer s bank forwards the draft and bi of ading to its correspondent bank in the city in which the customer is ocated; and this bank presents the draft to him for acceptance. The customer accepts the draft simpy by signing, dating, and writing the word accepted across the face of the draft. After accepting the draft, the customer receives the order bi of ading from the bank and is abe to secure his shipment of goods from the issuing carrier. The accepted draft, now a trade acceptance, is then returned to the seer s bank and then to the seer, he may either hod it to maturity or ask his bank to discount it for him, since as a trade acceptance it is a fu fedged negotiabe instrument. In either event, it wi be presented to the buyer for payment on its due date. Terms of Trade Credit Promissory notes and trade acceptances are both used rather sparingy in commercia transactions; therefore, the more reevant terms of trade credit are those pertaining to open accounts. Three aspects of this form of credit warrant discussion: (1) the size of the cash discount, if any, from the net invoice price which is given for making cash payment within a specified period;

350 Financia Management (2) the period within which payment must be made if the cash discount is to be aowed; and (3) the maximum period that can eapse before payment of the net invoice price is required if the cash discounts is not taken. It is important to distinguish a cash discount from both a quantity discount and a functiona discount. A quantity discount generay expressed as a percentage reduction form a ist price-is given for purchasing certain minimum amounts of a particuar item. Functiona discounts are differentia discounts given to different types of customers a whoesaer, for exampe, may be given a arger discount than a retaier. Terms of trade credit, which vary from industry to industry, are specified on each invoice and may be categorised according to both the net period within which payment is expected and the terms of the cash discounts aowed. In genera, cash discounts coud be set as high as 10 % but the average is coser to 2 to 6 percent; the discount periods are usuay fairy short, in most cases 10 or 20 days. CBD And COD Cash before deivery (CBD) and Cash on deivery (COD) are two common forms of payment. Under CBD, as buyer must pay for the goods before the suppier wi ship them, when a suppier imposes these terms, he either knows nothing at a about the buyer s creditworthiness or, more frequenty, he knows too much about the customer s unreiabiity in managing his business affairs. In the atter circumstances, to eiminate the risk of non-payment competey, he may even wait for the customer s check to cear even before shipping the order. Under COD, suppier wi ship the goods ordered, but the buyer must pay for them before taking possession. The ony risk invoved with COD is that the customer may refuse the shipment and the seer wi have to pay shipping costs both ways. Transactions competed under either CBD or COD terms are considered cash transactions since suppiers are required to extend no credit at a. Net-terms, no cash discount When net terms are quoted, the suppier specifies the period permitted for payment in fu payment. For exampe, net 30 means that the amount of net invoice must be paid in fu within 30 days. If the seer bis on a monthy basis, he may stipuate such terms as net 15 EOM, meaning that a goods shipped before the end of the month must be paid for in fu by the fifteenth of the foowing month. Sometimes, bi-to bi terms are specified, that is, the bi for a previous deivery is coected at the time a new deivery is made.

Working Capita Financing 351 Cash discount terms In addition to extending credit on net terms, suppiers may offer a cash discount for payment more prompt than the net terms require. The terms 2/10, net 30, for exampe, indicate that the buyer is offered a 2 per cent discount for payment within 10 days of the date of the invoice. If this discount is not taken, the fu amount is due within 30 days. When the buyer is far removed from the seer, or the method of shipping the goods is sow, terms may be 2/10, net 30 AOG. That arrangement affords the buyer the opportunity of inspecting the goods before paying for them. More important, it provides a buyers with an equa opportunity to earn the cash discount, regardess of the transit time required for the goods to reach them. Rationae for trade credit terms The variation in trade credit terms described above have a rationae. First; the period of time for which credit is granted is reated to the nature of the commodity sod. Highstye items or perishabe merchandise are generay sod on fairy short credit terms because of the high turnover of the items. Second, the estimated degree of credit risk is generay refected in the terms of sae. Retai shops in the appare trades are characterised by a rather high rate of faiure and if not faiure a exceptionay ong credit period (six months on an average), for exampe. This may expain the rather arge cash discounts usuay aowed to such retaiers - the size of the discount refecting suppier s desires to be paid as quicky as possibe. Third, the nature and extent of competition among suppiers is expressed in credit terms as we as in prices and service. When a product is new, or if a suppier is soiciting business from a new account, granting more ibera credit terms than are customary may be one way of generating additiona saes. Fourth, a suppier short of working capita may offer rather arge cash discounts to his customers to induce them to sette their accounts quicky. In this way, the suppier reduces his coection period and thus reduces his tota working capita requirements. A thiny capitaised suppier may find that the cost of offering arge cash discounts is ess than the cost of borrowing or raising additiona equity capita to meet his working capita needs. Finay, the financia strength of the suppier reative to that of his customers is aso a determinant of credit terms. Athough it might appear that a financiay strong suppier coud dictate stringent terms, by doing so he may succeed ony in osing some customers and possiby even putting others out of business.

352 Financia Management In reaity, in many ines of business, smaer companies are carried by their suppiers. Trade credit as a source of funds Since buyers generay do not pay for goods unti some time after they are deivered, trade credit is a short-term source of business funds. If a firm automaticay pays a its bis a certain number of days after the invoice date becomes a buit-in source of financing that varies with the production cyce. As the firm increases its eve of production, and thus its purchases, accounts payabe increase commensuratey providing some of the funds needed to finance the increase in production. Simiary, as production decreases, purchases, and thus account payabe, decrease. Athough change in the size of a firm s account payabe may not be abe to move with inventory adjustments, there wi ordinariy be a strong degree of correspondence between the two. If a firm adheres stricty to the practice of aways paying its bis a certain number of days after invoice date, trade credit cannot be considered a discretionary source of financing. Instead, it becomes determinate insofar as it is dependent on the purchasing pan of the firm which, as we discussed earier, is dictated argey by its production cyce. Athough prompt payment of such obigations is generay to be commended, certain advantages may be gained from using trade credit as a discretionary source of short-term financing. When the company gets the trade credit, it woud ike to pay back as ate as possibe, because these are the funds that require no interest payments and are free of cost. Right. Wrong, these funds are not free of cost because the sae price of these aready incudes the cost of the time for which the credit is given. Cost of Trade Credit For purposes of measuring the true cost, or the effective annua rate of interest associated with use of trade credit as a discretionary source of short-term business funds, it is necessary to consider the effects of its use both when : (1) a company fais to take its cash discounts but nevertheess pays within the net period, and (2) a company fais to take its discounts and aows its payabe to become overdue. These two situations are the ony ones that invove an actua cost to the debtor. If no cash discount is offered, then there is no cost for the use of credit during the net period, however ong it may be. By the same token, if a discount is avaiabe and the buyer takes it, there is aso no cost for the use of credit during the discount period. However, if a cash discount is offered and is not taken, there is an expicit opportunity cost for the use of third credit.

Working Capita Financing 353 For exampe, the Road Company purchases it raw materias on terms of 2/10 net 30. It thus has the option of using the funds for 20 days after the discount period if it passes the discount but pays on the fina day of the net period. Road Co., however, must pay 2 % of the priviege of using the funds for 20 days. It is given by the equation: R = C(365 D) D (100-C) where C D R = the cash discount = the number of extra days Road has the use of the suppier s funds = the annua interest rate for the use of these funds In our exampe, C = 2 percent, D = 20: the effective annua interest rate for the company woud be R = 2 (365) 20 (100-2) 37.24 per cent Thus, we see that passed discounts can transform trade credit from a normay easy sources of funds into a very expensive form of short-term financing. Therefore, if other financing is avaiabe even though with high interest rates, say 20 or 24%, Road s financia administrator woud be we advised to borrow in sufficient time so that it can take advantage of any cash discounts offered by its suppiers. Sometimes companies that are short of cash and ack reserve borrowing power may be forced to not ony pass up cash discounts but aso postpone payment beyond the net period. This practice is referred to as stretching accounts payabe or riding trade creditors. There are two types of costs incurred by a company that stretches its accounts payabe (1) the expicit cost of discounts foregone, as outined above, and (2) the impicit cost of permitting its trade credit rating to deteriorate. If a company rides its creditors excessivey, so that its trade payabe become noticeaby deinquent, its credit rating among a suppiers in the trade wi surey suffer. They wi view the company as increasingy risky to se to and may quicky begin to impose rather strict terms of sae, upto and incuding COD or CBD. Proper Use of Trade Credit As compared with other kinds of short-term business credit bank oans, for exampetrade credit is amost automatic. And because it may be much more readiy acquired,

354 Financia Management business companies must exercise continuing care to avoid faing into the habit of using trade credit to excess. Because suppiers regard the extension of trade credit as a part of their overa saes promotion programs, they often extend trade credit to many marginay creditworthy companies-sma, new companies and od, decining companies-that do not quaify for and consequenty cannot obtain credit from other sources of short-term funds. It is aso quite easy to get into debt through the use of trade credit. A company needs ony to order additiona goods from its suppiers; and if it is occasionay ate in making payment, the saes promotion aspect of trade credit extension may prompt suppiers to ook the other way, so that the company s credit reputation may suffer no immediate harm. Finay, trade credit is exceedingy usefu and vauabe precisey because business companies can usuay obtain it when, as, and to the extent that it is needed. When inventory shoud be increased to anticipate the seasona expansion of saes, for exampe trade credit wi automaticay finance a part of the increase. Then, as the seasona saes convert into cash through coections, the company may use the funds to reduce trade payabe. For this reason, trade credit is often termed a spontaneous source of funds. Thus, a company s financia officer whie assuring that his company benefits from the avaiabiity of trade credit in every egitimate way, shoud aways maintain the business iquidity required to pay a his company s bis as they come due. Beyond this, even considering the extremey high cost of passing discounts, he shoud certainy pan to pay a of his company s trade bis within the discount period. Doing so wi have favourabe resuts, not ony on the company s credit reputation in the trade but, more important, on its current and ong-run profitabiity as we. In a negative but equay significant sense, doing so wi automaticay avoid the possibe financia over extension of the company that coud resut from its succumbing to the temptation to use trade credit excessivey because it is there. Commercia Banks advances Bank credit is the most basic and the most widey used method of short term finance (apart from trade credit) because of the avaiabiity of funds and reativey permanent source of funds as compared to the trade credit. We wi discuss the requirements of the banks which they take into consideration before accepting the corporate as a cient, then we take a ook at RBI Guideines governing the same incuding the methods of cacuating the amount that the bank is going to finance and asty we take a ook at some of the recent issues concerning bank finance.

Working Capita Financing 355 A business firm may have diverse credit needs and may require either (1) a revoving credit arrangement, (2) a seasona ine of credit, (3) funding on a transaction basis, or (4) get its bis discounted. Banks wi take care that it meets the kind of requirements that the company has and not push their own systems of financing. Banks do participate even in financing some of the money market instruments (ike CPs) but the basic funding remains through the working capita oans ony. A ine of credit is simpy a forma or informa agreement between a commercia bank and a borrowing customer regarding the maximum amount of credit the bank is wiing to extend to that customer over a given number of months usuay a quarter. These imits are usuay roabe from year to year after reassessment of the requirements. Seasona business borrowers commony request seasona ines of credit. By preparing and anaysing cash budget refecting his firm s operations over some period, the financia administrator estimates the patterns of his seasona financing needs and arranges a ine of credit with the firm s bank, the upper imit of which equas the firm s forecasted peak requirements, as shown in his cash budget. The seasona buid up of inventories, accounts receivabe, or both create needs for funds, the firm simpy signs promissory notes for the amounts required at the times they are required, and the bank credits the firm s account in the proper amounts. Subsequenty, the post seasona shrinkage in working capita needs permits the firm to repay the advances with funds generated from the sae of inventories and the coection of accounts receivabe. (for exampe in sugar industry where demand for WC buids up for six months and comes down in the rest six months). Banks usuay access the peak seasona demand and off-season demand separatey and sanction credit on this basis. Revoving Credit Agreements Earier the whoe working capita oan was revoving credit in the sense that the company coud repay whatever part of the oan it wanted to. Revoving ines typicay were continuous and were negotiated as forma commitments to end by the bank, and a commitment fee was charged on any portion of the ine that ied unused. The main probem was that the bank had to keep aside a huge portion of funds, which, in the case of corporates not utiising them, were not earning any return except the return from the ca money markets (which were very ow as compared to the returns from the oans). To rectify this probem the banks divided the working capita oans into two parts, demand oan and cash credit in a ratio of 80:20. Demand oan became the fixed portion of the bank working capita financing and ony the cash credit was aowed to be kept fuctuating.

356 Financia Management Transaction Basis When a firm borrows ony occasionay, for specific purposes that may differ from time to time, it wi generay negotiate each oan with the bank as a separate transaction. Bi Discounting Under this a borrower can obtain the bank credit through the bank s purchase of (or discount of) its bis. The amount covered under this agreement is covered within the overa working capita imits. Before purchasing or discounting the bis the bank satisfies itsef with the creditworthiness of the drawer. In practice, the banks hod the bis as security against the credit it gives to the company. Cost of Bank Credit Interest rates on bank oans to business are determined through negotiation between borrower and ender. The rate charged tends to vary directy with the credit quaity, or the credit-worthiness, of the borrower. The argest, soundest companies possessing the highest credit quaity are abe to borrow at the prime rate, the owest rate charged on business oans at any point in time. The prime rate is the one at which the nation s argest banks end to their biggest and best business-borrowing customers. It is the connecting ink between a commercia bank s oan rates and short- term, open-market money rates. The prime rate measures, in effect, the opportunity cost to banks of ending rather than investing in short-term, open market instruments. Since the atter are virtuay risk ess, it foows that primerate borrowers must possess credit quaities of the very highest order to quaify for the owest bank oan rate. This rate is usuay used for the working capita financing, whie for extending shortterm credit (especiay in commercia paper) this rate is amost never used as the benchmark and banks frequenty end beow this rate. Exampe: M&M Beverage Company has a Rs 300,000 ine of credit which requires a compensating baance equa to 10 per cent of the oan amount. The rate paid on the oan is 12 per cent per annum, Rs 200,000 is borrowed for a six-month period, and the firm does not, at present, have a deposit with the ending bank. The cost of the oan incudes the interest expense and, in addition, the opportunity cost of maintaining an ide 2 Athough technicay incorrect, the same answer coud have been obtained by assuming a tota oan of Rs 200,000 of which ony 90 per cent of Rs 180,000 was avaiabe for use by the firm; that is, Rs12,000 1 RATE = = 13.33 per cent Rs180,000 18/360 Interest is now cacuated on the Rs 200,000 oan amount (Rs 12,000 = Rs 200,000.12 ½)..

Working Capita Financing 357 cash baance equa to the 10 per cent compensating baance. To accommodate the cost of the compensating baance requirement, assume that the added funds wi have to be borrowed and simpy eft ide in the firm s checking account. Thus, (a) the amount actuay borrowed (b) wi be arger than the needed Rs 200,000. In fact, the needed Rs 200,000 wi comprise 90 per cent of the tota borrowed funds due to the 10 per cent compensating baance requirement, hence 90B =Rs 200,000, such that B =Rs 222,222. Thus, interest is paid on a Rs 222,222 oan Rs 222,222.12 ½ = Rs 13,333.32), of which ony Rs 200,000 is avaiabe for use by the firm. 2 The effective annua cost of credit therefore is Rs 13,333.32 1 R ATE = = 13.33 per cent Rs 200,000 18/360 If the firm normay maintains at east Rs 200,000 (or 10 per cent of the needed funds) in a demand deposit with the eading bank, then the cost of the credit is, RATE Rs 12,000 1 = 12 per cent Rs 200,000 18/360 = In the M&M Beverage Company exampe the oan required the payment of principa Rs 222,222) pus interest Rs 13,333.32) at the end of the six-month oan period. Frequenty, bank oans wi be made on a discount basis. That is, the oan interest wi be deducted from the oan amount before the funds are transferred to the borrower, extending the M&M Beverage company exampe to consider discounted interest invoves reducing the oan proceeds (Rs 200,000) in the previous exampe by the amount of interest for the fu six months (Rs 13,333.32). The effective rate of interest on the oan is now: Rs 13,333.32 1 RATE = =.1429, Rs 200,000 - Rs 13,333,32 18/360 or 14.29 per cent The effect of discounting interest was to raise the cost of the oan from 13.33 per cent to 14.29 per cent. This resuts from the fact that the firm pays interest on the same amount of funds as before Rs 222,222); however, this time they get the use of Rs 13,333.32 ess, or Rs 200,000 Rs 13,333.32 = Rs 186,666.68. 3 3 If M&M needs the use of a fu Rs 200,000, then they wi have to borrow more than Rs 222,222 to cover both the compensating baance requirement and the discounted interest. In fact, the firm wi have to borrow some amount B such that B.10 B (.12 ½) B = Rs 200,000.84 B = Rs 200,000 Rs 200,000 B = = Rs 238,095.84 The cost of credit remains the same at 14.29 per cent, as we see beow: Rs 14,285,70 1 RATE = =.1429,or 14.29 per cent Rs 238,095- Rs 23,810 - Rs 14,285.70 18/360

358 Financia Management Compensating Baances Banks require cient firms with a ine of credit or a revoving credit arrangement to maintain a current account or demand deposit baance that is reated either to the credit imit or to the amount borrowed. The required baances are caed compensating baances and under some circumstances have the effect of raising the interest rate on the oan. The usua practice is for banks to require that 10 to 20 per cent of the borrowed on a ine of credit be kept as a demand deposit baance. Assume that a firm borrows Rs 2 crore on a ine of credit and the ending bank requires a 15 per cent credit baance; 15 per cent of this Rs 2 crore oan, or Rs 30,00,000, wi have to be kept in the firm s current account at the bank to meet the compensating baance requirement. Whether this compensating baance raises the interest rate on the oan is dependent on whether the firm has a need to maintain a cash baance of Rs 300,000. Assume that the interest rate on the oan is 8 per cent. The firm wants to maintain a minimum baance of Rs 37,00,000 in its unit account. In this case meeting the compensating baance requirement does not increase the interest rate on the credit ine. Next, assume that the firm has no need to maintain any unit account baance at the ending bank. By maintaining a compensating baance of 15 per cent of the oan, it is effectivey getting to use ony 100 15 = 85 per cent of the oan. However, the interest rate is appicabe on 100 per cent of the oan. Therefore, the effective interest is higher than 8 per cent and is given by effective interest rate = stated interest rate / 1 compensating baance fraction = 8 % / 1 0.15 = 9.4 % The effective interest rate is 9.4 per cent. Firms borrowing on a ine of credit can try to reduce the effective interest rate by shifting some of their cash maintenance needs to the bank where they have their ine of credit. The effective interest rate can aso be owered by securing a ine of credit at the bank where the firm conducts the majority of its cash receipts and disbursements transactions. Interest Rates on Unsecured Loans Interest rates on unsecured oans are negotiated between the bank and the cient firm. In genera, though, the interest rate is reated to the cient s credit worthiness. The most creditworthy cients pay the prime rate. The prime rate is the owest rate appicabe to business oans. The ower the credit worthiness of the firm, the higher the interest rate the bank is going to charge on unsecured oans. The interest rates appicabe to a firm s are determined by the bank s risk casses and oan pricing matrix.

Working Capita Financing 359 Risk Casses. Bank typicay cassify credit appicants into a series of risk casses. The baances may aso use Credit Rating Agencies ratings to suestatide than credit worthiness. Seected risk categories which may be maintenance as foows: Cass 1. Highest rated. Long-term debt is AAA or AA rated. Stabe cash fows, interest coverage. Cass 2. High quaity. Long-term debt is rated A. Good interest coverage. Cass 3. Upper-medium quaity. Debt is rated A. Interest coverage, though good, may be impaired under adverse economic conditions. Cass 4. Medium quaity. Debt is rated BBB. Adequate interest coverage. Access to aternative financia markets imited except during favourabe economic periods. Cass 5. Lower-medium quaity with debt rated at BB or B. Interest coverage is acceptabe but is subject to severe fuctuations. Cass 9. Coections of oans is questionabe. Not enough coatera to cover existing debt. Cass 10. Debt is not coectibe. Loan Pricing Matrix. Once a credit appicant has been assigned a risk cass, the interest rate appicabe wi be estabished from using a oan-pricing matrix. The oanpricing matrix of a bank is shown in Tabe 3. According to this oan pricing matrix, a firm in risk cass 3 that borrows on a ine of credit woud be paying the prime rate pus 0.7 per cent as interest rate on its oan. A firm in risk cass 4, seeking an unsecured transaction oan for 60 days, woud incur an interest rate of prime pus 1.5 per cent. The assignment to risk casses is based stricty on conservative financia considerations. On occasions the bank may fee that the need to deveop the market for the bank s commercia ending practices requires that marketing considerations be given precedence over financia considerations. A risk cass 2 firm may find that a bank, eager to and its borrowing business, is wiing to assign the firm to risk cass 1. However, very rarey if ever wi a bank be wiing to treat a risk cass 9 or 10 firm as a risk cass 5 firm. Tabe 3: Commercia Loan Pricing Matrix a Type of Loan Rick Cass a P stands for the ending rate at the time oan is issued. Interest rate are in per cent.

360 Financia Management Concept of Credit Quaity The credit quaity of a prospective business borrower is reveaed to the ending banker through inquiries made of the company s trade creditors; through reports requested of credit-rating agencies; through anaysis of the company s financia statements; and by trade comparison - comparisons of the prospective borrower s financia situation with that of other simiary sized firms in the same genera ine of business activity. Required Security There are four basic types of securities the bank can ask for: 1. Hypothecation: A charge that is made against movabe property (ike inventory) for an amount of debt where neither the ownership nor possession is passed to the creditor. Banks generay grant hypothecation on the basis of it s satisfying itsef with the quaity of the assets. 2. edge: Under this arrangement the borrower is required to transfer the physica possession of the property offered as a security to the bank to obtain credit. The bank retains the right to se off the property to recover its dues its oans are not paid on time. 3. Mortgage: It is the transfer of ega or equitabe interest in a specific immovabe property for the payment of debt. In case of mortgage, the physica possession of the property may remain with the borrower with the ender getting the fu ega tite. 4. Lien: Lien means right of the ender to retain property beonging to the borrower unti he repays credit. It can be a particuar ien in which the right is retained unti the caim associated with the property is fuy paid. Genera ien, on the other hand, is appicabe ti a dues of the ender are paid. Banks usuay enjoy the faciities of genera ien so as to more securey safeguard their interests. A combination of 1 and 4 above is used in India. Pubic deposits Pubic deposits, aso known as fixed deposits, had been an important source of raising money for working capita. But because of many scams of the finance companies, the term fixed deposits earned so much bad pubicity that it is now ony used by companies with good credit standing. However, the market is quite sma now compared to the one that existed earier.

Working Capita Financing 361 Inter Corporate Deposits One of the most utiised money market instruments, ICDs are the hamark of ending and borrowing between companies and high-networth individuas. Usuay backed by a security, (typica security being shares) ICD is normay for three months, but higher and shorter periods are aso prevaent depending upon the needs. Normay the maximum time frame of an ICD is six months. But ICDs are roabe (turned over from one period to another) and can extent to any period with the mutua consent of the ender and the borrower. It is one of the instruments which many cash rich corporates ike to park their funds in as the security is good and the interest rate is much higher than what they woud get from banks for the same time period. Risks of defaut are aso much higher and it is normay not possibe to offoad the securities in the market, as the market may not be abe to absorb the same. Importance of persona contacts cannot be denied as this market operates from word of mouth and no advertising is done because it coud harm the reputation of the corporate borrowing through ICDs. One of the top criteria for getting ICDs is the credibiity of the company in the market, the essor the credibiity the ower the chances of getting the ICDs and the higher the interest rate the company may have to pay. Short Term Loans from Financia Institutions Athough Bank Finance is one of the most important source of working capita funds, money market is no ess important. Money market is usefu when the company does not require a continuous source of working capita and is need of funds for ony some time. For this short term needs, which are over and above its norma needs of working capita, going to banks is infeasibe because either the imits with the banks have aready been exhausted or the process is so ong that by the time the bank sanctions, the situation for which the funds were required may aready be gone. Short term oans can be raised using highy iquid debt securities that have short terms unti they mature. They are known as money market instruments. A money market instruments are debts that mature within 364 days or ess. Money market securities normay pay fixed rate of interest that is above the rate paid by them for norma working capita financing. This is because the need is for shorter duration and the risk of defaut is higher. Money market instruments can pay interest, to their investors, as a discount from their face (or maturity) vaues or on the maturity return both the principa and the interest together.

362 Financia Management A short-term oan is one having a maturity of ess than one year. Loans maturing within 1 to 10 years are considered to be intermediate-term or term oans. Sources for term oans are banks, insurance companies, and pension funds. Some of the more important characteristics of term oans are discussed in the foowing paragraphs. Characteristics of Term Loans Term oans are different from other types of oans in a variety of ways incuding maturity, repayment schedue, coatera, costs, and provisions. Maturity. As stated previousy, the maturity for a term oan varies from 1 to 10 years. The 10-year imit is somewhat arbitrary in cassifying a oan as a term oan. However, in recent years financia institutions are becoming ess reuctant to issue term oans with maturities up to 10 years. The cassification of oans with maturities of up to 10 years as term oans is becoming very common. The maturity of a term oan is dependent upon the financia institution ending the funds. Banks are generay reuctant to issue term oans with maturities in excess of 5 to 6 years. On the other hand, insurance companies and pension funds frequenty underwrite term oans with maturities of 10 years. Repayment Schedue. Short-term oans are generay repaid as the firm generates excess cash fows. Long-term oans are generay repaid in fu at maturity. Term oans are typicay repaid according to a specified schedue. The most typica situation requires fixed payments, which incude both principa and interest, on a monthy, semiannua, quartery, or annua basis. The size of the periodic payment is such that when the ast payment is made, the oan is fuy paid and the ender is provided his required return. The repayment of term oans is discussed in the foowing section. The particuar procedure of making equa payments periodicay to repay a oan is caed oan amortisation. For exampe, a company borrows Rs 800,000 for 10 years and makes year-end equa payments of Rs 124,655.25 every year for 10 years. At the end of the tenth year the oan wi have been fuy repaid and wi have provided the ender a 9 per cent interest rate. On rare occasions the oan amortisation is such that ony a portion of the oan is repaid, eaving a arge or baoon fina payment. For exampe, the ender and borrower by mutua agreement may amortise ony Rs 600,000 of the Rs 800,000 oan. In this case the 10 annua payments woud be Rs 111,491.44 each. The borrower woud aso have to repay the unamortised Rs 200,000 portion of the oan at the end of the tenth year. Both of these exampes are expained in the next section. Coatera. Financia institutions underwriting term oans generay require coatera on the oans. Since these oans are used for specific purposes such as purchase of computers

Working Capita Financing 363 machinery, and so forth, the oans can be readiy secured by the new equipment being purchased. Occasionay, stocks bonds, rea estate, and other assets are aso used as coatera for term oans. Costs. The interest rate on a term oan is usuay higher than the interest rate on shortterm oans. Term oans rates aso refect the credit worthiness of the borrower and the iquidity and marketabiity of the coatera used to secure the oan. For a financiay sound borrower, the term oan rate wi be about 0.5 per cent higher than the prime ending rate. Interest rates on term oans can either remain fixed for the duration of the oan or vary with changes in the prime rate. If the term oan has a variabe interest rate, then the oan agreement may aso specify the foor and ceiing rates. For exampe, a term oan agreement may provide that the interest on the unamortised portion of the oan wi be at a prime pus 0.5 per cent rate but in no case wi be higher than 10 per cent or ower than 7 per cent. In this case the 7 and 10 per cent rates are the foor and ceiing rates, respectivey. In addition to interest expense, term oans may entai other costs. The ending institution may charge a moderate oan commitment fee. Occasionay, the ending institution may require that warrants or options to buy common stock at specified prices be provided by the borrower. This aows the ender to participate in the anticipated growth of the borrower s business. Insurance companies providing term oans prefer to use this device to gain additiona returns. Provisions. Financia institutions making term oans need to assure them seves that the borrower continues to have the potentia to make interest and principa payments at the schedued intervas. This need to secure their financia position eads term enders to incorporate a variety of provisions in the ending agreement. These provisions are designed to provide the ender with timey financia information about the borrower and to impose certain restrictions on the borrower. For exampe, the ending arrangement may require the borrower to maintain a minimum current ratio. If the borrower s current ratio fas beow the minimum eve, then, at its option, the ender may require immediate payment of the unamortised portion of the term oan. Another provision reguates the amount of new ong-term debt that the borrower can acquire. This provision typicay requires that the borrower must secure the ender s approva before the borrower can issue any new ong-term debt or sign eases. This provision aows the ender to exercise contro over the borrower s indebtedness and to keep the borrower from becoming too indebted. Another common term oan provision requires the borrower to provide the ender with

364 Financia Management periodic sheets, income statements, cash budgets and sources, and uses of funds statements. This aows the ender to monitor the borrower s financia condition and to take or suggest corrective actions when needed. Finay, the term oan agreement may aso require the borrower to not make changes in its executive ranks without the ender s permission. The ender may aso require sufficient ife insurance on the borrower s key manageria personne. These provisions are designed to protect the ender from osses resuting from unforeseen changes in the borrower s important personne. Repaying Term Loans Term oans are generay repaid on a periodic, systematic basis. Term enders prefer this procedure because it enhances the borrower s capabiity to repay the oan. A arge ump-sum oan repayment at maturity may pace a heavy financia burden on the borrower, whereas with sma periodic payments the borrower is not unduy financiay burdened. A second reason for amortising oans has to do with the use of funds from the oans. Term oans are usuay obtained for purchasing equipment. Loan amortisations are more desirabe because oan repayments can be geared to the cash fows being generated by the equipment. In this section two different oan amortisation procedures wi be considered fu amortisation and one that resuts in a baoon payment. Fu Amortisation. Under fu amortisation, the borrower makes periodic payments unti the oan and interest is fuy paid. To expain the exampe cited previousy, assume that Centra Manufacturing Corporation borrows Rs 800,000 for 10 years at an interest rate of 9 per cent. The interest rate is the effective interest rate on the remaining baance. In addition, the bank making this term oan requires that the oan be repaid in 10 equa instaments which woud incude interest as we as payment on the principa. The annua payment required to repay this oan can be determined by using Equation. 8, which we renumber 1 for convenience. P O = P IFAP n/i (1) where P 0 is the present vaue of an annuity of P rupees receive every year for N years and discounted at one per cent. In the term oan situation the annua payment is P rupees and is found by P = P O IFA n/i (2) In the exampe cited, P O is Rs 800,000. The annuity factor, rounded off to four decima paces, for Re 1 received every year for 10 years and discounted at 9 per cent is shown as 6,4177 in Appendix B. Then P is

Working Capita Financing 365 P = Rs 800,000 / 6,4177 = Rs 124,655.25. After Centra has made 10 annua payments of Rs 124,655,25, it wi have fuy repaid the term oan and the bank wi have been provided with its 9 per cent interest rate. Tabe 4 shows how this annua payment is divided between interest and payment on principa. At the time of oan, or at time O, the beginning baance is Rs 800,000. At the end of the first year an annua payment of Rs 124,655.25 is made. This amount incudes interest of Rs 800,000 0.09% = Rs 72,000. The remaining payment, Rs 124,655.25 Rs 72,000 = Rs 52,655.25 is appied to the beginning baance to pay off a portion of the oan. The first-year ending baance is Rs 800,000 Rs 52,655.25 = Rs 747,344.75. The first-year ending baance becomes the second-year beginning baance. Interest on this is computed at 9 per cent. The difference between the secondyear payment and interest is used to reduce the second-year beginning baance. This process continues unti the fina payment is made at the end of the tenth year and the oan is competey repaid. Tabe 4: Term Loan Amortisation 1 2 3 4=2 0.09 5=3 4 6=2 5 End of Year Beginning Baance Annua Payment Interest at 9 % Loan Repayment Ending Baance 0 Rs 800,000.00 Rs Rs Rs Rs 800,000,00 1 800,000.00 124,655.25 72,000.00 52,655.25 747,344.75 2 747,344.75 124,655.25 67,261.03 57,394.22 689,950.53 3 689,950.53 124,655.25 62,095.55 62,559.70 627,390,83 4 627,390.83 124,655.25 56,465.17 38,190.08 559,200.75 5 559,200.75 124,655.25 50,328.07 74,327.18 484,873.57 6 484,873.57 124,655.25 43,638.62 81,016.63 403,856.94 7 403,856.94 124,655.25 36,347.12 88,308.13 315,548.81 8 315,548.81 124,655.25 28,399.39 96,255.86 219,292.95 9 219,292.95 124,655.25 19,736.37 104,918.88 114,374.07 10 114,374.07 124,655.25 10,281.18 a 114,374.07 a For the tenth year ony, interest is the difference between annua payment baance. This rounding-off error exists because ony four decimas were utiised in the annuity factor used in computing the annua payment. One word of caution reated to Tabe 4 has to do with the rounding-off error. We used a rounded-off annuity factor of 6.4177 from Appendix B. the actua annuity factor is 6.4176550. Rounding off the annuity factor changes the annua payment sighty. The net cumuative resut is that when one cacuate the interest for the ast year, it becomes Rs 114,374.07 0.09% = Rs 10,293.67. It shoud be recognised that minor errors are caused by rounding-off annuity and discount factors. This error is remedied by either using more significant decimas or by treating interest expense in the ast year as a

366 Financia Management residua item the difference between the annua payment and the tenth-year beginning baance. Baoon Payment Amortisation. On occasion firms prefer to amortise ess than the fu amount of the oan. Amortising ony a portion of the term oan resuts in the firm s making a reativey arge or baoon payment when the oan matures. One reason for doing this may be that the unamortised portion of the oan on maturity may equa the anticipated savage vaue of the equipment to be purchased with the term oan. Another reason is that with a baoon payment the firm s annua payments are smaer, except of course for the ast payment, which incudes the unamortised oan. A firm may choose a baoon payment with the idea of refinancing the unamortised oan at maturity. Assume that Centra Manufacturing and the ending bank agree to amortise Rs 600,000 of the Rs 800,000, with the unamortised portion or Rs 200,000 due at the end of the tenth year. One way to evauate this term oan is to view it as two separate oans-one for Rs 600,000 and one for Rs 200,000. The annua payment for Rs 600,000 portion is determined by using Equation 2; P = Rs 600,000 / 6.4177 = Rs 93,491.44 The Rs 200,000 portion is not repaid unti the ast year. Interest due every year for 10 years on this amount is Rs 200,000 0.09% = 18,000. Tota annua payment for the first 9 years on this oan is Rs 93,491.44 + Rs 18,000 = Rs 111,491.44. The tenth and fina payment woud incude the unamortised portion of the oan aso and woud equa Rs 111,491.44 + Rs 200,000 = Rs 311,491.44. In this section we have considered two aternative, term oan repayment procedures. Variations woud incude situations in which the appicabe interest rate is not fixed or the annua payment amount is not fixed. The technique for amortising term oans of these types is simiar to the procedure outined in Tabe 4. Advantages and Disadvantages of Term Loans As with any financing procedure, term oans are not without their advantages and disadvantages. Advantages. The reationship between borrower and ender is one-to-one, and it is easy for them to negotiate oans terms that meet the specia need of the borrower. Repayment schedues, annua payments, and maturity date can be negotiated to meet the borrower s needs. The borrower aso finds it easy to negotiate with one ender and does not have to go through a Securities and Exchange Commission registration as is the case with typica bond financing. The ending institution aso may not seek certain financia information that the firm may be hesitant to divuge. Term oans can be arranged

Working Capita Financing 367 more quicky than ong-term oans. The firm or borrower is assured to funds for a number of years, which is not the case with borrowing on a credit ine. Finay, smaer firms with imited access to capita markets find term oans very convenient. Disadvantages. The borrower may fee that, at times, term oan provisions are too restrictive. The imitations on issuing new debt may hinder the firm s abiity to finance future growth. Another disadvantage of term oans is that at times the cost may be high. If the oans invove issuance of options on warrants that are exercised, then the affective cost of the oan to the borrower increases. Despite these disadvantages, term oans are a major source of financing. Debentures for working capita Debentures have been traditionay used for ong term funding the capita projects, but they can aso be used for funding short term requirements of working capita and become the part of ong sources used for funding working capita requirements. Funding is used by corporates for a medium time frame and hence are a stabe source of funds. Commercia Paper CP refers to the short-term promissory notes issued by bue-chip corporations - arge, od, safe, we known companies ike TISCO, ONGC, SAIL, etc. The maturities normay vary from 90 to 180 days as compared to US where the maturity period ranges from 5 days to 270 days, and the denominations are for a minimum of Rs 10 ac or more - usuay more. These notes are backed ony by the high credit ratings (normay P1+ the highest grade avaiabe) of the issuing corporations which means that there is no security given by the company when issuing CP. CPs are normay issued at a discount to its face vaue and are redeemed at the face vaue. Credit Terms The maturity of this credit source is generay six months or ess, athough some issues carry 270-days maturities. The interest rate on commercia paper is generay sighty ower (one-haf to one per cent) than the prime rate on commercia bank oans. Aso, interest is usuay discounted, athough commercia paper is avaiabe at times that is interest bearing. New issues of commercia paper are either directy paced (sod by the issuing firm directy to the investing pubic) or deaer paced. Deaer pacement invoves the use of a commercia paper deaer, who ses the issue for the issuing firm. Many of the major finance companies pace their commercia paper directy. The voume of direct versus

368 Financia Management deaer pacements is roughy four to one in favour of direct pacements. Deaers are used primariy by industria firms that make ony infrequent use of the commercia paper market or that, owing to their sma size, woud have difficuty pacing the issue without the hep of a deaer. Commercia Paper as a Source of Short-term Credit A number of advantages accrue to the user of commercia paper: Using commercia paper for short-term financing, however, invoves a very important risk. That is, the commercia paper market is highy impersona and denies even the most creditworthy borrower any fexibiity in terms of repayment. When bank credit is used, the borrower has someone with whom he can work out any temporary difficuties he might encounter in meeting a oan deadine. This fexibiity simpy dose not exist for the user of commercia paper. Estimating the Cost of Commercia Paper The cost of commercia paper can be estimated using the simpe effective cost of credit equation (RATE). The key points to remember are that commercia paper interest is usuay discounted and that if a deaer is used to pace the issue a fee must be paid. Even if a deaer is not used, the issuing firm wi incur costs associated with preparing and pacing the issue, which aso must be considered in estimating the cost of credit. Exampe: The EPG Mfg. Company uses commercia paper reguary to support its needs for short-term financing. The firm pans to se Rs 100 crore in 270-day-maturity paper on which it expects to have to pay discounted interest at an annua rate of 12 per cent per annum. In addition, EPG expects to incur a cost of approximatey deaer pacement fees and other expenses of issuing the paper. The effective cost of credit to EPG can be cacuated as foows: RATE Rs 9 crores 1 =.1320,or 13.20 per cent Rs100crores - Rs 100,000- Rs 9 crore 270/360 = Where the interest cost is cacuated as Rs 100 crore.12 270/360 = Rs 9. Thus, the effective cost of credit to EPG is 13.2 per cent. CPs have to be credit rated in India. The highest credit rating hoder corporates are issuing CPs at around 8-12 % at this moment, which is much ower than the interest rate they woud have paid if they had gone through either the ICD market or the bank finance route. Sti CPs are not utiised to their maximum possibe extent as the banks do not ike to fund through them because they ose on the interest they coud have charged if the corporates went through bank finance instead.

Working Capita Financing 369 Pedging Accounts Receivabe After cash and marketabe securities, accounts receivabe are considered to be the most iquid assets on a firm s baance sheet. A financia institution such as a bank or finance company wi readiy make a oan secured by accounts receivabe. The ender wi evauate the quaity of the receivabe to be pedge and the average size of account pedged. Once these have been estabished, the pedging procedure can be impemented. These steps are expained in the foowing paragraphs. Quaity of Receivabes Pedged. The ending institution is gone to evauate thoroughy the quaity of the receivabes the borrower wants to pedge. If, on the average, the receivabes appear to be of very high quaity with amost a 100 per cent probabiity of payment, the ender may oan up to 90 per cent of the face amount of the receivabes pedged. If the receivabes appear to be of reativey ow quaity, the ender may be wiing to end ony 25 per cent of the face vaue of the receivabes. The higher the receivabe quaity, the higher their oan vaue. Athough a ender may be wiing to end anywhere from 25 to 90 per cent of the face vaue of the receivabes pedged, he retains the right to reject any receivabe that he does not wish to accept as a pedge. In addition, the ender hods the borrower iabe for any accounts that become deinquent or defaut after they have been pedged. Size of Accounts. Pedging receivabes invoves a considerabe amount of record keeping for the ender. These record-keeping costs remain reativey constant irrespective of the rupee amount of the account being pedged. Smaer-size accounts cost more per rupee of oan than arger-size accounts. A firm with a ot of sma-size accounts receivabe wi find it difficut to raise funds by pedging receivabe at a reasonabe cost. A firm may be abe to negotiate a foating ien oan with a ending institution. With a foating ien the ender does not maintain records on individua accounts. Rather, a genera ien is assigned to a receivabes. Since the ender is not tracking individua accounts under a foating ien the chances of fraud by the borrower are higher than with specific pedging of accounts. As a precaution against exposing itsef to undue risk, a ender wi rarey end more than 25 per cent of the face amount of receivabes subject to a foating ien. Pedging Procedure. Once the oan vaue of receivabes has been estabished, the borrower sends to the ender a ist of accounts, biing dates, and amounts invoved. Assume that the ender has agreed to end 80 per cent of the face vaue of receivabes pedged. The borrower sends to the ender a schedue of accounts totaing Rs 1 crore. The borrower is now eigibe to borrow any amount up to 80 per cent of Rs 1 crore, or Rs 80,00,000, upon signing a promissory note.

370 Financia Management Pedging of receivabes can be either on a notification or non-notification basis. On a notification basis the borrower notifies its accounts that payments on the receivabes are to be made directy to the ender. On a non-notification basis the account is not informed of the financia arrangements between borrower and ender. The account remits payments to the borrower, who forwards is to the ender. The ender then checks the payment against the schedue provided by the borrower and reduces the borrower s oan baance by a corresponding amount. When pedging receivabes is on a nonnotification basis, the ender reies on the borrower to forward account payments to him. Shoud the borrower keep the checks, the ender woud be utimatey hoding receivabes that have been paid. To prevent fraud of this natures, non-notification pedging aows the ender to randomy audit the borrower s books to see that payments on a pedged accounts are being forwarded to the ender. The ender wi aso adjust the rupee vaue of accounts pedged for any discrepancies between the amount invoiced and the amount paid. These discrepancies are caused by the account taking a cash discount for eary payment, taking credit for merchandise returned or adjusting for other invoice errors. Interest Rates. Interest rates with pedged receivabes financing are 2 to 4 per cent higher than the prime-ending rate. The ending institution may aso charge a processing fee, which may equa 1 to 3 per cent of the average annua oan. Commercia finance companies charge rates that are higher than the rates charged by banks. The tota effective interest with this type of receivabes financing wi vary from 10 to 20 per cent. This high interest rate does not impy that secured oans are more expensive than unsecured oans. The rates are high because the borrower is risky and does not have access to norma sources of unsecured oans. Factoring Factoring is an arrangement between the company and the factor (another company providing factoring services) in which the factor agrees to buy the bis receivabe of the company for a commission and an interest for the period for which he is expected to keep the bis before receiving payments from the parties on whom the bi is drawn. Factoring can be on recourse basis (in which the risk of defaut is borne by the company) or without recourse (in which the risk of defaut is borne by the factor himsef). The biggest benefit of factoring is that the receivabes can be converted into cash and redepoyed into the business. The most negative aspect is that the interest rate is higher than most other short-term debt instruments because it depends upon the quaity of the parties on which the bis are drawn (except ICDs where it is equivaent). Hence company going in for factoring is ooked down upon considering the fact that the company was

Working Capita Financing 371 not abe to mobiise the required funds from the norma short-term sources. Whie the book debt purchasing is fundamenta to the functioning of factoring, the factor can provide three other basic services to the companies: Saes edger administration and credit management Credit coection and protection against defaut and bad debt osses Financia accommodation against the assigned book debts In deveoped countries ike the US the factors provide various other services in addition to the basic services mentioned above. They incude: i. Providing information on the prospective buyers ii. iii. Credit risk management Financia counseing There are seven different types of factoring services avaiabe abroad. The brief comparison of them is tabuated beow: Types of Factoring Types of Services Avaiabiity of Protection against Notification to Saes edger Coection Finance bad debts debtors administration 1. Fu non-recourse factoring 2. Recourse factoring Y Y Y Y Y Y N Y Y Y 3. Buk factoring Y N Y N N 4. Maturity factoring N Y Y Y Y 5. Agency factoring Y S Y S N 6. Invoice discounting 7. Undiscosed factoring Y N N N N Y S N N N Y = Provided, N = Not Provided, S = Sometimes Provided Factoring is different from bi discounting in the aspect that bi discounting is just providing a credit on the bis without any onus on the company providing the credit to coect or manage the receipts. Bi discounting is termed as Invoice discounting in the above tabe and you can yoursef see that apart from providing finance it offers no other service which fu non-recourse factoring provides. Sti the biggest benefit of going for factoring to a speciaist organisation is that the

372 Financia Management company gets speciaised service in credit management which heps it save costs in credit administration as aso heps the company concentrate on other areas of operations. Inventory Loans Inventory oans provide a second source of security for short-term secured credit. The amount of the oan that can be obtained depends on both the marketabiity and perishabiity of the inventory. Some items, such as raw materias (geains, oi, umber, and chemicas), serve as exceent sources of coatera, since they can easiy be iquidated. Other items, such as work-in-process inventories, provide very poor coatera, owing to their ack of marketabiity. There are severa methods by which inventory can be used to secure short-term financing. These incude a foating or banket ien, chatte mortgage, fied warehouse receipt, and termina warehouse receipt. Foating Lien Agreement Under a foating ien agreement the borrower gives the ender a ien against a his inventories. This provides the simpest but east secure form of inventory coatera. The borrowing firm maintains fu contro of the inventories and continues to se and repace them as it sees fit. Obviousy, this tota ack of contro over the coatera greaty diutes the vaue of this type of security to the ender. Correspondingy, oans made with foating iens on inventory as coatera are generay imited to a reativey modest fraction of the vaue of the inventories covered by the ien. In addition, foating iens usuay incude future as we as existing inventories. Chattee Mortgage Agreements The ender can increase his security interest by having specific items of inventory identified (by seria number or otherwise) in the security agreement. Such an arrangement is provided by a chatte mortgage. The borrower retains tite of the inventory but cannot se the items without the ender s consent. This type of agreement is very costy to impement, as specific items of inventory must be identified; thus, it is used ony for major items of inventory such as machine toos or other capita asset. Fied Warehouse Financing Agreements Increased ender contro over inventories used as oan coatera can be obtained through the use of a fied warehouse agreement. Here the inventories used as coatera are physicay separated from the firm s other inventories and paced under the contro of a third-party fied warehousing firm. Note that the inventories are not removed from the borrower s premises, but they are paced under the contro of a third party who is

Working Capita Financing 373 responsibe for protecting the security interests of the ender. This arrangement is particuary usefu where arge buky items are used as coatera. For exampe, a refinery might use a part of its inventory of fue oi to secure a short-term bank oan. Under a warehousing agreement the oi reserves woud be set aside in specific tanks or storage vesses, which woud be controed (monitored) by a fied warehousing concern. The warehousing concern, upon receipt of the inventory, takes fu contro of the coatera. This means that the borrower is no onger aowed to use or se the inventory items without the consent of the ender. The warehousing firm issues a warehouse receipt for the merchandise, which carries tite to the goods, represented therein. The receipt may be negotiabe, in which case tite can be transferred through sae of the receipt, or nonnegotiabe, whereby tite remains with the ender. With a negotiabe receipt arrangement the warehouse concern wi reease the goods to whoever hods the receipt, whereas with a nonnegotiabe receipt the goods may be reeased ony on the written consent of the ender. The cost of such a oan can be quite high, since the services of the fied warehouse company must be paid for by the borrower. Exampe: The M.M. Company foows a practice of obtaining short-term credit based on its seasona finished goods inventory. The firm buids up its inventories of outdoor furniture throughout the winter months for sae in spring the summer. Thus, for the twomonth period ended March 31, it uses its fa and winter production of furniture as coatera for a short-term bank oan. The bank ends the company up to 70 per cent of the vaue of the inventory at 14 per cent interest pus a fixed fee of Rs 2000 to cover the costs of a fied warehousing arrangement. During this period the firm usuay has about Rs 200,000 in inventories, which it borrows against. The annua effective cost of the short-term credit is therefore. Rs 3267 + Rs 2000 1 RATE = = 22.57 per cent Rs140.000 60/360 where the financing cost consists of two month s interest Rs 140,000.14 60/360 = Rs 3267) pus the fied warehousing fee of Rs 2000. Termina Warehouse Agreements The termina warehouse agreement differs from the fied warehouse agreement just discussed in ony one respect. Here the inventories pedged as coatera are transported to a pubic warehouse that is physicay removed from the borrower s premises. An added degree of safety or security is provided to the ender, as the inventory is totay removed from the borrower s contro. Once again the cost of this type of arrangement

374 Financia Management is increased by the necessity for paying the warehouse concern; in addition, the inventory must be transported to and eventuay from the pubic warehouse. The same warehouse receipt procedure described earier for fied warehouse oans is used. Again, the cost of this type of financing can be quite high. Lease Financing Firms are generay interested in acquiring the use of equipment. One way to acquire use is to buy the equipment. The same resut can aso be achieved by easing the equipment. A ease is a contractuay estabished obigation by the essee to pay the essor a series of payments for the use of certain assets. In this section we she consider types of eases, ease capitaisation s, and the advantages and disadvantages of easing. Type of Leases There are two major types of eases operating and financia. Operating Lease. An operating or service ease is one that aows the essee at his convenience. Teephone service is an exampe of an operating ease. The teephone user can, at his or her convenience, discontinue teephone service. Another exampe of a service ease is easing copying equipment from companies such as Xerox Corporation and A. B. Dick Corporation. These companies typicay ease their equipment on a 30 day canceation notice basis. If a essee cances a service ease, the equipment is eased to another essee. The essor expected to recover the costs pus profits over the economic ife of the equipment. Operating ease payments usuay incude charges for servicing and maintaining the eased equipment. Financia Lease. A financia ease is a non-canceabe, contractua obigation of the essee to pay the essor a fixed amount for a specified time period for the use of certain assets. A financia ease incudes the foowing features: 1. The ease is non-canceabe. The essee cannot wak away from the ease without becoming iabe for the remaining ease payment. 2. The ease is fuy amortised. A fuy amortised ease is one that returns to the essor a his costs pus a reasonabe return. 3. A financia ease does not incude repair and maintenance services. A variation of the financia ease in which the essor pays the maintenance and insurance costs is caed a maintenance ease. A specia type of financia ease is a sae and easeback arrangement. In a sae and easeback a firm ses an asset to another fir, who eases the asset back to the first firm. Specia features of a sae and easeback arrangement are as foows:

Working Capita Financing 375 1. Assets invoved can be either od or new. A firm coud se an od fuy depreciated pant and then ease it back. Another firm coud buy a new IBM computer, se it to a finance company, and then ease it right back. 2. Assets are sod at or cose to appraised market vaue. 3. The easeback arrangement cas for ease payments that return a costs pus a fair return to the essor. That it, the ease is fuy amortised. Sae and easeback arrangements and financia eases are identica. The practica distinction is that financia eases invove assets new to the firm whereas sae and easebacks typicay invove assets that the firm is aready using. Interna Revenue Service Lease Requirements The tota amount of a ease payment is tax deductibe, provided that the ease quaifies as a bonfire ease. Without this IRS safeguard some firms woud have a tendency to ca an instament sae a ease, say an equipment has a usefu ife of 20 years and is being purchased on a 10-year instament oan pan. The company conceivaby coud write up the sae as a ease with the instament oan payments being caed ease payments. When the instament oan is fuy paid that is, when the ease obigations are met the buyer coud buy the residua rights to the equipment for a nomina amount of Re. 1. If the IRS were to et this instament sae quaify as a ease, it woud put other firms at a competitive disadvantage. The reason is that whie other firms are writing off the asset over 20 years, this firm by expensing the ease payments woud be depreciating the asset over 10 veers. It woud be underpaying its taxes and increasing its net cash fows. To prevent this type of abuse, the IRS requires that the foowing criteria be met before a ease quaifies as a ease and not an instament oan: 1. Lease obigation must be for ess than 30 years. 2. The ease must provide a fair return to the essor. 3. Any ease renewa option granted to the essee must not be different than one that woud be provided to a third party. 4. Any purchase option granted to the essee must not be different than one that woud be provided to a firm not a party to the ease. If these criteria are not met, the ease does not quaify as a bonfire ease and the ease payments are not fuy tax deductibe. A easing arrangement that does not meet IRS criteria for a ease is treated as a purchase financed through an instament oan. The tax deductions are the same as for any other equipment purchase, that is, depreciation, interest expanse, and so forth.

376 Financia Management Lease Capitaisation s Financia eases ca for the essee to make periodic payments to meet contractua obigations. As such it is not conceptuay different from a oan. Lease capitaisation invoves capitaising the ease payments at an appropriate capitaisation rate and showing the capitaised amount as a iabiity. An entry equa to the capitaised ease obigations is shown on the assets side of the baance sheet. The capitaisation rate is generay equa to the essee s margina cost of borrowing. For exampe, a corporation eases a computer system for 6 years. Lease payments are to be made in six annua payments of Rs 340,000 each. The first payment is made on the day that the computer is instaed. The second payment is due 2 years from today, and so on. Payments three through six are capitaised at the firm s margina borrowing rate of 9 per cent. The capitaised vaue of payments 3 through 6 is Rs 340,000(0.84168 + 0.77218 +0.70843 + 0.64993) = Rs 1,010,555. The baance sheet entry for this easing transaction woud be Assets Liabiities Net eased assets Rs 1,350,555 Current iabiities Lease obigation Rs 340,000 Long-term iabiities Lease capitaisation Rs 1,010,555 These entries woud be adjusted each year as the firm makes its ease payment.4 keep in mind that the net capitaised vaue of the ease of Rs 1,350,555 + Rs 340,000 = Rs 1,690,555. Cost of Leasing The typica situation in easing invoves a decision either to borrow and buy or to ease the equipment. The best aternative of buying or easing is the one with the highest net present vaue. This situation is discussed in the ast section of the chapter. Another situation coud be when the item avaiabe is for ease ony and cannot be purchased. Here the easing anaysis becomes interminged with the capita budgeting decision itsef. A eases, however, invove, a rate of return to the essor. One way to conceptuaise a before-tax cost of easing is to view the essor s cost of easing. Consider the computer system ease exampe given previousy. Assume that the computer system costs the essor Rs 1.68 crore and that the investment tax credit is passed aong to the essee. Maintenance and service costs are aso borne by the essee. From the essor s viewpoint, the ease invoves an outfow of Rs 1.68 crore at t = 0 for the purchase, an infow of Rs

Working Capita Financing 377 340,000 at t = 0 from the first ease payment, another Rs 340,000 at t 1 for the second payment, and so on. The rate of return for the essor is that discount rate which equates the sum of the present vaues of ease payments with Rs 1.68 crore. Or Rs 1,680,000s = E 5 t=0 Rs 340,000 (1+r) t = Rs 340,000 (E 5 t=0 (1+r)-t = Rs 340,000 (1+ E 5 t=1 (1+r)-t (3) = Rs 340,000 (1 + IFA5/r) Equation 3 can be restated in terms of the annuity factor IFA as IFA5/r = (Rs 1,680,000/Rs 340,000 1 =3.94118 (4) From Appendix B IFA (5 year/8 per cent) IS 3.99271 and IFA (5year/9 per cent) is 3.88965. By interpoation r is found to be 8.5 per cent. A way of identifying the easing cost is to consider this 8.5 per cent return to the essor as the 4 essee s cost of easing. It shoud be recognised that in cacuating the cost of easing this way, we are ignoring tax effects and consequenty depreciation as a tax shied. This method, however, does provide us with a reasonabe perspective on easing cost. Equation 4 can be generaised to estimate the essor s rate of return on any ease. If it is assumed that the first ease payment is made at the time the equipment is instaed, then IFA n 1/r = C/L 1 (5) Where n = ength of ease C = cost of equipment L = annua ease payment r = essor s rate of return on the ease The annuity factor can be used in conjunction with Appendix B to sove for r as shown in the exampe given previousy. One interesting factor to note is that the gross ease capitaised vaue does not necessariy have to equa the cost of the equipment being eased. The answer ies in the fact that the essors rate of return is generay different from the essee s ease capitaisation rate. Advantages and Disadvantages of Leasing Leasing equipment possesses a variety of advantages and disadvantages for the essee.

378 Financia Management Advantages of Leasing. Lease financing is viewed to possess a number of advantages for the essee. Perhaps one of the major advantages of easing is that it provides for the use of equipment with 100 per cent debt financing. That is, a firm that is easing equipment does not have to make a down payment. Such is not the case when a firm borrows to buy the same equipment. Very rarey wi a ending institution provide a oan equa to the purchase price of the equipment. More typicay, it wi require the firm to take an equity position equa to 10 or 20 per cent of the equipment s purchase price. Some, however, argue that this advantage may be iusory, because 100 per cent financing provided by easing uses up more of the firm s debt capacity than buying the equipment with an 80 per cent oan. The current trend in financia reporting is toward fu discosure of financia obigations created by easing arrangements. Once firms are required to capitaise ease obigations and to integrate ease capitaisation s fuy into their financia statements, the advantage of 100 per cent financing in easing wi diminish significanty. Another advantage of easing is that it provides the essee with fexibiity in acquiring the use of speciaised equipment that may become obsoete for the essee but may be sti a productive asset for another firm. Items such as essee but may be sti a productive asset for another firm. Items such as computers and copying machines fa in this category. A third generation IMB equipment may become obsoete as far as a arge manufacture is concerned but may be readiy utiised by a sma manufacturer. A firm may prefer to ease a computer and then et the essor hande the subsequent ease of the computer to another firm. The essor has speciaised skis in doing this and can do a better job of easing the equipment again. Another advantage of easing is that the provisions typicay associated with term oans are not present in ease financing. A firm that does not with to conform to minimum current ratio requirements, and so forth, may find the ack of these restrictions in ease financing to be a starring enough motive to prefer easing to borrowing. A fina advantage in easing is that the essor and essee can negotiate over who utiises the investment tax credit. A firm that is not abe to fuy utiise the tax credit may et the essor retain the credit and sette for ower annua ease payments. This panning fexibiity is not avaiabe with borrowing and buying when the tax credit goes to the buyer. Disadvantages of Leasing. The major disadvantage of easing is that the residua vaue of the eased asset at the termination of the ease beongs to the essor. The typica easing arrangement cas for a fu amortisation of the cost of the equipment. One frequenty encounters exampes where the cost of easing an automobie covers compete amortisation over 4 years of the automobie cost. If, after 4 years, the essor

Working Capita Financing 379 can se the eased automobie for more than zero rupees, he or she gained at the expense of the essee. Another exampe is fu amortisation of costs in a sae and easeback of a buiding and the and on which it is constructed. Whie the buiding wi generay depreciate in vaue, very rarey wi the and vaue decine to its eventua fuy amortised cost of zero rupees. Another disadvantage of easing is that typicay the essor s rate of return is higher than the essee s cost of borrowing. This makes borrowing a more desirabe aternative than easing. Reguation of Bank Finance Recommendation of Latest Committee Banks were tied by the guideines issued by the Reserve Bank of India (RBI), which in turn has been infuenced by various committees appointed by it from time to time. Now the RBI has consideraby reaxed the rues, but the banks sti stick to the guideines to a high degree because shifting from protected to totay open environments is not easy and banks want to make the transition smoothy. We wi first discuss the deveopment of the guideines through various committees. The norms of working capita finance foowed by banks since mid-70 s were mainy based on the recommendations of the Tandon Committee. The Chore Committee made further recommendations to strengthen the procedures and norms for working capita finance by banks.

380 Financia Management Chapter-14 Reguation of Bank Finance Traditionay, industria borrowers enjoyed a reativey easy access to bank finance for meet-ing their working capita needs. Further, the cash credit arrangement, the principa device through which such finance has been provided, is quite advantageous from the point of view of borrowers. Ready avaiabiity of finance in a fairy convenient form ed to, in the opinion of many informed observers of the Indian banking scene, over-borrowing by indus-try and deprivation of other sectors. Concerned about such a distortion in credit aocation, the Reserve Bank of India (RBI) has been trying, particuary from the mid-sixties onwards, to bring a measure of discipine among industria borrowers and to redirect credit to the priority sectors of the economy. From time to time, the RBI has been issuing guideines and directives to the banking sector toward this end. Important guideines and directives have stemmed from the recommenda-tions of certain speciay constituted groups entrusted with the task of examining various aspects of bank finance to industry. In particuar, the foowing committees have signifi-canty shaped the reguation of bank finance for working capita in India: the Dehejia Com-mittee, the Tandon Committee, the Chore Committee, and the Marathe Committee. The key eements of reguation are discussed beow: Norms for Inventory and Receivabes In the mid-seventies, the RBI accepted the norms for raw materias, stock-in-progress, fin-ished goods, and receivabes that were suggested by the Tandon Committee for fifteen ma-jor industries. These norms were based, inter aia, on company finance studies made by the Reserve Bank of India, process periods in different industries, discussions with industry experts, and feedback received on the interim reports. These norms represented the maxi-mum eves for hoding inventory and receivabes in each period. From the mid-1980s onwards, specia committees were set up by the RBI to prescribe norms for severa other industries and revise norms for some industries covered by the Tandon Committee. However, these norms are now regarded as indicative. Banks have a discretion to deviate from the norms. Sti banks often ook at them.

Reguation of Bank Finance 381 Maximum Permissibe Bank Finance The Tandon Committee had suggested three methods for determining the maximum per-missibe bank finance (MPBF). To describe these methods, the foowing notation is used: CA = current assets as per the norms aid down CL = non-bank current iabiities ike trade credit and provisions CCA = core current assets this represents the permanent component of working capita The methods for determining the MPBF are described beow: Method 1 Method 2 Method 3 MPBF = 0.75 (CA - CL) MPBF = 0.75 (CA) - CL MPBF = 0.75 (CA - CCA) - CL To iustrate the cacuation of the MPBF under the three methods, consider the data for Ambex Company: Current Assets1 Rs (in miions) Raw materia 18 Work-in-process 5 Finished goods 10 Receivabes (incuding bis discounted) 15 Other current assets 2 Tota 50 Current Liabiities Trade creditors 12 Other current iabiities 3 Bank borrowings (incuding bis discounted) 25 Tota 40 The MPBF for Ambex Company as per the three methods is as foows: Method 1 0.75 (CA - CL) = 0.75 (50-15) = Rs 26.25 miion Method 2 0.75 (CA) CL = 0.75 (50) - 15 = Rs 22.5 miion Method 3 0.75 (CA - CCA) CL = 0.75 (50-20 2 ) - 15 = Rs 7.5 miion The second method has been adopted. Note that under this method the minimum current ratio works, out to be 1.33. An exampe wi iustrate this point. Suppose the current assets and current iabiities (excuding bank finance) for a firm are 100 and 50 respectivey. The MPBF wi be:

382 Financia Management 0.75 (CL) -CA = 0.75 (100) - 50 = 25 This means that the current iabiities incuding MPBF wi be: 50 + 25 = 75. Hence, the current ratio works out to 100/75 = 1.33. Forms of Assistance Traditionay, bank credit to industry has been mainy in the form of cash credit which was introduced by the Scottish bankers. Under the cash credit system, the bank bears the respon-sibiity of cash management because the borrowers have the freedom to determine their drawas within the cash credit imit provided by the bank. With a view to bringing about a better discipine in the utiisation of bank credit, in 1995 a oan system for deivery of bank credit was introduced. Under the new dispensation, within the MPBF so arrived at in terms of the extant guideines, banks/consortia/ syndicates are required to restrict sanction of cash credit imits to borrowers up to a certain portion (which is currenty 25 per cent) of the MPBF. Where borrowers desire to avai of bank credit for the baance portion (which is currenty 75 per cent) of the MPBF, or any part thereof, this wi be considered on merit by banks/consortia/syndicates in the form of a short-term oan (or oans) repayabe on demand for working capita purpose for a stipuated period. Banks/consortia /syndicates wi have the discretion to stipuate repayment of the short-term oan for working capita purposes by a borrower in instaments or by way of a buet or baoon payment. In case the oan is repaid before the due date, it wi be credited to the cash credit account. Information and Reporting System Whie banks can devise their own information and reporting system they argey foow the system recommended by the Chore Committee. Its key components are as foows: 1. Quartery Information System Form I This gives (i) the estimates of production and saes for the current year and the ensuing quarter, and (ii) the estimates of current assets and iabiities for the ensuing quarter. 2. Quartery Information System Form II This gives (i) the actua production and saes during the current year and for the atest competed year, and (ii) the actua current assets and iabiities for the atest competed quarter. 3. Haf-yeary Operating Statements Form III This gives the actua operating performance for the haf-year ended against the estimates for the same. 4. Haf-yeary Funds Fow Statement Form IIIB This give the sources and uses of funds for the haf-year ended against the estimates for the same. The thrust of the information and reporting system is (i) to strengthen the partnership between the borrower and the banker, (ii) to give the banker a deeper insight into the opera-tions and funds requirements of the borrower, and (iii) to enabe the banker to

Reguation of Bank Finance 383 monitor cosey the performance and efficiency of the borrower. Pubic Deposits Many firms, arge and sma, have soicited unsecured deposits from the pubic in recent years, mainy to finance their working capita requirements. Cost The interest rate payabe on pubic deposits was subject to a ceiing of ti mid-1996. Just before the ceiing was withdrawn, it was 15 per cent. When the ceiing was withdrawn in 1996, companies started offering higher returns. Some of the NBFCs offered about 20 per cent. Due to unheathy competition, RBI has re-imposed the ceiing of 15 per cent. Reguation The Companies (Acceptance of Deposits) Amendment Rues 1978 governs fixed deposits. The important features of this reguation are: Evauation Pubic deposits cannot exceed 25 per cent of share capita and free reserves. The maximum maturity period permitted for pubic deposits is 6 months and the maximum maturity period aowed is 3 years. For non-banking financia corporations (NBFCs) however, the maximum maturity period is 5 years. A minimum maturity period of 3 months, however, is aowed for deposits amounting to 10 per cent of share capita and free reserves. A company which has pubic deposits is required to set aside, as deposit or investment, by 30th Apri of each year, an amount equa to 10 per cent of the deposits maturing by 31st March of the foowing year. The amount so set aside can be used ony for repaying such deposits. A company inviting deposits from the pubic is required to discose certain facts about its financia performance and position. Pubic deposits offer the foowing advantages to the company: The procedure for obtaining pubic deposits is fairy simpe. No restrictive covenants are invoved. No security is offered against pubic deposits. Hence the mortgageabe assets of the firm are conserved. The post-tax cost is fairy reasonabe. The demerits of pubic deposits are: The quantum of funds that can be raised by way of pubic deposits is imited.

384 Financia Management The maturity period is reativey short. Inter-Corporate Deposits A deposit made by one company with another, normay for a period up to six months, is referred to as an inter-corporate deposit. Such deposits are usuay of three types: Ca Deposits In theory, a ca deposit is withdrawabe by the ender on giving a day s notice. In practice, however, the ender has to wait for at east three days. The interest rate on such deposits may be around 12 per cent annum. Three-months Deposits More popuar in practice, these deposits are taken by borrowers to tide over a short-term cash inadequacy that may be caused by one or more of the foowing factors: disruption in production, excessive imports of raw materia, taxpayment, deay in coection, dividend payment, and unpanned capita expenditure. The interest rate on such deposits is around 14 per cent annum. Six-months Deposits Normay, ending companies do not extend deposits beyond this time frame. Such deposits, usuay made with first-cass borrowers, carry an interest rate of around 16 per cent per annum. Characteristics of the Inter-Corporate Deposit Market It may be of interest to note the foowing characteristics of the inter-corporate deposit mar-ket. Lack of Reguation The ack of ega hasses and bureaucratic red tape makes an inter-corporate deposit transaction very convenient. In a business environment otherwise characterised by a pethora of rues and reguations, the evoution of the inter-corporate deposit market is an exampe of the abiity of the corporate sector to organise itsef in a reasonaby ordery manner. Secrecy The inter-corporate deposit market is shrouded in secrecy. Brokers regard their ists of borrowers and enders as guarded secrets. Tightipped and circumspect, they are somewhat reuctant to tak about their business. Such discosures, they apprehend, woud resut in unwecome competition and undercutting of rates. Importance of Persona Contacts Brokers and enders argue that they are guided by a reasonaby objective anaysis of the financia situation of the borrowers. However, the truth is that ending decisions in the inter-corporate deposit markets are based on persona contacts and market information which may ack reiabiity. Given the secrecy that shrouds this operation and the nonavaiabiity of hard data, can it be otherwise?

Reguation of Bank Finance 385 Short-term Loans from Financia Institutions The Life Insurance Corporation of India, the Genera Insurance Corporation of India, and the Unit Trust of India provide short-term oans to manufacturing companies with an exce-ent track record. Eigibiity A company to be eigibe for such oans shoud satisfy the foowing conditions: It shoud have decared an annua dividend of not ess than 6 per cent for the past five years. (In certain cases, however, this condition is reaxed provided the company has paid an annua dividend of at east 10 per cent over the ast three years.) The debt-equity ratio of the company shoud not exceed 1:5:1. The current ratio of the company shoud be at east 1:33. Features The average of the interest cover ratios for the past three years shoud be at east 2:1. The short-term oans provided by financia institutions have the foowing features: They are totay unsecured and are given on the strength of a demand promissory note. The oan is given for a period of 1 year and can be renewed for two consecutive years, provided the origina eigibiity criteria are satisfied. After a oan is repaid, the company wi have to wait for at east 6 months before avaiing of a fresh oan. The oans carry an interest rate of 18 per cent per annum with a quartery rest, which works out to an effective rate of 19.29 per cent per annum. However, there is a rebate of 1 per cent for prompt payment, in which case the effective rate comes down accordingy. Rights Debentures for Working Capita Pubic imited companies can issue rights debentures to their sharehoders with the object of augmenting the ong-term resources of the company for working capita requirements. The key guideines appicabe to such debentures are as foows: The amount of the debenture issue shoud not exceed (a) 20 per cent of the gross current assets, oans, and advances minus the ong-term funds presenty avaiabe for financing working capita, or (b) 20 per cent of the paid-up share capita, incuding preference capita and free reserves, whichever is the ower of the two.

386 Financia Management The debt: equity ratio, incuding the proposed debenture issue, shoud not exceed 1:1. The debentures sha first be offered to the existing Indian resident sharehoders of the company on a pro rata basis. Commercia Papers An emerging source of financing working capita requirements of corporate enterprises is Commercia Paper (CP). Commercia paper is a short-term money market instrument, consisting of unsecured promissory notes with a fixed maturity, usuay between seven days and three months, issued in bearer form and on a discount basis. Issue may be made on an interva basis or more generay under revoving underwriting faciity extended by banks, taiored to the needs of the cash fow requirements of the issuer. Thus, commercia paper is a Certificate evidencing an unsecured corporate debt of short maturity. It represents a promise by the borrowing company to repay oan at a specified date. In aw, the CP comes cosest to a Promissory note. Since CP represents unsecured, short-term promissory notes, ony the highy reputed and creditworthy companies are abe to take advantage of this source of funds. Commercia paper can be sod directy by issuing company or through commercia paper deaers who either act as broker or purchase the paper outright for quick resae. Issuing companies taior both the maturity and the amount of the notes to the needs of the investors. Thus. the maturities and amounts of the notes to the needs of the investors. Thus, the maturities and amounts of directy paced paper cover a wide range of combinations. Commercia paper is different from banker s acceptance. Thus, in the former it is the obigation of the issuing company whie in the case of the atter both the drawer and the accepting bank have obigations. Another major difference is that issues of commercia paper do not have to be tied to a specific transaction whereas in most of the circumstances banker s acceptances have to be tied to a specific transactions. Genesis of Commercia Paper The genesis of commercia paper is to enabe highy rated Corporate borrowers to diversify their sources of short-term borrowings and aso to provide an additiona instrument to investors. A CP is not tied to any specific trade transaction. It differs from other money market instruments ike bankers acceptances in the sense that it is an obigation of the issuer ony, whereas acceptances are obigations of both the drawer and the accepting bank. A CP does not carry any underying coatera security.

Reguation of Bank Finance 387 Basicay, the issue of CPs is an important step in financia disintermediation bringing the borrower and the investor in touch with each other, without the intervention of the banking system as financia intermediary. However, to the extent CPs substitute the working capita oan, the banking system woud ose its oan portfoio and probaby woud osts its deposits as we, if the funds were with the banking system before investment in CP. The banks end up osing both the asset and the iabiity through this disintemediation process and the profit margin earned on the march woud vanquish. Theory suggests that the CPs woud be predominanty funded by the short-term surpus of the corporate sector. This is unikey to be true in India, especiay when the market expands. The corporate sector wi continue to the issue of CPs, intercorporate oans and portfoio management scheme for empoying their surpus and in the ong run, it is the money in the banks that wi find its way to the CP market. Further CP faciitates securitisation of oans resuting in creation of a secondary market for the paper and efficient movement of money providing cash surpuses to cash deficit entities. In internationa context, securitisation of debt paves way to gobaisation of oan assets. Potentiaity of Commercia Paper as a Source of Corporate Finance Commercia paper serves as a very usefu instrument for meeting working capita needs of firms. However, ony arge and we estabished business enterprises with a track record of high creditworthiness can make use of CP as a means of financing their short-term needs because CP is an unsecured promissory note and does not carry any tangibe security. Basic reason for popuarity of CP as a means of financing is that it is usuay ess expensive than short-term bank credit by about 1 to 2 per cent and cost differentia increases in periods of easy money. Since no compensating baance requirements are associated with the issuing of CP, cost of its issue woud further be ower than that of the bank credit. Another reason for the usefuness of CP as a source of financing is that by means of this instrument firms can raise arge amount of funds which they cannot take from a singe bank. CP provides sufficient fexibiity in business financing in as much as issuing firm may decide the quantum of CP and its maturity on the basis of its future cash fows. Financiay, use of CP adds to the prestige of the issuing company, it seems more ikey that the prestige was there before the paper was sod. A significant drawback of this source of financing is that it is ess reiabe source of credit than bank oans. Because of the impersona nature of the market, a buyer of commercia paper fees no obigation to see the borrower through a period of hard times or tight money. Buyers of CP simpy ook for the best yied possibe for a shortterm investment at a minimum risk. Thus, aacrity with which buyers of CP wi switch to more attractive investments eaves firms high and dry in hard days when money market condition becomes tight forcing the management to seek funds from banks. It is

388 Financia Management generay noted that banks do not ook favouraby on credit requests ony in periods of tight money. A firm reying too heaviy on CP may, therefore, find itsef shut off from an important source of capita in future periods of need. Therefore, a finance manager must be carefu not to impair reations with its bank. He must maintain ines of credit of commercia banks in order to tide over money market conditions. Another imitation is that CP must be paid when due. There is no extension of maturity, as in the case of a short-term bank oan. Growth of Commercia Paper Market The roots of commercia paper can be traced back in the eary 19th century when the firms in the U.S.A. began seing open market paper as a substitute for a bank oan needed for satisfying short-term financia require-ments. These firms facing great probem in getting oan from banks because of the existence of the unit-banking system were compeed to go to the market directy to raise resources from cities ike New York. During the first hundred years or so, the CPs were issued by non-financia business firms ony. But subsequenty, consumer financia companies aso began issuing the paper, first through deaers and ater directy with investors. By eary 1950s, the U.S.A. had a arge market for CPs. The commercia paper market in the U.S.A. is highy organised and sophisticated and the paper must be sod in denomination of $ 100,000. The issuing companies taior both the maturity and the amount of the paper to the needs of the investors. Thus, the maturities and amounts of directy paced paper cover a wide range of combinations. Most U.S. papers are exempted from registration under the U.S. Securities Act, 1933. They have a maturity span of 270 days or ess which is onger than the Indian paper. Under Section 3(a) (3), CPs are sod ony to accredited investors to finance non-current transactions. The U.S. marketed commercia paper worth $ 323 biion in 1986 accounting for over 90 per cent of the vaue of issues outstanding with a nationa CP markets is by far the argest in the word. The U.K. CP market is modeed after the U.S. CP market. The Bank of Engand has prescribed that the issuer of the stering CP must have net assets of at east U.K. Pound 50 miion with shares isted in the Stock Exchange in London or be a whoy owned subsidiary guaranteed by a parent which fufis this criteria. Further, ony a pubic imited company can issue CP. The maturity period of CPs range between 7 and 364 days. In Canada, the second most important and the odest commercia paper market where CP was aunched in the eary fiftees, the CPs are generay issued for a term ranging from 7 to 364 days. CP issued by a Canadian company is generay secured by the pedge of assets.

Reguation of Bank Finance 389 In Japan Yen paper was issued in 1987. It carries maturities ranging from two weeks to nine months. Normay maturity period varies between 3 months and 4 months. In Hongkong commercia paper market was opened in 1979 when MTRC (Mass Transit Raiway Corporation) issued CPs. In Singapore CP was intro-duced for the first time in 1980 when the Singapore merchant bank, DBS Daiwa, issued a CP on behaf of C.I. to, a Japanese trading company. Commercia paper in India came into existence in eary 1990 foowing striking deveopments in Indian money market. In recent few years, there was unprecedented transformation in the money market from a highy reguated, narrow iiquid and shaow market to a highy iberaised, substantiay dereguated vibrant market bessed with new money market instruments. The new monetary poicy adopted by the Reserve Bank of India to update and upgrade the existing money market in India, gave birth to the 182 days treasury bis, Inter Bank participations, Certificates of Deposits and Commercia Papers. A highy speciaised money market institution, Discount and Finance House of India Ltd., was set-up. Ceiing on the rates in the ca money market was removed. The new financia services market came into existence with a arge number of banks permitted to set-up their subsidiaries for promoting merchant banking, investment banking, equipment easing, venture capita finance, etc. It was in the wake of these deveopments that CP was aunched in our country. Since the inception of CPs scheme in India in January, 1990,23 companies issued CPs worth Rs. 419.4 crores (50 issues) ti June 30,1991. There has been phenomena progress in the CP market in recent years in as much as it rose from Rs. 4,000 crores in December, 1993 to Rs. 9,000 crores in June 1994. Athough the maturity period of CPs issued by the companies varied from three to six months, the majority of CPs were issued with a maturity of six months. The effective interest rates were in the range of 11.7 to 18.50 per cent. Reguatory Framework for Commercia Paper Foowing the recommendation of the Vaghu Committee on the deveop-ment of the money market in January, 1987, the RBI announced the broad scheme of CP in its Credit poicy in March, 1989. In January, 1990 the RBI issued detaied guideines for the issue of CP. These guideines were modified in Apri, 1991. The major features of these guideines are: (i) (a) An issuing company must have a tangibe network of ateast Rs. 10 crores. (b) The company must enjoy a fund-based Working Capita imit of Rs. 10 crores and above. (c) Have a minimum Current ratio of 1.33:1.

390 Financia Management (ii) (iii) (d) (e) (f) The Company must obtain a PI rating from Credit Rating and Information Services of India Ltd. which shoud not be more than 2 months od at the time of issue. The company must have Heath Code No. 1 raising from the Company s brokers. The company must have got its shares isted on ateast one stock exchange. Minimum size of a CP issue is Rs. 25 akhs and the face vaue of each CP instrument shoud be Rs. 5 akhs. The maximum amount that can be issued by issue of CP wi be 30% of the fund-based working capita imit. Once the issue is paced in the market, the fund-based working capita imit of the company wi be correspondingy reduced. (iv) The issuing company has to get the RBI permission every time it issues CP and the RBI wi operate a queue system to reguate the CP market. (v) (vi) (vii) CP may be issued to any person or corporate bodies registered or incorporated in India (incuding banks) as we as unincorporated bodies. The issue of CP cannot be underwritten or coaccepted in any manner. The paper being a usance promissory note, wi be negotiabe by endorsement and deivery. The discount rate sha be determined by the free market. Recenty, RBI iberaised the terms of issue of CP to come into force retrospectivey from May 30, 1991. According to the iberaised terms, proposas by eigibe companies from the issue of CP woud not require prior approva of the RBI. Such companies woud have to submit the proposas to the financing banking company which provided working capita faciity either as a soe banker or as a eader of the Consortium. The Bank on being satisfied of the compiance of then norms woud take the proposa on record before the issue of CP. In its attempt to boost up commercia paper market in the country the RBI further reaxed rues in June, 1992. Thus, the minimum working capita imit required by a company to issue CPs has been sashed to Rs. 5 crores from Rs. 10 crores. The minimum rating required from CRISIL has been owered to P 2 from P 1 whie the minimum rating needed from ICRA is now A 2 instead of A 1. Further the ceiing on the aggregate amount which can be raised through CP has been raised to 75% of the working capita from 30%. A cosey hed company has aso been permitted to borrow CPs provided a the criteria are met. According to the RBI s monetary poicy for the second haf of 1994-95, the stand-by faciity for commercia paper (CP) has been aboished. As per the poicy when CPs are issued, banks wi have to effect a pro rata reduction in the cash credit imit and it wi no

Reguation of Bank Finance 391 onger be necessary for banks to restore the cash credit imit to meet the iabiity on maturity of CPs. This wi impart a measure of independence to CP as a money market instrument. The intrinsic strength of the issuing company wi be refected from the ratings of its CP. Athough CP has been deinked from working capita imits, the ceiing of 75 per cent of maximum permissibe bank finance continues. Thus, with the revised guideines an issuing company wi have to approach the bank every time to have a higher cash credit imit, once it issues CP and its cash credit imit is brought down to that extent. Now, CP wi not be a sef-iquidating arrangement. Earier, there was a virtua guarantee by the bankers to adjust the CP on maturity which definitey was an added advantage. Future of Commercia Paper in India Commercia paper as vibrant instrument of financing working capita needs has a very bright future in changing economic scenario in view of growing iberaisation and decontro and widening openings for the private sector even in strategic sectors of the economy. Corporate enterprises requiring burgeoning funds to meet their expanding needs wi find it easier and cheaper to raise funds from the market by issuing commercia paper. Furthermore, use of this instrument provides greater degree of fexibiity in business finance to the issuing company in as much as it can decide the quantum of CP and its maturity on the basis of its future cash fows. Fears are expressed in some quarters that popuarity of CP wi adversey affect the banks business. However, the situation wi not be as aarming as is made out. It must be noted that the use of CP is restricted ony to highy creditworthy and arge profitabe organisations. Medium and sma enterprises wi, therefore, have no aternative but to resort to banks for their working capita needs. Demand for bank oans wi certainy surge in future owing to massive expansion that it ikey to take pace in sma sector in view of the current industria poicy of the Government. In the events of any oss of income the same may be effected by fees earned by the banks in their capacity as issuing and paying agents of the papers. However, the popuarity of CP as the most ucrative means of short-term finance wi pass through the acid test in view of deinking of CPs from cash credit faciities. With the deinking, CP wi not be a sef-iquidating arrange-ment. In the changed situation, corporates wi prefer the cash system of CP as against issuance of CPs which wi resut in better utiisation of cash credit imits. There can be two probabe ways to increase the credit off take. One way of giving impetus to cash credit coud be by offering a finer rate to the borrowers who on an average avai themseves of 70 per cent or above of cash credit imits.

392 Financia Management As a coroary to this, a commitment fee of 1. 5 to 2 per cent on the utiised cash credit imits on the unutiised cash credit imits wi be added to the cost of funds being raised through commercia papers offsetting, to some extent, the owered interest rate on CP. Further, the issuing companies wi now no onger have banks funds as stand-by faciity and they can no onger pace reiance on the banks working capita imits to meet the iabiity on maturity of CPs. Under the circumstances CPs wi continue to be issued but wi be restricted ony to good companies with inherent strength. Athough CPs have made a good start, its future wi depend on a number of factors. First such factor is conditionaities imposed on issue of CPs. Too many restrictions presenty camped on issuing companies are ikey to ki the potentiaity of CP as a source of corporate financing. For instance, companies in India do not have the discretion about the timing of CP issues and their ro overs. It is the RBI which decides in these matters. Further, the companies woud find it impossibe to ro over the CP issue in view of the queue system operated by RBI for CP issues. For instance, CP issue by a company is dated 1th March, 1991. After six months, the instrument matures and the company has to get into the queue system for the next CP issue. The stipuation that ony companies rated PI are eigibe to issue CPs is much too harsher. There are some good companies with PI rating who have been deprived of opportunities to issue CP. The highy rigid iquidity norms do ensure impeccabe quaity standards but they suffocate the growth. For commercia paper market to grow, issuers must have option to offer CPs with attractive terms incuding maturity range, denominationa range and interest rate range. Indian CP as such is not going to attract investors of varied notions and preferences. The minimum time imit of 3 months does not seem to be short enough and funds wi unnecessariy be tied. It is fet that the inactivity period shoud be as ess as 15 days. It woud indeed be a miestone in corporate financing if a tax exempt commercia paper is introduced in the market. Such paper coud be issued by pubic sector undertakings, mutua funds, a-india financia institutions etc. Further the short-term paper through reguar ro overs can ensure reguar suppy of funds. The RBI shoud expore the possibiity of opening the door of the commercia paper market to internationa investors on the same ines as offshore mutua funds. Initiay the profitabe pubic sector undertakings may be aowed to issue foreign currency denominated paper ony to internationa institutions, pension funds, provident funds and deveopment banks. In sum, commercia paper as an instrument of corporate finance has tremendous scope if structura rigidities are removed and ony such reguatory measures are taken by the RBI as are justifiabe to issuers, investors, deaers and other concerned parties to the paper.

Reguation of Bank Finance 393 Backdrop Factoring With growing industriaisation and consequentia growth in the voume of industria production and saes, timey coection and efficient management of receivabes has assumed importance. In the buyer s market of today, it seems to go without observing that one shoud demand credit on one s purchases and give credit on saes. The system feeding on itsef is sef-perpetuating. Since saes aways exceed purchases during a given period, a arger amount of credit is given than taken and if coections are deayed, iquidity of the firm is bady affected. The probem becomes more serious for smaer enterprises due to their reativey weak financia position and imited access to capita market. To hande this probem and prompted debt coections, companies in the USA, UK and most European countries have resorted to factoring services in one form or the other as an aternative method of converting accounts receivabe into cash. These services have recenty been extended in some South American countries as we as countries in the south Eastern and Far Eastern parts of Asia. Factoring in these countries covers both domestic and internationa trade. The USA and European Countries account for neary 90 per cent of goba factoring turnover at present Is India need for introducing factoring is being keeny fet. Concept of Factoring Factoring is a method by which a businessman can obtain cash for invoices he sends to his customers in respect of suppy of goods and services to them. Factoring is aso termed as Invoice Discounting. Factoring invoves the sae of receivabes to a financia institution such as an od ine factor a commercia financia company or one of a few commercia banks. The factor purchases accounts acceptabe to him generay without recourse; if the customer does not pay, the factor takes the oss. The cient no onger carries factored account receivabe on his baance sheet, in effect having converted them into cash. Firms owing the accounts receivabe to cient firms are notified that the account has been sod to the factor and are asked to remit directy to the factor. It is noteworthy that the factor sedom agrees to buy a of the accounts receivabe of a cient firm; instead, he retains the right to screen the accounts and seects those acceptabe to him. The cient firm can continue to se to customers whose accounts are unacceptabe to the factor, but it must carry them itsef and assume a risks on them. Factoring invoves rendering of services varying from the bi discounting faciities offered by commercia banks to a tota takeover of administration of the saes edger and credit contro functions, from credit approva to coecting cash, credit insurance and provision of finance. Factoring agreement is normay continuous. As new receivabes arise, they

394 Financia Management are reguary sod to the factor. Under the typica factoring arrangement the cient maintains a running account with the factor. As receivabes are sod to the factor, the proceeds are put at the cient s disposa in this account. Often, cients are given the priviege of overdrawing their account with the factor, or, in effect, of borrowing on an unsecured basis, in addition to drawing against the proceeds of the factored accounts. Aso, interest is normay credited by the factor on funds eft with him. Functions of Factoring A factor performs a number of functions for his cient. These functions are: 1. Maintenance of Saes Ledger A factor maintains saes edger for his cient firm. An invoice is sent by the cient to the customer, a copy of which is marked to the factor. The cient need not maintain individua saes edgers for his customers. On the basis of the saes edger the factor reports to the cient about the current status of his receivabes, as aso receipt of payments from the customers and as part of a package, may generate other usefu information. With the hep of these reports, the cient firm can review its credit and coection poicies more effectivey. 2. Coection of Accounts Receivabes Under factoring arrangements a factor undertakes the responsibiity of coecting the receivabes for his cient. Thus, the cient firm is reieved of the rigours of coecting debts and thereby enabes to concentrate on improving the purchase, production, marketing and other manageria aspects of the business. With the hep of trained manpower backed by infrastructura faciities a factor systematicay undertakes foow up measure and makes timey demand on the debtors to pay the amounts. Normay, debtors are more responsive to demands or reminders from a factor as they woud not ike to go down in the esteem of credit institution as a factor. 3. Credit Contro and Credit Protection Another usefu service rendered by a factor is credit contro and protection. As a factor maintains extensive information records (generay computerised) about the financia standing and credit ratio of individua customers and their track record of payments, he is abe to advise its cient on whether to extend credit to a buyer or not and if it is to be extended the amount of the credit and the period therefore. Further, the factor estabishes credit imits for individua customers indicating the extent to which he is prepared to accept the cient s receivabes on such customers without recourse to the cient. This speciaised service of a factor assists cients in handing far greater voume of business with confidence than woud have been possibe otherwise.

Reguation of Bank Finance 395 In addition, factor provides credit protection to his cient by purchasing without recourse to him every debt of approved customers (within the stipuated credit imit) and assumes the risk of defaut in payment by customers ony in case of customers financia inabiity to pay. 4. Advisory Functions At times, factors render certain advisory services to their cients. Thus, as a credit speciaist a factor undertakes comprehensive studies of economic conditions and trends and thus is in a position to advise its cients of impending deveopments in their respective industries. Many factors empoy individuas with extensive manufacturing experience who can even advise on work oan anaysis, machinery repacement programmes and other technica aspects of a cient s business. Factors aso hep their cients in choosing suitabe saes agent because of their cose reationships with various individuas and non-factored organisations. Types of Factoring Over a period of time, the factors word over have devised different types of factoring services to suit the requirements of their cients. On the basis of the nature of the services, factoring may be categorised as: 1. Fu Factoring 2. Recourse Factoring 3. Maturity Factoring 4. Advance Factoring 5. Undiscosed Factoring 6. Invoice Discounting 7. Buyer-based Factoring 8. Seer-based Factoring 1. Fu Factoring Under fu factoring arrangement, a factor renders services of coection of receivabes and maintains saes edgers, credit contro and credit protection. On the basis of credit worthiness of the firm a monetary imit is fixed upto which trade credit provided by the cient wi be taken over by the factor without recourse to the cient. The iabiity of the factor is imited ony to the defauts arising out of customers financia inabiity to pay. If the payment is withhed for reasons of dispute regarding inherent defect in goods, quaity, quantity, counter caim, etc., recourse wi be avaiabe to the factor against the cient.

396 Financia Management 2. Recourse Factoring In this type of factoring the factor does not provide any protection to the cient against a customer s faiure to pay debts. It may, therefore, not be necessary for the factor to either approve the customer or fix a credit imit. If the customer does not pay the invoice on maturity for any reason, the factor is entited to recover from the cient the amount paid in advance. 3. Maturity Factoring This type of factoring invoves no financing ab initio and hence no drawing imit is made avaiabe to the cient. But the factor administers the cient s saes edger and renders debt coection services. The amount of each invoice is made over to the cient at the end of the credit period on an agreed maturity date, ess the factor charges. The maturity date is decided upon at the commencement of the agreement by reference to the average-time taken by the cient to coect a debt. The maturity date bears no reation to the date on which the receivabe is actuay due for payment as it is a estimated data of coection. Such factoring coud be with or without recourse. If it is without recourse, the amount wi be made over to the cient regardess of whether the factor has been abe to coect the invoice or not. If the debtor becomes insovent, on proof of invovency, payment wi be made to the cient even before maturity. In with recourse factoring, the factor wi either pay the cient on coection of invoice or on maturity date with recourse ater on. 4. Advance Factoring In this kind of factoring, factor is prepared to pay for debts in advance of receiving the payment due from the customers. This is ony a prepayment and not an advance. A drawing imit is made avaiabe to the cient as soon as the invoice is accounted for. 5. Undiscosed Factoring Unike a other types of factoring, in undiscosed factoring customers are not informed about the arrangements between the factor and the cient The factor maintains the saes edger on the basis of the copy of invoice. He provides the cient with either debt defaut cover or finance or both as desired. Debt coection is done by the cient who makes over payment of each invoice to the factor. The factor keeps a check on its risk by receiving from the cient on age-wise anaysis of debts at reguar intervas. The types of services which may be offered under an undiscosed arrangement are very fexibe. This may be on non- recourse basis and/or seasona and/or seective basis. 6. Invoice Discounting Under this arrangement the factor buys a or seected invoices of its cient at a discount. The factor neither maintains saes edger for his cient nor undertakes debt coection function. He ony provides finance to his cient.

Reguation of Bank Finance 397 7. Buyer-based Factoring Buyer-based factoring invoves factoring of a the buyer s payabes. Thus, the factor woud maintain a ist of approved buyers and any caims on such buyers (by any seer) woud be factored without recourse to the seers. 8. Seer-based Factoring In this type of factoring the factor takes over the credit function of the seer entirey. After invoicing his customer (who shoud be previousy ceared by the factor), the seer submits a copy of the invoice, the deivery, chaan, the buy-se contract and reated papers ike quaity stipuations and test certificate to the factor who takes over the remaining operations ike reminding the buyer for payment, maintaining his account and coecting the amount The seer coses his transaction after assigning the debt to the factor, by treating the transaction as a cash sae. In such a case, the factor is aso abe to suppy additiona information to the management, viz., approved, unapproved and disputed caims outstanding, saes anaysis by area, by saesman, by products, etc., excise and saes tax payments and the ike. Modus Operandi of a Factor Where a firm has decided to factor its receivabes, it submits particuars such as ist of customers, amount of the order, terms of saes, etc., in the case of approved buyers and 90% of the invoice ess commission to the factor before despatching any merchandise to its customers. The factor scrutinises each customer s account of the cient firm to make a decision whether to accept or reject. A decision may aso be taken to imit purchases on account of a singe buyer. The factor returns to the cient the ist submitted with these orders. The cient is free to suppy to a customer, who has been rejected by the factor at his own risk. After the goods are despatched, the cient firm prepares an assignment schedue and attaches a copy of invoice and deiver chaan. In this assignment schedue, compete detais about the sae, such as the customer s name, address, terms of sae, due dates and amounts of invoices are recorded. The invoices are stamped before being sent to the buyer directing him to make the payment to the factor. Sufficient copies of each instrument are made out in advance so that a the parties invoved have records. The factor scrutinises the assignment schedue to segregate approved and unapproved buyers. The cient company s account is then credited with the entire amount of the invoice ess commission, in the case of approved buyers and 90% of the invoice ess commission, for unapproved buyers. The factor prepares on accounts current at the end of the month to revea the exact financia standing the cient has with him. The interest charges and commissions are aso recorded therein.

398 Financia Management Potentiaity of Factoring as a Source of Short-term Finance Factoring is becoming popuar a over the word in view of the variety of services rendered by factors to business organisations. Its importance has tended to increase in recent years owing to growing industriaisation and consequentia growth in the voume of industria production and saes. A factor, by dint of the function of buying debts without recourse, not ony provides financia support to his cient firm and meets a portion of its working capita, but aso reieves the atter of the botheration of coecting the receivabes from the customers and suffering osses due to bad debts. The firm may aso avoid the necessity of operating a credit department for anaysis and coection. In addition to rendering financia assistance, a factor assists his cient in credit panning and contro. On the basis of the information and assessment of creditworthiness of potentia customers, a factor is abe to advise his cient whether to extend credit to a particuar buyer or not, and if it is to be extended, the amount and period therefor. A factor may aso generate other usefu information for his cients. The factor, on account of a arge voume of transactions handed by him, is in a position to computerise the operations and hence is equipped to perform book-keeping services for more efficienty and expeditiousy than an average business concern. It is important to note that firms that are sma or have seasona saes patterns may reaise substantia savings in credit and coections because the factor serving a arge number of accounts can reaise economies of scae and aso can achieve better diversification with respect to defaut risk. However, the most critica fa-out of factoring is institutionaisation and perpetuation of credit and perhaps even deayed payments. Further, any tough stance taken by the factor against a defauting buyer may have its direct impact on such borrower cutting short his orders on the particuar seer. In a buyer s market, few seers can afford to irritate customers. Need for Factoring in India At present the commercia banks in India provide working capita finance through purchasing/discounting of receivabes aowing over-draft/cash credit against hypothecation of outstanding book debts, aowing over-draft/cash credit against bis sent for coection through the bank and aowing overdraft/cash credit against amounts due from Government/Semi-government agencies in respect of suppies made to them. Whie the banks do finance the receivabes, such finance is with recourse to the suppier who bears the risk of defaut by the debtor. The bank s credit support to the suppier is, thus, for a imited or pre-determined period and on the expiry of the said period, if the dues are not reaised, it generay cas upon the suppier/borrower to repay the finance. Thus, the bank finance is aways with recourse to the seer, i.e., if the buyer fais to make payment for any reason, the bank recovers the amount invoved from its customer, viz., the seer.

Reguation of Bank Finance 399 Further, banks provide coection services ony in respect of bis purchased/discounted or not. But they do not undertake coection of book debts (open account saes) of their customers. The existing arrangements are not adequate to cater to a the requirements of seer in present conditions. Thus, the basic probems faced by seers is the growing pressure on their working capita resources on account of their inabiity to obtain timey payment for their credit saes. Whie for saes on open eement for the period the credit is normay expected to be outstanding, often interest is reaised for the period the payments are deayed for the estimated time. Due to growing competition seers hardy insist on payment of overdue interest and hence frequenty suffer erosion in profit margins and working capita deficits. Deayed payment spanning up to 5 month or more is fairy widespread. At times deayed payment is due to probems experienced by buyers in reaising their own dues, thus indicating inter-dependence of different sectors in ensuring timey payments. The probem of deays coud be mitigated to a great extent if there is an efficient system of receivabes management and coection machinery. At present ony arge organisations have separate credit management departments excusivey to attend to these matters. SSI units can hardy afford a separate staff for the purpose. Quite often, when required to attend to their recovery personay. Consequenty, they are unabe to give due attention to improving their products and enarging their markets. Whie some information on creditworthiness and reiabiity of buyers in far off paces coud be obtained through the banks, the information so avaiabe is not adequate for the suppier to know the operationa, financia and market status of the buyer to decide upon credit terms which may be offered. As a resut, they foow cautious approach. In view of the above, desirabiity and usefuness of factoring services to suppiers of goods of services in India was considered by the Reserve Bank of India in January, 1988 when it appointed a study group under the chairmanship of Mr. C. S. Kayansundaram, Ex-managing director of State Bank of India, to examine the feasibiity and mechanics of starting factoring organization in India and recommending for their constitution, organisationa set-up, scope of activities and other reated matters. Whie recognising the need for speciaised agencies for handing factoring business, the group has cautioned that factoring per se woud not be a compete soution for deays and defauts in payments. However, it fees that the professiona approach of factor in credit assessment, debt coection, manage-ment of saes edger, etc. shoud bring about a noticeabe improvement in the payment cuture. The group has estimated the aggregate potentia demand for factoring services at about Rs. 4,000 crores, it is of the view that in the eary years, demand for factoring services woud mainy emerge from the SSI sector and those medium and arge units, which are

400 Financia Management experiencing coection deays particuary in industries such as ight engineering, textie, consumer durabes, automobie anciaries and chemicas. Pricing of Factoring Services A factor charges fee for the services rendered by it to the cient. The fee charged varies depending on the type of services and creditworthiness, quaity of portfoio and turnover of the cients. Normay the factoring fee in the U.S., U.K. and European Countries ranges between 1 and 3% of the face amount of the receivabes purchased. If funds are advanced to the seer before the receivabes are coected by the factor, an additiona interest charge is evied that is normay tied to, and above the prime rate. In India, whie a simiar consideration can hod good, the base eve of charges of the factors woud depend upon the various costs to be borne by him, which in turn depend upon the cost of funds and the cost of management. The RBI group fees that the price for factoring services may be around 16 per cent per annum for financing and 2.5 to 3 per cent for other services. It fees that such pricing shoud enabe the factors to reach a eve of business which wi generate reasonabe rate of return on their investment. It has emphasized that. the factors wi have to become more efficient than banks in handing the receivabes of their cients. Factoring Organisation in India In most of the deveoped countries commercia banks have set-up their subsidiaries to perform the factoring functions in view of the fact that banks have considerabe experience and have easy access to credit information on both seers and buyers. Their arge network of branches as aso avaiabiity of sufficient financia resources provide them additiona advantages. A few banks in India are expected to set-up subsidiaries to provide factoring services soon. The RBI study group has suggested that ony seect promoter institutions, groups of individuas with good trust record in finance and management shoud be permitted into this new fied, at east in the eary years. This is considered necessary since such institutions have to set-up good standards and inspire confidence in the pubic. The group has further suggested that initiay the organisations may be promoted preferaby on zona basis such as one each for north, east, south and west. As regards ownership of such institutions, it fees that factoring organisations in the private sector may not be abe to raise sufficient resources at competitive cost for handing business of the expected magnitude.. The report of the Working Group on Money Market (Vaghu Committee) constituted by the Reserve Bank of India has aso recommended that banks shoud be encouraged to

Reguation of Bank Finance 401 set-up factoring divisions which coud pay a vita roe in acceerating efficient and speedy fow of resources to the corporate entities. Accordingy, Reserve Bank of India has, of ate, aowed Canara Bank to set-up Corporate subsidiary with Rs. 10 crore Capita in co-operation with Andhra Bank and sma Industries Deveopment Bank to render factoring services in southern region. State Bank of India and Punjab and Sind Bank have been permitted to form subsidiary to provide factoring services in Northern region. With a view to catering to the needs of eastern region United Commercia Bank, United Bank of India and Aahabad Bank have been permitted to foat subsidiary with Rs. 5 crores. India s first factoring company was set-up jointy by Canbank Financia Services Ltd., and Rashtriya Chemica and fertiizers Ltd., to act as a speciaised agency to deaers in fertiizers and farmers using the fertiizers through factoring of trade bis and receivabes. Bank Guarantees Bank guarantee is one of the faciities that the commercia banks extend on behaf of their cients in favour o third parties who wi be the beneficiaries of the guarantees. In fact when a bank guarantee is given no credit is extended and banks do not part with any funds. There wi be ony a guarantee to the beneficiary to make payment in the event of the customer on whose behaf the guarantee is given, defauting in his commitment. So, if the customer fais to pay as per the terms of the guarantee, the banker giving the guarantee has to pay and caim reimbursement from his cient. The banker s iabiity arises ony if his customer fais to pay the beneficiary of the guarantee. That is why bank guarantee imits are known as non-borrowings imits or non-fund imits. Important features - The foowing points are to be considered regarding bank guarantee: Guarantees shoud be for a definite period and as far as possibe shoud not run for more than one year. The guarantees shoud be in respect of a definite object or enforceabe on happening of a definite event. Guarantee shoud be in respect of transactions which arise out of trade and commerce, or any other genuine business. Guarantees shoud be specific as to amount. Guarantees shoud be covered by a counter guarantee by a customer giving the bank absoute right of payment under guarantee on the happening of contingency guaran-teed against.

402 Financia Management Reiabe credit reports shoud be obtained on the customers for whom the guarantee is given. Such reports shoud be kept uptodate. The guarantees shoud as far as possibe reate to the norma business of the customers. The banks wi insist the customer to deposit the margin, depending on case to case, before the issue of bank guarantees. The banks wi charge commission on bank guarantees issued or extended. Asset securitisation The emerging financia scenario has created a fierce competition among the companies to raise funds through innovative financia products from the capita and/or money markets. Additiona source of capita can be accessed through securitisation reieving the norma receivabe/deposit coection process for finance companies and banks, without disturbing the iabiities side of the baance sheet. Companies can rise finance and increase their ending activity thus enhancing the profitabiity. Meaning - The term Securitisation refers to both switching away from bank intermediation to direct financing via capita market and/or money market, and the transformation of a previousy iiquid asset ike automobie oans, mortgage oans, trade receivabes, etc., into marketabe instruments. Securitisation is a process of transformation of iiquid asset into security which may be traded ater in the open market. Securitisation is the process of transforming the assets of a ending institution into negotiabe instruments. For banks and financia institutions, securitisation, fundamentay, invoves conversion of ong-term assets into a current asset. It is a structured transaction whereby the bank transfers or ses oans of a particuar portfoio to a speciay created trust which breaks the oan into convenient amounts and raises money from the investors by seing the instru-ments which represent the oan amounts. In India, ICICI has paved the way by securitisation of bis of exchange in 1991, and ater HDFC and a few other finance companies have adopted this method. At present a number of other companies are adopting this procedure. The iiquid assets such as mortgage oans, into oan receivabe, cash credit receivabes, etc., on the baance sheet of the originator (such as Finance Companies, Financia Institutions, Banks, etc.) are packaged, underwritten and sod in the form of securities to investors through a carefuy structured process.

Reguation of Bank Finance 403 These securities coud be in the form of commercia paper, participation certificates. Notes or any other form of security permissibe under the ega frame work of the country. In a securitisation process, the underying assets are used both as a coatera and aso to generate the income to pay the principa and interest to the investors of the asset backed securities. Securitisation process Firsty, assets have to be originated through trade receivabes, ease rentas, housing oans, automobie oans, etc., according to their maturity pattern and interest rate risk and formed into a poo. Secondy, a trust has to be estabished soey to purchase receivabe from the originator, create instruments according to the maturity period and risk of the asset, se instruments and transfer the funds to the originator. The trust may aso act as a receiving and paying agent. For this purpose, the trust has to obtain credit rating to make the transactions more attractive to the investor (athough the rating is not mandatory). The trust woud have to obtain some form of iquidity support from a third party ender to cover the possibiity that the oan portfoio woud generate insufficient payment when due. The trust may aso have to obtain insurance cover, often provided by a poo insurance poicy. It has to appoint a merchant banker or syndicate of merchant bankers for underwriting the whoe issue. The securities have to be sod to the investors either by a pubic issue or by private pacement. Obviousy, the good quaity oans wi be eigibe for securitisation. The repayment pattern of assets in particuar wi be the deciding factor to structure the instruments.

404 Financia Management Bank/Financia Institution/Company Baance Sheet Liabiities Assets Trade receivabes Automobie oans Housing oans Mortgage oans, etc. Investors Poo of Assets Trust Instruments Credit Rating Third Party support Insurance cover Underwriting Advantages Figure: Process Fow Chart of Asset Securitisation The main benefit to the originator is the additiona source of capita can be accessed through securitisation reieving the norma receivabe, deposit coection process. Without disturbing the iabiities side of the baance sheet the originator can raise finances and increase their activity of ending which enhances the profitabiity. The originator can reduce their existing debtors and can reduce their risk. By seing the debtors in the form of securities, iquidity of the entity/bank can be enhanced. Cash coming in from sae of assets can be used to fund either capita and reserves or to end again. In case cash is used to fund capita and reserves, it resuts in owering the debtequity ratio. If in case cash is ent, it increases the turnover and profit utimatey for the business. Securitisation aso improves the income to asset ratio by increasing income on the one hand and reducing the tota voume of assets on the other. The main benefit to an investor is that he gets a security which is backed by adequate coateria and has credit enhancement. Most of such securities are rated by credit rating agencies. Hence, it becomes

Reguation of Bank Finance 405 reativey easier for an investor to compare the risk-return profie of asset backed securities with other investibe instruments and make an informed choice. In a securitisation exercise the credit risk is shifted partiay, or even competey from the issuer of securities to the securitised asset and/or third parties depending on the structure of the transaction. The security, thus, is insuated from other risks associated with the originator or the issuer. The recent RBI directive that Banks sha extend 40% of the maximum permissibe bank finance (MPBF) for amounts above Rs. 20 crores, by way of short-term oans repayabe within one year, makes them an idea asset for debt securitisation. Loan transfers This type of transaction, where oans are transferred to an existing third party without the creation of a new company, the issuer, as a vehice for the dea. Technicay oans cannot be sod in the same way as tangibe assets, but there are three main ways in which the benefits and risks under the oan agreement can be sod to a third party. Novation : The rights and obigations attached to the oan are canceed and repaced by new ones whose main effect is to change the identity of the ender. Assignment: Loans may be assigned by either a statutory or equitabe assignment. Sub-participation: Rights and obigations are not transferred, but the ender enters into a non-recourse, back to back agreement with a third party, the subparticipant whereby the atter pays the ender some or a of the amount of the oan in return for a share of the cash fows. In this type of transaction the origina ender: has no residua beneficia interest in the principa of the oan and that the subparticipant has no forma recourse to the ender for osses. has no obigation to provide further finance. does not intentionay bear any osses from interest rate changes. Hedging approach to working capita financing Under hedging approach to financing working capita requirements of a firm, each asset in the baance sheet assets side woud be offset with a financing instrument of the same approximate maturity. The basic objective of this method of financing is that the permanent component of current assets, and fixed assets woud be met with ong-term funds and the short-term or seasona variations in current assets woud be financed with short term debt. If the ong term funds are used for short-term needs of the firm, it can identify and take steps to correct the mismatch in financing.

406 Financia Management Consortium ending and oan syndication by banks When the individua bank finds it difficut to meet the huge financia requirements of a borrower, it gives rise to mutipe banking which may be in the forms (i) Consortium ending or (ii) Loan syndication. Consortium ending- When the financia needs of a singe unit are more than a singe bank can cater the needs, then more than one bank come together to finance the unit jointy spreading the risk as we as sharing the responsibiities of monitoring and finance. The arrangement is caed the consortium ending and it enabes the industria units to mobiise arge funds for its operations. This is generay formaised by a consortium agreement. RBI has advised that banks which are ending to units requiring arge outay of funds form a consortium arrangement among banks. Borrowers enjoying funds based imits of Rs. 50 crores and above from more than one bank shoud be brought under the above arrange-ment. There is no ceiing or number of banks in consortium. However the share of each bank shoud be a minimum of five per cent or Rs. one crore whichever is more. It wi not be permissibe for any bank outside the consortium to extend any additiona credit faciity or open current account for the borrowers without the knowedge and concurrence of the consortium members. Loan syndication - On the recommendations of Narasimhan Committee, 1991, and further reviewed by a Committee under the Chairmanship of Mr. J. V. Shetty, then CMD, Canara Bank. Recenty RBI guideines signaed formation of oan syndication as a part of ending system. There are two methods of syndication direct ending and through participation. Direct ending: In respect of direct ending a the enders sign the oan agreement independenty with the borrower and agree to end upto their respective share. The obigations of the syndicate members are severa and they do not underwrite one another. Through participation: In this method of ending the ead bank is the ony ending bank, so far as the borrower is concerned, that approaches the other enders to participate in the oan. This normay takes pace without the knowedge of the borrower. The ead bank grants a certain portion of the oan to each participant as agreed. It aso agrees to pay to the participants a pro rata share of receipts from the borrower. Types of participation - There can be four types of participation : Substitution : There is an agreement the borrower and the ead bank and other participants to permit the ead bank to disburse the oan on behaf of the participants. Undiscosed agency: Here, the ead bank is appointed as agent by the syndicate before the oan is signed, but does not discose this fact to the borrower. It is, therefore, the principa as far as the borrower is concerned.

Reguation of Bank Finance 407 Sub-oan: Under this method, each participant grants a oan directy to the ead bank on the condition that the ead bank repays ony to the extent of receipts from the borrower. Assignment: The ead bank assigns a proportion of the oan and of the benefit of the oan agreement to the participants in consideration of the Purchase price or pro rata share of the oan to be contributed by them. Non performing assets Under the new RBI monitoring system, Bank s performances have been cruciay dependent on recognition of income and non-performing assets. On the recommendations of high eve committee under the Chairmanship of Sri M. Narasimhan, the RBI had issued circuars from time to time under the heading income recognition, asset cassification, provisioning and other reated matters. The recommendations of the Committee highights that the poicy of income recognition shoud be based on objective and based on recovery rather than any subjective consideration. The non-performing asset, as used in banking parance, mean an asset the income (interest) of which is overdue for at east two quarters. Banks are not permitted to book income on accrua basis on such assets but ony on reaisation basis in respect of nonperforming assets. For provisioning, the assets (oans and advances) are to be cassified as (i) Standard (ii) Sub-standard (iii) Doubtfu, and (iv) oss as per the RBI circuar issued in this regard. The RBI has aso introduced simiar circuar for revenue recognition, cassification of assets, provisioning and other reated matters appicabe to Non-banking Finance Companies (NBFCs) registered with RBI. Security for short-term financing In norma course of business, the short-term oans wi be provided by the banks against on some specific assets offered to the ender as security for repayment. Accounts receiv-abes and inventory are two types of current assets offered for financing working capita requirements. The foowing points are worthnoting in providing security of the above current asset. Pedge of accounts receivabes The ender evauates the quaity of receivabes and the risks invoved taking accounts receivabe as security. Generay the security wi be given on the baances ying in debtors in the Books of Account. In specific cases, any specia accounts may be pedged to the ender for a particuar oan. The borrower wi continuousy reporting the ender of the debtors paid and new debtors baances added in the records.

408 Financia Management Even though the ender have caim on the book debts, ony the borrower wi coect the receivabes and the enders right wi arise when the borrower fais to repay the oans. If a oan is made on the notification basis, the notified debtor wi directy pay his due amount to the ender instead of the borrower. Charge on inventory - The manufacturing and trading companies, generay create charge on their stocks against working capita faciities provided by the Banks or Finance companies. The charge is created on the inventory items in the foowing ways : Foating charge : With creation of foating charge on the stocks, the borrowing firm gives the ender a genera caim against the entire cass of assets which are moving items. The ender s right on the stocks wi be crystaised ony when the borrower defauts in payment of his dues. Charge against trust receipts: When the items in inventory are easiy identifiabe, such as goods having seria numbers, a trust receipt can be eyed to guarantee a oan. A trust receipt is an agreement between the borrower and ender under which the borrower hods the goods in inventory and immediatey forwards any sae proceeds from the sae of the inventory to the ender. Pedge of Warehouse receipts : When the inventory is kept at borrower s warehouse, but which is separated from other inventories can be pedged separatey for specific oan purpose based on the warehouse receipt. If inventory is kept at third party warehouse then, there wi be cost of warehousing aso. The borrower can dea with or operate with the inventory pedged on warehouse receipt ony when the charge is ifted by payment or otherwise. Recommendations various committees Bank Financing Dehejia Study Group The Nationa Credit Counci constituted, in October 1968, a study Group under the Chairmanship of Shri V.T. Dehejia to examine the subject of the extent to which credit needs of industry and trade are ikey to be infated and how such trends coud be checked. Since the buk of bank credit is short-term, the Group s enquiry was primariy concerned with the infation of the short-term bank credit. The credit needs of industry or trade may be considered to be infated or either of the two sectors may be regarded to have received credit in excess of its genuine requirements (i) if, over a period of years, the rise in short-term credit is found to be substantiay higher than the growth in the vaue of industria production; (ii) if the rise in short-term credit in appreciaby higher than the increase in inventories with industry or trade, (iii) if there is a diversion of short-term bank borrowings of concerns in industry for buiding up of fixed assets or other non-current assets such as oans and investments, (iv) if there is doube or mutipe financing of the same stocks; (v) if the period of credit is unduy engthened.

Reguation of Bank Finance 409 The Group submitted its report in September, 1969. Major Findings The major finding of Dehejia Study Group are isted beow: Expansion of Bank Credit to Industry in Excess of Output The Group found that the bank credit during the period from 1960-61 to 1966-67 expanded at a higher rate than the rise in industria output. This finding was supported by the avaiabe data on inventories in reation to short-term bank credit. Between 1961-62 and 1966-67, the rise in the vaue of inventories with industry was 80% whie the rise in short-term bank credit was as much as 130%. The ratio of short-term bank borrowings to inventories went up from 40% in 1961-62 to 52% in 1966-67. A simiar anaysis showed that some industries, particuary those in the traditiona group, and severa industria units obtained credit from banks over and above the rise in their production. The Group therefore came to the concusion that in the absence of specific restraints, there was a tendency on the part of the industry generay to avai itsef of short term credit from banks in excess of the amount based on the growth in production and/or inventories in vaue terms. Fixing Credit Limits by Banks The basis on which banks fix credit imits had an important bearing on the size of bank credit in reation to the requirements of individua borrowers. For fixing credit imit banks generay took into account severa features of the working of the oanee concerns, such as production, saes, inventory eves, past utiisation etc. The prevaent practices of banks in this regard were so varied that they were unikey to prevent the emergence of excess demand for credit from certain borrowers. By and arge, the schedued banks were incined generay to reate their credit imits to the security offered by their constituents but many do not appear to make any attempt to assess the overa financia position of the borrowers through a cash fow anaysis and in the ight of this study fixed their credit imits. Vauation of Stocks and Margin Requirements Banks did not generay adopt a uniform method of vauation of stock. The usua method, for indigenous goods was based on cost or market vaue whichever is ower and for imported goods on anded cost. Simiary, there was considerabe divergence in practice as regards the prescription of margins by the banks. Some banks stipuated a ower margin or pedge advances against hypothecation of stocks, whie a few others did not make this distinction. In the opinion of the Group, the varying practice coud not be said to constitute an important factor in the emergence of excess credit.

410 Financia Management Diversion of Short-term Credit to Acquisition of Long-term Assets A study of 255 companies over the period from 1961-62 to 1966-67 showed a deterioration in their current ratio and the increase in short-term iabiities was utiised for financing the gap between ong-term assets and ong-term iabiities. One-fifth of the gross-fixed assets of these companies was financed by expansion in short-term iabiities incuding the bank oans. The tendency on the part of a number of industria units to utiise short-term bank credit and other current iabiities for acquisition of non-current assets was, in the Group, due to (a) generay suggish condition in the capita market since 1962 (b) the imited nature of the appraisa of appications for short term oans as compared to medium term oans and (c) stipuation of repayment schedues for medium oans. Lending System The Group considered that the ending system, as was prevaent in Indian banking, woud have appear greaty assisted prevaent in Indian banking, woud have appear greaty assisted certain units in industry on increased reiance on short-term debt to finance their non-current investment. The working capita advances of banks were granted by way of cash credit imits which were ony technicay repayabe on demand. The system was found convenient in view of the emphasis paced by banks on the security aspect. These short-term advances though secured by current assets were not necessariy utiised for short-term purposes. The resut was that cash credit advances had no onger remained a short-term or sef-iquidating in as much as athough cash accruas arising from saes were adjusted in a cash credit account from time to time. The Group found that on a arge number no credit baance emerged or debt baances fuy wiped out over a period of years as the withdrawas were in excess of receipts. The possibiity of heavy reiance on bank credit by industry arose mainy out of the way in which the system of cash credit which accounted for about 70% of tota bank credit had been operated. Suggestions The Group was of the opinion that uness measures were taken to check the tendency for diversion of bank credit for acquiring ong term assets, it might assume wider dimensions. The Group made foowing suggestions for a change in the ending system. Method of Appraisa of Credit Appications The appraisa of credit appications shoud be made with reference to the tota financia situation, existing and projected, as shown by cash fow anaysis and forecasts submitted by borrowers. This woud hep a diagnosis of the extent to which current iabiities of industria units had been put to non-current use and the manner in which iabiities and assets of borrowers were ikey to move over a period of time. Initiay, advances of,

Reguation of Bank Finance 411 say Rs. 50 akhs and over shoud be anaysed this way and then the system may graduay be extended to borrowers with advances of over Rs. 10 akhs. Segregation of the Credit Market The outstandings in the existing as we as further cash credit accounts shoud be distinguished as between (i) the hard core which woud represent the minimum eve of raw materias, finished goods and stores which the industry was required to hod for maintaining given eve of production and (ii) the stricty short-term component which woud be the fuctuating part of the account. The atter part of the account woud represent the requirements of funds for temporary purchases, e.g. short-term increase in inventories, tax, dividend and bonus payments etc., the borrowing being adjusted in a short period out of saes. In the case of financiay sound companies, the Group was of the opinion to segregate the hard core eement in the cash credit borrowings and put on a forma term oan basis and subject to repayment schedue. But when the borrowers financia position was not too good or the size of the hard core, was so arge that repayment coud not be expected within 7/10 years, it woud be difficut for the banks to continue to carry these iabiities over a ong period of time. The possibe soutions to be attempted woud be: the bringing in of ong-term deposits and unsecured oans by the promoters and their friends, additiona issue of equity or preference capita, a debenture issue with a ong maturity. When the hard core was to be paced on a forma term oan basis, the proposa shoud be subject to a detaied appraisa. The documents shoud contain convenants in regard to the end-use of the oan, maintenance of minimum financia ratios, repayment obigations restrictions on investments on shares and debentures. To determine the hard core eement of the cash credit account, the Group considered that it woud be worthwhie to attempt to study of industry-wise norms for minimum inventory eves. Doube or Mutipe Financing Doube or mutipe financing may resut where credit faciities are granted against receivabes either by way of documents against acceptance bis or drawing against book debts; the purchase is aso in a position to obtain bank credit by way of hypothecation/pedge of the stocks which have not been paid for. For eiminating doube or mutipe financing, the Group suggested that a customer shoud generay be required to confine his deaings to one bank ony. In case the credit requirements of borrowers were to be arge and coud not be met out of resources of one bank, the Group has commended the adoption of consortia arrangement. Period of Trade Credit To prevent undue ongation of the period of trade credit and the tying up of resources of banks for unproductive purpose, the group suggested that the period of trade credit shoud not normay exceed 60 days and in specia circumstance up to 90 days (excuding

412 Financia Management saes of capita equipment on deferred payment terms). The undue deay in the settement of bis by governments coud be discouraged by stipuating that the atter shoud pay interest on bis if they were not paid within 90 days after their receipt. Commitment Charges on Unutiised Limits As a compementary measure to check the extension of extra credit, the group suggested that a evy of commitment charge on unutiised imited couped with, if necessary, a minimum interest charge coud be considered. The commitment evy might be progressivey raised with the size of the unutiised imits. As the initia stages, imits sanctioned upto Rs. 10 akhs might be exempted from the point of view of administrative convenience. Need for Greater Recourse to Bi Finance The Study Group emphasised the need for greater recourse to bi finance. The Group recommended that commercia banks, industry and trade shoud try, where feasibe and administrativey convenient, to initiate and deveop the practice of issuing usance bis as this woud not ony impose financia discipine, on the purchaser but aso hep suppier or producer to pan his financia commitments in a reaistic manner. An adequate growth in the voume of usance bis woud aso faciitate the deveopment of a genuine bi market in India. With a view to encouraging the deveopment of such bi market a reduction in the stamp duty on usance bi was recommended by the Group to the government. The Group beieved that the oss in revenue foowing a reduction in stamp duty woud be more than made good by the resutant arger voume of usance bis. Inventory Contro With regard to inventory contro, the Group considered that as an integra part of restraining the demand for bank credit by industry, adequate attention shoud be paid to the question of adequacy or otherwise of stocks of inventories hed by various industries and the scope for minimising the stocks needed by industry. Impications Financia discipine impicit in Dehejia Study Group was intended to hep the corporate and other borrowers in formuating financia pans, reguating production on a more rationa basis and economising the demand for bank credit. As regards banks, a periodica reease of the part of the resources otherwise ocked up in ro over cash credit/ overdraft to industry woud enabe them to meet to this extent further demands of priority sectors of the economy and to diversify their oan transactions. This, in turn, woud increase the scope for mobiisation of deposits. Commercia banks woud thus be abe to pay a more effective roe in serving the community and the ends of socia justice.

Reguation of Bank Finance 413 Tandon Study Group The Reserve Bank of India constituted a Study Group to frame guideines for foow up of bank credit in Juy 1974 under the Chairmanship of Shri Prakash Tandon. The terms of reference of the Group were: (i) (ii) (iii) To suggest guideines for commercia bank to foow-up and supervise credit from the point of view of ensuring proper end-use of funds and keeping a watch on the safety of the advances and to suggest the type of operationa data and other information that may be obtained by banks periodicay from such borrowers and by the Reserve Bank of India from the eading banks. To make recommendations for obtaining periodica forecasts from borrowers of (a) business/production pans, (b) credit needs, To make suggestions for prescribing inventory norms for different industries both in the private and pubic sectors and indicate the broad criteria for deviating from these norms. (iv) (v) (vi) (vii) To suggest criteria regarding satisfactory capita structure and sound financia basis in reation to borrowings. To make recommendations regarding the sources for financing the minimum working capita requirements. To make recommendations as to whether the existing pattern of financing working capita requirements by cash credit/overdraft system etc. requires to be modified, if so, to suggest suitabe modifications. To make recommendations on any other reated matter as the Group may consider germane to the subject of enquiry or any other aied matter which may be specificay referred to it by the Reserve Bank of India. Observations and Recommendations The Study Group submitted its report to the RBI in August 1975. The summary of the Group s main observations and recommendations is given beow: Suppy of and Demand for Funds Nationaisation of the major commercia banks in 1969 raised expectations of a new sense of direction in bank ending, and indeed advances to new caimants of credit, and especiay to sma industry and agricuture had since gone up. The pubic sector has emerged as an important user of credit due both to its growing dominance and its turning increasingy to commercia banks for its working capita finance instead of reying on government. Another new source of demand was the growing awareness of the need to achieve an equitabe geographica deveopment of industry, and in its

414 Financia Management distribution of credit. Though industria production increased at a sow pace but the ca on bank credit essentiay for maintaining inventories even at the same eve had gone up with rising prices. If the growth process is resumed then the voume of inventory required to maintain a higher eve of production wi increase and correspondingy the demand for bank credit. This state of affairs caused no probem in the year when the credit-deposit ratio in the banking system was ow and a sudden spurt in credit demand coud easiy be taken care of and access to refinance from the Reserve Bank was easy. With contro on monetary expansion as part of anti-infationary poicy and a use in demand for funds both from the od and the new caimants the existing system of bank ending came under considerabe strain and the fundamenta weakness of the system had been exposed. Cash Credit System and Financia Indiscipine The probem of potentia imbaance in demand for and suppy of funds is accentuated by the manner in which banks extend credit under the present cash credit system of ending, where a banker sanctions a maximum imit within which the borrower can draw at his wi. Under this procedure, the eve of advances in a bank is determined not by how much a banker can end at a particuar point of time by the borrower s decision to borrow at the time. When the borrower s need for funds is ow, the banker is faced with the probem of arge unutiised funds, and when the borrower s need for funds, the banker faces the probem of meeting the demand without notice. In fact, avaiabiity of funds with the bank and the customers need do not aways match. The weakness of the cash credit system can be iustrated by taking the foowing exampe of a borrower s financia position; Current Liabiities Current Assets Bank borrowings Rs. 75,000 Inventory Rs. 1,00.000 Other current Rs. 10,000 Other current assets Rs. 10,000 iabiities Rs. 85,000 Rs.1,10,000 Let us assume that the entrepreneur has raised equity and term oans for covering the cost of fixed assets as we as a portion of current assets. The banker s function is perceived as providing funds required for carrying the baance of the current asset. Against the tota inventory of Rs. 1,00,000, an advance of Rs. 75,000 is sanctioned by way of cash credit. The advance is secured by a charge over inventory with an appropriate margin in this case 25% the margin representing the borrower s contribution to carry the current assets. So ong as there is security, which is decared in the periodica stock statements, the borrower is permitted to draw up to the drawing imit, computed on the basis of the vaue stocks ess stipuated margin, or the sanctioned imit, whichever is ower.

Reguation of Bank Finance 415 Under this system, it is possibe for a borrower to draw against avaiabe security and utiised the funds for purposes other than increasing his current assets of repaying his other current iabiities; he can, for instance, use the funds for acquiring fixed or noncurrent assets, as the foowing exampe iustrates: Current Liabiities Current Assets Creditors for purchase Rs. 50,000 Inventory Rs. 1,00,000 Bank borrowings Rs. 75,000 Other current assets Rs. 10,000 Other Current iabiities Rs. 10,000 Rs. 1,35,000 Rs. 1,10,000 Inventory of the vaue of Rs. 1,00,000 is carried to the extent of Rs. 50,000 by creditors for purchases; but the borrower is enabed to borrow up to Rs. 75,000 on the security of stocks worth Rs. 1,00,000 ess the prescribed margin of 25%, the drawing imit being Rs. 75,000. Had the customer drawn genuiney for meeting his current assets requirements ony, his maximum eigibiity (assuming ni contribution from him to carry the current assets) woud have been Rs. 50,000; the excess of Rs. 25,000, he can divert to nonapproved uses without the banker s knowedge. Such diversion of bank funds was made possibe by the banker s fixation on security under the cash credit ending system. To the extent that outstandings in a cash credit account never fe beow certain eve during the course of a year, there was an eement of what is caed a hard core borrowings which was in reaity a quasi-permanent ockup of bank funds in the borrower s business. The time is now opportune to review the existing system and effect changes in such a way that under the new system the borrower coud pan his credit needs and the banker woud be abe to pan his deposit credit function to assure finance to industry for its genuine production needs. Norms of Inventories and Receivabes According to the Study Group, the main function of a banker is ony to suppement the borrower s resources to carry a reasonabe eve of current assets. The Study Group has, therefore, stipuated norms for 15 major industries. Not ony wi the bank credit be reguated according to the norms but the units in these industries (except cotton and jute) themseves are not supposed to carry inventories/receivabes in excess of the stipuated norms. In the case of cotton and jute industries, whie stocks woud be maintained according to the permission of the Textie or Jute Commissioner, the bank credit woud be reguated according to the norms. Bunched receipt of raw materias incuding imports. Power cuts, strikes and other unavoidabe interruptions in the process of production. Transport deays and bottenecks.

416 Financia Management Accumuation of finished goods due to non-avaiabiity of shipping space for exports or other disruptions in saes but not under circumstances where a saes stimuation is needed through reduction in prices. Buid up of stocks of finished goods, such as machinery due to faiure on the part of purchasers for whom these were specificay manufactured to take deivery. Need to cover fu or substantia requirements of raw materias for specific export contract of short duration. For the industries, for which no norms have been stipuated banks are expected to keep in view the purpose and spirit behind the norms exercise and prevent excessive buidup of inventories receivabes. Working Capita Gap and Bank Finance The Group has identified working capita gap viz., the borrower s requirements of finance to carry current assets (based on norms) other than those financed out of his other current iabiities, coud be bridged party from his owned funds and ong term borrowings and party by bank borrowings. The maximum permissibe eve of bank borrowings coud be worked out in three ways: (i) (ii) (iii) Bank can work out the working capita gap, i.e., tota current assets ess current iabiities other than bank borrowing and finance a maximum of 75% of the gap; the baance to come out of ong-term funds, i.e., owned funds and term borrowings. Borrower to provide for a minimum of 25% of tota current assets out of ongterm funds, i.e., owned funds pus term borrowings. A certain eve of credit for purchases and other current iabiities wi be avaiabe and the bank wi provide the baance. Tota current iabiities incusive of bank borrowings wi not exceed 75% of current assets. Same as (ii) above, but excuding core current assets from tota current assets on the theory that core current assets shoud be financed out of ong-term funds, i.e., owned funds pus term borrowing. The three aternatives may be iustrated by taking the foowing exampe of a borrower s financia position, projected at the end of the next year:

Reguation of Bank Finance 417 Current Liabiities TABLE-1: Baance Sheet 370 * As per suggested norme or past practice, whichever is ower in reation to projected production for the next year. Current Assets* Creditors for purchase 100 Raw materias 200 Other current iabiities 50 Stocks-in-process 20 Bank borrowings, incuding bis discounted with bankers 150 Finished goods 90 Receivabes incuding bis discounted with bankers 50 200 350 Other current assets 10 The 1st Method woud mean the banker financing upto a maximum of 75% of the working capita gap of 220, i.e., 165 and the borrower providing at east 55 out of his ong-term funds, i.e., owned funds pus ong-term borrowings. This method wi give a minimum current ratio of 1:1. The 2nd Method woud mean the borrower financing a minimum of 25% of tota current assets (92) through ong-term funds and the gap, i.e., maximum of 128 (278-150), wi be provided by the bank. This wi give a current ratio of at east 1.3.1. TABLE-2: Permissibe Leves of Bank Finance 1st Method 2nd Method 3rd Method Tota current assets 370 Tota current assets 370 Tota curreni assets 370 Less: Current Liabiities other than bank Less: 25% of above from ong-term Less: Core current assets (Iustrative borrowings sources figure) from ong-term 150 92 sources 95 ----- ----- ----- 278 275 Working capita gap 220 Less: current Rea current assets 275 iabiities other than Less: 25% of above from. 69 bank borrowings ong-term sources 206 Less: 25% of above from ong-term sources Maximum bank borrowings permissibe 55 Working capita gap 220 Less: current iabiities other than the bank borrowings 165 Maximum bank borrowings permissibe 128 Working capita gap Maximum bank borrowings permissibe 150 56 220 56 Excess borrowings 35 Excess borrowings 72 Excess borrowings 144 Current ratio 1.17:1 Current ratio 1.33:1 Current ratio 1.79:1 The 3rd Method woud mean a further reduction in bank borrowing and strengthening of the current ratio.

418 Financia Management It is important to note that in an exercise ike this for computing the eve of bank finance, the cassification of current assets and current iabiities shoud be made as per the usuay accepted approach of bankers and not as per definitions in the Companies Act. For instance, instaments of term oans payabe within 12 months from the date of baance sheet are cassified by the banker as current iabiities whie it is not so in the baance sheet prepared in accordance with the requirements of the Companies Act. These differences in cassification have been brought out in the form for anaysis of baance sheet prescribed by the Reserve Bank under its Credit Authorisation Scheme. The 3rd Method wi provide the argest mutipier of bank finance; however, to avoid hardship to borrowers, a beginning may be made with the 1st Method, pacing a borrowers in this method within a period of about one year, and the idea of the 3rd Method may be reached in stages. The ibera approach under the 1st Method has been suggested as the first step, particuary to faciitate financia structuring of new companies, setting up projects in backward areas and aso for fexibiity in restructuring of existing companies with a weak financia base. Stye of Credit Once the quantum of bank funds to finance a reasonabe eve of current assets is agreed to, there is aso need to change the stye of extending bank credit. Instead of making avaiabe the entire credit imit as a cash credit for a year, it may be bifurcated into a oan and a demand cash credit, which wi be reviewed annuay. The oan component woud comprise the minimum eve of borrowing which the borrower expects to use throughout the year, whie the cash credit part coud take care of his fuctuating requirements. As the oan woud carry interest throughout the year, it wi induce a discipine in the customer to pan his need carefuy to ensure that as itte of it as possibe ies ide. The demand cash credit shoud be charged a sighty higher rate of interest than the oan component. This approach wi give the borrower an incentive for good panning. In order to ensure that customers do not use the new cash credit faciity in an unpanned manner, the financing shoud be paced on a quartery budgeting-reporting system for operationa purposes. Bi Finance Apart from oan and demand cash credit, a part of the tota requirements within the overa eigibiity, coud aso be provided by way of bi imits to finance receivabes. It is desirabe that, as far as possibe, receivabes shoud be financed by way of bis rather than cash credit against book debts, though the atter cannot be atogether eiminated, particuary when the period of credit is short and the amount is sma. These bis coud be on a demand basis or on a usance basis depending on the marketing practice in the industry.

Reguation of Bank Finance 419 To the extent feasibe, the banking system shoud move towards financing the purchaser, who is in fact the debtor, rather than the seer, who is the creditor. In other words, the seer wi be paid off immediatey after the sae and the bank credit wi be extended ony to the purchaser. As regards financing of the purchaser, however, there are two different points of view. One view is that purchases shoud aso as far as possibe, be on the basis of bis, for the foowing reasons: the amount wi be drawn ony at the time of actua need. the end-use of credit is automaticay taken care of, credit to purchaser is directy reated to his actua need, which is not the case with the seer s bis, where credit is extended as a measure of saes promotion irrespective of the purchaser s abiity to pay or his need for credit. a bi enabes discipine to be imposed in respect of payments for purchases-it ensures timey payment to suppiers, which a system of book entries does not aways ensure. It is argued on the other side that under the proposed revised system, the cash credit mode of financing is superior to bi financing in respect of the borrower s purchase operations for the foowing reasons: drawas for non-approved purposes wi be detected by the new information system proposed and by scrutiny of cheques; end-use of credit wi be effectivey taken care of by the proposed information system, the cost of operations to the borrower and the banker wi be high; borrower wi have to pay more for cost of stamp duty which the banker s administrative cost wi go up because of additiona paper work without the assistance of mechanisation or computerisation, and the advantages of centraised borrowing by way of a cose watch over aggregate outstandings, debit and credit summations and borrowing trends woud be ost. In view of the foregoing, it seems desirabe that each banks shoud take its own decision, in consutation with the borrower, having regard to the size of his operations, the individua transactions and the administrative set-up obtaining in the bank. Coverage of the Proposed Approach The proposed approach to ending and the stye of credit may be extended to a borrowers having credit imits in excess of Rs. 10 akhs from the banking system, whie the information system may be introduced, to start with, in respect of borrowers with imits of Rs. 1 crore and above from the entire banking system. Progressivey, banks shoud extend this system, first to borrowers with imits of Rs. 50 akhs to Rs. 1 crores and next to those enjoying imits of Rs. 10 akhs to Rs. 50 akhs.

420 Financia Management Information System To meet the specific requirement of the new ventures and to ensure the end-use and safety of bank advance, the borrower is expected to subject himsef to the budgeting and reporting system. The borrower wi suppy appropriate operationa data and figures reating to financia position at periodica intervas on the prescribed forms which have been devised for the purpose. The information so furnished by the borrower wi have to be screened thoroughy and speediy and a view taken of his tota activities. A borrowers with tota credit faciities from the Banking System in excess of Rs. 10 akhs shoud submit (i) Operating Statement (ii) Funds Fow Statements (iii) Peak Leve Baance Sheet and Proforma Baance Sheet for the ensuing year at the ensuing, year at the time of submitting the oan appication (whether for renewa/enhancement of fresh imits). The borrower with aggregate credit faciities from the banking System exceeding Rs. one crore shoud submit (i) quartery operating statement (ii) quartery funds fow statement and (iii) current assets and current iabiities every quarter for the purpose of foow-up. Foow-Up A bank has to foow-up and supervise the use of credit to verify first, whether the assumptions on which the ending decision was taken continue to hod good, both in regard to the borrower s operations and the environment, and second, whether the end-use is according to the purpose for which the credit was given. From the quartery forms, the banker wi verify whether the operationa resuts confirm to earier expectations and signs, if any, of significant divergence reading as red signas to both the banker and the customer. However, variance of say +10% may be treated as norma. In addition to the quartery data, the arger borrowers shoud submit a hafyeary proforma baance sheet and profit and oss account within two months from the end of the haf year. Management Efficiency Management competence is an important factor, in the efficiency of operations. refected in profitabiity and working capita and financia management. The banker shoud be kept in mind appraisa of management may be essentia particuary when more emphasis has been on viabiity and deveopment rather than on security aone. Further, changes in ownership or manageria pattern may aso have to be watched, where circumstances warrant. Inter-firm Comparison To faciitate inter-firm and industry-wise comparison for assessing efficiency, it woud be of added advantage if companies in the same industry coud be grouped under three or four categories, say, according to size of saes and the group wise

Reguation of Bank Finance 421 financia ratios compied by the Reserve Bank of India, for furnishing to banks. Besides examining financia and operating ratios, certain productivity ratios may aso be examined to determine efficiency in use of resources man, money, machines and materias. A banker can choose his own criteria, but some usefu ones are: abour efficiency; capita efficiency and fixed assets efficiency. Cassification of Customers For purposes of better contro, there shoud be a system of borrower cassification in each bank, within a credit-rating scae. Such a system of cassification according to credit-risk wi faciitate easy identification of the borrower whose affairs require to be watched with more than ordinary care. An incidenta advantage of such cassification wi be the formuation of a rationa base for purpose of fixing the rates of interest for the respective borrowers. Norms for Capita Structure The debt-equity reationship is a reative concept that depends on severa factors and circumstances such as the state of the capita market at any one time, government poicy on created money, the need to maintain current assets at a specified eve (which again is contingent on other factors), margina efficiency of capita or the opportunity cost, etc. The experience of other countries in this matter may not be of much assistance in formuating guideines in the Indian context. In discussing norms for capita structure, the Group kept in mind both the reationships ong-term debt to equity and tota outside iabiities to equity. Where a company s ong-term debt-net worth and tota outside iabiities-net worth ratios are worse than the medians, the banker woud endeavour to persuade the borrower to strengthen his equity base as eary as possibe. This woud be a more practica approach for the banker than attempting to egisate absoute standards of ong-term debt net worth and tota outside iabiities net worth ratios for a industries or even industry by industry. The impact of taxation in considering this subject is aso important for, under the tax structure, it is advantageous to trade as much as possibe on borrowed capita to maximise earnings per share. The higher the eve of borrowings, or the financia everage, the greater is the advantage in view of this and couped with the cheap money poicy, there may be imited incentive to the borrower for efficient management of funds. Introduction of higher interest rates in the banking system has changed this position. In fact, the ending banker ikes to see as high an equity stake as possibe because it makes advances safer and, in times of credit shortage, makes avaiabe bank funds so further. However, one cannot ose sight of the need to promote the capita market whie resoving this dichotomy of interest between the banker and borrower as the utimate goa being to assist in maximising investment and production. If the end-product of industry has to be sod at a cheaper price and adequate dividends are aso to be given to make equity

422 Financia Management attractive to the investor, no company can afford, even if it were possibe, to trade entirey on owned funds, nor rey too heaviy on borrowed funds. There has thus to be a baance between the two what the company provides and what it borrows. Probems in Impementing Tandon Committee Report The Reserve Bank of India in its notification dated August 21, 1975 considered some of the main recommendations of the Group and advised the banks accordingy. The scheme was required to be impemented at the micro-eve where advances were made to the borrowers. But a thorough understanding of the scheme required knowedge about the anaysis of financia statements and credit appraisa by the officers at branch eve. This knowedge was sowy spreading and ti the officers at the grass root eve were equipped with the basic knowedge of credit appraisa, the impementation was bound to be quite sow. Another probem was that of gearing the attitudes of the bankmen to this new scheme being something new as being not in the routine nature of credit appraisa, it was difficut task to kinde the interest of the staff to study the Tandon Scheme for enforcing it in the case of big industria customers. In addition, the new scheme aso caed for in-depth knowedge about each industry and various units in each industry so that the norms coud be reaisticay appied in each case to determine the eve of current assets, working capita gap and the stye of credit. It s not ony the bankers but aso the customers were required to be trained in understanding the impications of the norms and the quartery information system, an innovation brought in by the Tandon Committee. No doubt the big parties had the quaified staff to give the data in forms prescribed on quartery basis, but these forms were not forthcoming in time. If they were submitted each time after the current quarter or even much ater upon reminder, the very purpose of caing for quartery data were to be defeated as in that event foow-up supervision and contro were difficut or not possibe. In the case of some of the big parties, it had been found that they were run ike famiy concerns on partnership or proprietary basis and they did not maintain proper books of accounts. Such parties were ikey to pead inabiity to furnish the data as per the Tandon form. To make matter worse or difficut for banks, they maintained account in regiona anguage too. Even if the forms were coming with ot of persuasion and understanding from the borrowers, it was difficut to convince them in individua cases to abide by the norms for carrying current assets if they were aready above the norms. No doubt, utimatey it was the banker s judgement that shoud prevai in credit decisions after a diaogue with the parties, but in super-imposing such decisions over the customers judgement, there was ikey to be misunderstanding or cash sort of thing with the borrowers. It was quite possibe that aggrieved borrowers getting esser imit might perhaps consider higher imits.

Reguation of Bank Finance 423 Another probem which was no ess important coud be about the manipuation in the figures of other current assets, other current iabiities etc. as the permissibe bank finance was based on figure work ony. Further it was fet that the cacuation of excess finance poses a reaistic probem because whie the working capita gap was computed on the basis of the projected net current assets, the figures of iabiity were the existing ones and not the projected eves. For growing higher eves of current assets, the Committee provided exceptions where under higher hodings might be permitted. It was feared that each party might argue to be brought within the exceptions to circumvent the rigours of the norms. However, in order to improve the operationa efficiency and to deveop a beter understanding of the new ending system of banks, if a the banks are serious in impementing the Tandon Scheme and if they are abe to get the cooperation from their customers, the probem areas are nothing and can be ignored. On the other hand, if unwarranted concessions and deviations are shown by banks against the ethics of the impementation of the scheme as a whoe, the very phiosophy of the Tandon Scheme wi be defeated and it wi create a situation in which the scrupuous banks wi regret for going the Tandon way. Chore Committee Whie reviewing the monetary and credit trends in March 1979 the Governor of the Reserve Bank of India stressed the need for exercising continued restraint on expansion of credit. He aso indicated in his meeting with bankers the need for considering certain ong-term issues reating to banking operations. In his etter dated 16th March 1979 to a schedued commercia banks, he indicated: I woud ike to initiate action on certain structura matters which need further examination. It is necessary to take a fresh ook at another major probem faced by banks in impementing the credit reguatory measures, viz., the extensive use of the cash credit system. Its drawbacks have been pointed out by the various Committees in the past incuding the Tandon Committee, which suggested the bifurcation of credit imits into a demand oan and a fuctuating cash credit component. Athough the banks were advised to impement this recommendation, I am afraid, the progress achieved has been very sow. Ceary, this probem needs to be ooked into further and for this purpose I proposes to set up immediatey a sma Working Group, to report to me...on the reforms to be introduced. It was in this context that the Reserve Bank of India appointed the Working Group under the Chairmanship of Shri K.B. Chore to review the system of credit in a aspects. The term of reference of the Working Group were as foows: (1) To review the operation of the cash credit system with reference to the gap between sanctioned credit imits and the extent of their utiisation;

424 Financia Management (2) In the ight of the review, to suggest: (a) modifications in the system with a view to making the system more amenabe to rationa management of funds by commercia banks, and/or (b) aternative types of credit faciities, which woud ensure greater credit discipine and aso enabe banks to reate credit imits to increase in output or other productive activities; and (3} To make recommendations on any other reated matter as the Group may germane to the subject. The Group made foowing recommendations in its fina report. Recommendations Credit System The advantages of the existing system of extending credit by a combination of the three types of ending, viz., cash credit, oan and bi shoud be retained. At the same time, it is necessary to give some directiona changes to ensure that wherever possibe the use of cash credit woud be suppanted by oans and bis. It woud aso be necessary to introduce necessary corrective measures to remove the impediments in the use of bi system of finance and aso to remove the drawbacks observed in the cash credit system. Bifurcation of Credit Limits Bifurcation of cash credit imit into a demand oan portion and a fuctuating cash credit component has not found acceptance either on the part of the banks or the borrowers. Such bifurcation may not serve the purpose of better credit panning by narrowing the gap between sanctioned imits and the extent of utiisation thereof. It is not ikey to be vountariy accepted and it does not confer enough advantages to make it compusory. Reducing Over-dependence on Bank Borrowings The need for reducing the over-dependence of the medium and arge borrowers both in the private and pubic sectors-on bank finance for their production/trading purposes is recognised. The net surpus cash generation of an estabished industria unit shoud be utiised party at east for reducing borrowing for working capita purposes. Enhancement of Owner s Contribution In order to ensure that the borrowers do enhance their contributions to working capita and to improve their current ratio, it is necessary to pace them under the Second Method of ending recommended by the Tandon Committee which woud give a minimum current ratio of 1.33:1. As many of the borrowers may not be immediaty in a position to work under the Second Method of ending, the excess borrowings shoud be segregated and treated as a working capita term oan which shoud be made repayabe in instaments. To induce the borrowers to repay this oan, it shoud be charged a higher rate of interest. For the present, the Group recommends that the additiona interest may

Reguation of Bank Finance 425 be fixed at 2% per annum over the ratio appicabe on the reative cash credit imits. This procedure shoud made compusory for a borrowers (except sick units) having aggregate working capita imits of Rs. 10 akhs and over. Peak Leve and Norma Non peak Leve Limits to be Separate Whie assessing the credit requirements, the bank shoud appraise and fix separate imits for the norma non-peak eve as we as for the peak eve credit requirements indicating the periods during which the separate imits woud be utiised by the borrower. This procedure woud be extended to a borrowers having working capita imits of Rs. 10 akhs and above. One of the important criteria for deciding such imits shoud be the borrowers utiisation of credit imits in the past. Financing Temporary Requirements through Loan If any ad-hoc or temporary accommodation is required in excess of the sanctioned imit to meet unforeseen contingencies the additiona finance shoud be given, where necessary, through a separate demand oan account or a separate non-operatabe cash credit account. There shoud be a stiff penaty for such demand oan or nonoperatabe cash credit portion, at east two per cent above the norma rate, uness Reserve Bank exempts such penaty. This discipine may be made appicabe in cases invoving working capita imits of Rs. 10 akhs and above. Pena Interest The borrower shoud be asked to give his quartery requirement of funds before the commencement of the quarter on the basis of his budget, the actua requirement being within the sanctioned imit for the particuar peak eve/non peak eve periods. Drawing ess than or in excess of the operative imit so fixed (with a toerance of 10% either way) but not exceeding sanctioned imit woud be subject to a penaty to be fixed by the Reserve Bank from time to time. For the time being the penaty may be fixed at 2% per annum. The borrower woud be required to submit his budgeted requirements in tripicate and a copy each woud be sent immediatey by the branch to the controing office for record. The penaty wi be appicabe ony in respect of parties enjoying credit imits of Rs. 10 akhs and above, subject to certain exemptions. Information System The non-submission of the returns in time is party due to certain features in the forms themseves. To get over this difficuty, simpified forms have been proposed. As the quartery information systems, is part and parce of the revised stye of ending under the cash credit system, if the borrower does not submit the return within the prescribed time, he shoud be penaised by charging the whoe outstanding in the account at a pena rate of interest, 10% per annum more than the contracted rate for the advance from the due date of the return ti the date of its actua submission.

426 Financia Management Reaxation from Norms Requests for reaxation of inventory norms and for ad-hoc increase in imits woud be subjected by banks to cose scrutiny and agreed to ony in exceptiona circumstances. Toning Up-Assessment Technique The banks shoud devise their own check ists in the ight of the instructions issued by the Reserve Bank for the scrutiny of data at the operationa eve. Deays in Sanction Deays on the part of banks in sanctioning credit imits coud be reduced in cases where the borrowers cooperate in giving the necessary information about their past performance and future projections in time. Bi System As one of the reasons for the sow growth of the bi system is the stamp duty on usance bis and difficuty in obtaining the required denominations of stamps, these questions may have to be taken up with the state governments. Saes Bi Bank shoud review the system of financing book debts through cash credit and insist on the conversion of such cash credit imits into bi imits. Drawee Bi System A stage has come to enforce the use of drawee bis in the ending system by making it compusory for banks to extend at east 50% of the cash credit imit against raw materias to manufacturing units whether in the pubic or private sector by way of drawee bis. To start with, this discipine shoud be confined to borrowers having aggregate working capita imits of Rs. 50 akhs and above from the banking system. Segregation of Dues of Sma Scae Industries Banks shoud insist on the pubic sector undertakings/arge borrowers to maintain contro accounts in their books to give precise data regarding their dues to the sma units and furnish such data in their quartery information system. This woud enabe the banks to take suitabe measures for ensuring payment of the dues to sma units by a definite period by stipuating, if necessary, that a portion of imits for bis acceptance (drawee bis) shoud be utiised ony for drawee bis of sma scae units. Discount House To encourage the bi system of financing and to faciitate ca money operations an autonomous financia institution on the ines of the Discount Houses in UK may be set up.

Reguation of Bank Finance 427 Correation between Production and Bank Finance No concusive data are avaiabe to estabish the degree of correation between production and quantum of credit at the industry eve. As this issue is obviousy of great concern to the monetary authorities the Reserve Bank may undertake a detaied scientific study in this regard. Communication of Credit Contro Measures to Branches and Foow-up Credit contro measures to be affective wi have to be immediatey communicated to the operationa eve and foowed up. There shoud be a Ce attached to the Chairman s office at the Centra Office of each bank to attend to such matters. The Centra Offices of banks shoud take a second ook at the credit budget as soon as changes in credit poicy are announced by the Reserve Bank and revise their pan of action in the ight of the new poicy and communicate the corrective measures to the operationa eves as quicky as possibe. Monitoring of Key Branches and Critica Accounts The banks shoud continuousy monitor the credit portfoio of the key branches irrespective of the fact whether there is a change in credit poicy or not. For effective credit monitoring, the number of critica accounts shoud be kept under a cose watch over the utiisation of imits and inventory buid up. Deay in Coection of Bis/Cheques To reduce the deay in coection of bis and cheques, return of documents by the coecting branches, etc, the Group suggested to tone up the communication channes and systems and procedures within the banking system. Bi Faciities and Current Accounts with other Banks Athough banks usuay object to their borrower s deaing with other banks without their consent, some of the borrowers sti maintain current accounts and arrange bi faciities with other banks. Apart from diuting the contro over the advance by the main banker, this practice often enabes the borrower to divert saes proceeds for unapproved purposes without the knowedge of his main banker. Banks shoud be suitaby advised in this matter by the Reserve Bank to check this unheathy practice. Marathe Committee With the incorporation of the guideines of the Tandon Committee and the Chore Committee, bank ending to industry came increasingy under the direct supervision of the Reserve Bank of India. In 1982 it was fet that an independent review of the Credit Authorisation Scheme (CAS) which had been in operation for severa years woud be usefu and accordingy the Reserve Bank of India appointed a Committee in November 1982 to review the working of the Credit Authorisation Scheme. The Committee which

428 Financia Management came to be referred as the Marathe Committee submitted its report in Juy 1983. The starting point for the Marathe Committee s work provided by the objectives of the CAS, was enarged and re-defined and noted by the Committee as foows: (a) (b) (c) (d) To ensure that additiona bank credit is in conformity with the approved purposes and priorities and that the bigger borrowers do not pre-empt scarce resources. To enforce financia discipine on the arger borrowers where necessary, on uniform principes; Where a borrower is financed by more than one bank, to ensure that the customer s proposa is assessed in the ight of the information avaiabe with a the banks; and To bring about improvement in the techniques of credit appraisa by banks and their system of foow-up. Recommendations The Marathe Committee which was given wide terms of reference to examine the Credit Authorisation Scheme from the point of view of its operationa aspects stressed that the CAS is not to be ooked upon as a mere reguatory measure which is confined to arge borrowers. The basic purpose of CAS is to ensure ordery credit management and improve quaity of bank ending so that a borrowings, whether arge or sma, are in conformity with the poicies and priorities aid down by the Centra Banking Authority. If the CAS scrutiny has to be imited to a certain segment of borrowers, it is ony because of administrative imitations or convenience; and it shoud not impy that there are to be different criteria for ending to the borrowers above the cut off point as compared to those who do not come within the purview of the Scheme. Further, the Committee was of the view that it is not possibe to avoid deays or improve quaity of ending merey by concentrating on a singe point. The borrowers have to do their bit by providing a the necessary and reevant information in time and in adequate detai. The ong time taken in commercia banks in processing appications has to be reduced by suitabe organisationa changes. Simiary the time taken for scrutiny in the Reserve Bank aso requires attention party because it is the ast stage of the process, and because of earier deays. it is found more irksome by the borrower. Improvements in the system as a whoe has to be a conscious and continuous process in order to achieve the desired resut. The major recommendation of the Marathe Committee was in the area of providing an incentive for the borrowers to compy with a the requirements of the scheme incuding the information system and for the banks to improve the quaity of credit appraisa. It recommended that banks be aowed discretion to depoy credit in CAS cases which fufi the foowing requirements, without RBI s prior authorisation: (i) The estimates/projections in regard to production, saes, chargeabe current assets, other current assets, current iabiities (other than bank borrowings) and

Reguation of Bank Finance 429 (ii) (iii) net working capita are reasonabe in terms of past trends and norms (wherever specified), and assumptions regarding most ikey trends during the future projected period. The cassification of assets and iabiities as current and non-current is in conformity with the guideines issued by RBI. The borrower has been submitting quartery operating statements for the past 6 months within the stipuated time and undertakes to do so in future aso, (iv) The borrower undertakes to submit his annua accounts prompty and the bank carries out the annua review of faciities irrespective of the fact whether the borrower needs enhancement in credit faciities or not. The progress made in the adoption of the fast track represented by the above recommendation of the Marathe Committee has been rather sow. This is not perhaps surprising, as the five eigibiity conditions which have been aid down are quite comprehensive and further the sanction of credit faciities under the fast track woud sti come under post-disbursa scrutiny of the RBI as in the case of sanction of credit faciities above Rs. 1 crore and beow the cut-off point (now Rs. 4 crores for prior authorisation). The Marathe Committee envisaged that the need for a reguatory roe for the Reserve Bank in respect of individua credit imits wi diminish, if not disappear if the banks are abe to evove an operationa cuture which wi be immune to unheathy pressures and which wi have an in-buit discipine in conforming to the broader parameters of poicy aid down by the Centra Banking Authority. It however, cautioned that the gradua diminution of the area in which prior authorisation by the Reserve Bank is needed before banks can disburse credit to individua parties shoud not, therefore, mean any erosion of its roe The basic approach to reguation of credit to industry and trade adopted by the Reserve Bank over the years as briefy reviewed above may be broady summed up as foows: (a) (b) (c) (d) The basis of bank ending shoud be changed from security-based ending to ending based on funds fow. Credit needs are to be assessed and met by banks based on industry-wise working capita norms, deviations from these norms beyond the prescribed toerance imits being seen as evidence improper credit use by the borrower requiring prompt rectification. Reiance of borrowers on bank finance for financing working capita shoud be progressivey reduced by insistence on maintenance of a current ratio of 1,33:1 by a growing segment of borrowers, the minimum acceptabe ratio being 1:1. Assessment of credit needs shoud be made on the basis of detaied information

430 Financia Management (e) (f) to be provided by borrowers on past performance and future projections of working capita needs and overa performance. Fina cearance by RBI of credit requests for amounts above the cut-off point under CAS was an essentia eement in the credit aocation system as banks were not aways in a position to resist pressures from their arger cients, nor adequatey equipped to undertake scrutiny of credit requests with the required degree of thoroughness. Continuous efforts are to be made by the borrowers, banks and the Reserve Bank to improve the information system which is seen as the key to the success of the approach to credit aocation outine above. The borrowing community has over the years argued strongy against what it considers as the infexibiity and other inadequacies of the system of working capita financing adopted by the banks and the Reserve Bank of India. They have had the opportunity to present their views, in writing and during discussions, to the various committees and Study Groups appointed by the Reserve Bank of India to improve the methods of bank ending to industry and trade. Their criticism of the credit appraisa system as it has evoved over the past two decades covers conceptua as we as procedura aspects of the system. Some of these criticisms voiced by them are pointed out beow. Variation in Inventory eve: The norms evoved by the Tandon Committee for assessing working capita requirements of different industries have been criticised by borrowers on the ground that the norms do not provide for variations in inventory eves occasioned by the operation of severa commercia factors, apart from ocationa factors and impact of unforeseen deveopments. For exampe, it is pointed out that in the case of industria units ocated in areas with inadequate transport faciities inventory eves woud refect the onger ead time for suppy of raw materias and despatch of finished goods. It has aso been argued that the norms which may be vaid under idea conditions, do not distinguish between different units and variations in market conditions overtime. The eves of inventories in particuar and the eve of tota working capita requirements aso depend on a host of extraneous factor in the economy over which the borrower, has no contro. These factors are inadequate and uncertain avaiabiity of power affecting production schedues, transport bottenecks resuting from non -avaiabiity of raiway wagons, non-avaiabiity of shipping space in the case of exports, changes in import poicy, bottenecks at the ports, bunching of imports, unanticipated changes in prices of raw materias and products made avaiabe by the pubic sectors canaising agencies, government poicies regarding the permitted eve of stocks in specific industries, ad hoc aocations by canaising agencies of scarce raw materias, strikes and disturbed industria reations affecting purchase of suppies or saes of finished goods, uncertainties associated with imposition of duties in the annua budget of the government, sudden

Reguation of Bank Finance 431 changes in suppy schedues prescribed by arge pubic sector buyers, and so on. Under these circumstances borrowers point out that with the best of efforts they cannot project their working capita requirements even for one quarter, et aone for a year, with any degree of certainty. The management of these uncertainties itsef consumes considerabe time and efforts, and sanction of credit based on rigid norms compounds the difficuties in managing the industria unit. These probems get magnified in the case of smaer borrowers as they are ess abe to determine the terms of purchase or sae of goods and have a weaker financia structure as compared to the arger borrowers. Specification of different norms for different stages of production and marketing, detaied instructions regarding cassification of items as current iabiities and current assets, difficuties in assessing the vaidity of projections of working capita requirements based on uncertainties referred to above, a combine to make the credit appraisa process a difficut and time consuming exercise. Again it is stated that during the protracted time over which credit appraisa is being undertaken, unforeseen deveopments occur, prices and market situation change, monetary poicy stance may change, resuting in a need to revise earier projections which eads to another cyce of deays. This brings in a tendency to infate the amount of credit sought in the origina appication for sanction of credit imits. Long-term Resources Contribution: The main thrust of the Chore Committee recommendations was on bringing a arger segment of borrowers under the Method II of ending wherein the borrowers are required to contribute ong term resources through their own funds and term oans to the extent of 25 per cent of tota current assets as against Method I of ending where their contribution woud be no more than 25 per cent of the difference between current assets and current iabiities excuding bank borrowings. The borrowers are of the view that a rigid enforcement of this change woud hurt industria units. The resources at the disposa of the borrowers are imited and the appication of Method II of ending shoud be gradua and based on the capacity of the units to augment their interna resources and term oans in situation where the financia strength and industry characteristics of different borrowers vary widey, and the state of the capita market is aso not uniform over the years. Borrowers have argued that they need funds for modernisation, expansion and diversification, and further many of them need to improve their capacity utiisation which cas for higher eves of working capita. Whie term ending financia institutions insist on greater contributions by the borrowers towards the cost of fixed investment in projects being financed by them, bank insist on higher contributions by borrowers for financing their working capita requirements. The borrowers fee that both these demands can hardy be met by them at the same time with their imited resources. Form of Bank credit: Bank credit sanctioned to borrowers takes the form of cash credit oans and bi financing. Whie cash credit is the more favoured form of financing,

432 Financia Management banks specify separate imits for each type of assistance. The Chore Committee particuary stressed the need to insist on providing a part of the assistance by way of drawee bi imits. Separate imits are aso specified for raw materias, finished products and receivabes. The borrowers point out that this compartmentaisation hampers their abiity to make the best use of the credit sanctioned to them and shoud therefore, be dispensed with, particuary since the components of working capita undergo changes in the course of operations. The banks too have to spend considerabe time and effort to monitor the use of bank credit in accordance with the various sub-imits specified by them. There is no doubt that the importance of timey avaiabiity of credit shoud be refected in the credit appraisa process at a stages, and borrowers shoud faciitate quick decisions by prompty providing the information caed for by banks. Margin requirements: Long term financia institutions have reason to be concerned that their reativey cheaper assistance is diverted to buiding up of working capita. At the same time banks are vigiant that borrowers do not appropriate arger than justified bank credit by diverting their own resources for expansion, modernisation or inter-corporate transactions. New companies find it difficut to have adequate margin for working capita as they are expected to conform to Method II of ending by banks from the time they start operations. Borrowers with a pronounced seasona operation aso face difficuties in meeting margin requirements during the peak season even when they are abe to bring in their contribution during the year as a whoe as required under Method II of ending. These factors appear to have compicated the financing of industria operations. Tax Concessions: Tax concessions avaiabe on additiona fixed investment are attractive to industria concerns who are naturay keen on avaiing of these concessions to the maximum extent possibe, even if it means that they do not maintain margins stipuated by the bankers or margins for working capita at eves which they estimated whie working out their project cost. Ony when the borrowing concerns improve turnover of their capita, strengthen their equity base and obtain ong term funds from the capita market wi they be abe to maintain adequate working capita margins on a reguar basis. These options are open more to the arger companies who have a good past record of operations than to others, incuding new companies who are not we known in the capita market. Credit Utiisation: The overa credit imit for a borrower is determined on the basis of Tandon/Chore norms and is generay thought of as being based on cash fow projections. But this is not reay the case. The approach outined by the Tandon Committee rests on the use of baance sheet data and the norms, therefore, are derived on the basis of funds fow statements. As a resut, the true cash requirements of a borrower are not propery discernibe in the statements provided to the banker for assessment of credit imits. The extent of mismatch between credit imits and the credit requirements of the

Reguation of Bank Finance 433 borrower woud necessariy vary according to the scae of activity and seasona factors. There is another aspect of credit imits which needs to be highighted. The credit imit sanctioned to a borrower which is vaid unti it is reassessed, does not represent the extent of credit which the borrower is free to avai of at any point in time. The utiisation of credit imit depends on the borrower having the necessary drawing power as computed from the stock statements submitted to the bank periodicay. This means that the utiisation of credit imits is reated, through the appication of margin requirements, to the eve of inventories, book debts and other eigibe assets indicated in the stock statement avaiabe to the banker. This is so because the operating banker prefers to base his decision to end on a ega document such as the stock statement rather than on funds fow or even a cash fow statement indicating credit requirements for a given future period generay of three to six months. Bank ending, therefore, essentiay retains its security orientation despite the appication of more sophisticated norms. Credit imits based on Tandon/Chore norms serve the purpose of providing a ceiing to the utiisation of credit based on drawing power. Thus the quantum of credit that can be utiised by a borrower at any given time is equa to the drawing power or the credit imit, whichever is ower. The present credit appraisa procedures do not prevent utiisation of credit faciities over and above what is justified on the basis of a cash fow anaysis, so ong as the drawing power is not exhausted. As the stock statements are avaiabe once a month or ess frequenty, and their submission can be deayed if it suits the borrower, the drawing power based on the atest avaiabe stock statement does not necessariy represent current credit requirements. Moreover, banks are often obiged to condone excess drawas when they are in the nature of fait accompi, these being detected with a ag when the stock statement for the reevant period is submitted. Information System: One of the major causes of deay in sanctioning of credit imits by banks has been the faiure of borrowers to submit the quartery statements under the prescribed information system in the time and in adequate detai. This is so even after the Chore Committee revised the formats reating to the information to be submitted which were introduced when the Tandon Committee recommendations were impemented. Even in the case of arger borrowers whose credit requests were subject to prior authorisation of the Reserve Bank of India, it was found that out of the 2321 appications processed by the Reserve Bank of India in 1982, further particuar were sought in as many as 702 cases. The Marathe Committee has noted whie there has been considerabe improvement in the commercia bank s appraisa systems, there are sti wide variations as between banks and sometimes, in the quaity of proposas put up by the same bank. There are deays, often inordinate, in processing appications. Simiary, among the borrowers aso many have introduced modern techniques for the management of working capita and finance. In severa cases, toos ike panning for working capita, cash budgeting and management information systems are increasingy being used. But

434 Financia Management here again there is considerabe variation even amongst arge borrowers; and the reativey smaer ones are sti way behind, Atogether, whie the working of the CAS has contributed a great dea and the banks as we as the borrowers have in many cases improved their systems, there is sti ong way to go. Considering that the CAS has been in operation since 1965, these observations of the Marathe Committee are not encouraging. The reuctance of borrowers to compy with the requirements of the information system which constitutes a critica eement for the success of the present system of credit appraisa is a rea hurde in the way of achieving the objectives of the credit appraisa system. The use of the funds fow approach based on baance sheet information in setting credit imits instead of a cash fow approach aso makes monitoring of credit imits over the short term a difficut task. The operation of the credit appraisa system since the introduction of the Tandon Committee norms has evidenty succeeded in reducing dependence of industria borrowers on bank finance for meeting their working capita requirements. In the case of medium and arge pubic imited companies in the manufacturing sector the ratio of bank finance to tota current assets decined from 30.1 per cent in 1974-75 to 26.8 per cent in 1980-81, as reveaed in the reguar suryes of the finances of such companies undertaken by the Reserve Bank of India. In the case of arge pubics imited companies in the manufacturing sector for which survey resuts are avaiabe, it is seen that the ratio job bank finance to tota current assets decined from 26.9 per cent in 1980-81 to 26.3 per cent in 1981-82 and further to 23.1 per cent in 1982-83. The reduced reiance on bank finance has been made possibe for the better estabished companies since 1980 by either greater access to the capita market faciitated by modifications in the officia guideines for the issue of convertibe and non-convertibe debentures. For the buk of the essor known industria borrowers however, this woud not be the case. The atter have responded of stricter credit appraisa by banks by resorting to ways and means in increasing their current iabiities. The RBI survey indicates that to 1980-81 the ratio of current iabiities excuding bank borrowing in current assets was 53.3 per cent for arge pubic imited companies in the manufacturing sector. In comparison the ratio was 45.5 per cent for the medium and arge pubic imited companies in 1980-81 having risen from 36.9 per cent in 1974-75. This is not a surprising finding and one can reasonaby surmise that the effect of stricter credit appraisa was being passed on successivey by the arger borrowers to the smaer and weaker borrowers, to greater or esser degree depending on prevaiing economic conditions and the stance of monetary poicy. Burden of Financing Saes: The transmission mechanism of the impact of stricter enforcement of working capita norms in financing the arger borrowers noted above is suggestive of a simiar transmission of the burden of financing saes to government and semi-government agencies and pubic sector organisations who as a group are considered

Reguation of Bank Finance 435 to be sow in reeasing payments for suppies. The industria units whose funds are ocked up for ong periods due to deayed payment by government agencies woud perforce deay, in turn, their payments to their own suppiers, starting off a chain of events resuting in an extra burden of financing being paced on the sma scae industries who generay are unabe to obtain their suppies other than against cash payment. This probem has been recognised for quite some time now and not much progress has been made in evoving a suitabe soution. Even the Tandon Committee came up against this probem whie it was aying down norms for working capita financing. It noted that ike the pubic sector, government purchase agencies are the biggest buyers in the country. Today payments by Government and pubic sector wi ony increase the eve of receivabes of industry and consequenty the working capita requirements from banks for productive purpose. It woud be usefu if the Reserve Bank coud initiate discussions on this matter. We aso fee that Government shoud, pending streamining its procedures, agree to pay interest on estabished deayed payments. Even after a period of amost ten years since the Tandon committee made these remarks, no improvement in the position was noticeabe. The Tandon Committee itsef did not provide any cushion for such deayed payments from government agencies in evoving working capita norms, even though their recommendations were meant to cover a borrowers with credit imits of Rs. 10 akhs or more, thereby incuding a arge number of sma scae industria units. It is a matter of concern that the combined effect of stricter enforcement of credit norms in the case of the arger borrowers, and deayed payments by pubic sector and government agencies and other arge units woud be such as to pace a heavy financia burden on the suppiers in the sma scae sector, who are as a consequence driven to take recourse to credit from outside the organised sector at reativey higher cost as compared to bank finance. Remedia measures by way of earmarking credit imits for making payments to anciaries and sma scae industries have been thought of but are sti an insignificant eement in the present system of credit aocation and perhaps not easy to impement. Like the sma scae industries sector, another sector which finds itsef at a considerabe disadvantage in the present system of credit aocation, is the trade and distribution sector. As regards its roe as a suppier of raw materias to the industria sector it shares to some extent the probems faced by the sma scae industries in regard to working capita finance, though not a units in the trade sector are sma or financiay vunerabe, or weak in terms of bargaining power. The trade sector, in addition, has aso to face a different kind of probem in regard to working capita finance.

436 Financia Management Kannan Committee Report (The Latest Committee) With a view to free the banks from rigidities of the Tandon Committee recommendations in the area of Working Capita Finance and considering the ongoing iberaisation in the financia sector, IBA constituted, foowing a meeting of the Chief Executives of seected pubic sector banks with the Deputy Governor of Reserve. Bank of India on 31.8.96, a committee on Working Capita Finance incuding Assessment of Maximum Permissibe Bank Finance (MPBF), headed by K. Kannan, Chairman and Managing Director of Bank Baroda. The Committee examined a the aspects of working capita finance and gave far reaching recommendations on the modaities of assessment of working capita finance in its report submitted to IBA on February 25,1997. It observed that since commercia banks in India are undergoing a metamorphosis of dereguations and iberaisations, it is imperative that micro-eve credit administration shoud be handed by each bank individuay with their own risks-perceptions, risks-anaysis and risks-forecastings. The fina report of the Committee was submitted to RBI for its consideration in March, 1997. In its fina report, the Kannan Committee aso pointed that aongwith modification of existing systems of working capita assessment and credit monitoring, certain undermentioned areas require to be given greater attention: (1) Reguar interface with the borrower to have a better understanding of (i) his business/activity; and, (ii) probems/constraints faced by him and the future action pan envisaged; (2) Periodica obtaining of affidavits from the borrowers, decaring highights of their assets, iabiities and operating performance (in ieu of subjecting even the high rated/high vaued borrowers to severa routine inspections/verifications) in order to bestow faith-oriented, rather than ab initio doubt-oriented, approach in monitoring the credit dispensation. (3) Periodica exchange of information between/among financing banks/financia institutions to pick-up the aarm signas at the eariest. (4) Estabishing, within, a time bound programme, a Credit Information Bureau to provide updated information of existing/new borrowers before taking a credit decision. (Modaity of Information Bureau in advanced countries may be taken as a guide for foating an appropriate Credit Information Bureau). Accordingy, the Kannan Committee recommended that the arithmetica rigidities, imposed by Tandon Committee (and reinforced by Chore Committee) in the form of MPBF-computation, having so far been in vogue, shoud be given a go-by. The committee aso recommended for freedoms to each bank in regard to evoving their own system of working capita finance for a faster credit deivery in order to serve more effectivey various segments of borrowers in the Indian economy.

Reguation of Bank Finance 437 Concurring with recommendations of the Kannan Committee, Reserve Bank of India (vide circuar No. IECD No. 23/08.12.01/96 dated 15.04.1997) advised to a the banks, inter-aia, as under: It has now been decided that the Reserve Bank of India sha withdraw forthwith the prescription in regard to assessment of working capita needs based on the concept of maximum permissibe bank finance (MPBF) enunciated by Tandon Working Group. Accordingy, an appropriate system may be evoved by banks for assessing the working capita needs of borrowers within the prudentia guideines and exposure norms aready prescribed. The turnover method, as aready prevaent for sma borrowers. may continue to be used as a too of assessment for this segment: since major corporates have adopted cash budgeting as a too of funds management, banks may foow cash budget system for assessing the working capita finance in respect of arge borrowers; there shoud aso be no objection to the individua banks retaining the concept of the present maximun, permissibe bank finance, with necessary modifications or any system. Reserve Bank of India further directed that: Working capita credit may henceforth be determined by banks according to their perception of the borrower and the credit needs. Banks shoud ay down, through their boards, transparent poicy and guideines for credit dispensation in respect of each broad category of economic activity. New System of Assessment of Working Capita Finance Considering that Indian economy has aready ushered into shores of iberaisation and dereguations necessiating the banks in India to expeditiousy integrate with goba trends, foowed by an ongoing process of eimination of barriers between operationa areas of deveopment banks and commercia banks, the Kannan Committee coud not find any convincing justification to continue with separate assessment/fixations of jargon of various sub-imits, within overa working capita requirements, such as pre-sae finance, post-sae finance, domestic credit, export/ import credit, fund based imits and non-fund based imits. Instead, the Committee fet that Line of Credit System (LCS), as is prevaent in many advanced countries, shoud repace the existing system of assessment/fixation of sub-imits within tota working capita credit requirement. Under LCS, the borrower s working capita credit requirement is assessed at an outer imit (i.e., the maximum imit) which is fexibe enough to be used in one or more of the foowing forms as seected by the borrower in ieu of his requirements from time to time. In other words, the Line of Credit is not a credit faciity per se, but, is an outer imit for tota (funded and non-funded) working capita finance, and within this outer imit, various types

438 Financia Management of working capita funded and non-funded credit faciities (iustrative ist furnished in Tabe-1) with appropriate imits sha be made avaiabe to the borrower. TABLE 1 Note: The directive of Reserve Bank of India for Loan Deivery System in Working Capita finance are to be compied with scrupousy. The Committee noted: Entire Current Assets are to be the prime security for the confirmed Line of Credit LCS (i.e., fixed/outer imit of working capita finance whether funded finance or nonfunded finance) and any excess drawings/requirement over and above the confirmed LCS may be subjected to additiona rate of interest, say, upto 2.00%, to take care of the bank s cost of managing the uncommitted funds/obigation. However, specific ong term working capita requirements such as (Saes to Eectricity Boards, Bis Discounting under IDBI/SIDBI scheme etc. guaranteed by State/ Centra Government is proposed to continue to be separate as is at present. The financing pattern in this regard woud continue to be assessed taking into account quantum of Deferred Receivabes as is the practice at present. In the above context, the committee suggested that the existing system of assessment of working capita finance (based on MPBF-computations of Tandon Committee recommendations) may be repaced by a new system of assessment of working capita finance, ambodying essence of the deepy considered recommendations of the committee. The new system is proposed for a borrowers engaged in egay permitted economic/ financia activities excepting the foowing give in Tabe 2. TABLE 2 (1 (2 (3 (4 (5 1. NBFCs (Non banking Finance Companies) for whom, separate guideines for assessment of W/C finance are devised by RBI; 2. Construction Companies/Contractors for whom, separate guideines for assessment for assessment of W/C finance are suggested by RBI; 3. Tea Companies for whom. Cash Budget system is used to assess W/C finance 4. Ship breaking companies Existing system of W/C finance is to be continued. 5. Diamond Industry Existing system of W/C finance is to be continued. 6. Sma Scae Industria Undertakings requiring W/C funded finance upto Rs. 2 crores; for whom, RBI has directed to use "Turnover Method" propounded by Nayak Committee"

Reguation of Bank Finance 439 5. Diamond Industry Existing system of W/C finance is to be continued. 6. Sma Scae Industria Undertakings requiring W/C funded finance upto Rs. 2 crores; 7. Sma borrowers (a sectors) requiring: Working Capita finance upto Rs. 2.00 Lacs (Rupees Two Lacs) for whom, RBI has directed to use "Turnover Method" propounded by Nayak Committee" Most of such borrowers are usuay covered under one or the other Schemes Sponsored by various Governments/oca bodies. Therefore, financing requirements of such borrowers sha be met as per the directives of the reevant sponsored scheme. 8. Specific Long term working capita requirements such as Bis Discounting under IDBI/SIDBI schemes etc. Existing separatey set out guideines to continue to be in force. **Note: In Case of A Non-Priority Sector Borrowers, not covered under above points from 1 to 8', the Working Capita Credit requirement sha be assessed as per the Turnover Method appicabe for SSI-Borrowers requiring W/C-finance upto Rs. 200.00 acs. As a consequence of the proposed withdrawa of the existing system of working capita finance based on MPBF-system, though a arge eeway is avaiabe to the bank to adopt a new method/system, the committee envisaged to retain, with appropriate modifications, strengths, and to remove weaknesses, of existing MPBF-system simutaneousy doing away with its rigidities as regards (i) computation of working capita bank finance, and (ii) supervision and monitoring of the credit dispensed by the banks so that the proposed new system ensures faster credit deivery with inherent need and merit based fexibiities. Therefore, the committee proposed to shift emphasis from the Liquidity Leve Lending (which is de facto security based ending practised and stipuated so far by the banks), to the Cash Deficit Lending (which is in essence need based ending indicating the financia support required by a borrower). The cash deficit ending has been aimed at to percieve the borrower s requirement, rather than to assess, after the deserving risk-anays and risk-forecasting on case to case basis with perusa of the acceptabiity of the borrower s overa financia status, projected eve of iquidity and activity, market reports, industry/activity profie and the economic strata which a particuar borrower beongs to. As such, the new system of working capita finance may be caed as Desirabe Bank Finance (DBF). The committee recommended to put DBF method in force immediatey with the aim to make it fuy operationa over a period of 3-4 months, i.e., with effect from Apri 1, 1998 in order to afford, wherever necessary, adequate breathing time to bank staff and borrowers for deveoping famiiarity with DBF method and aso to coincide with start of new financia year for most of the borrowers as we as for the bank to afford operationa convenience. The outines of the DBF-method, as conceived by Kannan Committee, are discussed hereunder:

440 Financia Management 1. Genera Guideines 1. The DBF method sha be appicabe to working capita finance granted by a bank whether it is in soe banking or in mutipe banking or in consortium banking arrangements. In mutipe banking or consortium banking, there may be a situation where other banks are foowing a different method of working capita finance. In such a case:. (a) if a bank is eader or hoding the highest share in tota working capita finance (i.e., tota of funded and non-funded finance), the bank sha adopt the DBF-method and other banks sha be requested to accept the same; (b) if a bank is not a eader or hoding smaer percentage shares in tota working capita finance (i.e., tota of funded and non-funded finance), the bank may accept the assessment done by the consortium eader or the bank having argest share in the working capita financing, as the case may be, provided the bank is prima facie satisfied with efficacy of the method adopted by the consortium eader or the bank having argest share; otherwise, the bank sha foow DBF-method. (2) Wherever any of borrower is having muti-division activities/businesses, the working capita credit requirement sha be perceived/assessed separatey for each of the division as is done at present. (3) At present, cassification of Current Assets and Current Liabiities for the purpose of arriving at current ratio and for computing MPBF are different and the dua approaches often causes misunderstandings and confusions. Therefore, the committee proposed that, henceforth, there wi be ony one singe cassification of Current Assets and Current Liabiities and wi be substantiay be the same as is directed in the Form No. 111 (i.e., the extant CMA-guideines for cassification of C/As and C/Ls for the purpose of arriving at Current Ratio) subject to the changes briefed out hereunder: (a) (b) (c) The components of the inventory procured under any of the Nonfunded imits (viz., Letter of Credit and Guarantee) sha form part of Tota Current Assets and the corresponding outstanding iabiities for payments therefore sha be added to Tota Current Liabiities so as to arrive at the rea financia position and short term sovency position of the borrower. Accordingy, the cash margins for L/Cs and Guarantees sha be part of tota Current Assets. The amount of the Inter- corporate Deposits (ICDs), repayabe by the

Reguation of Bank Finance 441 borrower within a period of 12-months, sha be treated part of Tota Current Liabiities. Simiary, if the borrower has made investments in ICDs for a period esser than-12-months, then, such ICDs sha be treated as Current Assets and the other ICDs sha be treated as Noncurrent Assets. (d) (e) (f) The instruments/outstandings, such as, Commercia Paper (CP), Certificate of Deposits (CD) and other money market instruments, represent temporary (for a period ess than 12 months) parking of the funds by the borrower. Such instruments/outstandings are to be treated as Current Assets. However, ICDs, investments in shares and debentures (incuding in associates and subsidiaries), even hed for a period of ess than 12 months, sha be treated as Non-current Assets. Wherever, DBF-method envisages any item s cassification different, from the extant CMA-guideines, the cassification of Current Assets and Current Liabiities sha be done in conformity with the DBF-method. (4) Before sanction of any adhoc/excess over the sanctioned imit (whether funded or non-funded faciity), the borrower sha be asked to submit a proper Cash Fow statement so as to satisfy timey adjustment/iquidation of the adhoc-excess. The adhoc-excess may be subjected, at the discretion of the sanctioning authority, to evy of additiona interest upto 2.00% p.a. to moot the cost of arranging additiona funds/ obigations for the adhoc/excess. (5) Banks instructions on foow-up and supervision of working capita finance sha continue to be in force, mutatis mutandis with DBF-method and its guideines narrated hereinafter. (6) There sha be no commitment charge on unutiised portion of working capita finance. However, on a persistent defaut in avaiing at east 80% of the sanctioned imit, the Branches, where such accounts are maintained, sha ensure to review/to get reviewed, as the case may be, the borrower s working capita credit requirement by the competent authority for necessary revision/modification in the sanctioned imit. (7) At the time of fresh sanction and sanction for review with modifications in the existing imits, and aso for modifications in any of the stipuated terms and conditions, the borrowers are at present required to furnish foowing forms to which foowing modifications are proposed in TabIe-3

442 Financia Management TABLE 3 Forms Nos Existing particuars I. Particuars of existing/ proposed imits from the banking system Proposed Particuars Particuars of existing/proposed imits/faciities/finance from: (a) each banks; (b) each financia institution for working capita credit requirement; (c) NRFCs; (d) ICDs. II. Operating Statement Operating statement with additiona particuars required under the DBF-method. III. IV. Anaysis of Baance Sheet Comparative statement of Curren Assets and Current Liabiities V, Computation of MPBF for Working Capita VI. Funds Fow Statement Anaysis of Baance Sheet with additiona particuar required under the DBF-method. Comparative Statement of Current Assets and Current Liabiities with additiona particuars required under DBFmethod. Cash Budgets as required under the DBF-method Report on Financia indicators as required under the DBFmethod. Remarks Appicabe to a the borrowers irrespective of the size of the finance required. {} (} {} {} Operationa guideines and the appicabiity criterion for the various borrowers sha be formuated separatey in the micro-eve detais and guideines/ instructions. {} {) {} {) (8) As aready discussed above, under the DBF-method, a Line of Credit (i.e., the outer imit for entire working capita finance) sha be fixed, within which, the borrowers sha be given freedom to seect, for fu one year or for a part of the year, sub-imits in one or more out of the various existing types of credit faciities. In other words, the ine of credit is not a credit faciity or credit deivery mode per se, but, is an outer imit of tota (funded and non-funded) working capita finance, and within this outer imits, various existing types of working capita funded and non-funded credit faciities with appropriate imits sha be made avaiabe to the borrower at the discretion of the sanctioning authorities. (9) RBI had advised that in the interest of deveoping bis cuture in the system, out of the tota inand credit purchases of the borrowers, not ess than 25%, shoud be through bis drawn on them by concerned seers. Accordingy, the RBI had again urged to ensure that with effect from January 1, 1998, of the tota credit purchases of the borrowers, not ess than 25 per cent, shoud be through bis drawn on them by concerned seers. The Committee supported the above instruction fuy. (10) The Drawing power sha continue to be cacuated with periodica statements

Reguation of Bank Finance 443 of stock, book-debts etc. as per bank s extant guideines. However, the care has to be taken for fixation of the margin to ensure that against the adequate hoding of stocks, book-debts etc., the aggregate drawing power does not become short of the Line of Credit, i.e., the outer imit fixed for tota working capita imit. In other words, the existing discrepancy of the drawing power usuay being ess than the MPBF shoud not happen whie working out the drawing power under the proposed DBF method. Categorisation of Borrowers According to Size of Working Capita Finance 1. For Non-SSI borrowers requiring working capita finance over Rs. 2.00 acs and upto Rs. 10.00 acs from the banking system: Considering size of the imit (extent of funded W/C finance) required by such borrowers, and aso the operationa vagaries these borrowers are constrained to face and as aso their en mass contribution to micro-eve economic strata, the Committee proposed a simpified turnover-based method of perceiving W/C credit requirement for such borrowers as per the Annexure- 2. For Non-SSI borrowers requiring working capita finance over Rs. 10.00 acs and upto Rs. 500.00 acs, and SSI borrowers requiring working capita finance over Rs. 200-00 acs but upto Rs. 500.00 acs from the banking system: For this segment of the borrowers aso, the Committee proposed to adopt turnover based method of perceiving W/C credit requirement. Nevertheess, since this segment of borrowers are pre-supposed to have a better data base of their operations and of financia heath and, size of the imit to these borrowers demands a high eve of bank-exposure, the committee proposed reativey detaied anaysis and supervision. Therefore, the method enunciated as per the Annexure-2 is proposed. 3. For a borrowers requiring W/C finance over Rs. 500.00 acs but upto Rs. 1000.00 acs (for both SSI as we as Non-SSI borrowers) from the banking system: The borrowers requiring the above said size of imit are either corporate or ikey to graduate to corporate-constitution in near future and, as such, are beieved to have a better data-base of their operations. Moreover, the aggregate of the imits under the above said size puts the bank s exposure as a whoe at a substantia eve. Therefore, the committee proposed that assessment of working capita finance within this size of imit shoud continue to be on the basis of hoding of Current Assets/Liabiities at present and ater on switch over to the method of Cash Deficit financing when it is stabiised fuy of higher scae of working capita finance. Accordingy, the Annexure- 4. For a borrowers requiring W/Cfinance over Rs. 1000.00 ac (for both SSI as we as Non-SSI borrowers) from the banking system: The borrowers,

444 Financia Management requiring this size of imit, (i) are in upper strata of the economy; (ii) are predominanty corporates, and therefore, are statutoriy required to maintain various financia data base and statements (such as, baance sheet, profit and oss Account, Fund Fow statements etc.) as per the proforma prescribed under the reevant statutes/acts apart from being statutoriy subjected to at east annua audits; (iii) have in-buit system to maintain easiy and prompty retrievabe wide data-base to faciitate in-depth anaysis and understanding of the borrower s profie; and, (iv) usurp a ion s share of the bank s endabe resources in the arena of working capita finance. Such borrowers do not generay run out of adequate hoding eve of inventory and/or receivabes but suffer more from the cash deficits arising from time to time. Further, because of the mammoth size of the finance required by such borrowers, the banks are more required to vigi their funds-managing abiity to timey resource the funds-avaiabiity as we as to conceive a proper funds-depoyment. In view of the above, arriving at a merit based credit decision necessitates a coser riskforecasting derived from: (i) (ii) detaied risks-anaysis carried out with the intra-firm comparison, and interfirm comparison if necessary, of the borrower s financia and operationa statements and projections; and, risk-perceptions based on the interface with the borrowers, the market reports, industry/activity-profie, manageria competence, government poicies and crosscountry risks (wherever appicabe). In this context, the committee suggested that the quantum of working capita finance shoud be decided based on perception of the cash-deficit ikey to be experienced by the borrower over the foreseeabe/predictabe near future as per the Cash Budget proformae on the Annexure-4A. However, since the cash deficit system is to have its induction for the first time, the committee suggested the banks to satisfy upon the veracity of the perceptions, generated out of the aforesaid, with a ist of financia indicators. It may be noted that reasonabeness of Current ratio and Debt equity ratio (DER) as we as margin and hoding eve of inventory/receivabes sha be at the discretion of the sanctioning/recommending authorities as per individua merits on case to case basis. Nevertheess, wherever the sanctioning authorities acquiesces to (i) Current Ratio (a) ess than 1.17 for working capita finance ess than Rs. 10.00 acs, and (b) ess than 1.33 for working capita finance of and above Rs. 10.00 acs; and, (ii) Debt equity ratio more than 2:1, necessary justification for accepting ower current ratio and/or higher DER is to be eucidated. However, periodica verification of current assets/iabiities is to be done by the bank s officia(s) and/or, subject to approva of the sanctioning authority

Reguation of Bank Finance 445 and generay on haf-yeary basis, by a practising Chartered Accountant (other than the company s statutory/interna auditors). However, wherever the branch-officia picks up any aarm signa and consider it necessary that a detaied inspection/verification of the securities charged to the bank is required to be carried out by a Chartered Accountant or approved vauer/engineer, they may do so (in consutation with the next higher authority) without waiting for forma approva of the sanctioning authority provided the branch seeks confirmation for this action within a period of-15-days of having initiating the said inspection/verification. Some of the recommendations with suitabe modification have aready been accepted by Reserve Bank for impementation. Whie announcing the Monetary and Credit Poicy for the first haf of 1997-98 on 15th Apri, 1997, Reserve Bank of India inter-aia spet out various measures reating to credit dispensation by the banks. Fu freedom has since been given to banks to frame its own methods for assessment of working capita needs of the borrowers. The detais of important measures announced by Reserve Bank are us under: (i) Prescription as regards to assessment of working capita needs based on the concept of Maximum Permissibe Bank Finance (MPBF) enunciated by Tandon Working Group has been withdrawn. Banks may evove an appropriate system for assessing working capita needs of the borrowers, within the prudentia guideines and exposure norms which have aready been prescribed by Reserve Bank of India. Prudentia exposure norms as per extant guideines of Reserve Bank of India provide that the maximum exposure of a bank for a its fund based and nonfund based credit faciities, investments, underwriting, investment in bonds and commercia paper and any other commitment shoud not exceed 25 per cent of its (bank s) networth to an individua borrower and 50 per cent of its networth to a group. It may however, be noted that whie cacuating exposure, the non-fund based faciities are to be taken at 50 per cent of the sanctioned imit. To iustrate the point et us consider the foowing exampes: Exampe 1. Net worth of the bank Rs. in crore Maximum exposure permitted for an individua Borrower (25% of networth of the bank) Maximum exposure permitted for a borrowers under the same group (50% of net worth of the bank) Exampe 2. Limits sanctioned to a borrower (i) Fund Based 100 (ii) Non Fund Based 100 Tota Exposure Tota 200 (i) For fund Based imits @ 100% of imits 100 175 350 700

446 Financia Management Tota credit imits to the above borrower are Rs. 200 crores wihch are in excess of the maximum exposure norm of Rs. 175 crores. But for the purpose of determining exposure we have taken non-fund based imits at 50 per cent of its vaue and tota exposure is taken at 150 cores which is we within the norm. (ii) (iii) (iv) (v) (ii) Non Fund Based Tota Exposure (vi) Tota 200 (i) For fund Based imits @ 100% of imits 100 (ii) For Non-funds Based imits @ 50% of imits 50 As per a recent cassification of Reserve Bank, oans and advances against bank s own deposits may not be incuded whie arriving at over a exposure to a borrower. Tota exposure to group is permitted upto 60 per cent if the additiona exposure is on account of finance to infrastructure finance. However, exposure norm to individua borrower remains restricted to 25% ony even in such cases. The turn over method, as aready prevaent for sma borrowers, may continue to be used as a too of assessment for this segment. For sma scae and tiny industries etc., this method of assessment may be extended upto tota credit imits of Rs. 2.00 crores as against existing cut-off point of Rs. 1.00 crore. Banks may adopt cash budgeting system for assessing the working capita finance in respect of arge borrowers. Reserve Bank of India has however, not suggested any specific form for assessment of working capita based upon cash budgeting. Kannan Groups has given a form which may be adopted by the banks with suitabe modifications. In any case it has been eft to the banks to evove their own method/form for this purpose. The banks may aso retain the concept of the present maximum permissibe bank finance with necessary modification or any other system as they deem fit. Banks shoud ay down with due approva of their boards, transparent poicy and guideines for credit dispensation in respect of each broad category of economic-activity. Rsserve Bank s instructions reating to directed credit (such as priority sector, export etc.), quantitative imits on ending (such as against shares and for consumer durabes etc.) and prohibitions of credit (such as bridge finance, rediscounting of bis earier discounted by NBFCs etc.) sha continue to be in force. 100 150

Reguation of Bank Finance 447 (vii) The present reporting system to Reserve Bank of India under the Credit Monitoring Arrangement (CMA) sha aso continue in force. MPBF system as per the recommendation. of Tandon Committee report was introduced in November, 1975 and has been we estabished by now. Despite its prescription being withdrawn by Reserve Bank, most of the banks are sti continuing with this approach. Cash budgeting system wi require many changes in the accounting system being present adopted by the borrowers and a new information system, the transition to the new system is, therefore going to be sow and perhaps no Indian Bank has adopted this system of assessment of working capita needs so far in the rea sense. Many banks have however, adopted turnover method for assessment of working capita needs upto Rs. 2.00 crores in respect of a borrowers. Recent RBI Guideines Regarding Working Capita Finance The foowing recent changes have been made by RBI in the guideines for bank ending for working capita purposes and by way of term oans. These measures are set out beow: (i) Lending Norms for Working Capita (a) (b) (c) Banks woud henceforth decide the eves of hoding of individuas item of inventory as aso of receivabes, which shoud be supported by bank finance, after taking into account the production/processing cyce of an industry as we as other reevant factors. RBI woud no more prescribe detaied norms for each item of inventory as aso of receivabes; it woud ony advise the overa eves of inventory and receivabes for different industries to serve as broad indicators for guidance of banks. Banks woud be free to sanction ad hoc credit imits to borrowers, where considered necessary and charging of additiona interest for this purpose is no onger mandatory. Other aspects of the ending discipine, viz., maintenance of minimum current ratio, submission and use of data furnished under quartery information system, etc. woud continue, though with certain modifications, which woud make it easier for smaer borrowers, to compy with these guideines. ii. Treatment of term oan instaments for assessment of working capita purposes Hitherto term oan instaments faing due for repayment in the next tweve months were treated as part of current iabiities for assessment of maximum permissibe bank finance (MPBF). In terms of current poicy, which was impe-mented in stages, such instaments are not required to be treated as an item of current iabiities for the imited

448 Financia Management purpose of assessing MPBF. These instaments continue to be treated as current iabiities for a other purposes incuding for cacuation of current ratio. iii. Export Credit (i) (ii) (iii) In order to ensure that the credit requirements of exporters are prompty met and their additiona credit requirements out of firm orders/confirmed etters of credit, not taken into account whie fixing their reguar credit imits, the banks were advised in December 1992 to sanction such additiona credit imits, even in excess of maximum permissibe bank finance (MPBF). Borrowing units engaged in export activities need not bring in any contribution from their ong-term sources towards financing that portion of current assets as is represented by export receivabes. Banks were aso advised not to appy the Second Method of Lending for assessment of MPBF to those exporter borrowers, who had to their credit export of not ess than 25 per cent of their tota turnover during the previous accounting year provided their aggregate fund-based working capita imits from the banking system were ess than Rs. 1 crore. Whie announcing the credit poicy for the first haf of 1997-98 (Apri-Sept.), the RBI has withdrawn its earier instructions regarding MPBF and has given freedom to banks to determine working capita requirements of the borrowers on their own. The cash credit to oan ratio in the working capita imit has been fixed as foows: Category of Borrower (i) Borrowers with a credit imit of ess than Rs. 10 crore (ii) Borrowers with credit imit Cash Credit to Loan Ratio Bank and the Borrower can sette freey between Rs. 10 and 20 crore 25 : 75 (iii) Borrowers with credit imit Rs. 20 crore and more 20:80