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= e
r
1 = e
0.1823
1 = 20%
Time-Value Equivalence:
Two things are equivalent when the produce the same effect. The comparison of various
alternative projects necessitates the use of equivalence principle, wherein receipts and payments
occurring at different time periods are expressed on an equivalent basis. In fact, equivalence is
the heart of making engineering economic decisions.
Ex: i) Rs 100 today is equivalent to Rs. 108 after 1 year at 10% interest compounded annually
ii) Rs. 100 today is equivalent to Rs. 23.74 received at the end of each year for the next 5
years.
iii) Rs. 23.74 received at the end of each year for the next 5 years is equivalent to a lump
sum of Rs. 179.1 received 10 years from now.
iv) Rs. 23.74 received at the end of each year for the next 5 years is equivalent to Rs.
31.77 at the end of years 6, 7, 8, 9 and 10.
Cash Flow Diagrams
A cash flow diagram is a pictorial representation of all cash inflows and outflows along a time
line. The time line is the horizontal scale, which is divided into time periods, usually in years.
Cash inflows and cash outflows are then located on the time-line in adherence to problem
specifications by drawing vertical lines above the axis and below the axis respectively.
Compound Interest Factors:
Single-Payment Compound Amount / Future value of an amount:
Here, the objective is to find the-single future-sum (F) of the initial payment (P) made at time 0
after n periods at an interest rate i compounded every period.
P
0
A
1
2 3 4 - - n
F
Fig 1: Cash flow diagram of single-payment compound amount
The formula to obtain the single-payment compound amount is:
F = P (1+i)
n
= P (F/P, i, n)
Where, (F/P, i, n) is called as single-payment compound amount factor
Ex: A person deposits a sum of Rs. 20,000 at the interest rate 18% compounded annually for
10 years. Find the maturity value after 10 year.
Sol: P = Rs. 20,000
i = 18% compounded annually
n = 10 years F
F = P (1 + i)
n
= P (F/P, i, n) = 20,000 (F/P, 18%, 10)
= 20,000 x 5.234 = Rs. 1, 04, 680
The maturity value of Rs. 20,000 invested now at 18% compounded yearly is equal to
Rs.1, 04, 680 after 10 years.
Single Payment present worth amount:
Here, the objective is to find the present worth amount (P) of a single future (F) which will be
received after n periods at an interest rate of compound at the end of every interest period.
Fig 2: Cash flow diagram of single-payment present worth amount
The formula to obtain the present worth is:
P = F / (1+i)
n
= F (P/F, i, n)
Where, (P/F, i, n) is called as single-payment present worth factor
Ex: A person wishes to have a future sum of Rs. 1, 00, 000 for his sons education after 10
years from now. What is the single-payment that the deposit now so that he gets the
desired amount after 10 years? The bank gives 15% interest rate compounded annually.
Sol: F = Rs.1.00.000
i = 15%, compounded annually
n = 10 years
P = F/ (1+i)
n
= F (P/F, i, n) = 1, 00, 000 (P/F, 15%, 10)
P
0
1 2 3 4 A
-
-
- n
F
i%
i%
= 1, 00, 000 x 0.2472 = Rs. 24,720
The person has to invest Rs.24, 720 now so that he will get a sum of Rs.10, 000 after 10
years at 15% interest rate compounded annually.
Equal-Payment Series Compound Amount / Future value of an annuity:
The objective is to find the future worth of n equal payments which are made at the end of every
interest period till the end of the n
th
interest period at an interest rate of compounded at the end of
each period.
Fig 3: Cash flow diagram of equal-payment series compound amount.
The formula to get F is:
F = A [(1+i)
n
1] / i = A (F/A, i, n)
Where, (F/A, i, n) is termed as equal-payment series compound amount factor.
Ex: A person who is not 35 years old is planning for his retired life. He plans to invest an
equal sum of Rs.10, 000 at the end of every year for the next 25 years starting from the
end of the next year. The bank gives 20% interest rate, compounded annually. Find the
maturity value of his account when he is 60 years old.
Sol: A = Rs. 10,000
n = 25 years
i = 20%
F = A [(1+i)
n
1] / i = A (F/A, i, n) = 10,000 (F/A, 20%, 25)
= 10,000 x 471.981 = Rs. 47, 19, 810
The future sum of the annual equal payments after 25 years is equal to Rs. 47, 19,810.
Sinking Fund Amount:
In this type of investment mode, the objective is to find the equivalent amount (A) that should be
deposited at the end of every interest period for n interest periods to realize a future sum (F) at
the end of the nth interest period at an interest rate of i.
Fig 4: Cash flow diagram of equal payment series sinking fund
A A A A - - A
F
1 2 3 4
n
0
i %
A A A A - - A
F
1 2 3 4
n
0
i %
The formula to get F is:
A = F [i / {(1+i)
n
1}] = F (A/F, i, n)
Where, (A/F, i, n) is called sinking fund factor.
Ex: A company has to replace a present facility after 15 years at an outlay of
Rs.5, 00, 000. It plans to deposit an equal amount at the end of every year for the next 15
years at an interest rate of 18% compounded annually. Find the equivalent amount that
must be deposited at the end of every year for the next 15 years.
Sol: F = Rs. 5, 00, 000
n = 15 years
i = 18%
A = F [i / {(1+i)
n
1}] = F (A/F, i, n) = 5, 00, 000 (A/F, 18%, 15)
= 5, 00, 000 X 0.0164 = Rs.8, 200
The annual equal amount which must be deposited for 15 years is Rs.8, 200.
Equal Payment Series Present worth amount:
The objective is to find the present worth of an equal payment made at the end of every interest
period for n interest periods at interest rate of i compounded at the end of every interest period.
The formula to compute P is:
P = A [(1+i)
n
1] / i (1+i)
n
= A (P/A, i, n)
Where, (P/A, i, n) is called equal-payment series present worth factor.
Fig 5: Cash flow diagram of equal-payment series present worth amount.
Ex: A company wants to set up a reserve which will help company to have an annual
equivalent amount of Rs. 10, 00, 000 for the next 20 years towards its employees welfare
measures. The reserve is assumed to grow the rate of 15% annually. Find the single-
payment that must be made now the reserve amount.
Sol: A = Rs.10, 00, 000
i = 15%
n = 20 years
P = A [(1+i)
n
1] / i (1+i)
n
= A (P/A, i, n) = 10, 00, 000 x (P/A, 15%, 20)
= 10, 00, 000 X 6.2593 = Rs. 62, 59, 300
The amount of reserve which must be set-up now is equal to Rs. 62, 59, 300
Equal-Payment Series Capital Recovery Amount:
A A A A - - A
n
1 2 3 4
P
i %
The objective is to find the annual equivalent amount (A) which is to be recovered at the end of
every interest period for n interest periods for a loan (P) which is sanctioned now at an interest
rate of i compounded at the end of every interest period.
Fig. 6: Cash flow diagram of equal-payment series capital recovery amount.
The formula to compute P is as follows:
A = P [i (1+i)
n
/ {(1+i)
n
1}] = A (P/A, i, n)
Where, (A/P, i, n) is called capital recovery factor.
Ex: A bank gives a loan to a company to purchase an equipment worth Rs. 10, 00, 000 at an
interest rate of 18% compounded annually. This amount should be repaid in 15 yearly
equal installments. Find the installment amount that the company has to pay to the bank.
Sol: P = Rs. 10, 00, 000
i = 18%
n = 15 years
A = P [i (1+i)
n
/ {(1+i)
n
1}] = A (P/A, i, n) = 10, 00, 000 x {AIP, 18%, 15)
= 10, 00, 000 x (0.1964) = Rs. 1, 96, 400
The annual equivalent installment to be paid by the company to bank is Rs. 1, 96, 400.
Uniform gradient series factor (A/G, i, N):
In some cases, the periodic payments don't occur at an equal series. They may increase or
decrease by a constant amount. For example a series of payments would be uniformly increasing
in Rs. 200, 250, 300 and 350 occurring at the end of the first, second, third and fourth years.
Similarly a uniformly decreasing series will be Rs. 200, 150, 100, 50 occurring at the end of first,
second, third and fourth years. In each case, an equal payment series provides the base with a
constant annual increase or decrease at the end of the second year.
The pattern of an arithmetic gradient is then A', A' + G, A' + 2G ... A' + (N-l) G where N is the
duration of the series. The calculation can be made simple by converting the series to an
A
-
-
A
1
A A
-
-
A
-
-
A
-
-
A
n A
-
-
A
-
-
A
-
-
A
-
-
A
-
P
0
200
250
300
1 2 3 4
G
2G 3G
Fig 7
350
equivalent annuity of equal payments A. The formula for the translation is developed by
separating the series in two parts:
1) First for base annually designated A
2) Second for an arithmetic gradient series increasing by G each period.
(1)
End of year
(2)
Gradient series
(3)
Set of series equivalent
to gradient series
(4)
Annual series
0 0 0 0
1 0 0 A
2 G G A
3 2G G+G A
: : :
: : :
n-1 (n-2) G G+G+G+G A
n (n-1) G G+G+G.+G+G A
F = G (F/A, i, n 1) + (F/A, i, n-2) + G (F/A, i, 2) + (F/A, i, 1)
=
( ) ( ) ( ) ( ) ( ) [ ] 1 1 1 .... 1 1
2 2 1
+ + + + + + + +
n i i i i
i
G
n n
( ) ( ) ( ) ( ) [ ]
i
nG
i i i i
i
G
n n
+ + + + + + + + +
1 1 1 ... 1 1
2 2 1
The bracket terms constitute the equal payment series compound amount factor for n years.
Therefore,
( )
i
nG
i
i
i
G
F
n
1
]
1
1 1
= G (A/G, i, n)
Thus, A = A + G (A/G, i, n)
Annuity with an unknown:
Annuity is characterized by:
(1) Equal payments (A)
(2) Equal periods between payment N and
(3) The first payment occurring at the end of the first period.
Ex: We purchased a machine by paying Rs 10,000 to reduce the cost of production. The
machine's life time is 5 years and has no resale value and the machine reduces the cost of
production by Rs. 3000. Find out what rate of return will be earned on the investment.
Sol: A = 2000
N = 5
P = 10,000
P = A (P/A, i, 5)
3333 . 3
3000
000 , 10
/ A P
For i = 15, (P/A 15, 5) = 3.3572
For i = 16, (P/A, 16, 5) = 3.2743
By interpolation:
i =
753 . 0 15
2743 . 3 3522 . 3
2743 . 3 3333 . 3
1 15 +
,
_
+
= 15.75%.
Annuity due:
A series of payment made at the beginning instead of the end of each period is referred as
annuity due. In this case, calculation will be as follows:
1. The series should be divided in to two equal parts.
2. First payment should be treated separately
3. Remaining payment should follow the rule of general annuity calculation.
Ex: What is the present worth of a series of 10 years end payments of Rs 1000 each, when the
first payment is due today and the interest rate is 5%?
Sol: A = Rs 1000
P = A + A (P/A, 5, 9) = 1000 +1000 (7.1078)
= 1000 + 7107.8 = Rs. 8107.8
Deferred annuity:
In case of deferred annuity the first payment doesn't begin until some date later than the end of
the first period.
Procedure:
i) Divide the series in to two equal parts.
ii) One part is number of payment paid which follow the general annuity calculation
iii) Second part is the number of period
iv) Find out present worth of annuity, and then discount these values through pre-annuity
period.
Evaluation of Engineering Projects
Project can be defined as a temporary endeavor to create a unique product or service e.g.
designing a new product, building a plant etc. Project contains a combination of organizational
resources pulled together to create something which did not previously exist. All projects involve
capital expenditure which is nothing but an initial fund requirement at present, mostly, and
resulting in expected future benefit patterns.
Capital budgeting is a process used to determine whether a firms proposed investments or
projects are worth undertaking or not. This is a strategic asset allocation process and
management needs to use capital budgeting techniques to determine which project will yield
more return over a period of time.
A Project whose cash flows have no impact on the acceptance/rejection of other projects is
termed as Independent Project. A set of projects from which at most one will be accepted is
termed as Mutually Exclusive Projects.
Following are the capital budgeting techniques:
Present worth method / Net Present Value method
Future worth method
Equivalent Annual Worth method
Internal Rate of Return method
Profitability Index
Payback Period
Capital budgeting techniques give same acceptance or rejection decisions regarding independent
projects but conflict may arise in case of mutually exclusive projects. In such cases, net present
value method should be given priority due to its more conservative or realistic reinvestment rate
assumption. The Net Present Value and Internal Rate of Return, both methods are superior to the
payback period, but Net present Value is superior to even Internal Rate of Return.
Present Worth Method (PW):
Under this method, the present worth of all cash inflows (revenues) is compared against the
present worth of all cash outflows (costs) associated with an investment project. The cash flow of
each alternative will be reduced to time zero at discount rate i. Then, depending on the type of
decision, the best alternative will be selected by comparing present worth amounts of the
alternatives. The difference between the present worth of the cash flows (inflows outflows)
referred to as Net Present Worth (NPW) determines whether or not the project will be accepted.
For Independent Projects:
If PW > 0, then select the proposal
If PW < 0, then reject the investment project.
If PW = 0, remain indifferent to the investment.
For mutually exclusive alternatives, PW of cash flows can be calculated by either revenue
based present worth method or cost based present worth
In a revenue dominated cash flow diagram, the profit, revenue, salvage value (all inflows) will
be assigned with positive sign. The costs (out flows) will be assigned with negative sign. In a
cost dominated cash flow diagram, the costs (out flows) will be assigned with positive sign and
the profit, revenue; salvage value (all inflows) will be assigned with negative sign. In case the
decision is to select the alternative with maximum profit, then the alternative with the maximum
PW will be selected. If the decision is to select the alternative with the minimum cost, then the
alternative with the least PW will be selected.
S
Revenue dominated cash flow diagram
R
1
R
2
R
3
R
n
0 1 2 3 n
P
Where, P is the initial investment
R
n
is the net revenue at the end of nth year.
i is the interest rate compounded annually
S is the salvage value at the end of the nth year.
The present worth expression is:
PW (i) = -P + R
1
(P/F, i, 1) + R
2
(P/F, i, 2) + . + R
n
(P/F, i, n) + S (P/F, i, n)
If it is a uniform series or equal payment series then the formula will be
PW (i) = -P + R (P/F, i, n) + S (P/F, i, n)
Cost dominated cash flow diagram S
0 1 2 3 4 5 n
P C
1
C
2
C
3
C
4
C
5
C
n
Where, P is the initial investment
C
n
is the net cost of operation and maintenance at the end of the nth year
S is the salvage value at the end of the nth year
C
n
is the discounted rate of interest
The present worth expression is:
PW (i) = P + C
1
(P/F, i, 1) + C
2
(P/F, i, 2) + . + C
n
(P/F, i, n) - S (P/F, i, n)
If it is a uniform series or equal payment series then the formula will be
PW (i) = P + C (P/F, i, n) - S (P/F, i, n)
Ex: Given the following information, suggest which technology should be selected based on
present worth method, assuming 15% interest rate compounded annually.
Technology Initial Cost (Rs.) Service Life Annual O & M Cost
A
B
4,00,000
5,00,000
15 Years
15 Years
25,000
29,000
Sol: The cash flow diagram of technology A is:
0 1 2 3 . 14 15
Rs. 25,000
Rs. 4, 00, 000
PW (15%)
A
= 400000 + 25000 (P/A, 15, 15) = Rs. 400000 + Rs. 25,000 (5.8474)
= Rs. 4, 00, 000 + Rs. 1, 46, 185 = Rs. 5, 46, 185
The cash flow diagram for technology B is:
0 1 2 3 . 14 15
Rs. 29,000
Rs. 5, 00, 000
PW (15%)
B
= Rs. 500000 + Rs. 29000 (P/A, 15, 15) = Rs. 500000 + Rs. 29,000 (5.8474)
= Rs. 5, 00, 000 + Rs. 1, 69, 575 = Rs. 6, 69, 575
Since PW amount of technology A is lower, hence technology A is to be selected.
Comparison of Projects having Unequal Lives:
In order that projects are comparable, they must be made co-terminated i.e. their termination
point be made same. Projects are made co-terminated by using either Common Multiple Method
or Study Period Method.
In common multiple method, LCM of lives of various projects is calculated and projects are
repeated as many times till their LCM is reached. Suppose, three projects have lives respectively
2, 3 and 4 years, then their LCM is 12 which means the 1
st
project would be repeated 5 more
times, 2
nd
for 3 more times and the 3
rd
for 2 more times to make all projects co-terminated.
In study period method, a limited period which is same for both projects is selected and cash
flows during the period are considered while all cash flows beyond the period are ignored.
Ex: The data of two lease options (A & B) are given below:
A B
First Cost (Rs.)
Annual Lease Cost (Rs.)
Annual Returns (Rs.)
Lease Term (years)
-150, 000
-35, 000
10, 000
6
-1, 80, 000
-31, 000
20, 000
9
(a) Determine which lease option should be selected if the interest rate is 15%?
(b) If the study period of 5 years is used, which option should be selected?
Sol: (a) LCM of the lives of two lease options i.e. of 6 and 9 is 18.
PW
A
= -1, 50,000 [1 + (P/F, 15, 6) + (P/F, 15, 12)] 35,000 (P/A, 15, 18)
+ 10,000 [(P/F, 15, 6) + (P/F, 15, 12) + (P/F, 15, 18)]
= Rs. 4, 50, 360
PW
B
= -1, 80,000 [1 + (P/F, 15, 9)] 31,000 (P/A, 15, 18)
+ 20,000 [(P/F, 15, 9) + (P/F, 15, 18)]
= Rs. 4, 13, 840
Since PW
B
> PW
A
, Option B is selected.
(b) For 5-year study period:
PW
A
= -1, 50,000 35,000 (P/A, 15, 5) + 10,000 (P/F, 15, 5) = -2, 62, 360
PW
B
= -1, 80,000 31,000 (P/A, 15, 5) + 20,000 (P/F, 15, 5) = -2, 73, 970
Since PW
B
< PW
A
, Option A is selected.
Comparisons of Projects having Infinite Lives:
There are some projects like dams, bridges, rail roads etc. whose life is very difficult to
determine. In such cases, projects are compared by finding their capitalized costs. Capitalized
Cost is the sum of first cost and the present worth of disbursements assumed to last forever.
Capitalized cost = P + A (P/A, i, n), n = P + A / i
A is the difference between annual receipts and annual disbursements
Ex: A grant of Rs. 6, 00,000 was given for the construction of a dam. Annual maintenance
cost is estimated at Rs. 20,000. In addition, Rs. 30,000 will be required in every 10 years
for major repairs. Find out the initial cost if annual rate of interest is 5%.
Sol: First cost = Capitalized cost Annual disbursement / i
= 6, 00,000 [20,000 + 30,000 (A/F, 5, 10)] / 0.05
= 6, 00,000 4, 47,700 = Rs. 1, 52,300
Advantages of PW Method:
It recognizes time value of money and suitable to apply even to uneven cash flow streams
It takes into account the earning over the entire life of the project
It considers the objective of maximum profitability
Disadvantages of PW Method:
It is very difficult to determine appropriate discount rate
PW calculation is very sensitive to discount rate
It wholly excludes the value of any real options that may exist within the investment
Future Worth Method (FW):
Future worth method is particularly useful in an investment situation where we need to compute
the equivalent worth of a project at the end of its investment period rather than at its beginning.
For a single project:
If FW > 0, accept the project
If FW < 0, reject the investment proposal
If FW = 0, remain indifferent to the investment.
For a mutually exclusive alternatives future worth cash flows can be calculated by
i) Revenue based future worth - alternative with the maximum future worth amount should
be selected as the best alternative.
ii) Cost based future worth - alternative with the minimum future worth amount should be
selected as the best alternative.
The formula for the future worth for a given interest rate i is
FW(i) = - P (F/P, i, n) + R
1
(F/P, i, n-1) + R
2
(F/P, i, n-2) + . + R
n
+ S
If it is equal payment series then the formula will be
FW (i) = - P (F/P, i, n) + R (F/P, i, n) + S
If the cash flow stream is cost-based, then the future worth is given by
FW (i) = P (1 + i)
n
+ C
1
(1 + i)
n-1
+ C
2
(1 + i)
n-2
+ ..+ C
n
S
= P (F/P, i, n) + C
1
(F/P, i, n-1) + C
2
(F/P, i, n-2) + . + C
n
- S
In equal payment series the formula will be
FW (i) = P (F/P, i, n) + C (F/P, i, n) - S
Ex: Given the following particulars, which machine should be selected based on future worth
method, assuming 20% interest rate, compounded annually?
Particulars Machine A Machine B
Initial cost (Rs.)
Life (years)
Annual O & M cost (Rs.)
Salvage value (Rs.)
80,00,000
12.0
8,00,000
5,00,000
70,00,000
12.0
9,00,000
4,00,000
Sol: Cash flow diagram of machine A is:
S = Rs. 5, 00, 000
i = 20%
0 1 2 3 4 12
Rs. 8, 00, 000
Rs. 80, 00, 000
FW (20%)
A
= 80, 00,000 (F/P, 20, 12) + 8, 00,000 (F/A, 20, 12) -5, 00,000
= Rs. 10, 24, 92, 800
Cash flow diagram of machine B is:
S = Rs. 4, 00, 000
i = 20%
0 1 2 3 4 12
Rs. 9, 00, 000
Rs. 70, 00, 000
FW (20%)
B
= 70, 00, 000 (F/P, 20, 12) + 9, 00, 000 (F/A, 20, 12) - 4, 00, 000
= Rs. 9, 76, 34, 900
The future worth (cost) of machine B is less than that of machine A. So machine B
should be selected.
Ex: Which alternative from the following should be selected based on future worth method of
comparison assuming 12% interest rate compounded annually.
Alternative A Alternative B
Initial cost (Rs.)
Useful life (year)
4,00,000
4.0
8,00,000
4.0
Salvage value (Rs.)
Annual cost (Rs.)
2,00,000
40,000
5,50,000
- Nil -
Sol: Cash flow diagram of alternative A is:
S = Rs. 2, 00, 000
i = 12%
0 1 2 3 4
Rs. 40, 000
Rs. 4, 00, 000
FW (12%)
A
= Rs. 4, 00, 000 (F/P, 12%, 4) + Rs. 40, 000 (F/A, 12%, 4) - Rs. 2, 00, 000
= Rs. 6, 20, 760
Cash flow diagram of alternative B is:
S = Rs. 5, 50, 000
i = 12%
0 1 2 3 4
Rs. 8, 00, 000
FW (12%)
B
= Rs. 8, 00, 000 (F/P, 12%, 4) - Rs. 5, 50, 000 = Rs. 7, 09, 200
The alternative A should be selected as it involves less future worth (cost).
Equivalent Annual Worth Method (EAW):
In this method, all the receipts and disbursements occurring over a period are converted to an
equivalent uniform yearly amount. A large number of engineering economic decisions are based
on annual comparison like cost accounting procedures, depreciation charges, tax calculations etc.
Diagram of EAW
0 1 2 3
The term equivalent annual worth (EAW) is used when costs and receipts are both present.
Diagram of EAC
R
1
R
2
R
3
R
n
C
1
C
2
C
3
C
n
C
o
s
t
R
e
c
e
i
p
t
n
0
C
1
C
o
s
t
s
R
e
c
e
i
p
t
s
C
2
C
3
C
4
C
n
1 2 3 4
n
.
.
1 0 3
2, 00, 000
2 4
The term equivalent annual cost (EAC) is used to designate comparison involving only costs.
For single alternatives if
EAW > 0, Accept the investment proposal
EAQ < 0, Reject the investment proposal
EAW = 0, Remain indifferent to the investment.
For multiple alternatives or mutually exclusive alternatives if all the alternatives are revenue
dominated, the alternative with higher EAW will be selected. If all the alternatives are cost
based, the alternative with least EAW will be accepted.
Ex: Consider a machine that costs Rs.40, 000 and a 10 year useful life. At the end of 10 years,
it can be sold for Rs.5, 000 after tax adjustment. If the firm could earn after-tax revenue
of Rs.10, 000 per year with this machine, should it be purchased at interest rate of 15%,
compounded annually?
Sol: Initial cost (P) = Rs.40, 000/-
Useful life (n) = 10 years
Salvage value = Rs. 5, 000/-
Revenue = Rs.10, 000/-
i = 15%, compound annually
Case I : PW (15%) = -P + R (P/A, i, n) + S (P/F, i, n)
= - 40, 000 + 10, 000 (P/A, 15%, 10) + 5, 000 (P/F, 15%, 10)
= - 40,000 + 10, 000 (5.0188) + 5000 (0.2472) = Rs. 11, 424
Case II: EAW (15%) = PW (i) (A/P, i, n) = Rs. 11424 (A/P, 15%, 10)
= Rs. 11424 (0.1993) = Rs. 2277
Since EAW (15%) > 0, so the project is accepted.
Ex: Suggest which machine should be purchased at 15% interest rate based on annual
equivalent worth method.
Machine A Machine B
First Cost Rs.3,00,000 Rs.6,00,000
Life period 4 years 4 years
Salvage value Rs.2,00,000 Rs.3,00,000
O & M Cost Rs.30,000 Rs.0
Sol: The cash flow diagram of machine A is shown below.
30, 000
3, 00, 000
6, 00, 000
2 1 3 4 0
3, 00, 000
EAC (15%)
A
= P (A/P, i, n) + C S (A/F, i, n)
= 3, 00, 000 (A/P, 15%, 4) + 30, 000- 2, 00, 000 (A/F, 15%, 4)
= Rs. 95, 033
The cash flow diagram of machine B is shown below.
EAC (15%)
B
= P (A/P, i, n) S (A/F, i, n)
= 6, 00, 000 (A/P, 15%, 4) 3, 00, 000 (A/F, 15%, 4))
= Rs. 1, 50, 090
Since the equivalent annual cost of Machine A is less than that of Machine B, it is
advisable to purchase Machine A.
Rate of Return Method:
The rate of return is a percentage that indicates the relative yield on different uses of capital.
Three rates of return appear frequently in engineering economy studies:
The minimum acceptable rate of return (MARR) is the rate set by an organization to
designate the lowest level of return that makes an investment acceptable.
Internal rate of return (IRR) is the rate on the unrecovered balance of the investment in a
situation where the terminal balance is zero. It is a discount rate at which NPV = 0.
External rate of return (ERR) is the rate of return that is possible to obtain for an
investment under current economic conditions. For example, suppose analysis of an
investment shows that it will realize an IRR of 50 percent. Rationally, it is not reasonable
to expect that we can invest in the external market and get that high a rate. In engineering
economy studies, the external interest rate most often set to the MARR.
Minimum Acceptable Rate of Return (MARR):
The minimum acceptable rate of return, also known as the minimum attractive rate of return, is a
lower limit for investment acceptability set by organizations or individuals. It is a device
designed to make the best possible use of a limited resource. Rates vary widely according to the
type of organization, and they vary even within the organization. Historically, government
agencies and regulated public utilities have utilized lower required rates of return than have
competitive industrial enterprises. Within a given enterprise, the required rate may be different
for various divisions or activities. These variations usually reflect the risk involved. For instance,
the rate of return required for cost reduction proposals may be lower than that required for
research and development projects in which there is less certainty about prospective cash flows.
Internal Rate of Return Method (IRR):
The internal rate of return, represented by i in the traditional interpretation of interest rates, is the
rate of interest earned by an alternative investment on the unrecovered balance of an investment.
The internal rate of return can be calculated by equating the annual, present, or future worth of
cash flow to zero and solving for the interest rate (IRR) that allows the equality. While solving
for the interest rate, it may result in a polynomial equation which may result in multiple roots of
the equation. In such cases the IRR may or may not be one of the equation roots.
Calculation of IRR:
IRR is The Discount rate at which the costs of investment equal to the benefits of the
investment. Or in other words IRR is the Required Rate that equates the NPV of an investment
zero. The ascertainment of IRR involves trial and error method and if IRR falls between two
interest rates, then it is found out using interpolation.
If IRR exceeds firms MARR, then the project is accepted, otherwise, it is rejected. For mutually
exclusive projects, project with highest IRR is selected.
Ex: A person is planning a new business. The initial outlay and cash flow pattern for the new
business are as listed below. The expected life of the business is five years. Find the rate
of return for the new business.
Period 0 1 2 3 4 5
Cash flow (Rs.) -1,00,000 30,000 30,000 30,000 30,000 30,000
Sol: Initial investment = Rs. 1, 00, 000
Annual equal revenue = Rs. 30, 000
Life = 5 years
PW(i) = -1, 00, 000 + 30, 000 (P/A, i, 5)
When i = 10%, PW (10%) = -1, 00, 000 + 30, 000 (P/A, 10%, 5)
= -1, 00, 000 + 30, 000(3.7908) = Rs. 13, 724
When i = 15%, PW (15%) = -1, 00, 000 + 30, 000 (P/A, 15%, 5)
= -1, 00, 000 + 30, 000 (3.3522) = Rs. 566
When i =18%, PW (18%) = -1, 00, 000 + 30, 000 (P/A, 18%, 5)
= -1, 00, 000 + 30, 000 (3.1272) = Rs. -6, 184
= 15% + 0.252% = 15.252%
Therefore, the IRR for the new business is 15.252%.
Ex: A firm has identified three mutually exclusive investment proposals whose details are
given below. The life of all the three alternatives is estimated to be five years with
negligible salvage value. The minimum attractive rate of return for the firm is 12%.
Alternative
A1 A2 A3
Investment Rs. 1,50,000 Rs. 2,10,000 Rs. 2,55,000
Annual net income Rs. 45,570 Rs. 58,260 Rs. 69,000
Find the best alternative based on the rate-of return method of comparison.
Sol: Alternative A1
Initial outlay = Rs. 1, 50, 000
Annual profit = Rs. 45, 570
Life = 5 years
PW (i) = -1, 50, 000 + 45, 570 (P/A, i, 5)
PW (12%) = -1, 50, 000 + 45, 570 (P/A, 12%, 5)
= -1, 50, 000 + 45, 570 (3.6048) = Rs. 14, 270.74
PW (15%) = -1, 50, 000 + 45, 570 (P/A, 15%, 5)
= -1, 50, 000 + 45, 570 (3.3522) = Rs. 2, 759.75
PW (18%) = -1, 50, 000 + 45, 570 (P/A, 18%, 5)
= -1, 50, 000 + 45, 570 (3.1272) = Rs. -7, 493.50
Therefore, IRR of the alternative A1 is
= 15.81%
Alternative A2
Initial outlay = Rs. 2, 10, 000
Annual profit = Rs. 58, 260
Life of alternative A2 = 5 years
PW (i) = -2, 10, 000 + 58, 260 (P/A, i, 5)
PW (12%) = -2, 10, 000 + 58, 260 (P/A, 12%, 5)
= -2, 10, 000 + 58, 260 (3.6048) = Rs. 15.65
PW (13%) = -2, 10, 000 + 58, 260 (P/A, 13%, 5)
= -2, 10, 000 + 58, 260 (3.5172) = Rs. -5, 087.93
Therefore, IRR of alternative A2 is
= 12%
Alternative A3
Initial outlay = Rs. 2, 55, 000
Annual profit = Rs. 69,000
Life of alternative A3 = 5 years
PW (i) = -2, 55, 000 + 69, 000 (P/A, i, 5)
PW (12%) = -2, 55, 000 + 69, 000 (P/A, 12%, 5)
= -2, 55, 000 + 69, 000 (3.6048) = Rs. -6, 268.80
PW (11%) = -2, 55, 000 + 69, 000 (P/A, 11%, 5)
= -2, 55, 000 + 69, 000 (3.6959) = Rs. 17.1
Therefore, IRR of alternative A3 is
= 11%
From the above data, it is clear that the rate of return for alternative A3 is less than the
minimum attractive rate of return of 12%. So, it should not be considered for comparison.
The remaining two alternatives are qualified for consideration. Among the alternatives
A1 and A2, the rate of return of alternative A1 is greater than that of alternative A2.
Hence, alternative A1 should be selected.
IRR Misconceptions:
IRR method for project evaluation leads to conflicting results under following conditions:
(i) The pattern of cash inflows plays an important role in project evaluation while using IRR
method. i.e. the cash flows of one project may increase over time, while those of others
may decrease and vice versa. The major drawback with the IRR method is that for
mutually exclusive projects, it can give contradictory investment decision when
compared with NPV. Consider the following example.
In the above example A and B are mutually exclusive projects. Both projects require an
initial outlay of $ 1,000,000 but the pattern of cash inflows is different. Cash inflows for
Project A are increasing over the period of time while for Project B these are declining.
IRR decision rule leads to select Project A as Project A IRR > Project B IRR. But
decision on the basis of NPV evaluation implies that project B is more viable. Thus on
the basis of mere IRR the company may select less profitable project.
(ii) The cash outflow of the projects may differ. i.e. a project may need capital outlay not
only at the time of investment but after regular intervals during its expected life.
Consider the following example:
Project A requires an initial outlay at the beginning of the project while Project B needs
cash outflow in year 2 and year 4 also. Decision based on IRR method leads to select
project B but NPV of project B is less than of Project A. again under such circumstances
IRR method plays a deceive role.
Summarizing the above discussion the timings and pattern of cash flows can produce
conflicting results in the NPV and IRR methods of project evaluation.
Public Projects and Cost-Benefit Analysis:
Public projects are undertaken by the Government to enhance the standard of living and welfare
of citizens. Activities such as police forces, health care services, education system belong to
public projects. While evaluating the private projects, the focus is on maximizing profit, in case
of public projects, the objective might be providing goods/services to public at minimum cost
The basic measure of accepting a public project is a benefit-cost (B/C) ratio.
B/C ratio = PW of Benefits / PW of Costs
= FW of Benefits / FW of Costs
= EAW of Benefits / EAW of Costs
Like private projects, cash flows in public projects are also discounted at a suitable rate known as
Social Discount Rate.
For Independent Projects,
If B/C ratio > 1, Accept the project
B/C ratio < 1, Reject the project
B/C ratio = 1, Depends on the Govt.
For Mutually exclusive projects, one involving higher B/C ratio is selected. Here, incremental
analysis can also be used to compare carious alternative projects.
Benefits of a public project can be of two types:
i) Primary benefits availability of water, electricity, irrigation etc.
ii) Secondary benefits recreational benefits, other benefits.
For example, benefits from a dam include:
a) water supply for domestic as well as industrial use
b) flood control
c) hydro-power generation
d) recreation
Costs in a public project are all resources required to achieve stated objectives which are:
i) Imputed costs of existing assets employed on another project besides the current use of it.
ii) Preliminary costs of investigation and technical services required to start a project.
iii) Spillover costs which constitute all significant adverse effects caused by the project.
Ex: In a particular locality of a state, the vehicle users take a roundabout route to reach
certain places because of the presence of a river. This results in excessive travel time and
increased fuel cost. So, the state government is planning to construct a bridge across the
river. The estimated initial investment for constructing the bridge is Rs. 40, 00, 000. The
estimated life of the bridge is 15 years. The annual operation and maintenance cost is Rs.
1, 50, 000. The value of fuel savings due to the construction of the bridge is Rs. 6, 00,
000 in the first year and it increases by Rs. 50, 000 every year thereafter till the end of the
life of the bridge. Check whether the project is justified based on BC ratio by assuming
an interest rate of 12%, compounded annually.
Sol: Initial investment = Rs. 40, 00, 000
Annual operation and maintenance = Rs. 1, 50, 000
Annual fuel savings during the first year = Rs. 6, 00, 000
Equal increment in fuel savings in the following years = Rs. 50, 000
Life of the project = 15 years
Interest rate = 12%
Total present worth of costs
= Initial investment (P) + Present worth of annual operating and maintenance cost (C
P
)
= Rs. 40, 00, 000 + 1, 50, 000 (P/A, 12%, 15)
= Rs. 40, 00, 000 + 1, 50, 000 x 6.8109 = Rs. 50, 21, 635
Present worth of fuel savings (B
P
):
A1 = Rs. 6, 00, 000
G = Rs. 50, 000
n = 15 years
i = 12%
Present worth of the fuel savings (B
P
)
= [A1 + G (A/G, 12%, 15)] (P/A, 12%, 15)
= [6, 00, 000 + 50, 000 (4.9803)] (6.8109) = Rs. 57, 82, 556
BC Ratio = B
p
/ (P + C
p
) = 57, 82, 556 / 50, 21, 635 = 1.1515
Since the B/C ratio > 1, the construction of the bridge across the river is justified.
Ex: Two mutually exclusive projects are being considered for investment. Project Al requires
an initial outlay of Rs. 30, 00, 000 with net receipts estimated as Rs. 9, 00, 000 per year
for the next 5 years. The initial outlay for the project A2 is Rs. 60, 00, 000, and net
receipts have been estimated at Rs. 15, 00, 000 per year for the next seven years. There is
no salvage value associated with either of the projects. Using the benefit cost ratio, which
project would you select? Assume an interest rate of 10%.
Sol: Alternative A1
Initial cost (P) = Rs. 30, 00, 000
Net benefits / year (B) = Rs. 9, 00, 000
Life (n) = 5 years
Annual equivalent of initial cost
= P x (A/P, 10%, 5) = 30, 00, 000 x 0.2638 = Rs. 7, 91, 400
B/C ratio =
= 9, 00, 000 / 7, 91, 400 = 1.137
Alternative A2
Initial cost (P) = Rs. 60, 00, 000
Net benefits / year (B) = Rs. 15, 00, 000
Life (n) = 7 years
Annual equivalent of initial cost
= P x (A/P, 10%, 7) = 60, 00, 000 x 0.2054 = Rs. 12, 32, 400
= 15, 00, 000 / 12, 32, 400 = 1.217
The B/C ratio of alternative A2 is more than that of alternative A1 and hence, alternative
A2 is selected.
Limitations of Cost-benefit analysis:
Difficulties in benefit assessment
Arbitrary social discount rate
Ignores opportunity cost
Difficulties in cost assessment
Payback Period Method (PBP):
It is defined as the time period required for a project to return back the capital employed in it. For
example, an investment of Rs. 50,000 which returns Rs. 10,000 per year will have a five year
payback period. Shorter PBPs are more desirable for investors than longer PBPs.
Thus, PBP = First Cost / Net Annual Savings
Discounted Payback Period:
One of the limitations in using payback period is that it does not take into account the time value
of money. However, the discounted payback period solves this problem. This technique is
somewhat similar to payback period except that the expected future cash flows are discounted for
computing payback period. If discounted payback period is smaller than some pre-determined
number of years then an investment is worth undertaking.
For example an initial investment of Rs. 10,000 (Year 0) generates cash flows from Years 1-6 as
given below:
Year Cash Flows PV of Cash Flows Cumulative Cash Flows
0 -$10,000 -$10,000 $-10,000
1 1500 1389 -8611
2 2500 2143 -6468
3 4000 3175 -3293
4 3000 2205 -1088
5 3000 2042 +954
6 3000 1891 +2845
The Payback Period occurs in Year 4, when the cash flow turns from a Negative (-1088) to a
Positive (+954).
Thus, Discounted Payback Period = 4 Years + (1088 / 2042) = 4.53 Years
Depreciation Analysis
Depreciation is the decrease in value of physical properties with the passage of time and use.
Production equipment gradually becomes less valuable through wear and tear. This lessening in
value is recognized in accounting practices as an operating expense. Instead of charging the full
purchase price of a new asset as one time expense, the outlay is spread over the life of the asset
in the accounting records. Annual depreciation deductions are intended to match the yearly
fraction of value used by an asset in the production of income over the assets actual economic
life. The actual amount of depreciation can never be established until the asset is retired.
Fixed assets are assets having long-term perspective such as plant, building, machinery etc.
Depreciation is a permanent continuing and gradual shrinkage in book value of a fixed asset.
Current assets are never depreciated. Moreover, depreciation is always charged on book value of
the asset and not on market value of it.
Causes of Depreciation:
1. Physical depreciation: It is caused mainly from wear and tear when the asset is in use
and from corrosion, rust, rot and decay from being exposed to wind, rain, sun and other
elements of nature.
2. Economic Factors: These cause the asset to be put out of use even though it is in good
physical condition. These arise due to obsolescence (Assets become outdated as a result
of introduction of new model of it) and inadequacy (termination of the use of an asset
because of growth and change in size of the firm).
3. Time factors: There are some assets, which loses its values after a particular time period.
Assets having lease, copyrights and patents right loses its value after the time is over.
4. Depletion: Consumption of exhaustible natural resources to produce product or services
is termed as depletion. Removal of oil, timber, rock or minerals from a site decreases the
value of the holding.
5. Accident: Sometimes due to accident or sudden failure the asset loses its technological
characteristic inherent in it.
Need For Providing Depreciation:
To know the true profits: As depreciation is an expense, it is desirable to charge
depreciation on fixed assets for earning purposes. Depreciation amount must be deducted
out of the income earned in order to calculate true net profit/loss of business enterprises.
To show true financial position: Financial position can be studied from the balance
sheet which contains assets and liabilities of a business. If depreciation is not charged on
fixed assets, then their values are overstated which will not show the true financial
position of a business.
To make provisions for replacement of assets: If depreciation is not provided, profits
are overstated and are distributed as dividends to the shareholders. Provision for
depreciation is a charge to P/L account and the accumulated amount provides additional
working capital besides providing sum for replacement of the asset.
Depreciation Methods:
Terminologies:
P = Purchase price (unadjusted basis) of assets.
S = Salvage value or future value at end of assets life. It is the expected selling price of a
property when the asset can no longer be used by its owner.
N = useful (tax) life of asset. This is the expected period of time that a property will be used
in a trade or business or to produce income.
N = number of years of depreciation
D
t
(n) = Annual depreciation charges.
B
t
(n) = Book value shown on accounting records at end of year.
B
t
(0) = p
Straight line method (SL):
The most widely used and simplest method for the calculation of depreciation is straight line
method. The straight line method assumes that the value of an asset decreases at a constant rate.
Thus if an asset has a first cost of Rs.5, 000 and an estimated salvage value of Rs. 500, the total
depreciation over its life will be Rs. 4, 500. If the estimated life in 5 years, the depreciation per
year will be 4, 500 5 = 900. This is equivalent to a depreciation rate of 1/5 = 20% per year.
The depreciation in any year is
n
F P
D
T
The book value is
,
_
n
F P
t P B
T
And the depreciation rate per year is
n
1
Ex: Initial cost of the asset = Rs. 5000
Life time = 5 years
Salvage value = 0
From the following data find out
a) The depreciation charge during year 1
b) The depreciation charge during year 2
c) The depreciation reserve accumulated by the end of year 3
d) The book value at the end of year 3
Sol: (a) & (b): In case of straight line method as the depreciation charge is constant, the
depreciation charges for year 1 and 2 is constant.
5
5000
) 2 ( ) 1 (
n
F P
D D
T T
= 1000 per year
(c) The depreciation reserve at the end of the third year is the sum of the annual
depreciation charges for the first three years and is equal to 3 (1000) = Rs. 3000
(d) The book value at the end of third year is
2000
5
5000
3 5000
,
_
Declining balance Method (DB):
Value of an asset diminishes at a decreasing rate. The declining balance depreciation assumes
that an asset decreases in value faster early rather than in the latter portion of its service life. By
this method a fixed percentage is multiplied times the book value of the asset at the beginning of
the year to determine the depreciation charge for that year. Thus as the book value of the asset
decreases through time, so does the size of the depreciation charge. For example,
First cost = Rs. 5, 000
Salvage value = Rs. 1, 000
Life of the asset = 5 years and
Depreciation rate is 30% per year.
Declining Balance method
End of year Depreciation charge during year Book value at end of year
0 5000
1 (0.30) (50000) = 1,500 3,1500
2 (0.30) (3,500) = 1,050 2,450
3 (0.30) (2,450) = 735 1,715
4 (0.30) (1,7115) = 515 1,200
5 (0.30) (1,200) = 360 840
For a depreciation rate a, the general relationship expressing the depreciation charge in any year
for declining balance depreciation is:
D
(t)
= a. BV
(t-1)
BV
(t)
= BV
t-1
D
t
Therefore, declining-balance depreciation
BV
(t)
= BV
t-1
a. BV
t-1
Thus, D
(t)
= a (1-a)
t-1
P
And BV
(t)
= (1 - R) P = P (1-a)
t
Double Declining Balance method (DDB):
If the declining balance method of depreciation is used for income tax purposes the maximum
rate that may be used is double the straight line rate that would be allowed to a particular asset
being depreciated. Thus for an asset with an estimated life of N years, the maximum rate that
may be used with this method is R = 2/N. Many firms and individuals choose to depreciate their
assets using declining balance depreciation with maximum allowable rate. Such a depreciation
method is commonly known as the Double Declining Balance method of depreciation.
Ex: Initial cost = 5000
N = 5 years
S = 0.
Find D
t
(1), D
t
(2) and depreciation reserves at the end of year 3, and B
t
(3).
Sol: The depreciation rate
4 . 0 5 / 2
2
N
a
D
t
(1) = [B
t
(0)] (0.4) = 5000 (0.4) = 2000
D
t
(2) = [B
t
(l)] (0.4) = (5000 - 2000) (0.4) = 1200
The depreciation reserve at the end of year 3 is
D
t
(l) + D
t
(2) + [B
t
(2) (0.4)] = 2000 + 1200 + 720 = 3920
B
t
(3) = P - depreciation reserve = 5000 - 3920 = 1080
Switch From DB/DDB to SL depreciation
A difficulty may arise with the use of declining balance depreciation because in the above
example salvage value is zero. After the end of life time or at the end of year 5, we find that:
B
t
(5) = P (1 R)
N
= 5000 (0.6)
5
= 388.88
It is not uncommon for the book value with DB/DDB depreciation to exceed the assets value at
the end of its life. It is allowable under the tax law to depreciate an asset over the early portion of
its life using DB depreciation and then switching to SL depreciation for the remainder of the
assets life. The switch usually occurs when the next periods SL depreciation amount on
undepriciated balance of the asset exceeds the next periods DB depreciation charge.
Suppose, an asset has first cost of 5000, a five year useful life and no salvage value. Determine
an accelerated depreciation schedule. Applying the double declining balance method as was done
for Rs. 5000 and N values.
We know book value B
t
(5) = 388.8 is higher than the zero salvage value. Therefore to make
book-value zero, we have to switch to straight line method.
End of year DDB
charges
Book value
with DDB
SL depreciation on
undepreciated balance
Book value
DDB SL
0 5000 5000
1 2000 3000 5000/5 = 100 3000
2 1200 1800 3000/4 = 750 18000
3 720 1080 1800/3 = 600 1080
4 432 648 1080/2 = 540 540
5 259.2 388.8 540 0
At the end of year 2, the book value resulting from DDB depreciation is 1800 which equal the
undepreciated balance because S = 0.
Then the SL charges for the last 3 years would be = 1800/3 = 600
Since this annual charge is less than DDB charge for 3
rd
year, (720), accelerated depreciation is
continued another year. Thus B
t
(3) = 1080 and the SL depreciation charge for each of the last 2
years 1080/2 = 540. This is larger than the DDB depreciation charge for year 4 (432) and signals
the time to switch.
Sum - of the - years - Digits Method:
To compute the depreciation deduction by the SYD method, the digits corresponding to the
number for each permissible year of life are first listed in reverse order. The sum of these digits
is then determined. The depreciation factor for any year is a number from the reverse ordered
listing for that year divided by the sum of the digits. For example for a property having a
depreciable life of five years, SYD depreciation factors are as follows:
Year Number of the year in Reverse order SYD Depreciation Factor
1. 5 5/15
2. 4 4/15
3. 3 3/15
4. 2 2/15
5. 1 1/15
The depreciation for any year is the product of the SYD depreciation factor for that year and the
difference between the cost basis (B) and the estimated final SV.
Ex: The cost of a vehicle is Rs. 1, 00,000 and the salvage value after 4 years of its useful life
is Rs. 20,000. Calculate the depreciation charges and book value of the asset every year
using sum-of-years-digit method.
Sol: SYD = 1 + 2 + 3 + 4 = 10
Depreciable Amount = 1, 00,000 20,000 = Rs. 80,000
End of Year SYD depreciation rate Depreciation Charge Book Value
1 4/10 32,000 68,000
2 3/10 24,000 44,000
3 2/10 16,000 28,000
4 1/10 8,000 20,000
Modified Accelerated Cost Recovery System (MACRS):
To determine depreciation schedule appropriate for depreciable property, MACRS has defined
various property classes (life of the asset) and all assets fall into any of the categories. Assets
having life more than or equal to 15 years are depreciated at 150%/N and assets below 15 years
life are depreciated at 200%/N where N is the assets property class.
Procedure for calculation of MACRS Declining balance depreciation
1. Divide the appropriate percentage (either 200 or 150 per cent) by the number of years
in the recovery period to calculate MACRS depreciation rate.
2. Divide the result from step 1 by 2 to convert the percentage to the half year
convention for the first year of services.
3. The percentage for the second year of service is calculated by multiplying the
remaining basis (the current book value) by the base rate.
4. The procedure is continued until a switch to the straight line methods allowed in order
to reach the terminal salvage value. Since the mid-year convention is used in MACRS,
the remaining life at the end of the year is determined by N K + 0.5 for K = 1, 2 ..N,
Straight line depreciation for the remaining year is calculated as
D (k) = BV (k) / (N k + 0.5)
Ex: Switch from declining balance to straight line Depreciation in MACRS of a 7-year
property class asset having purchase price of Rs. 10,000 with no salvage value
Sol: The base rate is 200% / 7 = 28.57
Depreciation charges and book values for different periods are presented below:
MACRS to Straight line
End of
year
MACRS
Depreciation rate
Declining
balance
deduction
Straight line
deduction
Book value
after
depreciation
0 10,000
1 14.29 1429 1333 8571
2 24.29 2429 1319 6122
3 17.49 1749 1113 4373
4 12.49 1249 972 3124
5 8.93 893 893 2231
6 8.93 637 893 1338
7 8.93 455 893 445
8 4.45 325 445 0
In the above table up to 4
th
year, straight line depreciation is less than declining balance
deduction. In the fifth year straight line deduction is equal to dealing balance deduction.
From that year we will switch over to straight line deduction such that book value is zero.
After-tax Economic Evaluations:
Most of the firms pay different types of taxes and one of the most important taxes is income tax
which is levied on the net income of the person. But tax most of the time influences a decision. A
simple adjustment of rate of return calculated without regard for taxes gives an approximation to
the after tax rate of return.
IRR
after tax
= IRR
before tax
(1 - effective income tax rate)
For after tax comparisons, following table can be prepared.
Column heading Column number Arithmetic computation in column
Investment year 1
Before tax operating cash flow 2
Book value before depreciation 3
MACRS depreciation rate 4
Depreciation charge 5 4 x original basis
Book value after depreciation 6 (3) (5)
Cash flow for debt 7
Cash flow for debt interest 8
Taxable Income 9 (2) (5) (8)
Cash flow for taxes 10 Tax rate x (9)
After tax cash flow 11 (2) (7) (10)
After tax comparison can be made by any comparison methods like PW, EAW or IRR.
Ex: Initial investment on a machine is 60, 000, i = 15% (After taxes). The Machine is 5 years
MACRS recovery property. Over six years, investment estimated to save 25,000/year.
Annual operating cost is 5,000. It will be depreciated by MACRS method and will have
no salvage value. Income tax rate is 40%. Does the proposal to invest on the machine
satisfy the firms new minimum acceptable rate of return?
Sol: Lets find out IRR
before tax
PW = - 60,000 + (20,000) (P/A, i, 6) = 0
PW (25%) = - 60, 000 + (20, 000) (2.9514) = - 60, 000 + 59, 028 = -972
PW (23%) = - 60, 000 + 61, 846 = 1, 846
Using interpolation,
IRR =
% 2
) 972 ( 1846
1846
% 23
1
]
1
+
= 23% + [0.655] 0.02 = 23.14
Thus, IRR
after tax
= (23.14%) (1 - 0.40) = 13.84%
It will be rejected as if it is below 15%
After - tax flows (After depreciation)
Investment
year
Before tax
cash flow
Depreciation
charge
Taxable
loan
Taxes 40% After taxes
cash flow
0 -60,000 -60,000
1 20,000 12,000 8,000 3,200 16,800
2 20,000 19,200 800 320 19,680
3 27,000 11,520 8480 3392 16608
4 20,000 6912 13088 5235.2 14764.8
5 20,000 6912 13088 5235.2 14764.8
6 20,000 3456 19,644 7857.6 12142.4
IRR
after-tax
= 15.87 %
As it is more than 15%, investment can be made on the machine.
Costing
The cost accounting consists of two words: Cost and Accounting. Cost means the resources
sacrificed for the production of a commodity and accounting refers to the financial information
system. Cost accounting system can be described as measurement and reporting of resources
used in monetary terms. Cost accounting is the branch of accounting dealing with the
classification, recording, allocation, summarization and reporting of current and prospective cost.
Costing and cost accounting
We use costing and cost accounting interchangeably. But they should not be. Costing refers to
the technique and process of ascertaining cost. The technique consists of the principles and rules
for the determining the costs of products and services.
Cost accounting on the other hand, is defined as the process of accounting for cost from the point
at which expenditure is incurred. It is that specialized branch of accounting which involves
classification, accumulation, allocation, absorption and control of costs.
According to CIMA, cost accounting is the application of costing and cost accounting principles,
methods and techniques to the science, art and practice of cost control. It includes the
presentation of information derived those from for the purpose of managerial decision making:
a) Cost Ascertainment: Ascertaining the cost of goods produced and services rendered has
been the chief function of cost accounting. This purpose is some times referred to as
product costing or cost accumulation.
b) Cost Analysis: Cost analysis is one of the important functions of cost accounting as it
helps in decision making. While making decision, we require information about cost,
revenue and other information. So we have to analyze the cost.
c) Cost Control: To control the cost is chief motive of every management. Cost information
shows the performance of the organization. There are two types of cost control method:
Standard Costing and Budgetary Control. Actual costs are compared to the budgeted cost.
This help in controlling the cost.
Objectives of cost accounting
1. The cost accounting helps in ascertaining the cost of production of every units, job,
operation process, department and service.
2. It indicates management any inefficiency and extent of various forms of waste, whether
in material, time, expense or in the use of machine, equipment and tools.
3. It provides actual figures of cost for comparison with estimates and to assist the
management in their price fixing policy.
4. It present comparative cost data for different periods and different volumes of production
and assist the management in budgetary control.
5. It record and report to the concerned manager how actual costs compare with standard
cost and possible causes of differences between them.
6. It indicates exact cause of increase/decrease in profit/loss shown by financial accounts.
7. It provides data for comparison cost within firm and also between similar firms
Cost Centre vs. Cost Unit:
A cost centre is a location (department), person (salesman) or item of equipment (machine) in
relation to which cost may be ascertained. The main purpose of ascertaining cost of a cost centre
is control of cost. For example, in the functional area of marketing, it may become necessary to
distinguish between selling costs which become the responsibility of one area sales manager with
those for which another area manager is responsible. Therefore, in order to relate costs to the
managers concerned and compare the profitability of different areas, a sales territory may be
constituted as a cost centre.
The ascertainment of cost necessitates the determination of unit in terms of which costs are
ascertained. The unit of product/service chosen for the purpose is called a cost unit. The choice
of a cost unit depends on what is being produced, whether goods or services and what is relevant
to the purpose of cost ascertainment. Some of the examples of cost units are given below:
Industry Cost Unit
Cement Tonne
Bricks 1000 bricks
Nursing home Bed per day
Electricity Kilowatt hour
Transport Passenger kilometer
Printing press Thousand copies
Carpets Square foot
Hotel Room per day
Elements of Cost:
Following are the three broad elements of cost:
MATERIAL - The substance from which a product is made is known as material. It can be
direct as well as indirect. The material which becomes an integral part of a finished product and
which can be conveniently assigned to specific physical unit is termed as direct material. Some
of the examples of direct material are components specifically purchased, primary packing
materials, partly produced components etc. The material which is used for purposes ancillary to
the business and which cannot be conveniently assigned to specific physical units is termed as
indirect material. Consumable stores, oil and waste, printing and stationery material etc. are
some of the examples of indirect material.
LABOR - For conversion of materials into finished goods, human effort is needed and such
human effort is called labor. Labor can be direct as well as indirect. The labor which actively and
directly takes part in the production of a particular commodity is called direct labor. Direct labor
costs are, therefore, specifically and conveniently traceable to specific products. The labor
employed for the purpose of carrying out tasks incidental to goods produced/services provided, is
indirect labor. It cannot be practically traced to specific units of output. Wages of storekeepers,
foremen, Directors fees, salaries of salesmen etc, are examples of indirect labor costs.
EXPENSES All costs other than materials and labor are termed as expenses. These may be
direct or indirect. Direct expenses can be directly, conveniently and wholly allocated to specific
cost centers/cost units. Examples of such expenses are hire purchase of machinery, cost of
defective work etc. Indirect Expenses are those which cant be directly, conveniently and wholly
allocated to cost centers or cost units. Examples of such expenses are rent, lighting, insurance
charges etc.
Overhead - The term overhead includes indirect material, indirect labor and indirect expenses.
Thus, all indirect costs are overheads. Overheads may be incurred in a factory or office or selling
and distribution divisions. Thus, overheads may be of three types:
Factory Overheads: They include the following things:
Indirect material used in a factory such as lubricants, oil, consumable stores etc.
Indirect labor such as gatekeeper, timekeeper, works managers salary etc.
Indirect expenses such as factory rent, factory insurance, factory lighting etc.
Office and Administration Overheads: They include the following things:
Indirect materials used in an office such as printing and stationery material, brooms etc.
Indirect labor such as salaries payable to office manager, office accountant, clerks, etc.
Indirect expenses such as rent, insurance, lighting of the office
Selling and Distribution Overheads: They include the following things:
Indirect materials used such as packing material, printing and stationery material etc.
Indirect labor such as salaries of salesmen and sales manager etc.
Indirect expenses such as rent, insurance, advertising expenses etc.
Various components of total cost can be depicted with the help of the table below:
Direct material plus Direct labor plus Prime cost or direct cost or first cost
Direct expenses
Prime cost plus works overheads Works or factory cost or manufacturing cost
Works cost plus office and
administration overheads
Office cost or total cost of production
Office cost plus selling and
distribution overheads
Cost of sales or total cost
Cost Sheet:
Cost sheet is a document that provides for the assembly of an estimated detailed cost in respect
of cost centers and cost units. It analyzes and classifies in a tabular form the expenses on
different items for a particular period.
Example: Following information has been obtained from the records of XYZ Ltd. for the period
from June 1 to June 30, 1998. Prepare a statement of cost.
Cost of raw materials on June 1,1998 30,000
Purchase of raw materials during the month 4,50,000
Wages paid 2,30,000
Factory overheads 92,000
Cost of work in progress on June 1, 1998 12,000
Cost of raw materials on June 30, 1998 15,000
Cost of stock of finished goods on June 1, 1998 60,000
Cost of stock of finished goods on June 30, 1998 55,000
Selling and distribution overheads 20,000
Sales 9,00,000
Administration overheads 30,000
Solution:
Statement of cost sheet of XYZ Ltd. for the period ending on June 30, 1998.
Opening stock of raw materials
Add-- purchase
30,000
4,50,000
-----------
-
4,80,000
15,000
Less-- closing stock of raw material
Value of raw materials consumed
Wages
Prime cost
Factory overheads
Add-- opening stock of work in progress
Less-- closing stock of work in progress
Factory cost
Add-- Administration overhead
Cost of production of goods manufactured
Add--opening stock of finished goods
4,65,000
2,30,000
6,59,000
92,000
7,87,000
12,000
7,99,000
---
7,99,000
30,000
8,29,000
60,000
8,89,000
Less-- closing stock of finished goods
Cost of production of goods sold
Add-- selling and distribution overheads
Cost of sales
Profit
Sales
55,000
8,34,000
20,000
8,54,000
46,000
9,00,000
Classification of Cost:
Cost may be classified into different categories as follows:
1. Fixed, Variable and Semi-Variable Costs:
The cost which varies directly in proportion with every increase or decrease in the volume of
output or production is known as variable cost (Direct cost). For example wages of laborers, cost
of direct material, power etc. The cost which does not vary but remains constant within a given
period of time and a range of activity in spite of the fluctuations in production is known as fixed
cost (Indirect cost). Some of its examples are rent, insurance charges, managers salary etc. The
cost which does not vary proportionately but simultaneously does not remain stationary at all
times is known as semi-variable cost. Some of its examples are depreciation, repairs etc.
2. Product Costs and Period Costs:
The costs which are a part of the cost of a product rather than an expense of the period in which
they are incurred are called as product costs. They become an expense at that time. These costs
may be fixed as well as variable, e.g., cost of raw materials and direct wages, depreciation on
plant and equipment etc.
The costs which are not associated with production are called period costs. They are treated as an
expense of the period in which they are incurred. They may also be fixed as well as variable.
Such costs include general administration costs, salaries salesmen and commission, depreciation
on office facilities etc.
3. Decision-Making Costs and Accounting Costs:
Decision-making costs (future costs) are special purpose costs that are applicable only in the
situation in which they are compiled. They have no universal application. Accounting costs
(historical costs) are compiled primarily from financial statements. They have to be altered
before they can be used for decision-making.
4. Relevant and Irrelevant Costs:
Relevant costs are those which change by managerial decision. Irrelevant costs are those which
do not get affected by the decision. For example, if a manufacturer is planning to close down an
unprofitable retail sales shop, this will affect the wages payable to the workers of a shop. This is
relevant in this connection since they will disappear on closing down of a shop. But prepaid rent
of a shop is irrelevant costs which should be ignored.
5. Shutdown and Sunk Costs:
A manufacturer or an organization may have to suspend its operations for a period on account of
some temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc.
During this period, though no work is done yet certain fixed costs, such as rent and insurance of
buildings, depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs
of the idle plant are known as shutdown costs. Sunk costs are the past costs which have been
created by a decision that was made in the past and cant be changed by any decision that will be
made in future. Investments in plant and machinery, buildings etc. are examples of such costs.
6. Out-of-Pocket Costs
Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that
will vary depending upon the nature of the decision made. For example, a company has its own
trucks for transporting raw materials and finished products from one place to another. It seeks to
replace these trucks by keeping public carriers. In making this decision, of course, the
depreciation of the trucks is not to be considered but the management should take into account
the present expenditure on fuel, salary to driver and maintenance. Such costs are termed as out-
of-pocket costs.
7. Opportunity Cost
Opportunity cost refers to an advantage in measurable terms that have foregone on account of
not using the facilities in the manner originally planned. For example, if a building is proposed to
be utilized for housing a new project plant, the likely revenue which the building could fetch, if
rented out, is the opportunity cost which should be taken into account while evaluating the
profitability of the project.
8. Cost Estimation and Cost Ascertainment
Cost estimation is the process of pre-determining the cost of a certain product job or order. Such
pre-determination may be required for several purposes such as budgeting, measurement of
performance efficiency, preparation of financial statements, make or buy decisions etc. Cost
ascertainment is the process of determining costs on the basis of actual data. Hence, the
computation of historical cost is cost ascertainment while the computation of future costs is cost
estimation.
9. Cost Allocation and Cost Apportionment
Cost allocation refers to the allotment of all the items of cost to cost centers or cost units whereas
cost apportionment refers to the allotment of proportions of items of cost to cost centers or cost
units Thus, the former involves the process of charging direct expenditure to cost centers/cost
units whereas the latter involves the process of charging indirect expenditure to cost centers/cost
units. For example, the cost of labor engaged in a service department can be charged wholly and
directly but the canteen expenses of the factory cant be charged directly and wholly. Its
proportionate share will have to be found out. Charging of costs in the former case will be
termed as allocation of costs whereas in the latter, it will be termed as apportionment of costs.
10. Cost Reduction and Cost Control
Cost reduction and cost control are two different concepts. Cost control is achieving the cost
target as its objective whereas cost reduction is directed to explore the possibilities of improving
the targets. Thus, cost control ends when targets are achieved whereas cost reduction has no
visible end. It is a continuous process.
11. Marginal Costing and Absorption Costing
Marginal costing is formally defined as the accounting system in which variable costs are
charged to cost units and the fixed costs of the period are written-off in full against the aggregate
contribution. Absorption costing on the other hand, charges all costs, both variable and fixed, to
the cost centers/cost units.
Marginal Costing:
The ascertainment of marginal cost is based on the classification and segregation of cost into
fixed and variable cost. Marginal cost is the cost of the marginal or last unit produced. In this
connection, a unit may mean a single commodity, a dozen, or any other measure of goods. For
example, if a manufacturing firm produces X unit at a cost of Rs. 300 and (X + 1) units at a cost
of Rs. 320, the cost of an additional unit will be Rs. 20 which is marginal cost. The marginal cost
varies directly with the volume of production and marginal cost per unit remains the same. It
consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does
not contain any element of fixed cost which is kept separate under marginal cost technique.
Marginal costing may be defined as the technique of presenting cost data wherein variable costs
and fixed costs are shown separately for managerial decision-making. Marginal costing
technique has given birth to a very useful concept of contribution where contribution is given by:
Contribution = Sales revenue less variable cost (marginal cost)
Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution
goes toward recovery of fixed cost and profit, and is equal to fixed cost plus profit. In case a firm
neither makes profit nor suffers loss, contribution will be just equal to fixed cost. This is known
as break even point.
Break-even Analysis:
The break-even analysis (BEA) also known as Cost-Volume-Profit (CVP) analysis has
considerable significance for economic research, business decision-making, investment analysis
etc. This technique traces relationship between costs, revenue and profit at varying levels of
output. In BEA, the break-even point (BEP) is located at the level of output at which the net
income or profit is zero. At this point, total cost is equal to the total revenue. Hence, BEP is the
no-profit-no-loss point.
The term marginal cost is usually applied to the variable cost of a unit of product/service
Marginal costing is a form of management accounting based on the distinction between:
a) the marginal costs of making selling goods or services, and
b) fixed costs, which should be the same for a given period of time, regardless of the level
of activity in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of Rs. 5 per unit
and that sells for Rs. 8 per unit. For every additional unit of the product that is made and sold, the
firm will incur an extra cost of Rs. 5 and receive income of Rs. 8. The net gain will be Rs. 3 per
additional unit. This net gain per unit, the difference between the sales price per unit and the
marginal cost per unit, is called contribution. Contribution means making a contribution towards
covering fixed costs and making a profit. Before a firm can make a profit in any period, it must
first of all cover its fixed costs.
Cost-Volume-Profit (C-V-P) Relationship:
In marginal costing, marginal cost varies directly with the volume of production or output. On
the other hand, fixed cost remains unaltered regardless of the volume of output. If volume is
changed, variable cost varies as per the change in volume. Apart from profit projection, the
concept of C-V-P is relevant to virtually all decision-making areas, particularly in the short run.
The relationship among cost, revenue and profit at different levels may be expressed in graphs
such as breakeven charts, profit volume graphs, or in various statement forms. Profit depends on
a large number of factors, most important of which are the cost of manufacturing and the volume
of sales. Both these factors are interdependent. Volume of sales depends upon the volume of
production and market forces which in turn is related to costs. Management has no control over
market. In order to achieve certain level of profitability, it has to exercise control and
management of costs, mainly variable cost. This is because fixed cost, a non-controllable cost is
dependent on such factors as Volume of production, Product mix, Productivity of the factors of
production, Technology, Size of plant etc.
Thus, the cost-volume-profit analysis furnishes the complete picture of the profit structure. This
enables management to distinguish among the effect of sales, fluctuations in volume and the
results of changes in price of product/services.
Assumptions:
Following are the assumptions on which the theory of CVP is based:
The changes in the level of various revenue and costs arise only because of the changes in
the number of product (or service) units produced and sold.
Total costs can be divided into a fixed component and a component that is variable with
respect to the level of output.
There is linear relationship between revenue and cost.
The unit selling price, unit variable costs and fixed costs are constant.
The analysis either covers a single product or assumes that the sales mix sold in case of
multiple products will remain constant as the level of total units sold changes.
Limitations of break even analysis:
Selling costs are especially difficult to handle in break-even analysis. This is because the
changes in selling costs are a cause and not a result of changes in output and sales.
Costs in a particular period may not be caused entirely by the output in that period. For
example, maintenance expenses may be the result of past output
Break-even analysis assumes that profits are a function of output ignoring the fact that
they are also caused by other factors such as technological change, improved
management, changes in the scale of the fixed factors of production, etc.
A basic assumption in break-even analysis is that the cost-revenue-volume relationship is
linear. This is realistic only over narrow ranges of output
Break-even analysis is not an effective tool for long-range use and its use should be
restricted to the short run only.
Marginal Cost Equations and Breakeven Analysis:
Sales Marginal cost = Fixed cost + Profit = Contribution
1. Contribution
Contribution is the difference between sales and marginal or variable costs. It contributes toward
fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability
of products, departments etc.
2. Profit Volume Ratio (P/V Ratio), its Improvement and Application
The ratio of contribution to sales is P/V ratio. It is the contribution per rupee of sales and since
the fixed cost remains constant in short-run, P/V ratio will also measure the rate of change of
profit due to change in volume of sales. The P/V ratio may be expressed as follows:
P/V Ratio = Contribution = Change in Contribution = Change in Profit
Sales Change in Sales Change in Sales
A fundamental property of marginal costing system is that P/V ratio remains constant at different
levels of activity. A change in fixed cost does not affect P/V ratio.
3. Breakeven Point
Breakeven point is the volume of sales or production where there is neither profit nor loss.
S (sales) V (variable cost) = F (fixed cost) + P (profit)
At BEP P = 0
Thus, Break-even point (BEP) = F / (S -V) = Fixed cost / (Sales Variable cost)
= Fixed cost / Contribution per unit
Break-even Sales = Fixed cost
P/V Ratio
4. Margin of Safety (MOS)
Margin of safety is calculated as the difference between the total sales (actual or projected) and
the breakeven sales. It may be expressed in monetary terms (value) or as a number of units
(volume). A large margin of safety indicates the soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs, increasing volume of
sales or selling price and changing product mix.
Margin of safety = Sales at selected activity Sales at BEP = Profit
P/V Ratio
Problem:
A company producing a single article sells it at Rs. 10 each. The marginal cost of production is
Rs. 6 each and fixed cost is Rs. 400 per annum. You are required to calculate the following:
P/V ratio
Breakeven sales
Sales to earn a profit of Rs. 500
Profit at sales of Rs. 3,000
New breakeven point if sales price is reduced by 10%
Margin of safety at sales of 400 units
Particulars Amount Amount Amount Amount
Units produced 1 50 100 400
Sales (units * 10) 10 500 1000 4000
Variable cost 6 300 600 2400
Contribution (sales- VC) 4 200 400 1600
Fixed cost 400 400 400 400
P/V Ratio = (Contribution / Sales) x 100 = 0.4 or 40%
Breakeven sales (Rs.) = Fixed cost / (P/V Ratio) = 400/ 0.4 = Rs. 1,000
Sales at BEP = Contribution at BEP/ (P/V Ratio) = 100 units
Contribution at profit Rs. 500 = Fixed cost + Profit = Rs. 900
Sales to earn a profit of Rs. 500 = Contribution / (P/V Ratio) = 900/.4 = Rs. 2,250 (or 225 units)
Contribution at sales Rs. 3,000 = Sales x P/V Ratio = 3000 x 0.4 = Rs. 1,200
Profit at sales of Rs. 3,000 = Contribution Fixed cost = Rs. 1200 Rs. 400 = Rs. 800
New P/V ratio when sales price is reduced by 10% = Rs. 9 Rs. 6 / Rs. 9 = 1/3
Sales at BEP = Fixed cost/PV ratio = Rs. 400 / (1/3) = Rs. 1200
Margin of safety (at 400 units) = (4000 1000) / 4000 x 100 = 75 %
(Actual sales BEP sales/Actual sales x 100)
Problem:
The sales and profits during two years are as follows:
Year Sales Profit
2006 1, 00,000 15,000
2007 1, 20,000 23,000
You are required to find out:
a) P/V ratio
b) Fixed cost
c) Profit at an estimated sales of Rs. 1, 25,000
d) Sales required to earn a profit of Rs. 20,000
Solution:
a) P/V ratio = Change in profit x 100 = 8,000 x 100 = 40%
Change in sales 20,000
b) Since contribution is 40% of sales, Variable cost = 60% of sales = Rs. 60,000
Fixed cost = 1, 00,000 60,000 15,000 = Rs. 25,000
c) Contribution, when sales is Rs. 1, 25,000 = 1, 25,000 x 0.4 = Rs. 50,000
Profit = 50,000 25,000 = Rs. 25,000
d) Sales required to earn a profit of Rs. 20,000 = (Fixed cost + Desired profit) / (P/V ratio)
= (25,000 + 20,000) / 0.40 = Rs. 1, 12,500
Breakeven Analysis - Graphical Presentation
Breakeven chart is a device which shows the relationship between sales volume, marginal costs
and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect
of change of one factor on other factors and exhibits the rate of profit and margin of safety at
different levels. A breakeven chart contains total sales line, total cost line and the point of
intersection called breakeven point.
Construction of a Breakeven Chart
1. Select a scale for sales on horizontal axis and a scale for cost and revenue on vertical axis
2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel
to horizontal axis
3. Plot variable costs for some activity levels starting from the fixed cost line and join these
points. This will give total cost line. Alternatively, obtain total cost at different levels;
plot the points starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by joining zero and the
point so obtained.
The following Figure shows a typical break even chart.
Limitations and Uses of Breakeven Charts
A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost
and sales price remain constant. In practice, all these factors may change and the original
breakeven chart may give misleading results. But then, if a company sells different products
having different percentages of profit to turnover, the original combined breakeven chart fails to
give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a
breakeven chart for each product or a group of products. A breakeven chart does not take into
account capital employed which is a very important factor to measure the overall efficiency of
business. Fixed costs may increase at some level whereas variable costs may sometimes start to
decline. For example, with the help of quantity discount on materials purchased, the sales price
may be reduced to sell the additional units produced etc. These changes may result in more than
one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher
levels of sales.
Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing,
i.e. in forecasting, decision-making, long term profit planning and maintaining profitability. The
margin of safety shows the soundness of business whereas the fixed cost line shows the degree of
mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the
product or division under consideration.
Multiple Product Situations:
In real life, most of the firms turn out many products. Here, there is no problem with regard to
the calculation of break-even point. However, the assumption has to be made that the sales mix
remains constant. This is defined as the relative proportion of each products sale to total sales. It
could be expressed as a ratio such as 2:4:6, or as a percentage as 20%, 40%, and 60%.
The calculation of breakeven point in a multi-product firm follows the same pattern as in a single
product firm. While the numerator will be the same fixed costs, the denominator now will be
weighted average contribution margin. The modified formula is as follows:
Breakeven point (in units) = Fixed costs / Weighted average contribution margin per unit
B.E. point (in revenue) = Fixed cost / Weighted average P/V ratio
The weights are assigned in proportion to the relative sales of all products. Here, it will be the
contribution margin of each product multiplied by its quantity.
Example:
A furniture manufacture produces and sells the cabinets, office tables and chairs. The various
details regarding his business are given below:
Product Selling price per
unit Rs.
Variable cost per
unit Rs.
% of rupee sales
volume
File cabinet 1000 900 20
Office tables 500 400 30
Chairs 200 125 50
Capacity of the firm = Rs 1, 50, 000 of total sale volume
Annual fixed cost = Rs 20, 000
Calculate
1) S
BEP
and 2) Profit if firm works at 80% of capacity
Solution:
The contribution towards fixed cost in each case is
a) File cabinet - Rs 1000 - Rs 900 = Rs 100
b) Office tables - Rs 500 - Rs 400 = Rs 100
c) Chairs - Rs 200 - Rs 125 = Rs 75
Now there contributions are to be converted into percentages of sell prices and the formula is
contribution percentage
100
Pr
Pr
x
ice Selling
Cost Variable ice Selling
x x
Office tables
% 20 100
500
100
100
500
400 500
x x
Chairs
% 5 . 37 100
200
75
100
200
125 200
x x
To get the total contribution per rupee sales volume for the file cabinet, office tables and chairs,
we multiply the contribution percentage of each of the products by the percentage of sales
volume for that particular product and add the figures so obtained.
Furniture (a) Contribution % (b) % of sales in Rs (c) b x c/100
File cabinet 10 20 2000/100=2.00
Office tables 20 30 600/100 = 6.00
Chairs 37.5 50 1875/100=18.7
26.75 or 27%
27% is the total contribution per rupee of overall sales given the present product sales mix.
1)
74074 . 100
27
20000
% 27
20000
arg
Rs x
ratio in M on Contributi
Costs Fixed
BEP
2) Profit = Total revenue Total costs
Here Total revenue = 80% of the total capacity of the firm (given data in the problem)
Therefore, Profit
= 80% of Rs 1, 50, 000 - (Total fixed cost + Total variable cost)
= 1, 20, 000 - (20,000 + 73% of 1, 20, 000)
= Rs 12, 400
Managerial Uses of Break-even Analysis
Break-even analysis not only highlights the areas of economic strength and weaknesses in the
firm but also sharpens the focus on certain leverages which can be operated upon to enhance its
profitability. Through break-even analysis, it is possible to devise managerial actions to enhance
profitability of the firm. The break-even analysis can be used for the following purposes:
Safety Margin: The break-even chart can help the manager to get a fast idea about the
profits generated at the various levels of sales. But while deciding upon the volume at
which the firm would operate, apart from the demand, manager should consider the
Safety Margin associated with the proposed volume. The safety margin refers to the
extent to which the firm can afford a decline in sales before it starts incurring losses. If
the safety margin is dropping over a period of time, it would mean that the firms
resistance capacity to avoid losses has become poorer. A margin of safety can be negative
as well. In that case, it reveals the percentage increase in sales necessary to reach the BEP
so as at least to avoid losses.
Volume Needed to Attain Target Profit: Break-even analysis may be utilized for the
purpose of determining the volume of sales necessary to achieve a target profit.
Target sales volume =
unit in m on Contributi
etprofit T t Fixed
arg
arg cos +
Change in Price: The manager is often faced with a problem of whether to reduce price
or not. Before deciding on this question the manager must consider a number of points. A
reduction in price leads to a reduction in the contribution margin. This means that the
volume of sales will have to be increased to maintain the previous level of profit. The
higher the reduction in the contribution margin, the higher is the increase in sales needed
to ensure the previous profit. However, reduction in price may not always lead to a
proportionate increase in the volume of sales. Assuming that the present conditions
continue, break-even analysis will help the manager to know the required volume of sales
to maintain the previous level of profit. And on the basis of its knowledge and
experience, it will be much easier for the management to judge whether the required
increase in sales will be feasible. The formula for determining the new volume of sales to
maintain the same profit, given a reduction in price, is:
New volume of sales = Fixed cost + Profit______
Variable cost New Selling price
Change in Costs:
If Variable Costs Change
An increase in variable costs leads to a reduction in the contribution margin. Therefore,
when increases in costs are expected or is unavoidable, a common question which arises
is what total sales volume we need to maintain our present profits without any increase in
price or, in the alternative, what price should be fixed for the product to maintain our
present profit without any change in sales volume. The formula to determine the new
quantity (Q
n
) when there is a change in variable costs is:
New quantity = Fixed cost + Profit ______
New selling price Variable cost
If Fixed Costs Change
An increase in fixed costs of a firm may be caused either by external circumstances (e.g.,
an increase in machinery costs, taxes, etc) or by a managerial decision (e.g., an increase
in salaries). Then a question arises on what total sales volume do we need to maintain to
have our present profits without any increase in price or in the alternative, what price
should be set if there is no change in sales volume? The formula to determine the new
quantity (Q
n
) or the new price (SP
n3
) given a change in fixed costs would be:
VC SP
FC FC
Q Q
n
n
+
+
COMMERCIAL BANKING
A bank is an institution which deals with money and credit. It accepts deposits from the public,
makes the funds available to those who need them, and helps in the remittance of money from
one place to another.
According to the Indian Companies Act, 1949, banking means the accepting for the purpose of
Indian Companies lending or investment, of deposits of money from the public, repayable on
demand or otherwise, and withdrawal by cheques, draft or otherwise.
FUNCTIONS OF COMMERCIAL BANKS OR MODERN BANKS
In the modern world, banks perform such a variety of functions that it is not possible to make an
all-inclusive list of their functions and services. However, some basic functions performed by the
banks are discussed below.
a. Accepting Deposits:
The first important function of a bank is to accept deposits from those who can save but
cannot profitably utilize this saving themselves. People consider it more rational to
deposit their savings in a bank because by doing so they, on the one hand, earn interest,
and on the other, avoid the danger of theft. To attract savings from all sorts of
individuals, the banks maintain different types of accounts:
(i) Fixed Deposit Account (Time deposits) - Money in these accounts is deposited
for fixed period of time (say one, two, or five years) and cannot be withdrawn
before the expiry of that period. The rate of interest on this account is higher than
that on other types of deposits. Longer the period, higher will be rate of interest.
(ii) Current Deposit Account (Demand deposits) - These accounts are generally
maintained by the traders and businessmen who have to make a number of
payments every day. Money from these accounts can be withdrawn in as many
times and in as much amount as desired by the depositors. Normally, no interest is
paid on these accounts.
(iii) Saving Deposit Account - The aim of these accounts is to encourage and
mobilize small savings of the public. Certain restrictions are imposed on the
depositors regarding the number of withdrawals and amount to be withdrawn in a
given period. Cheques facility is provided to the depositors. Rate of interest paid
on these deposits is low as compared to that on fixed deposits.
(iv) Recurring Deposit Account - The purpose of these accounts is to encourage
regular savings by the public, particularly by the fixed income group. Generally
money in these accounts is deposited in monthly installments for a fixed period
and is repaid to the depositors along with interest on maturity.
b. Advancing of loans:
The second important function of a bank is advancing of loans to the public. After
keeping certain cash reserves, the banks lend their deposits to the needy borrowers.
Before advancing loans, the banks satisfy themselves about the creditworthiness of the
borrowers. Various types of loans granted by the banks are discussed below:
(i) Money at Call - Such loans are very short period loans and can be called back by
the bank at a very short notice of say one day to fourteen days. These loans are
generally made to other banks or financial institutions.
(ii) Cash Credit - It is a type of loan which is given to the borrower against his
current assets, such as shares, stocks, bonds, etc. The bank opens the account in
the name of the borrowers and allows him to withdraw borrowed money from
time to time up to a certain limit as determined by the value of his current assets.
Interest is charged only on amount actually withdrawn from the account.
(iii) Overdraft - Sometimes, the bank provides .overdraft facilities to its customers
though which they are allowed to withdraw more than their deposits. Interest is
charged from the customers on the overdrawn amount.
(iv) Discounting of Bills of Exchange - This is another popular type of lending by the
modern banks. In a bill of exchange the debtor accepts the bill drawn upon him by
the creditor and agrees to pay. After making some marginal deductions (in the
form of commission), the bank pays the value of the bill to the holder. When the
bill of exchange matures, the bank gets its payment from the party which had
accepted the bill. Thus, such a loan is self-liquidating.
(v) Term Loans - The banks have also started advancing medium-term and long-
term loans. The maturity period for such loans is more than one year. The amount
sanctioned is either paid or credited to the account of the borrower. The interest is
charged on the entire amount of the loan and the loan is repaid either on maturity
or in installments.
c. Credit Creation:
A unique function of the bank is to create credit. In fact, credit creation is the natural
outcome of the process of advancing loan as adopted by the banks. When a bank
advances a loan to its customer, it does not lend cash but opens an account in the
borrowers name and credits the amount of loan to this account. Thus, whenever a bank
grants a loan, it creates an equal amount of bank deposit. Creation of such deposits is
called credit creation which results in a net increase in the money stock of the economy.
d. Promoting Cheques System:
Banks also render a very useful medium of exchange in the form of cheques. Through a
cheque, the depositor directs the bankers to make payment to the payee. Cheque is the
most developed credit instrument in the money market. In the modern business
transactions, cheques have become much more convenient method of settling debts than
the use of cash.
e. Agency Functions:
Banks also perform certain agency functions for and on behalf of their customers:
(i) Remittance of Funds - Banks help their customers in transferring funds from one
place to another through cheques, drafts, etc.
(ii) Collection and Payment of Credit Instruments - Banks collect and pay various
credit instruments like cheques, bills of exchange, promissory notes.
(iii) Execution of Standing Orders - Banks execute the standing instructions of their
customers for making various periodic payments. They pay subscriptions, rents,
insurance premium etc. on behalf of their customers.
(iv) Purchasing and Sale of Securities - Banks undertake purchase and sale of
various securities like shares, stocks, bonds, debentures etc. on behalf of their
customers.
(v) Collection of Dividends on Shares - Banks collect dividends, interest on shares
and debentures of their customers.
(vi) Acting as Representative and Correspondent - Sometimes the banks act as
representatives and correspondents of their customers. They get passports,
travelers tickets, book vehicles, plots for their customers and receive letters on
their behalf.
f. General Utility Function:
In addition to agency services, the modern banks provide many general utility services as
given below:
(i) Locker Facility - Banks provide locker facility to their customers. The customers
can keep their valuables and important documents in these lockers for safe
custody.
(ii) Travelers Cheques - Banks issue travelers cheques to help their customers to
travel without the fear of theft or loss of money. With this facility, the customers
need not take the risk of carrying cash with them during their travels.
(iii) Letters of Credit - Letters of credit are issued by the banks to their customers
certifying their creditworthiness. Letters of credit are very useful in foreign trade.
(iv) Collection of Statistics - Banks collect statistics giving important information
relating to industry, trade and commerce, money and banking. They also publish
journals and bulletins containing research articles on economic and financial
matters.
(v) Underwriting Securities - Banks underwrite the securities issued by the
government, public or private bodies. Because of its full faith in banks, the public
will not hesitate in buying securities carrying the signatures of a bank.
(vi) Gift Cheques - Some banks issue cheques of various denominations (say of
Rs.11, 21, 31, 51.101, etc.) to be used on auspicious occasions.
(vii) Foreign Exchange Business - Banks also deal in the business of foreign
currencies. Again, they may finance foreign trade by discounting foreign bills of
exchange.
BANKS AND ECONOMIC DEVELOPMENT
In a modern economy, banks are to be considered not merely as dealers in money but also the
leaders in development. They are not only the store houses of the countrys wealth but also are
the reservoirs of resources necessary for economic development. It is the growth of commercial
banking in the 18th and 19th centuries that facilitated the occurrence of industrial revolution in
Europe. Similarly, the economic progress in the present day developing economies largely
depends upon the growth of sound banking system in these economies.
Commercial banks can contribute to countrys economic development in following ways:
1. Capital Formation:
Capital formation is the most important determinant of economic development and banks
promote capital formation. Capital formation has three well-defined stages:
(a) Generation of saving - They stimulate savings by providing a number of
incentives to the savers, such as, interest on deposits, free and cheap remittance of
funds, safe custody of valuables, etc.
(b) Mobilization of saving - By expanding branches in different areas and giving
various incentives, they succeed in mobilizing savings generated in the economy.
(c) Canalization of saving in productive uses - They not only mobilize resources
from those who have excess of them, but also make the resources so mobilized
available to those who have the opportunities of productive investment.
2. Encouragement to Entrepreneurial Innovations:
In underdeveloped countries, entrepreneurs generally hesitate to invest in new ventures
and undertake innovations largely due to lack of funds. Facilities of bank loans enable the
entrepreneurs to step up investment and innovational activities, adopt new methods of
production and increase productive capacity of economy.
3. Monetization of Economy:
Monetization of the economy is essential for accelerating trade and economic activity.
Banks, which are creators and distributors of money, allow money to play active role in
the economy.
4. Influencing Economic Activity:
Banks can directly influence economic activity, and hence, the pace of economic
development through its influence on:
(a) Variations in Interest Rates - A reduction in the interest rates makes the
investment more profitable and stimulates economic activity. An increase in the
interest rate, on the other hand, discourages investment and economic activity.
(b) Availability of Credit - Bankers can also influence economic activity by the
availability of credit. Through their credit creation activity the banks increase the
supply of purchasing power and hence the aggregate demand. This, in turn,
increases investment, production and trade in the economy.
5. Implementation of Monetary Policy:
Economic development needs an appropriate monetary policy. But, a well-developed
banking system is a necessary pre-condition for the effective implementation of the
monetary policy. Control and regulation of credit by the monetary authority is not
possible without the active cooperation of the baking system in the country.
6. Promotion of Trade and Industry:
Economic progress in the industrially advanced countries in the last two hundred years or
so is mainly due to expansion in trade and industrialization which could not have been
made possible without the development of banking system. The use of bank cheque, the
bank draft and the bill of exchange has revolutionized the internal and international trade.
7. Encouragement to Right Type of Industries:
By granting loans (particularly medium-term and long-term), the banks can provide
financial resources to the right type of industries to secure necessary material, machines
and other inputs. In a planned economy, it is necessary that the banks should formulate
their loan policies in accordance with the broad objectives and strategy of
industrialization as adopted in the plan. This will promote right type of industrialization
in the economy.
8. Regional Development:
Banks can also play an important role in achieving balanced development in different
regions of the economy. They can transfer surplus capital from the developed regions to
the less-developed regions where it is scarce and most needed. This reallocation of funds
between regions will promote economic development in underdeveloped areas of the
economy.
9. Development of Agriculture and Other Neglected Sectors:
Underdeveloped economies are primarily agricultural economies and majority of the
population in these economies live in rural areas. Therefore, economic development in
these economies requires the development of agriculture and small-scale industries in
rural areas. So far, banks, in underdeveloped countries have been paying more attention
to trade and commerce and have almost neglected agriculture and industry. Thus,
necessary structural and functional reforms in the banking system of the underdeveloped
countries should be made in older to encourage the banks to play developmental role in
these economics.
TYPES OF BANKS
Banks can be classified into various types on the basis of their functions, ownership, domiciles
etc. The following are the various types of banks:
1. Commercial Banks:
The banks which perform all kinds of banking business and generally finance trade and
commerce are called commercial banks. Since their deposits are for a short period, these
banks normally advance short-term loans to the businessmen and traders. However,
recently, the commercial banks have also extended their areas of operation to medium-
term and long-term finance. Majority of the commercial banks are in the public sector.
But, there are certain private sector banks operating as joint stock companies. Hence, the
commercial banks are also called joint stock banks.
2. Industrial Banks:
Industrial banks also known as investment banks, mainly meet the medium-term and
long-term financial needs of the industries.
The main functions of the industrial banks are:
(a) They accept long-term deposits
(b) They grant long-term loans to the industrialists to enable them to purchase land,
construct factory building, purchase heavy machinery, etc.
(c) They help selling or even underwrite the debentures and shares of industrial firms
(d) They can also provide information regarding the general economic position of the
economy.
In India, industrial banks, like Industrial Development Bank of India, Industrial Finance
Corporation of India, State Finance Corporations, are playing significant role in the
industrial development of the country.
3. Agricultural Banks:
Agricultural credit needs are different from those of industry and trade. Industrial and
commercial banks normally do not deal with agricultural finance.
The agriculturists require:
(a) Short-term credit to buy seeds, fertilizers and other inputs, and
(b) Long-term credit to purchase land, to make permanent improvements on land, to
purchase agricultural machinery and equipment, etc.
In India, agricultural finance is generally provided by co-operative institutions.
4. Exchange Banks:
Exchange banks deal in foreign exchange and specialize in financing foreign trade. They
facilitate international payments through the sale and purchase of bills of exchange and
thus play an important role in promoting foreign trade.
5. Saving Banks:
The main purpose of saving banks is to promote saving habits among he general public
and mobilize their small savings. In India, postal saving banks do this job. They open
accounts and issue postal cash certificates.
6. Central Bank:
Central bank is the apex institution which controls, regulates and supervises the monetary
and credit system of the country.
Important functions of the central bank are:
(a) It has the monopoly of note issue
(b) It acts as the banker, agent and financial adviser to the slate
(c) It is the custodian of member banks reserves
(d) It is the custodian of nations reserves of international currency
(e) It serves as the lender of the last resort
(f) It functions as the bank of central clearance, settlement and transfer and
(g) It acts as the controller of credit.
7. Classification on the Basis of Ownership:
(a) Public Sector Banks - These are owned and controlled by the government. In
India, the nationalized banks and the regional rural banks come under these
categories
(b) Private Sector Banks - These banks are owned by the private individuals or
corporations and not by the government or cooperative societies
(c) Cooperative Banks - Cooperative banks arc operated on the cooperative lines. In
India, cooperative credit institutions are organized under the cooperative
societies law and play an important role in meeting financial needs in the rural
areas.
8. Classification on the Basis of Domicile:
(a) Domestic Banks - These are registered and incorporated within the country
(b) Foreign Banks - These are foreign in origin and have their head offices in the
country of origin.
9. Scheduled and Non-Scheduled Banks:
In India, banks have been broadly classified into scheduled and non-scheduled banks. A
Scheduled Bank is that which has been included in the Second Schedule of the Reserve
Bank of India Act, 1934 and fulfills the three conditions:
(a) It has paid-up capital and reserves of at least Rs. 5 lakhs
(b) It ensures the Reserve Bank that its operations are not detrimental to the interest
of the depositors
(c) It is a corporation/cooperative society and not a partnership or single owner firm.
The banks which are not included in the Second Schedule of the Reserve Bank of India
Act are non-scheduled banks.
BALANCE SHEET OF A BANK
The balance sheet of a bank is a statement of its liabilities and assets at a particular time.
Liabilities refer to all debit items representing the obligations of the bank or others claims on the
bank. In other words, all those items because of which the bank is liable to pay to others form the
liabilities of the bank. Assets, on the other hand, refer to all credit items representing the banks
claims on others and its ownership of wealth.
Table 1: Balance Sheet of a bank
Liabilities Assets
1. Share Capital 1. Cash
2. Reserve fund (a) Cash in hand
3. Deposits: (b) Cash with central bank
(a) Demand deposits (c) Cash with other banks
(b) Time deposits 2. Money at call and shot notice
(c) Saving deposits 3. Bills purchased or discounted
4. Borrowings from other banks 4. Investments
5. Acceptance and endorsements. 5. Loans and advances
6. Other liabilities 6. Acceptance and endorsements
7. Buildings and other fixed assets
Total Total
Thus, the balance sheet shows how a bank raises funds and how it invests them. It is customary
that the liabilities are mentioned on the left side and the assets on the right side of the balance
sheet. The totals on the two sides (i.e., the total liabilities and the total assets) are always equal.
Liabilities of the Bank:
1. Share Capital:
A joint stock bank initially raises its funds by issuing share capital. In other words, share
capital is the contributions made by the shareholders. Share capital is in the form of:
(a) Authorized capital - the maximum amount of capital the bank is authorized to
raise in the form of shares
(b) Issued capital - the part of the authorized capital issued in the form of shares for
public subscription
(c) Subscribed capital - the part of the issued capital actually subscribed by the
public and part of the subscribed capital actually paid by the subscribers.
(d) Paid-up capital - It is the actually paid-up share capital which constitutes the
liability of the bank.
2. Reserve Fund:
Reserve fund is the amount accumulated over the years out of undistributed profits.
Normally, all the profits of the bank are not distributed among the shareholders; some
part is retained undistributed for meeting contingencies. This reserve fund actually
belongs to the shareholders.
3. Deposits:
Deposits from the public constitute the major portion of the banks working capital.
Various types of deposits accepted by the bank are:
(a) Demand deposits - the deposits which can be withdrawn at any time and on
which no interest is paid
(b) Time deposits - the deposits which can be withdrawn after a fixed period of time
and on which high rate of interest is paid and
(c) Saving deposits - the deposits which can be withdrawn to the limited extent in a
given period and on which some interest is paid.
4. Borrowings from Banks:
Sometimes, the bank borrows loans from other banks on temporary basis to meet the
increased demand for money. Central bank is the lender of the last resort and provides
loan facilities to the banks in special circumstances. All these borrowings form the
liability of the borrower bank.
5. Other Liabilities:
Certain other miscellaneous liabilities are incurred by the bank. For example, by acting as
an agent the bank makes collections on behalf of its customers and thus creates liability.
Again, the profits earned by the bank represent the liability because they arc payable to
the shareholders.
Assets of the Bank:
The asset side of the balance sheet shows the manner in which the funds of the bank are utilized.
Given below are various assets of the bank arranged in an ascending order of profitability and
descending order of liquidity:
1. Cash:
Cash is the most liquid but non-earning asset and is considered as the first line of defense.
Every bank keeps certain amount of cash in order to meet the cash requirements of its
depositors.
2. Money at Call and Short Notice:
Money at call and short notice refers to loans which are recoverable by the bank on
demand or at a very short notice. These loans are for a maximum period of 15 days. Such
loans are earning as well as highly liquid assets which can be converted into cash quickly
and without loss.
3. Bills purchased or discounted:
The bank utilizes its funds in trade bills and treasury bills which it discounts. The amount
of the bills is collected by the bank on maturity. The bills discounted are short-term
(normally of 90 days) self-liquidating assets. They are self-liquidating because, at the end
of the commercial transaction, the money will be repaid.
4. Investments:
Some funds are invested in profit-yielding assets, mainly the government securities.
Government securities arc relatively safe because there is certainty of repayment after
maturity. Moreover, the banks can borrow from the central bank against these securities.
5. Loans and Advances:
Loans and advances are the most profitable and the least liquid assets of the bank. Banks
provide loans and advances to the businessmen either through overdraft or by discounting
of bills of exchange. The difference between loans and advances is that the advances are
for short period and loans are for relatively longer period. Loans and advances earn high
rate of interest, carry greater risk and are generally non-shiftable.
6. Building and other Fixed Assets:
Banks assets also include the value of the movable and immovable properties of the
bank, such as office buildings, furniture etc. These assets do not contribute to the income
of the bank and constitute very small properties of the assets of the bank.
The importance of the balance sheet of a bank clearly brings out the following points:
i) It represents the complete functioning of the bank. It tells how the bank raises money and
how it invests it.
ii) It throws light on the financial position (i.e., liquidity and solvency position) of the bank
because it contains all information about the liabilities and assets of the bank.
iii) The progress of the bank over time can be determined by comparing the balance sheet of
different periods
iv) A comparison of balance sheet of different banks gives comparative picture of financial
position of a bank vis a vis that of others.
v) It gives an estimate of the confidence of the public in the bank. Increasing saving or time
deposits of bank represent that the confidence of the people in the bank is also increasing.
vi) It shows the loans and investment policy of the bank.
vii) It provides information about the interest of various persons, such as shareholders,
debtors, creditors, etc.
NEW TRENDS IN COMMERCIAL BANKING
Drastic changes have been experienced in both theory and practice of commercial banking the
world over especially in the post-war period. Major changes are discussed below:
1. New Developments in Banking Theory:
Traditional commercial loan theory has now been completely discarded and has given
place to the modern shiftability and anticipated income theories. All these theories
attempt to resolve the liquidity-earning problem of the bank, i.e., how a bank can achieve
the two conflicting objectives of liquidity as well as profitability simultaneously.
According to commercial loan theory, the banks can ensure sufficient liquidity by
granting only short-term self- liquidating loans secured by goods in the process of
production or goods in transit. The shiftability theory requires the banks to solve their
liquidity problem by purchasing highly liquid assets which can be easily shifted to other
banks in times of need for liquidity. According to the recent anticipated income theory,
the banks can solve their liquidity problem even by advancing long-term loans if the
borrowers repay the loans in series of continuous installments.
2. Term Lending:
Term loans not only increase earnings of the banks, but also improve their liquidity
because such loans are almost always repaid on an installment basis. The term loans are
also beneficial to the borrowers. They are used to purchase machinery and equipment for
the industries where the expected income flow from the investment will not be sufficient
to repay a short-term loan.
3. Hire Purchase Finance:
Hire purchase finance, which refers to the credit facilities for the purchase of durable
goods on installment basis, is another post-war development in commercial banking. The
dealers selling on hire-purchase get advances from the banks by hypotheticating their
goods to the banks. Hire purchase facilities help the small entrepreneurs to start new
business and the existing small producers to purchase new tools and equipment. The
commercial banks entered into this highly profitable business by acquiring the direct
ownership of, or a partnership in the established hire-purchased finance companies.
4. Personal Loans:
Another departure from the traditional banking practice is the advancing of personal
loans by commercial banks. This is a direct consequence of post-war policy of
redistribution of income in favor of the working class which was instrumental in
stimulating consumer credit by the banks. Commercial banks started granting personal
loans for meeting expenditures to purchase motor cars, household appliances,
professional equipment, house repairs and decorations, etc.
CHANGING PATTERNS OF COMMERCIAL BANKING IN
DEVELOPING COUNTRIES
Quite recently, the commercial banking has undergone a number of structural and functional
changes in developing countries like India. The major changes are mentioned below:
i) The commercial banks in the developing countries are slowly departing from the
traditional strict self-financing rules favoring risk free self-liquidating loans. They have
now started adhering to the shiftability theory which maintains that as long as the assets
of the commercial banks can be shifted or sold for liquidity, the banks can extend the
period of lending.
ii) The Indian commercial banks have recently started providing hire-purchase finance.
These banks advance loans for purchasing consumer durables (mainly motor cars) and
producers equipment.
iii) Some Indian banks grant personal loans to their customers for purchasing consumer
durable, like motor cars, scooters, electric fans, professional equipment, agricultural
equipment, etc. Such loans are made available to the individuals with stable and
continuous income, particularly to the government servants, employees of statutory
bodies and of established industrial, financial, and commercial institutions.
iv) The structure of commercial bank lending in the developing countries (e.g., India, Ghana,
and Libya) has changes from commerce to industry.
v) In India, after the nationalization of major commercial banks in 1969, direct lending to
agriculture by the commercial banks has shown notable increases.
RESERVE BANK OF INDIA
The Reserve Bank of India is Indias central bank. It is the apex monetary institution which
supervises, regulates controls and develops the monetary and financial system of the country.
The Reserve bank was established on April 1, 1935 under the Reserve Bank of India Act, 1934.
Initially, it was constituted as a private shareholders bank with a fully paid-up capital of Rs. 5
crore. But, it was nationalized on January 1, 1949.
Organization:
1. Issue Department - Its main function is to issue, and distribute the paper currency.
2. Banking Department - This department deals with government transactions, manages
public debt and arranges for the transfer of government funds, maintains the cash reserves
3. Department of Banking Development - It aims at expanding banking facilities in
unbanked and rural areas.
4. Department of Banking Operations - Its function is to supervise, regulate and control
the working of the banking institutions in the country.
5. Agricultural Credit Department - It deals with the problems of agricultural credit and
provides facilities of rural credit to state governments and state cooperatives.
6. Industrial Finance Department - Its main objective is to provide financial help to the
small and medium scale industries.
7. Non-Banking Companies Department - It supervises the activities of non-banking
companies and financial institutions in the country
8. Exchange Control Department - It conducts the business of sale and purchase of
foreign exchange.
9. Legal Department - It provides advice to various departments on legal issues. It also
gives legal advice on the implementation of banking laws in the country.
10. Department of Research and Statistics. It conducts research on problems relating to
money, credit, finance, production, collect important statistics relating to various aspects
of the economy; and publish these statistics.
11. Department of Planning and Reorganization - It deals with the formulation of new
plans or reorganization of existing policies for making them more effective.
12. Economic Department - It is concerned with framing proper banking policies for better
implementation of economic policies of the government.
13. Inspection Department - It undertakes the function of inspecting various offices of the
commercial banks.
14. Department of Accounts and Expenditure - It keeps proper records of all receipts and
expenditures of the Reserve Bank.
15. RBI Services Board - It deals with the selection of new employees, for different posts in
the Reserve Bank.
Management:
The management of the Reserve Bank is under the control of Central Board of Directors
consisting of 20 members:
(a) The executive head of the Bank is called Governor who is assisted by four Deputy
Governors. They are appointed by the Government of India for a period of five years.
The head office of the Reserve Bank is at Bombay
(b) There are four local boards at Delhi, Calcutta, Madras and Bombay representing four
regional areas, i.e., northern, eastern, southern and western respectively. These local
boards are advisory in nature and the Government of India nominates one member each
from these boards to the Central Board
(c) There are ten directors from various fields and one government official from the Ministry
of Finance.
FUNCTIONS OF RESERVE BANK
The Reserve Bank of India performs various traditional central banking functions as well as
undertakes different promotional and developmental measures to meet the dynamic requirements
of the country.
The broad objectives of the Reserve Bank are:
(a) Regulating the issue of currency in India
(b) Keeping the foreign exchange reserves of the country
(c) Establishing the monetary stability in the country and
(d) Developing the financial structure of the country on sound lines consistent with the
national socio-economic objectives and policies.
Main functions of the Reserve Bank are described below:
1. Note Issue:
The Reserve Bank has the monopoly of note issue in the country. It has the sole right to
issue currency notes of all denominations except one rupee notes. One rupee notes are
issued by the Ministry of Finance of the Government of India. The Reserve Bank acts as
the only source of legal tender because even the one rupee notes are circulated through it.
2. Banker to Government:
The Reserve Bank acts as the banker, agent and adviser to Government of India:
(a) It maintains and operates government deposits
(b) It collects and makes payments on behalf of the government
(c) It helps the government to float new loans and manages the public debt
(d) It provides development finance to the government for carrying out 5- year plans
(e) It undertakes foreign exchange transactions on behalf of the Central Government
(f) It acts as the agent of the Government of India in the latters dealings with the
IMF, the World Bank, and other international financial institutions
3. Bankers Bank:
The Reserve Bank acts as the bankers bank in the following respects:
(a) Every Bank is under the statutory obligation to keep a certain minimum of cash
reserves with the Reserve Bank. The purpose of these reserves is to enable the
Reserve Bank to extend financial assistance to the scheduled banks in times of
emergency and thus to act as the lender of the last resort.
(b) The Reserve Bank provide financial assistance to scheduled banks by discounting
their eligible bills and through loans and advances against approved securities
(c) Under the Banking Regulation Act, 1949 and its various amendments, the
Reserve Bank has been given extensive powers of supervision and control over
the banking system. These regulatory powers relate to the licensing of banks and
their branch expansion; liquidity of assets of the banks; management and methods
of working of the banks; reconstruction and liquidation of banks etc.
4. Custodian of Exchange Reserves:
The Reserve Bank is the custodian of Indias foreign exchange reserves. It maintains and
stabilizes the external value of the rupee, administers exchange controls and other
restrictions imposed by the government, and manages the foreign exchange reserves. The
Reserve Bank sells and buys foreign currencies in order to achieve the objective of
exchange stability.
5. Controller of Credit:
As the central bank of the country, the Reserve Bank undertakes the responsibility of
controlling credit in order to ensure internal price stability and promote economic growth.
Through this function, the Reserve Bank attempts to achieve price stability in the country
and avoids inflationary and deflationary tendencies in the country. The Reserve Bank
regulates money supply in accordance with the changing requirements of the economy.
6. Ordinary Banking Functions:
The Reserve Bank also performs various ordinary banking functions:
(a) It accepts deposits from the central government, state governments and even
private individuals without interest
(b) It grants loans and advances to the central government, state governments, local
authorities, scheduled banks and state cooperative banks repayable within 90 days
(c) It buys and sells securities of the Government of India and foreign securities
(d) It can borrow from any scheduled bank in India or from any foreign bank
(e) It can open an account in the World Bank or in some foreign central bank
(f) It buys and sells gold and silver.
7. Promotional and Developmental Functions:
The Reserve Bank also performs a variety of promotional and developmental functions:
(a) By encouraging the commercial banks to expand their branches in the semi-urban
and rural areas
(b) By establishing the Deposit Insurance Corporation, the Reserve Bank helps to
develop the banking system of the country, instills confidence of the depositors
and avoids bank failures
(c) Through the institutions like Unit Trust of India, the Reserve Bank helps to
mobilize savings in the country
(d) Since its inception, the Reserve Bank has been making efforts to promote
institutional agricultural credit by developing cooperative credit institutions
(e) The Reserve Bank also helps to promote the process of industrialization in the
country by selling up specialized institutions for industrial finance
MONETARY POLICY OF THE RESERVE BANK
Monetary policy refers to the policy of the central bank of a country to regulate and control the
volume, cost and allocation of money and credit with the aim of achieving the objectives of
optimum levels of output and employment, price stability, balance of payment equilibrium, or
any other goal set by the government.
Monetary and fiscal policies are closely interrelated and therefore should be pursued in
coordination with each other. Fiscal policy generally brings about changes in money supply
through the budget deficit. An excessive budget deficit, for example, shifts the burden of control
of inflation to monetary policy. This requires a restrictive credit policy. On the contrary, a fiscal
policy, which keeps the budget deficit at a very low level, frees the monetary authority from the
burden of adopting an anti-inflationary monetary policy.
In a developing economy like India, appropriate monetary policy can play a positive role in
creating conditions necessary for rapid economic growth. Moreover, since these economies are
highly sensitive to inflationary pressures, the monetary policy should also serve to control
inflationary tendencies by increasing savings by the people, checking credit expansion by the
banking system and discouraging deficit financing by the government
In India, during the planning period, the aim of the monetary policy of the Reserve Bank has
been to meet the needs of the planned development of the economy. With this broad aim, the
monetary policy has been pursued to achieve the twin objectives of the economic policy of the
government:
(a) To accelerate process of economic growth with a view to raise national income,
(b) To control and reduce the inflationary pressures in the economy.
Policy of Credit Expansion:
The overall trend in the economy during planning period has been that of continuous expansion
of currency and credit with an objective of meeting the developmental needs of the economy.
This expansion has been achieved by adopting the following measures:
1. Revision of Open Market Operations:
The Reserve Bank revised its open operations policy in October 1956, according to which
it started giving discriminatory support to the sale and purchase of government securities.
2. Liberalization of the Bill Market Scheme:
Through the bill market scheme, the commercial banks receive additional funds from the
Reserve Bank to meet the increasing credit requirements of their borrowers.
3. Facilities to Priority Sectors:
The Reserve Bank continues to provide credit facilities to priority sectors such as small-
scale industries and cooperatives, even though the general policy of the Bank is to control
credit expansion.
4. Credit Facilities through Financial Institutions:
The Reserve Bank has also been instrumental in the establishment of various financial
institutions like Industrial Development Bank of India, Industrial Finance Corporation of
India, Industrial Credit and Investment Corporation of India, State Finance Corporations,
and National Bank for Agriculture and Rural Development.
5. Deficit Financing:
Continuous increase in money supply in the country has been caused by adopting the
method of deficit financing to finance the budgetary deficit of the government. This has
been made possible through changes in the reserve requirements of the Reserve Bank.
6. Anti-Inflationary Fiscal Policy:
The Seventh Five Year Plan prefers an anti-inflationary fiscal policy to an anti-
inflationary monetary policy and emphasizes a positive, promotional and expansionary
role for monetary policy.
Policy of Credit Control:
The Reserve Bank has adopted a number of credit control measures to check the inflationary
tendencies in the country:
1. Bank Rate:
The bank rate is the rate at which the Reserve Bank advances to the member banks
against approved securities. Bank rate is considered as a pace-setter in the money market.
Changes in the bank rate influence the entire interest rate structure.
2. Net Liquidity Ratio:
In order to check excessive borrowings from the Reserve Bank by the commercial banks,
the Reserve Bank introduced the system of net liquidity ratio in September 1964.
According to this system, a commercial bank can borrow from the Reserve Bank at the
bank rate only if it maintains a minimum net liquidity ratio to its total demand and time
liabilities, and it will have to pay a penal rate of interest to the Reserve Bank, if the net
liquidity ratio falls below the minimum ratio fixed by the Reserve Bank.
3. Open Market Operations:
Through the technique of open market operations, the central bank seeks to influence the
excess reserves position of the banks by purchasing and selling of government securities.
When the central bank purchases securities from the banks, it increases their cash reserve
position and hence their credit creation capacity. On the other hand, when central bank
sells securities to the banks, it reduces their cash reserves and the credit creation capacity.
4. Cash-Reserve Requirement (CRR):
The central bank of a country can change the cash-reserve requirement of the bank in
order to affect their credit creation capacity. An increase in the cash- reserve ratio reduces
the excess reserve of the bank and a decrease in the cash-reserve ratio increases their
excess reserves.
5. Statutory Liquidity Ratio (SLR):
Under the original Banking Regulation Act 1949, banks were required to maintain liquid
assets in the form of cash, gold and unencumbered approved securities equal to not less
than 25% of their total demand and time deposits liabilities.
FINANCIAL MARKET
Financial markets arc functionally classified into:
(a) Money market and
(b) Capital market.
This classification is on the basis of term of credit, i.e., whether the credit is supplied for a short
period or long period. Money market refers to institutional arrangements which deal with short-
term funds. Capital market, on the other hand, deals in long-term funds.
CHART 1
STRUCTURE OF INDIAN MONEY MARKET
Indian Money Market
Organized Sector Unorganized
Sector
Indigenou
s Bankers
Money
Lenders
Reserve
Bank
of India
Commerc
ial banks
P.O.
Saving
Banks
Non-
banking
Companies
Cooperativ
e Banks
Scheduled
Commercial
Banks
Non-
scheduled
Banks
Public
Sector
Banks
Indian
Banks
Foreign
Banks
Regional
Rural
Banks
State
Bank
Group
Nationaliz
ed banks
STRUCTURE OF INDIAN MONEY MARKET
i) Broadly speaking the money market in India comprises two sectors organized and
unorganized sectors. The organized sector consists of the Reserve Bank of India, the
State Bank of India with its seven associates, twenty nationalized commercial banks,
other schedule and non-scheduled commercial banks, foreign banks, and Regional Rural
Banks. It is called organized because its parts are systematically coordinated by the RBI.
ii) Non-bank financial institutions such as the LIC, the GIC and subsidiaries. The UTI also
operate in this market, but only indirectly through banks, and not directly.
iii) Quasi-government bodies and large companies also make their short term surplus funds
available to the organized marker through banks.
iv) Cooperative credit instructions occupy the intermediary position between organized and
unorganized parts of the Indian money market. These institutions have a three-tier
structure. At the top there are state cooperative banks. At the local level, there are
primary credit societies and urban cooperative banks.
Unorganized Sector of the Indian Money Market
The unorganized segment of the Indian money market is composed of unregulated non-bank
financial intermediaries, indigenous bankers and money lenders which exist even in the small
towns and big cities. Their lending activities are mostly restricted to small towns and villages.
The persons who normally borrow from this unorganized sector include farmers, artisans, small
traders and small scale producers who do not have any access to modern banks. The following
are some of the constituents of unorganized money market in India.
1. Indigenous Bankers:
Indigenous bankers include those individuals and private firms which are engaged in
receiving deposits and giving loans and thereby act like a mini bank. Their activities are
not at all regulated. During the ancient and medieval periods, those indigenous bankers
were very active. But with the growth of modern banking, particularly after the advent of
British, the business of the indigenous bankers received a set back. Moreover, with the
growth of commercial banks and Co-operative banks the area of operations of indigenous
bankers has again contracted further.
2. Unregulated non-bank financial intermediaries:
There are different types of unregulated non-bank financial intermediaries in India. They
are mostly constituted by loan or finance companies, chit funds etc. A good number of
finance companies in India are engaged in collecting substantial amount of funds in the
form of deposits, borrowings and other receipts. They normally give loans to wholesale
traders, retailers, artisans, and different self-employed persons at a rate of interest ranging
between 36 to 48%.
3. Money Lenders:
Money lenders are advancing loans to small borrowers like marginal and small farmers,
agricultural laborers, artisans, factory and mine workers, low paid staffs, small traders
etc. at a very high rate of interest and also adopt various malpractices for manipulating
loan records of these poor borrowers. The money lending operation of the money lenders
is totally unregulated and unsupervised which leads to worst exploitation of the small
borrowers.
Organized Sector of Indian Money Market:
The organized segments of the Indian money market is composed of the Reserve bank of India,
the State Bank of India, Commercial banks, Co-operative banks, foreign banks, finance
corporations and the Discount of Finance House of India Limited. Mumbai, Calcutta, Chennai,
Delhi, Bangalore and Ahmedabad are the leading centers of the organized sector of the Indian
money market. The Mumbai money market is a well organized one, having the head offices of
the RBI and different commercial banks, well developed stock exchange, the bullion exchange
and fairly organized market for Government securities.
The main constituents of the organized sector of Indian money market include:
(i) The Call Money Market:
The call money market in a most common form of developed money market. The call
money market in India is very much centered at Mumbai, Chennai and Calcutta and out
of which the Mumbai is the most important one. In such market, lending and borrowing
operations are carried out for one day. Normally, scheduled commercial banks, Co-
operative banks and the Discount and Finance House of India operate in this market
ii) The Treasury bill Market:
Treasury bill markets are markets for treasury bills. In India such treasury bills are short
term liability of the Central Government which is of 91 day and 364 day duration.
Normally, the treasury bills should be issued so as to meet temporary revenue deficit over
expenditure of a Government at some point of time. But, in India, the treasury bills are,
now a day, considered as a permanent source of funds for the Central Government. In
India, the RBI is the major holders of the treasury bills, which is around 90 % of the total.
(ii) The Commercial Bill Market:
The Commercial bill market is a kind of sub-market which normally deals with trade bills
or the commercial bills. It is a kind of bill which is normally drawn by one merchant firm
on the other and they arise out of commercial transactions. The purpose for issuing a
commercial bill is simply to reimburse the seller as and when the buyer delays payment.
But, in India, the commercial bill market is not so developed. This is mainly due to
popularity of the cash credit system in bank lending.
(iii) The Certificate of Deposit (CD) Market:
The certificate of Deposit (CD) was introduced in India by the RBI in, March 1989 with
the sole objective of widening the range of money market instruments and also to attain
higher flexibility in the development of short term surplus funds for the investors. In
India, six financial institutions, viz,, IDBI, ICICI, IFCI, IRBI, SIDBI and Export and
Import Bank of India were permitted in 1993 to issue for period varying between 1 to 3
years. Banks normally pay high rates of interest on CDs.
(iv) The Commercial Paper Market:
In India, the Commercial Paper (CP) was introduced in the money market in January
1990. A listed company having working capital not less than Rs. 5 crore can issue CP.
(v) Money Market Mutual Funds:
In India, the RBI has introduced a scheme of Money Market Mutual Funds (MMMFs) in
April 1992. The main objective of this scheme was to arrange an additional short term
revenue for the individual investors. This scheme has failed to receive much response as
the initial guidelines were not attractive. Thus, in November, 1995, the RBI introduced
some relaxations in order to make the scheme more attractive and flexible. As per the
exiting guidelines, the banks, public financial institutions and the private financial
institutions are allowed to set up MMMFs.
The Indian money market has its distinctive characteristics as it suffers from various defects. The
following are some of its characteristics:
1. Lack of adequate integration:
There is lack of adequate integration in the Indian money market. The organized and the
unorganized sector of Indian money market are totally separate from each other and they
have independent financial operations of their own. Therefore, activities of one sector
have no impact on the activities of the other sector. It is very difficult to establish a
national money market under such a background. Moreover, the various constituents of
the Indian money market viz., commercial banks, Co-operative banks and foreign banks
are competing among themselves and the competition is much in the countryside.
2. Shortage of funds:
Another important feature of Indian money market is the shortage of funds. Therefore,
the demand for loanable funds in the money market is much higher than that of its
supply. In recent years, the development of rural banking structure, with the opening rural
branches of commercial banks and with the expansion of Co-operative banks, has
improved the fund position of the Indian money market, to some extent.
3. Lack of adequate banking facilities:
Indian money market is also characterized by lack of adequate banking facilities. Rural
banking network in the country is still inadequate. In the rural areas, a substantial number
of populations, having small saving potential, have no access to facilities. Under such a
system, a huge amount of small savings are not mobilized which needs to be mobilized.
4. Lack of rational interest rate structure:
There is lack of rational interest structure which is mostly resulted from lack of co-
ordination among different banking institutions. Recently, there in some improvement in
this regard, particularly after the introduction of standardization of interest rates by the
RBI for its rationalization.
5. Absence of Organized Bill Market:
There is absence of organized bill market in India although the commercial banks
purchase and discount both inland and foreign bills to a limited extent. Although, the RBI
has introduced its limited bill market under its scheme of 1952 and 1970, but the same
scheme has failed to popularize the bill finance in India.
6. Existence of Unorganized Money Market:
Another important feature of Indian money market is the existence of its unorganized
character, where one of its segments is constituted by the indigenous bankers and money
lenders. Although the RBI has tried to bring the indigenous bankers under its direct
control but the attempts have failed. Thus, as the indigenous bankers remained outside
the organized money market, therefore, RBIs control over the money market is quite
limited.
7. Seasonal stringency of money and fluctuations in interest rates:
Another important feature of Indian money market is its seasonal stringency of money
and the volatile fluctuation of interest rates. India, being a agricultural country has to face
huge demand for funds during the period of October to June every year so as to meet its
requirement for farm operations and also for trading in agricultural produce. But the
money market is not having sufficient elasticity. Thus it creates seasonal stringency of
funds leading to a rise in the rate of interest. But in the rainy and slack season the demand
for fund slumps down leading to an automatic fall in the rate of interest. Such regular
fluctuations in interest rates are not at all conducive to developmental activities of the
country.
UNDERDEVELOPMENT OF INDIAN MONEY MARKET
Considering the various defects of Indian money market it can be observed that the money
market in India is relatively under-developed. Moreover, in respect of resources, organization
stability and elasticity, the said market cannot be compared with the developed money markets
of London and New York. But among the third world countries India has been maintaining the
most developed banking system. Even then the organization of the money market is still
underdeveloped. The under development nature of Indian money market is mostly determined by
the following shortcomings.
Firstly, Indian money market fails to possess an adequate and continuous supply of short term
assets such as treasury bills, bills of exchange, short term Government bonds etc.
Secondly, this market is lacking the highly organized banking system, so important for the
successful working of a money market.
Thirdly, the sub-markets like acceptance market and the commercial bill market are non-existent
in Indian money market.
Fourthly, Indian money market has totally failed to develop market for short term assets and
accordingly there are no dealers of short term assets who act as intermediaries between the
Government and the entire banking system.
Fifthly, Indian money market in suffering from lack of co-ordination between its different
constituents.
Sixthly, Indian money market again fails to attract any foreign funds.
Finally, Indian money market cannot be termed as a developed one considering its supply of
fund and the liquidity position.
In recent years, serious efforts have been made by the Government and the RBI to remove the
shortcomings of Indian money market. RBI, in the mean time has reduced considerably the
differences between the various constituents of money market. Differences in the interest rates
have also been reduced by the RBI and the monetary stringency has also been reduced by the
RBI through open market operations and bill market scheme.
Even then Indian money market is still very much dependent on the call money market which is
again characterized by high volatility. In the mean time, the RBI has introduced various
measures to reform the money market. The following are some of the important reform measures
introduced to strengthen the Indian money market:
(i) Remission of Stamp Duty:
In order to remove the major administrative constraint in the use of bill system, the
Government has remitted the stamp duty in August 1989.
(ii) Deregulation of interest rates:
Another important step to strengthen the money market was to deregulate the money
market interest rates since May, 1989. This will bring interest rate flexibility and
transparency in money market transactions.
(iii) Introduction of new instruments:
The RBI has introduced certain money market instruments for strengthening the market
conditions. These instruments are 182 days treasury bills, longer maturity treasury bills,
certificates of Deposits (CDs), Commercial Paper (CP) and dated Government securities.
Discount and Finance House of India (DFHI) promoted the 182-day treasury bills
systematically and these bills were the first security sold by auction for financing the
fiscal deficit of the Central Government.
(iv) DFHI:
The Discount and Finance House of India (DFHI) was setup in April 25, 1988 as a part of
the reform package for strengthening money market. The main function of DFHI is do
bring the entire financial system consisting of the scheduled commercial banks, co-
operative banks, foreign banks and all India financial institutions, both in the public and
private sector, within the fold of the Indian money market. This House will normally buy
bills and short term papers from different banks and financial institutions in order to
invest all of their idle funds for short periods.
v) Money Market Mutual Funds (MMMFs):
The Government announced the establishment of Money Market Mutual Funds
(MMMFs) in April 1992 with the sole objective to bring money market instruments
within the reach of individuals. The MMMFs have been set up by different scheduled
commercial banks and public financial institutions. The shares or units of MMMFs have
been issued only to individuals.
Thus the aforesaid measures to reform Indian money market have helped it to become more
advanced, solvent and vibrant. With the introduction of new instruments, the secondary market
has also been developed considerably. Moreover, with the setting up of DFHI and MMMFs, the
lot of Indian money market has also achieved considerable progress in recent times and is also
expected to achieve further progress in the years to come.
INDIAN CAPITAL MARKET
By the term Capital market we mean a market for long term funds, whereas the money market
constitutes the market for short term funds. Capital market includes all existing facilities and
institutional arrangements developed for borrowing and lending medium and long term funds
available in the market. This is not a market for capital goods; rather it is a market for raising and
advancing money capital for investment purposes. In a capital market, the demand for long term
funds mostly arises from private sector manufacturing industries, agricultural sector and also
from the Government, which are again largely utilized for the economic development of the
country. Even the consumer goods industries usually need a considerable support from the
capital market.
Similarly, both the State and Central Governments, which are engaged in developing infra-
structural facilities viz., transport, power, irrigation, and communications etc. along with the
development of basic industries also, need a considerable support from the capital market. In a
capital market, the supply of funds usually comes from individual savers, corporate savings
various banks, insurance companies specialized financial agencies and also the Government.
The following are some of the institutions supplying funds to the Indian Capital market:
i) Commercial banks in India, which are interested in government securities and on
debentures of companies are considered as important investors;
ii) The insurance companies like LIC and GIC have also attained growing importance in the
Indian Capital market and are mostly investing in government securities;
iii) Various special institutions viz., the IDBI, IFCI, ICICI, UTI etc. are giving long form
capital to the private sector of the country, and
iv) Provident funds of employees which constitute a major volume of savings but their
investments are very much restricted in government securities.
After independence, the rapid growth and expansion of the corporate and public enterprises has
necessitated the development of the capital market in India. The capital market is composed of
the borrowers who demand fund and the lenders who supply fund in the market. A sound capital
market always tries to offer adequate quantity of capital to any industrial and business house at a
reasonable rate which is expected to result high prospective yield to make borrowing worth while
Structure of Development Banks of India
Development banks in India have developed in the post-independence period. The structure of
Indian development banks can be divided into two broad categories:
(a) Those which promote agricultural development and
(b) Those which promote industrial development.
1. Agricultural Development Banks
(i) At All-India Level: National Bank for Agriculture and Rural Development
(ii) At State Level: State Land Development Banks (SLDBs).
(iii) At Local Level: Primary Land Development Banks (PLDBs), and branches of
State Land Development banks (SLDBs).
2. Industrial Development Banks
i) At All-India Level. Industrial Finance Corporation of India (IFCI), Industrial
ii) Development Bank of India (IDBI), Industrial Credit and Investment Corporation
of India (ICICI), Industrial reconstruction Bank of India (IRBI).
iii) At State Level. State Finance Corporations (SFCs) and State Industrial
Development Corporations (SIDs).
3. Industrial Finance Corporation of India (IFCI)
Industrial Finance Corporation is the first industrial development bank set up by the
Government of India in July 1948. It was established with a view to provide medium and
long-term credit to the eligible industrial units in the country. It extends financial
assistance to large and medium sized industrial units in both private and public sectors
and also to cooperatives.
Functions:
The IFCI provides assistance in the following forms:
i) It grants loans and advances to industrial concerns both in rupees and foreign
currency repayable within 25 years.
ii) It subscribes to the shares and debentures issued by the industrial concerns.
iii) It underwrites the issues of stocks, shares, bonds, (debentures of the industrial
concerns subject to the condition that such stocks, shares, etc. are disposed of by
the Corporation within a period of 7 years from the time of acquisition.
In recent years, the Corporation has started asking interest in the promotional activities
such as organizing techno-economic surveys, setting up of technical consultancy
organizations etc.
4. State Finance Corporations
The Industrial Finance Corporation provides financial assistance to large public limited
companies and cooperative societies and does not cover the small and medium-sized
industries. In order to meet the varied financial needs of small and medium sized
industries, the Government of India passed the State Finance Corporations Act in 1951,
which empowers the state governments to establish such Corporations in their states.
Functions:
Various functions of and types of financial assistance to be provided by the SFCs are
given below:
i) The SFCs have been established to provide long-term finance to small-scale and
medium-sized industrial concerns organized as public or private companies,
corporations, partnership or proprietary concerns.
ii) The SFCs extend loans and advances to the industrial concerns repayable within a
period of 20 years.
iii) The SFCs underwrite the issue of stocks, shares, bonds and debentures by industrial
concerns.
iv) The SFCs are prohibited from subscribing directly to the shares or stock of any
company having limited liability, except for under-writing purposes, and granting
any loan or advance on the security of own shares.
5. Industrial Development Bank of India (IDBI)
The IDBI is the apex financial institution in the field of development banking in the
country. It was established in July, 1964 with the twin objectives of:
(a) Meeting growing financial needs of rapid industrialization in the country
(b) Coordinating the activities and assisting the growth of all institutions engaged in
financing industries.
It is an organization with sufficiently large financial resources which not only provides
direct financial assistance to the large and medium-large industrial units, but also helps
the small and medium industries indirectly by extending refinancing and rediscounting
facilities to other industrial financing institutions.
Functions:
Various types of assistance to be provided by the IDBI are as follows:
(i) Direct Financial Assistance - The IDBI provides direct financial assistance to
industrial concerns in the form of granting loans and advances, and subscribing to,
purchasing or underwriting the issues of stocks bonds or debentures
(ii) Indirect Financial Assistance - The IDBI provides indirect financial assistance to
the small and medium industrial concerns through other financial institution.
(iii) Development Assistance. The Development Assistance Fund is used to provide
assistance to those industries which are not able to obtain funds in the normal
course mainly because of heavy investment involved or low rate of returns.
(iv)Promotional Function. Besides providing financial assistance, the IDBI also
undertakes various promotional activities such as marketing and investment
research, techno- economic surveys.
6. Industrial Credit and Investment Corporation of India (ICICI)
The Industrial Credit and Investment Corporation of India was registered as a private
limited company in 1955. It was set up as a private sector development bank to assist and
promote private industrial concerns in the country.
Broad objectives of the ICICI are:
(a) To assist in the creation, expansion and modernization of private concerns
(b) To encourage participation of internal and external capital in the private concerns
(c) To encourage private ownership of industrial investment.
Functions:
The ICICI performs the following functions:
i) It provides long-term and medium-term loans in rupees and foreign currencies.
ii) It participates in the equity capital of the industrial concerns.
iii) It underwrites new issues of shares and debentures.
iv) It guarantees loans raised by private concerns from other sources.
v) It provides technical, managerial & administrative assistance to industrial concerns
7. Unit Trust of India (UTI)
The Unit Trust of India was established in 1964 as a public sector investment institution.
The main objective of the UTI is to mobilize the savings of the small and medium income
groups and channeling them into productive investment. It thus, the one hand, contributes
to the industrial development and diversification of the economy, on and the other hand,
provides the small savers the opportunity for sharing the benefits of industrial
development by utilizing their savings in profitable and less risky investments.
Functions:
(a) It sells its units to the investors in small and medium income groups
(b) It invests the funds so collected through the sale of units in industrial and
corporate securities
(c) It distributes the annual gross income among the unit-holders in the form of
dividends.
8. Industrial Reconstruction Corporation of India (IRCI)
Considering the seriousness of the problem of industrial sickness, the Government of
India established the Industrial Reconstruction Corporation of India in April 1973.The
main purpose of the IRCI was to prevent and cure the problem of industrial sickness. It
was expected to provide assistance to the sick units for their rehabilitation and
reconstruction. The IRCI was set up with an authorized capital of Rs. 25 crore, issued
capital of Rs.10 crore and paid-up capital of Rs. 2.5 crore.
The resources of the Corporation have been subscribed by Industrial Development Bank
of India (1DBI), Industrial Finance Corporation of India (IFC1), Industrial Credit and
Investment Corporation of India (1CICI), Life Insurance Corporation (LlC), State Bank
of India (SBI) and the nationalized banks. The Government of India has granted an
interest -free loan of Rs. 10 crore to the Corporation.
9. Industrial Reconstruction Bank of India (IRBI)
By a special Act passed in March 1985, the Government converted the IRCI into the
IRBI. The 1RB1 has been set up as a statutory corporation with the objective of
functioning as the principal institution for providing financial assistance needed for
rehabilitation of sick industrial concerns. The authorized capital of the IRBI is Rs. 200
crore and paid-up capital as on March, 31, 19S9 was Rs. 112.5 crore. During 1993-94 the
IRBI sanctioned financial assistance of Rs. 425.8 crore of which Rs. 188.6 crore
disbursed. At the end of June 1991, the cumulative financial assistance sanctioned and
disbursed stood at Rs, 1244 and Rs. 919 crore respectively.
IRBI has been converted into a full-fledged development financial institution with a new
name Industrial Investment Bank of India Ltd. (IIBI) with effect from March 27, 1997.
10. Export-Import (EXIM) Bank of India
The Export-Import (EXIM) Bank of India is the principal financial institution in India for
coordinating the working of institutions engaged in financing export and import trade. It
is a statutory corporation wholly owned by the Government of India. It was established
on January 1, 1982 for the purpose of financing, facilitating and promoting foreign trade.
Functions:
The main functions of the EXIM Bank are as follows:
i) Financing of exports and imports of goods and services, not only of India but also
of the third world countries;
ii) Financing of export & import of machinery and equipment on lease basis
iii) Financing of joint ventures in foreign countries;
iv) Providing loans to Indian parties to enable them to contribute to the share capital
of joint ventures in foreign countries;
v) To undertake limited merchant banking functions such as underwriting of stocks,
shares, bonds or debentures of Indian companies engaged in export or import; and
vi) To provide technical, administrative and financial assistance to parties in
connection with export and import.
10. Small Industries Development Bank of India (SIDBI)
Small Industries Development Bank of India (SIDBI) was established as wholly owned
subsidiary of Industrial Development Bank of India (IDBI) under the small Industries
Development of India Act 1989. It is the principal institution for promotion, financing
and development of industries in the small scale sector. It also coordinates the functions
of institutions engaged in similar activities. For this purpose, SIDBI has taken over the
responsibility of administrating Small Industries Development Fund and National Equity
Fund from IDBI.
Functions:
SIDBI provides assistance to the small scale industries sector in the country through the
existing banking and other financial institutions, such as, State Financial Corporations,
Stale Industrial Development Corporations, commercial banks, cooperative banks etc.
The major functions of SIDBI are given below:
i) It refinances loans and advances provided by the existing lending institutions to
the small scale units.
ii) It discounts and rediscounts bills arising from sale of machinery to and
manufactured by small scale industrial units.
iii) It grants direct assistance and refinance loans extended by primary lending
institutions for financing export of products manufactured by SSIs.
iv) It provides services like factoring, leasing, etc. to small units.
v) It provides financial support to National Small Industries Corporation for
providing; leasing, hire-purchase and marketing help to the small scale units.
11. Life Insurance Corporation (LIC) of India
Life Insurance Corporation of India (LIC) was established in 1956 to spread the massage
of life insurance in the country and to mobilize peoples savings for nation-building
activities. Main features of LIC are given below:
1. Saving Institution - Life insurance both promotes and mobilizes saving in the
country. The income tax concession provides further incentive to higher income
persons to save through LIC policies. The total volume of insurance business has
also been growing with the spread of insurance-consciousness in the country.
2. Term Financing Institution - LIC also functions as a large term financing
institution in the country. The annual net accrual of invested funds from life
insurance business and net income from its vast investment is quite large.
3. Investment Institutions - LIC is a big investor of funds in government securities.
Under the law, LIC is required to invest at least 50% of its accruals in the form of
premium income in government and other approved securities. LIC funds are also
made available directly to the private sector through investment in shares,
debentures, and loans.
4. Stabilizer in Share Market - LIC acts as a downward stabilizer in share market.
The continuous inflow of new funds enables LIC to buy shares when the market is
weak. But, the LIC does not usually sell shares when the market is overshot. This
is partly due to the continuous pressure for investing new funds and partly due to
the disincentive of capital gains tax.
12. General Insurance Corporation (GIC) of India
General Insurance companies sell insurance against specific risks, such as of loss from
fire and accident, to property of various kinds, such as motor vehicles, goods, machinery,
buildings, etc., and also against risk of personal accidents and sickness. The policies of
these companies do not involve saving feature. The purchaser of general insurance
simply buys a service and not any financial asset. In this way, general insurance
companies cannot be considered as financial intermediaries in the true sense. However,
they do accumulate large amounts of funds from premiums and investment income and
thus manage portfolios of assets like other financial institutions.