LESSON - 1

NATURE OF FINANCIAL MANAGEMENT

Learning Objectives
After reading this lesson you should be able to:
Know the meaning of financial management.
Identify the changes in the concept of finance.
Understand the goals of financial management.
Detail the scope of finance function.
Explain the functions of Finance Manager.
Lesson Outline
A. Financial Management as a branch of management
B. Evolutionary changes in the concept of finance
C. Definitions of Financial Management
D. Goals of Financial Management
E. Scope of finance function
F. Functions of Treasurer and Controller
G. Routine Duties of Financial Manager
H. Social Responsibility of Financial Manager
Finance is to business what blood is to the human body. Thus it is the lifeblood of
business. Fortunately for the human body there is an automatic regulation of the
quantity and quality of blood required. No such auto control is available in the case of a
business firm. Hence the necessity to manage finances of that the firm may have at its
disposal adequate funds of various types but at the same time avoiding idleness of
funds. There was a time when it was thought that financial management consisted
merely of providing funds required by the various departments or divisions of the firm.
This has now changed completely and it is accepted that proper financial management
consists of a dynamic approach towards the achievement of firm's objectives.
A. Financial Management as a Branch of Management
Of all the branches of management, financial management is of the highest importance.
The primary purpose of a business firm is to produce and distribute goods and services
to the society in which it exists. We need finance for the production of the goods and
services as well as their distribution. The efficiency of production, personnel and
marketing operations is directly influenced by the manner in which the finance function
of the enterprise is performed by the finance personnel. Thus it may be stated that all
the functions or activities of the business are ultimately related to finance function. The
success of the business depends on how best all these functions can be coordinated. A
tree keeps itself green and growing as long as its roots sap the life juice from the soil and
distribute the same among the branches and leaves. The activities of an organisation
also keep going smoothly as long as finance flows through its veins. Any and every
business activity will ultimately be reflected through its finance the mirror and also the
barometer of the enterprise functions.
Finance and Other Functional Areas of Management
Financial Management and Research & Development:
The R&D manager has to justify the money spent on research by coming up with new
products and process which would help to reduce costs and increase revenue. If the
R&D department is like a bottomless pit only swallowing more and more money but not
giving any positive results in return, then the management would have no choice but to
close it. No commercial entity runs an R&D department for conducting infructuous
basic research.
For instance, until 5 years ago, 80% of the R&D efforts of Bush India, the 45-year old
consumer electronics company, well known for its audio systems, was in TVs and only
20% was in audio. But the fact that a 15-year stint in the TV market starting from 1981
when the company shifted its interest from the audio line to TV manufacturing, led the
companys decline to near oblivion, pushing the once famous Bush brand name to near
anonymity, called for a change in production and re-orientation of R&D, strategy. The
company has also identified and shut down some of its non-productive divisions and
trimmed its workforce. At the beginning of 1992, Bush had 872 employees. By the end
this was cut down to 550. The company had to further cut it down to 450 by the end of
1993.
Financial Management and Materials Management:
Likewise the materials manager should be aware that inventory of different items in
stores is nothing but money in the shape of inventory. He should make efforts to reduce
inventory so that the funds released could be put to more productive use. At the same
time, he should also ensure that inventory of materials does not reach such a low level as
to interrupt the production process. He has to achieve the right balance between too
much inventory and too little inventory. This is called the 'liquidity-profitability trade-
off' about which you will read more in the lessons on Working Capital Management.
The same is true with regard to every activity in an organisation. The results of all
activities in an organisation are reflected in the financial statements in rupees.
Financial Management and Production Management:
In any manufacturing firm, the Production Manager controls a major part of the
investment in the form of equipment, materials and men. He should so organize his
department that the equipment under his control are used most productively, the
inventory of work-in-process or unfinished goods, and stores and spares is optimised
and the idle time and work stoppages are minimised. If the Production Manager can
achieve this, he would be holding the cost of the output under control and thereby help
in maximizing profits. He has to appreciate the fact that whereas the price at which the
output can be sold is largely determined by factors external to the firm like competition,
government regulations etc., the cost of production is more amenable to his control.
Similarly, he would have to make decisions regarding make or buy, buy or lease etc., for
which he has to evaluate the financial implications before arriving at a decision.
Financial Management and Marketing Management:
Marketing is one of the most important areas on which the success or failure of the firm
depends to a very great extent. The philosophy and approach to the pricing policy are
critical elements in the company's marketing effort, image and sales level.
Determination of the appropriate price for the firm's products is important both to the
marketing and the financial managers and, therefore, should be a joint decision of both.
The marketing manager provides information as to how different prices will affect the
demand for the company's products in the market and the firms competitive position
while the finance manager can supply information about costs, change in costs at
different levels of production, and the profit margins required to carry on the business.
Thus, the finance manager contributes substantially towards formulation of the pricing
policies of the firm.
Financial Management and Personnel Management:
The recruitment, training and placement of staff is the responsibility of the Personnel
Department. However, all this requires finances and, therefore, the decisions regarding
these aspects cannot be taken by the Personnel Department in an isolation of the
Finance Department. Thus, it will be seen that the financial management is closely
linked with all other areas of management. As a matter of fact, the financial manager
has a grasp over all areas of the firm because of his key position. Moreover, the attitude
of the firm towards other management areas is largely governed by its financial position.
A firm facing a critical financial position will devise its recruitment, production and
marketing strategies keeping the overall financial position in view. A firm having a
comfortable financial position may give flexibility to the other management functions,
such as, personnel, materials, purchase, production, marketing and other policies.
B. Evolutionary Change in the Concept of Finance
The word "finance" has been interpreted differently by different authorities. More
significantly, the concept of finance has changed markedly from time to time. For the
convenience of analysis different viewpoints on finance have been categorized into three
major groups.
1. Finance means Cash only: Starting from the early part of the present century,
finance was described to mean cash only. The emphasis under this approach is only on
liquidity and financing of the firm. Since nearly every business transaction involves
cash, directly or indirectly, finance is concerned with everything that takes place in the
conduct of the business. However, it must be noted that this meaning of finance is too
broad to be meaningful.
2. Finance is raising of funds: The second grouping, also called the 'traditional
approach', is concerned with raising funds used in an enterprise. It covers, (a)
instruments, institutions, practices through which funds are raised and (b) the legal and
accounting relationships between a company and its sources of funds, including the
redistribution of income and assets among these sources. This concept of finance is, of
course, broader than the first, as it is concerned with raising of funds.
Finance, during the forties through the early fifties, was dominated by this traditional
approach. However, it could not last for long because of some shortcomings. First, this
approach emphasised the perspective of an outsider lender.
It only analysed the firm and did not emphasis decision-making within the firm. Second,
this approach laid heavy emphasis on areas of external sources of long-term finance.
However, short-term finance, i.e. working capital is equally important. Third, the
function of efficient employment of resources was totally ignored.
3. Finance is raising and utilisation of funds: The third grouping is called the
Integrated Approach or 'Modern Approach'. According to this approach, the concept of
finance is concerned not only with the optimum way of raising of funds but also their
proper utilisation in time and low cost in a manner that each rupee is made to work at
its optimum without endangering the financial solvency of the firm. This approach to
finance is concerned with (a) determining the total amount of funds required in the
firm, (b) allocating these funds efficiently to the various assets, (c) obtaining the best
mix of financing-type and amount of corporate securities, (d) use of financial tools to
ensure proper and efficient use of funds.
C. Definitions of Financial Management
In general, finance may be defined as the provision of money at the time it is
wanted. However, as a management function it has a special meaning. Finance function
may be defined as the procurement of funds and their effective utilisation. Some of the
authoritative definitions are as follows:
According to Ezra Solomon, "Financial management is concerned with the efficient
use of an important economic resource, namely Capital Funds".
In the words of Howard and Upton, "Finance may be defined as that administrative
area or set of administrative functions in an organisation which relate with the
arrangement of cash and credit so that the organisation may have the means to carry out
its objectives as satisfactorily as possible".
Phillippatus has given a more elaborate definition of the term 'financial management'.
According to him "Financial management is concerned with the managerial decisions
that result in the acquisition and financing of long-term and short-term credits for the
firm. As such it deals with the situations that require selection of specific assets (or
combination of assets), the selection of specific liability (or combination of liabilities) as
well as the problem of size and growth of an enterprise. The analysis of these decisions is
based on the expected inflow and outflow of funds and their effects upon managerial
objectives".
Financial Management may also be defined as "planning, organising, direction and
control of financial resources with the objectives of ensuring optimum utilisation of such
resources and providing insurance against losses through financial deadlock". This
definition clearly explains four broad elements viz., planning, organising, direction and
control. The details under these elements are as follows:
a) Ascertainment of need Planning
b) Determination of sources Planning
c) Collection of funds Organizing
d) Allocation of funds Organizing
e) Communication of planned objective Direction
f)
Monitoring of funds (though 'financial discipline' in
respect of funds utilization)
Control
g) Knowing performance actuals Control
h)
Judging performance against norms, standards, targets
etc.
Control
i)
Taking corrective action which in turn involves
removal of snags as well as revision of targets.
Control
While the functions under planning and organising are mostly of 'discrete' nature
(undertaken from time to time and very often independently) those under control area
are 'continuous' in nature. All the principles, steps and weapons of managerial control
are applicable in proper control of financial resources and their utilisation. Hence, it is
rightly said by Howard and Upton that financial management is an application of
general managerial principles to the area of financial decision making viz., funds
requirement decision, investment decision, financing decision and dividend decision.
Hunt, William and Donaldson have rightly called it as 'Resource Management'.
Financial management is intimately interwoven into the fabric of management itself.
Not only is this because the results of management's actions are expressed in financial
terms, but also principally because the central role of financial management is
concerned with the same objectives as those of management itself and with the way in
which the resources of the business are employed and how it is financed. Because it is
about making profits and profits will be determined by the way in which the resources of
the business in terms of people, physical resources, capital, and any other specific
talents are organized.
Financial management is concerned with identifying sources of profit and the factors
which affect profit. That is to say with operating activities in the way in which the assets
are used, and from a longer term point of view, the process of allocating funds to use
within the business. In these activities, financial managers form part of a management
team applying their specialist advice and processing and marshalling the data upon
which decisions are based.
D. Goals of Financial Management
The goal of the financial management should be to achieve the objective of the business
owners, who are the suppliers of capital. In the case of company, the owners are
shareholders. The financial managers function is not to fulfill his own objectives, which
may include higher salaries, earning reputation, or maintaining and advancing his
personal power and prestige. If the manager is successful in company's endeavour, he
will also achieve his personal objectives. It is generally agreed that the financial
objective of the firm should be the maximization of owners wealth. However, there is
disagreement as to how the economic welfare of owners can be maximized. Two well
known and widely discussed criteria which are put forth for this purpose are: (a) profit
maximization, and (b) wealth maximization.
(a) Profit Maximization:
Traditionally, the business has been considered as an economic institution and profit
has come to be accepted as a rationally valid criterion of measuring efficiency. As a goal,
however, profit maximization suffers from certain basic weaknesses:
- it is vague,
- it is a short-run point of view,
- it ignores risks, and
- it ignores the timing of returns.
Please use headphones
An unambiguous meaning of the profit maximization objective is neither available nor
possible. It is rather very difficult to know about these: Does it mean short-term profits
or long-term profits? Does it refer to profit before or after tax? Does it refer to total
profits or profit per share?
Besides it being ambiguous, the profit maximization objective takes a short-run point of
view. Professor Drucker and Professor Galbraith contradict the theory of profit
maximization and observe that exclusive attention on profit maximization misdirects
managers to the point where they may endanger the survival of the business. Prof.
Galbraith gives the following points to argue his line of reasoning: (1) it undermines the
future for todays profit; (2) it shortchanges research promotion and other investments;
(3) it may shy away from any capital expenditure that may increase the invested capital
base against which profits are based, and the result is dangerous obsolescence of
equipment. In other words, the managers are directed into the worst practices of
management. Risk and timing factors are also ignored by this objective. The streams of
benefits may possess different degrees of certainty and uncertainty. Two firms may have
same total expected earnings, but if the earnings of one firm fluctuate considerably as
compared to the other, it will be more risky. Also, it does not make a difference between
returns received in different time periods i.e., it gives no consideration to the time value
of money and value benefits received today and benefits after six months or one
year. For these reasons, the profit maximization objective cannot be taken as the
objective of financial management.
(b) Wealth Maximization:
The maximization of wealth is a more viable objective of financial management. The
same objective, if expressed in other terms, would convey the idea of net present worth
maximization. Any financial action which creates wealth or which has a net present
worth is a desirable one and should be undertaken. Wealth of the firm is reflected in the
maximization of the present value of the firm i.e., the present worth of the firm. This
value may be readily measured if the company has shares that are held by the public,
because the market price of the share is indicative of the value of the company. And to a
shareholder, the term wealth is reflected in the amount of his current dividends and the
market price of share. Ezra Solomon has defined wealth maximization objective in the
following manner:
"The gross present worth of a course of action is equal to the capitalized value of the flow
of future expected benefits, discounted (or capitalized) at a rate which reflects the
certainty or uncertainty. Wealth or net present worth is the difference between gross
present worth and the amount of capital investment required to achieve the benefits."
From the above clarification, one thing is certain that the wealth maximization is a long-
term strategy that emphasises raising the present value of the owner's investment in a
company and the implementation of projects that will increase the market value of the
firm's securities. This criterion, if applied, meets the objections raised against earlier
criterion of profit maximization. The financial manager also deals with the problem of
uncertainty by taking into account the trade-off between the various returns and
associated levels of risks. It also takes into account the payment of dividends to
shareholders. All these ingredients of the wealth maximization objective are the result of
the investment, financing and dividend decisions of the firm.
Please use headphones
E. Scope of finance function
The question of 'scope of finance function' determines the decisions or functions to be
carried out by the financial manager in pursuit of achieving the objective of wealth
maximization. The various functions of the financial manager relate to the estimation of
financial requirements, investment of funds in long-term and short-term assets,
determining the appropriate capital structure, identification of the various sources of
finance, decision regarding retention of earnings and distribution of dividend, and
administering proper financial controls. These decisions have been categorized into two
broad groupings:
(1) Long-term financial decisions:
The long term financial decisions pursued by the financial manager have significant long
term effects on the value of the firm. The results of these decisions are not confined to a
few months but extend over several years and these decisions are mostly irreversible. It
is, therefore, necessary that before committing the scarce resources of the firm a careful
exercise is done with regard to the likely costs and benefits of various decisions like...
i. Investment Decision (capital allocation for fixed and current
assets): Investment decision (also known as capital-budgeting decision) is concerned
with the allocation of given amount of capital to fixed assets of the business. The
important characteristic of fixed assets is that their benefits are realized in the future
(generally after one year). Thus, capital-budgeting decision adds to the total fixed assets
of the concern by selecting and investing in new investments. lt must be properly
understood at this stage that because the future benefits are not known with certainty,
investment proposals necessarily involve risk. Consequently, they must be evaluated in
relation to their expected income and risk they add to the function as a whole.
Obviously, the management will select investments adding something to the value of the
firm. The criteria of judging the profitability of projects is the difference between the
cost of the investment proposals and its expected earnings. The important methods
employed to judge the profitability of the investment proposals are:
(a) Payback method, (b) Average rate of return method, (c) Internal rate of return
method, and (d) Net present value method.
A careful employment of these methods helps in determining the contribution of
investment projects to owners' wealth.
ii. Financing Decision (capital sourcing): Financing decision (also known as
capital structure decision) is intimately tied with the investment decision. To undertake
investment decision the firm needs proper finance. The solution to the question of
raising finance is solved by financing decision. There are number of sources from which
funds can be raised. The most important sources of financing are equity capital and debt
capital. The central tasks before the financial manager is to determine the proportion of
equity capital and debt capital. He must endeavour to obtain a financing mix or optimal
capital structure for the firm where overall cost of capital is the minimum or the value of
the firm is maximum. In taking this decision, the financial manager must bear in mind
the likely effects on shareholders and the firm. The use of debt capital, for instance,
affects the return and risk of the shareholders. Not only the return on equity will
increase, but also the risk. A proper balance will have to be struck between return and
risk. When the shareholder's return is maximized with minimum risk, the market value
per share will be maximized and firm's capital structure would be optimum. Once the
financial manager is able to determine the best combination of debt and equity, he must
raise this appropriate amount through best available sources.
Fig. 1.1 Decisions, Return, Risk, and Market Value
iii. Dividend Decision: The next crucial financial decision is the dividend decision.
This decision is the basis of dividends payment policy, reserves policy, etc. The
dividends are generally paid as some percentage of earnings on the paid-up capital.
However, the policy pursued by management concerning dividends payment is
generally stable in character. Stable dividends policy implies the payment of same
earnings percentage with only small variations depending upon the pattern of earnings.
The stable dividends policy among other things, increases the market value of the share.
The amount of undistributed profits is called 'retained earnings'. In other words,
dividends payout ratio determines the amount of earnings retained in the firm. The
amount of earnings or profit to be kept undistributed with the firm must be evaluated in
the light of the objective of maximizing shareholders' wealth.
(2) Short-Term Financial Decisions (Working capital management):
i. cash,
ii. investments (marketable securities),
iii. receivables, and
iv. inventory
The job of the financial manager is not just limited to the long-term financial decisions,
but also extends to the short-term financial decisions aiming at safeguarding the firm
against illiquidity or insolvency. Surveys indicate that the largest portion of a financial
manager's time is devoted to the day-to-day internal operations of the firm; this may be
appropriately subsumed under the heading Working Capital Management. Working
capital management requires the understanding and proper appreciation of its two
concepts - gross and net working capital. Gross working capital refers to the firm's
investment in current assets such as cash, short-term securities, debtors, bills receivable
and inventories. Current assets have the distinctive characteristics of being convertible
into cash within an accounting year. Net working capital refers to the difference between
current assets and current liabilities. Current liabilities are those claims of outsiders
which are expected to mature for payment within an accounting year and include trade
creditors, bills payable, bank overdraft and outstanding expenses. For the financial
manager both these concepts of gross and net working capital are relevant.
Investment in current assets affects firm's profitability, liquidity and solvency. In order
to ensure that neither insufficient nor unnecessary funds are invested in current assets,
the financial manager should develop sound techniques of managing current assets. He
should estimate firm's working capital needs and make sure that funds would be made
available when needed.
The cost of capital acts as the core in the framework for financial management decision
making. In has a two-way effect on the investment, financing and dividend decisions. It
influences and is in turn influenced by them. The cost of capital leads to the acceptance
or rejection of projects, as it is the cut-off criterion in investment decisions. In turn, the
profitability of projects raises or lowers the cost of capital. The financing decisions affect
the cost of capital because it is the weighted average of the cost of different sources of
capital. The need to raise or lower the cost of capital, in turn, influences the financing
decisions. The dividend decisions try to meet the expectations of the investors raise or
lower the cost of capital. The following figure explains the components of finance
functions and their interrelation.
Fi nancial Contr ol s: The long-term and short-term decisions, together, determine the
value of the firm to its shareholders. In order to maximize this value, the firm should
strive for optimal combination of these decisions. In an endeavour to make optimal
decisions, the financial manager makes use of certain tools in the analysis, planning and
control activities of the firm. Some such important tools are:
a. Financial Accounting Statements
b. Analysis of Financial Ratios
c. Funds Flow Analysis and Cash Flow Analysis
d. Financial Forecasting
e. Analysis of Operating and Financial Leverage
f. Capital Expenditure Budgeting
g. Operating Budgeting and Budgetary Control
h. Costing and Cost Control Statement
i. Variance Analysis Reports
j. Cost-Volume-Profit Analysis
k. Profitability Index
l. Financial Reports
Or ganisation for Finance Function: Almost anything in the financial realm falls
within such a committees realm, including questions of financing, budgets,
expenditures, dividend policy, and future planning. Such is the power of financial
committee that in most cases their recommendations are approved as a matter of course
by the full board of directors.
On the operational level, the financial management team may be headed up by a
financial Vice President. This is a recent development; the financial Vice President
answers directly to the President. Serving under him are Treasurer and Controller. An
illustrative organisation chart of finance function of management in a large organisation
is given below:
Board of Directors
|
President
|
---------------------------------------------------------------------------
| | | | |
VP Mktg VP Purchase VP Production VP Finance VP
Personnel
|
-------------------------
| |
Treasurer Controller
Fig. 1.3 Organization Chart of Finance Functions of Management
The chart below shows that the Vice President Finance exercises his function through
his two deputies known as 'Controller' concerned with internal matters, and 'Treasurer'
who basically handles external financial matters.
The Controller is concerned with the management and control of the firm's assets. His
duties include providing information for formulating the accounting and financial
policies, preparation of financial reports, direction of internal auditing, budgeting,
inventory control, taxes, etc. The Treasurer is mainly concerned with management of
the firm's funds. His duties include forecasting the financial needs, administering the
flow of cash, managing credit, floating securities, maintaining relations with financial
institutions, and protecting funds and securities. A brief description of the functions of
the Controller and the Treasurer, as given by the Controllers Institute of America, is
given below and in Fig. 1.4.
F. Functions of Controller and Treasurer
Functions of Controller:
1. Planning and Control: To establish, coordinate and administer, as part of
management, a plan for the control of operations. This plan would provide to the
extent required in the business, profit planning, programmes for capital investing
and for financing, sales forecasts and expense budgets.
2. Reporting and Interpreting: To compare actual performance with
operating plans and standards, and to report and interpret the results of
operations to all levels of management and to the owners of business. To consult
with the management about the financial implications of its actions.
3. Tax Administration: To establish and administer tax policies and
procedures.
4. Government Reporting: To supervise or coordinate the preparation of
reports to government agencies.
5. Protection of Assets: To ensure protection of business assets through
internal control, internal auditing and assuring proper insurance coverage.
6. Economic Appraisal: To appraise economic and social forces and
government influences and interpret their effect upon business.
Functions of Treasurer:
1. Provision of Finance: To establish and execute programmes for the
provision of the finance required by the business, including negotiating its
procurement and maintaining the required financial arrangements.
2. Investor Relations: To establish and maintain adequate market for the
company's securities and to maintain adequate contact with the investment
community.
3. Short-term Financing: To maintain adequate sources for the company's
current borrowings from the money market.
4. Banking and Custody: To maintain banking arrangements, to receive, have
custody of and disburse the company's moneys and securities and to be
responsible for the financial assets of real estate transactions.
5. Credit and Collections: To direct the granting of credit and the collection of
accounts receivables of the company.
6. Investments: To invest the company's funds as required, and to establish and
coordinate policies for investment in pension and other similar trusts.
7. Insurance: To provide insurance coverage as may be required.
Another way of looking at these functions is...
The Controller function generally concentrates on the asset side of the balance sheet,
while the Treasurer function concentrates on the claims side i.e., identifying the best
sources of finance to utilize in the business and timing the acquisition of funds.
Controller's and Treasurer's Functions in the Indian Context:
The terms 'controller' and 'treasurer' are essentially used in U.S.A. However, this pattern
is not popular in India. Some companies do use the term 'Controller' for the official who
performs the functions of the chief accountant or the management accountant.
However, in most cases, in case of Indian companies, the term General Manager
(Finance) or Chief Finance Manager is more popular. Some of the functions of the
Controller and the Treasurer such as government reporting, insurance coverage, etc.,
are taken care of by the Secretary of the company. The Treasurer's function of
maintaining relations with its investors is also not much relevant in the Indian context
since by and large Indian investors/shareholders are indifferent towards attending the
general meetings. The finance manager in Indian companies is mainly concerned with
the management of the firm's financial resources. His duties are not compounded with
other duties generally in large companies. It is a healthy sign since the management of
finances is an important business activity requiring extraordinary skill and attention. He
has to ensure that the scarce financial resources are put to the optimum use keeping in
view various constraints. It is, therefore, necessary that the finance manager devotes his
full time attention and energies only in raising and utilising the financial resources of
the firm.
G. Routine Duties of Financial Manager
Apart from the three broad functions of financial management mentioned above, the
financial manager has to perform certain routine or recurring functions as these:
(i) Keeping track of actual and projected cash outflows and making adequate provision
in time for any shortfall that may arise.
(ii) Managing of cash centrally and supplying the needs of various divisions and
departments without keeping idle cash at many points.
(iii) Negotiations and relations with banks and other financial institutions.
(iv) Investment of funds available and free for a short period.
(v) Keeping track of stock exchange prices in general and prices of the company's shares
in particular.
(vi) Maintenance of liaison with production and sales departments for seeing that
working capital position is not upset because of inventories, book debts, etc.
(vii) Keeping management informed of the financial implication of various
developments in and around the company.
Non-Routine Duties:
The non-recurring duties of the financial executive may involve preparation of financial
plan at the time of company promotion, expansion, diversification, readjustments in
times of liquidity crisis, valuation of the enterprise at the time of acquisition and merger
thereof, etc. Today's financial manager has to deal with a variety of developments that
affect the firm's liquidity and profitability, including...
(i) High financial cost identified with risk-bearing investments in a capital-intensive
environment.
(ii) Diversification by firms into differing businesses, markets, and product lines.
(iii) High rates of inflation that significantly affect planning and forecasting the firms
operations.
(iv) Emphasis on growth, with its requirements for new sources of funds and improved
uses of existing funds.
(v) High rates of change in technology, with an accompanying need for expenditures on
research and development.
(vi) Speedy dissemination of information, employing high speed computers and
nationwide and worldwide networks for transmitting financial and operating data.
H. Social Responsibility of Financial Manager
Another point that deserves consideration is social responsibility: should businesses
operate strictly in the stockholder's best interest, or are firms also partly responsible for
the welfare of society at large? In tackling this question, consider first the firms whose
rates of return on investment are close to normal, that is, close to the average for all
firms. If such companies attempt to be socially responsible, thereby increasing their
costs over what they otherwise would have been, and if the other business in the
industry do not follow suit, then the socially oriented firms will probably be forced to
abandon their efforts. Thus , any socially responsible acts that raise costs will be
difficult, if not impossible, in industries subject to keen competition.
What about firms with profits above normal levels - can they not devote resources to
social projects? Undoubtedly they can many large, successful firms do engage in
community projects, employee benefit programmes, and the likes to a greater degree
than would appear to be called for by pure profit or wealth maximization. Still, publicly
owned firms are constrained in such actions by capital market factors. Suppose a saver
who has funds to invest is considering two alternative firms. One firm devotes a
substantial part of its resources to social actions, while the other concentrates on profits
and stock prices. Most investors are likely to shun the socially oriented firm, which will
put it to a disadvantage in the capital market. After all, why should the stockholders of
one corporation subsidise society to a greater extent than stockholders of other
businesses? Thus, even highly profitable firms (unless they are closely held rather than
publicly owned) are generally constrained against taking unilateral cost increasing social
action.
Does all this mean that firms should not exercise social responsibility? Not at all - it
simply means that most cost-increasing actions may have to be put on a mandatory
rather than a voluntary basis, at least initially, to insure that the burden of such action
falls uniformly across all businesses. Thus, fair hiring practices, minority training
programmes, product safety, pollution abatement, antitrust actions, and are more likely
to be effective if realistic rules are established initially and enforced by government
agencies. It is critical that industry and government cooperate in establishing the rules
of corporate behavior and that firms follow the spirit as well as the letter of the law in
their actions. Thus, the rules of the game become constraints, and firms should strive to
maximize stock prices subject to these constraints.
REVIEW QUESTIONS
1. "Finance is the oil of wheel, marrow of bones and spirit of trade, commerce and
industry"- Elucidate.
2. Discuss the role and significance of financial management in the functional areas of
modern management.
3. Some of the early concerns of financial management are related to preservation of
capital, maintenance of liquidity and reorganisation. Do you think these topics are still
important in our current unpredictable economic environment?
4. Who discharges the finance function and what are his specific responsibilities?
5. Contrast profit maximization and value maximization as criteria for financial
management decisions in practice.
6. Why is it inappropriate to seek profit maximization as the goals of financial decision
making? How do you justify the adoption of present value maximization as an apt
substitute for it?
7. "The operative objective of financial management is to maximize wealth or net
present worth'- Ezra Solomon. Explain the statement and explain the finance function
performed by a Finance Manager to achieve this goal.
8. Explain the scope of finance function and suggest an organisational structure that you
consider suitable for an effective financial control of a large manufacturing concern.
9. Discuss the respective roles of 'Treasurer' and 'Controller' in the financial set-up of a
large corporation. Out of these two finance officers who is more important in the
modern contest and why?
10. As a Financial Manager of a company, how would you reconcile between financial
goals and social objectives of the concern?
SUGGESTED READINGS
1. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi, Tata
McGraw Hill Co.
2. Hampton, J.J.: Financial Decision Making, New Delhi, Prentice Hall of India.
3. Pandey, I.M.: Financial Management, New Delhi, Vikas Publishing House.
4. Van Home, James C : Financial Management and Policy, New Delhi, Prentice Hall of
India.
- End of Chapter -
LESSON - 2
WORKING CAPITAL MANAGEMENT
Learning Objectives
After reading this lesson you should be able to:
Understand the concept of working capital
Classify the different types of working capital
Recognize the element of working capital
Assess the requirements of working capital
Identify the strength and weakness of inadequate or excess working capital.
Lesson Outline
A. Concept of Working Capital
B. Classification of Working Capital
C. Elements of Working Capital
D. Assessment of Working Capital Requirements
E. Problems of inadequacy of Working Capital
F. Reasons for inadequacy of Working Capital
G. Excessive Working Capital
H. Principles of Working Capital
Proper management of working capital is very important for the success of an
enterprise. It aims at protecting the purchasing power of assets and maximising the
return on investment. Constant management is required to maintain appropriate levels
in the various working capital components. Sales expansion, dividend declaration, plant
expansion, new product line, increased salaries and wages, rising price levels etc. put
added strain on working capital maintenance. Failure of business is undoubtedly due to
poor management and absence of a management skill. Shortage of working capital, so
often advanced as the main cause for failure of concerns, is nothing but the clearest
evidence of mismanagement which is so common.
Please use headphones
It has been found that the major portion of a financial manager's time is utilized in the
management of working capital. Current assets account for a very large portion of the
total investment of a firm. In some of the industrial current assets on an average
represent over three-fifth of the total assets. In the case of trading concerns they account
for about 80 percent. A firm may, sometimes, be able to reduce the investment in fixed
assets by renting or leasing plant and machinery. But it cannot avoid investment in cash,
accounts receivable and inventory. The management of working capital also helps the
management in evaluating various existing or proposed financial constraints and
financial offerings. All these factors clearly indicate the importance of working capital
management in a firm.
A. Concepts of Working Capital
There are two concepts regarding the meaning of Working Capital - Net working Capital
and Gross Working Capital. According to one school of thought (supported by
distinguished authorities like Lincoln, Doris, Stevens and Saliers), Working Capital is
the excess of Current Assets over Current Liabilities, as designated in the following
equation:
Working Capital = Current Assets Current Liabilities
According to another school of thought (supported by authorities like Mead Baker,
Mallot and Field), Working Capital represents only the current (capital) assets.
There is basis for both these contentions. To understand them, correct conception of
current assets and liabilities is essential.
Current Assets are those assets that in the ordinary course of business can be or will
be turned into cash within a brief period (not exceeding one year, normally) without
undergoing diminution of value and without disrupting the organisation. Examples of
current assets are:
(i) Cash in hand and in bank;
(ii) Accounts receivable from customers (less reserves);
(iii) Promissory Notes and Bills receivable from customers (less reserves);
(iv) Inventories comprising of raw material, work-in-progress, finished goods (of
manufactures)
(v) Marketable securities held as temporary investment;
(vi) Prepaid expenses;
(vii) Maintenance materials;
(viii) Accrued income.
Current Liabilities are those liabilities intended at their inception to be paid in
ordinary course of business within a reasonable short time (normally within a year) out
of the current assets or by creating another current liability or the income of the
business. Its examples are:
(i) Accounts payable to creditors;
(ii) Notes or Bills payable;
(iii) Accrued expenses, such as accrued taxes, salaries and interest;
(iv) Bank over-draft, cash credit;
(v) Bonds to be paid within one year;
(vi) Dividends declared and payable.
The arguments of the first school of thought in regarding working capital as the excess
of current assets over current liabilities are that:
1. It is an established definition of working capital which is in use since long;
2. This concept of working capital enables the shareholders to judge the financial
soundness of the concern and the extent of protection afforded to them. It is particularly
because with an increase in short-term borrowings the working capital does not
increase; it will increase only by following the policy of ploughing back of profits or
conversion of fixed assets into liquid assets or by procuring fresh capital from
shareholders;
3. Any concern with an excess of current liabilities can successfully tide over periods of
emergency, e.g., depression;
4. Further, there is no obligation on the part of the company to return the amount
invested by the shareholders;
5. Such a definition is of great use in ascertaining the true financial position of
companies having current assets of similar amount.
Those who regard working capital and current assets as synonymous advance the
following arguments in support of their contention:
1. Earnings in each enterprise are the outcome of both fixed as well as current assets.
Individually these assets have no significance. The points of similarity in these assets are
that both are borrowed and they yield profit much more than the interest cost. But the
distinction in the two lies in the fact that fixed assets constitute the fixed capital of a
company, whereas current assets are of a circulating nature. Hence, logic demands that
current assets should be considered as the working capital of the company;
2. This definition takes into consideration the fact that there would be an automatic
increase in the working capital with every increase in the funds of the company; but it is
not so according to the net concept of working capital;
3. Every management is interested in the total current assets out of which the operation
of an enterprise is made possible, rather than in the sources from where the capital is
procured;
4. The former concept of working capital may hold good only in the case of sole trader or
partnership organisation; but under the modern age of company organisation, where
there is divorce between ownership, management and control, the ownership of current
or fixed assets is of little significance.
B. Classification of Working Capital
Generally speaking, the amount of funds required for operating needs varies from time
to time in every business. But a certain amount of assets in the form of working capital
are always required, if a business has to carry out its functions efficiently and without a
break. These two types of requirements, permanent and variable, are the basis for a
convenient classification of working capital:
1. Permanent or Fixed Working Capital:
As is apparent from the adjective 'permanent' it is that part of the capital which is
permanently locked up in the circulation of current assets and in keeping it moving. For
example, every manufacturing concern has to maintain stock of raw materials, works-in-
progress (work-in-process), finished products, loose tools, and spare parts. It also
requires money for the payment of wages and salaries throughout the year. The
permanent or fixed working capital can again be subdivided into
(i) Regular Working Capital
It is the minimum amount of liquid capital needed to keep up the circulation of the
capital from cash to inventories to receivables and back again to cash. This would
include a sufficient cash balance in the bank to discount all bills, maintain an adequate
supply of raw materials for processing, carry a sufficient stock of finished goods to give
prompt delivery and effect the lowest manufacturing costs, and enough cash to carry the
necessary accounts receivables for the type of business engaged in.
(ii) Reserve Margin or Cushion Working Capital
It is the excess over the need for regular working capital that should be provided for
contingencies that arise at unstated periods. The contingencies included
(a) raising prices, which may make it necessary to have more money to carry
inventories and receivables, or may make it advisable to increase inventories;
(b) business depressions, which may raise the amount of cash required to ride out
of usually stagnant periods;
(c) strikes, fires and unexpectedly severe competition, which use up extra supplies
of cash; and
(d) special operations, such as experiments with new products, or with new
method of distribution, war contracts, contractors to supply new businesses, and
the like, which can be undertaken only if sufficient funds are available, and which
in many cases mean the survival of a business.
2. Temporary or Variable Working Capital: The variable working capital changes
with the volume of business. It may be subdivided into
(i) Seasonal Working Capital: In many lines of business (e.g. jaggery or sugar and fur
industry operations are highly seasonal and, as a result, working capital requirements
vary greatly during the year. The capital required to meet the seasonal needs of industry
is termed as Seasonal Working Capital.
(ii) Special Working Capital: Special Working Capital is that part of the variable working
capital which is required for financing special operations, such as the inauguration of
extensive marketing campaigns, experiments with new products or with new methods of
distribution, carrying out of special jobs and similar to the operations that are outside
the usual business of buying, fabricating and selling.
This distinction between permanent/fixed and temporary/variable working capital is of
great significance particularly in arranging the finance for an enterprise. Regular or
fixed working capital should be raised in the same way as fixed capital is procured -
through a permanent investment of the owner or through long-term borrowing. As
business expands, this regular capital will necessarily expand. If the cash returning from
sales includes a large enough profit to take care of expanding operations and growing
inventories, the necessary additional working capital may be provided by the earned
surplus of the business. Variable needs can, however, be financed out of short-term
borrowings from banks or from public in the form of deposits. The position with regard
to the 'fixed working capital' and 'variable working capital' can be shown with the help of
the following figures:
From the above figure it should not be presumed that permanent working capital shall
remain fixed throughout the life of the concern. As the size of the business grows,
permanent working capital too is bound to grow. The position can be depicted with the
help of the following figure:
So unlike a static concern, the fixed working capital of a growing concern will increase
with the growth in its size.
C. Elements of Working Capital
(i) Cash: Management of cash is very important from firms point of view. There must
be balance between the twin objectives of liquidity and cost while managing cash. There
must be adequate cash to meet the requirements of all segments of the organisation.
Excess cash may be costly for the concern as it will increase the cost in terms of interest.
Less cash may also be harmful to the concern as it will not be able to meet the liabilities
as the appropriate time. Thus the requirements of the cash must be estimated properly
either by preparing cash flow statements or cash budgets. This will help the
management to invest the idle funds remuneratively and shortages, if any, may be met
timely by making different arrangements. Therefore, it is necessary that every segment
of the organisation must have adequate cash in order to meet the requirements of that
segment without having surplus balances. Cash management is highly centralized
whereby cash inflows and outflows are centrally controlled but in multi-divisional
companies it may be possible to decentralize cash requirements so that every company
may have cash for its requirements.
(ii) Marketable (Temporary) Investments: Firms hold temporary investments for
surplus cash flows arising either during seasonal operations or out of sale of long term
securities. In most cases the securities are held primarily for precautionary purposes
most firms prefer to rely on bank credit to meet temporary transactions or speculative
needs, but to hold some liquid assets to guard against a possible shortage of bank credit.
The cash forecast may indicate whether excess cash available is temporary or not. If it is
found that excess liquidity will be temporary, the cash should then be invested in
marketable but temporary investments.
It should be remembered that even if a substantial part of idle cash is invested even
though for a short period, the interest earned thereon is significant.
(iii) Receivables: Management of receivables involves a trade-off between the gains
due to additional sales on account of liberal credit facilities and additional cost of
recovering those debts. If liberal credit facilities are given to the customers, sales will
definitely increase. But on the other hand bad debts, collection expenses and interest
charge will increase. Similarly if the credit policy is strict, the sales will be less and
customers may go to the competitors where liberal credit facilities are available. This
will result in loss of profit because of less sales but there will be saving because of less
bad debts, collection and interest charges. Management of debtors also covers analysis
of the risks associated with advancing credit to a particular customer. Follow up of
debtors and credit collection are the remaining aspects of receivables management.
(iv) Inventories: Inventories include all investments in raw materials, work-in-
progress, stores, spare parts and finished goods; they constitute an important part of the
current assets. The purchase of inventory involves investment which must be properly
controlled. There are many issues of inventory management which must be taken into
consideration as fixation of minimum and maximum level, deciding the issue of pricing
policy, setting up the procedures for receipts and inspection, determining the economic
ordering quantity, providing proper storage facilities, keeping control on obsolescence
and setting up an effective information system with reference to inventories. Inventory
management requires the attention of stores manager, production manager and
financial manager. There must be adequate inventories in order to avoid the
disadvantages of both inadequate and excessive inventories.
(v) Creditors: Management of creditors is very important aspect of working capital. If
the payment of creditors is delayed there is a possibility of saving of some interest but it
can be very costly because it will spoil the goodwill of the concern in the market. As far
as possible, the credit manager should try to get the liberal credit terms so that payment
may be made at the stipulated time.
D. Assessment of Working Capital Requirements
The following factors are considered for a proper assessment of the quantum of working
capital requirements:
(i) The Production Cycle: There is bound to be time span in raw materials input in
manufacturing process and the resultant output as finished product. To sustain such
production activities the requirement of investment in the form of working capital is
obvious. The lesser the production cycle (or the operating cycle) the lesser will be the
requirements of working capital. There are enterprises due to their nature of business
will have shorter cycle than others. Further, even within the same group of industries,
the more the application of technological advances in, will result in shortening the
operating cycle. In this context the choice of product requiring shorter or greater
operating cycle will have a direct impact on the working capital requirements. This is a
factor of paramount importance irrespective of whether a new industry is venturing
production of the first time or an ongoing business. Hence it can be said that the time
span for each stage of the process of manufacture if geared to improve upon will lead to
better efficiency and utilisation of working capital.
(ii) Work-in-Process: A close attention is to be given to the accumulation of work-in-
progress or work-in-process. Unless the sequences of production process leading to
conversion into finished product is kept under close observation to achieve better
production and productivity, more and more working capital funds will be tied up. In
this context, proper production planning and control is vital.
(iii) Terms of Credit from Suppliers of Materials & Services: The more the
terms of credit is favourable i.e. the more the time allowed by the creditors to pay them,
the lesser will be the requirement of working capital. Hence, the negotiation with the
suppliers in respect of price and the credit period is an important aspect in working
capital management. In this process the impact of the requirement of finance is shared
by the creditors for goods and services.
(iv) Realisation from Sundry Debtors: The lesser the time span between selling
the product and the realisation, the quicker will be the inflow of cash. This, in turn, will
reduce the finance required for working capital purposes. A realistic credit control will
reduce locking up of finance in the form of sundry debtors. The impact of better
realisation will not only help in reducing the working capital fund requirement but also
can boost up the finance needed for other operational needs. The important factors in
credit control will be: (a) volume of credit sales desired; (b) terms of sales and (c)
collection policy.
(v) Control on Inventories: The decision to maintain appropriate minimum
inventories either in the form of raw material, stores materials, work-in-process or
finished products is an important factor in controlling finance locked up. The better the
control on inventories the lesser will be the requirements of working capital. The
following vital factors involved in inventory management are to be considered for an
effective inventory control: (a) volume of sales, (b) seasonal variation in sales, (c) selling
off the shelf, (d) stocking to gain from higher price under inflationary conditions, (e) the
operating cycle, i.e., the time interval between manufacturing, selling and realisation,
and (f) safety or buffer stock. A minimum policy level of stock may have to be
maintained to seize the opportunity of selling when there is spark in demand for the
product.
(vi) Liquidity versus Profitability: The management dilemma as to the optimal
balancing between liquidity (or solvency) and the profitability is another factor of great
importance on the determination of the level of working capital requirement. In other
words, the level of liquidity and the profitability is to be maintained according to the
goals of financial management.
(vii) Competitive Conditions: The whole question of cash inflow depends as to the
quickness in selling the products and the realisation thereof. In this context, the nature
of business and the product will be the two important contributory factors as to the
policy on the quantum of working capital requirements.
(viii) Inflation and the Price Level Changes: In an inflationary trend, the impact
on working capital is that more finance is needed for the same volume of activity i.e.,
one has to pay more price for the purchase of same quantity of materials or services to
be obtained. Such raising impact of prices can be fully or partly compensated by
increasing the selling price of the product. All business may not be in a position to do so
due to their nature of product, competitive market, or Governments regulatory prices.
(ix) Seasonal Fluctuation and Market Share of Product: There are products
which are mostly in demand in certain periods of the year. In other words, there may
not be any sale or only a fraction of the total sale in off-season due to seasonal nature of
demand for the product. There may be shifting of demand due to better substitute of the
product available. This means the company affected by this economics, attempts to plan
diversification to sustain profit, expansion and growth of the business. In certain
businesses, demands for products are of seasonal in nature and for certain businesses,
the raw materials buying have to be done during certain seasonal timings. Naturally the
working capital requirement will be more in certain periods than in others.
Please use headphones
(x) Management Policy on Profits, Retained Profit, Tax Planning and
Dividend Policy: The adequacy of profit will lead to strengthening the financial
position of the business through cash generation which will be ploughed back as internal
source of financing. Tax planning is an integral part of working capital planning. It is
not only the question of quantum of cash availability for tax payment at the appropriate
time but also through tax planning the impact of tax payable can be reduced. Dividend
Policy considers the percentage of dividend to be paid to the shareholders as interim
and/or final dividend. There must be cash available at the appropriate time after the
dividend is declared. This way the dividend payment is connected with working capital
management.
(xi) Terms of Agreement: It refers to the terms and conditions of agreement to repay
loans taken from bankers and financial institutions and acceptance of fixed deposits
from public. The question of fund arrangement whether for working capital needs or to
long term loans is to be decided after taking into account the repayment ability. The
cash flow projection will have to be made accordingly.
(xii) Cash (Flow) Budget: In order to meet certain cash contingencies it may be
necessary to have liquidity in form of marketable securities as cash reservoir. This extra
cash reserve may remain as an idle fund. This type of cash reserve is necessary to meet
emergency disbursements.
(xiii) Overall Financial and Operational Efficiency: A professionally managed
company always applies appropriate tools and techniques to achieve efficiency and
utilisation of working capital fund. Adequacy of assessment and control of business will
lead to improve the 'working capital turnover'. Management also will have to keep itself
abreast of the environmental, technological and other changes affecting the business so
that an effective and efficient financial management can play a vital role in reducing the
problems of working capital management.
(xiv) Urgency of Cash: In order to avoid product becoming obsolete or to undercut
the competitors to hold the market share or in case of emergency for cash funds, it may
be necessary to sell out products at a cheaper rate or at a discount or allowing cash
rebate for early realisation from sundry debtors (customers). This situation may boost
up the cash availability. However, this sort of critical situation should be avoided as this
results in reducing profit.
(xv) Importance of Labour Mechanisation: Capital intensive industries, i.e.
mechanized and automated industries, will require lower working capital, while labour
intensive industries such as small scale and cottage industries will require larger
working capital.
(xvi) Proportion of Raw Material to Total Costs : If the raw materials are costly,
the firm may require larger working capital, while if raw materials are cheaper and
constitute a small part of the total cost of production, lower working capital is required.
(xvii) Seasonal variation: During the busy season, a business requires larger
working capital while during the slack season a company requires lower working
capital. In sugar industry the season is November to June, while in the woolen industry
the season is during the winter. Usually the seasonal or variable needs of working capital
are financed by temporary borrowing.
(xviii) Banking Connections: If the corporation has good banking connections and
bank credit facilities, it may have minimum margin of regular working capital over
current liabilities. But in the absence of the availability of bank finance, it should have
relatively larger among of net working capital.
(xix) Growth and Expansion: For normal rate of expansion in the volume of
business, one may have greater proportion of retained profits to provide for more
working capital; but fast growing concerns require larger amount of working capital. A
plan of working capital should be formulated with an eye to the future as well as present
needs of a corporation.
E. Problem of Inadequacy of Working Capital
In case of inadequacy of working capital, a business may have to face the following
problems:
(i) Production Facilities: It may not be possible to have the full utilisation of the
production facilities to the optimum level due to the inability of buying sufficient raw
material and/or major renovation of the plant and machinery.
(ii) Raw Material Purchases: Advantage of buying at cash discount or on favourable
terms may not be possible due to paucity of funds.
(iii) Credit Rating: When financial crisis continues, the credit worthiness of the
company may be lost, resulting in poor credit rating.
(iv) Seizing Business Opportunities: In case of boom for the products and for the
business, the company may not be in a position to produce more to earn 'opportunity
profit' as there may be inadequacy of finished products availability.
(v) Proper Maintenance of Plant and Machinery: If the business is on financial
crisis, adequate sums may not be available for regular repair and maintenance,
renovation or modernisation of plant to boost up production and to reduce per unit cost.
(vi) Dividend Policy: In the absence of fund availability it may not be possible to
maintain a steady dividend policy. Under such financial constraint, whatever surplus is
available will be kept in general reserve account to strengthen the financial soundness of
the business.
(vii) Reduced Selling: Due to the constraint in working capital, the company may not
be in a position to increase credit sales to boost up the sales revenue.
(viii) Loan Arrangement: Due to the emergency for working capital the company
may have to pay higher rate of interest for arranging either short-term or long-term
loans.
(ix) Liquidity versus Profitability: The lower liquidity position may also result in
lower profitability.
(x) Liquidation of the Business: If the liquidity position continues to remain weak
the business may run into liquidation. To remedy the situation of working capital crisis,
the following steps are required:
(a) An appraisal and review is to be conducted to minimize the operating cycle.
(b) Adequate credit control measures are to be adopted for early and prompt
realisation from the debtors.
(c) Proper planning and control of cash management through cash flow
forecasting.
(d) Whether more credit periods can be obtained for buying is to be explored.
F. Reasons for Inadequacy of Working Capital
Inadequacy or shortage of working capital may arise for various reasons, of which, the
main reasons are:
(i) Operating Losses: This may arise when the cost of production and other related
costs are more than the sales revenue, reduction in sales, falling prices, increased
depreciation, etc. It is obvious that a company facing losses will not have any cash
generation to sustain its ongoing business.
(ii) Extraordinary Losses: There may be exceptional losses due to fall in price of
finished product stocks, government action, obsolescence or otherwise. The effect of
such a loss will be a reduction in current assets or increase in current liabilities without
any corresponding favourable change in the working capital composition.
(iii) Expansion of Business: The company during the profitable years might have
invested substantially in fixed capital assets, increased production and increased credit
sales to make the sales volume grow rapidly. Against those activities, the pitfalls of over-
trading may show its ugly face subsequently. That is why a balancing judgment between
investment, liquidity and profitability is to be drawn and projected to save the business
falling into financial crisis. Thus the continuity and growth of the business may be
jeopardized. Along with the increased sales there may be increase in inventories and
higher sundry debtors. Such excessive build-up of inventories and receivables may
amount to alarming figures.
(iv) Payment of Dividend and Interest: The payment of interest from borrowings
will have to be made as per terms of agreement. Similarly, the payment of dividend may
have to be arranged to keep up the business prestige to the public and to the
shareholders. There may be profit to declare dividend but there may not be adequate
cash to disburse dividend. In case of insufficient funds to meet the aforesaid liabilities,
the mobilising of funds will be necessary.
G. Excessive Working Capital
The following are the major disadvantages of having or holding excessive working
capital:
(i) Overtrading: A time may come when overtrading will engulf the financial
soundness of the business.
(ii) Excessive Inventories: The inventories holding may become excessive under the
influence of excessive funds availability.
(iii) Liquidity versus Profitability: The situation of liquidity and the profitability
may be imbalanced.
(iv) Inefficient Operation: Availability of excessive production facilities may result
in higher production but sales may not be anticipated to match goods produced.
(v) Lower Return on Capital Employed: There may be reduced profit in relation to
total capital employed, resulting in lower rate of return on capital employed.
(vi) Increased Fixed Capital Expenditure: As enough fund is available, there may
be boost-up in acquiring plant and machinery to enhance production facilities. In case
there is not enough sales potentiality with adequate margin of profit such fixed
investment may not be worthwhile for fund employment.
H. Principles of Working Capital Management
1. Principle of Risk Variation: If working capital is varied relative to sales, the
amount of risk that a firm assumes is also varied and the opportunity for gain or loss is
increased. This principle implies that a definite relation exists between the degree of risk
that management assumes and the rate of return. That is, the more risk that a firm
assumes, the greater is the opportunity for gain or loss. It should be noted that while the
gain resulting from each decrease in working capital is measurable, the losses that may
occur cannot be measured.
It is believed that while the potential loss, the exactly opposite, occurs if management
continues to decrease working capital, that is to say, potential losses are small at first for
each decrease in working capital but increase sharply if it continues to be reduced. It
should be the goal of management to find that point of level of Working Capital at which
the incremental loss associated with a decrease in Working Capital investment becomes
greater than the incremental gain associated with that investment. Since most of the
managers do not know what the future holds, they tend to maintain an investment in
working capital that exceeds the ideal level. It is this excess that concerns since the size
of the investment determines firms rate of return on investment. The obvious
conclusion is that managers should determine whether they operate in business that
reacts favourably to changes in working capital levels, if not, the gains realized may not
be adequate in comparison to the risk that must be assumed when working capital
investment is decreased.
2. Principle of Equity Position: Capital should be invested in each components of
working capital as long as the equity position of the firm increases. It follows from the
above that the management is faced with the problem of determining the ideal 'level' of
working capital. The concept that each rupee invested in fixed or variable working
capital should contribute to the net worth of the firm should serve as a basis for such a
principle.
3. Principle of Cost of Capital: The type of capital used to finance working capital
directly affects the amount of risk that a firm assumes, as well as the opportunity for
gain or loss and cost of capital.
Whereas the first principle dealt with the risk associated with the amount of working
capital employed in relation to sales, the third principle is concerned with the risk
resulting from the type of capital used to finance current assets. It has been observed
that return to equity capital increases directly with the amount of risk assumed by the
management. This is true but only to a certain point. When excessive risk is assumed, a
firms opportunity for loss will eventually overshadow its opportunity for gain, and at
this point return to equity is threatened. When this occurs, the firm stands to suffer
losses. Unlike rate of return, cost of capital moves inversely with risk; that is, as
additional risk capital is employed by management, cost of capital declines. This
relationship prevails until the firms optimum capital structure is achieved; thereafter,
the cost of capital increases.
4. Principle of Maturity of Payment: A company should make every effort to relate
maturities of payment to its flow of internally generated funds. There should be the least
disparity between the maturities of the firms short term debt instrument and its flow of
internally generated funds because a greater risk is generated with greater disparity. A
margin of safety should, however, be provided for short term debt payments.
5. Principle of Negotiation:
The risk is not only associated with the amount of debt used relative to equity, it is also
related to the nature of the contracts negotiated by the borrower.
Some of the clauses of the contracts such as restrictive clauses and dates of maturity
directly affect a firms operation. Lenders of short term funds are particularly conscious
of this problem and they ask for cash flow statements. Lenders realize that a firm's
ability to repay short term loan directly related to cash flow and not to earnings and,
therefore, a firm should make every effort to tie maturities to its flow of internally
generated funds. This concept serves as the basis for the final hypothesis of this
presentation. Specifically, it may be stated as follows:
"The greater the disparity between the maturities of firms short term debt instrument
and its flow of internally generated funds, the greater the risk and vice-versa".
One can see that it is possible for a firm to face insolvency or embarrassment even
though it might be making a profit. It is extremely difficult to predict accurately a firms
cash flow in an economy such as ours. Therefore, a margin of safety should be included
in every short term debt contract; that is, adequate time should be allowed between the
time the funds are generated and the date of maturity.
Steps Involved in Efficient Management of Working Capital
1. Proper financial set up with appropriate authority and responsibility.
2. Coordination between the following functional areas in the organization:
Production planning and control
Sales credit control
Material management
Optimal utilisation of fixed plant and machinery together with other facilities
Sale of uneconomical fixed assets
Acquiring plant and machinery to augment production
Cost reduction programme
3. Financial planning and control for achieving increased profitability to have adequate
'cash generation' and 'plough back' of profits so that there is adequate internal source of
finance.
4. Proper cash management through projection of cash flow and source and application
of funds flow statement.
5. Establishing appropriate Information and Reporting System.
REVIEW QUESTIONS
1. Discuss the importance of working capital for a manufacturing concern.
2. Explain the various determinants of working capital of a concern.
3. What are the advantages of having ample working capital funds?
4. Differentiate between fixed working capital and variable working capital.
5. What are the different principles of working capital management?
6. Summarise the causes for and changes in working capital of a firm.
SUGGESTED READINGS
1. Agarwal, N.K.: Working Capital Management, New Delhi, Sterling Publications (P)
Ltd.
2. Khan, M.Y. and Jain, P.K.: Financial Management, New Delhi, Tata McGraw Hill Co.
3. Ramamoorthy, V.E.: Working Capital Management, Madras, Institute for Financial
Management and Research.
- End of Chapter -
LESSON - 3
WORKING CAPITAL FORECASTING TECHNIQUES
Learning Objectives
After reading this lesson you should be able to:
Know the concept of working capital cycle
Identify the working capital gap
Explain the working capital forecasting techniques
Chapter Outline
A. Percent-of-sales method
B. Regression Analysis method
C. Working Capital Cycle method
D. Illustrative examples
Working capital requirements can be determined mainly in three ways: Percent-of-sales
method, Regression Analysis method, and the Working Capital Cycle method.
A. Percent-of-Sales Method: It is a traditional and simple method of determining
the volume of working capital and its components, sales being a dominant factor. In this
method, working capital is determined as a per cent of forecasted sales. It is decided on
the basis of past observations. If over the year, relationship between sales and working
capital is found to be stable, then this relationship may be taken as a standard for the
determination of working capital in future also.
This relationship between sales and working capital and its various components may be
expressed in three ways:
(i) as number of days of sales,
(ii) as turnover, and
(iii) as percentage of sales.
The percent-of-sales method of determining working capital is simple and easy to
understand and is useful in forecasting of working capital requirements, particularly in
the short term. However, the greatest drawback of this method is the assumption of
linear relationship between sales and working capital. Therefore, this method cannot be
recommended for universal application. It may be found suitable by individual
companies in specific situations.
Please use headphones
B. Regression Analysis Method: As stated earlier the regression analysis method is
a very useful statistical technique of forecasting. In the sphere of working capital
management it helps in making projection after establishing the average relationship in
the past years between sales and working capital (current assets) and its various
components. The analysis can be carried out through the graphic portrayals (scatter
diagrams) or through mathematical formula. The relationship between sales and
working capital or various components may be simple and direct indicating complete
linearity between the two or may be complex in differing degree involving simple linear
regressions or simple curvilinear regression, and multiple regressions situations.
This method, with a range of techniques suitable for simple as well as complex
situations, is an undisputed refinement on traditional approaches of forecasting and
determining working capital requirements. It is particularly suitable for long-term
forecasting.
C. The Working Capital Cycle Method: The working capital cycle refers to the
period that a business enterprise takes in converting cash back into cash. As an example,
a manufacturing firm uses cash to acquire inventory of materials that is converted into
semi finished goods and then into finished goods. When finished goods are disposed of
to customers on credit, accounts receivable are generated. When cash is collected from
customers, we again have cash. At this stage one operating cycle is completed. Thus a
circle from cash-back-to-cash is called the working capital cycle. This concept is also be
termed as 'Pipe Line Theory' as popularly known.
Fig. 3.1 Working Capital Cycle
Thus we see that a working capital cycle, generally, has the following four distinct
stages:
1. The raw materials and stores inventory stage;
2. The semi-finished goods or work-in-progress stage;
3. The finished goods inventory stage; and
4. The accounts receivable or book debts stage.
Each of the above working capital cycle stage is expressed in terms of number of days of
relevant activity and requires a level of investment to support it. The sum total of these
stage-wise investments will be the total amount of working capital of the firm. A series
of such operating cycle recur one after another and chain continues till the end of the
operating period.
In this way the entire operating period has a number of operating cycles. It is important
to note that the velocity or speed of this cycle should not slacken at any stage, otherwise
the normal duration of the cycle will be lengthened, resulting in an increased need for
working fund. The faster the speed of the operating cycle, shorter will be its duration
and larger will be the number of total operating cycles in a year (operating period) which
in turn would be instrumental in giving the maximum level of turnover with
comparatively lower level of working fund.
The four steps involved in this method are :
(i) computing the duration of the operating cycle,
(ii) calculating the number of operating cycles in the operating period,
(iii) estimating the total amount of annual operating expenses, and
(iv) ascertaining the total working capital requirements. Each step is discussed with
some detail in the following paragraphs.
(i) Duration of Operating Cycle : The duration is computed in days by adding
together the average storage period of raw materials, works-in-progress, finished goods
and the average collection period and then deducting from the total the average
payment period. The formula to express the framework of the operating cycle is: O = (R
+ W + F + D) - C where:
O = Duration of operating cycle
R = Raw material average storage period
W = Average period of work-in-progress
F = Finished goods average storage period
D = Debtors collection period
C = Creditors payment period
The average inventory, trade creditors, work-in-progress, finished goods arid book debts
can be computed by adding the opening and closing balances at the end of the year in
the respective accounts and dividing the same by two. The average per day figures can
be obtained by dividing the concerned annual figures by 365 or the number of days in
the given period.
(ii) Number of Operating Cycle in Operating Period: This is found out by
dividing the total number of days in the operating period by number of days in the
operating cycle as
N = P/O
where N = Number of operating cycle in operating period, P = Number of days in the
operating period, and O = Duration of operating cycle (in days)
Suppose the operating period is one year (365 days) and the duration of operating cycle
is 73 days then the number of operating cycles in the operating period will be:
N = 365 /73 = 5 cycles
(iii) Total amount of Annual Operating Expenses: These expenses include
purchase of raw materials, direct labour costs and the overhead costs-calculated on the
basis of average storage period of raw materials and the time-lag involved in the
payment of various items of expenses. The aggregate of such separate average amounts
will represent the annual operating expenses.
(iv) Estimating the Working Capital Requirement: This is calculated by dividing
the total annual operating expenses by the number of operating cycles in the operating
period as shown below:
R = E/N
where, R = Requirement of Working Capital (Estimated), E = Annual Operating
Expenses, and N = Number of operating cycles in the operating period.
The amount of working capital thus estimated is increased by a fixed percentage so as to
provide for contingencies and the aggregate figure gives the total estimate of working
capital requirements. The operational cycle method of determining working capital
requirements gives only an average figure. The fluctuations in the intervening period
due to seasonal or other factors and their impact on the working capital requirements
cannot be judged in this method. To identify these impacts, continuous short-run
detailed forecasting and budget exercises are necessary.
D. Illustrative Examples
Illustration 1
The following data have been extracted from the financial records of Prabhakar
Enterprises Limited:
Raw Materials cost = Rs. 8 per unit,
Direct Labour cost = Rs. 4 per unit,
Overheads cost = Rs.80,000
Additional information:
i. The company sells annually 25,000 units @ Rs. 20 per unit. All the goods produced
are sold in the market.
ii. The average storage period for raw materials is 40 days and for finished goods it is 18
days.
iii. The suppliers give 60 days credit facility to the firm for purchases. The firm also sells
goods on 60-days credit to its customers.
iv. The duration of the production cycle is 15 days and raw material is issued at the
beginning of each production cycle.
v. 25% of the average working capital is kept as cash for contingencies.
On the basis of the above information, estimate the total working capital requirements
of the firm under Operating Cycle Method.
Solution
Duration of Operating Cycle Days
i. Materials storage period 40
ii. Production cycle period 15
iii. Finished goods storage period 18
iv. Average collection period 60
-----
133
Less: Average payment period -60
----
Duration of Operating Cycle 73
Number of Operating Cycles in a year = Total Number of Days in a year divided by
Duration of Operating Cycle = 365/73 = 5 Cycles in a year.
Total Annual Operating Expenses
i. Raw Material 25,000 x 8 = 2,00,000
ii. Direct Labour 25,000 x 4 = 1,00,000
iii. Overheads 80,000
----------
Total Operating Expenses for the year 3,80,000
-----------
Estimating Working Capital Requirements
= Total Annual Operating Expenses / Number of Operating Cycles in a year
= 3,80,000 / 5 = Rs. 76,000
Add: 25% of the above by cash for contingencies = Rs. 19,000
--------------
Total Working Capital Requirement = Rs. 95,000
--------------
Illustration 2 : Messrs Senthil Industries Ltd are engaged in large scale retailing.
From the following information, you are required to forecast their working capital
requirements of this trading concern.
Projected annual sales = Rs. 65 lakhs
Percentage of Net Profit on cost of sales = 25%
Average credit allowed to Debtors = 10 weeks
Average credit allowed by Creditors = 4 weeks
Average stock carrying (in terms of sales requirement) = 8 weeks
Add 10% to computed figures to allow for contingencies.
Solution
Statement of Working Capital Requirements
Note: It has been assumed that the creditors include those for both goods and
expenses, and that all such creditors allow one month credit on average.
Interpretation of Results:
The amount of working capital fund above is to be interpreted as the amount to be
blocked up in inventory, debtors (minus creditors) at any time during the period (year)
in view, in order that the anticipated activity (sales primarily) can go on smoothly. The
amount is not for a period of time but at any point of time. It represents the maximum
(or the highest) quantum of locking up at any time during the period.
Illustration 3 : Ramaraj Brothers Private Limited sells goods on a gross profit of 25%.
Depreciation is taken into account as a part of cost of production. The following are the
annual figures given to you:
Sales (2 months credit) Rs. 18,00,000
Materials consumed (1 month
credit) Rs. 4,50,000
Wages paid (1 month lag in
payment) Rs. 3,60,000
Cash manufacturing expenses (1 month lag in
payment) Rs. 4,80,000
Administration expenses (1 month lag in
payment) Rs. 1,20,000
Sales promotion expenses (paid quarterly in
advance) Rs. 60,000
Income tax payable in 4 instalments, of which one falls in the next
year Rs. 1,50,000
The company keeps one month's stock each of raw materials and finished goods. It also
keeps Rs. 1,00,000 in cash. You are required to estimate the working capital
requirements of the company on cash basis assuming 15% safety margin.
Solution
Working Notes:
1. Total Manufacturing Expenses
Sales Rs. 18,00,000
Less: Gross Profit 25% of sales - Rs. 4,50,000
Total Cost Rs. 13,50,000
Less: Cost of materials - Rs. 4,50,000
Wages - Rs. 3,60,000 -
Rs. 8,10,000
Total Manufacturing Expenses Rs. 5,40,000
2. Depreciation
Total Manufacturing Expenses Rs. 5,40,000
Less: Cash Manufacturing Expenses - Rs. 4,80,000
Depreciation Rs. 60,000
3. Total Cash Cost
Total Manufacturing Cost Rs. 13,50,000
Less: Depreciation - Rs. 60,000
Rs. 12,90,000
Add: Administration expenses + Rs. 1,20,000
Sales promotion expenses + Rs. 60,000
Total Cash Cost Rs. 14,70,000
Please use headphones
REVIEW QUESTIONS
1. What are the different methods of forecasting working capital requirements?
2. Explain: (a) Core Current Assets (b) Working Capital Gap (c) Working Capital Cycle
PRACTICAL PROBLEMS
1. The Board of Directors of Guru Nanak Engineering Company Private Ltd requests you
to prepare a statement showing the Working Capital Requirements Forecast for a level
of activity of 1,56,000 units of production. The following information is available for
your calculation:
A. Rs. per units
Raw materials 90
Direct Labour 40
Overheads 75
------
205
Profits 60
------
Selling price per unit 265
B.
(i) Raw materials are in stock on average one month,
(ii) Materials are in process, on average two weeks,
(iii) Finished goods are in stock, on average one month
(iv) Credit allowed by suppliers one month
(v) Time lag in payment from debtors 2 months
(vi) Lag in payment of wages 1 weeks
(vii) Lag in payment of overheads is one month
Other information: 20% of the output is sold against cash. Cash in hand and at Bank is
expected to be Rs.60,000. It is to be assumed that production is carried on evenly
throughout the year, wages and overheads accrue similarly and a time period of 4 weeks
is equivalent to a month.
[Ans: Working Capital Required Rs.74,13,000]
Notes: (i) Since wages and overheads accrue evenly on average, half the wages and
overheads would be included in working progress. Alternatively if it is assumed that the
direct labour and overhead are introduced at the beginning, full wages and overhead
would be included.
2. A proforma cost sheet of a company provides the following particulars:
Elements of Cost
Raw material 40%
Labour 10%
Overheads 30%
The following further particulars are available:
(a) Raw materials are to remain in stores on an average 6 weeks
(b) Processing time is 4 weeks
(c) Finished goods are required to be in stock on average period of 8 weeks
(d) Credit period allowed to debtors on average 10 weeks
(e) Lag in payment of wages 4 weeks
(f) Credit period allowed by creditors 4 weeks
(g) Selling price is Rs.50 per unit
You are required to prepare an estimate of working capital requirements adding 10%
margin for contingencies for a level of activity of 1,30,000 units of production.
[Ans: Working Capital Required = Rs. 25,25,000]
3. From the following information extracted from the books of a manufacturing concern,
compute the operating cycle in days -
Period covered 365 days
Average period of credit allowed by suppliers 16 days
SUGGESTED READINGS
1. Agarwal, N.K.: Working Capital Management, New Delhi, Sterling Publications (P)
Ltd.
2. Kulshrestha, R.S.: Financial Management, Agra, Sahitya Bhavan.
3. Ramamoorthy, V.E.: Working Capital Management, Madras, Institute for Financial
Management and Research.
- End of Chapter -
LESSON - 4
WORKING CAPITAL FINANCING POLICY
Learning Objectives
After reading this lesson you should be able to:
- Assess the need for working capital policy.
- Identify the different approaches to working capital policy.
- Understand the implications of conservative policy.
- Evaluate the Risk - Return in Aggressive policy.
- Arrive at a Moderate or Balanced approach to the problem of financing of current
assets.
Lesson Outline
A. Matching (Moderate) Approach
B. Aggressive Approach
C. Conservative Approach
D. Balanced Policy
E. Illustrative examples
The current assets financing plan may be readily related to the broader issue of the
financing plan for all the firm's assets. The firm has a wide variety of financing policies it
may choose, and the fact that short-term financing usually is less costly but involves
more risk than long-term financing plays an important part in describing the degree of
aggressiveness or conservatism of the firm's financing policy.
In comparing financing plans we should distinguish between three different kinds of
financing. A firm's investment is namely financed by a mix of these sources of financing:
(i) A permanent investment in an asset is one that the firm expects to hold for period
longer than one year. Permanent investments are made in the firm's minimum level of
current assets as well as in its fixed assets. Permanent sources of financing include
intermediate and long-term debt, preference share and equity share.
(ii) Temporary investments are comprised of the firm's investments in current assets,
which will be liquidated and not replaced within the current year. For example, a
seasonal increase in the level of inventory is a temporary investment as the holding up
in inventories will be eliminated when it is no longer needed. Temporary source of
financing is a current liability. Thus, temporary financing consists of the various sources
of short-term debt including secured and unsecured bank loans, commercial paper,
factoring of accounts receivables, and public deposits.
(iii) Besides permanent and temporary sources of financing, there also exist
spontaneous sources. Spontaneous sources consist of the trade credit and other
accounts payable that arise spontaneously in the firms day-to-day operations. Examples
include wages and salaries payable, accrued interest, and accrued taxes. These expenses
generally arise in direct conjunction with the firm's ongoing operations; they are
referred to as spontaneous. Popular example of a spontaneous source of financing
involves the use of trade credit. As the firm acquires materials for its inventories, credit
is often made available spontaneously or on demand by the firm's suppliers. Trade
credit appears on the firm's balance sheet as accounts payable. The size of the accounts
payable balance varies directly with the firm's purchases of inventory items, which in
turn are related to the firm's anticipated sales. Thus, a part of the financing needs by the
firm is spontaneously provided by its use of trade credit.
The long term working capital can be conveniently financed by (a) owners equity
e.g. shares and retained earnings, (b) lenders' equity e.g. debentures, and (c) fixed assets
reduction e.g. sale of assets, depreciation on fixed assets etc. This capital can be
preferably obtained from owner's equity as they do not carry with them any fixed
charges in the form of interest or dividend and so, do not put any burden on the
company.
Intermediate working capital funds are ordinarily raised for a period varying from
3 to 5 years through loans which are repayable in installments e.g., working capital
term-loans from the commercial banks or from finance corporations.
A. Matching (or Moderate) Approach: Matching approach is also called Hedging
Principle. It involves matching the cash flow generating characteristics of a firms
assets with the maturity of the source of financing used. The rationale for matching is
that since the purpose of financing is to pay for assets, when the asset is expected to be
relinquished so should the financing be relinquished. Obtaining the needed funds from
a long-term source (longer than one year) would mean that the firm would still have the
funds after the inventories have been sold. In this case the firm would have "excess"
liquidity, which they either hold in cash or invest in low yielding marketable securities.
This would result in an overall lowering of firm's profits. Similarly arranging finance for
shorter periods that the assets require is also costly in that there will be extra
transaction costs involved in continually arranging new short-term financing. Also,
there is always the risk that new financing cannot be obtained in times of economic
difficulty.
The firm's permanent investment in assets is financed by the use of either permanent
source of financing (intermediate-and long-term debt, preference shares, and equity
shares) or spontaneous source (trade credit and other accounts payable), its temporary
investment in assets is financed with temporary (short-term debt) and/or spontaneous
sources of financing. Note the matching approach has been modified to state: Asset
needs of the firm, not financed by spontaneous sources, should be financed in
accordance with the rule: permanent asset investments financed with permanent
sources and temporary investments financed with temporary sources.
Since total assets must always equal to the sum of spontaneous, temporary, and
permanent sources of financing, the hedging approach provides the financial manager
with the basis for determining the sources of financing to use at any point in time.
Please use headphones
B. Aggressive Approach: The firm's financing plan is said to be aggressive if the firm
uses more short-term negotiated financing than is needed under a matching approach.
The firm is no longer financing all its permanent assets with long-term financing. Such
plans are said to be aggressive because they involve a relatively heavy use of (riskier)
short-term financing. The more short-term financing used relative to long-term
financing, the more aggressive is the financing plan. Some firms are even financing part
of their long-term assets with short-term debt, which would be a highly aggressive plan.
C. Conservative Approach: Conservative financing plans are those plans that use
more long-term financing than is needed under a matching approach. The firm is
financing a portion of its temporary current assets requirements with long-term
financing. Also, in periods when the firm has no temporary current assets the firm has
excess (unneeded) financing available that will be invested in marketable securities.
These plans are called conservative because they involve relatively heavy use of (less
risky) long-term financing.
Comparison of Conservative, Hedging, and Aggressive Approaches: These
approaches to working capital financing can be compared on the basis of (a) cost
considerations, (b) profitability considerations, and (c) risk considerations (probability
of technical insolvency). The following statement gives a comparative evaluation.
Please use headphones
D. Balance Policy: Because of the impracticalities in implementing the matching
policy and the extreme nature of the other two policies, most financial managers opt for
a compromise position. Such a position is the balanced policy. As its name implies,
management adopting this policy balances the trade-off between risk and profitability in
a manner consistent with its attitude toward bearing risk. The long-term financing is
used to support permanent current assets and part of the temporary current assets.
Thus short-term credit is used to cover the refraining working capital needs during
seasonal peaks. This implies that as any seasonal borrowings are repaid, surplus funds
are invested in marketable securities. This policy has the desirable attribute of providing
a margin of safety not found in the other policies. If temporary needs for current assets
exceed managements expectations, the firm will still be able to use unused short-term
lines of credit to fund them. Similarly, if the contraction of current assets is less than
expected, short-term loan payments can still be met, but less surplus cash will be
available for investment in marketable securities. In contrast to the other working
capital policies, a balanced policy will demand more management time and effort.
Under the policy, the financial manager will not only have to arrange and maintain
short-term sources of financing but must be prepared to manage the investment of
excess funds.
The Appropriate Working Capital Policy
The analysis so far has offered insights into the risk-profitability trade-off inherent in a
variety of different policies. Just as there is no optimal capital structure that all firms
should adopt, there is no one optimal working capital policy that all firms should
employ. Which particular policy is chosen by a firm will depend on the uncertainty
regarding the magnitude and timing of cash flow associated with sales; the greater this
uncertainty, the higher the level of working capital necessary. In addition, the cash
conversion cycle will influence a firms working policy; the longer the time required to
convert current assets into cash, the greater the risk of illiquidity. Finally, in practice,
the more risk averse management is the greater will be the net working capital position.
The management of working capital is an ongoing responsibility that involves many
interrelated and simultaneous decisions about the level and financing of current assets.
The considerations and general guidelines offered in this lesson should be useful in
establishing an overall net working capital policy.
E. Illustrative examples
Illustration 1
Following is the summary of Balance Sheets of a firm under the three approaches:
-------------------------------------------------------------------------------------------
Policy / Approach
------------------------------------------
Conservative Hedging Aggressive
-------------------------------------------------------------------------------------------
Liabilities
Current liabilities 5,000 15,000 25,000
Long-term loan 25,000 15,000 5,000
Equity 50,000 50,000 50,000
------------------------------------------
Total 80,000 80,000 80,000
------------------------------------------
Assets
Current assets
a) Permanent requirement 20,000 20,000 20,000
b) Seasonal requirement 15,000 15, 000 15,000
Fixed assets 45,000 45,000 45,000
------------------------------------------
Total 80,000 80,000 80,000
------------------------------------------
Additional Information
(i) The firm earns, on an average, approximately 6% on investments in current assets
and 18% on investments in fixed assets.
(ii) Average cost of current liabilities is 5% and average cost of long-term funds is 12%.
Compute the costs and returns under any three different approaches, and comment on
the policies.
Solution
1. Computation of costs under the three approaches:
-------------------------------------------------------------------------------------------------
Policy / Approach
---------------------------------------------------------
Conservative Hedging Aggressiv
e
--------------------------------------------------------------------------------------------------
Cost of Current liabilities, 5% on 5,000 = 250 15,000 = 750 25,000
= 1,250
Cost of long-term funds, 12% on 75,000 = 9,000 65,000 = 9,000 55,000
= 6,600
---------------------------------------------------------
Total
Cost 9,250 9,750 7,850
--------------------------------------------------------------------------------------------------
2. Computation of returns under the three approaches:
-------------------------------------------------------------------------------------------------
Policy / Approach
---------------------------------------------------------
Conservative Hedging Aggressiv
e
--------------------------------------------------------------------------------------------------
Return on Current assets, 6% on 35,000 = 2,100 35,000 = 2,100 35,000
= 2,100
Return of Fixed Assets, 18% on 45,000 = 8,100 45,000 = 8,100 45,000
= 8,100
---------------------------------------------------------
Total
Return 10,200 10,200 10,200
Less: Cost of
financing (9,250) (8,550) (7,850)
--------------------------------------------------------------------------------------------------
Net
return 950 1,650 2,350
--------------------------------------------------------------------------------------------------
Comments:
(i) Cost of financing is highest being Rs. 9,250 in conservative approach, and lowest (Rs.
7,850) in aggressive approach, the total funds being the same, i.e., Rs. 80,000.
(ii) Return on investment (net) is lowest in conservative approach being Rs.950, and
highest in aggressive approach being Rs. 2,350.
(iii) Risk is measured by the amount of net working capital. The larger the net working
capital, the lesser will be the degree of technical insolvency or the lesser will be the
inability to meet obligations on maturity dates. In other words,
larger net working capital means less risk. The net working capital is comparatively
larger in conservative approach and therefore, the degree of risk is low. The net working
capital is comparatively lower in aggressive approach, and, therefore, the degree of risk
is high. Risk is also measured by the degree of liquidity. The larger the degree of
liquidity, the lesser will be the degree of risk. One of the measurements of degree of
liquidity is current ratio; it is also known as 'Working Capital Ratio'. This ratio signifies
the firms ability to meet its current obligations. The larger the ratio, the greater the
liquidity, and the lesser the risk. In conservative approach, current ratio is the highest
being 7:1, and in aggressive approach, this ratio is lowest being 1.4 : 1. Therefore, there is
low risk in conservative approach.
The aforementioned analysis leads to the following conclusions:
(i) In conservative approach, cost is high, risk is low, and return is low.
(ii) In aggressive approach, cost is low, risk is high, and return is high.
(iii) Hedging approach has moderate cost, risk and return. It aims at trade-off between
profitability and risk.
REVIEW QUESTIONS
1. Evaluate the following statement: "A firm can reduce its risk of illiquidity with higher
current-asset investments, but the return on capital goes down."
2. What are the risk-return trade-offs involved in choosing a mix of short-and long-term
financing?
3. There are four different policies that managers must consider in designing their
working capital policy. Explain the salient features of each policy. What are the
advantages and disadvantages of each such policy?
PRACTICAL PROBLEMS
1. The management of Jayant Electrical Ltd is faced with various alternatives for
managing its current assets. The company is producing 1,00,000 units of electrical
heaters. This is its maximum installed capacity. Its selling price per unit is Rs.50. The
entire output is sold in the market. Fixed assets of the company are valued at Rs. 20
lakhs. The company earns 10% on sales before interest and taxes. The management is
faced with three alternatives about the size of investment in current assets.
(i) To operate with current assets of Rs. 20 lakhs, or
(ii) To operate with current assets of Rs. 15 lakhs, or
(iii) To operate with current assets of Rs 10 lakhs.
You are required to show the effect of the above three alternative current assets
management policies on the degree of profitability of the company.
[Ans: (i) Conservative Policy (ii) Moderate Policy (iii) Aggressive Policy]
2. (a) Total investments:
In Fixed Assets 1,20,000
In Current Assets 80,000 2,00,000
(b) Earning (EBIT) is 25%.
(c) Debt-ratio is 60%.
(d) Rs. 80,000 being (40% assets) financed by the equity shareholder, i.e., long-term
sources.
(e) Cost of short-term debt and long-term debt is 14% and 16% respectively.
(f) Assume Income tax @ 50%.
As a result of the financing policy, ascertain the return on equity shares.
[Ans : Return on equity is highest in aggressive policy]
SUGGESTED READINGS
1. Agarwal, N.K: Working Capital Management, New Delhi, Sterling Publications (P)
Ltd. 1983.
2. Pandey, I.M.: Financial Management, New Delhi, Vikas Publishing House.
3. Ramamoorthy, V.E: Working Capital Management, Madras; Institute for Financial
Management and Research, 1978
- End of Chapter -
LESSON - 5
SOURCES OF WORKING CAPITAL FINANCE
Learning Objectives
After reading this lesson you should be able to:
Identify the various sources of working capital finance
Know the cost of trade credit
Understand the regulation of bank credit
Evaluate the significance of Public Deposits and inter-corporate loans/deposits
Recognise the emergence of new instruments like Commercial Papers,
Convertible Warrants, etc.
Lesson Outline
Trade Credit - Customers Advances
Commercial Bank Credit - Cash Credit/Discounting
Regulation of Bank Credit - Tandon Committee - Chore Committee - Marathe
Committee
Commercial Papers
Inter Company Deposits/Loans
Public Deposit
One of the important tasks of the finance manager is to select an assortment of
appropriate sources to finance the current assets. A business firm has various sources to
meet its financial requirements. Normally, the current assets are supported by a
combination of long term and short term sources of financing. In selecting a particular
source a firm has to consider the merits and demerits of each source in the context of
prevailing constraints. The following is a snapshot of various sources of working capital
available to a concern:
SOURCES OF WORKING CAPITAL
Long term, Medium term & Short term sources
The long term working capital can be conveniently financed by (a) owners equity e.g.
shares and retained earnings, (b) preferred equity, (c) lender's equity e.g., debentures,
and (d) fixed assets reduction e.g., sale of assets, depreciation on fixed assets etc. This
capital can be preferably obtained from owners equity as they do not carry with them
any fixed charges in the form of interest or dividend and so do not throw any burden on
the company.
Intermediate working capital funds are ordinarily raised for a period varying from 3 to 5
years through loans which are repayable in installments e.g., term-loans from the
commercial banks or from finance corporations. Short term working capital funds can
be obtained for financing day-to-day business requirements through trade credit, bank
credit, discounting bills and factoring of account receivables. Factoring is a method of
financing through accounts receivable under which a business firm sells its accounts to
financial institution, called the Factor.
Please use headphones
SOURCES OF SHORT-TERM FINANCE
In choosing a source of short term financing, the finance manager is concerned with the
following five aspects of each financing arrangement.
(i) Cost: Generally the finance manager will seek to minimise the cost of financing,
which usually can be expressed as an annual interest rate. Therefore, the financing
source with the lowest interest rate will be chosen. However, there are other factors
which may be important in particular situations.
(ii) Impact on credit rating: Use of some sources may affect the firms credit rating
more than use of others. A poor credit rating limits the availability, and increases the
cost of additional financing.
(iii) Reliability: Some sources are more reliable than others in that funds are more
likely to be available when they are needed.
(iv) Restrictions: Some creditors are more apt to impose restrictions on the firm than
others. Restrictions might include rupee limits on dividends, management salaries, and
capital expenditures.
(v) Flexibility: Some sources are more flexible than others in that the firm can
increase or decrease the amount of funds provided very easily. All these factors must
usually be considered before making the decision as to the sources of financing.
Trade Credit: Trade credit represents credit granted by manufacturers, wholesalers,
etc., as an incident of sale. The usual duration of credit is 30 to 90 days. It is granted to
the company on open account, without any security except that of the goodwill and
financial standing of purchaser. No interest is expressly charged for this, only the price
is a little higher than the cash price. The use of trade credit depends upon the buyers
need for it and the willingness of the supplier to extend it.
The willingness of a supplier to grant credit depends upon:
(i) the financial resources of the supplier;
(ii) his eagerness to dispose of his stock;
(iii) degree of competition in the market;
(iv) the credit worthiness of the firm;
(v) nature of the product;
(vi) size of discount offered;
(vii) the degree of risk associated with customers.
The length of the credit period depends upon:
(a) Customers marketing period;
(b) Nature of the product (long credit for new, seasonal goods and short credit on
perishable goods and low-margin goods); and
(c) Customer location (long distance evidencing the amount that he owes to the seller)
Cost of Trade Credit
The trade credit as a source of financing is not without cost. The cost of trade credit is
clearly determined by its terms. However, the terms of trade credit vary industry to
industry and from company to company. However, regardless of the industry, the two
factors that must be considered while analysing the terms and the cost of trade credit
are:
(i) the length of time the purchaser of goods has before the bill must be paid, and
(ii) the discount, if any, that is offered for prompt payment. For instance, a company
purchases goods worth Rs. 10,000 on terms Rs. 10,000/2/10, net 30 days. It means if
the payment is made within ten days the firm will be entitled for 2% cash rebate;
otherwise the payment is to be made within 30 days in full. If the company wants to use
Rs.9,800 for 20 days at a cost of Rs.200, then its actual cost works to 2.049.
Advantages of Trade Credit
Trade credit as a form of short term financing has the following advantages:
(i) Ready availability: There is no need to arrange financing formally.
(ii) Flexible means of financing: Trade credit is a more flexible means of financing.
The firm does not have to sign a Promissory Note, pledge collateral, or adhere to a strict
payment schedule on the Note.
(iii) Economic means of financing: Generally, during periods of tight money, large
firms obtain credit more easily than small firms do. However, trade credit as a source of
financing is still more easily accessible by small firms even during the periods of tight
money.
Customers Advances: Depending upon the competitive condition of the market and
customs of trade, a company can meet its short-term requirements at least partly
through customer/dealers advances. Such advances represent part of the price and carry
no interest. The period of such credit will depend upon the time taken to deliver the
goods. This type of finance is available only to those firms which can dictate terms to
their customers since their product is in great demand as compared to the products of
the other competitive firms.
Commercial Bank: Bill Discounting and Cash Credit: Bank credit is the primary
institutional source for working capital finance. Banks offer both unsecured as well as
secured loans to business firms. At one time banks confined their lending policies to
such loans only. Banks, now, provide a variety of business loans, tailored to the specific
needs of the borrowers. Still, short term loans are an important source of business
financing such as seasonal build-ups in accounts receivable, and inventories. The
different forms in which unsecured and secured short-term loans may be extended are
discounting of bills of exchange, overdraft, cash credit, loans and advances. Banks
provide credit on the basis of the security. A loan may either be secured by tangible
assets or by personal security. Tangible assets may be charged as security by any one of
the following modes, viz., lien, pledge, hypothecation, mortgage, charge, etc.
Please use headphones
Discounting and Purchase of Bills: Under the Bill Market scheme, the Reserve
Bank of India envisages the progressive use of bills as an instrument of credit as against
the current practice of using the widely prevalent cash credit arrangement for financing
working capital. To popularise the scheme, the discount rates are fixed at lower rates
than those of cash credit, the difference being about 1 to 1.5 per cent.
Cash Credits: Banks in India normally make loans and advances in three forms viz.,
cash credits, overdrafts and loans. Cash credit is an arrangement by which a banker
allows the customer to borrow money up to a certain limit (called cash credit limit)
against some tangible security or on the basis of a promissory-note signed and fixes the
limit annually or quarterly after taking into account several material levels, etc. The
banker keeps adequate cash balances so as to meet the customers demand as and when
demand arises. Once the cash credit arrangement is made, the customer need not take
the whole advance at once but may draw out or utilise the bank credit at any time
without keeping a credit balance. Further, the borrower can put back any surplus
amount which he may find with him for the time being. The bank can also withdraw the
credit at any time in case the financial position of the borrower goes down. Generally the
borrower is charged interest on the actual amount utilised by him and for the period of
actual utilisation only; interest is charged by the bank on daily debit balance.
Overdrafts: When a customer having a current account requires a temporary financial
accommodation, he is allowed to overdraw (to draw more than his credit balance) his
current account up to an agreed limit. Overdraft accounts can either be secured or
unsecured, usually, security is insisted upon for an overdraft arrangement. The
customer is allowed to withdraw the amount by cheques as and when he needs it and
repay it by means of deposits into his account as and when it is feasible for him. Interest
is charged on the daily debit balance i.e.,the exact amount overdrawn by the customer
and for the period of actual utilisation. This is more advantageous to the customer-
borrower in the sense that the interest is charged only on the amount drawn by him. But
the banker is comparatively at a disadvantage because he has to keep himself in
readiness with the full amount of the overdraft and he can charge interest on the
amount actually drawn. An overdraft, is different from a cash credit in that the former is
supposed to be for a comparatively short time where as the latter is not so.
Loans: When an advance to a customer is made in a lumpsum against security or
otherwise, without liberty to him of repaying, with a view to making a subsequent
withdrawal, it is called a loan. The entire loan amount is paid to the borrower in cash or
is credited to his current account and interest is charged on the full amount of the loan
from quarterly rests from the date of sanction. Where the loan is repayable in
installments the interest is charged only on the reduced balance. A loan once repaid in
full or in part cannot be withdrawn again by the borrower, unless the banker grants a
fresh loan which will be treated as a separate transaction. In this respect a loan account
differs from a cash credit or an overdraft account. A banker prefers to make an advance
in the form of a loan because he can charge interest on it, rather than overdraft or cash
credit because in the latter case there is continuity and magnitude of operation.
Critical Evaluation of Bank Finance:
Bank credit offers the following advantages to the borrowing companies:
(1) Timely assistance: Banks assist the borrowing companies by providing timely
assistance to meet the working capital requirements. A company can usually rely upon
the bank for amounts of loan up to an agreed limit sanctioned by bank in advance.
(2) Flexibility: Bank assistance is flexible to the company. The accommodation can
easily be got extended and may be used when it is urgently needed. It helps the company
in maintaining goodwill in the market. Also, if the amount of loan or a part of it is no
more required it can be repaid and interest on it be saved.
(3) Economy: Bank assistance entails the payment of only interest and does not
involve the kind of costs which are to be incurred in the issue of securities such as
commission on underwriting etc. Moreover, the rate of interest is not very high. The
interest is payable only for the period the loan remains unpaid. Thus it reduces the cost
of borrowings.
(4) No permanent burden: The borrowings can be repaid if it is no more required.
In this way, it is not a permanent burden to the concern.
(5) No interference with company management: The loan provided by the bank
is simply a loan and no string is attached to it. Generally banks do not interfere with the
management of the borrowing companies, till the bank is assured of the repayment of
loans.
(6) Secrecy: This is by far the greatest advantage of bank finance. Any information
supplied to bank regarding financial position of the borrowing company is not made
public in any way by the bank.
Drawbacks of Bank Finance: Bank accommodation and loans suffer from the
following drawbacks:
(1) Burden of mortgage or hypothecation: The stock of raw material, finished or
semi finished goods are to be kept in a godown under bank control and can be used only
with the permission of bank or after paying the amount of loan.
(2) Short-duration of assistance: Banks provide only short-term assistance
generally for the period less than a year and its renewal or extension is quite uncertain
depending upon the discretion of banks authorities.
(3) Cumbersome terms: Banks grant assistance generally, to the extent of 50 to 75%
of the cost of security pledged or hypothecated, thus having a margin of 25% to 50%. In
addition, banks press the borrowing companies to have the goods in their godowns.
Minimum interest is paid on a certain specific amount whether it is drawn or not and
repayment of loan is strictly enforced as per the agreement entered into between the
company and the bank. Thus, the terms of borrowings are too harsh. It also increases
the cost of new borrowings and of the production.
REGULATION OF BANK CREDIT SINCE 1965
Since 1965, the availability of bank credit to industry has been the subject matter of
regulation and control with a view to ensure equitable distribution of bank credit to
various sectors of the economy as per planning priorities. The following are of special
significance in this respect:
(i) Credit Authorisation Scheme, 1965
(ii) Dehejia Committee, 1969
(iii) Tandon Committee Report, 1975
(iv) Chore Committee Report, 1979
(v) Marathe Committee 1,1992, and
(vi) Nayak Committee
Credit Authorisation Scheme, 1965
The Credit Authorisation Scheme (CAS) was introduced by the Reserve Bank of India in
November 1965 as a measure to regulate bank credit in accordance with plan priorities
i.e., purpose-oriented. Under this Scheme, the scheduled commercial banks are required
to obtain Reserve Banks prior authorisation before granting fresh credit limits
(including commercial bill discounts and term loans) of Rs. 1 crore or more to any single
party or any limit that would take the total limits enjoyed by such party from the
banking system as a whole to Rs. 1 crore or more on secured or unsecured basis. If the
existing credit limits exceed Rs. 1 crore, such prior authorisation is also required for
grant of any further credit facilities.
New Procedures for Quicker Release of Funds under CAS, based on
Marathe Committee 1982
The Reserve Bank of India (RBI) had issued guidelines under which banks can release
funds to their borrowers up to 50 per cent of the additional limits under the modified
Credit Authorisation Scheme (CAS) which come into force from April 1, 1984 without
waiting for prior authorisation from the RBI subject to the five requirements. The five
requirements under this "Fast Track Procedure" are:
1. Reasonableness of the estimates and projections of production, sales, current
assets, etc, given by the client
2. Proper classification of current assets and liabilities
3. Maintenance of minimum current ratio of 1.33:1
4. Prompt submission of quarterly operating statements as also annual accounts by
borrowers, and
5. Regular annual review of the credit facilities by the banks
The proposals should be certified by an authorised senior officer of the bank regarding
the fulfillment of these requirements.
All proposals seeking the benefit of the Fast Track Procedure simultaneously go through
the normal process of scrutiny by the RBI. If it is found that the credit limits sanctioned
by the commercial banks are not need-based or were excessive, corrective action will be
taken. In such cases the RBI may stipulate that until further notice, credit proposals
from these borrowers should be referred to it for its prior authorisation. With effect
from April 1, 1984, banks may grant facilities on an ad hoc basis for a period not
exceeding three months to any of CAS borrowers under exceptional circumstances up to
25 per cent of the existing packing credit limit or 10 per cent of the existing working
capital limit subject to an overall ceiling of Rs.75 lakhs against Rs.50 lakhs now.
Prior authorisation from the RBI will not be necessary for letters of credit (L.C.)
facilities subject to the following conditions.
Banks should not open letters of credit for amounts out of proportion to the borrower's
genuine needs and without ensuring that the borrowers have made adequate
arrangement for retiring the bills received under the letters of credit out of their own
resources or from the existing borrowing arrangements.
Tandon Committee
The Reserve Bank of India constituted in July 1974 a study group to frame guidelines for
follow-up of bank credit under the chairmanship of P.L.Tandon. The report submitted
by the committee in August 1975 is popularly referred to as the Tandon Committee
Report.
Recommendations: The recommendations of this committee are given below:
1. Norms for Inventory and Receivables: The Committee has come out with a set
of norms that represent the maximum levels for holding inventory and receivables in
each of 15 major industries, covering about 50 per cent of industrial advances of banks.
As norms cannot be rigid, deviations from norms can be permitted under extenuating
circumstances such as bunched receipt of raw materials including imports, power-cuts,
strikes, transport bottlenecks etc., for usually short periods. Once normalcy is restored,
the norms should become applicable. The norms should be applied to all industrial
borrowers with aggregate limits from the banking system in excess of Rs. 10 lakhs and
extend to smaller borrowers progressively.
2. Approach to Lending: (i) As a lender the bank should only supplement the
borrowers resources in carrying a reasonable level of current assets in relation to his
production requirements.
(ii) The difference between total current assets and current liabilities other than bank
borrowing is termed as working capital gap. The bank should finance a part of the
working capital gap and the balance should be financed through long-term sources
comprising equity and long-term borrowings.
(iii) Three alternative methods have been suggested for calculating the maximum
permissible bank borrowing. The methods will progressively reduce the maximum
permissible bank borrowing. These three methods are explained by means of a
numerical example which indicates the projected financial position as at the end of the
next year.
Method 1...
Under this method, 75% of the working capital gap may be provided by banks and
the customer should provide the balance 25% from long-term funds like owned
funds or term-loans.
Method 2...
According to this method, the borrower should be required to provide through
long-term resources 25% the gross current assets while the balance could be
provided by trade creditors and current liabilities as also the banks.
Method 3...
This method is similar to Method 2, but it further requires that even out of the
gross current assets, the core current assets should be determined and separately
funded from long-term resources. The Committee did not lay down any mode for
the determination of the core current assets and left it to the lending banks to
find out method for such determination.
The Committee recommended that if in any borrowers case, the limit under the
particular method in its case had been exceeded, the excess should be converted into a
funded debt and liquidated within an agreed period. It was also suggested that the
change over should be gradual, viz., a borrower may first be brought into the base
provided under Method 1, and then he should be carried towards Method 2, and
thereafter to Method 3. In fact, till now, Method 3 has not been applied.
Example:
Let us try to apply these methods to a company which has the following current assets
and current liabilities position.
The current assets have been worked out on the basis of suggested norms or past
practices, whichever is lower.
3. Reporting System regarding Bank Credit: The Committee suggested that in
order that the lending bank could follow up the position of a borrower, certain
periodical statements (in addition to the audited Balance Sheet) should be submitted by
the borrower to the lending bank, e.g.
(i) Quarterly Profit & Loss Account
(ii) Quarterly Statement of Current Assets & Current Liabilities
(iii) Quarterly Funds Flow Statement
(iv) Half-yearly Proforma Balance Sheet and Profit & Loss Account
(v) Monthly Stock Statements in a revised form
The Committee suggested that the above information system should be introduced
initially with borrowers whose limits aggregated rupees one crore and above within a
period of 6 months, and then progressively extended to borrowers with limits of rupees
fifty lakhs and above, and then to borrowers with credit limits of rupees ten lakhs and
above. According to the committee, the banker should be guided by the borrowers total
operations and not merely by the value of the current assets. The credit that should be
allowed must be entirely need-based and the borrower's requirement should be planned
in advance with the assistance of the banker. A financial analysis of the borrower's
operating results along with inter-firm comparison should be carried out by the banker
so that the efficiency and performance of the borrower can be judged, and a time-bound
programme can be laid down as corrective measure.
4. Inter-firm Studies: To facilitate inter-firm and industry-wise comparisons for
assessing efficiency, it would be of advantage if companies in the same industry could be
grouped under three or four categories, say, according to size of sales and the group-
wise financial ratios compiled by the RBI for furnishing to banks.
5. Classification of Borrowers: For the purpose of better control, there should be a
system of borrower classification in each bank. This will facilitate easy identification of
the borrowers whose affairs require to be watched with more than ordinary care and will
also provide a rational base for the purposes of fixing rates of interest for the respective
borrowers.
6. Bank credit for Trade: While financing trade, banks should keep in view, among
other things, the extent of owned funds of the borrower in relation to the credit limits
granted, the annual turnover, possible diversion to other units or uses and how much is
being ploughed back from profit into the business. They should avoid financing of goods
which have already been obtained on credit.
7. Norms for Capital Structure: In discussing the norms for capital structure we
have to keep in mind both the relationships long-term debt to equity and total outside
liabilities to equity. Where a company's loan-term debt / networth and outside
liabilities, networth ratios are worse than the medians, the banker should try to
persuade the borrower to strengthen his equity base as early as possible.
8. The committee favoured the retention of the basic elements of the existing system
because
(i) it provides more flexibility to borrowers,
(ii) it is cheaper to borrowers, and
(iii) it leaves abundant discretion and judgment to the bankers operate in a realistic
manner given daily developments. Central to existing system is the cash credit
arrangements with its three elements of annual credit limits, drawing accounts and
drawing power based on security stipulations.
9. The Committee also suggested that within the overall eligibility, a part of the
borrowers requirements should be met by the banker by way of a bills limit apart from
the loan or other cash credit arrangements. This, however, should be only a sort of
interim arrangement. In most cases, the bankers apply Method 1 advocated by the
Committee for determining the maximum limit of borrowings to be allowed to a
borrower. In some cases only, Method 2 is applied, while Method 3 has not yet been
applied in any case. The Committees Report has been subsequently modified to some
extent by the Chore Committee Report of 1979.
Chore Committee
The RBI constituted in April 1979 a six-member working group under the chairmanship
of K.B. Chore, Chief Officer, Department of Banking Operations and Developments, RBI
to review mainly the system of cash credit and credit management policy by banks.
Recommendations
The highlights of the Chore Committee report as considered by the RBI are as follows:
1. Enhancement on borrower's contribution: The net surplus cash generation of
an established industrial unit should be utilised partly at least for reducing borrowing
for working capital purpose. In assessing the maximum permissible bank finance, banks
should adopt the second method of lending recommended by the Tandon Committee,
according to which, the borrowers contribution from owned funds and term finance to
meet the working capital requirement should be equal to at least 25 per cent of the total
current assets. In cases where the borrowers may not be in a position to comply with
this requirement immediately, the excess borrowing should be segregated and treated as
Working Capital Term Loan (WCTL) which could be made repayable in half-yearly
installments within a definite period which should not exceed five years in any case. The
WCTL should carry a rate of interest which should, in no case, be less than the rate
sanctioned for the relative cash credit limit and banks may in their discretion, with a
view to encouraging an early liquidation of the WCTL, charge a higher rate of interest,
not exceeding the ceiling. Provisions should be made for charging of penal rate of
interest in the event of any default in the timely repayment of WCTL.
2. Lending System: The existing system of three types of lending (cash credit, loans
and bills) should continue but wherever possible the use of cash credit should be
supplemented by loans and bills. However, there should be scrutiny of the operations of
the Cash Credit Accounts by at least reviewing large working capital limits once in a
year. The discipline relating to the
submission of quarterly statements to be obtained from the borrowers under the
information system is also-to be strictly enforced in respect of all borrowers having
working capital limits of Rs.50 lakhs and over from the banking system.
3. Bifurcation of Cash Credit: The RBFs earlier instructions to banks to bifurcate
the cash credit accounts (as recommended by the Tandon Committee) in demand loan
for corporation and fluctuating cash credit component and to maintain a differential
interest rate between these two components are withdrawn. In cases where the cash
credit accounts have already been bifurcated, steps should be taken to abolish the
differential interest rates with immediate effect.
4. Separate limits for peak level and normal non-peak level period: Banks
should appraise and fix separate limits for the 'normal non-peak level' as also for the
'peak level' credit requirements for all borrowers in excess of Rs. 10 lakhs indicating the
relevant periods.
5. Drawals of fund to be regulated through Quarterly Statement: Within the
sanctioned limits for peak and non-peak periods, the borrower should indicate in
advance his need for funds during the quarter. Excess of under-utilisation against this
operative limit beyond tolerance of 10 per cent should be deemed to be an irregularity
and appropriate corrective action should be taken.
6. Ad hoc or temporary limits: Borrowers should be discouraged from frequently
seeking ad hoc or temporary limits in excess of sanctioned limits to meet unforeseen
contingencies. Additional interest of 1 per cent per annum should normally be charged
for such limits.
7. Encouragement for bill finance: Advances against book debts should be
converted to bills wherever possible and at least 50 per cent of the cash credit limit
utilised for financing purchase of raw material inventory should also be changed to this
bill system. The RBI tentatively accepted a few major recommendations of Chore
Committee on cash credit system for reshaping and reforming the existing system and
asked the commercial banks to submit their opinion on the feasibility of implementing
the recommendations and their possible future impact. The Chore Committee's
recommendations will pre-empt all internal accruals towards augmenting working
capital, leaving nothing for modernisation and expansion.
Commercial Papers: Commercial Papers (CPs) are short-term use promissory notes
with a fixed maturity period, issued mostly by the leading, reputed, well-established,
large corporations who have a very high credit rating. It can be issued by body
corporates whether financial companies or non-financial companies. Hence, it is also
referred to as Corporate Paper.
Features of a Commercial Paper
(i) They are unsecured and backed only by the credit standing of the issuing company.
(ii) They are negotiable by endorsement and delivery like pro-notes and hence are highly
flexible instruments.
(iii) Since Commercial Papers are issued by companies with good credit-rating, they are
regarded as safe and liquid instruments. In India, as per the RBI guidelines, any private
or public sector company can issue Commercial Papers provided,
(a) its minimum tangible net worth (paid up share capital plus reserves and
surplus) is equal to Rs.4 crores and it has a minimum current ratio of 1.33:1 as per
the latest audited balance sheet;
(b) it enjoys a working capital limit of Rs. 4 crores or more;
(c) it is listed on one or more of the stock exchanges; and
(d) it obtains every 6 months an excellent credit rating (Pi or AI) from a rating
agency approved by RBI like CRISIL, ICRA, CARE, etc.
(iv) Commercial Papers are normally issued at a discount and are in large
denominations.
(v) Issues of Commercial Papers may be made through banks, merchant banks, dealers,
brokers, open market, or through direct placement through lenders or investors.
(vi) Commercial Papers normally have a buy-back facility; the issuers or dealers can buy
back Commercial Papers if needed.
(vii) The maturity period of Commercial Papers may vary from 3 to 6 months.
(viii) The minimum denomination of a Commercial Paper is to be Rs.5 lakhs and the
maximum amount of Commercial Paper finance that a company can raise is limited to
20% f the maximum permissible bank finance.
(ix) No prior approval of RBI is needed to make Commercial Paper issues and
underwriting of the issue is not mandatory.
(x) The minimum size of a commercial paper issue is Rs. 25 lakhs.
Commercial Papers are mostly used to finance current transactions of a company and to
meet its seasonal needs for funds. They are rarely used to finance the fixed assets or the
permanent portion of working capital. The rise and popularity of Commercial Papers in
other countries like USA, UK, France, Canada and Australia, has been a matter of
spontaneous response by the large companies to the limitations and difficulties they
experienced in obtaining funds
from banks.
Commercial Papers in India
The introduction of Commercial Papers in India is a result of the suggestions of the
Working Group (known as Vaghul Committee) on Money Market in 1987. Subsequently,
in 1989, the RBI announced its decision to introduce a scheme by which certain
categories of borrowers could issue Commercial Papers in the Indian Money Market.
This was followed by RBI Guidelines on issue of Commercial Papers in January 1990,
further revised in April 1991. These guidelines apply to all Non-Banking Finance and
Non-Finance Companies. Some recent issues of Commercial Papers by Indian
Companies and their CRISIL Ratings are shown below:
Note :
P1: Highest Safety - This rating indicates that the degree of safety regarding timely
payment on the instrument is very strong.
CRISIL may apply '+' (plus) or '-' (minus) signs for ratings to reflect comparative
standings within categories.
Inter-Corporate Deposits: A deposit made by one company with another, normally
for a period up to six months, is referred to as an inter-corporate deposit. Such deposits
are of three types:
i. Call Deposits
In theory, a call deposit is withdrawable by the lender on giving a days notice. In
practice, however, the lender has to wait for at least three days. The interest rate
on such deposits may be around 14 per cent per annum.
ii. Three months Deposits
More popular in practice, these deposits are taken by borrowers to tide over a
short-term cash inadequacy that may be caused by one or more of the following
factors: disruption in production, excessive imports of raw material, tax payment,
delay in collection, dividend payment, and unplanned capital expenditure. The
interest rate on such deposits is around 16 per cent annum.
iii. Six months Deposits
Normally, lending companies do not extend deposits beyond this time-frame. Such
deposits, usually made with first-class borrowers, carry an interest rate of around
18 per cent per annum.
Growth of Inter-Corporate Deposit Market
Traditionally, some prosperous companies in the fold of big business houses such as
Birlas and Goenkas carried substantial liquid funds meant primarily to exploit
investment opportunities in the form of corporate acquisitions and takeovers. Until such
opportunities arose, the liquid funds were deposited with other companies with an
understanding that they would be withdrawn at short notice.
From the early seventies (more particularly from 1973), the inter-corporate deposit
market grew significantly in the wake of the following development:
(i) Substantial excise duty provisions made by the companies ever since the Bombay
High Court made a ruling that excise duty was not payable on post-manufacturing
expenses.
(ii) Curbs on working capital financing imposed by the Reserve Bank of India after the
first oil shock of 1973.
(iii) Imposition of restrictions on acceptance of public deposits (this was perhaps caused
largely by the failure of W.G. Forge and Company Limited).
(iv) Burgeoning liquidity of scooter companies (little Bajaj, Honda etc.) and, of late, of
car companies (like Maruti Udhyog), which have received massive booking deposits
from their customers.
Characteristics of the Inter-Corporate Deposit Market
- Lack of Regulation: While Section 58 A of the Companies Act, 1956, specifies
borrowing limits for inter-corporate loans of a long-term nature, inter-corporate
deposits of a short-term nature are virtually exempt from any legal regulation. The lack
of legal hassles and bureaucratic red tape makes an inter-corporate deposit transaction
very convenient. In a business environment otherwise characterised by a plethora of
rules and regulations, the evolution of the inter-corporate deposit market is an example
of the ability of the corporate sector to organise itself in a reasonably orderly manner.
- Secrecy: The inter-corporate deposit market is shrouded in secrecy. Brokers regard
their lists of borrowers and lenders as guarded secrets. Tightlipped and circumspect,
they are somewhat reluctant to talk about their business. Such disclosures, they
apprehend, would result in unwelcome competition and undercutting of rates.
- Importance of Personal Contacts: Brokers and lenders argue that they are guided
by a reasonably objective analysis of the financial situation of the borrowers. However,
the truth is that lending decisions in the inter-corporate deposit markets are based on
personal contacts and market information which may lack reliability.
Public Deposits: Public deposits constitute an important source of industrial finance
in some of the Indian industries, particularly in sugar, cotton textiles, engineering,
chemicals, and electricity concerns. Although public deposits are principally a form of
short-term finance, but have since long been utilised to provide long and medium term
finance by cotton mills of Bombay, Ahmedabad and Sholapur and tea gardens of Bengal
and Assam. The system is a legacy from the old past when the banking system had not
developed adequately and the money was kept for safe custody with the mahajans. In
Bombay and Ahmedabad the men who established the mill companies were either
merchants or shroffs in whom the public had confidence, and hence their savings were
entrusted to them. These deposits are received from (i) the public, (ii) the shareholders
and (iii) the employees of the mills.
Popularity of Public Deposits
Hardly a day passes with a big advertisement in the news papers issued by one company
or the other inviting deposits from the public. Their major selling point is the attractive
rate of interest they offer. When the banks were giving just 12 per cent, some of these
companies were offering even up to 15 to 24 percent. Over a period of three years this
difference in the rate of interest can mean a lot, especially when compounded.
Merits
Given below is a brief of plus points of fixed deposits with companies:
(1) Returns: The interest has to be paid irrespective of the level of profits of a
company. It has to be paid even if a company incurs loss in a particular year. This is in
sharp contrast with dividend on shares, which becomes payable only if there are profits
and even then only if the directors recommend such a payment.
(2) Frequent payments: Many companies offer interest payments on half-yearly,
quarterly, or even on monthly basis. One can expect frequent returns, instead of just
once or twice in a year.
(3) Regularity: If the companys management is honest and efficient, it is quite likely
that the interest payments will be regular, and that the principal sum will be returned on
the due date.
(4) No fluctuations: The principal sum is not subject to any fluctuations unlike the
market prices of shares. One can be sure of the value of ones investments.
(5) Preference over shareholders: In case the company goes into liquidation, the
fixed deposit holder enjoys preference over the shareholders, for both the principal and
the interest as unsecured creditor of the company.
(6) Tax deduction at source: Income tax will not be deducted at source up to an
interest income of Rs. 10,000 at one time, or during one year for one deposit holder (on
sums exceeding Rs. 10,000 tax is deducted at source at the rate of 10%). So far, so good.
Many brokers advertise and circulate literature enumerating the merits of fixed
deposits. But all these merits are subject to a major qualification provided the company
is financially sound.
Now, turn to the other side of the story. There are many risks associated with fixed
deposits with companies:
Risks
(1) Lack of security: Fixed deposits are absolutely unsecured. If a company becomes
insolvent there is no chance that a fixed deposit holder may get anything back. It is no
consolation that the shareholders is also going to lose in such a case. The Central
Government or the Reserve Bank of India does not come to the rescue of the deposit-
holder. The broker who might have lured the innocent investors to invest in that
company will not even, perhaps, acknowledge his letters of complaints. The investor can
do one thing to write off the investment as bad debt.
(2) No protection: There are many tales of woe even when a company does not
become insolvent. Several companies neither pay interest nor return the principal.
Therefore, for very understandable reasons, they do not even reply to registered letters.
There is no statutory authority on earth to whom one, as a small investor, can go for any
effective remedy. The Company Law Board or the Registrar of Companies cannot, and
do not, generally, come to one's rescue.
REVIEW QUESTIONS
1. What are the different sources of financing working capital requirements?
2. Explain the merits and demerits of trade credit as a source of working capital finance
to industry.
3. Critically evaluate bank credit as a main source of working capital finance to
industrial undertakings.
4. In recent years the availability of bank credit to industry has been the subject matter
of regulation and control - why and how?
5. Write a critical appraisal of the recommendations of Tandon Study Group or Chore
Committee.
6. Write brief notes on the following:
(a) Credit Authorisation Scheme
(b) Marathe Committee
(c) Commercial Paper
(d) Inter Corporate Deposits
(e) Public Deposits
SUGGESTED READINGS
1. Kulkarni, P.V. : Corporate Finance, Bombay, Himalaye Publishing
House.
2. Srivastava, R.M. : Financial Management, Meerut, Prakati Prakashan.
- End of Chapter -
LESSON - 6
CASH MANAGEMENT
Learning Objectives
After reading this lesson you should be able to:
Understand the nature of cash
Identify issues in cash management
Appreciate the motives for holding cash.
Detail the factors influencing the level of cash balance to hold.
Examine the strength and weakness of cash surplus/deficit.
Explain and evaluate the techniques of expediting collections.
Lesson Outline
Nature of Cash
Motives for Holding Cash
Cash Planning - Cash Budget
Factors Influencing the Level of Cash Balance
Advantages of Maintaining Ample Cash
Cash Deficit/Surplus
Techniques of Expediting Cash Collections
Evaluation of Cash Management
Illustrative Examples
Cash means and includes actual cash (in hand and at bank). Cash is like blood stream in
the human body gives vitality and strength to a business enterprise. The steady and
healthy circulation of cash throughout the entire business operation is the basis of
business solvency.
Nature of Cash
Cash is the common purchasing power or medium of exchange. Cash forms the method
of collecting revenues and paying various costs and expenses of the business. As such, it
forms the most important component of working capital. Not only that, it largely
upholds, under given conditions, the quantum of other ingredients of working capital
viz., inventories and debtors, that may be, needed for a given scale and type of
operation. Approximately 1.5 to 2 per cent of the average industrial firm's assets are held
in the form of cash. However, cash balances vary widely not only among industries but
also among the firms within a given industry, depending on the individual firms specific
conditions and on their owner's and manager's aversion to risk.
Cash as a Liquid Asset
Cash is the most liquid asset that a business owns. Liquidity refers to commonly
accepted medium for acquiring the things, discharging the liabilities, etc. The main
preoccupation of a businessman should be cash, which is the starting point and the
finishing point. It is the sole asset at the commencement and the termination of a
business. It should be remembered that a want of cash is more likely to cause the demise
of a business than any single factor. Credit standing of the firm with sufficient stock as
cash is the strengthened. A strong credit position of the firm helps it to secure from
banks and other sources generous amount of loans on softer terms and to procure the
supplies on easy terms.
Cash as a Sterile Asset
Cash itself is a barren or sterile asset and in nature until and unless human beings apply
their head and hand. That is cash itself can not earn any profit or interest or yield
unless; it is invested in the form of near-cash or non-cash assets.
Cash as a Working Asset
While cash is a factor contributing to the liquidity position of the enterprise, fixed assets
are real producer of earnings; on planning it would be the objective of management to
maintain in each asset group the appropriate amount of resources to easy but on
efficient production and to meet the requirements of the future. Should an excess cash
balance be is covered, it would be non-working asset and should be employed elsewhere
to produce some income.
Cash as a Strange Asset
A firm seeks to receive it in the shortest possible time but to hold as little as possible. It
is more efficient to maintain good credit sources than to hold extra cash or low interest
bearing market instruments against unexpected use. Clearly, it is preferable, whenever
possible to hold income-earning marketable investment in lieu of cash and to use short-
term borrowing to meet peak seasonal needs.
Issues in Cash Management
In a business enterprise, ultimately, a transaction results in either an outflow or an
inflow of cash. Its shortage may degenerate a firm into a state of technical insolvency
and even to liquidation. Though idle cash is sterile, its retention is not without cost.
Holding of cash balance has an implicit cost in the firm of opportunity cost. It varies
directly with the quantity of cash held. The higher the amount of idle cash, the greater is
the cost of holding it in the form of loss of interest which could have been earned either
by investing it in some interest bearing securities or by reducing the burden of interest
charges by paying off the past loans, especially in the present era of ever increasing cost
of borrowing. Hence, a finance manager has to adhere to the five Rs of financial
management, viz
(i) the right quality of finance for liquidity considerations;
(ii) the right quantity whether owned or borrowed;
(iii) the right time to preserve solvency;
(iv) the right source; and
(v) the right cost of capital the organisation can afford to pay.
In order to, resolve the uncertainty about cash flow prediction, lack of synchronisation
between cash receipts and payments, the organisation should develop some strategies
for cash management. The organisation should evolve strategies regarding the following
areas and facets of cash management:
(i) Determining the organisation's objective of keeping cash,
(ii) Cash planning and forecasting
(iii) Determination of optimum level of cash balance holding in the company.
(iv) Controlling flow of cash by maximising the availability of cash i.e., economising cash
by accelerating cash inflows or decelerating cash outflows.
(v) Financing of cash shortage and cost of running out of cash.
(vi) Investing idle or surplus cash.
Motives for Holding Cash
According to John Maynard Keynes, the famous economist, there are three motives that
both individuals and businessmen hold cash. They are:
(i) the Transaction motive.
(ii) the Precautionary motive.
(iii) the Speculative motive.
Yet another motive which has been added as the fourth one by the modern writers on
financial management is Compensation motive Thus, there are altogether four primary
motives for maintaining cash balances.
1. Transactions Motive: This motive requires a firm to hold cash to conduct its
business in the ordinary course. The firm needs cash primarily to make payments for
purchases, wages, operating expenses, taxes, dividends, etc. The need to hold cash
would not arise, if there were perfect synchronisation between cash receipts and cash
payments, i.e. enough cash is received when the payment has to be made. But cash
receipts and payments are not perfectly synchronised. Sometimes cash receipts exceed
cash payments, while at other times cash payments are more than cash receipts; hence,
the firm should maintain some cash balance to make the required payments. For
transaction purposes, a firm may invest its cash in marketable securities. Usually, the
firm will purchase the securities whose maturity corresponds with some anticipated
payments, such as dividend, taxes etc., in future. However, the transactions motive
mainly refers to holding cash to meet anticipated payments whose timing is not
perfectly matched with cash receipts.
2. Precautionary Motive: According to this motive, a firm should maintain sufficient
cash to act as a cushion against unexpected events. Even though, by the use of budgets,
the financial needs of a firm, can be estimated, yet inaccuracies are likely to occur in
predicting the cash flows which require the attention of the management. These
inaccuracies may be caused by (a) floods, strikes and failure of an important customer to
pay in time, (b) bills may be presented for settlement earlier than expected, (c)
unexpected slow down in collection amounts receivables, (d) cancelation of some order
for goods as the customer is not satisfied,(e)sharp increase in cost of raw materials. That
is why it is necessary to maintain higher cash balances. The size of the cash balance to be
maintained also depends upon the ability of the firm to borrow funds at short notice. If
the firm has the ability to borrow funds at short notice, it is not necessary to maintain
higher cash balances. If the management is not prepared to take the risk the
precautionary balances will be larger than it would be if the management is prepared to
take the risk. To compensate the loss of return on these balances, the firm will invest a
large part of the balances in short-term (marketable) securities, so that they can be
converted into cash immediately. The amount of income that a firm is willing to forego
by holding precautionary balances will be criterion for the upper limit for investment in
cash.
3. Speculative Motive: It refers to the desire, of a firm to take advantage of
opportunities which present themselves at unexpected moments and which are typically
outside the normal course of business. While the precautionary motive is defensive in
nature, in that firm must make provisions to tide over unexpected contingencies, the
speculative motive represents a positive and aggressive approach. Firms aim to exploit
profitable opportunities and keep cash in reserve to do so.
4. Compensation Motive: Yet another motive to hold cash balance is to compensate
banks for providing certain services and loans. Banks provide a variety of services banks
charge a commission or fee, for others they seek indirect compensation. Usually clients
are required to maintain a minimum balance of cash at the bank. Since this balance
cannot be utilised by the firms for transaction purposes, the banks themselves can use
the amount to earn a return. To be compensated for their services indirectly in this
form, they require the clients to always keep a bank balance sufficient to earn a return
equal to the cost of services. Such balances are compensating balances. Compensating
balances are also required by some loan agreements between a bank and its customers.
During periods when the supply of credit is restricted and interest rates are rising, banks
require a borrower to maintain a minimum balance in his account as a condition
precedent to the grant of loan. This is presumably to compensate the bank for a rise in
the interest rate during the period when the loan will be pending.
Cash Planning
Cash Planning involves the formulation of cash policies resulting from normal and
abnormal requirements. Normal cash requirements are those which are predictable and
occur as a result of routine operations and include cash of such items as raw materials,
supplies, interest, wages and salaries, replacement of fixed assets which are worn-out
through use, dividends, and taxes. Abnormal requirements, which cannot be anticipated
in the routine of the business process, include cash for fixed assets which are replaced
for reasons other than normal depreciation, purchases resulting from price declines, and
interruption of cash flow which reduce cash receipts without a corresponding reduction
in cash disbursement. The main purpose of cash planning is low synchronise cash
receipts with cash outgo. In most firms perfect synchronisation is difficult to achieve
mainly because the inflow and outflow are affected by several factors.
Tools of Cash Planning
(i) Net Cash Forecast through Projected Cash flow Statements which give the
estimated receipts and disbursements on a month by month basis.
(ii) Cash Budget as a tool of cash planning and control.
(iii) Statement of Working Capital Forecast
(iv) Cash Ratios like Acid Test Ratio, Turnover of cash etc.
(v) Cash Reports: A cash report showing the monthly position can supplement the
cash budget in the task of controlling the cash. The management must try to maintain a
balance between cash receipts and payments and cash reporting helps very much in this
direction.
Please use headphones
(vi) Proforma Statements: In addition to the above tools, Cash Planning requires
two additional statements viz.,(a) Proforma Balance Sheet and (b) Proforma Profit and
Loss Statement. The proforma balance sheet establishes a connection between planning
for the use of assets. The proforma profit and loss statement reveals the management
planning regarding sales (revenue), expenses and net profit.
Cash Budget as a Tool of Cash Planning and Control: The cash budget may be
used either as a simple forecasting device or as a means of aggressive strategy or
planning. When used as a forecasting device, operating projections are made; cash
inflows and outflows are matched, deficiencies are provided for and surplus funds
invested. Aggressive planning involves estimating different levels of operations and
judging the inflows and outflows to obtain the mix that makes the greatest contribution
to the profitability of the enterprise without entailing too much risk.
Cash budget is a formalised structure for estimating cash in come and cash expenditure
over some period of time. The net cash position of the enterprise as it moves from one
budgeting sub-period to another, is highlighted. The cash budget includes only cash
flow, non-cash items such as depreciation, loss in sale of fixed assets etc., are excluded.
The period of time covered by the cash budget may be a year, six months, three months
or some other period. The sub-periods may be a day, a week, a month or a quarter,
depending upon the needs of the enterprise. If the firms flow of funds is dependable
and it has large cash balance, a cash budget covering a period of one year divided into
three-month intervals may be appropriate. Where substantial uncertainty is associated
with the flow of funds a quarterly cash budget broken into monthly intervals may be the
most suitable. The cash budget since, it shows the size of cash balance at the end of each
sub-period as well as the amount and term of financing required, is the key to arranging
for needed funds at the most favourable terms available. Adequate time is available to
study the needs.
Factors Influencing the Level of Cash Balance to Hold
1. Credit Position : If a firm enjoys a sound credit position, it is not necessary for it to
keep heavy cash balances. If a firm wants to purchase its inventories on trade credit, it
can keep only small cash balances. It will not be possible in such a case for a firm to
synchronise the credit it allows and the credit it avails.
2. Position of Accounts Receivable : The amount of cash required is affected by the
time factor viz the time required for converting the accounts receivable into cash. If the
credit term of the firm is longer, the turnover also will be slow. Therefore when the
outflow and the turnover could not synchronise, it becomes necessary for a firm to
maintain larger cash balance required to meet its requirements.
3. Nature of the Product/Business : Nature of the business has also great i
influence on the cash requirements. If one business was to carry larger inventory as
compared to that of similar business, it becomes necessary for the firm to invest
additional funds in inventory. Further, cash requirement is influenced by the firms
demand. If the firms demand is volatile, larger cash will be required.
4. Sales in relation to Assets : Another factor affecting the cash requirement is the
volume of sales in relation to assets. In the case of firms with larger sales, as huge sums
are invested in inventories and accounts receivable they should carry heavy cash
balances. When sales increase cash requirements do not increase in the same proportion
but there is definite increase in cash.
5. Management's Attitude : Cash requirement of a firm is influenced by the attitude
of the management also. If the management is of conservative type it will hold larger
cash than that which is less conservative. The demands of such a firm will be more of
liquid nature. But a firm which plans its requirements effectively is less conservative. By
planning, a firm will be able to predict its requirements accurately.
6. Distribution Channel : Distribution channel refers to the number of middlemen in
the process of distribution of service or product. If the distribution channel is long and
the credit policy is liberal the level of cash may be higher. If goods and services are sold
through departmental stores or chain stores the cash holdings will differ substantially.
7. Size and Area of Operation : Area of operation refers to the geographical area in
w hich the organisation is working. If the organisation working on large scale it is
possible that organisation must have to keep higher cash level.
8. Duration of Production Cycle : It refers to the time period taken by the raw
material to become finished product. In case of long production cycle the level of cash
holding is likely to be high and vice-versa.
Advantages of Maintaining Ample Cash
(1) A shield for Technical Inefficiency: The provision of ample cash funds can
prove to be a shield for technical inefficiency of a management.
(2) Maintenance of Goodwill: The goodwill and reputation of a business firm
depends to a large extent on this fact that the firm retires all the obligations and meets
the payments as and when they mature. It can be possible only when the firm maintains
a good cash balance ascertained carefully for normal operations and adjustment for
abnormal contingencies.
(3) Cash Discounts can be Availed: If a firm has sufficient cash, it can avail cash
discounts offered by the suppliers. It will lower down the raw material cost and finally
the cost of production.
(4) Good Bank Relations: Commercial banks like to maintain good relations with
such firms having high liquidity in funds. Large companies maintaining large liquid
balances of cash in excess of their immediate needs, need to borrow very little if at all,
on current account.
(5) Exploitation of Business Opportunities: Firms having good cash position can
exploit the business opportunities very well. They can take risk of entering into new
ventures.
(6) Encourage to new Investments: Firm having good cash position can maintain a
sound (cash) dividend policy. It encourages the new investment in the shares of such
firm because shareholders like cash dividend more.
(7) Increase in Efficiency: Unless there is an adequate supply of cash to bridge the
gap a stringency develops. Operations are slowed, if not paralysed. Creditors press for
their payments. If payments can not be made in time, bankruptcy and failure follow.
(8) Overcoming Abnormal Situations: Such firms can overcome abnormal
financial conditions also with cash and without causing loss to the interest of existing
shareholders.
(9) Other Advantages: Cash is often the primary factor deciding the course of
business destiny. The decision to expand the business, the decision to add any new
product in the product line of the company, etc., are decided by the cash position of the
firm.
Utilisation of Cash Surplus
A cash surplus is obviously a more acceptable proposition for a firm than a cash deficit.
However, a cash surplus is idle cash and, therefore, unproductive. This surplus may be
deployed for the greater benefit of the firm. If it is available permanently, it may be
utilised for the purchase of additional equipment, for expansion, for the introduction of
a new product, etc. However, it should not be recklessly squandered on hare brained
loss-making schemes simply because it happens to be available.
Cash surplus should be utilised in the following ways:
(i) If it is available permanently, it should be deployed profitably in the business by a
planned phase of re-equipments, expansion, etc.
(ii) If it is available for a short period, it may be invested in several short-term
investments like Certificates of Deposit, Commercial Papers, Money Market Mutual
Funds etc. However, short-term cash surpluses should not be used in speculative
investments.
(iii) Short-term surplus may be used to qualify for the benefit of discounts from
suppliers by prompt payment or by negotiating concessional prices with the suppliers.
(iv) If the cash surplus is permanent, it may be utilised
(a) for the repayment of capital borrowed at exorbitant rates of interest;
(b) for the extension of loans to subsidiaries;
(c) for the investment of funds through mergers and acquisitions;
(d) for new plant facilities in order earn a higher rate of return;
(e) for the purchase of own securities to be used in acquisitions, stock option plans
or other payments;
(f) for the investment in the development of a products or the improvement of the
old ones, etc.
It is not always desirable for a company or group of companies to build up a reserve or
surplus cash funds in order to make a more effective use of money. The group may
already have borrowed; it is therefore, far better and more cost effective to reduce such
borrowings than to place surplus cash funds in the money market.
Please use headphones
Avoiding Cash Deficit or Cash Insolvency
Cash deficit, as stated earlier, presents a more difficult problem. A firm may reduce its
cash deficit by a closer internal control rather than by resorting to external financing. A
cash deficit may be dealt with in the following ways:
(i) The collections from customers and sundry debtors should be accelerated.
(ii) Liquidating marketable securities held by the firm.
(iii) Accounts receivable should be discounted with a bank.
(iv) Factoring the receivables.
(v) Redundant assets should be sold out.
(vi) Payments to suppliers may be deferred to the extent possible. The firm may also
take advantage of liberal trade credit terms.
(vii) Expenditure on wages, salaries, etc., should be brought under control by
maintaining the activity at a constant level instead of encouraging cyclical fluctuations.
The payment of corporate taxes cannot be avoided. However, a firm may pay on the last
day of payment so that early payment and late payment can both be avoided.
(viii) Capital investment decisions should be avoided or delayed in order that a firm may
be freed for the time being from commitment of funds.
(ix) Interest obligations are contractual. To avoid their payment, therefore, amounts to
be default. A firm, however, should ensure that the period of interest payment does not
coincide with the payment of inventory or other working capital items.
(x) Dividend payments may not be made in cash. It would be worthwhile to take
stockholders into confidence to explain clearly the exigency of cash deficit. Non-
payment of dividend might otherwise shatter their confidence.
(xi) The bank balance should be maintained in such a manner that cash deficit
situations do not get out of hand.
(xii) Utilising bank credit.
The ultimate hazard of running out of cash, however, and the one which lurks in the
background of every debt decision, is the situation in which cash is so reduced - that
legal contracts are defaulted, bankruptcy occurs and normal operations cease. Since no
private enterprise has a guaranteed cash inflow, there must always be some risk.
However, this event may occur rarely. Consequently, any addition to mandatory cash
outflows resulting from new debt or any other act or event must increase that risk.
Costs of Being Short of Cash or 'Short Costs'
The 'Costs' of being short of cash come in the form of not being able to take advantage of
discounts, and short-lasting special buying opportunities, and that of cost associated
with credit impairment are called short costs. Detailed explanation of these costs is
given below:
1. Loss of Discount : Discounts for paying cash promptly are usually very generous
and the effective return on capital employed is often well above that earned on any other
asset. To take advantage of discount, cash is required to be paid in very short period of
time. For instance, a concern purchases goods worth Rs. 10,000 on terms Rs.
10,000/2/10, net 30 days. It means if the payment is made within ten days the firm will
be entitled for 2% cash rebate; otherwise the payment is to be made within 30 days in
full. If the concern wants to use Rs.9,800 for 20 days at a cost of Rs.200 and then its
actual cost works to 2.04%. Further, taking the discount would mean a lower acquisition
price for inventories. Thus, the impact of not being able to take advantage of a cash
discount is therefore quite significant.
The quantity discount would require a higher purchase order. As a result, the higher
carrying costs might outweigh the advantage of quantity discount. But this may not be
true in all cases.
2. Cost associated with credit impairment
(i) No credit given all dealings for cash; alternatively, the credit terms could be made
less generous;
(ii) Creditors could mark-up their prices up in order to compensate for poor payments;
(iii) Suppliers may refuse to deal at all;
(iv) Suppliers may give slow or unreliable delivery times, if there is an excess of demand
for supplies, then the poor paying firm may find that it is the last on the list of priority
customers;
(v) Short-term and long-term financing will not be easily obtainable reasonable terms;
(vi) Banks may charge
(a) higher (bank) charges on loans, overdrafts and cash credits
(b) penalty rates to meet a short fall in compensating balances
(vii) The attendant decline in sales and profits;
(viii) In some cases the shortage of cash may lead to creditors to petition for a winding
up of the firm. This has very adverse publicity effects.
The quantification of credit impairment is difficult and will probably have to be
subjectively estimated. Apart from the loss of creditors' confidence, a strained liquidity
position also places pressures on individual mangers. The amount of time spent by
senior executives to satisfy creditors when the cash balances are low is likely to be very
costly.
3. Transaction Costs : These costs are associated with raising cash to tide over the
shortage of cash. This is usually the brokerage incurred in relation to the sale of some
short-term near-cash assets such as marketable securities. These represent the fixed
costs associated with the transaction. They consist of both explicit and implicit costs.
4. Borrowing Costs : Interest on loan, commitment charges, and other expenses
relating to the loan raised to cover the cash deficit are called borrowing costs. The
borrowing or financing costs are closely associated with the opportunity cost.
Techniques of Expediting Collections
Several techniques are employed to reduce the span between the time a customer makes
payment and the time such funds are available for use by a firm. The following are the
techniques designed to accelerate the collection of accounts receivables:
(i) Concentration Banking
(ii) Lock-Box System
(iii) Playing on the float
(i) Concentration Banking: In this system, large firms which have a large number of
branches at different places, selects some of these which are strategically located as
collection centres for receiving payment from customers. Instead of all the payments
being collected at the head office of the firm, the cheques from a certain geographical
area are collected at a specified local collection centre. Under this arrangement, the
customers are required to send their payments (cheques) to the collection centre
covering the area in which they live and these are deposited in a local bank account of
the concerned collection centre, after meeting local expenses, if any. Funds beyond a
predetermined minimum balance are automatically transferred daily by wire transfer or
telex, to a central or concentration banks account. A Concentration bank is the
Companys head office bank i.e., one with which the firm has a major account usually a
disbursement account. Hence this arrangement is referred to as Concentration Banking.
On the basis of their daily report of collected funds, the finance manager can use them
according to need.
However, the Company will have to incur additional cost to man these collection
centres. Compensating balances to cover the cost of service are usually maintained with
the local or regional banks. An in-depth cost-benefit analysis of each region, where the
collection centre is to be set up, should be undertaken by the company. Normally, the
establishment of collection centres depends upon the volume of business in the area.
Concentration Banking, as a system of decentralised billing and multiple collection
points, is a useful technique to expedite the collection of accounts receivable...
- First of all it reduces the time needed in the collection process by reducing the mailing
time. Since the collection centres are near the customers, the time involved in the
sending the bill to the customer is reduced. Thus, mailing time is saved both in respect
of sending the bill to the customers as well as in the receipt of payment.
- Secondly, the decentralised system hastens the collection of cheques because most of
the cheques deposited in the company ;s regional bank are drawn on banks located in
that area. Thus, a company can reduce the time a cheque takes to collect.
- Lastly, concentration banking permits the company to store its cash more efficiently.
This is so mainly because by pooling funds for disbursement in a single account, the
aggregate requirement for cash balances were maintained at each branch office.
(ii) Lock-Box System: Under this arrangement firms hire a post office box called the
'lock box' at important collection centres. The customers are required to remit payments
to the lock box. The local banks of the firm, at the respective places, are authorised to
open the box and pick up the remittances (cheques) received from the customers.
Usually, the authorised banks pick up the cheques several times a day and deposit them
in the firm's accounts. After crediting the account of the firm, the banks send a deposit
slip along with list of payments and other enclosures, if any, to the firm by way of proof
and record of collection. Thereafter, depending upon the arrangements made with each
regional lock-box bank, funds in excess of balances maintained to cover costs are
transferred automatically to company head quarters.
Concentration Banking vs. Lock-Box System
The lock-box system is like concentration banking in that the collection is decentralised
and is done at branch level. But the main difference between them is that under
concentration banking the customer sends the cheque to the collection centres or local
branches while he sends them to a post office box under the lock-box system. In case of
concentration banking, cheques are received by a collection centre and after processing,
they are deposited in the bank.
The lock-box arrangement is an improvement over the concentration banking system
since the former eliminates the processing time the receipt and deposit of cheques
within the firm. This system, reduces the exposure to credit losses by expediting the
time at which data can come to know of dishonoured cheques and weak credit situations
sooner. The lock-box bank performs the clerical task of handling the remittances prior
to deposits, services which the bank may be able to perform at a lower cost and
consequently the overhead expenses are lowered. Further, it facilitates control by
divorcing remittances from the accounting department. However, the basic limitation of
the lock-box system lies in additional cost which the companys bank will charge in lieu
of additional services rendered. Since the cost for these services is directly in proportion
to the number of cheques handled by the bank, obviously the lock box arrangement will
prove useful and economical too when average remittance is large.
Concentration banking is the most popular technique employed by business firms in
India to intensify cash inflows. Over three fifth of the firms rely on this technique. There
is, however, customers resistance to lock-box system and they insist on sending cheques
directly to company head quarters, in spite of companys insistence that remittance
should be forwarded to the regional lock-box. The customer have been traditionally used
to 7-10 days float (previously involved in making a remittance)and often draw and mail
cheques against funds that would not be in their bank accounts for one week. The use of
the lock-box system meant that they had to have bank balances to cover such
remittances in the bank, not later than one day after the cheque had been mailed.
(iii) Playing on the Float: The term 'float' refers to the amount of money tied up in
cheques that have been written and issued, but have yet to be collected and encashed.
Alternatively, float represents the difference between the bank balance and book balance
of cash of a firm. The difference between the balance as shown by the firms record and
the actual bank balance is due to transit and processing delays. If the financial manager
accurately estimates when the cheques issued will be deposited and collected, he can
invest the float during the float period to earn a return. Float used in this sense is
called 'cheque kitting'.
There are three ways of doing it:
(a) paying from a distant bank,
(b) scientific cheque encashing involving the time-lag in the issue of cheques and their
encashment, and
(c) the issue of bank draft.
If a firms own collection and clearing process is more efficient than that of the
recipients of its cheques and this is generally true of larger, more efficient firms then the
firm should show a negative balance on its own records and a positive balance on the
books of its bank. Obviously, the firm must be able to forecast its positive and negative
clearing accurately in order to make use of float.
Cash Management Models
Baumol Patinkin, Archer, Miller and Orr, and Orgler have developed some interesting
models for cash management and to determine the minimum level of cash balances to
be held by a business firm.
Baumol's mathematical model is based on the combination of inventory theory with
monetary theory. In his model, cash is taken as an inventory item which flows out at a
constant rate and is replenished instantaneously by borrowing or by selling securities. It
is assumed that the size and timing of cash inflows are fully controllable to which a fixed
cost per order(cost of converting the securities into cash) and a variable carrying cost
per rupee (in the form of opportunity cost of holding cash i.e., the return on marketable
securities) are attached. Since the cash outflows are known the only cash management
decision is to decide about the volume of cash and the frequently at which cash is to be
procured. Baumol has concluded that generally some cash should be kept even in a state
of no change and that the transaction demand for cash will vary approximately in a
proportion with the money value of transactions with the object of minimising total cost.
However, since the model is subject to unreal assumptions, it does not provide an
applicable tool for cash management.
Patinkin's model attempts to determine the optimum level of cash balance at the
beginning of each period with the object of minimising the probability of cash shortage
during the period.
This model also assumes that...
(i) net cash flows in each period are equal to zero;
(ii) cash flows cannot be controlled by a financial executive; and
(iii) all transactions between cash and other assets take place at the beginning of each
period.
Though this model takes into account both the cash inflows and outflows and is, unlike
Baumols model, deterministic in nature, the above assumptions limit the practical
application of the model.
Mehta observes that as an approach to cash management, the Economic Order
Quantity (EOQ) model is less than satisfactory. The assumptions about cash flows create
problems. Unlike the physical stock, the cash inflows, will be interspersed with
payments and at times receipts may exceed cash outflows. In fact, the cash balance can
move in either direction, whereas in the usual inventory model demand' during any
period is assumed to be non-negative.
Archer's simple probabilistic model aims at determining optimum level of cash and
marketable securities together to be held by a business firm. About this model, it has
been commented that the model is largely based on a financial officers subjective
decision.
Merlon H.Miller and Daniel Orr developed somewhat different probability model.
In this model, unlike Baumols model, cash flows are assumed to fluctuate in a
completely stochastic manner. Transactions can increase as well as decrease cash
balance. Their main assumption about the model is that only two forms of assets exist:
cash and marketable securities. As regards the optimum level of cash balance, Miller
and Orr suggest that there is not only one specific minimum level of ideal cash balance
but a range of ideal cash balances. Within this range cash balance be allowed to move
upwards as well as downwards and no action is needed. But when the balance reaches
the upper limit of the range, it is to be reduced to a predetermined level by purchasing
marketable securities and when the cash balance reaches the lower limit, it is to be
replenished by the sale of marketable securities. Orglers extensive linear programming
model deals with cash management of the firm as a whole. The objective function
includes payments, short-term financing, and security transaction. The function is
maximised subject to managerial and institutional constraints including minimum cash
balance requirements. This model also points towards the value of operations research
techniques in cash management.
Evaluation of Cash Management
In evaluating cash management, the finance manager has to
(i) check all receipts and payments against the projections.
(ii) compare the actual performance against predetermined plans and objectives.
(iii) find out discrepancy, if any, analysing these variations in order to pinpoint the
underlying causes, and finally
(iv) take remedial steps to correct the anomaly so that the performance conforms to the
plans and goals of the economy. This means that there should be continuous budget
evaluation of the cash position so as to make continuous control through policy
decisions.
The following ratios have been used to evaluate different aspects of cash management
performance.
1. To test the adequacy of cash:
(a) Liquid ratio or Quick ratio;
(b) Net Cash flows to Current Liabilities ratio;
(c) Cash in terms of number of days of current obligations.
2. To assess the effective control of cash flows:
(a) Cash to Current Assets ratio;
(b) Cash Turnover in Sales ratio;
(c) Rate of Growth in Cash; and
(d) Absolute liquid funds to Current Liabilities.
3. For productive utilisation of surplus cash:
(a) Marketable securities to current assets ratio; and
(b) Marketable securities to absolute liquid funds.
To test a firms liquidity and solvency, current ratio and liquid ratio are calculated.
Traditionally 2:1 for Current Ratio and 1:1 Quick Ratio are taken as satisfactory
standards for these purposes. The computation of cash in terms of number of days of
current obligations is another measure to assess the sufficiency of cash. It is not
practical to suggest any standard ratio in this regard to determine the adequacy of cash.
It is influenced by the firms cash flows pattern, maturity schedule of its current
obligations, and its ability to procure extra funds if develops.
The average Cash to Current Assets Ratio indicates the firms liquidity position. The
proportion of cash to total current assets directly affects the profitability of a firm. A
downward trend in this ratio over a period indicates tighter control whereas upward
trend reveals a slack control over cash resources. Greater cash turnover in sales
indicates the effective utilisation of cash resources. If a business can turnover its cash
larger number of times, it can finance greater volume of sales with relatively lesser cash
resources. This will increase the profitability of a concern. Moreover, such a business
would not require proportionate increase in cash resources with the increase in sales
volume. The proportion of marketable securities in current assets indicates the firms
prudence to invest temporary surplus in such short term investments to augment its
overall profitability.
Firms in India do not normally purchase marketable securities for the purpose of
investing idle cash for short durations for two reasons:
(i) Most of the firms consider it to be a speculative activity not meant for manufacturers
and
(ii) Investment in securities has same element of risk on account of fluctuations in their
prices.
Illustration 1
The following information is available in respect of a firm:
(a) On an average accounts receivable are collected after 80 days; inventories have an
average of 100 days and accounts payable are paid approximately 60 days after they
arise.
(b) The firm spends a total of Rs. 1,81,20,000 annually at a constant rate.
(c) It can earn 8% on investments.
Calculate:
(i) The firms cash cycle and cash turnover assuming 360 days in a year.
(ii) Minimum amounts of cash to be maintained to meet payments as they become due.
(iii) Savings by reducing the average age of inventories to 90 days.
Solution
(i)
Cash cycle = 80 + 100 - 60 = 120 days
Cash Turnover = 360 (assuming days in a year) divided by 120 days = 3 times
(ii)
Minimum operating cash = Annual expenses / Cash Turnover = Rs. 1,81,20,000 / 3 =
Rs. 60,40,000
(iii)
New cash cycle = 80 + 90 - 60 (or old cash cycle of 120 days minus 10 days) = 110 days
New Cash Turnover = 360 / 110 = 3.2727 times
New Minimum operating cash = Rs.1,81,20,000 / 3.2727 = Rs. 55,36,713
Reduction in investments = Rs. 60,40,000 - Rs. 55,36,713 = Rs. 5,03,287
Savings = 8% of Rs. 5,03,287 = Rs. 40,263.
Illustration 2
A firm uses a continuous billing system that results in an average daily receipt of
Rs.40,00,000. It is contemplating the institution of Concentration Banking, instead of
the current system of centralised billing and collection. It is estimated that such a
system would reduce the collection period of accounts receivables by 2 days.
Concentration banking would cost Rs. 75,000 annually and 8% can be earned by the
firm on its investments. It is also found that a Lock-Box system could reduce its overall
collection time by 4 days and could cost annually Rs. 1,20,000.
(i) How much cash would be released with the Concentration Banking system?
(ii) How much money can be saved due to reduction in the collection period by 2 days?
Should the firm institute the concentration banking system?
(iii) How much cash would be freed by lock-box system?
(iv) How much can be saved with lock-box?
(v) Between Concentration Banking and lock-box system which is better?
Solution
(i) Cash released by the concentration banking system = Rs. 40,00,000 x 2 days = Rs.
80,00,000
(ii) Savings = 8% x Rs.80,00,000 = Rs. 6,40,000. The firm should institute the
concentration banking system. It costs only Rs. 75,000 while the savings expected are
Rs. 6,40,000. Net savings = 6,40,000 - 75,000 = Rs. 5,65,000.
(iii) Cash released by the lock-box system = Rs. 40,00,000 x 4 days = Rs. 1,60,00,000.
(iv) Savings in lock-box system = 8% on Rs.1,60,00,000 = Rs. 12,80,000.
(v) Net savings = 12,80,000 - 1,20,000 = Rs. 11,60,000
Difference net saving = 11,60,000 - 5,65,000 = 5,95,000
Thus, the lock-box system is better. Its net savings Rs. 11,60,000 are higher than that
from concentration banking.
Additional savings of Rs. 5,95,000 if lock box system is introduced. Hence it is better to
go for lock box system than Concentration Banking.
REVIEW QUESTIONS
1. Explain the nature of cash and state the scope and objectives of cash management.
2. Since cash does not earn, can we still call it a working asset? Why? What are the
principal motives for holding cash? How do they relate to cash as a working asset?
3. Enumerate the factors that influence the size of cash holdings of company. Discuss
the inventory approach to cash management.
4. Discuss the methods accelerating cash inflows and decelerating cash inflows of a
company.
5. Describe how a lock-box arrangement may be used to accelerate cash flow. What costs
are involved with the use of a lock-box?
6. Discuss the management problems involved in planning and control of cash. Explain
the main tools of cash planning and control.
7. What is a firms cash cycle? How are the each cycle and cash turnover of a firm
related? What should a firms objectives with respect to its cash cycle and cash turnover
be?
8. Explain the following:
(a) Compensating balance
(b) Deposit float
(c) Lock-box system
(d) Cash forecast
(e) Cash Budget
(f) Cash ratios
(g) Cash reports
(h) Cash flow statement
(i) Payment float
(j) Cash losses
PRACTICAL PROBLEMS
1. A firm purchases raw-materials on credit of 30 days. All the sales of the firm are made
on credit basis and the credit term allowed to its customers is 60 days. However in
actual practice the average age of the firms Accounts Payables is 35 days and that of
Accounts Receivables is -70 days. The average age of the firms inventory (that is the
time-lag between the purchase of raw-materials and the sale of finished goods) is 40
days.
From the above data calculate
(i) The firms cash-cycle and
(ii) The firms cash turnover
2. A group of new customers with 10% risk of non-payment desires to establish business
connections with you. This group would require one and a half month of credit and is
likely to increase your sales by Rs.60,000 p.a. Production, administrative and selling
expenses amount to 80% of sales. You are required to pay income tax @ 50%. Should
you accept the offer if the required rate of return is 40% (after tax)?
[Ans.: Return works out to 50%. This is higher than desired rate of return of 40%, hence
the offer should be accepted]
3. A companys present credit sales amount of Rs.50 lakhs. Its variable cost ratio is 60%
of sales and fixed costs amount to Rs.10 lakhs per annum. The company proposes to
relax its present credit policy of 1 month to either 2 months or 3 months, as the case may
be.
The following information is also available:
Present policy Policy
1 Policy 2
Average age of debtors 1 months 2 months 3
months
Increase in sales --
20% 30%
Percentage of bad
debts 1.0 2.5 5.0
If the company requires a return on investment of 20% before tax, evaluate the
proposals.
[Ans.: Policy 1 is more profitable as it gives surplus of Rs.2,13,333 after meeting the
required return on investment at 20% before tax]
SUGGESTED READINGS
1. Bhabatosh Banerjee : Cash Management Calcutta, The World Press (P) Ltd.,
2. Khan, M.Y. and Jain, P.K. : Financial Management, New Delhi, Tata McGraw Hill Co.
3. Pandey, I.M : Financial Management, New Delhi, Vikas Publishing House
4. Van Home, James C. : Financial Management and Policy, New Delhi, Prentice Hall of
India.
- End of Chapter -
LESSON - 7
INVESTMENT MANAGEMENT
Learning Objectives
After reading this lesson you should be able to:
Understand the concept of investment
Recognize the reasons for holding marketable securities
Detail the process of investment management
Explain the investment criteria
Suggest suitable basis for valuation of securities
Lesson Outline
Portfolio of Marketable Securities
Investment Department/Adviser
Process of Investment Management
Classification of Securities
Investment Criteria
Valuation of Marketable Securities
There are basically three concepts of investment...
(i) economic investment i.e., an economist's definition of investment;
(ii) investment in a more general or extended sense, which is used by "the man on the
street"; and
(iii) the sense in which a finance manager is very much interested, namely, financial
investment.
Financial Investment is a form of this general or extended sense of the term. It means an
exchange of financial claims like stocks, bonds, etc., collectively called securities. The
term financial investment is often used by investors to differentiate between the pseudo-
investment concept of the consumer and the real investment of the businessman.
Portfolio of Marketable Securities/Temporary Investments
There are two basic reasons for holding (temporary) investments in the corporate
portfolio of marketable securities:
(i) they serve as a substitute for cash balances and
(ii) they are used as temporary investment for surplus cash-flows arising either during
seasonal operations or out of sale of long term securities.
Some firms hold portfolios of marketable securities in lieu of larger cash balances,
liquidating part of the portfolio to increase the cash account when cash outflows exceed
inflows. In such situations, the marketable securities could be a substitute for
transaction balances, precautionary balances, or speculative balances, or all three. In
most cases, the securities are held primarily for precautionary purposes most firms
prefer to rely on bank credit to meet temporary transactions or speculative needs, but to
hold some liquid assets to guard against a possible shortage of bank credit. Thus such
temporary investments occur for one of three reasons: (a) seasonal or cyclical
operations, (b) to meet known financial requirements, and (c) immediately following the
sale of term-securities.
The cash forecast may indicate whether excess cash available is temporary or not. If it is
found that excess liquidity will be only temporary, then the cash could be invested for
short term. If a substantial part of idle cash is invested even though for a short period,
the interest earned thereon is significant. Failure on the part of the management to
invest idle cash not only deprives the firm of a reasonable income but also be an
injustice and failure in serving the interest of the shareholders. On the other hand, if the
cash forecast indicates that the excess cash is not temporary and not caused by only
seasonal variation and the same need not be used in the business, then it should be
invested in productive assets.
Investment Department/Advisor : For effective management of securities a firm
should have investment department or investment advisor. The size of the investment
department will depend upon many factors, including the size of the investment
portfolio or the type securities purchased and held in the investment portfolio. As in
other operations, the degree of specialisation depends upon the magnitude of the
investment, portfolio and the resources available. The firm having a large security
portfolio may employ a separate staff with people skilled in various phases of
investment programme and with funds for research and analysis. The firm with small
investment portfolio may not afford a separate investment organisation. The investment
function in such firm may be performed by a single individual on a part-time basis.
Process of Investment Management : Investment management is the process by
which money is managed. The process involves
(a) collection of information with regard to the proposed investments,
(b) analysis of that information,
(c) establishment of the investment policy that is to be followed,
(d) decision making process as to investments,
(e) appropriate back-up for administrative arrangements, and
(f) measurement of the investment performance achieved.
The first objective of an investment team is to collect as much relevant information as
possible about potential investments with regard to fixed interest securities. This tends
to be a relatively simple exercise in that the basic facts are set out in the initial
prospectus. Of more immediate relevance are up-to-date market prices, current yields,
and supply and demand reports. Economics play a major part in investment decision
making, and in particular in the area of Government Securities /Market. Consequently,
Investment Managers must be aware of the latest economic developments and
forecasts.
The collection of information in equity type investments such as ordinary
shares and properties is a more difficult task, as the range of possible investments is
immense and not two are similar. Most of the larger investment management teams
employ a number of security analysis, but even if they do, the vast majority of teams rely
on the analysis work carried out by stock-brokers, with the investment manager
analysing the competing stock-brokers output.
The second relates to analysis of the information which has been collected.
Generally speaking the investment analyst's duty is to assimilate the information and to
produce recommendations for consideration. Obviously there is a reliance on the
information supplied by stockbrokers and statistical services, and in addition there is
the analyst's own output.
The establishment of the correct investment policy for a fund is perhaps the most
important aspect of investment management. The investment policy to be followed must
be laid down by the proprietors of the fund, but quite often the investment manager by
the nature of his training is well placed to assist in the formation of such policy. In fact
the quality of an investment management team can often be judged by their grasp of the
fundamentals in this area. The point here is that the objectives of investors vary, and
different investors require different investments with different attributes.
The investment policy of a fund must be such that the liabilities of the fund must be met
as they arise. Furthermore, they must be met at the minimum cost. In order to achieve
this, investment managers must maximise the return on the investments, but the risk
factor must not be exceeded. Thus the investment policy must recognise the risk factor
and establish the appropriate level of risk to be accorded to the fund.
Having collected the information, analysed it and produced recommendations,
established policy and risk levels, one arrives at the decision making process. While this
is clearly seen to be the point on which the fate of the fund will depend, it will be
appreciated that, if the earlier foundation parts of the investments management process
are carried out correctly, the actual decision on buying and selling is relatively easy
to make. Consider the process under which, for example, investment policy has
indicated that the fund needs more ordinary shares to meet its long-term liabilities, that
an analysis of the portfolio reveals that no oil shares are held, that this is considered too
high risk from a lack of industrial diversification point of view, and that the analyst is
recommending an investment in Bharat Petroleum. Under such circumstances, the
management decision is straightforward.
One then comes to the administrative arrangement - contract notes, valuations,
meetings, dividend collection, tax reclamation, safe-keeping of securities and nominee
company services. Generally speaking, these arrangements present little difficulty to the
investment manager, who is probably backed up by sophisticated computer
programmes to handle the investment function. Clients will usually find that these
arrangements can be tailored to his individual needs.
In one sense the measurement of investment performance is the last stage of the
investment management process. An investor who pays someone to manage a portfolio
in the hope of achieving superior performance has every right to insist on knowing what
sort of performance is actually achieved. Such performance can be used to alter the
constraints placed on the manger, the objective stated for the account or the amount of
money allocated to the manager. Perhaps more important by measuring performance a
client can forcefully communicate his interests to an investment manager and perhaps
influence the way in which the portfolio is managed.
Classification of Securities : Securities which are included in the official list of a
Stock Exchange forth purpose of trading, are known as Listed Securities. The Listed
Securities may be
(i) Public debts,
(ii) Semi Government Securities,
(iii) Securities of Public utility companies, and
(iv) Industrial securities.
Public debts are those securities which an issued by the Governments (both the
Central as well as the States) under various loan programmes e.g. Savings Bonds,
Defence bonds, Developments Bonds, etc. Securing issued by Semi-Government bodies
such as Port Trust, Municipalities and Corporations are known as Semi-Government
Securities. Public debt securities and Semi-Government securities are in general,
called "gilt-edged securities". They are so called because their edges have a gold lining.
Trustee securities include promissory notes, debenture stock or other securities of any
State Government or of Central Government. Trustee securities are preferred because
they are considered safe and trustees are allowed to invest trust funds. (Section 4 of the
Indian Trust Act, 1882). Securities issued by the various State Electricity Boards,
tramways, gas, telephone and hydro-electric power companies are called the Securities
of the Public Utility Companies. Industrial securities include shares, stocks,
stock warrants and debentures of various manufacturing, trading, extracting and
shipping companies The word "Blue chip" is used to describe ordinary shares of
progressive, soundly run public limited companies which are not likely to be seriously
affected by temporary trade recessions.
Listed Securities may be further classified into two categories:
(i) Cleared Securities, i.e. securities on forward list, and
(ii) Non-cleared Securities on cash list.
The following conditions should be fulfilled before securities are included in the cleared
securities list:
(i) The securities must be fully paid up equity shares of a company, other than a banking
company;
(ii) They must have been admitted for dealing for at least three years on any stock
exchange,
(iii) They must not be included in the cleared securities list of any other stock exchange,
(iv) The company must be of sufficient public importance and the subscribed capital
represented by securities must be least Rs.25 lakhs and their value at the market price
must be at least one crore of rupees,
(v) Lastly, there must be adequate public interest in the company and at least 49 percent
of the capital represented the securities must held by public and such holdings are to be
evenly distributed among a large number of shareholders.
In general, securities are also classified, into (i) Primary (or direct) securities and (ii)
Secondary (or indirect) securities. Primary Securities are claims against those units
whose principal economic activity is to buy and sell productive factors and current
output. Secondary securities are those claims against financial institutions-whose
economic activity is the purchase and sale of financial assets.
Investment Criteria
A wide variety of securities, differing in terms of default risk, interest risk, liquidity risk,
risk of marketability and expected rate of return, are available. The following criteria are
applied while selecting a security for investment.
(a) Safety (Default Risk): In the selection of marketable securities for investment,
the most important aspect to be considered is that they should be free from default risk.
There should be safety as regard principal or there should be the minimum risk of
default. The risk that an issuer will be unable to make interest payments, or to repay the
principal amount on schedule, is known as default. If the issuer is the Treasury (either
the Central or the State), the default risk is negligible; thus treasury securities are
regarded as being comparatively default-free. Generally, safety of the investment
depends upon the credit of the institution issuing it. Government (gilt-edged) securities
are considered very safe when compared to corporate securities.
(b) Rate of Return or Profitability: The yield on the securities must be reasonable
and stable. As already pointed out, the higher a securitys risk, the higher the return on
the security. Generally, securities which are of low marketability will have higher yield.
The yield therefore depends upon the marketability of the securities. Thus the finance
managers, like other investors must make a trade-off between risks and return when
choosing investments for their marketable securities portfolios.
(c) Interest Rate Risk: Securities prices vary with changes in interest rates. Further,
the prices of long term bonds are much more sensitive to shifts in interest rates rather
than prices of short term securities.
(d) Marketability or Liquidity Risk: A security that can be sold on the short notice
for close to its quoted market price is defined as being highly liquid. Marketability of a
security relates to the ability of the owner to convert it in to cash without appreciable
reduction in their price. For financial instruments marketability is judged in relation to
the ability to sell at a significant price concession. The more marketable the security, the
greater the ability to execute a large transaction near the quoted price. In general, the
lower the marketability of a security, the greater the yield necessary to attract investors.
Thus, the yield differential between securities of the same maturity is caused not only by
differences in default risk but also by differences in marketability.
Considering the motives for holding securities, it is advisable to hold short term
securities as far as possible. The question of holding long term securities arises only
when the securities are needed for a longer period not for the purpose of disposing them
off in the near future. Government and quasi-government securities meet the test of
marketability as they can be disposed off in fairly big lot without reducing their price.
Industrial securities except blue-chips in general are not easily marketable,
consequently, when it is desired to sell particularly in cash, a large block of such shares
at a time of pressure it proves difficult to do so without considerable price reduction.
(e) Maturity: Maturity period is yet another important factor to be considered. In
general, the longer the maturity, the greater the risk of fluctuation in the market value of
the security. Consequently, investors need to be offered a risk premium to induce them
to invest long-term securities. Only when interest rate are expected to fall significantly
they are willing to invest in long term securities yielding less than short and
intermediate term securities.
Preference to short dated securities is due to the presence of possibility of money rate
risk in the long-dated securities. Money rate risk arises from change in market price
consequent upon interest rate fluctuations. If the market rate of interest tends to shoot
up and the security holders want to dispose of their investments the price of the security
will go down because the securities carry the rate lesser than the prevailing rate of
interest. Thus, money rate is intimately related with maturity of securities. It should
however, be noted here that money rate risk arises only when securities are disposed off
before their maturity period. Therefore, it is advisable to a firm to invest its funds in
securities of difference maturity pattern. That is, the firm should stagger its investment
portfolio in such a way that a certain amount of securities mature at regular intervals. A
security which conforms to the above criteria is considered a good and the same to be an
ideal investment it must further satisfy the following requirements also.
(f) Purchasing Power Risk: Another type of risk that is to be considered is
purchasing risk that inflation will reduce the purchasing power of a given sum of money.
Purchasing power risk, which is important to both firms and individual investors during
times of inflation, is generally regarded to be lower on assets whose returns can be
expected to rise during inflation than on assets whose returns are fixed. Thus, real estate
and equity investments are thought of as being better hedges against inflation than are
debentures and other fixed income securities.
(g) Stability of Price: The market price of several securities is subject to heavy
fluctuations and a firm should not invest its surplus funds in such securities to make
speculative gains or losses. The prices of government and quasi-government securities
are generally stable unlike the industrial securities.
(h) Acceptable denominations (Divisibility): The (face) value of the security
should not be too high; it should be of acceptable denomination so as to be easily
marketable even outside the stock exchange.
(i) Absence of contingent liability: A security which carries with it an onerous
liability cannot be considered good.
(j) Callability: Callability also affects the yield to maturity. Because the marketable
securities position of most firms is confined to short-term securities, is not an important
factor. Callability risk is caused by the chance that the security may be legally called for
sale.
(k) Convertibility: Convertibility risk arises out of conversion of one type of security
in to another. Exchange rates may become unfavourable, as a result of which a
corporation may suffer losses in foreign exchange transactions. This is known as
Forward Exchange Risk.
(l) Ascertainment of Title and Value: The easy ascertainment of value of security
offered is also an important point for consideration. The value of debentures, shares,
Government Bonds, etc. can be ascertained with the help of stock brokers and stock
market quotations.
(m) Chance of Capital Appreciation: Investor normally aims not only to get a
reasonable and stable return on his investment but also to the chances for capital
appreciation. Capital appreciation is possible in the case of companies getting super
profit on account of their monopoly character or favourable operating performance.
(n) Taxability: The last but not the least factor which requires the attention of the
investor is impact of taxes. The income from the investment should enjoy tax exemption
or tax concession because market yield of securities is very much affected by tax factor.
There are certain categories of securities which are exempted either partially or fully
from levy of income tax, wealth tax, etc. In view of the differential tax treatment yield of
different securities differ. Tax exempted securities are sold in the market at lower rate
than other securities of the same maturity. Hence, tax factor should be considered while
choosing securities for investment as secondary reserve or near-cash items.
Please use headphones
Valuation of Marketable Securities
The marketable securities may be valued under the following three bases:
(a) Valuation at Cost: Investment in securities have traditionally been carried at cost,
and no gain or loss recognised until the securities were sold. One of the basic concepts of
financial accounting is that the gains shall not be recognised until they are realised and
the usual test of realisation is the sale of asset in question. In current practice the market
value of marketable securities is disclosed a separate note in the balance sheet.
(b) Valuation at the Lower of Cost or Market Price: Though valuation of
securities at cost is generally accepted, the accounting theory also treats as acceptable
the lower of cost or market price method. The objective of this method of valuation is to
give effect to market declines without recognising market increases, and the result is a
more conservative valuation of investments in the balance sheet.
(c) Valuation at Market Price: An increasing number of financial accountants also
argue that investments in marketable securities should be valued at current market
price regardless of whether this price is above or below cost. However, it is not a current
practice to value security investments at market value.
Disclosing the Basis of Valuation in the Balance Sheet
Because of the variety of methods possible for valuation of fixed as well as current
assets, it is necessary that the balance sheet should contain a notation as to the valuation
method being used. It is also important that the method selected be used consistently
from year to year.
REVIEW QUESTIONS
1. What are the different motives for holding marketable securities in investment
portfolio?
2. What are the functions of an Investment Department in a large undertaking?
3. State and explain the different steps involved in the process of investment
management.
4. How will you measure the investment performance?
5. Briefly explain the different categories of marketable securities available for
investment in India.
6. Explain:
(a) Default risk
(b) Liquidity risk
(c) Blue chips
(d) Trust securities
(e) Listed securities
(f) Growth Stock
SUGGESTED READINGS
1. Bhalla. V.K. : Investment Management, New Delhi, S. Chand & Co., Ltd.
2. Chandra, Prasanna : Fundamentals of Financial Management, New Delhi,
Prentice Hall of India.
3. Hampton. J.J. : Financial Decision Making, New Delhi, Prentice Hall of India.
4. Preeti Singh : Investment Management, Bombay, Himalaya Publishing
House.
- End of Chapter -
LESSON - 8
RECEIVABLES MANAGEMENT
Learning Objectives
After reading this lesson you should be able to:
Know the objectives of Credit (Receivables) Management.
Identify the decision areas in Credit Management.
Detail the relevant costs associated with Receivables Management.
Evaluate the Credit Policy, Credit Standard and Credit Terms and Collection
Policy.
Explain the concept of Credit Scoring Credit Factoring.
Lesson Outline
Objectives of Credit Management
Decision Areas in Credit Management
Credit Control Department
Credit Policy - Credit Standard - Credit Scoring - Credit Terms
Collection Policy - Credit Insurance - Factoring of Receivables
Evaluation of Credit Management
Illustrative Examples
The whole spectrum of a business can not entirely based on cash transactions. The sale
(purchase) of goods or services is an essential part of the modern competitive economic
system. In fact credit sales and therefore, receivables are treated as marketing tool to
boost the sale of goods/services. The credit sales are generally made on open account
and the expansion of the business depends on the expansion of credit available which in
turn depends on credit worthiness of the firm.
Credit allowed i.e., deferred terms of payment to a purchaser (customer) helps him
(i) to produce goods by buying input materials for which spot payment is not required,
(ii) to have greater volume of sales through credit terms of payment and
(iii) to deploy productive resources more economically.
Greater volume of sales necessitate greater volume of production resulting in lower unit
cost may lead to the possibility of lowering the selling price. Granting of credit involves
use of financial resources i.e., a firm should be able to sell its goods on credit. At the
same time the seller must be in a position to pay his creditors in time for the purchase of
goods and services.
Objectives of Credit Management
The main objective of credit management can be enumerated as follows:
(a) Increase the volume of credit sales to the optimum level in relation to the credit
period.
(b) To determine what extent the debtors volume is to be in relation to the overall
financial soundness of the firm.
(c) To have business volume to optimal level so that the point of overtrading and
undertrading will not occur.
(d) Balancing of liquidity versus profitability in the context of trade off between credit
volume of sales and the time span for realisation from credit customers.
(e) Control over cost of investment in sundry debtors and the cost of collection.
(f) At what level the price fixation to be done taking into account the cash discount,
trade discount etc.
(g) To decide the price factor and the credit factor in relation to the competitors
business.
(h) To take into account the external factors such as mercantile business conventions,
effect of inflation, seasonal factors, government regulations and general economic
condition.
(i) The proper lines of communication and co-ordination between finance, production,
sales, marketing and credit control department.
Crucial Decision Areas in Credit Management
Trade credit management involves a study on
(i) costs associated with the extension of credit and accounts receivables,
(ii) credit policies involving credit standard, credit terms, collection policies, credit
insurance,
(iii) determination of size of receivables, and
(iv) forecasting of receivables.
Please use headphones
Costs Associated with the extension of Credit
The major categories of costs associated with the extension of credit and accounts
receivables are (i) capital cost, (ii) administration cost, (iii) collection cost (iv)
delinquency (overdue) cost and (v) default risk.
(i) Capital Cost: The increased level of accounts receivable is an investment in current
assets and it involves the tying up of capital. There is a time-lag between the sale of
goods to and payments by, the customers. Meanwhile, the firm has to pay employees
and suppliers of raw materials thereby implying that the firm should arrange for
additional funds to meet its own obligations, while awaiting for payment from its
customers. The cost on the use of additional capital to support credit sales which
alternatively could be profitably employed elsewhere, is therefore, a part of the cost of
extending credit or receivables.
(ii) Administrative Cost: The maintenance of receivables calls for the use of an
administrative machinery in different ways. A firm may have to create and maintain a
credit department with staff, accounting records, and even to conduct investigations to
find out the credit worthiness or otherwise of its customers. Administrative expenses are
therefore incurred on the maintenance of receivables.
(iii) Collection Cost: An effective maintenance of receivables depend ultimately upon
the effective collection of receivables. The cost of collection includes the expenses
regarding engaging collection agencies or bill collectors, sending collection letters, cost
of discounting bills of exchanges, collection of bills of exchange and other bank charges.
A number of collection letters and reminders usually follow, which eventually increases
the cost of collection.
(iv) Delinquency Cost: The cost which arises out of the failure of the customers to
meet their obligations when payment on credit sales become due after the expiry of the
period at credit is called delinquency cost. The important components of this cost are (a)
blocking up of funds for an extended period, (b) cost associated with steps that have to
be initiated to collect the overdues e.g. legal charges.
(v) Default Risk i.e., bankruptcy: This refers to the cost of writing off bad debts in
the event of debtors being adjudged as insolvent.
Credit Control Department
Where the firm is a sizable one, it is desirable that a person, called Credit Manager, be
placed in-charge of Credit Control Department. The Credit Controller or Manager
should try to keep the bad debts down to the minimum and he may advocate the
restriction of the sales to customers who would pay quickly. However, the Sales
Department may be inclined to increase the sales by all possible means, and may not be
careful in selecting credit customers by keeping in mind the question of recoverability of
dues. These two interests conflict each other, though on the whole, both are beneficial to
the organisation. It may be theoretically proper to segregate the functions of Credit
Control Department and the Sales Department or even the Accounts Department.
Usually most firms keep the task of credit control in the same department as is in charge
of the Sales Ledger. This method provides an advantage of showing the limit of the
credit and the actual amount outstanding in one single record, viz., the Sales Ledger
Card.
Functions of a Credit Manager
The following are the functional details of a credit manager:
(i) Maintaining credit card;
(ii) Involvement in credit decision;
(iii) Reporting credit position;
(iv) Institution of credit procedures;
(v) Involvement in customers complaints;
(vi) Review of credit control system and procedures:
(vii) Attending or initiating legal formalities or actions;
(viii) Decisions on bad debts/doubtful debts;
(ix) Training the credit department personnel;
(x) Liaisoning with other departments.
Administration of Credit Control
The following are the important aspects involved in administration of credit control.
(i) The sales invoice should indicate the due date of payment,
(ii) The customers ledger should be recorded with the following among others, namely,
the credit period allowed and the credit in terms of value.
(iii) Customer must signify his acceptance of credit terms in writing.
(iv) Close follow-up of realisation.
(v) Month-end statement of account to be sent for customers confirmation.
(vi) Personal call by salesman and /or personnel from credit control department for
collection of dues.
(vii) Credit assessment and review to be made to reassess the credit worthiness of the
customers. A fresh decision on credit terms will depend on such an exercise.
(viii) There may be the necessity that persons to be entrusted for credit control should
have adequate-knowledge of administering credit control.
CREDIT POLICY
The term "Credit Policy" refers to those decision variables that influence the amount of
trade credit i.e., the investment in receivables. A firms credit policy provides the
guidelines for determining whether to extend credit to customer (and to the customers
as a whole) and how much credit to extend and to how long the credit period is to be
allowed/fixed. The credit policy includes (i) credit standards, (ii) credit period, (iii)
credit terms, (iv) collection policy of the firm, and (v) provision of credit insurance.
Credit Standard
The credit manager has the responsibility for administering policy. However, because of
the pervasive importance of credit, the credit itself is established by the executive
committee, which normally consists of the President/Director in-charge of finance,
production and marketing.
The 'easy' credit policy involves
(a) extending credit to a more risky class of customers,
(b) extending the allowable payment period,
(c) raising the cash discount allowed for prompt payments, and
(d) reducing the 'pressure' of the collection procedure on overdue accounts. The new
terms will be 3/15 and 45 instead of the current 2/10, net 30.
These changes are expected to increase sales, but they will also increase the losses on
bad debts and the investment in accounts receivables.
The 'tough' credit policy involves
(a) tightening credit standards,
(b) reducing credit terms to 1/10, net 20 and
(c) increasing the collection of efforts on overdue accounts.
lt will result not only in lower sales but also in lower bad debt losses and a smaller
investment in accounts receivable.
The credit standard followed by a firm has an impact on sales and receivables. The sales
and receivable are likely to be high, if the credit standards of the firm are relatively
loose. In contrast, if the firm has relatively tight credit standards, the sales and
receivable levels are expected to be relatively low.
Relaxing credit standards involves two costs:
(i) additional establishment expenses i.e., enlarged credit department and the clerical
expenses involved in maintaining additional accounts and servicing the added volume of
receivables, and
(ii) bad debt losses which increase with increased sales and a slower average collection
period.
If new customers are attracted by the relaxed credit standards, collecting from these
customers is likely to be slower than collecting from existing customers. In addition, a
more liberal expansion of credit may cause certain existing customers to be less
conscientious in paying their bills on lime. Those who decide credit policy must consider
this possibility.
The extent to which credit standards can be realised should depend upon the matching
between the profits arising due to increased sales and costs to be incurred on the
increased sales. Determining the optimal credit standards involves equating the
marginal costs of credit to the marginal profits on the increased sales. Marginal costs
include bad debt losses, investigation and collection costs and higher costs tied-up to
accounts receivables if the customers delay payment longer than the usual period.
Since credit costs and credit quality are closely related, it is important to be able to judge
the quality of an account. A good credit manager can make reasonably accurate
judgments of the probability of default by different classes of customers. To evaluate
credit risk, credit managers consider the five C s of credit- Character, Capacity, Capital,
Conditions and Collateral.
Char acter is a customers own desire to pay off debts. This factor is of considerable
importance, because every credit transaction implies a promise to pay. Experienced
credit managers frequently insist that the moral factor is the most important issue in a
credit evaluation.
Capaci ty is a subjective judgment of customers ability to pay debts as reflected in the
cash flows of the individuals or firm. It is also gauged by their past records,
supplemented by physical observation of customers plants or stores, and their business
methods.
Capi tal refers to the financial strength of the customer, which depends primarily on
the customers net worth relative to outstanding debt obligations.
Conditions refer to the impact of general economic trends or to special developments
in certain areas of the economy that may affect customers ability to meet their
obligations.
Collater al is any asset that customers may offer as a pledge to secure credit. Collateral,
thus, serves as a cushion or shock absorber if one or several of the first four Cs are
insufficient to give reasonable assurance of repayment on maturity.
Information on these items is obtained from the firms previous experience with
customers, supplemented by a well developed system of information gathering groups.
The credit worthiness of a customer can be assessed by any one of the following:
(a) Past records about the business
(b) Opinions of salesmen who have acquired information by interviewing the
customer
(c) Valuation by professionals on the customers business and assets
(d) Analysts of the financial statement of business
Credit information can be gathered by employing the following indirect methods:
Bazar Reports or Trade Reference: Reports about the credit applicant can be
obtained from the various markets particularly from businessmen carrying on the same
trade.
Bank Reference or Reports from banks: Information about the customer can be
obtained from different banks with which the customers deal. Most commercial banks
maintain credit department of their own to perform credit investigation for their
customers.
Other Sources: Credit information on business firms, especially the large ones, might
be available from credit rating agencies, trade journals, newspapers, magazines, trade
directories, public records such as tax returns/statements, municipal records, etc.
Credit-Scoring Systems
Many firms have used sophisticated statistical techniques in conducting their credit
analysis. Multiple discriminant analysis employs a series of variables to categorise
people or objects into two or more distinct groups. A credit-scoring system utilises
multiple discriminant analysis to categorise potential credit customers into two groups:
good cr edi t r i sk and bad cr edit r isk. An important advantage of a credit-scoring
system is that all of the variables are considered simultaneously, rather than
individually as in the traditional analysis of five Cs. The plastic credit cards used by
millions of citizens are the result of credit-scoring systems. In addition to widespread
usage in consumer credit, credit-scoring systems are increasingly used in commercial
credit.
Suppose that a large retail firm had historical information on 200 customers who paid
promptly and 200 customers who did not. Using data from those 400 credit
applications, multiple discriminant analysis were made to determine the particular set
of credit variables that best distinguishes the prompt group from the non-prompt group.
The following profiles of eight variables were identified:
Multiple discriminant analyses also determine the numerical weightings which each of
the variables should be given in calculating a total weighted credit score for each credit
applicant. The relative weights of the right variables are shown in parentheses
(brackets). The discriminant procedure also provides information to management on
how credit-score levels are related to likely payment patterns by customers. Suppose the
following guidelines were developed:
Notice that for credit scores between 60 and 80, the guidelines call for additional credit
investigation.
The model of Credit-Scoring System given below shows how the credit score would be
calculated for a hypothetical applicant. The middle column includes the particular
values for the applicant. When combined with the relative weights, a total credit score of
104.1 is obtained. Since this easily exceeds the critical level of 80, the customer would be
granted credit without further analysis.
One advantage of credit scoring, already mentioned, is that several variables are
considered collectively. This captures interrelationships between variables that may be
overlooked in a traditional credit analysis. Another advantage is that credit-scoring
systems can be used to routinely accept or reject credit applications for which the final
decision is relatively clear. This frees time for credit analyst to focus in greater detail on
marginal applications. In so doing, credit scoring does not substitute for sound human
judgment, but rather serves to direct that judgment to more difficult credit decisions. A
disadvantage of credit scoring is that expenses are incurred by the firm in developing a
workable system. Care must be taken in constructing samples of good and bad
customers. Managerial judgment is needed in selecting the best profile of credit
variables. Management must also experiment with the resulting guidelines to ensure
that the costs of wrong decisions are minimised.
Model of Credit-scoring System
Variable Mesurement Value Weight
Weighted
value
Age In years as reported 36 0.4 14.4
Marital
Status
Coded 1 (yes) or 0 (no) 1 20.0 20.0
Occupation
Coded 1 to 5 for
different professions
4 4.3 17.2
Time on last
job
In years as reported 6 0.9 5.4
Annual
Income
In thousands of rupees
as reported
22.5 0.6 13.5
Residence
Coded 1 to 5 for
different postal zones
3 4.6 13.8
Home No. of years owned as 4 1.2 4.8
ownership reported
Telephone Coded 1 (yes) or 0 (no) 1 15.0 15.0
Total Credit Score 104.1
Credit Terms : The stipulations under which the firm sells on credit to its customers
are called credit terms. Credit terms have four components - the cash discount, the cash
discount period, the credit period and the credit limit. Changes in each of these
components affect the firms sales, profits, average collection period and bad debt
expenses. Each trade has its customary terms of credit which frequently dictate the
nature of credit terms to be offered by a firm. New firms normally offer liberal credit
terms so as to attract customers. Sometime, even an established firm may offer still
more favorable terms in order to retain old customers and to attract new ones.
Cash Discount : Many firms offer to grant cash discounts to their customers in order
to induce them to pay their bills early. The cash discount terms indicate the rate of
discount and the period for which discount has been offered. If a customer does not
avail this offer, he is expected to make the full payment by the net date. For example,
credit terms expressed as "2/10, net 30'. This implies that a 2 per cent discount will be
granted if the payment is made on or before the 10th day; if the offer is not availed, the
full payment has to be made by the 30th day. When a firm initiates or increases the rate
of cash discount, the following changes and effects on profits can be expected:
Advantages of Cash Discount: The seller gives this discount because
(i) he receives his sale proceeds quickly (promptly) and can use it to buy more goods
without having to borrow from his bank,
(ii) he saves time and expenses in the collection of bills. This leads to less clerical work,
less postage, less stationery etc., usually, delay leads to default or payment once delayed
means payment denied. Hence remember the old saying, a rupee saved is a rupee
earned;
(iii) he has less trouble over bad debts; and
(iv) he avoids litigation or unnecessary legal expenses.
Credit Period : The time duration for which credit is extended to the customers is
referred to as credit period. It is generally stated in terms of net date. Normally, the
credit period of the firm is governed by the industry norms, but firms can extend credit
for longer duration to stimulate sales. Changes in the credit period also affects the firm's
profitability. Increasing the credit period should increase the sales both the average
collection period and bad debt expenses are likely to increase as well. Thus the net effect
on profit may be negative. If the firms bad debts build up, it may tighten up its credit
policy as against the industry norms.
Cash Discount Period : In addition to the size of the cash discount offered, the length
of the discount period also may affect the average collection period and profit. When the
cash discount period is increased there is a positive effect on profits because many
customers who did not take the cash discount in the past, may now be tempted to avail
it, thereby reducing the average collection period. However, there is also a negative
effect on profit when discount period is extended because people who already were
taking the cash discount will be able to still take it and pay later, thereby lengthening the
average collection period For all practical purposes, the discount period is variable
within only a narrow range. The minimum period for mailing invoice and receipt of
cheques is about ten days. To increase it significantly beyond ten days defeats its
purpose. In reality, then the discount period is not an important decision variable.
Credit Limit : The firm has not only to determine the duration of credit but also the
amount of credit. The decision on the magnitude of credit. will depend on the amount of
contemplated sales and customer's financial strength. In case of the customer who is a
frequent buyer of the firms goods, a line of credit can be established. For example, if a
customer normally buys goods of Rs. 25,000 per month on the average, for him the line
of credit can be fixed at this level. The credit line must be reviewed periodically in order
to know the development in the account. If the tendencies of slow paying are found, the
credit line can be revised downward. At times, a customer may ask for the amount of
credit in excess of his credit line. The firm may grant excess credit to him, if the product
has a high margin or if the additional sales help to use the unutilized capacity of the
firm.
Collection Policy : Collection policy refers to the procedures the firm follows to obtain
payment of past-due accounts. Prompt collection of accounts tends to reduce
investment required to carry receivables and the costs associated with it A firm with
long over-due accounts will be exposed to greater amount of risk of non-payment. It is
also possible that customers who have not cleared the payment long due may be hesitant
to place order on the firm for further supplies causing loss of some sale to the firm.
The overall collection policy of the firm is determined by the combination of the
collection procedures it undertakes. These procedures include such things as reminder
letters sent, phone calls, personal calls and legal action. Monthly statements should be
sent to the customers of overdue accounts. Some of the customers may not pay until
they are reminded. It should be ensured that statement of accounts are sent promptly at
the end of each month.
The most important variable of credit policy is the amount expended on collection of
accounts. Other things remaining same, the greater the amount spent on collection
efforts, the lower the percentage of bad debt losses and the shorter is the average
collection period and vice-versa.
Some of the common impediments in debts collection visible in many companies are (i)
inadequate invoicing producers, (ii) incomplete documents, (iii) non-compliance with
the terms of dispatch, (iv) absence of debtors information such as list of outstandings,
age schedule, etc.
Some of the effective steps in debt collection drive are:
1. Organizing and maintaining an efficient credit (collection) department.
2. Setting credit standards and terms and defining clearly the collection policies and
procedures.
3. Preparing periodically, the customers accounts by age, sales regions, territories, etc.,
and sending them to respective sales offices staff for follow up.
4. Assigning specific responsibility for collection.
5. Offering incentives like cash discounts for prompt payments.
6. Organizing a machinery for settlement in case of disputes.
7. Reviewing the customers accounts periodically, to identify frequent default and
irregular accounts in order to tighten the credit terms and avoid bad debts. It is only the
effective follow-up which can produce quick liquidity and as such there is no substitute
for close and systematic review of customers accounts.
Financing of Debtors : Some of the financial policies used to finance debtors and
ensure efficient credit management to vogue especially in industrialized countries are,
factoring of debtor, borrowing against purchasing of debtors, etc. In India, however,
though borrowings against debtors (i.e. working finance facilities against pledge of
books debts) is not uncommon, factoring and purchasing of debtors are hot very
popular. There is need for separate agencies to undertake debt collection. For non-
banking finance companies this would be a new avenue of business.
Credit Insurance : This is a method by which insurance cover is obtained for possible
bad debts. There are several types of which, the following are the most important:
(a) The Whole Turnover Policy: This covers the total turnover for the period of 12
months and premium of a specified percentage is payable on the turnover. The turnover
relating to associate companies, Government department, nationalized industry and
local authority are considered free of risk and not included,
(b) The Specific Account Policy: It provides insurance cover to any account which
involves a large sum of debt.
Valuation of Sundry Debtors
The basis of valuation is the amount, which it is estimated, will be realised by collection
in the ordinary course of business. This will involve a reduction in the book value from
the sale price figure to the estimated collectable value and this is affected by means of
provisions for doubtful debts and discounts allowable. Books debts should be classified
as under:
(a) according to age;
(b) according to security reliability; and
(c) showing separately, debts due by persons connected with the management and
others.
According to age, sundry debtors should be classified into:
(i) debts outstanding for a period exceeding six months;
(ii) other debts.
According to security and reliability, sundry debtors should be classified as under:
(i) debts fully secured and in respect of which the company is fully secured;
(ii) debts considered good for which company holds no security other than the
debtors personal security; and
(iii) debts considered doubtful or bad.
The debts due frompersons connected with the management and others should
be classified as under:
(i) debts due by directors or other officers of the company or any of them either severally
or jointly with any other person;
(ii) debts due by firms in which any director is a partner.
(iii) debts due by private companies in which any director is a director or a member;
(iv) debts due from other companies under the same management. By way of a note in
the balance sheet, the maximum amount due by directors or other officers of the
company at any time during the year should be stated.
The provision in respect of bad and doubtful debts should be shown by way of
deduction. Such a provision should not exceed the amount of debts stated for
considered doubtful or bad.
FACTORING of RECEIVABLES
Receivables may be pledged as collateral which is called discounting of receivables or
sold to a financing agency, which is called 'factoring'. Commercial, banks and finance
companies are the primary institutions that lend against a pledge of receivables. Factor
purchases accounts receivables outright.
The pledging of accounts receivable is characterized by the fact that the lender not only
has a claim against the receivables but also has recourse to the borrower (seller). If the
person or the firm that bought the goods does not pay the selling firm must take the
loss. In other words, the risk of default on the accounts receivables pledged remains
with the borrowers. Also, the buyer of the goods is not ordinarily notified about the
pledging of the receivables.
Factor or Factoring Company is a firm that, by arrangement, purchases the trade debts
of its clients and collects them on its own behalf. The factor has the right to select the
debts he will service and may not be prepared to make advances against debts that he
considers doubtful. Factoring is common method of financing receivables in United
States but developed more recently (since 1960) in the United Kingdom.
In India, factoring of receivables has been introduced based on the recommendations of
Kalyanasundaram Committee, 1986. Four factoring concerns have been permitted by
the Reserve Bank of India.
Southern Zone : Canbank Factor Ltd., Sponsored by Canara Bank.
Western Zone : SBI Factor & Commercial Services Ltd., Sponsored by State
Bank of India.
Eastern Zone : All bank Factor Ltd., Sponsored by Allahabad Bank.
Northern Zone : PNB Factor Ltd., Sponsored by Punjab National Bank.
Functions of Factors
The factor performs three functions in carrying the normal procedure for factoring of
debts are
(i) Financing (lending)
(ii) Risk bearing
(iii) Credit checking
(i) Financing: The factor's function is to help to provide the trade with working
capital. Once the client sends a batch of invoice to the factor, he can draw a high
percentage of the amount in invoices. The client may have to pay about 2% over the
bank rate for a period only from the date of advance to the date of payment by the
customer. This finance strictly speaking is not borrowing and will not appear in the
balance sheet as such the companys ability to raise further finance is not affected. A
firm employing a factoring organisation will thus have more capital at its disposal, an
important consideration in a time of credit restriction.
(ii) Risk bearing: Factors by making finance available to their clients are taking credit
risk instead of providing of finance. The degree of service provided and willingness to
bear risk of bad debts and other terms vary from company to company. Forbearing risk
and servicing the receivables, the factor receives a fee of 1 to 3 per cent of the face value
of the receivables sold. The fee will vary according to typical size of individual accounts,
the volume of receivables sold and the quality of accounts.
(iii) Credit checking: Credit checking about the buyer's credit worthiness and
acceptability may be done either by the credit department of the seller or by the factor.
Where factoring is available a small and a medium sized firm can avoid establishing a
credit department. The factor maintains a credit department and makes credit check on
accounts. The factors service might well be less costly than a department that may have
excess capacity for the firms credit volume. At the same time, if the firm uses part of the
time of anon-credit specialist to perform credit checking, lack of education, training and
experience may result in excessive losses.
Procedure for Factoring Accounts Receivable
When a seller receives an order from a buyer, a credit approval slip is written and
immediately sent to the factoring company for a credit check up. If the factor does not
approve the sale, the seller generally refuses to execute the order. This procedure
informs the seller, prior to the sale, about the credit worthiness and acceptability to the
factor. If the sale is approved, shipment is made and the invoice is stamped to notify the
buyer to make payment directly to the factoring company. Factoring is normally a
continuous process instead of the single cycle.
Kinds of Factoring
There are different kinds of factoring done by factors:
(i) Notification and Non-notification factoring and
(ii) Recourse and Non-recourse factoring.
There are some factors who buy clients invoices by advancing heavy percentage of
invoice value and the balance will be paid after the debt is collected. In this case,
although the firms buy invoices the supplier is responsible for collecting the debt and to
guarantee the payment. This kind of facility offered is called "Non-notification
factoring" whereby the customers is not notified the sale of the invoice. It should be
noted that the facility offered, by which cash is advanced, is based upon the credit
worthiness of the customers and the credit control procedures of the firm.
When a firm factors its receivables, it may be either with or without recourse depending
upon the type of arrangement negotiated. If the factoring arrangement involves full
recourse, the firm will want to maintain same sort of credit department, in order to limit
its risk exposure. On the others hand, if the receivables are sold without recourse the
factor bears both the risk of bad debt losses and of the expenses associated with the
collection of accounts.
Advantages:
For the seller of the goods and also the exporter factoring arrangement has a number of
advantages...
(i) It gives him all the advantages of a cash trade while allowing him to offer credit to his
customers (either local or overseas or both).
(ii) It relieves overall the work involved in sales accounting and debt collecting.
(iii) It eliminates the uncertainty and risk of bad debts should buyers become insolvent.
(iv) Consequently, the cash flows of the firm are more predictable.
Its principal shortcoming is that it can be expensive. For a small firm, the savings may
be quite significant. Second, the firm is using a highly liquid asset as security and such
financing may be regarded as a confession of a firms unsound financial position.
Evaluation of Receivables Management
The possible measures of appraising performance of the credit department are as
follows:
(a) Percentage of orders rejected to credit sales,
(b) Percentage of monthly collections on past dues accounts to the accounts due at the
beginning of each month, and
(c) Percentage of bad debts to credit sales.
When taken together, these measures may present a picture of undesirable strictness or
leniency. Thus an unusually low turnover of receivables in relation to the characteristic
ratio of the industry, a negligible reduction rate, a high proportion of past due accounts
would require tightening of credit standards and collection procedures. The problem
would have to be analyzed on the basis of historical and horizontal standards in order to
find out whether or not percentage and ratios are unusually high or low.
Turnover of Debtors (Debtor's Velocity) Ratio:
This ratio explains the relationship of net (credit) sales of a firm to its books debts
indicating the rate at which cash is generated by turnover of receivables or debtors. The
purpose of this ratio is to measure the liquidity of the receivables or to find out the
period over which receivables remain uncollected i.e. ageing of receivables.
Net (Credit) sales
Turnover of Debtors Ratio (number of times in a year) = ----------------------------------
--
Average or year-end
Debtors
If the annual turnover rate is say 6 times, this means that, on an average receivables are
collected in 2 months, i.e., average collection period is 2 months time. Alternatively,
average collection period is calculated thus,
Accounts receivables
Average Collection Period (Number of days in a year) = ------------------------- x 365
Annual Credit
sales
Trade debtors include bills receivables along with book debts. Bills arising not from
regular sales e.g., a bill receivable from the buyer of fixed assets, should be excluded.
Bad and doubtful debts and their provisions are not deducted from the total debtors in
order to avoid the impression that a large amount of receivables have been collected. If
the breakup of sales into cash and credit sales is not available, the analyst has to use the
total sales for computation of the ratio. As to the calculation of daily sales, the number of
working days of the firm enduring the year is customarily taken as 360 days rather than
365 days exact; Average collection period is analysed with reference to the (billing)
terms of sales and then, overdue are counted after the expiry of credit period allowed.
Creditor's (Creditor's Velocity) Ratio:
This ratio shows the velocity of the debt discharged by matching annual credit purchases
to the outstanding payables (both trade creditors and bills payables) at the accounting
date.
Net (Credit) Purchase
Creditors or Payables Ratio (Number of times in a year) = -------------------------------
--
Average (or yearend)
payables
Smaller the payable ratio, greater the credit period enjoyed and consequently larger the
benefit reaped from credit suppliers.
Payables
Average Payment Period (Number of days in a year) = -------------------- X 365
Credit Purchases
Ageing of Accounts Receivables:
Ageing of Accounts is yet another method of analyzing the liquidity of receivables. This
involves classifying the amounts due in each account according to the period that it is
outstanding or categorizing the receivables at a point of time according to the
proportions billed in previous months. For instance, such a classification as on 31
December of any year may reveal that 60% of the amounts outstanding are not more
than a month old, 20% may be more than a month but less than 2 months old, 12% may
be outstanding for more than 60 days (2 months) but less than 90 days (3 months) and
8% of the amount may be more than 3 months old. If the terms of sale require payment
within 30 days, the information as regards ageing of accounts shows that 40% of the
amount of receivables are overdue, 20% are upto one month overdue, 12% upto 2
months overdue and 8% are more than 2 months overdue. Evidently, the accounts with
outstanding dues which are long overdue need to be investigated and written off, if they
are uncollectable. With the information on ageing of accounts, the analyst can get an
accurate picture of the investment in receivables and changes in the basic composition
of the investment over time.
The Ageing Schedule breaks down debtors according to length of time for which they
have been outstanding and gives a detailed idea of the quality of debtors. The average
collection period measures the quality of debtors in an aggregative way while ageing
schedule very clearly spots out the slow paying debtors.
Illustration 1
A firm sells goods of Rs. 10,000 on '2/10, Net 30' days basis. The customer has two
options (i) either to avail of cash discount by making payment on or before 10th day; or
(ii) to keep the credit open and pay full amount by the 30th day. Assuming that bank
finance is available to customers on 18 per cent per annum, suggest which option would
be more beneficial to the customer to exercise.
Solution
In case the first option is exercised, the customer saves Rs. 200 and has to pay only Rs.
9,800.
If the customer does not avail of the facility of 2% cash discount and pays Rs. 10,000 on
the 30th day, then it would imply that he is paying interest of Rs. 200 on Rs. 9,800
(10,000-200) for getting the facility of keeping Rs. 9,800 for duration of 20 days. This
by implication would mean that Rs. 200 is the interest on Rs. 9,800 for 20 days. On this
basis the interest for 12 months can be calculated as follows:
Interest for 12 months = (200 x 30 days x 12 months) / 20 days = Rs.3,600
Annual Rate of Interest = (3,600 / 9,800 ) x 100 = 36.74% (approx)
As the rate of bank credit is only 18%, there is no point in exercising the second option
and paying 36.74% interest. Therefore the customer must make the payment by the 10th
day and take advantage of 2% cash discount. In case cash is not readily available then
resorting to borrowing from bank (@ 18%) and making the payment by the 10th day (to
get a discount Rs. 200) will be beneficial to the customer.
Illustration 2
A firm is considering pushing up its sales by extending credit facilities to the following
categories of customers:
(a) Customers with a 10% risk of non-payment, and
(b) Customers with a 30% risk of non-payment.
The incremental sales expected in case of category (a) are Rs. 40,000 while in case of
category (b) they are Rs.50,000. The cost of production and selling costs are 60% of
sales while the collection costs amount to 5% of sales in case of category (a) and 10% of
sales in case of category (b). Advise the firm about extending credit facilities to each of
the above categories of customers.
Solution
(a) Extending Credit Facilities with 10% Risk of Non-payment
Incremental Sales Rs.
Less: Loss in collection (10%) 40,000
4,000
------------
Net sales realized 36,000
Less: Production and selling costs (60% of sales) 24,000
Collection costs (5%) 2,000 26,000
-------------
Incremental Income 10,000
-------------
Thus, the firm can have extra income of Rs.10,000 by accepting the 10% risk group. It
may, therefore, lower its credit standards in favour of this category of customers.
(b) Extending Credit Facilities with 30% Risk of Non-payment
Sales by accepting 30% risk group Rs.
Less: Loss in collection (30%) 50,000
15,000
------------
Net sales realized 35,000
Less: Production and selling costs (60% of sales) 30,000
Collection costs (10%) 5,000 35,000
-------------
Incremental Income Nil
-------------
Thus, the firm does not stand to gain or lose on account of extending credit to customers
with 30% risk of non-payment. The firm should not, therefore, extend credit to such
customers unless it is beneficial for the firm in the long-term because of having a wider
market for its products.
Illustration 3
The following are the details regarding the operations of a firm during a period of 12
months.
Sales Rs 12 Lakhs
Selling Price per unit Rs 10
Variable cost price per unit Rs 7
Total cost per unit Rs 9
Credit period allowed to customers One month
The firm is considering a proposal for a more liberal extension of credit which will result
in increasing the average collection period from one month to two months. This
relaxation is expected to increase the sales by 25% from its existing level.
You are required to advise the firm regarding adoption to the new credit policy,
presuming that the firms required return on investment is 25%.
Solution
Computation of New Sales
Present Sales 1.2 Lakh units x Rs 10 = Rs 12 Lakhs
Additional Sales 30 K units x Rs 10 = Rs 3 Lakhs
Total sales = Rs 15 Lakhs
Computation of New Total Cost
Present cost of sales 1.2 Lakh units x Rs 9 = Rs 10.8 Lakhs
Cost of additional sales 30 K units x Rs 7* = Rs 2.1 Lakhs
Total cost of sales = Rs 12.9 Lakhs
* Only variable costs to be considered.
Existing investment in receivables = Rs. 10.8 Lakhs x 1 month /12 months (since credit
period is 1 month)
= Rs 90K
New average cost per unit = New total costs / New total output
= Rs 12.9 Lakhs / 1.5 Lakh units = Rs 8.60
Average Investment in Receivables under new sales pattern
Total annual sales = 1.5 Lakh units
Cost of sales (1.5 Lakh units x Rs 8.6) = Rs. 12.9 Lakhs
Average collection period = 2 Months
Amount invested in receivables = (Rs 12.9 Lakhs x 2 months) / 12 months = Rs 2.15
Lakhs
Additional investment in receivables = New investment - Existing investment
= Rs 2.15 Lakhs - Rs 90 K = Rs 1.25 K
Profitability on additional sales = Additional units sold x Contribution per unit
= 30 K x Rs 3 = Rs 90,000
Return on additional investment in receivables = (Rs 90,000 / Rs 1.25 K) x 100 = 72%
The required return on investment is only 25% where the actual return on additional
investment in receivables comes
to 72%. The proposal should, therefore, be accepted.
Illustration 4
XYZ Corporation is considering relaxing its present credit policy and is in the process of
evaluating two proposed policies. Currently, the firm has annual credit sales of Rs 50
lakhs and accounts receivable turnover ratio of 4 times a year. The current level of loss
due to bad debts is Rs 1.5 Lakhs. The firm is required to give a return of 25% on the
investment in new accounts receivables. The companys variable costs are 70% of the
selling price. Given the following information which is the better option?
Present Policy Policy Option I Policy
Option II
Annual Credit sales Rs 50 Lakhs Rs 60 Lakhs Rs 67.5
Lakhs
Accounts receivables turnover ratio 4 times 3 times 2.4
times
Bad debt losses Rs 1.5 Lakhs Rs 3 Lakhs Rs 4.5
Lakhs
Solution
XYZ Corporation Evaluation of Credit Policies
Present Policy Policy Option I Policy Option II
Annual Credit Sales Rs 50,00,000 Rs 60,00,000 Rs 67,50,000
Accounts receivable turnover 4 times 3 times 2.4 times
Average collection period (12
months / Accounts
3 months 4 months 5 months
receivables turnover)
Average level of accounts
receivables (Annual credit
sales /Receivabls turnover)
50,00,000/4 =
Rs 12,50,000
60,00,000/3 =
Rs 20,00,000
67,50,000/2.4 =
Rs 28,12,500
Marginal increase in
investment in receivables less
profit margin (i.e. 70% of
increase in Receivables)
- 5,25,000 5,68,750
Marginal increase in sales - 10,00,000 7,50,000
Profit on marginal increase in
sales (30%)
- 3,00,000 2,25,000
Marginal increase in bad
debts losses
- 1,50,000 1,50,000
Profit on marginal increase
(sales less marginal bad debt
losses)
- 1,50,000 75,000
Required return on marginal
investment at 25%
- 1,31,250 1,42,188
Surplus (loss) after required
rate of return
- 18,750 (67,188)
The above analysis shows that the Policy Option I gives a surplus of Rs 18,750, whereas
Policy Option II shows a deficit of Rs. 67,188 on the basis of 25% return. Thus, Policy
Option I is better.
Notes:
1. (5,52,000 x 25) /100 = Rs 1,31,250
2. (5,68,750 x 25) /100 = Rs 1,42,188
Illustration 5
A firm has annual sales of Rs. 15,00,OOO. It grants 2 months credit to its customers
with no cash discount facility. It intends to offer a discount of 2/10, net 60. It is
expected that this will reduce the average collection period to one month and 50% of the
customers (in value) will take advantage of this benefit. The selling price is Rs. 10 per
unit, while the average cost per units comes to Rs. 8.60.
You are required to advise the firm regarding this new scheme presuming that the
required return on investment is 25% and one month is of 30 days.
Solution
Rs.
Annual credit sales 15,00,000
Cash discount allowed (15,00,000 x 50/100 x 2/100) 15,000
Present investment in receivables (15,00,000 x 2/12 x 8.6/10) 2,15,000
Expected investment in receivables (15,00,000 x 1/12 x 8.6/10) 1,07,500
Decrease in investment in receivables 1,07,500
Savings in capital costs (1,07,500 x 25/100) 26,875
Net savings (Rs. 26,875 - Rs. 15,000) 11,875
Since the new credit terms will result in a net savings of Rs. 11,875, hence the firm may
adopt them.
REVIEW QUESTIONS
1. Explain the objectives of receivables management.
2. What are the determinants on the size of investment in receivables?
3. What system of control would you suggest to keep the investment in receivables
within reasonable limits?
4. What benefits and cost are associated with the extension of credit? How should they
be combined to obtain an appropriate credit policy?
5. What are a firms credit standards? On what basis are they normally established?
6. What is meant by a firms credit terms? What do they determine?
7. What are collection policies? How can they be evaluated?
8. Explain briefly (i) Credit insurance (ii) Factoring (iii) Ageing of Receivables (iv)
Delinquent debts (v) Credit scoring.
9. A company manufactures several products which are marketed all over India through
wholesalers. How would the company decide the credit control policy it should adopt?
10. What factors should be taken in to account in deciding upon the credit limits to be
allowed to a new customers who is likely to have substantial transaction with the seller?
PRACTICAL PROBLEMS
1. Chidambaram & Co. Limited has currently annual credit sales of Rs.7,80,000. Its
average age of accounts receivable is 60 days. It is contemplating a change in its credit
policy that is expected to increase sales to Rs. 10,00,000 and increase the average age of
accounts receivable to 72 days. The firms sale price is Rs. 25 per unit, the variable cost
per unit is Rs. 12 and the average cost per unit at Rs.7,80,000, sales volume is Rs. 17.
Assume 360 days in a year.
(i) What is the average accounts receivable with both the present and the proposed
plans?
(ii) What is the average cost per unit with the proposed plan?
(iii) Calculate the marginal investments receivable resulting from the proposed change.
(iv) What is the cost of marginal investment if the assumed rate of return is 15%?
[Ans. (i) Rs. 1,28,000 (ii) Rs. 16 per unit (iii) Rs. 37,330 and (iv) Rs. 5,600]
2. A firm has credit sales amounting to Rs. 32,00,000. The sale price per unit is Rs. 40,
the variable cost is Rs. 25 per unit while the average cost per unit is Rs. 32. The average
age of accounts receivable of the firm is 72 days. The firm is considering to tighten the
credit standards. It will result in a fall in the sales volume to Rs. 28,00,000 and the
average age of accounts receivable to 45 days. Assume 20% rate of return. Is the
proposal under consideration feasible?
[Ans. The firm should not adopt more strict credit collection policy as it will decrease
profits by Rs. 1,05,350]
3. Ramasamy & Co. Limited is examining the question of relaxing its credit policy. If
sells at present 20,000 units at a price of Rs. 100 per unit, the variable cost per unit is
Rs. 88 and average cost per unit at the current sales volume is Rs. 92. All the sales are
on credit, the average collection period being 36 days. A relaxed policy is expected to
increase sales by 10% and the average age of receivables to 60 days. Assuming 15%
return, should the firm relax its credit policy?
[Ans. The firm should relax its credit policy as it increases profit by Rs. 1,200]
SUGGESTED READINGS
1. Chandra, Prasanna : Fundamentals of Financial Management, New Delhi,
Tata McGraw Hill Co.
2. Hampton, J J. : Financial Decision Making, New Delhi, Prentice Hall
of India.
3. Khan, M.Y. and Jain, P.K.: Financial Management, New Delhi, Tata McGraw Hill
Co.
4. Pandey, I.M. : Financial Management, New Delhi, Vikas Publishing
House
- End of Chapter -
LESSON - 9
INVENTORY MANAGEMENT
Learning Objectives
After reading this lesson you should be able to:
Know the motives for holding inventories
Understand the costs-risks involved in inventory decisions
Detail inventory control techniques
Explain and calculate EOQ and stock points
Examine the several methods of inventory valuation
Lesson Outline
Motives for Holding Inventories
Objectives for Inventory Management
Costs for Inventory Policies and Decisions
Inventory Control Techniques - EOQ - Stock levels - ABC Analysis etc.
Inventory Valuation - LIFO - FIFO - HIFO - NIFO etc.
Illustrative Examples
The success of a business concern largely depends upon efficient purchasing, storage,
consumption and accounting. The uncontrolled inventories e dangerous and at times it
is called as graveyard of business. Hence, inventory control system should be designed
to ensure the provision of the required quantity of material at the required time to meet
the needs of production and sales, while at the same time keeping the investment in
them at a minimum.
Motives For Holding Inventories
Generally three motives are involved in holding inventories.
(i) The transaction motive which emphasizes the need to maintain inventories to
facilitate smooth production and sales operations (called transaction inventory).
(ii) The precautionary motive which necessitates holding of inventories to guard
against the risk of unpredictable changes in demand and supply force (called
precautionary inventory).
(iii) The speculative motive which influences the decision to increase or reduce
inventory levels to take advantage of price fluctuations (called speculative inventory).
Objectives of Inventory Management
Broadly, the objectives of inventory management can also be classified into operative
objectives and financial objectives. Oper ative obj ectives aims at avoiding production
bottlenecks by providing continuous supply of all types of materials, avoidance of
wastage like theft, pilferage, leakage, spoilage etc., promotion of manufacturing
efficiency and prompt execution of their orders to ensure better service to customers.
The financial objectives of inventory management include effecting economy in
purchasing through economic order quantity and taking advantage of favourable
markets, maintaining optimum level of investment in inventories, etc.
Management information on stocks is required by the production department so that
they can schedule workloads, shift work and machine usage. Information on finished
goods is required by the marketing department so that they can estimate whether
customer's requirements can be met or not.
Cost for Inventory Policies and Decisions
There are four cost factors involved in general inventory policies:
(i) Acquisition or Ordering Cost: The cost associated with the placement of a
purchase order i.e. expenses of the firm in acquiring or processing inventory. The cost
associated with ordering consists of:
(a) Salaries of the staff in administration and purchase department,
(b) Rent for the space used by the purchase department,
(c) The postage, telegram and telephone bills,
(d) The stationery and other consumable required by the purchasing department,
(e) Entertainment charges on vendors,
(f) Travelling expenses,
(g) Lawyers and court fees due to legal matters arising out of purchase, etc.
All these costs usually come to 15 to 20% as ordering cost. The expenditure on ordering
of material is directly proportional to the number of orders placed.
(ii) Material Cost: It is the cost of materials itself.
(iii) Carrying or Holding Cost: It is the cost associated with keeping the materials in
stock. The following costs are incurred in keeping materials in store, and the longer the
materials are stored, the greater these costs become:
(a) Capital costs i.e. the loss of return that could be obtained if the capital tied up
in stock was employed elsewhere,
(b) Space costs such as rent, heating, lighting etc.,
(c) equipment costs like bins, racks, etc.,
(d) personal costs involved in storing, stock taking, security etc.,
(e) insurance costs i.e. protection against fire, theft, etc.,
(f) property taxes,
(g) cost of handling the material,
(h) stationery and other consumables used by the stores,
(i) cost of wastage and material losses in the store,
(j) obsolescence and deterioration costs. The higher the stock levels, the longer the
time materials in stock, and so the greater is the risk, and therefore ultimate cost
of obsolescence,
(k) depreciation and repair cost for the stores facilities and handling equipment.
These costs come nearly 20 to 25%. These costs are arbitrary and vary from
industry to industry and from time to time and also from item to item in the same
industry.
(iv) Overstock and understock costs: Carrying inventory which results where there
is stock left on hand after the demand for the item has terminated. This cost is called the
overstock cost. Understock cost refers to the cost of running out of goods or cost
associated with shortages i.e., lost sales or profits.
S.No. Inventory with cost Inventory without cost
(i) Return on Investment Stock out costs
(ii) Storage cost Lost sale, Loss of future sale (demand x future
profitability)
(iii) Handling cost Loss of customers/goodwill
(iv) Handling equipment Down time cost
(v) Obsolescence Idle labour, idle production
(vi) Spoilage and shelf life Capacity and other cost
Please use headphones
INVENTORY CONTROL TECHNIQUES
In most manufacturing concerns inventories are controlled through the following
techniques:
(i) Economic Order Quantity,
(ii) Determination of Stock Levels,
(iii) Inventory Turnover Ratio,
(iv) Input-Output Ratio Analysis,
(v) A B C Analysis,
(vi) Perpetual inventory or Continuous stock taking,
(vii) Value Analysis.
Economic Order Quantity (E.O.Q.)
The Economic Order Quantity (E.O.Q.) is the optimum or the most favourable quantity
which should be ordered for purchase each time when the purchases are to be made.
The Economic Order Quantity is one where the cost of carrying is equal to, or almost
equal to the cost of not carrying. The E.O.Q is also known as "Reorder Quantity" or
"Standard Order Quantity" and it depends upon two factors viz, cost of carrying and cost
of ordering and receiving per order. The cost of carrying or holding costs can be
estimated by the management on the basis of sales of past years but costs of not carrying
enough are only estimated.
EOQ = (2CO / I)
where, I = interest payment including variable cost of storage per unit per year,
C = Consumption of materials concerned in units,
O = Cost of ordering and receiving per order
Assumptions
Inventory is consumed at a constant rate
Costs do not vary over the period of time
Lead time is known and constant
Ordering cost, carrying cost and unit price are constant
Holding or carrying costs are proportional to the value of stocks held
Ordering cost varies proportionately with price
For example, a unit of material V costs Rs. 50 and the annual consumption is 2,00,000
units. The cost of placing an order and receiving the material is Rs. 200 and the interest
including variable cost of storage per unit per year is 10% per annum.
EOQ = (2CO / I) = (2 x 2,00,000 x 200/10% of Rs.50) = (800,00,000/5) =
16000000 = 4000 units
The E.O.Q. approach can be extended to production runs to determine the optimum size
manufacture. Two factors deciding the economic production size are set-up costs and
carrying costs. Set-up cost is roughly equivalent to the ordering cost per order. It
includes,
(a) engineering cost of setting up the production line or machine,
(b) paper-work, cost of processing the work order and authorising production, and
(c) ordering cost to provide raw materials for the batch or order.
The set-up cost will reduce with bulk production runs, but the carrying costs will
increase as large stocks of manufactured inventories will be held. Thus, the economic
production lot size is one where the total of set-up cost and carrying cost is minimum.
Illustration 1
A manufacturer buys certain equipment from supplier at Rs. 30 per unit. Total annual
needs are 800 units. The following further data are available:
Annual return on investment 10%
Rent, insurance, taxes per unit per year Re. 1.
Cost of placing an order Rs. 100
Determine the economic order quantity.
Solution
Cost of carrying inventory per unit = 30 x 10% + 1 = Rs. 4
E.O.Q = Square Root of (2 x 100 x 800) / 4 = 160000 / 4 = 400/4 = 200 units
Determination of Stock Levels
The demand and supply method of stock control technique determines different stock
levels viz; Maximum level, Minimum level, Reorder level, Average level, Danger level,
etc.
Maximum Stock Level : It represents the quantity of inventory above which should
not be allowed to be kept. This quantity is fixed keeping in view the disadvantages of
over stocking. The disadvantages of over stocking are:
(i) working capital is blocked up unnecessarily in stores and interest may have to be paid
thereon;
(ii) more storage space is required so more rent, insurance charges and other costs of
carrying inventory have to be incurred;
(iii) there is risk of deterioration in quality, depreciation in quantity due to evaporation,
rusting etc., and risks of obsolescence besides the risk of loss due to breakage, theft,
excessive consumption also, and
(iv) there is a possibility of financial loss on account of subsequent fall in prices.
The following are the factors helpful in deciding the limits of inventory to be stored:
(a) amount of capital available and required for purchases,
(b) storage facilities and storage costs,
(c) rate of consumption of the material,
(d) possibilities of price fluctuations,
(e) seasonal nature of supply of materials, (possibility of loss due to evaporation,
moisture, deterioration in quality, etc.,
(g) insurance costs,
(h) possibility of change in fashion and habit which will outdate the products
manufactured from that material,
(i) restrictions imposed by government or local authority or Trade association in
regard to materials in which there are inherent risks e.g. we and explosion or as to
imports or procurement,
(j) economic order quantity, and
(k) lead time.
Lead Time: From the time the requisition for an item is raised; it may take | several
weeks or months before the supplies are received, inspected, and taken in stock. This
time is called as Lead time or "Procurement Time" and involves the time for the
completion of all or some of the following activities:
(i) Raising of a purchase requisition,
(ii) Inquiries, tenders, quotations,
(iii) Receiving quotations, tenders, their scrutiny and approval,
(iv) Placement of order on a supplier/suppliers,
(v) Suppliers time to make the goods ready (may have to be manufactured or
supplied ex-stock),
(vi) Transportation and clearing,
(vii) Receipt of materials at the company,
(viii) Inspection and verification of the materials,
(ix) Taking into stock, and
(x) Issuing items and carrying them to the place of work.
This lead time required to procure any item can be divided into two parts namely
internal lead time (also known as Administrative Lead Time) required for
organizational formalities to be completed and external lead time (also known as
Delivery Lead Time) as shown below:
Total Lead Time
Internal Lead Time + External Lead Time + Internal Lead Time
(Requisition order) (Placement of order (Taking unit stock)
and receipt of goods)
It is a common belief that external lead time should be controlled and reduced, but it
has been found in actual practice that internal lead time constitutes a considerable part
of total lead time and offers ample scope for reduction. The management must make a
determined and deliberate effort to reduce lead time by selectively delegating powers,
better paper work procedures, and fixing targets individually for all activities. Obviously,
in order to receive supplies before the stock reaches zero level, it is necessary to order
the materials much in advance i.e., when the stock available is sufficient to last during
the lead time.
Minimum Stock Level : This represents the quantity below which stock should not
be allowed to fall. This is known as 'safety' or 'buffer stock'. The main purpose of this
level is to ensure that production is not held up due to shortage of any material. This
level is fixed after considering: (i) average rate of consumption of materials, and (ii) lead
time.
Reorder Level (or Order level) : It is the point at which if stock of the material in
store reaches the store-keeper should initiate the purchase requisition for fresh supplies
of the materials. This level is fixed between maximum and minimum-stock levels in
such a way that the difference of quantity of the materials between the reorder level and
the minimum level will be sufficient to meet the requirement of production up to the
time the fresh supply to the material is received.
Danger Level : This is a point at which issues of the material are stopped and issues
are made only under specific instructions. This level is generally fixed below he
minimum stock level. When stock of materials reaches the danger level the purchase
officer should take special arrangements to get the materials at any cost.
Just-in-time Inventory Control: The just-in-time inventory control system,
originally developed by Taiichi Okno of Japan, simply implies that the firm should
maintain a minimal level of inventory and rely on suppliers to provide parts and
components just-in-time to meet its assembly requirements. This may be contrasted
with the traditional inventory management system which calls for maintaining a healthy
level of safety stock to provide a reasonable protection against uncertainties of
consumption and supply-the traditional system may be referred to as a just-in-case
system.
The just-in-time inventory system, while conceptually very appealing, is difficult to
implement because it involves a significant change in the total production and
management system. It requires inter alia
(i) a strong and dependable relationship with suppliers who are geographically not
very remote from the manufacturing facility,
(ii) a reliable transportation system, and
(iii) an easy physical access in the form of enough doors and conveniently located
docks and storage areas to dovetail incoming supplies to the needs of assembly
line.
Formulae for Determination of Stock Levels
Maximum Stock Level = Reorder level + Reorder Quantity - (Minimum consumption x
Minimum Reorder period)
Reorder Level = Maximum consumption x Maximum Reorder period
Minimum Stock Level = Reorder level - (Normal consumption x Normal reorder
period)
Average Stock Level = Minimum level + of Reorder Quantity
= (Minimum stock + Maximum stock)
Danger Level = Maximum delivery time x Maximum rate of consumption
= Minimum rate of consumption x Emergency delivery time
Illustration 2
From the following information calculate the Maximum stock level, Minimum stock
level, Reordering level, Average stock level and Danger level.
- Normal consumption 300 units per day
- Maximum consumption 420 units per day
- Minimum consumption 240 units per day
- Reorder quantity 3,600 units
- Reorder period 10 to 15 days
- Normal reorder period 12 days
- Time required to emergency purchase 4 days
Solution
Reorder Level = Maximum consumption x Maximum Reorder period
= 420 units per day x 15 days = 6,300 units
Minimum Stock Level = Reorder level - (Normal consumption x Normal reorder
period)
= 6,300 units - (300 units per day x 12 days) = 6,300 - 3,600
= 2,700 units
Maximum Stock Level = Reorder level + Reorder quantity - (Minimum consumption
x Minimum reorder period)
= 6,300 units + 3,600 units - (240 units per day x 10 days)
= 9,900 - 2,400 = 7,500 units
Average Stock Level = (Minimum stock level + Maximum stock level)
= (2,700 units + 7,500 units) = 5,100 units
Danger Level = Minimum rate of consumption x Emergency delivery time
= 240 units per day x 4 days = 960 units
Control through ABC Analysis - Selective Control
Different types of analyses, each having its own specific advantages and purpose, help in
bringing a practical solution to the control of inventory. The most important of all such
analysis is ABC analysis. The others are:
FSN (Fast, Slow, Non-moving items) Analysis
GOLF (Government controlled, Ordinarily available, Locally available and Foreign
items) Analysis
HML (High, Medium, Low cost) Analysis
SDE (Scarce, Difficult, Easily Available) Analysis
SOS (Seasonal and Off-seasonal) Analysis
VED (Vital, Essential, Desirable) Analysis
An effective inventory control system should classify inventories according to values so
that the most valuable items may be paid greater and due attention regarding their
safety and care, as compared to others. Hence, it is desirable to classify the production
and supply items, both purchased and manufactured, depending upon their importance
and subject each class of group of items to control commensurate with importance. This
is the principle of "contr ol by impor tance and excepti on" (CIE) or selecti ve
contr ol as applied to inventories and the technique of grouping is termed as ABC
analysis or classification which it said to be "Always Better Contr ol". As the items
are classified in the importance of their relative value, this approach is also known as
Pr opor ti onal (par ts) Value Analysis (PVA) or Annual Usage Value (AUV)
analysis.
The general procedure for implementing the ABC technique is as follows:
(i) Classify the items of inventories;
(ii) Determine the expected use in units over a given period of time;
(iii) Determine the total cost of each item by multiplying the expected units by its
unit price;
(iv) Rank the items in accordance with total cost, giving first rank that the item
highest total cost and so on;
(v) Calculate percentage (ratio) of number of units of each item to total units of all
items and the percentage of total cost of each item to total cost of all items;
(vi) Combine items on the basis of their relative value to form three categories - A,
B and C e.g., classify the inventory as A,B, or C based on the top 20%, the next
30% and the last 50% valuation respectively;
(vii) Decide cut-off points and methods of control;
(viii) Tag the inventory with A, B, C classification and record these classifications
in the item inventory master record.
Illustration 3
The following information is known about a group of items. Classify the material in A, B,
C classification.
______________________________________________________________________________
_____
Model Number Annual consumption in Unit price in Rs.
pieces
__________________________________________________________
501 30,000 10
502 2,80,000 15
503 3,000 10
504 1,10,000 5
505 4,000 5
506 2,20,000 10
507 15,000 5
508 80,000 5
509 60,000 15
510 8,000 10
______________________________________________________________________________
______
Solution
______________________________________________________________________________
____________
Model Number Annual Unit price Annual Rank
consumption Rs. consumption (According
in pieces value (Rs.) to value)
______________________________________________________________________________
____________
501 30,000 10 3,00,000 6
502 2,80,000 15 42,00,000 1
503 3,000 10 30,000 9
504 1,10,000 05 5,50,000 4
505 4,000 05 20,000 10
506 2,20,000 10 22,00,000 2
507 15,000 05 75,000 8
508 80,000 05 4,00,000 5
509 60,000 15 9,00,000 3
510 8,000 10 80,000 7
_____________ ______________
___
Total 8,10,000 87,55,000
______________________________________________________________________________
______________
____________________________________________________________
_____
Model No. %
items Annual % Rank
consumption
value Rs.
____________________________________________________________
_____
A Category 502 10% 42,00,000 48% 1
506 10% 22,00,000 25% 2
__________________________________
__
Total 20% 64,00,000 73%
__________________________________
__
B Category 509 10% 9,00,000 10% 3
504 10% 5,50,000 6% 4
508 10% 4,00,000 5% 5
__________________________________
__
Total 30% 18,50,000 21%
__________________________________
__
C Category 501 10% 3,00,000 3% 6
510 10% 80,000 1% 7
507 10% 75,000 1% 8
503 10% 30,000 % 9
505 10% 20,000 % 10
__________________________________
__
Total 50% 5,05,000 6%
__________________________________
__
Grand Total 100% 87,55,000 100%
____________________________________________________________
____
Control Through Perpetual Inventory System
The Institute of Costs and Management Accountants, England defines the perpetual
inventory system as a system of records maintained by the controlling department,
which reflects the physical movements of stocks and their current balance. Thus, this is
a method of ascertaining balance after every receipt and issue of materials through stock
records, to facilitate regular checking and to avoid closing down for stock-taking. In
order to ensure accuracy of perpetual inventory record, it is desirable to check the
physical stocks by a programme of continuous stock-taking. Any discrepancy noted
between physical stocks and the stock records can be investigated and rectified, then
and there.
INVENTORY VALUATION
Materials are issued to different jobs or work orders from the stores. These jobs or work
orders are charged with the value of materials issued to them. Following are the
important methods of valuing material issues:
A. Based on Cost Price or Actual Cost
(i) The First in First Out (FIFO) Method
(ii) The Last in First Out (LIFO) Method
(iii) The Highest in First Out (HIFO) Method
(iv) The Next in First Out (NIFO) Method
(v) The Base Stock Method
(vi) The Specific (or Actual) Fixed Price Method
(vii) The Inflated Price Method
(viii) Fixed Cost Method
(ix) Average Cost Method
(a) Simple average price method
(b) Periodic simple average price method
(c) Weighted average price method
(d) Periodic weighted average price method
(e) Moving simple average price method
(f) Moving weighted average price method
B. Based on Market Price Method
(x) Realizable Value Method
(xi) Replacement Value Method
C. Based on Standard Price Method
(xii) Current Standard Price
(xiii) Basic Standard Price
Methods Based on Actual Cost
First In First Out (FIFO) Method
This method operates under the assumption that the materials which are received first
are issued first and, therefore, the flow of cost of materials should also be in the same
order. Issues are priced at the same basis until the first batch received is used up, after
which the price of the next batch received becomes the issue price. Upon this batch
being fully used, the price, of the still next batch is used for pricing and so on. In other
words, the materials issued are priced at the oldest cost price listed in the stores ledger
account and consequently the materials in hand are valued at the price of the latest
purchases.
Example:
Receipts
2nd Jan (first consignment) 500 kilos @ Rs. 8 per kilo
5th Jan (second consignment) 300 kilos @ Rs. 8.20 per kilo
Issues
7th Jan 600 kilos
500 kilos @ Rs. 8 per kilo = Rs. 4,000
100 kilos @ Rs. 8.20 per kilo = Rs. 820
_________
Total issue value = Rs. 4,820
-------------
Advantages
1. This method is realistic in so far as it assumes that materials are issued to production
in the order of their receipts.
2. The valuation of closing stock tends to be nearer current market prices as well as at
cost.
3. Being based on cost, no unrealized profits enter into the financial result.
4. The method is easy to operate if the prices do not fluctuate very frequently.
Disadvantages
1. The issue prices may not reflect current market prices and, therefore, when price
increases the cost of production is unduly low.
2. The cost of consecutive similar jobs may differ simply because the prior job exhausted
the supply of lower priced stock. This renders comparison between different jobs is
difficult.
3. The method may involve cumbersome calculations if the prices fluctuate quite
frequently.
The FIFO method is most successfully used when
(a) the size and the cost of raw material units are large,
(b) materials are easily identified as belonging to a particular purchased lot, and
(c) not more than two or three different receipts are on a materials card at one time.
Last In First Out (LIFO) Method
This method operates on the assumption that the latest receipts of materials are issued
first for production and the earlier receipts are issued last, i.e., in the reverse order to
FIFO. It uses the price of the last batch received for all the issues until all units from this
batch have been issued after which the price of the previous batch received becomes the
issue price. Usually, a new delivery is received before the first batch is fully used, in
which case the new delivery price becomes the 'last-in' price and is used for pricing
issues until either the batch is exhausted or a new delivery is received.
Example:
Take the same data as given in earlier example:
Receipts
2nd Jan (first consignment) 500 kilos @ Rs. 8 per kilo
5th Jan (second consignment) 300 kilos @ Rs. 8.20 per kilo
Issues
7th Jan 600 kilos
300 kilos @ Rs. 8.20 per kilo = Rs. 2,460
300 kilos @ Rs. 8 per kilo = Rs. 2,400
_________
Total issue value = Rs. 4,860
-------------
Advantages
1. The method keeps the value of issues close to the current market prices.
2. No unrealized profit or loss is usually made by using this method.
3. In periods of raising prices, the high prices of the most recent purchases are charged
to operations, thus reducing profit figure and resulting in a tax saving.
Disadvantages
1. The value of the closing stock may be quite different from the current market value
and hence may not be acceptable for income tax purposes.
2. Comparison among similar jobs is very difficult because different jobs may bear
different charges for materials consumed.
3. This method does not conform to the physical flow of materials.
4. The number of calculation complicates the stores accounts and increases the
possibility of clerical errors when rates of receipt are highly fluctuating.
Under condition of rising market prices, LIFO method is generally considered better.
This is so because under LIFO method reasonably correct effect of current prices is
reflected in the cost and the cost is not understated. The quotation of prices for the
products also becomes more safe than FIFO.
Highest In First Out (HIFO) Method
The method is based on the assumption that stock of materials should be always valued
at the lowest possible price. Materials purchased at the highest price are treated as being
first issued irrespective of the date of purchase. The method is very suitable when the
market is constantly fluctuating because cost of highly priced materials is recovered
from the production at the earliest. But it involves too many calculations as in the case
with the LIFO and FIFO methods. The method has not been adopted widely.
Next In First Out (NIFO) Method
The method attempts to value material issr.es at an actual price which is as near as
possible to the market price. Under this method the issues are made at the next price
i.e., the price of materials which has been ordered but not yet received. In other words,
issues are at the latest price at which the company has been committed even though
materials have not yet been physically received. This method is better than market price
method under which every time when materials are issued, their market price will have
to be ascertained. In case of this method materials will be issued at the price at which a
new order has been placed and this price will hold good for all future issues till a next
order is placed.
Base Stock Method
The method is based on the contention that each enterprise maintains at all times a
minimum quantity of materials in its stock. This quantity is termed as base stock. The
base stock is deemed to have been created out of the first lot purchased and therefore, it
is always valued at this price and is carried forward as a fixed asset. Any quantity over
and above the base stock is valued in accordance with any other appropriate method. As
this method aims at matching current costs to current sales the LIFO method will be
most suitable for valuing stock of materials other than the base stock. The base stock
method has the advantage of charging out materials at actual cost. Its other merits or
demerits will depend on the method which is used for valuing materials other than the
base stock.
Specific Price Method
Where materials are purchased for a particular job, they should be charged to that
particular job at their actual cost. This method can always be used where materials are
purchased and set aside for a particular job until required for production. This method
is best suited for job order industries which carry out individual jobs or contracts
against specific orders. From the point of view of costing, the method is desirable
because it ensures that the cost of materials issued is actual and that neither profit nor
loss arises out of pricing. This method however, is difficult to use if purchases and issues
are numerous and the materials issued cannot be identified.
Inflated Price Method
In case of certain materials wastage is unavoidable on account of their inherent nature,
e.g., if a log of timber is issued to various departments in pieces or if it is kept for
seasoning, there will be some loss in its quantity. In such a case the production should
be charged at an inflated price so as to recover the total cost of materials over the
different issues.
Average Cost Method
(a) Simple Average Price: Simple average price is the average of the prices without
any regard to quantities. The calculation of simple average price involves adding of
different prices dividing by the number of different pieces. The method operates under
the principle that when materials are purchased in lots and are put in store, their
identity is lost and, therefore, issues should be valued at the average price of all the lots
in store. Though this method is very easy to operate, but it is crude and usually produces
unsatisfactory results. The value of closing stock may be quite absurd. Moreover,
materials are not charged at actual cost and, therefore, a profit or loss will usually arise
out of pricing.
(b) Weighted Average Price: Weighted average price is calculated by dividing the
total cost of material in stock by the total quantity of material in stock. This method
averages prices after weighing (i.e., multiplying) by their quantities. The average price at
any time is simply the balance value divided by the balance units. Issue prices need to be
computed on the receipt of new deliveries and not at the time of each issue as in the case
of FIFO and LIFO.
Thus as soon as a fresh lot is received, a new issue price is calculated and all issues are
then taken at this price until the receipt of the next lot of materials. This method
operates under the assumption that the identity of the materials, when put in stores, is
lost and therefore their cost should reflect the average of the total supply.
Advantages
1. Since the receipts are much less frequent than issues, the method is not so
cumbersome because the calculation of the new issue price arises only when fresh
lots are purchased. All subsequent issues are then charged at this price until the
next lot is received.
2. The method even out the effect of widely varying prices of different
consignments comprising the stock.
3. A profit or loss may arise out of pricing.
4. Issue prices may run to a number of decimal points.
(c) Periodic Simple Average Price: This method is similar to the simple average
price except that here the issue price is calculated at the end of each period (normally a
month) covering the prices at which purchases were made during the period and not at
the occasion of each issue of material.
(d) Periodic Weighted Average Price: The periodic weighted average price is the
weighted average price of materials purchased during a period. It is calculated by
dividing the total cost of materials purchased during a period by the total quantity of
materials purchased during that period. A new average price is calculated at the end of
each period (normally a month).
(e) Moving Simple Average Price: This price is obtained by dividing the total of the
periodic simple average prices of a give number of periods, by the number of periods,
the last of the period being that for which material issues are valued. The calculation of
moving simple average price requires to decide upon the number of periods (months),
i.e. 3, 5, 7, etc. If, for example, a 5-monthly simple average is to be calculated, the
periodic simple average prices of 5 periods have to be added and total of these prices
divided by 5 would give simple moving average price.
(f) Moving Weighted Average Price: This is a derivation of the weighted average
method. To obtain the weighted average price, the weighted average price of a given
number of periods (including and preceding the period of accounting) have to be added
and divided by the number of periods.
Selection of a Suitable Method of Pricing Issues: No single method can be
appropriate in all circumstances. The selection of a proper method of pricing issues
depends on the following factors:
(a) the nature of the business and type of production, e.g., intermittent such as job or
continuous such as process;
(b) the method of costing used, whether the cost accounts are maintained according to
the standard costing system, if so, method of issuing materials on standard cost should
be used;
(c) the nature of materials e.g., if materials are to be kept for some time for maturing or
seasoning, an inflated price will have to be charged;
(d) the frequency of purchases and issues;
(e) the extent of price fluctuations;
(f) the policy of the management. If the management wants that the cost accounts
should represent the current position and correspond with estimates and besides that
they should disclose efficiency in buying, pricing materials issues at market price may be
suitable;
(g) relative value of material issued and relative size of batch of material issued;
(h) length of inventory turnover period and quantity of material to be handled; and
(i) the necessity for maintaining uniformity within an industry.
Illustration 4
XYZ Ltd, has purchased and issued the materials in the following order:
January 1 Purchases 300 units Rs. 3 per unit
Januray 4 Purchases 600 units Rs. 4 per unit
January 6 Issue 500 units --
January 10 Purchases 700 units Rs. 4 per unit
January 15 Issue 800 units --
January 20 Purchases 300 units Rs. 5 per unit
January 23 Issue 100 units --
Ascertain the quantity of closing stock as on 31st January and state what will be its value
(in each case) if issues are made under the following methods
(a) Average cost (b) FIFO method, and (c) LIFO method
Solution
(a) Average Cost method
January 1 Purchases 300 units Rs. 3 per unit
January 4 Purchases 600 units Rs. 4 per unit
January 6 Issue 500 units Average cost = (300 x 3 + 600 x 4) /
(300+600) = Rs. 3.67 per unit
January 10 Purchases 700 units Rs. 4 per unit
January 15 Issue 800 units Average cost = [400 x 3.67 + 700 x 4]
/(400+700) = Rs. 3.88 per unit
January 20 Purchases 300 units Rs. 5 per unit
January 23 Issue 100 units Average cost = [300 x 3.88 + 300 x 5]
/(300+300) = Rs. 4.44 per unit
January 31 Balance 500 units Average cost = Rs. 4.44 per unit
Value of Closing Stock = 500 x 4.44 = Rs. 2,220
(b) FIFO (First-in-first-out method)
January 1 Purchases 300 units Rs. 3 per unit
January 4 Purchases 600 units Rs. 4 per unit
January 6 Issue 500 units 300 units @ Rs.3 per unit + 200 units @
Rs. 4 per unit
January 10 Purchases 700 units Rs. 4 per unit
January 15 Issue 800 units 400 units @ Rs. 4 per unit + 400 units @
Rs. 4 per unit
January 20 Purchases 300 units Rs. 5 per unit
January 23 Issue 100 units 100 units @ Rs. 4 per unit
January 31 Balance 200 units @ Rs. 4 per unit + 300 units @ Rs. 5 per unit
Value of Closing Stock = 200 x 4 + 300 x 5 = Rs. 2,300
(c) Last-in-first-out method
January 1 Purchases 300 units Rs. 3 per unit
January 4 Purchases 600 units Rs. 4 per unit
January 6 Issue 500 units 500 units @ Rs.4 per unit
January 10 Purchases 700 units Rs. 4 per unit
January 15 Issue 800 units 700 units @ Rs. 4 per unit + 100 units @
Rs. 4 per unit
January 20 Purchases 300 units Rs. 5 per unit
January 23 Issue 100 units 100 units @ Rs. 5 per unit
January 31 Balance 300 units @ Rs. 3 per unit + 200 units @ Rs. 5 per unit
Value of Closing Stock = 300 x 3 + 200 x 5 = Rs. 1900
Illustration 5
The following information is obtained from the records of ABC Ltd.:
January 1 Opening stock 00 units Rs. 200
January 10 Purchases 40 units Rs. 100
January 25 Purchases 100 units Rs. 300
January 31 Sales 140 units Rs.700
On January 31st, the replacement cost was Rs. 3.5 per unit. Determine the closing stock,
cost of goods sold and profit for the month using LIFO, FIFO and Replacement cost (use
the format of a trading account).
Solution:
Using LIFO Method
Trading A/C
------------------------------------------------------------------------------------------------
Date Particulars Units Amount | Date Particulars Units A
mount
------------------------------------------------------------------------------------------------
Jan 1 Opening Stock 100 200 | Jan
31 Sales 140 700
Jan 10 Purchases 40 100 | Jan 31 Closing
Stock 100 200
Jan 25 Purchases 100 300 |
Jan 31 Profit 300 |
----------------------| ----------------
240 900 | 240 9
00
------------------------------------------------------------------------------------------------
Opening Stock value + Purchases value - Closing Stock value = Cost of goods sold
= 200 + 400 - 200 = Rs. 400
Using FIFO Method
Trading A/C
------------------------------------------------------------------------------------------------
Date Particulars Units Amount | Date Particulars Units A
mount
------------------------------------------------------------------------------------------------
Jan 1 Opening Stock 100 200 | Jan
31 Sales 140 700
Jan 10 Purchases 40 100 | Jan 31 Closing
Stock 100 300
Jan 25 Purchases 100 300 |
Jan 31 Profit 400 |
----------------------| ----------------
240 1000 | 240 1
000
------------------------------------------------------------------------------------------------
Opening Stock value + Purchases value - Closing Stock value = Cost of goods sold
= 200 + 400 - 300 = Rs. 300
Using Replacement Cost Method
Trading A/C
------------------------------------------------------------------------------------------------
Date Particulars Units Amount | Date Particulars Units A
mount
------------------------------------------------------------------------------------------------
Jan 1 Opening Stock 100 200 | Jan
31 Sales 140 700
Jan 10 Purchases 40 100 | Jan 31 Closing
Stock 100 325
Jan 25 Purchases 100 300 |
Jan 31 Profit 425 |
----------------------| ----------------
240 1025 | 240 10
25
------------------------------------------------------------------------------------------------
Opening Stock value + Purchases value - Closing Stock value = Cost of goods sold
= 200 + 400 - 325 = Rs. 275
Conclusion:
LIFO FIFO RCM
Closing Stock Rs. 200 Rs. 300 Rs. 325
Cost of goods sold Rs. 400 Rs. 300 Rs. 275
Profit Rs. 300 Rs. 400 Rs. 425
REVIEW QUESTIONS
1. What are the objectives of inventory management?
2. What is the financial managers role in respect of the management of inventory?
3. What purpose does safety stock serve? What are the benefits and costs associated
with safety stock?
4. What are inventory carrying charges? How are they calculated?
5. What are ordering costs? How are they calculated?
6. What are the costs of stock-outs? How should the costs of stock-out and the carrying
costs be balanced to obtain the safety stock?
7. What is lead time? What are the various activities occurring during the lead time?
8. How would you determine Economic Ordering Quantity?
9. What factors do you consider in fixing the maximum and the minimum stock levels?
10. What do you understand by A B C analysis? What are its advantages? Discuss the
inventory policies for A, B and C items.
11. Explain the following: (a) LIFO Method (b) FIFO Method.
PRACTICAL PROBLEMS
1. 10,000 units of a component are required per year. Rs. 100 is ordering cost on an
average per order. Rs. 2 is the average stock carrying cost p.a. per unit. What is the
economic ordering size? How many times should the orders be placed and what will be
total cost of ordering and of carrying cost of inventory.
[Ans: E.O.Q. 1,000 units; 10 times; Rs. 2.000]
2. Two components, A and B are used as follows: Normal usage 50 units per week each
Minimum usage 25 units per week each Maximum usage 75 units per week each
Reorder Quantity A : 300 units : B : 500 units Reorder Period A : 4 to 6 weeks: B : 2 to 4
weeks. Calculate for each component (i) Reorder level, (ii) Minimum level, (iii)
Maximum level, and (iv) Average Stock level.
[Ans. (i) A 450 units, B 300 units (ii) A 200 units, B 150 units (iii) A 650 units, B 750
units (iv) A 350 units, B 400 units]
3. A manufacturing company uses Rs. 50,000 materials per year. The administration
cost per purchase is Rs. 50, and the carrying cost is 20% of the average inventory. The
Company currently has an optimum purchasing policy but has been offered a 4 per cent
discount if they purchase five times per year. Should the offer be accepted? If not, what
counter offer should be made?
[Ans. E.O.Q. = Rs, 5,000; the offer should not be accepted because the cost will increase
by Rs. 46; any counter offer of more than 5% discount should be made].
4. The following are taken from the records of M/s Balaji & Co Thirupathi for the year
1994. The valuation of inventory is Re. 1 per kg or litre.
Opening stock Purchases Closing stock
Material A 700 kg 11,500 kg 200 kg
Material B 200 litres 11,000 litres 1,200 litres
Material C 1,000 kg 1,800 kg 1,200 kg
Calculate the material turnover ratio and express in number of days the average
inventory is held.
[Ans. Material A - 26.67 times; 14 days. Material B - 14.29 times; 26 days. Material C -
1.46 times; 250 days.]
SUGGESTED READINGS
1. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi-, Tata
McGraw Hill Co.
2. Gopalakrishnan, P: Inventory and Working Capital Management, New Delhi,
Macmillan India Ltd.
3. Menon, K.S.: Stores Management, Madras, Macmillan India Ltd.
- End of Chapter -
LESSON -10
COST OF CAPITAL
Learning Objectives
After reading this lesson you should be able to:
Recognise the significance of cost of capital
Understand the concept of cost of capital
Detail the controversial views regarding the cost of capital
Explain and calculate cost of debt, equity etc.
Lesson Outline
Significance of Cost of Capital
Concept of Cost of Capital
Assumption of the Cost of Capital
Controversial Views - Traditional Approach - MM approach
Calculation of Specific Cost of Capital
Weighted average cost of capital
Illustrative Examples
It has been stated in the first lesson that a crucial aspect in investment decision (capital
budgeting) is the cost of capital. It may be recalled that the cost of capital is usually
taken to be the cut-off rate for determining whether an investment opportunity should
be rejected or accepted. This is so in the case of Return on Investment (ROI) method
(i.e., the expected return is compared with the required return), Net Present Value
method. Profitability Index, Discounted Pay-back (i.e., the discount rate should be the
cost of capital rate) and Internal Rate of Return (i.e., the rate should not be lower than
cost of capital rate). Hence proper capital budgeting procedures require an estimate of
cost of capital. Secondly, many other decisions, including those related to leasing, bond
refunding, dividend policy, and to working capital policy require estimates of the cost of
capital. Thirdly, the concept of cost of capital is significant in designing the concerns
capital structure. The cost of capital is influenced by the capital structure changes. In
trying to achieve its optimal capital structure over time, a firm should aim at minimising
the cost of capital and maximising market value of the firm. Thus the knowledge of the
cost of capital is also helpful in deciding about the capital-source-mix i.e., method of
financing. Finally, the cost of capital framework can be gainfully applied to evaluate the
financial performance of top management. Such an evaluation will involve a comparison
of actual projected overall cost of capital, and an appraisal of the actual costs incurred in
raising the required funds.
The principle of cost of capital is applicable equally to the public sector undertakings
also. Unless the public sector earns a basic minimum of the cost of capital supplied to it
by the society, it will impoverish the society in due course, because the society might
have invested it elsewhere and got the returns. If certain companies in the public sector
cannot earn a profit for certain socially desirable reasons (e.g., Hindustan Latex Ltd.
producing contraceptives) other companies in the public sector like HMT, BHEL, etc.,
should earn more than their cost of capital in order to balance on the whole.
Concept of Cost of Capital
(i) Cut-off Rate: Cost of capital is the minimum required rate of return or earnings
from any given project needed to justify the use of capital. In other words, it is the rate
that must be paid to obtain funds for the operation of the firm. It is the cut-off rate, (also
known as the target-rate or the hurdle-rate) for the allocation of capital to investment
projects; in theory, it should be the rate of return on a project that will leave unchanged
the market price of the firms equity shares.
(ii) Lending/Borrowing Rate: The phrase "cost of capital" is used in two senses in
the literature on capital budgeting viz., the borrowing rate and the lending rate. The
borrowing rate is the rate which a given firm will have to pay for obtaining capital in the
market, whether it is from shareholders or other lenders. As between these two rates,
whichever rate is higher is to be used for discounting purpose while making investment
decisions. That is, where the borrowing rate is above the lending rate, the former
becomes the relevant rate of discount and vice versa.
(iii) Opportunity Cost: This is an alternative concept of cost of capital and is the rate
of return foregone or sacrificed by using limited resources available in one investment
project in preference to the next best alternative. For instance, if a person lending at a
rate of interest of 15% per annum finds that by lending on these terms he is foregoing
interest at 18 per cent per annum, which he could have easily earned by lending
elsewhere, then 18 per cent per annum is his opportunity cost (provided, of course, that
he cannot get a higher return than 18 per cent per annum on some other investment
bearing the same degree of risk). This is the opportunity cost because he has lost the
opportunity of investing at 18 per cent. It is the sacrificed alternative return. The cost of
capital in this sense is commonly known as lending rate, because his rate would be
earned by the firm if it were to lend its excess funds outside. The borrowing rate is said
to be outlay cost, involving financial expenditure and is, therefore, recorded in the books
of account.
(iv) Explicit cost and Implicit cost: The explicit cost of any source of capital may be
defined as the discount rate that equates the present value of the cash inflows that are
incremental to the taking of the financing opportunity with the present value of its
incremental cash outflows. The cash outflows may be interest or dividend payments,
repayment of principal, etc. Thus the explicit cost of capital is the internal rate of return
of the financial opportunity. The implicit cost is that rate of return associated with the
best investment opportunity for the firm and its shareholders that will be foregone if
that project presently under consideration by the firm were accepted. The implicit cost
is the opportunity cost.
(v) Composite Cost, Average Cost, Specific Cost etc: A firms supply of capital
may come from several sources, each source having a different cost. Therefore it is
essential to calculate a weighted average cost of capital for all the funds used by the
company. The capital structure of a company may include...
(i) Debt capital, carrying fixed interest rate (fixed cost of capital)
(ii) Preference share capital, carrying preference dividend rate (fixed cost of capital)
(iii) Equity capital, carrying no fixed rate of dividend (variable cost of capital)
(iv) Reserve funds, Trade credit etc., on which a company is not required to pay any
amount for their use. (No cost or variable cost of capital)
The cost of each source (i.e., specific source) is known as Specific Cost. The combined
average cost of shares, debt, reserves and retained earnings may be termed as overall or
composite cost of capital and is generally calculated as weighted cost of capital. Specific
cost of capital may be useful for short-run analysis but composite cost of capital should
be used for long-run analysis such as evaluation of capital expenditure decision, target
capital structure etc.
(vi) Marginal Cost of Capital: It refers to weighted average or simply additional cost
of new capital raised by the concern. Marginal cost of capital is also considered as more
important for capital budgeting purposes and financing decisions.
Assumptions of the Cost of Capital : The cost of capital and its determination as
discussed in this lesson are based on two assumptions given below:
(i) Business Risk is unaffected: It has been assumed that business risk complexion
of the concern would remain the same by accepting a new investment proposal. The
term business risk refers to the variability in annual earnings due to change in sales. If
a concern accepts a considerably more risky investment proposal than the average, the
business risk complexion is bound to change and investors are quite likely to expect an
increase in Cost of Capital. However, we assume no change in business risk and cost of
capital determined ignoring the change in business risk is used as accept/reject
criterion.
(ii) Financial Risk is also unaffected: It is also our assumption that financial risk
complexion would also remain unchanged. Financial risk refers to the risk on account of
pattern of capital structure. Here also, there may be a chance of capital structure being
changed due to acceptance of a particular investment proposal. This changed capital
structure would give rise to financial risk and suppliers may be demanding higher rate
than the cost of capital, ascertained on the basis of original capital structure. However,
one assumes that capital structure will remain constant, i.e., additional funds required
to finance the new project can be raised in the same proportion as the concerns existing
financing.
Thus, the cost of capital discussed here does not consider the business risk and financial
risk. It is something like rate of return with zero-risk level.
Controversial Views Regarding the Cost of Capital
There are two important approaches in this regard: (a) Traditional Approach; (b)
Modigliani and Miller (M.M.) Approach.
(a) Traditional Approach: According to this approach, a companys cost of capital
depends upon, the method and level of financing or its capital structure. It means that a
company can change its overall cost of capital by changing its capital structure, i.e.,
increasing or decreasing debt-equity ratio. Since the cost of debt is cheaper due to lower
but fixed rate and also tax saving (interest on debenture is allowed as deductible
expense) as compared to equity shares, the traditional theorists argue that the overall
cost of capital (i.e., weighted average cost) will decrease with every increase in debt
component in the total capital structure. However, debt component in the total capital
employed should be maintained at proper level because cost of debt is a fixed burden on
profit of the company. If the company has low profit, the increase in debt component
might have adverse impact upon the companys risk. The shareholders may raise their
expected rate of return due to increased risk in the business. The followers of the
approach are Ezra Solomon, Barges, Alexander and others.
(b) Modigliani and Miller Approach (M.M.Approach): According to this
approach, a change in capital structure (i.e., debt- equity ratio) does not affect the cost
of capital. In other words, the method and level of financing will not affect the cost of
capital; this will remain constant. This approach is based on the reasoning that each
change in debt-equity ratio offsets the change in one with the change in other due to
change in the shareholders expectations. For example, a change in capital structure in
favour of debenture may bring down the overall cost of capital but at the same time the
expectation of shareholders will go up from the present dividend rate because they will
find the business more risky. This increased expectation of shareholders will offset the
downfall in overall cost of capital and thus, the overall cost will not be affected at all.
Calculation of Specific Cost of Capital
To obtain the weighted cost of capital it is therefore necessary to evaluate each of these
items, which are discussed below:
A. Cost of Debt Capital - Debentures, Bonds, Public Deposits: In measuring
cost of capital, the first thing to be considered is the cost of debt e.g., debentures, bonds.
For calculating the cost of debt both contractual (explicit) as well as imputed costs
should be taken into consideration. The explicit costs are measured by interest rate duly
adjusted by tax rate. The yearly imputed interest can be calculated by the difference
between the actual receipts of debentures/bonds and the amount to be paid at the end of
maturity divided by the years of maturity.
Example:
Reliance Textiles issued 15% debentures worth Rs.1,000 maturing in 20 years. The
debentures are sold for Rs.960.
The yearly imputed interest will be...
Rs. 1,000 Rs. 960
---------------------- = Rs. 2
20 years
Ordinarily the yearly interest amount @ 15% will be Rs.150. Since debenture interest is
an allowable item for income tax purposes, assuming the corporate income tax is 50%,
the effective interest rate is only half of 15% i.e., 7.5% or Rs.75 and the 50% tax (half of
interest is borne by the Government). Thus, the cost of debentures issued at a discount
is calculated with the following formula:
Yearly interest amount + Yearly imputed interest
----------------------------------------------------- x Tax Rate
Average debenture receipts
Substituting the above figures in this formula,
Rs. 150 + Rs. 2
------------------------ x 50% = 7.76%
(Rs.960+ Rs. 1,000)/2
When it is possible for the borrower to issue debentures/bonds at full face value, before
tax cost of debt is simply the nominal (compound) rate of interest (which is also the
market yield).
Thus, the cost of debt finance can be defined in terms of required rate of return that the
debt financed investment must yield to prevent damage to the stock holders position.
That is, to keep the earnings available to the common stockholders unchanged, the firm
must, at least, earn a return equal to the interest rate on the .borrowed funds. If the firm
earns less than the interest rate, the earnings available to the common stockholders
would decrease and this may, in turn, affect the stock market price of the companys
share adversely. Further, the lowered market price of outstanding shares will set the
upper limit at which additional new shares can be issued. This is the implicit cost of the
use of debt finance, thus making the firm risky for future investment. However majority
of them favour the exclusion of such implicit costs in cost of capital consideration.
B. Cost of Preference Share Capital (Preferred Equity): Preference shares are
the fixed cost bearing securities. Their rate of dividend is fixed well in advance at the
time of their issue. Dividends on preference capital would be paid regularly except when
the firm does not make profits or is in a very tight cash position. The cost of preference
share capital is a function of the dividend expected by investors. The cost of a preference
share can be determined in the same manner as the cost of debentures except with one
difference. That is, the cost of preference share capital is not adjusted for taxes, because
dividend on preference capital is paid after taxes as it is not tax deductable. Thus, the
cost of preference share capital is substantially higher than the cost of debt.
Cost of Preference Share Capital = (P /C) x 100
Where, P = Dividend payments, C = Net proceeds from preference share issues
Normally, the stipulated rate of dividend is taken as P. For calculating the value of C
necessary adjustments have to be made for the terms of issues - issued at Par,
Discounter Premium. Thus,
(i) When preference shares are issued at Par,
C = Par value - Flotation expenses
(ii) When preference shares are issued at Discount,
C = Par value - (Discount + Flotation expenses)
(iii) When preference shares are issued at Premium,
C = Par value + Premium - Flotation expenses
C. Cost of Equity Capital: The cost of equity capital is the minimum rate of return
that the company must earn on the equity financed portion of an investment project in
order to leave the market price of the stock unchanged. Ordinarily the cost of equity
funds should not be less than the return the shareholders expect to get by investing their
equity funds elsewhere. That is, cost of equity funds must be somewhat greater than
shareholder1 s opportunity rate of return. Unlike the interest rate on debt and the fixed
rate of dividend on preference capital, the rate of dividend to the common stockholders
is not fixed. However the stockholders invest their money in common stocks with an
expectation of receiving dividends. But declaration of dividend depends upon the
management policy which varies as circumstances warrant.
The cost of equity can be found out by four approaches as stated below:
(i) D/P Ratio Approach - This approach is based on the principle as to what an
investor expects from the company when he puts his money in it. It means that the
investor arrives at a market price for a stock by capitalising dividends at a normal
rate torn. The glaring drawback of this approach is that it ignores earnings on
retained earnings. Further, it neglects the fact that stock market price rise may be
due to retained earnings also and not on account of high dividends alone.
(ii) E/P Ratio Approach - The proponents of this approach establish a
relationship between earnings and market price of the shares. Shareholders
capitalise a stream of unchanged earnings by the capitalisation rate of E/P in order
to evaluate their holdings. Some people use the current earnings in the current
market price for determining capitalisation rate while others recommend an
average of earnings at average market price. The chief limitation of this ratio
approach is that all earnings are not distributed to the shareholders in the form of
dividends. In fact, share price and earnings per share are not constant over the
years.
(iii) D/P + g Approach (or Dividend Model) - Solomon Ezra, Myron J.
Gordon, and Shapiro are the chief exponents of this approach. This approach takes
into consideration one important fact, namely, what the investor really gets after
he has invested. He usually gets the dividend as well as rate of growth in the
dividend, (g) which is assumed to be equal to the growth rate in earnings per share
and market price per share.
Expected Dividend per share
Cost of Equity capital = ------------------------------------------------------------ x
Growth rate
Market Price of a share less Discount and Floatation
costs
This approach too is criticised on the ground that it assumes that cost ;s equivalent
to cash outlay. Further all earnings whether paid in the form of dividend or not
belongs to shareholders and as such affect the market price of the shares.
(iv) Realised Yield Approach (or Earnings Model): This approach is based
on the rate of return actually realised for a period of time by investors in a
company. The supporters of this approach suggest that it can fairly be assumed
that past behaviour will materialise in the future and historic realised rate of
return would be an appropriate indicator of prospective investors required future
rate of return.
Expected Earnings per share
Cost of Equity capital = ----------------------------------------------------------- x
Growth rate
Market Price of a share less Discount and Floatation costs
D. Cost of Retained Earnings: According to some financial experts these funds are
cost-free or zero-cost. But this is not true for several reasons:
(a) If the entire earnings are distributed (and not retained) the company will have to
issue new shares for future finance and such that shares will have cost.
(b) If the earnings are distributed fully as dividends to the shareholders, they could have
invested these cash dividends in other stocks, bonds, real estate or in anything else and
earn a return equal to the opportunity cost.
Thus if the management decides to retain earnings, there is an opportunity cost
involved. This opportunity cost is simply the dividend foregone by shareholders. Here,
the firm must earn on the retained earnings at least as much as stockholders themselves
could earn in alternative investments of comparable risk. If the firm cannot invest
retained earnings and earn at least that rate of return, then it should pay these funds to
its stockholders and let them invest directly in other assets that do provide this return.
Many authors contend that the cost of retained earnings must take into account the
taxes a stockholder has to pay on dividends he receives as well as brokerage commission
to invest in another stock. Thus, a stockholder will have the use not of the entire
distribution of earnings but only of the portion that remains after taxes and brokerage
commission.
The total return he is able to achieve by investing the dividend in the stock of a Company
if identical risk is:
R = Ke (1 T) (1 - B)
where, T is his Marginal Tax Rate, and B is the brokerage / commission expressed as a
percentage.
E. Cost of Depreciation Funds: Depreciation (reserve) constitutes a second major
source of generated funds. Technically, depreciation itself is not a source of funds but it
serves to retained earnings as by a charge to costs and a corresponding understatement
of profit. As depreciation is simply an adjustment to the sources of retained earnings,
the cost of capital for depreciation should really be treated same as the cost of retained
earnings. Hence, the cost consideration relating to the retained earnings should also
apply to depreciation funds. The cost of depreciation funds should thus be equal to their
opportunity costs to the equity holders concerned. It should be noted that depreciation
is an admissible item for income tax purposes, its net effective cost would be after tax-
rate adjustment.
Alternative approach is to consider depreciation as a reduction of debt corresponding to
an investment in the asset-notionally, giving cash back to shareholders either by
purchasing shares in the market (which is not permitted by law) or a formal reduction in
capital. Therefore, the cost of capital of depreciation reserve can be taken at the
minimum as the cost of debt.
F. Cost of (Short Term Credit) Operating Debt: A short term credit either in the
form of bank credit or trade credit is also not cost-free to the firm. For instance, a
concern purchases goods worth Rs. 10,000 on terms Rs. 10,000/2/10, net 30 days. It
means if the payment is made within ten days the firm will be entitled for 2% cash
rebate; otherwise the payment is to be made within 30 days in full. If the concern wants
to use Rs. 9,800 for 20 days at a cost of Rs. 200 and then its actual cost works to 2.04%.
G. Weighted Average Cost of Capital: Once the cost factors for all the sources of
capital have been ascertained, they can be used to calculate the weighted cost of the
entire capital. Weighted average (also known as composite or overall cost of capital) is
an average of the costs of each of the sources of funds employed by the concern, properly
weighted by the proportion they hold in the capital structure. The following steps are
required to calculate the average cost of capital:
(a) ascertain the costs of individual components of the capital structure;
(b) multiply the cost of each source by its proportion in the capital structure;
(c) add the weighted costs of all sources of funds to get the weighted cost of
capital.
It should be noted that the component costs to be used to calculate the weighted cost of
capital should be the after-tax costs. The weighted average cost of new or incremental
capital is known as the marginal cost of capital.
There are several limitations in computing weighted average cost of capital.
(i) Determining the Weights: The first limitation arises with reference to
assigning proper weight to the specific components of financing on sound basis.
Normally, there are two types of bases for assigning weights - book values versus
market values. Book values are historical weights. When the market value of any
component method of financing differs from its book value the weighted average
cost of capital calculated will differ accordingly. This case is more frequent in case
of equity shares.
The cost of capital based on the market value approach is usually higher than it
would be if the book value is used. The market value weights are sometimes
preferred to the book value weights, for the market value represents the true
expectations of the investors. However the market value suffers from the following
limitations: (a) market value undergoes frequent fluctuations and has to be
normalised, (b) the use of market value tends to cause a shift towards larger
amounts of equity funds, particularly when additional financing is undertaken.
In the light of these limitations of the market value approach, it is desirable to use
the book value weights. This method has the following advantages: (a) it is easy
to know the book value, (b) the capital structure targets are usually fixed in terms
of book value, (c) investors are interested in knowing the debt-equity ratio on the
basis of book values, (d) it is easier to evaluate the performance of a management
in procuring funds by comparing on the basis of book values.
(ii) Choice of Capital Structure: The choice of the capital structure to be used
for determining the average is also not an easy task. Three types of capital
structure are there: current capital structure, marginal capital structure or
optimum capital structure. Generally current capital structure is regarded as the
optimum capital structure but it is not always correct. In other words, a firm can
not measure its costs directly at the derived capital structure, there costs can only
be estimated.
(iii) Untrue Assumptions: First of all, it is assumed that the firms existing
capital structure is optimal and the proposed increment capital is also optimal in
the existing structure. It does not come always true. Secondly it is also assumed
that the cost of raising funds is independent of the volume of funds raised. This
assumption also does not hold good in actual life.
Average cost of capital cannot be used in the following circumstances:
-When the company is trying to bring about radical changes in its debt policy, and
- When the dividend policy of the company is being changed with the objective of
readjustment of proportion of retained earnings.
Please use headphones
Illustration 1
Tantex Limited has 10% irredeemable debentures of Rs. 1,00,000. Par value of
debentures is Rs. 100. Find out the cost of capital, if debentures have been issued (i) at
par, (ii) at discount of 10% and (iii) at premium of 10%.
Solution
Case(i)... at par
P = 10, C=100,
Cost of capital = (10 / 100) x 100 = 10%
Case (ii)... at discount of 10%
P=10, C = 100 - 10 = 90,
Cost of capital = (10 / 90) x 100 = 11.11%
Case (iii)... at premium of 10%
P=10, C = 100 + 10 = 110,
Cost of capital = (10 / 110) x 100 = 9.09%
Illustration 2
DCM Limited has issued 9%, 10,000 Preference Shares of Rs. 100 each, and has
incurred the following expenses out the cost of capital: Underwriting commission 2%,
brokerage 1%, other expenses Rs. 10,000. If the present company tax rate is 50%, what
will be the cost of capital before tax and after tax?
Solution
P = 9,
Floatation charges (per Rs. 100)
Underwriting Commission = 2
Brokerage = 1
Other expenses (10,000/10,000) = 1
------
4
------
C = 100 - 4 = 96,
It = P/C x 100 = 9/96 x 100 = 9.375%
Id = It / (I - T) = 9.375 / (1 - 50%) = 9.375 / 0.5 = 18.75%
Illustration 3
From the facts given below, calculate the cost of retained earnings:
(i) The company has net earning amounting to Rs. 50,000.
(ii) It is expected that the retained earnings, if distributed to the shareholders, can be
invested by them in securities carrying return of 10% p.a.
(iii) The shareholders of the company are in 30% tax (marginal) brackets.
(iv) Shareholder will have to incur 2% brokerage cost for making new investments.
Solution
Profit before distribution 50,000
Less: Income tax 30% - 15,000
---------
Profit after tax 35,000
Less brokerage 2% - 700
---------
Retained earmings for investment 34,300
---------
AD = (34300/100) x 100 = 3430
I = AD/RE x 100 = 3430/50000 x 100 = 6.86%
where, RE = Cost of retained earnings
AD = Earnings from Alternative Investments of Retained Earnings
Alternatively, it can be calculated as under also:
Ir = Expected Rate (1 - Td) (1-B)
= 10 (1 - 0.3) (1 - 0.02) = 10 x 0.7 x 0.98 = 6.86%
Illustration 4
Compute the weighted average cost of capital from the following information:
Rs. Lakhs Before-tax costs
Equity Capital 3 15%
Preference Shares 2 13.5%
Retained Earnings 2 15%
Debentures 3 15%
-------------
10
-------------
Solution
Method of
financing (i)
Rs. Lakhs
(ii)
Proportion
(iii)
Cost before
tax (iv)
Cost after
tax (v)
Weighted Cost
(vi)
[(iii) x (v)]
Equity capital 3 30% 15% 15% 4.50%
Retained earnings 2 20% 15% 15% 3.00%
Preference capital 2 20% 13.5% 13.5% 2.70%
Debenture capital 3 30% 15% 7.5% 2.25%
10 100% 12.45%
Therefore, the weighted average cost of capital is 12.45%
REVIEW QUESTIONS
1. Define cost of capital. Explain its significance in financial decision-making.
2. How is the cost of debt computed? How does it differ from the cost of preference
share capital?
3. Explain the different approaches to the computation of cost of equity capital.
4. The cost of retained earnings is less than the cost of new outside equity capital.
Consequently, it is totally irrational for a firm to sell a new issue of stock and to pay
dividends during the same year. Comment on this statement.
5. State briefly the assumptions on which the Gordon model for the cost of equity is
based. What does each component of the equation represent?
6. Discuss the various approaches to determine the cost of retained earnings. Which
approach do you consider better and why? Also explain the rationale of treating retained
earnings as a fully subscribed issue of equity shares.
7. How is the weighted average cost of capital calculated? Explain with a numerical
example.
PRACTICAL PROBLEMS
3. A company issues 10,000 irredeemable debentures of Rs. 100 each @ 15 per
cent. The company has to incur the following floatation charges or issue expenses:
Underwriting commission 1.5%, brokerage 0.5%, miscellaneous expenses (for
printing, advertising and counseling fees etc.) Rs. 10,000. Assuming that the tax
rate for the company is 50%, compute the effective cost of debentures to the
company if the debentures are issued:
(i) At par, (ii) At a discount of 10%, and (iii) At a premium of 10%.
[Ans.: (i) 15.464%, (ii) 8.64% and (iii) before tax 14.02%]
4. Determine the cost of equity shares of company X from the following
particulars:
(i) Current market price of a share is Rs.140.
(ii) The underwriting cost per share on new shares is Rs. 5
(iii) The following are the dividends paid on the outstanding shares over the past
five years:
Year Dividend per Share (Rs.)
1 10.50
2 11.00
2 12.50
3 12.60
4 13.40
(iv) The company has a fixed dividend payout ratio.
(v) Expected dividend on the new shares at the end of 1st year is Rs. 14.10 per
share.
[Ans: 15.44%.]
SUGGESTED READINGS
1. Chakraborthi, S.K. : Corporate Capital Structure and Cost of Capital, New Delhi,
Vikas Publishing House.
2. Chandra, Prasanna : Fundamentals of Financial Management, New Delhi, Tata
McGraw Hill Co.
3. Khan, M.Y. and Jain, P.K. : Financial Management, New Delhi, Tata McGraw Hill
Co.
4. Pandey, I.M, : Capital Structure and Cost of Capital, New Delhi, Vikas Publishing
House
- End of Chapter -
LESSON-11
CAPITAL STRUCTURE PLANNING
Learning Objectives
After reading this lesson you should be able to:
Understand the terms like Financial structure, Asset structure and Capital
structure
List out the advantages and disadvantages of equity and debentures
Identify the characteristics of sound capital structure
Explain capital-gearing
Lesson Outline
Financial Structure and Capital Structure
Equity, Preference and Debentures
Characteristics of sound capital structure
Capital gearing concept
Illustrative Examples
The term 'Financial Structure' refers to total liabilities while 'Assets Structure' refers to
total assets. Having determined the finance required for a project to be undertaken, the
question arises what shall be the sources of finance, i.e., what are the securities to be
issued, and what shall be the proportion of various securities. Deciding the proportion of
securities is deciding capital structure. Thus, capital structure refers to the proportion of
equity capital, preference capital, reserves, debentures, and other long term debts to the
total capitalisation. Capital structure decision is not taken only when starting an
enterprise. In the beginning the entrepreneur may decide a 'target capital structure'. But
the capital structure decisions are made whenever additional finances are to be raised.
Capital structure planning is a very important part of the financial planning, as it plays
an important role in minimising the cost of funds.
According to Gerestenberg, Capital structure of a company refers to the make-up of its
capitalisation and it includes all long term capital resources viz. shares, loans, reserves,
and bonds. While drafting a capital structure, care must be taken to see that it is flexible
i.e., it should be able to incorporate any future changes, if necessary. It is often
suggested that a capital structure should be such which can maximise the long run value
per ordinary share in the market; for an individual company, there is necessity for
attaining a proper balance among debt and equity sources in its capital structure.
Forms of Capital Structure
(1) Equities only : Under this form, the entire capital is raised from shareholders and
there is only one class of share known as Equities.
Advantages
(a) There are no fixed charges, dividends, etc, on the borrowings.
(b) The management can deal with the earnings as per their wish.
(c) No compulsion for directors to return the equity capital.
(d) Better public response as equity shares are cheap.
(e) If additional capital is needed, it can be readily arranged for by issuing
some more shares.
Disadvantages
(a) Over-subscription and over-capitalisation may take place if only equity
shares are issued.
(b) Too much increase in the value of shares may lead to speculation.
(2) Equities and Preference Shares : Under this form, the capital structure of
company consists of mixture of equity and preference shares.
Advantages
(a) The market for the companys securities is widened.
(b) The capital structure no longer remains rigid, but instead it becomes
elastic.
(c) Use of preference shares enables the company to arrange for additional
funds more easily.
Disadvantages
(a) The companys liability is increased since a fixed rate of preference
dividend has to be paid regularly to preference shareholders.
(b) It usually costs more to finance with preference shares than with
debentures.
(3) Equities, Preference Shares and Debentures
In this form, the capital structure of a company is made up of equity shares, preference
shares and debentures.
Advantages
(a) Financing with debentures is usually cheaper than financing with shares.
(b) It is advantageous for tax purposes because interest on debenture is
treated as an expenditure unlike payment of dividend.
(c) The company gains by trading on equity.
Disadvantages
(a) Payment of interest on debentures during depression may prove difficult
for the company.
(b) Trading on equity may give rise to more losses during depression.
Every finance manager aims at developing a sound and most appropriate capital
structure for the company. But can there be an optimum capital structure? There is
diversity of opinion on this point. Generally speaking a sound or optimum capital
structure is one, which:
(i) maximises the worth or value of the concern,
(ii) minimises the cost of funds,
(iii) maximises the benefits to the shareholders by giving best earning per share and
maximum market price of the shares in the long run, and
(iv) is fair to employees, creditors and others.
There is no hypothesis which can determine the precise optimum capital structure. In
practice, an optimum capital structure can be determined only empirically.
It is better to determine a range of proportion of debt and equity, which could be termed
as an appropriate capital structure rather than a precise ratio.
Please use headphones
Characteristics of Sound Capital Structure
(1) Simplicity : A complicated capital structure may not be understood by all, on the
contrary it may raise suspicions and create confusion. A capital structure must be as
simple as possible. At least in the beginning the concern shall resort to minimum
number of securities as a source of finance, only then the investors will respond quickly.
(2) Profitability : As already emphasised a sound capital structure shall be able to
maximise the profit and minimise the cost of funds.
(3) Solvency : Creditors and bankers are usually fair-weather friends. They extend
credit during prosperity of business. In difficult financial position they tend to withdraw
the credit. Thus, the excessive use of credit, may threaten the solvency of the concern. In
a sound capital structure debt shall only be a reasonable proportion of the total capital
employed in the business.
(4) Flexibility : A sound capital structure shall keep room for expansion or reduction
of capital. Usually the increase in capital is not a problem but reduction of capital is very
difficult. Equity capital is considered to be something sacred which cannot be reduced
except in accordance with the provisions of Companies Act, 1956. Flexibility can be
introduced into capital structure by opting for redeemable preference shares or
redeemable debentures as one of the securities to be issued for raising finance.
(5) Intensive use of funds : A sound capital structure shall provide the concern with
sufficient funds needed for operations. It shall not cause surplus or scarcity of capital, as
both have adverse effect on the profitably. Fair capitalisation shall be a natural
consequence of capital structure.
(6) Conservation : The capital structure shall be conservative in the sense that the
debt raising capacity of the concern shall not be exceeded. Capital structure shall
generate sufficient cash for future requirements but shall not lead to excessive cash with
the company.
(7) Provision for meeting future contingencies : A business is bound to have ups
and downs. It is inevitable because of the trade cycles. In the period of depression, it will
be difficult to raise funds. Such future contingencies shall be anticipated and capital
structure shall make provision for such contingencies. Making provision for
contingencies does not mean raising excessive capital when the market is favourable but
keeping less risky securities reserved for future issues.
(8) Control : The sound capital structure ensures that the control over the company
remains in the hands of equity shareholders.
(9) Economy : Having raised the capital, it has to be maintained. The total cost of
maintaining the different securities issued shall be kept to minimum. Subject to other
constraints, the capital structure selected shall be the most economical.
CAPITAL GEARING
The term "capital gearin" is used to describe the relationship between the equity share
capital (including all reserves and undistributed profits) and fixed interest/ dividend
bearing securities of company. Fixed interest/dividend bearing securities are preference
shares, debentures, public deposits, term loans etc. Such sources are known as fixed cost
securities or senior securities.
Equity Capital
Capital Gearing = -------------------------
Fixed cost securities
Gearing is said to be high if capital carrying fixed rate of interest/dividend is more than
the equity capital. Similarly, gearing is low if capital carrying fixed rate of
interest/dividend is less than the equity capital. When both the capitals are equal it is
said to be evenly geared. Thus, the gearing is in inverse ratio to the equity share capital.
That is to say,
High Gear = Low equity share capital; Low Gear = High equity share capital
The capital gearing also reveals the suitability, or otherwise of the companys
capitalisation, that is to say,
Equity capital > Loan capital = Over-capitalisation = Low gearing equity capital
Equity capital = Loan capital = Optimum capitalization = Even gear
Whether or not high gear ratio is good for the enterprise will depend upon its
profitability trend. Thus if the company can foresee a trend of continuous increase,
relatively more and more profit will be available to equity shareholders as compared to
preference shareholders and debenture holders. In such a case high gearing would be
better.
Capital gearing may be planned or may be historical, the latter describing a state of
affairs where the capital structure has been evolved over a period of time, but not
necessarily in the most advantageous way. Capital gearing ratio is not only important to
prospective investors but also to the company because it affects distribution policies, the
building up of reserves as well as a stable dividend policy Hence, it must be properly
planned.
The significance of the gear-ratio lies in the marked effects of variations in profit on
equity share dividends when capital is high-geared; the effects are much more marked
than when capital is low-geared, as the following table shows:
-----------------------------------------------------------------------------------------------
Distribution of Profits
------------------------------------------------------------
Capital Structure Rs 1,60,000 Rs 1,82,000 Rs 1,50,000
-----------------------------------------------------------------------------------------------
(A) High Geared
Rs 6,00,000 Debentures (13%) 78,000 78,000 78,000
Rs 5,00,000 Preference shares
(12%) 60,000 60,000 60,000
Rs 2,00,000 Equity shares 22,000 44,000 12,000
(11%) (22%) (6%)
-----------------------------------------------------------------------------------------------
(B) Low Geared
Rs 1,20,000 Debentures (13%) 15,600 15,600 15,600
Rs 1,80,000 Preference shares (12%) 21,600 21,600 21,600
Rs 10,00,000 Equity shares 1,22,800 1,44,800 12,800
(12.3%) (14.5%) (11.3%)
-----------------------------------------------------------------------------------------------
The increase in distributable profits from Rs. 1,60,000 to Rs. 1,82,000 raises the rates of
possible dividend on the equity shares. High geared capital, from 11 % to 22%, an
increase of 105%. Low geared capital, from 12.3% to 14.5%, an increase of just over 18%.
A decrease in profits, from Rs. 1,60,000 to Rs. 1,50,000 reduces the rate of dividend.
High geared capital, from 11% to 6% - a decrease of 50%. Low geared capital, from 12.3%
to 11.3% - a decrease of just over 8%
Movements in equity dividend rates are thus, much wider when the capital is high-
geared than when it is low-geared; and the equity shares with high geared capital are
inclined to be speculative in consequence. In times of prosperity the speculative investor
will naturally tend to look for shares in companies with high geared capital, and in time
of recession to companies whose capital is low geared. The policy of using fixed cost
securities (debt capital including preference share capital) in the capital structure is
simply known as the policy of Trading on Equity. That is to trade on the strength of
the equity (shareholders).
Trading on equity may be of two types :
(i) Trading on thick equity meaning low-geared capital structure and
(ii) Trading on thin equity meaning high-geared capital structure.
Conditions for Trading on Equity
The following are the important requirements or conditions for the successful operation
of this policy:
(1) Stable Earnings : The permanent or long term borrowing should be undertaken
only when a reasonable stability of income makes the required payment of interest to
the debenture holders fairly certain. A company whose earnings are reasonably stable
may be justified in trading on equity. But if the earnings are subjected to violent
fluctuations borrowings should be resorted to a limited scale.
(2) Large Investment in Fixed Assets : Large amounts of fixed property constitute
a valuable adjunct for borrowing money, since they give the lender a feeling of security
and an assurance that the company will not vanish overnight. Generally, stable earning
and large fixed assets accompany each other. The public utility services provide such
unique combination; hence, they are in a position to benefit from this policy.
(3) Well Defined and Established Field of Enterprise : Third requirement for
satisfactory trading on the equity is that the field of enterprise be well defined and
established. The new and untried ventures should be invariably financed with the equity
shares.
(4) Cost of Borrowings : The next condition on this policy is the increasing cost of
borrowings. As the proportion of funds borrowed from debentures increases increased
investment risk tends to increase the rate of interest to be paid. But this check is
operative in a perfect money market only where tenders are thoroughly competent to
measure the risks involved,
(5) Custom or Usage : The next important restriction on this policy is of a practical
character. It is the custom or usage of the industry concerned which builds up the
general standard beyond which neither issuing company nor the purchasing institutions
would like to go. Although custom will neither gain universal observance nor guarantee
certain safety, it nevertheless plays an extremely useful part in the world of finance.
Factors Determining the Pattern of Capital Gearing (Capital Structure)
1. Trading on Equity : Classified into two broad categories viz. (i) Internal factors and
(ii) External factors. Internal factors include 'trading on equity' which means taking
advantage of equity share capital to borrowed funds on reasonable basis. It refers to the
additional profits that equity shares earn because of issuing other forms of securities,
viz., preference shares and debentures. It is based on the theory that if the rate of
interest on borrowed capital and the rate of dividend on preference capital which are
fixed, is lower than the general rate of the companys earning, the equity shareholders
will get advantages in the form of additional profits as dividends.
2. Idea of Retaining Control : If the promoters want to retain effective control of the
company, they may raise funds from the general public by the issue of debentures and
preference shares. Debenture holders and preference shareholders are usually not given
the voting rights enjoyed by the equity shareholders.
3. Flexibility of the Capital Structure : Elasticity or flexibility is an essential sine
qua non of an ideal capital plan. From this point of view the capital structure should be
designed in such a way that both (i) expansion and (ii) contraction of capital may be
possible. It requires the fixed charges of the company should be kept well within its
earning capacity so that the new issues of capital may be issued in the initial stage and
be reserved for emergencies and for expansion of the company.
4. The Cost of Financing : The cost of raising finance by tapping various sources of
finance should be estimated carefully to decide which of the alternatives is the cheapest.
Interest, dividends, underwriting commission, brokerage, stamp duty, listing charges
etc., constitute the cost of financing. Those securities which involve minimum costs
should be preferred. The corporation incurs the lowest expense in selling debentures
and highest in raising equity capital. The financial structure, therefore, should be
judiciously diversified with suitable mix as to minimise the aggregate cost of financing.
5. The Purpose of Financing : The funds may be required either for betterment
expenditure or for some productive purposes. The betterment expenditure may be done
out of funds raised by share issues or still better out of retained earnings. Funds
required for expansion, purchase of new fixed assets etc., may be raised through
debentures, if assets contribute to the earning capacity of the company.
6. Requirements of the Potential Investors : An ideal capital plan is that which
suits to the requirements of different types of investors. The investors who care more for
the security of principal and stability of income usually go in for debentures. The
preference shares have got a good appeal for those investors who want a higher and
stable income with enough safety of investment. Ordinary shares are meant for those
who want to take risk and participate in the management in order to have higher income
as well as capital appreciation. The nominal value of the share should also be adjusted
so As to secure subscription from the middle and lower classes of society.
7. Capital Market Conditions : The conditions prevailing in the money market also
influence the determination of the securities to be issued. During periods of inflation,
when people have plethora of funds, investors are ready to take risk and invest in equity
shares. But during depression or deflationary periods, people prefer debentures and
preference shares which carry fixed rate of return. If, therefore, a company wants to
raise more funds it must carefully watch the market sentiments, otherwise it will not
succeed in its plans.
8. Legal Requirements : Legal provisions regarding the issue of different securities
should be followed. Not all types of business may be subject to these legal provisions but
for some these do apply. In India banking companies are not allowed by the Banking
Regulation Act 1949 to issue any type of securities except the equity share capital.
9. Period of Finance : When funds are required for permanent investment in a
company equity shares should be issued. But when funds are required to finance
expansion programme and the management of the company feels that it will be able to
redeem the funds within the life time of the company, it may issue redeemable
preference shares and debentures or obtain long-term loans.
10. Nature and Size of Business : Nature of business of the company also counts in
determining the capital structure. Public utilities having assured market and freedom
from competition and stability of income may find debentures as suitable medium of
financing. Manufacturing enterprises do not always enjoy these advantages, and
therefore, they have to rely, to greater extent, on equity share capital. Service and
merchandising enterprise having fewer fixed assets cannot afford to raise funds by long-
term debentures because of their inability to offer their assets in mortgage for the loans.
11. Asset Structure : Composition and liquidity of asset may also influence the capital
structure decision of the firm. Firms with long-lived assets, especially when demand for
output is relatively assured - public utilities, for example-use long-term debt,
extensively. Similarly, greater the liquidity the more debt that generally can be used, all
other factors remaining constant. The less liquid the assets of firm, the less flexible firm
can be in meeting the fixed charges obligations.
12. Provision for Future : Financial planners always think of keeping their best
security to the last instead of issuing all types of securities at one stretch.
Illustration 1
There are three companies namely A, B and C whose owned capital in each company is
Rs. 1,00,000. They earn Rs. 10,000 Rs. 15,000 and Rs. 8,000 respectively. Each
company is in need of Rs. 1,00,000 as additional capital and it is hoped that the
company will be able to maintain the same rate of earnings. If they issue 14% debentures
what will be the impact on equity?
Solution
Comments: The analysis shows that company A and C should not obtain its additional
funds through 14% debentures. They should issue equity shares for additional funds.
Illustration 2
If a company has 30% debt and 70% equity and earns 25% on total capital before taxes,
what is the percentage on equity, assuming it pays 15% for debt capital and taxes are
50%?
Illustration 3
Kothari Oriental Leasing & Finance Company is a new firm that wishes to determine an
appropriate capital structure. It can issue 8% debt and 6% preferred and has a 50% tax
rate. The initial capitalisation of the firm will be Rs. 50 lakhs composed of Rs. 100 each.
The possible capital structure is:
90,000
Illustration 4
The Indo- American Co. Ltd. had the following capital structure on December 31,1994:
Rs.
7% Debentures 12,00,000
8% Bank Loan (Long-term) 2,00,000
9% Preference Shares of Rs. 10 each 14,00,000
38,000 Equity Shares of Rs. 100 each 19,00,000
Retained
earnings 13,00.000
________
_____
60,00,000
________
_____
The present earnings before interest and taxes are Rs. 18,00,000. The company is
contemplating an expansion programme requiring an additional investment of Rs.
10,00,000. It is hoped that the company will be able to maintain the same rate of
earnings. The company has the following alternatives:
(i) To issue debentures at 8%
(ii) To issue preference shares at 10%
(iii) To issue equity shares at a premium of Rs.10 per share.
Examine these alternatives in all their bearings and advise the company, (assume
income tax rate at 55%)
Solution
Comparative Statement of EPS in Different Alternatives
--------------------------------------------------------------------------------------------------------
---
Earnings per share III Alternative - II Alternative -
I Alternative - at present (Rs.) Issue of
equity Issue of preference Issue
of shares (Rs) shares @10%
(Rs) debentures (Rs)
--------------------------------------------------------------------------------------------------------
---
Total earnings (EBIT)
on present capital
of 9,00,000 9,00,000 9,00,000 9,00,000
Rs. 60,00,000
Total earnings on new
capital of Rs. 10,00,000 --
1,50,000 1,50,000 1,50,000
at present rate*
--------------------------------------------------------------------------------------------------------
---
Total
earnings 9,00,000 10,50,000 10,50,000 10,50
,000
Less: Interest on bank
loan @ 8% Rs.16,000
interest on debenture - 1,00,000 - 1,00,000 - 1,00,000 -
1,00,000
@ 7% Rs.84,000
Less: Interest on
proposed debenture -- -- --
80,000
under I Alternative @8%
--------------------------------------------------------------------------------------------------------
---
Profit before tax
(PBT) 8,00,000 9,50,000 9,50,000 8,70,000
Less: Tax @
55% 4,40,000 5,22,500 5,22,500 4,78,500
--------------------------------------------------------------------------------------------------------
---
Profit after tax
(PAT) 3,60,000 4,27,500 4,27,500 3,91,500
Less: Dividend on
existing 1,26,000 1,26,000 1,26,000 1,26,000
preference shares @ 10%
Less: Dividend on proposed -- -- --
--
preference share @ 10%
Earnings for
equity 2,34,000 3,01,500 2,01,500 2,65,500
shareholders
No. of equity
shares 38,000 38,000 38,000 38,000
+ 16,667
= 54,667
Earning per
share 234000/38000 301500/54667 201500/38000 265500/3
8000
= 6.16 = 5.52 =
5.30 =6.99
--------------------------------------------------------------------------------------------------------
---
* Earning on Rs.60,00,000 capital = Rs.9,00,000
Earnings on additional Rs.10,00,000 = (9,00,000/60,00,000) x 10,00,000 = Rs.
1,50,000
Present equity shares = 38,000
Add: New equity shares @ Rs 60 per share = Rs.10,00,000 / 60 = 16,667
Comments:
The present rate of earnings per share is Rs. 6.16. It will be in the interest of the
company and the equity shareholders to raise additional amount of capital by issuing
8% debentures, because, the earning per equity share will increase to Rs. 6.99 under this
alternative. Hence, the other two alternatives should be rejected as because the earning
per equity share will be reduced to Rs. 5.30 and Rs. 5.52 respectively as compared to the
present earning per share of Rs. 6.16.
REVIEW QUESTIONS
1. What do you understand by balanced capital structure? State its the characteristics.
2. Explain the considerations involved in evolving a balanced capital structure of a
corporation.
3. What is an optimal capital structure? Why should a company aim at an optimal
capital structure?
4. Discuss the factors which enter into designing an ideal capital structure of a company.
5. Illustrate the meaning and significance of gearing ratio. What are the effects of high
and low gearing on the financial position of a company during the various phases of
trade cycles?
6. Trading on equity magnifies both profits as well as losses. Explain.
7. Trading on equity is conditioned primarily by the stability and certainty of earnings1.
Discuss fully the above statement and explain the considerations involved in evolving a
balanced capital structure for a corporation.
8. What restrictions have been placed on debt-equity ratio of companies by the
government of India and why? Discuss the advisability of keeping proper balance
between debt and equity.
PRACTICAL PROBLEMS
Compute the average rate of return (after taxes) on the long term capital invested in
these two companies.
3. You are called upon to make a comparative assessment of the following three possible
positions for a certain firm:
Position I Position II Position III
(Rs) (Rs) (Rs)
Debt 1,00,000 2,50,000 4,00,000
Equity 4,00,000 2,50,000 1,00,000
Total capital 5,00,000 5,00,000 5,00,000
(i) Calculate the debt-equity ratio.
(ii) Presuming that the rate of interest required to be paid on debt is 15%. Calculate the
(maximum) rate of dividend payable to equity shareholders when the rate of earning is:
(a) 12% (under position I, II, and III)
(b) 16% (under position I, II, and III)
(c) 24% (under position I, II, and III)
SUGGESTED READINGS
1. Chandra, Prasanna: Fundamentals of financial Management, New Delhi, Tata
McGraw Hill Co.
2. Pandey, l.M.: Financial Management, New Delhi, Vikas Publishing House.
3. Paul, S.K.R: Financial Management, Calcutta, New Central Book Agency.
4. Kulshrestha, R.S.: Financial Management, Agra, Sahitya Bhawan.
- End of Chapter -
LESSON -12
LEVERAGE IN CAPITAL STRUCTURE
Learning Objectives
After reading this lesson you should be able to:
Understand the concept of leverage
Identify 'business risk' and 'financial risk'.
Explain and calculate financial and operating leverages
Examine the impact of leverages on E.P.S.
Lesson Outline
Meaning of Leverage
Classification of Leverage - Financial Leverage - Operating Leverage - Combined
Leverage
Financial Leverage and Trading on Equity - Limiting Factors
Characteristics of Operating Leverage
Illustrative Examples
Cost structure, capital structure and asset structure are very important factors in
maximising earnings per share (EPS) or return on equity (ROE) of a company. Cost
structure in terms of fixed and variable costs, gives rise to 'operating leverage' and the
(optimal) capital structure, in terms of fixed cost and variable cost securities, to financial
leverage. The optimal capital structure is the one that strikes a balance between these
risks and returns and thus maximises the price of the stock. The capital structure
decision is significant managerial decision which influences the shareholders return and
risk and ultimately the value of firm. Before discussing operating and financial leverages
let us consider the concept of leverage first.
Meaning of Leverage
The term 'leverage' has been borrowed from physical science where it refers to a device
(lever) by which heavy objects (weights) are lifted with a small force. In business
parlance, it refers to the relationship between percentage changes in fixed cost and in
earnings before interest and taxes (EBIT) viz. operating profit. Thus, leverage may be
defined as the employment of assets out of funds for which the firm pays a fixed cost or
fixed return. The fixed cost or fixed return may be thought of as the fulcrum of a lever.
When the revenues less variable costs (or earnings before interest and taxes) exceed the
fixed cost or fixed return, positive favourable leverage results. When the operating
income is less than the fixed cost or fixed return, the result is negative or unfavourable
leverage.
Leverage belongs to the category of capital-gearing. This is an American term which has
approximately the same meaning as "gearing". It is one of the important tools in the
hands of corporate financial managers. If used judiciously it can maximise the return to
equity shareholders.
Classification of Leverages
Leverage may be of five kinds:
(i) Return on Investment Leverage
(ii) Asset Leverage
(iii) Financial Leverage
(iv) Operating Leverage and
(v) Combined or Composite Leverage
(i) Return on Investment Leverage: It is an index of operational efficiency.
Sales EBIT EBIT
ROI Leverage = ----------------- x ------------- = ----------------
Total Assets Sales Total Assets
(ii) Assets Leverage: Assets turnover is the ratio of sales to total assets. Sales divided
by total assets aspect of ROI leverage is often referred to as Assets Leverage.
(iii) Financial Leverage: Financial Leverage (also known as Capital Leverage or
Capital Structure Leverage) refers to the use of funds obtained by fixed cost securities
such as debentures, bonds, preference shares etc., in the hope of increasing the return to
equity shareholders. It simply indicates the changes that take place in taxable income as
a result of changes in operating income. It signifies the existence of fixed cost securities
in the capital structure of a company. Debentures, bonds, preference shares etc., whose
rates of interest or dividend as the case may be are prefixed and do not change with the
level of profit. When in the capital structure of a company fixed cost securities are
greater as compared to equities the leverage factor or degree of leverage is said to be
large. That is a favourable or positive financial leverage which arises when the company
earns more from assets purchased with the funds (raised through fixed cost securities)
than return or costs payable for the use of the funds. An unfavourable or negative
financial leverage arises when the earnings from such assets are less than the fixed cost
payable on such funds.
Financial Leverage causes change in the earnings before interest and taxes (total
earnings before interest and taxes may remain the same). When there is change in
operating profit there will be a sharp change (i.e., at a greater rate) in the Earnings per
(Equity) Share (EPS). Increasing EPS is one of the reasons for higher market price of
shares. Thus, a favourable financial leverage causes the EPS to rise faster if other things
remain the same.
By using an indifference chart, one can study the relationship between earnings before
interest and taxes (EBIT) and earnings per share under various alternative methods of
financing. The degree of sensitivity of earnings per share to EBIT is dependent upon the
explicit cost of the method of financing, the number of common stocks to be issued, and
the nearness to the indifference point. Although an EBIT-EPS chart is useful in
analysing the explicit cost of various methods of financing, it does not take into account
any implicit costs inherent in the use of a specific method of financing.
Percentage of change in EPS
Degree of Financial Leverage = --------------------------------------
Percentage of change in EBIT
Alternatively,
Operating Profits EBIT
Degree of Capital Structure Leverage = ----------------------- = -----------
EBFT - Interest EBT
Financial Leverage and Trading on Equity
Quite often the terms financial leverage and trading-on-equity are used inter-
changeably. Although the concepts try to explain the impact on Return on Equity (ROE)
of the capital structure there is a subtle difference between the two. As pointed by one
authority on financial management, financial leverage explains the impact on EPS
(ROE) of changes in operating profit, given the capital structure proportions of debt,
preference and equity. Trading-on-equity, on the other hand, explains the impact of
ROE of change in capital structure proportions, given the level of operating profit.
Financial Breakeven
Financial Breakeven is defined as the value of EBIT that makes EPS equal to zero. At
financial breakeven, the firms EBIT is just sufficient to cover its fixed financing costs
(Interest and Preference dividend) on a before tax basis, leaving no earnings for
common shareholders. Above the financial breakeven the EBIT the firm produces a
positive level of earnings available to common shareholders and a positive EPS. Below
this level, profit available to common shareholders and EPS are both negative. It is thus
possible for a firm to earn a positive level of EBIT even though its EPS is negative. This
will happen when the firms EBIT is positive but less than its financial breakeven level.
If financial leverage is calculated at financial breakeven, the resulting coefficient of
financial leverage has an undefined value i.e., zero value.
Significance of Financial Leverage
Financial leverage is employed to plan the ratio between debt and equity so that earning
per share is improved. Following is the significance of financial leverage:
(1) Planning of Capital Structure : The capital structure is concerned with the
raising of long-term funds, both from shareholders and long-term creditors. A
financial manager has to decide about the ratio between fixed cost funds and
equity share capital. The effects of borrowing on cost of capital and financial risk
have to be discussed before selecting a final capital structure.
(2) Profit Planning : The earnings per share is affected by the degree of
financial leverage. If the profitability of the concern is increasing then fixed cost
funds will help in increasing the availability of profits for equity stockholders.
Therefore, financial leverage is important for profit planning. The levels of sales
and resultant profitability are helpful in profit planning. An important tool of
profit planning is break-even analysis. The concept of break-even analysis is used
to understand financial leverage. So financial leverage is very important for profit
planning.
Please use headphones
Limiting Factors
Increased debt has a psychological impact on investors who consider investment in the
company more risky. This financial risk offsets the increasing market price and brings
down the price-earnings ratio (P/E). What should be the premium for this financial risk
(known as implicit cost)? It will depend on the nature of the industry and the image of
the organisation.
Another checking factor for this increase in market price of shares is the cash outflow
over a period of time and limits the debt capacity of the firm. A large amount, of
borrowed capital will require increased cash inflows to meet the fixed charges of interest
and repayment of principal. The inability to generate sufficient cash flows to meet the
fixed obligations may cause cash insolvency in the firm and thus put it in a higher risk-
class. Even a possibility of cash inadequacy will increase the explicit cost of debt and
thus bring down the rising trend of EPS and P/E ratio. While introducing leverage to get
a higher EPS, cash budgets should be prepared so that the probability of being out of
cash with the increment of debt is negligible.
Another limiting factor on increased EPS due to financial leverage is the scarcity of
loanable funds at the prevailing rate of interest. The firm moves to a higher risk class
and, therefore, a higher interest rate will be demanded. The rate of gains from leverage
will certainly be checked but not stopped till the marginal rate of interest is equal to the
average cost of capital. When debts are not available at a reasonable rate of interest, it is
a point of caution for the firm. The investors view the concern more risky and ultimately
bring down the P/E ratio. Risk is a dynamic condition and the position can be improved
by paying off debts from the surplus earnings, thus improving the debt-equity position.
The optimum leverage situation will be the point where the marginal cost of debt is
equal to the companys average cost of capital.
With the introduction of financial leverage, the cost of debt remains fixed over a period
of time and, therefore, the weighted average cost of capital falls, which encourages the
firm to take up such projects as were previously above the cut-off rate. Expansion of
business due to low cost of capital offers the advantage of growing bigger and stronger
in a competitive market. The cost of equity automatically goes up which means a higher
market price for the shares.
Need for caution: From the above discussion, a few conclusions can be drawn for
successfully introducing financial leverage in a firm to maximise the wealth of
shareholders. Introduction of cheaper fixed costs funds rapidly increases the earnings
per share, thereby pushing up the market price of the shares and boosting the firm's
image. Leverage also brings down the overall cost of capital and thus induces the firm to
expand and become stronger. But this tool must be used cautiously so that the debt is
not increased to the extent where the firm is put in a very high risk class offsetting the
gains of leverage with a decrease in the Price-Earnings ratio.
Financial leverage can be harmful in the hands of a novice as over-enthusiasm to boost
the market price of the shares can lead to insolvency in adverse times if long-term cash
budgets with justifiable probability distribution are not prepared. The rate of gains is
checked by the demand for higher rate of interest due to increased risk in the firm, but
this should not be treated as a halting point as the situation can be improved by paying
off debts from surplus earnings and by following a low payout policy.
Illustration 1
A company has a choice of the following three financial plans. You are required to
calculate the financial leverage in each case and interpret it.
X Y Z
(Rs) (Rs) (Rs)
Equity Capital 2,000 1,000 3,000
Debt 2,000 3,000 1,000
Operating profit (EBIT) 400 400 400
Interest @ 10% on debt in all cases
Solution
The financial leverage will be computed as follows in each of these financial plans:
X Y Z
(Rs) (Rs) (Rs)
Operating Profit 400 400 400
Interest (10% on debt) 200 300 100
----------------------------------
Profit before tax (PBT) 200 100 300
----------------------------------
Financial leverage (OP / PBT) 400/200 400/100 400/300
= 2 = 4 =1.33
Financial leverage as explained earlier indicates the change that will take place in the
taxable income as a result of change in the operating income. For example, taking
Financial Pan X as the basis, if the operating profit decreases to Rs.200, its impact on
taxable income will be as follows:
Operating profit (OP or EBIT) Rs.200
Less: Interest Rs.200
Profit before Tax (PBT) Rs. 0
Financial leverage in case of Plan X is 2. It means that every 1% change in operating
profit will result in 2% change in taxable profit. In the above case, operating profit has
decreased from Rs.400 to Rs.200 (50% decrease). As a result the taxable profit has
decreased from Rs.200 to zero (100% decrease).
Illustration 2
A company has the following capital structure: Rs.
Equity share capital 1,00,000
10%Wreference share capital 1,00,000
8% Debentures 1,25,000
The present EBIT is Rs. 50,000. Calculate the financial leverage assuming that company
is in 50% tax bracket.
Solution
Rs.
Operating Profit 50,000
Less: Interest on debentures 10,000
Pref. dividend (pre-tax basis) 20,000 30,000
----------------
Profit before tax 20,000
----------------
Financial leverage = OP / PBT = 50,000 / 20,000 = 2.5
Illustration 3
The capital structure of a company consists of the following securities.
Rs.
10% Preference share capital 1 ,00,000
Equity share capital (Rs. 10 per share) 1,00,000
The amount of operating profit is Rs. 60,000. His company is in 50% tax bracket. You
are required to calculate the financial leverage of the company.
What would be new financial leverage if the operating profit increase to Rs. 90,000 and
interpret your results.
Solution
Computation of the Present Financial Leverage
Rs.
Operating profit (OP or EBIT) 60,000
Less: Preference dividend (after grossing up) 20,000
----------------
PBT 40,000
----------------
Present Financial Leverage = OP / PBT = 60,000 / 40,000 = 1.5
Computation of New Financial Leverage
Rs.
New Operating profit 90,000
Less: Preference dividend (after grossing up) 20,000
----------------
PBT 70,000
----------------
Present Financial Leverage = OP / PBT = 90,000 / 70,000 = 1.286
The existing financial leverage is 1.5. It means 1% change in operating profit (OP or
EBIT) will cause 1.5% change in taxable profit (PBT) in the same direction. For example,
in the present case operating profit has increased by 50% (i.e., from Rs.60,000 to Rs.
90,000). This has resulted in 75% increase in the taxable profit (i.e., from Rs. 40.000 to
Rs. 70,000).
Operating Leverage
The concept of operating leverage was in fact originally developed for use in making
capital budgeting decisions. Operating leverage may be defined as the tendency of the
operating profit to vary disproportionately with sales. The firm is said to have a high
degree of operating leverage if it employees a greater amount of fixed costs and a
smaller amount of variable costs and vice versa. Operating leverage occurs where a firm
has fixed cost that must be met regardless of volume or value of output or sales. The
degree of leverage depends on the amount of fixed costs. If fixed costs are high, even a
small decline in sales can lead to a large decline in operating income. If it employs more
fixed expenses/costs in its production process, greater will be the degree of operating
leverage. A high degree of operating leverage, other things held constant, implies that a
relatively small change of sales results in large change in operating income.
Higher fixed costs are generally associated with more highly automated capital intensive
firms and industries, the relationship between the changes in sales and the changes in
operating income. Operating leverage may be studied with the help of a break-even
chart or Cost-Volume-Profit analysis.
Firm A has a relatively small amount of fixed costs. Its variable cost line has a relatively
steep slope, indicating that its variable cost per unit is higher than those of other firms.
Firm B as considered to have a normal amount of fixed costs, in its operations and it has
a higher breakeven point than that of Firm A. Firm C has the highest fixed costs of all
and its break-even point is higher than either Firm A or Firm B. Once Firm C reaches its
break-even point, however, its operating profits rise faster than those of the other firms.
Firm A
Fig.12.1 Selling Price Rs. 2 per unit; Total Fixed Costs Rs. 20,000; Variable Cost
Rs.1.50 per unit.
Firm B
Revenue
Fig.12.2 Selling Price Rs. 2 per unit; Total Fixed Costs Rs. 40,000; Variable Cost
Rs.1.20 per unit.
Fig.12.3 Selling price Rs.2 per unit; Total Fixed Costs Rs.60,000; Variable costs Re.1
per unit
____________________________________________________________
_
Units sold Sales Operating costs Operating profit
Rs. Rs. Rs.
____________________________________________________________
_
20,000 40,000 80,000 -40,000
40,000 80,000 1,00,000 -20,000
60,000 1,20,000 1,20,000 0
80,000 1,60,000 1,40,000 20,000
1,00,000 2,00,000 1,60,000 40,000
1,10,000 2,20,000 1,70,000 50,000
1,20,000 2,40,000 1,80,000 60,000
____________________________________________________________
_
In general, higher a firm's operating leverage, the higher its business risk. If sale price,
cost and the like are held constant but output varies, then the higher the degree of
operating leverage, the greater is the degree of business risk. For most part, operating
leverage is determined by technology. Electrical utility firms, telephones, airlines, steel
mills, chemical companies, cement companies etc. have heavy investments in fixed
assets. This produces high fixed costs and operating leverage. Grocery/trading stores, on
the other hand, generally have significantly lower fixed costs, hence lower operating
leverage.
The degree of operating leverage can be measured with the help of the following
formula:
Percentage of change in sales volume Contribution
= ---------------------------------------- = ------------------ = C / EBIT
Percentage of change in income Operating Profit
Characteristics of Operating Leverage
(a) The degree of operating leverage depends upon the amount of fixed elements the
cost structure. Operating leverage is a function of three factors (i) the amount of fixed
cost, (ii) the contribution, and (iii) volume of sales.
(b) The concept of operating leverage cannot be applied at the Breakeven level, because
the denominator (i.e., operating profit) becomes zero.
(c) The operating leverage is a number (integer or fraction) and if the activity is
increased by a stated percentage the operating profit will be increased by the product of
that percentage and the operating leverage.
(d) The operating leverage decreases as the level of production or activity increases,
provided that other things remain the same. So, near about the break even volume of
production or sales, a small increase in the level of activity gives rise to a rapid increase
in profits. Companies acting just above the break-even capacity find it greatly profitable
to increase the activity.
(e) For levels of activity below the Break-even level, operating leverage is negative. In
that case it has to be interpreted that a given percentage increase or decrease in activity
will give rise to operating leverage limes that much percentage reduction or increase in
losses correspondingly.
(f) The operating leverage is the reciprocal (inverse) of the Margin of Safety. In view of
the reciprocal relationship, the inference is that the higher the operating leverage, the
lower will be the margin of safety and higher risk to the company.
Illustration 4
The installed capacity of a factory is 600 units. Actual capacity used is 400 units. Selling
price per unit is Rs. 10. Variable cost is Rs. 6 per unit. Calculate the operating leverage
in each of the following three situations:
1. When fixed costs are Rs. 400
2. When fixed costs are Rs. 1,000.
3. When fixed costs are Rs. 1,200.
The above example shows that the degree of operating leverage increases with every
increase in share of fixed cost in the total cost structure of the firm. It shows, for
example, in Situation 3 that if sales increase by rupee one, the profit should increase by
Rs. 4. This can be verified by taking Situation 3 when sales increase to Rs. 8,000. The
profit in such an event will be as follows:
Thus, the sales have increased from Rs. 4,000 to 8,000, i.e., a hundred percent increase.
The operating profits have increased from 400 to Rs. 2,000, i.e., by Rs.1,600 (giving an
increase of 400 per cent). The operating leverage is 4 in case of Situation 3, which
indicates that with every increase of one rupee in sales, the profit will increase four
times. This has been verified by the above example where a hundred per cent increase in
sales has resulted in 400 per cent increase in profits. The degree of operating leverage
may, therefore, be put as follows:
Percentage change in operating income
------------------------------------------- = 400/100 = 4
Percentage change in Sales
As a matter of fact, operating leverage exists only when the quotient in the above
equation exceeds one.
Composite or Combined or Total Leverage
Operating and Financial leverage combined themselves in a multiplicative form to bring
about a more proportionate change in EPS (ROE) for a given percentage change in
activity. This is because the dispersion and risk of possible earnings per share are
increased. The two types of leverages may be combined in different ways to obtain the
desired degree of overall leverage and risks, i.e., a compromise between the total risk
and the expected return.
EBIT C C
------ x ------ = ------
EBT EBIT EBT
Overall Breakeven: Overall Breakeven is defined as the level of output that makes
EPS equal to zero. At this level of output the combined or composite leverage has an
undefined value i.e., zero value.
For both operating and financial leverage one can determine the degree of leverage. In
the first case related the change in profits that accompanies a change in output; secondly
the change in earnings per share that accompanies a change in timings before interest
and taxes. By combining the two formulae, one can determine effect of a change in
output upon earnings per share.
The operating leverage and financial leverage are the two quantitative tools used
measure the returns to the owners viz., earnings per share (EPS) and market price of the
operating shares; of the two tools, financial leverage is considered to be superior
because it focuses attention on the market price of the share.
Between operating and financial leverage, operating leverage is less amenable to
managerial control. This is so because operating leverage for a company is influenced by
to a greater extent by the magnitude of fixed costs. But fixed costs are very much linked
to the nature of industry, choice of technology and the asset structure employed. Thus
manufacturing (capital-intensive) industries like cement, steel and heavy engineering
are likely to have higher fixed costs and a high operating leverage when compared to a
trading industry. The super imposition of a high financial leverage on an already high
operating leverage will result in a higher combined leverage which is likely to expose the
company to a greater risk and putting the interests of shareholders in danger.
From the above discussion it is evident that there is less scope to exercise greater control
in respect of operating leverage, one can exercise control in regulating the degree of
financial leverage. To sum up, companies having a high operating leverage should plan
for a capital structure having more equity and less debt to bring down the combined
leverage to a reasonable level. Similarly, companies with a low operating leverage can
bring up combined leverage to a more reasonable level by planning for a high financial
leverage, thereby the management can secure for the shareholders the benefits of
leverage without exposing them to great risk.
Illustration 5
Calculate the Operating and Financial leverages from the following information:
Contribution
Operating leverage = ------------------ = 25,000 / 10,000 = 2.5
Operating Profit
Operating profit or EBIT
Financial leverage = -------------------------- = 10,000 / 5,000 = 2
Profit before tax
Note: Combined leverage = Operating leverage x Financial leverage = 2.5 x 2 = 5
Alternatively,
Contribution(C)
Combined leverage = ------------------------ = 25,000 / 5,000 = 5
Profit before tax (PBT)
Illustration 6
A firm has sales of Rs. 10,00,000 variable cost of Rs. 7,00,000, fixed costs of Rs.
2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are the operating,
financial and combined leverages?
If the firm wants to double up its Earnings Before Interest and Tax (EBIT), how much of
a rise in sales would be needed on a percentage basis?
Solution
Statement of Present Profit
Operating leverage = C / OP = 3,00,000 / 1,00,000 = 3
Financial leverage = OP / PBT = 1,00,000 / 50,000 = 6
Combined leverage = Operating leverage x Financial leverage = 3 x 2 = 6
or
Combined leverage = Contribution / PBT = 3,00,000 / 50,000 = 6
Statement of Sales needed to double EBIT
Operating leverage is 3 times i.e.33
1
/3% increase in sales volume causes a 100% increase
in operating profit or EBIT. Thus at the sales of Rs. 13,33,333, the operating profit or
EBIT will become Rs. 2,00,000 (i.e. double the existing one).
Illustration 7
(a) Calculate (i) degree of Operating leverage, (ii) degree of Financial leverage and (iii)
Combined leverage from the following data:
Sales of 1,00,000 units @ Rs. 2 per unit = Rs. 2,00,000
Variable cost per unit @ Re. 0.70
Fixed costs = Rs.1,00,000
Interest charges = Rs. 3,668
(b) Which combinations of operating and financial leverages constitute: (i) risky
situation and (ii) an ideal situation.
Solution
(a) (i) Operating leverage = C / OP = 1,30,000 / 30,000 = 4.33
(ii) Financial leverage = OP / PBT = 30,000 / 26,332 = 1.14
(iii) Combined leverage = Operating leverage x Financial leverage or C / PBT
= 4.33 x 1.14 or 1,30,000 / 26,332 = 4.9
(b) (i) High operating leverage combined with high financial leverage will constitute
risky situation.
(ii) Normal Situation: One should be high and another should be low i.e. if company
has a low operating leverage, financial leverage can be higher and vice versa.
(iii) Ideal situation: Both should be low.
Illustration 8
Calculate the degree of operating leverage (DOL), degree of financial leverage (DFL) and
the degree of combined leverage (DCL) for the following firms and interpret the results:
Solution
Interpretation: High operating leverage combined with high financial leverage will
constitute risky situation. One should be high and another should be low. Low operating
leverage combined with low financial leverage will constitute an ideal situation. Hence,
firm 'C' is an ideal one because it has low fixed cost and no interest P/V ratio also is
highest i.e., 80%.
REVIEW QUESTIONS
1. What is meant by the term 'Leverage'? What are its types? With what type of risk is
each leverage generally associated?
2. Why is increasing leverage also indicative of increasing risk? State the situation when
there is neither a financial risk nor business risk.
3. What is meant by the concept 'Finance Risk'? What is the relationship between
leverage and the cost of capital? Explain.
4. Why must the financial manager keep in mind the firms degree of financial leverage
in evaluating various financial plans? When does financial leverage become favorable?
5. How does break-even analysis help in profit planning and capital structure planning?
Explain with suitable illustrations.
6. Explain the significance of operating and financial leverage analysis for a financial
executive in corporate profit and financial structure planning.
7. What is combined leverage? What does it measure? What would be the change in the
degree of combined leverage, assuming other things being equal, in each of the following
situation? (a) the fixed cost increases, (b) the firms EBT level increases (c) the firms
sales price decreases, (d) the firms variable cost per unit decreases.
8. What is the "indifference Point" and why is it so called? What is the usefulness of it in
capital structure planning?
PRACTICAL PROBLEMS
1. The following information is available from the records of a company: Selling Price =
Rs. 28 per unit. Variable Cost = Rs. 18 per unit. Breakeven point = 4,000 units. You are
required to find out the degree of operating leverage for (i) 5,000 units of output, (ii)
6,000 units of output and (iii) 8,000 units of output.
[Ans.: (i) 5 times or 500% (ii) 3 times or 300% (iii) 2 times or 200%]
2. Below is given the profitability statement of Kamath & Company Ltd. for the year
ending 31st December, 1994:
From the above data, you are required to compute (i) Degree of Operating Leverage, (ii)
Degree of Financial leverage, and (iii) Degree of Combined Leverage.
[Ans.: (i) 2.5 or 250% (ii) 1.6 or 160% (iii) 4 or 400%]
SUGGESTED READINGS
Pandey, I.M.: Financial Management, New Delhi, Vikas Publishing House.
Rathnam, P.V.: Financial Advisor, Allahabad, Kitab Mahal
Sharma R.K. & Gupta S.K: Financial Management, Ludhiana, Kalyani Publishers
- End of Chapter -
LESSON - 13
THEORIES OF CAPITAL STRUCTURE
Learning Objectives
After reading this lesson you should be able to:
Know the different approaches to the problem of capital structure
Detail contention of the traditional approach and its limitations
Explain the M.M. Theory and offer criticisms to it.
Lesson Outline
Traditional (Financial Structure) Theory - Assumptions - Limitations
Modigliani-Miller Theory - Assumptions - Limitations
Criticisms of M.M. Approach - Empirical Evidences
Illustrative Examples
A great deal of controversy has developed recently over whether the capital structure of
a firm, as determined by its financing decision, affects its cost of capital, owner's wealth,
and society's wealth,
Theories of Capital Structure
Different theories have been propounded by different authors to explain the relationship
between capital structure, cost of capital and value of the firm. The main contributors to
the theories are Durand, Ezra Solomon, Modigliani and Miller. The important theories
discussed below are:
(1) Net Income Approach
(2) Net Operating Income Approach
(3) The Traditional Approach
(4) Modigliani and Miller Approach
(1) Net Income Approach
According to this approach, a firm can minimise the weighted average cost of capital and
increase the value of the firm as well as market price of equity shares by using debt
financing to the maximum possible extent. The theory propounds that a company can
increase its value and reduce the overall cost of capital by increasing the proportion of
debt in its capital structure. This approach is based upon the following
assumptions :
(i) The cost of debt is less than the cost of equity.
(ii) There are no taxes.
(iii) The risk perception of investors is not changed by the use of debt.
The line of argument in favour of net income approach is that as the proportion of debt
financing in capital structure increases the proportion of an expensive source of funds
increase. This results in the decrease in overall (weighted average) cost of capital leading
to an increase in the value of the firm. The reasons for assuming cost of debt to be less
than the cost of equity are that interest rates are usually lower than dividend rates due
to element of risk and the benefit of tax as the interest is deductible expense. This theory
is explained in the following illustration.
Illustration 1
(a) A company expects a net income of Rs. 80,000. It has Rs. 2,00,000, 8% Debentures.
The equity capitalisation rate of the company is 10%. Calculate the value of the firm and
overall capitalisation rate according to the Net Income Approach (ignoring income-tax).
(b) If the debenture debt is increased to Rs. 3,00,000, what shall be the value of the firm
and the overall capitalisation rate?
Solution
(a) Calculation of the value of the firm
Net Income Rs.80,000
Less: Interest on debentures (8% of 2,00,000) Rs.16,000
------------
Earnings available to equity shareholders Rs.64,000
------------
Market value of Equity x Equity capitalization rate = Shareholders' earnings
Market value of Equity = Shareholder's earnings / Equity capitalization rate
= 64,000 / 10% = 6,40,000
Market value of firm = Market value of equity + Market value of debentures = 6,40,000
+ 2,00,000
= Rs.8,40,000
Calculation of overall capitalization rate
Overall cost of capital (Ke) = Earnings (EBIT) / Value of the firm (V)
= 80,000 / 8,40,000 = 0.0952 = 9.52%
(b) Calculation of the value of the firm if debentures debt is raised to
Rs.3,00,000
Net Income Rs.80,000
Less: Interest on debentures (8% of 3,00,000) Rs.24,000
------------
Earnings available to equity shareholders Rs.56,000
------------
Market value of Equity = 56,000 / 10% = 5,60,000
Market value of firm = Market value of equity + Market value of debentures = 5,60,000
+ 3,00,000
= Rs.8,60,000
Calculation of overall capitalization rate
Overall cost of capital (Ke) = Earnings (EBIT) / Value of the firm (V)
= 80,000 / 8,60,000 = 0.093 = 9.30%
Thus, it is evident that with an increase in debt financing, the value of the firm has
increased and the overall cost of capital has decreased.
(2) Net Operating Income Approach
This theory as suggested by Durand is another extreme of the effect of leverage on the
value of the firm. It is diametrically opposite to the net income approach. According to
this approach, change in the capital structure of a company does not affect the market
value of the firm and the overall cost of capital remains constant irrespective of the
method of financing. It implies that the overall cost of capital remains the same whether
the debt-equity mix 50:50 or 20:80 or 0:100. Thus, there is nothing as an optimal
capital structure and every capital structure is the optimum capital structure. This
theory presumes that:
(i) the market capitalises the value of the firm as a whole;
(ii) the business risk remains constant at every level of debt-equity mix.
The reasons propounded for such assumptions are that the increased use of debt
increases the financial risk of the equity shareholders and hence the cost of equity
increases. On the other hand, the cost of debt remains constant with the increasing
proportion of debt as the financial risk of the lenders is net affected. Thus, the advantage
of using the cheaper source of funds, i.e., debt is exactly offset by the increased cost of
equity. Net income approach has been explained in illustration 2.
Illustration 2
(a) A company expects a net operating income of Rs. 1,00,000. It has Rs. 5,00,000, 6%
Debentures. The overall capitalisation rate is 10%. Calculate the value of the firm and
the equity capitalisation rate (cost of equity) according to the Net Operating Income
Approach.
(b) If the debenture debt is increased to Rs. 7,50,000 what will be the effect on the value
of the firm and the equity capitalisation rate?
Solution
(a)
Net Operating Income = Rs. 1,00,000
Overall Cost of Capital = 10%
Market value of the firm (V) = Net Operating Income (EBIT) / Overall Cost of Capital
(Ke)
= 1,00,000 / 10%
= Rs.10,00,000
Less: Market value of debentures = Rs. 5,00,000
Market value of equity = Rs. 5,00,000
Earnings available to equity
shareholders
Equity Capitalization Rate or Cost of Equity (Ke) = -------------------------------------------
Market value of equity
= (EBIT - I) / (V - B)
where
EBIT = Earnings before Interest and Tax,
V = Value of the firm,
B = Value of Debt capital (Bonds),
I = Interest on debt
Ke = (1,00,000 - 30,000) / (10,00,000 - 5,00,000) = 70,000 / 5,00,000 = 0.14 = 14%
(b) If the debenture debt is increased to Rs. 7,50,000, the value of the firm shall remain
unchanged at Rs. 10,00,000. The equity capitalisation rate will increase as follows:
Equity Capitalisation Rate (Ke) = (EBIT - I) / (V - B)
= (1,00,000 - 45,000) / (10,00,000-7,50,000)
= 55,000 / 2,50,000 = 0.22 = 22%
(3) Traditional (Financial Structure Theory) Approach
The traditional approach asserts that the cost of capital is not independent of the capital
structure of the firm and that there is an optimal capital structure. The contention of the
traditional school is that there are two types of risks, viz., Business Risk and Financial
Risk. While business risk (market fluctuations, availability of materials etc.,) will always
be there more or less in the same measure. Financial risk keeps on increasing after a
certain stage as more and more debt capital commitments are undertaken.
According to this school there is a correlation between the cost of capital (composite)
and Debt-Equity Ratio. The relation between the two, when graphically expressed, takes
the form of an U-shaped curve. Cost of Capital will be very high if Debt/Equity ratio is
zero. Upto a certain stage the weighted cost of capital will progressively come down with
the injection of debt element into the capital structure step by step. But after this lowest
(optimum) point cost of capital will go up (e.g., higher rate of interest may have to be
offered to attract the subsequent debenture holders) along with further introduction of
debt element.
Assumptions are:
(i) The capital structure of a company consists of only two kinds of capital, viz.,
bonded debt and ordinary shares. This assumption is made for the sake of convenience.
(ii) The firms total financing remains constant. The firm can change its degree of
capital leverage either by selling shares and use the proceeds to retire debentures or
by raising more debt and reduce the equity capital.
(iii) The business risk of a company remains constant over time and assumed to be of
independent of its capital structure and financial risk. This assumption is made with a
view to focus attention exclusively on financial risk, associated with the capital structure
decision.
(iv) The firms total assets are given and do not change. The investment decisions are,
in other words, assumed to be constant.
(v) Perpetual life of the firm.
(vi) The cost of debt capital remains the same irrespective of the amount of debt
capital introduced by a company into its capital structure. Though this assumption helps
to simplify the analysis but it is not realistic.
(vii) Corporate income-tax is assumed not to exist. While this assumption is not
realistic it is made with a view to consider whether debt capital proves more attractive
than equity capital even if the tax shield on interest expense is ignored.
(viii) The company follows a 100 per cent dividend pay-out policy. This assumption
is made with a view not to complicate the capital structure issue with the effect of
retained earnings and is consistent with assumptions and (x) given below.
(ix) A company is free to repurchase and cancel its ordinary shares. This
assumption is made with a view to simplify the analysis by confining it to the situation
wherein a company can change its debt-equity ratio without at the same time, changing
its total assets. Thus, the debt-equity ratio can be increased by issuing bonds to
repurchase and cancel shares of an equal amount; the ratio cap be decreased by issuing
shares to retire debt.
(x) Transaction costs are assumed to be nil.
(xi) The operating income of a company is assumed not to grow over time. As the
companys total assets will not grow, and the depreciation amount is just sufficient to
meet normal replacement, it may not be unrealistic to assume rigidity in the operating
income. This would also simplify the analysis.
(xii) All the investors are rational and have identical (subjective) probability
distributions of the future operating earnings of the company. This would simplify the
analysis as all the investors have identical views with regard to the future operating
income of the company.
(xiii) The cost of equity capital is higher than the cost of debt capital. This is very
realistic as shareholders risks are greater than the risks of long-term creditors.
The traditional position if financial structure is that a financing pattern which includes a
moderate amount of debt would generally result in a least-cost financing solution. Tue
argument generally advanced is that because moderate debt resulted in creditor claims
that were quite safe, creditors were not likely to notice any change in the default
possibilities of their earnings within safe range. Further, increased debt in the capital
structure did not cause creditor to experience any perceptible risk, and equity
shareholders were also-assumed to be responsible. The predicted result was that a
capital structure with some debt would result in lower cost of capital than a structure
with no debt. The traditional theory of financial structure fails to take into account the
increased financial risk arising out of debt after a moderate point. Obviously, it will
raise the cost of equity and hence the overall cost of capital (overall cost = cost of equity
+ cost of debt). However, at optimal capital structure, the marginal real cost of debt is
the same as the marginal real cost of equity. For degrees of leverage before that point,
the marginal real cost of debt is less than that of equity; beyond that point, the marginal
real cost of debt exceeds that of equity.
Thus the traditional position implies that the cost of capital is not independent of the
capital structure of the firm. The firm can increase the total value of the firm and bring
cost of capital down through the judicious use of leverage.
Illustration 3
Compute the market value of the firm, value of shares and the average cost of capital
from the following information: Net operating Income Rs. 2,00,000; Total Investment
Rs. 10,00,000; Equity capitalisation rate
(a) 10%, if the firm uses no debt
(b) 11%, if the firm uses Rs. 4,00,000 debentures
(c) 13%, if the firm uses Rs. 6,00,000 debentures
Assume that Rs.,4,00,000 debentures can be raised at 5% rate of interest whereas Rs.
6,00,000 debentures can be raised at 6% rate of interest.
Solution
Computation of market value of firm, value of shares & the average cost of
capital
Earnings
Average Cost of Capital = ------------------- = EBIT / V
Value of the firm
2,00,000 2,00,000 2,00,000
= ------------ ------------- -----------
20,00,000 20,36,363 18,61,538
= 10% 9.8% 10.7%
It is clear from the above that if debt of Rs. 4,00,000 is used the value of the firm
increases and the overall cost of capital decreases. But if more debt is used to finance in
the place of equity, i.e., Rs. 6,00,000 debentures, the value of the firm decreases and the
overall cost of capital increases.
(4) Modigliani-Miller Approach
The Franco Modigliani and Merton H. Miller (M.M.) Approach on Cost of Capital
suggests that there is no correlation between cost of capital and debt-equity ratio, i.e.,
average cost of capital of any firm is independent of its capital structure and equal to the
capitalisation rate of pure equity stream of its class. This hypothesis explains that the
value of the firm and cost of capital is same for all the firms irrespective of the
proportion of debt included in a capital structure.
M.M. Theorem:
The market value of any firm is independent of its capital structure and is given by
capitalising its expected nature at the rate appropriate to its risk class. That is, if changes
in capital structure do not affect a firms cashflows, the amount of debt used by the firm
has no impact on firms value. Since debt equity ratio has no effect on firms value, it
follows that capital structure decisions is irrelevant. The value of the firm is determined
by its cashflows. These cashflows are themselves a product of the productive assets the
firm. To change the value of the firm we must change the magnitude or the risk of the
firms cashflows.
In this simplified model, they abstract away the effect of any taxes. The crucial support
for this hypothesis is the presence of arbitrage in the capital markets. Arbitrage refers
to a practice of simultaneous purchase and sale of a security or currency in different
markets to derive benefits from price differential. Arbitrage precludes perfect
substitutes from selling at different prices in the same market. In their case, the perfect
substitutes are two or more firms.
The assumptions underlying this approach are :
(i) The average expected future net operating income is represented by a subjective
random variable and that all investors agree on the expected value of this probability
distribution.
(ii) All the firms can be placed in equivalent risk class, so that all firms in a class can be
termed homogeneous.
(iii) Capital markets are perfect; information is perfect to all investors; investors are
rational; and no information cost exists.
(iv) The corporate income-tax is absent.
(v) Personal or homemade and Corporate leverage are perfect substitutes.
(vi) Institutional investors are free to deal in securities.
(vii) There does not exist any transaction costs.
(viii) Rate of interest at which company and individuals could borrow is the same.
(ix) The dividend payout ratio is 100%.
When graphically expressed, the M.M. Position would be as follows :
Fig. 13.2 M.M. Approach to Cost of Capital and Capital Structure
The M.M. thesis accepts the inherent business risk, but rules out the existence or
anything called financial risk. It also seeks to prove that the 'arbitrage' mechanism irons
out the apparent differences in cost of capital consequent upon the injection of
additional debt.
Please use headphones
Example:
Consider two firms that comprise a single risk class. These firms are identical in every
respect that company A is not levered and company B has Rs. 30,000 of 5% bonds
outstanding. According to the traditional position, company B may have a higher total
value and lower average cost of capital than company A. The valuation of the firms is
assumed to be the following:
M.M. approach maintains that this position cannot continue, for arbitrage will drive the
total value of the two firms together. M.M. argues that investors in company B are able
to obtain the same return with no increase in financial risk by investing in company A.
Moreover, they are able to do so with a smaller investment. These arbitrage transactions
would continue until the share prices of both firms come to be the same.
To illustrate, suppose that a rational investor owned 1 per cent of company B worth Rs.
772.72 (market value). Given this situation, he should
(a) Sell his stock in company B for Rs. 772.72.
(b) Borrow Rs. 300 at 5 per cent interest.
(c) Buy 1 per cent of the shares of the company A, per Rs. 1,000.
Prior to this series of transactions, investors expected return on investment in company
B was 11 per cent on Rs. 772.72 investment on Rs. 85, Now his return in company A is
Rs. 100 (10 per cent on Rs. 1,000). From this return they must deduct Rs. 15 for interest
charge on his personal borrowings (5 per cent of Rs. 300). Thus this net return is Rs. 85.
Thus his return in both the companies is same. Moreover his cash outlay of Rs. 700 is
less than Rs. 772.72 investment in company B. Because of the lower investment the
investor would prefer to invest in company A under the conditions described. This
action on the part of arbitragers would continue till the value of firms turn out to be
same. As a result their average cost of capital also must be the same.
Illustration 4
A company has earnings before interest and taxes of Rs. 1,00,000. It expects a return on
its investment at a rate of 12.5%. You are required to find out the total value of the firm
according to the Modigliani-Miller theory.
Solution
According to the M.M. theory, total value of the firm remains constant. It does not
change with the change in capital structure.
Value of the firm (V) = Earnings (EBIT) / Overall cost of capital (Ke) = 1,00,000 / 12.5
%
= Rs. 8,00,000
Illustration 5
There are two firms X and Y which are exactly identical except that X does not use any
debt in its financing, while Y has Rs. 1,00,000 at 5% debentures in its financing. Both
the firms have earnings before interest and tax of Rs. 25,000 and equity capitalisation
rate is 10%. Assuming the corporation tax of 50%, calculate the value of the firm.
Solution
The market value of firm X which does not use any debt, Vx = EBIT / Ke = 25,000 / 10%
= Rs. 2,50,000
The market value of firm Y which uses debt financing, Vy = Rs.2,50,000+ 5 x 10,000
= Rs.3,00,000.
Criticisms of M.M. Approach
This approach has, however, been critisised. According to David Durand, personal
leverage is not equivalent to corporate leverage. Due to capital market
imperfections, the cost of borrowings may be higher for individuals than for the
corporation. This proposition further concentrates on equilibrium state, which in actual
practice is unrealistic.
MMs theory seems to have ignored the vital fact that business risk is a function of
the degree of financial leverage. If a firm fails to service the debt during the loan
periods, it is very likely to collapse and will, therefore, not survive to reap the benefits of
leverage during the loan periods. Further, bank policy involves high costs and the
probability of the firms having to bear these costs tends to rise with leverage.
Another objection hurled against the MMs proposition is that it is unrealistic to assume
that there is no restriction on institutional investors in respect of their
dealing in securities. In real life situations, funds that many institutional investors
are not allowed to engage in the home made leverage that was described. Furthermore,
the Reserve Bank of India regulates margin requirements in respect of different types of
loans and has stipulated the percentage of advances under a margin loan. As a result, a
significant number of investors cannot substitute personal for corporate leverage.
It is also unrealistic to presume that there are 'no transaction costs'. In actual practice
security dealers have to incur brokerage, underwriting commission and similar other
costs in buying and selling corporate securities. Consequently, effectiveness of the
arbitrage mechanism may be impeded. Arbitrage will take place only up to the limits
imposed by transaction costs, after which it is no longer profitable. As a result the
leveraged firm could have a slightly higher total value.
The assumption of no corporate tax is basically wrong. Nowhere in the world corporate
income has been untaxed. As a matter of fact everywhere taxation laws have provided
for deductibility of interest payments of debt of calculating taxable income. If this is so,
debt becomes relatively much cheaper means of financing and the financial manager is
naturally encouraged to employ leverage. For that very reason debt may be preferred to
preferred stock. In view of this controversy, Modigliani and Miller in their subsequent
paper admitted that given the tax factor overall cost of capital can be lowered as more
leverage is inducted in capital structure of the firm. Consequently, the total market value
of the firm also increases with rising leverage.
To sum up, the Modigliani and Miller theory may be consistent with the assumption of
perfect competition. But since this assumption rarely holds in practice the financial
manager should, therefore, strive to achieve optimal capital structure. But
determination of optimal mix of debt in capital structure is not an easy matter. The most
direct method is perhaps to let the firms lenders locate that point. In negotiating with
the firm seeking loan, the long-term lenders put restrictions as protective clause in loan
covenant on the amount of additional debt the firm may acquire in future. The financial
manager may also detect the optimal point by noting, in course of negotiation for loan,
reluctance of lenders to lend at the earlier rate of interest or without incorporating
additional restrictions in the agreement. The market reaction to additional bond issues
being contemplated by the firm is manifested in share prices. Hence, optimal amount of
debt can be located by studying behavioural changes in share prices in response to the
trends that additional debt financing by the firms is under consideration.
Empirical Studies of the Leverage Effect
The M.M. approach has been tested by several researchers, the most important of them
being A. Barges, R.F. Wippern, L.V.N. Sarma and K.S. Hanumanta Rao.
Barge's Approach: A.Barges employed two approaches to test the validity of M.M.
hypothesis. First was the relation between the average cost of capital and the degree of
leverage employed which was analysed by him. Secondly the relation between yield of
the share and the debt equity ratio was analysed. The tests indicated that the average
costs had a tendency to decline and then to increase as leverage increased. His tests
revealed no significant correlation between equity shares yield, and debt equity ratio. In
the result in his analysis his calculation was that the M.M. hypothesis appeared to be
untenable.
Wippens Approach: He made statistical analysis on the basis of data from a number
of manufacturing industries. He argues that the debt equity ratio contains conceptual
biases irrespective of the fact whether book value or the market value is used. His results
revealed an increasing relationship between equity yield and leverage linearly. But the
ratio of increase in yield was not as much as that supported by M.M. approach. His
conclusion was in favour of the traditional approach in that share value can be increased
by the judicious use of debt financing.
Sarma and Rao's Approach: L.V.N.Sarma and K.S.Hanumanta Rao tested the M.M.
hypothesis by taking samples from several engineering industries. As a result of their
analysis, they got different results from those got by M.M, by investigating U.S. firms.
They concluded that their analysis revealed evidence in support of the proposition that
the value of the firm can be raised by a judicious use of leverage.
Reconciliation of the two Approaches:
A reconciliation between the two diametrically views has been made. The actual relation
between cost of capital and debt-equity ratio has been accepted to be somewhere
between the two views as given below:
Fig. 13.3 Reconciliation of Traditional and M.M. Approaches.
Cost of capital will come down initially as debt element is progressively introduced from
a zero-debt position. But after sometime and till a significant period in the life of the
company, cost of capital will not be influenced by debt equity ratio. This is represented
by the long horizontal segment of the curve. After this long period, of course, further
debt element would increase the composite cost of capital. This (reconciliation)
approach more or less represents the real situation.
REVIEW QUESTIONS
1. Explain "Net Income approach" to the problem of capital structure.
2. Explain "Net Operating Income Approach" as suggested by Durand to capital
structure planning.
3. Explain briefly the view of traditional writers on the relationship between capital
structure and the value of the firm.
4. Give a critical appraisal of the traditional approach and the Modigliani-Miller
Approach to the problem of capital structure.
5. Is the M.M. thesis realistic with respect to capital structure and the value of a firm? If
not, what are its main weaknesses?
6. How can the effect of profitability on designing an appropriate capital structure be
analysed? Illustrate your answer with the help of EBIT-EPS analysis.
7. "The total value of a firm remains unchanged regardless of variations in its financing
mix". Discuss this statement and point out the role of arbitraging and homemade
leverage.
SUGGESTED READINGS
1. Pandey, I.M: Financial Management New Delhi, Vikas Publishing House.
2. Rathnam.P.V.: Financial Advisor, Allahabad, Kitab Mahal.
3. Sharma R.K. & Gupta S.K : Financial Management, Ludhiana, Kalyani Publishers.
- End of Chapter -
LESSON - 14
EQUITY AND PREFERENCE SHARES
Learning Objectives
After reading this lesson you should be able to:
Understand the features of equity shares
Evaluate equity shares as a source of finance.
Explain Right shares, bonus shares
Know the different kinds of preference shares
Evaluate preference shares as a source of finance
Lesson Outline
Features of Equity Shares
Evaluation of Equity Shares as a source of finance
No-par Shares - Right Shares - Bonus Shares
Preference Shares
Evaluation of Preference Shares as a source of finance
Guidelines for issuing CCP shares
The equity share capital is the backbone of any company's financial structure. The word
'equity' means the ownership interest as measured by capital, reserves-and surplus. This
term is also used to refer to the unlimited interest of ordinary shareholders. Hence,
ordinary shares are often called 'equities'.
Features of Equity Shares
(1) Risk Capital: Equity shareholders have an unlimited interest in the company's
profits and assets. They are, in effect, the owners of the business. They provided the so-
called 'risk' or 'venture' capital of the company. In short, their prospects rise or fall with
the prosperity of their company and with the state of business conditions in general.
(2) Fluctuating Dividend: If the profits arc substantial, they may get good dividend;
if not, there may be little or no dividend, Thus, their return of income, i.e., dividend is of
fluctuating character and its magnitude directly depends upon the amount of profit
made by a company in a particular year.
(3) Changing Market Value: The par or paid up value of the equity share has no
relation to its market value. The former is fixed while the latter, i.e., the market value of
ordinary shares, depends mainly on the profit by the company. The market value is
determined by buyers and sellers who take into account earning dividends, prospects,
the quality and caliber of management and general business outlook.
(4) Growth Prospects: Equity share of a company may also act as 'growth' share i.e.,
with prospects for future growth in case the company over a period of has good scope for
quick expansion. Such, shares enjoy considerable of capital appreciation within 5 to 10
years.
(5) Protection against Inflation: Equity shares represent the best hedging or
insurance device, fully protecting investors against rising prices and against diminishing
purchasing power of the currency. Investments in fixed income securities such as
government security, debenture and preference shares are poor hedges in an
inflationary period.
(6) Voting Right: Equity shareholder enjoys a statutory right to vote in the general
meeting and thus exercise his voice in the management and affairs of his company. He is
also entitled to appoint a proxy to vote on his behalf and a proxy need not be a member.
His voting right is governed by the Articles but it must be in proportion to the amount
paid-up on shares. Usually one share one vote is the rule.
Evaluation of Equity Shares as a Source of Finance
While evaluating the potentialities of this source of finance, attention should be paid
both to its positive and negative aspects. From the Company's view point: (1) equity
shares are the most potent source of financing. Although a company may issue shares
under other circumstances, the main advantage of equity shares is that it provides a way
of raising funds for the company with no fixed commitment charges attached to it; (b)
Equity stock also facilitates the company to take benefits of leverage by taking debt
capital which is cheaper; (c) Equity shares do not create any charge on the assets of the
company and the assets may be used as security for further financing. All this
strengthens the credit of the company.
From investors viewpoint equity ownership gives the shareholders (i) an opportunity to
share in the profits when declared as dividends, (ii) an opportunity to make money on
appreciation in the value of the securities, (iii) to participate in Rights share issue or
bonus share issue, and (iv) the opportunity to vote for directors of the corporation. It is
especially important that the motives of investors be understood by those interested in
financial management because the securities must be made attractive to investors.
The above discussion of equity shares as a method of raising finance clearly brings out a
series of perquisites conferred on the company and shareholders. It must not, however,
be inferred that equity shares are free of limitations. In fact, the following problems
become apparent when one analyses the nature of equity shares: (a) the issuing of equity
capital causes dilution of control by the equity holders, (b) The exclusive use of equity
shares as a fund-raising device by the management deprives it from trading on equity
which results in losing opportunity of using cheap borrowed capital, (c) Also, the
excessive use of equity shares is likely to result in over-capitalisation with all its
attendant consequences, (d) It attracts only those classes of investors who can take risk.
Conservative and cautious investors (both individual and institutional) find it difficult to
subscribe for such issues.
No-par Shares
In the U.S.A. and Canada, many companies issue shares which have no-par or face
value. The total owned capital of the company is divided into a certain number of shares.
The share certificate merely states the number of shares held by a particular holder and
does not mention the face value of the share. The dividends on such shares are paid at
the rate of given amount per share instead of a certain percentage of the par value of
each share. Such shares cannot be issued in India, because the law requires every share
to have fixed nominal value. In the U.K., the Gedge Committee recommended that the
company law should allow companies to convert their ordinary shares having nominal
value into no par value shares.
The advantages usually claimed for such shares are:
(a) the balance sheet presents a realistic picture with such shares because the capital is
equal to the net worth (assets minus external liability) and is not an imaginary amount
as with shares of nominal value.
(b) Since the value of such shares is related to the earnings, the shareholders always
know the real value of their holdings.
(c) The shareholders are not liable to pay further calls because the total value of a no-par
share is collected in the beginning.
(d) The shares need not be marketed at a discount because there is no minimum jar
value of these shares. This avoids a lot of legal formality.
(e) Since the value of the shares is automatically adjusted with the earning capacity, no
reduction of capital is necessary.
On the contrary, the no-par value shares suffer from the following drawbacks:
(a) The no-par value shares may easily be used to deceive ignorant investors. In case of
such shares there is no standard by which fluctuations in share values can be
ascertained.
(b) Such shares make the balance sheet unduly complex and difficult to understand.
This makes the task of investors, creditors and tax authorities difficult.
(c) Unscrupulous management gets an opportunity to manipulate the sale proceeds of
shares and pay dividend out of capital.
(d) The creditors lose the additional security of uncalled capital which they get in case of
partly paid shares with par value.
(e) Since the capital account remains fluctuating from time to time, the promoters may
snatch unduly high amounts of remuneration for themselves.
Right Shares
Whenever an existing company wants to issue new equity shares, the existing
shareholders will be potential buyers of these shares. Generally, the Articles or
Memorandum of Association of the company gives the right to existing shareholder to
participate in the new equity issues of the company. This right is known as pre-emptive
right and such offered shares are called Right shares or Right Issue or 'Privileged
Subscription'. The term simply indicates the fact that such shares will be first offered to
the existing shareholders.
Under Section 81 of the Companies Act, 1956 where at any time after the expiry of two
years from the formation of a company or at any time after the expiry of one year from
the allotment of shares being made for the first time after its formation, whichever is
earlier, it is proposed to increase the subscribed capital of the company by allotment of
further shares, then such further shares shall be offered to the persons who, at the date
of the offer, are holders of the equity shares of the company, in proportion as nearly as
circumstances admit, to the capital paid on those shares at that date. Thus, the existing
shareholders have a pre-emptive right to subscribe to the new issues made by a
company. This right has at its root in the doctrine that each shareholder is entitled to
participate in any further issue of capital by the company equally, so that his interest: in
the company is not diluted.
Right Issue and Financial Policy
The issue of right shares always affects financial policy of the company as well as the
market. Some of the important ways in which financial policy is affected are given
below.
(i) When the right shares at low price available then share market of the existing shares
might be adversely influenced.
(ii) When the right shares at low-price are available then the potential investors might
feel tempted to invest money thereby the finances of the business can become sound.
(iii) Financial Policy will be unfavourably influenced in case right shares are offered to
existing shareholders much above their purchasing capacity.
(iv) When new shares have been added then less dividend will be paid and that will
adversely affect the business.
Whenever right shares are offered it is essential to review the market trends and
earnings position of the company so as to know how the shares are being traded in the
stock market. While fixing the price of the right shares, the following facts will have 1.0
be taken into consideration: (i) the price what the market can bear, (ii) state of the
capital market, (iii) trends in share market, (iv) profit earning capacity of the existing
shares, (v) the proposed plan of expansion, (vi) dividend policy of the company, (vii)
resource position of the enterprise, (viii) reserves position of the company, and (xi) the
size of the right issue.
Advantages of Right Issue
(a) Right issue gives the existing shareholders and opportunity for the protection of
their pro-rata share in the earning and surplus of the company,
(b) Existing shareholders can also maintain their proportion in the voting power as
before.
(c) There is more certainty of the shares being sold to the existing shareholders. If a
right issue is successful it is equal to favourable image and evaluation of the companys
goodwill in the minds of the existing shareholders;
(d) The flotation costs of a right issue will be comparatively lower than a public issue.
The expenses to be incurred, otherwise of shares are offered to public, are avoided.
Illustration 1
A corporation earns Rs. 80 lakhs after tax and has 18 lakh shares of Rs. 10 each
outstanding. The market price of a share is 25 times the EPS. The corporation plans 10
raise Rs. 180 lakhs of new equity funds through a rights offering and decides to sell the
new stock to shareholders at a subscription price of Rs. 60 per share. The financial
position before the company offers the right shares is as given below:
Balance Sheet as on.
(in Rs. Lakhs)
-------------------------------------------------------------------------
Liabilites Assets
-------------------------------------------------------------------------
Debentures @ 10% 800
Common Stock 200 Total Assets 2,000
Retained Earnings 1,000
----------- --------
Total 2,000 2,000
-------------------------------------------------------------------------
(i) How many rights will be required to purchase a share of the newly-issued stock?
(ii) What is the value of each rights?
(iii) What effect will the rights offering have on the price of the existing stock?
Solution
The corporation desires to raise Rs. 200 lakhs of new equity funds through a rights
offering. For this purpose, it will have to issue 3 lakhs of new shares to existing
stockholders.
New Equity Funds 1,80,00,000
----------------------------- = ------------------- = 3,00,000
Subscription price of a share 60
The outstanding stock of the corporation is 18 lakh shares. There are, therefore, 18 lakh
rights, as one share has one right. Hence,
(i) To purchase a share of the newly issued stock, 18,00,000 / 3,00,000 = 6 rights will
be required.
(ii) The value of each right
Mo - S 80 - 60
R = ------------- = ---------- = 20 / 7 = Rs. 2.86
N + 1 6 + 1
(iii) The stockholder has the choice of exercising his rights of selling them. If he has
sufficient funds, and if he wants to buy more shares of the company's stock, he will
exercise the rights. If he does not have the money, or does not want to buy more stock,
he will sell his rights. In either case, the stockholder will neither benefit nor lose by the
rights offering. This can be illustrated further. Suppose, a shareholder has 12 shares. As
each share has a market value of Rs. 80 per share, the stockholder has a total market
value of Rs. 960 in the companys stock. If he exercises his rights, he will be able to
purchase two additional shares (one share for 6 rights) at Rs. 60 each.
His new investment will thus amount to Rs. 960 + (60 x 2) = Rs. 1,080.
He now owns 12 shares of his company's stock which, after the rights offering have a
value of Rs. 1080 / (12+2)
= Rs.77.14
The value of his stock is Rs. 1,080, that is to say, exactly what he has invested in it.
Alternatively, if he sold his 12 rights, which have a value of Rs. 2.86 each as shown in (ii)
above, he would receive Rs. 34.32. He would now have his original 12 shares of stock,
plus Rs. 34.32 in cash. His original 12 shares of stock now have a market value of Rs.
77.14 each Rs.925.68 market value (77.14 x 12 = 925.68) of his stock plus Rs.34.32 in
cash is the same as the original Rs. 960 market value of stock with which he began (80 x
12 = 960). From a purely mechanical or arithmetical point, the stockholder neither
benefits nor gains from the sale of additional shares of stock through rights. Of course, if
he forgoes to exercise or sell his rights, or if the brokerage costs of selling the rights are
excessive, he may suffer a loss. But, in general, the issuing corporation would make
special efforts to minimise the brokerage costs; and adequate time is given to enable the
stockholder to take some action so that his losses are minimal.
Illustration 2
A company plans to issue common stock by privileged subscription. Twenty four rights
are needed to get one additional share of stock. The corporation declares the
subscription price at Rs. 9 against the current market price of Rs. 11 per share. You are
required to find out:
(a) The market value of one right when stock is selling rights;
(b) The market price of the stock when the stock goes ex-rights;
(c) The market value of a right when the stock sells ex-rights; and
(d) The value of one share of ex-rights stock, if only 5 rights are needed to get one
additional share of stock.
Solution
(a) The market value of one right, when the stock is selling rights on, is calculated by
the following formula:
Me - S
R = -----------
N
where Me is the rights on market price of outstanding stock;
S is the subscription price of the new stock;
N is the number of rights needed to purchase one new share.
In the above example,
R = (11 - 9) / 25 = 2/25 = Re. 0.08 = 8 paise
(b) The market price of the stock trading ex-right is computed by the following formula:
Me = Mo - R
where, Me is the market value of the stock trading ex-rights;
Mo is the market value of the stock with rights on;
R is the theoretical value of a right.
In the above example,
Me = 11 - 0.08 = Rs. 10.92
This can also be worked out with another formula:
(Mo x N) + S (11 x 24) + 9
Me = ------------------ = ------------------ = Rs. 10.92
N + 1 24 + 1
(c) The market value of 1 right, when the stock is selling ex-rights, may be calculated
with the following formula:
Mo - S 10.92 - 9
R = ------------- = ------------- = 1.92 / 24 = Rs. 0.08
N + 1 24
(d) The market value of one share of ex-rights stock, if it takes only 5 rights to subscribe
to an additional share of stock, will be:
(Mo x N) + S (11 x 5) + 9
Me = ------------------ = ----------------- = 64 / 6 = Rs. 10.66
N + 1 5 + 1
BONUS SHARES : Bonus shares are issued to the existing equity shareholders. When
the company has sufficient reserves and surplus but its cash position is weak, it may
think of issuing bonus shares. Issues of bonus shares in lieu of dividend are not allowed
as per section 205 of the Companies Act, 1956. By issue of bonus shares, the
accumulated profits and reserves of the company are converted into share capital and
hence it is also known as Capitalisation of Profits and Reserves.
Bonus shares may be paid to the existing shareholders in the following manners:
(a) Making the partly paid equity shares fully paid up without asking for cash from
shareholders; or
(b) Issuing and allotting equity shares to existing shareholders in a definite proportion
out of profits. For example, if a company has 50,00,000 equity shares of Rs. 10 each
fully paid up and reserves of Rs. 8,00,00,000. Now the company can issue bonus shares
in the ratio of 1 : 1, if desired.
Bonus shares are issued for any one of the following reasons:
(i) to give some benefit out of the reserves accumulated in excess of present or future
probable needs of the company;
(ii) to bring the issued share capital of the company in true relation to the capital
employed in the business;
(iii) to avoid exceptionally high profits and dividends from attracting competitors in the
line where monopoly has so far been enjoyed;
(iv) to prevent unduly high rates of dividends from dissatisfying their own employees
who might feel to have been underpaid and might seek for a claim to higher wages;
(v) to prevent such excessive profits from disturbing the companys business by creating
dissatisfaction amongst its own customers or suppliers.
Circumstances warranting the issue of bonus shares
(i) When the company wants to capitalise the huge accumulated profits and reserves;
(ii) When the company is unable to declare higher rates of dividend on its capital,
despite sufficient profits, due to legal restrictions on payment of dividends;
(iii) When the company cannot declare a cash bonus because of unsatisfactory cash
position and its adverse effects on working capital of the company;
(iv) When there is wide difference in the nominal value and market value of the shares
of the company.
Advantages of Bonus Shares
I. Advantages to the issuing company:
(a) Maintenance of liquidity position : A company can maintain its liquidity
position because cash dividends are not paid to the shareholders but bonus shares
issued by the company.
(b) Remedy for under-capitalisation : In under-capitalised concern the rate
of dividend is high. But by issuing bonus shares the rate of dividend per share can
be reduced and a company can be saved from the effect of undercapitalisation.
(c) Economic issue of securities : The issue of bonus shares is the most
economical whereas other types of securities cannot be issued at this minimum
cost.
(d) Other benefits : Issue of bonus shares increases the confidence of
shareholders in the company besides the conservation of control.
II. Advantages to investors:
(a) Tax saving : Bonus shares are issued out of profits and free from income tax
in the hands of individual investors. Otherwise had the profits been used for
payment of dividend, such payments are subject to income tax by the recipient of
dividend income.
(b) Increase in Equity holdings : Issue of bonus shares to existing
shareholders increases the size of individual shareholdings.
(c) Increase in income : In the long run the dividend income of the
shareholders is also increased. But it will be possible only when the company is
able to maintain the same rate of dividend as before on the increased capital also.
Disadvantages of Bonus Shares
(i) Issue of bonus shares excludes the possibility of new investors coming into the
company and throws more liability in respect of future dividend on the company shares.
(ii) Issue of bonus shares lowers the market value of the existing shares also in the
short-run.
Guidelines for issue of Bonus Shares
Issued by Securities and Exchange Board of India (SEBI) on 11th June 1992)
A company, shall, while issuing bonus shares, ensure the following:
1. No bonus issue shall be made within 12 months of any public/right issue.
2. The bonus issue is made out of free reserves built out of the genuine profits or share
premium collected in cash only,
3. Reserves created by revaluation of fixed assets are not capitalised.
4. The Development Rebate Reserve or the Investment Allowance Reserve is considered
as free reserve for the purpose of calculation of residual reserves test only.
5. All contingent liabilities disclosed in the audited accounts which have bearing on the
net profits, shall be taken into account in the calculation of the residual reserves.
6. The residual reserves after the proposed capitalisation shall be at least 40 per cent of
increased paid-up capital.
7. 30 per cent of the average profits before tax of the company for the previous 3 years
should yield a rate of dividend on the expanded capital base of the company at 10 per
cent.
Let the increased paid-up capital be Rs. 100. The residual reserve must be 40
percent, i.e. Rs. 40.
Total Rs. 100 + Rs. 40 = Rs. 140.
If total is Rs. 280, residual reserve must be (40 / 140) x Rs. 280 = Rs. 80
Reserve available for capitalisation Rs. 120 - Rs. 80 = Rs. 40
(ii) Profitability test
Average profits before tax during the last 3 years = Rs. 80
30 per cent of the average profit = (30 / 100) x Rs. 80 = Rs. 24
Rs. 24 should give a rate of dividend on the increased capital base at 10%
The increased capital base = (24 /10) x 100 = Rs. 240
Existing paid-up capital = Rs. 160
Amount available for capitalisation = Rs. 80 (Rs. 240 - Rs. l60)
Therefore, the amount available for capitalisation should be the lower of (i) and
(ii), i.e. Rs. 40
8. The capital reserves appearing in the balance sheet of the company as a result of
revaluation of assets or without accrual of cash resources are neither capitalised nor
taken into account in the computation of the residual reserves of 40 per cent for the
purpose of bonus issues.
9. The declaration of bonus issue in lieu of dividend is not made.
10. The bonus issue is not made unless the partly-paid shares if any existing, are made
fully paid-up.
11. The company (i) has not defaulted in payment of interest or principal in respect of
fixed deposits and interest on existing debentures or principal on redemption thereof,
and (ii) has sufficient reason to believe that it has not defaulted in respect of the
payment of statutory dues of the employees such as contribution to provident fund,
gratuity, bonus etc.
12. A company which announces its bonus issue after the approval of the board of
directors must implement the proposal within a period of 6 months from the date of
such approval and shall not have the option of changing the decision.
13. There should be a provision in the articles of association of the company for
capitlisation of reserves etc. and if not, the company shall pass a resolution at its general
body meeting making provisions in the articles of association for capitalisation.
14. Consequent to the issue of bonus shares, if the subscribed and paid-up capital
exceeds authorized share capital, a resolution shall be passed by the company at its
general body meeting for increasing the authorized capital.
15. The company shall get a resolution passed at its general body meeting for bonus
issue and in the said resolution the managements intention regarding the rate of
dividend to be declared in the year immediately after the bonus issue should be
indicated.
16. No bonus issue shall be made which will dilute the value or rights of the holder of
debentures, convertible fully or partly.
Further in respect of the nonresidential shareholders, it would be necessary for the
company to obtain the permission of the Reserve bank under the foreign exchange
Regulation Act, 1973.
PREFERENCE SHARES
'Preference' share as the name implies, have a prior claim on any profits the company
may earn ,but only a fixed rate of return (namely divident in this case) has been paid to
the debenture holders. Thus, it may suit the investor who wants limited but steady
return on his money. The preferential treatment is available on both the rights - right to
receive dividend and also right to receive back the capital in the event of dissolution or
liquidation, if there be any surplus.
Features of Preference Share
Preference shares have the following features:
(1) Return of income: As the name indicates, they have the first preference to get a
return of income, i.e.to share in the profits among all shareholders.
(2) Return of capital: Similarly, they have also the first preference to get back their
capital at the time of winding up of the company, among all shareholders.
(3) Fixed Dividend: As per terms of issue and as per articles of association, they shall
have a fixed rate dividend, e.g., a maximum of 15 percent cumulative or non-cumulative
as the case may be. Hence, they are called fixed-income securities.
(4) Non participation in prosperity: On account of fixed dividends, these
shareholders cannot have any chances to share in the prosperity of the company's
business. This drawback can be removed to some extent by granting them an additional
privilege to participate in the surplus profits along with equity shareholders at a certain
ratio, e.g. 2 : 1.
(5) Non-participation in Management: As per the Act, preference shares do not
enjoy normal voting rights and voice in the management of the company's affairs except
when their interests are being directly affected, e.g., change in their rights and privileges
or arrears of dividends for more than two or three years successively.
Voting Right of Preference Shares
From the commencement of the Amendment Act of 1974, no extra voting right can be
enjoyed by preference shares which were issued prior to April 1, 1956. However, private
companies which are not subsidiaries of public companies are not affected by this
Section.
Kinds of Preference Shares
1. Participating Preference Shares: The preference shares which are entitled to
participate in the surplus of profits of the company available for distribution over and
above the fixed dividend, are called as participating preference shares. Once the fixed
dividend on preference shares is paid, a part of the surplus profit is utilised for payment
of dividend to equity shareholders. The balance again may be shared by both equity and
participating preference shareholders. Thus, the participating preference shares are
entitled to (a) a fixed dividend and (b) a share in the surplus profits. The preference
shares, which do not carry a right to participate in the surplus profits in addition to a
fixed dividend, are called non-participating preference shares.
2. Redeemable Preference Shares: The share capital of a company can never be
returned to the shareholders during the life-time of the company. It will be returned to
them only at the time of winding-up of the company, should the proceeds of sale of
assets of the company remain after meeting the claims of its creditor But sec. 80 of the
Companies Act, 1956 permits a company limited by shares to issue preference shares
which may be redeemed after a specified period or at the discretion of the company, if so
authorised by the articles of the company. These preference shares are called
redeemable preference shares. It should also be remembered that the redemption of
redeemable preference shares does not amount to reduction of capital. However, the
issue of redeemable preference shares is subject to the following conditions:
a. The issue of redeemable preference shares must be duly authorised by the
Articles of Association of the company.
b. Preference shares should be fully paid so that they can be redeemed. It only
means that the partly paid-up shares cannot be redeemed.
c. Redeemable preference shares can be redeemed only out of the profits of the
company or out of the proceeds of fresh issue of shares specifically made for
the purpose of redemption.
d. If the shares are to be redeemed out of the profits of the company a sum equal to
the value of such shares should be transferred out of the net profits of the
company to a special reserve fund called "Capital Redemption Reserve Account".
e. The premium, if any, payable on redemption of the shares should have provided
for out of the profits of the company before the shares are redeemed.
f. New shares up lo the nominal value of the redeemable preference shares may be
issued for the purpose of redemption either before redemption of old shares or
within one month after the redemption of old shares.
g. Shares already issued cannot be converted into redeemable preference shares.
The preference shares which are not to be redeemed after a specific period are called
irredeemable preference shares. They become a perpetual liability to the company and
cannot be redeemed during the lifetime of the company.
With effect from 15/06/1988 in India a company cannot issue irredeemable preference
shares and existing irredeemable preference shares are to be redeemed within 10 years
from the above date or date of redemption whichever is earlier; Preference shares
having redemption period of ten or less years can be issued at present. If a company is
unable to redeem the preference shares, it has to petition to Company Law Board to
issue fresh redeemable preference shares in place of the existing including the dividend
there on. (Section 80A of the Companies Act 1956).
3. Cumulative Preference Shares: Normally when a company does not earn any
profit in a particular year no dividend on any share becomes payable for that year. But
the cumulative preference shares confer on the holders a right to dividend which is
cumulative in character. It only means that where in a particular year no dividend has
been declared on preference shares in the absence of profit, such unpaid dividends
would be considered as arrears and carried forward to subsequent years for the purpose
of payment. Only after the payment of such arrears from the profits of the company in
the subsequent years, any dividend on other type of shares can be paid. All preference
shares issued by a company are only cumulative unless otherwise stated in the articles of
the company. Those preference shares which do not carry cumulative right to dividends
are called non-cumulative preference shares. If a company does not earn any profit in a
particular year, neither dividend is declared on non-cumulative preference shares nor
the unpaid dividend is considered as arrears and carried forward to the subsequent year
for purpose of payment.
4. Convertible Preference Shares: The preference shares which carry the right of
conversion into equity shares within a specified period, are called Convertible
Preference Shares. The issue of convertible preference shares must be duly authorised
by the articles of association of the company. The preference shares which do not carry
the right of conversion into equity shares are called non-convertible preference shares.
Guidelines for Issue of CCP Shares
The following is the text of guidelines for issues of cumulative convertible preference
shares:
1. Applicability: The guidelines will apply to the issue of Cumulative Convertible
Preference (CCP) shares by public limited companies which propose to raise finance.
2. Objects of Issue: The objects of the issue of the above instrument should as under:
(i) setting up new projects, (ii) expansion or diversification of existing projects (iii)
normal capital expenditure for modernisation, and (iv) working capital requirements.
3. Quantum of Issue: The amount of issue of CCP shares will be to the extent the
company would be offering equity shares to the public for subscription. In case of
projects assisted by financial institutions, the quantum of the issue would be approved
by financial institutions/banks. The applicant company should submit to the Securities
Exchange Board of India (SHBI) a realistic estimate of the project costs, along with
copies of loiters indicating the approval/participation of the public financial institutions
in the financing of the project costs.
4. Terms of Issue:
(i) The aforesaid instrument would be deemed to be equity issue for the purpose of
calculation of debt equity ratio as may be applicable.
(ii) The entire issue of CCP would be convertible into equity shares between the
end of 3 years and 5 years as may be decided by the company and approved by
the SEBI.
(iii) The conversion of the CCP shares into equity would be deemed at being one
resulting from the process of redemption of the preference shares out of the
proceeds of a fresh issue of shares made for the purpose of redemption.
(iv) The rate of the preference dividend payable on CCP would be 10 per cent.
(v) The guidelines in respect of issue of preference shares, ratio of 1:3 as between
preference shares and equity shares would not be applicable to the new
instrument.
(vi) On conversion of the preference shares into equity shares, the right to receive
arrears of dividend, if any, on the preference shares upto the date of conversion
shall devolve on the holder of the equity shares on such conversion. The holder of
the equity shares shall be entitled to receive the arrears of dividend as and when
the company makes profit and is able to declare such dividend.
(vii) The aforesaid preference share would have voting rights, as applicable to
preference shares under the Companies Act, 1956,
(viii)The conversion of aforesaid preference shares into equity shares would be
compulsory at the end of 5 years and the aforesaid preference shares would not be
redeemable at any stage.
5. Denomination of CCP: The face value of aforesaid shares will ordinarily be Rs.
100 each.
6. Listing of CCP: The aforesaid instrument shall be listed on one or more stock
exchange in the country.
7. Articles of association of the company and resolution of the general
body: The articles of association of the applicant company should contain a provision
for the issue of CCP. Further the company shall submit with the application to the CCI a
certified copy of special resolution in this regard under Section 81 (IA) of the company.
This resolution shall specifically approve the issue of the CCP shares and provide for
compulsory conversion of the preference shares between the 3rd and 5th year as the
case may be.
8. Miscellaneous:
(a) All applications should be submitted to the SEBI in the prescribed form duly
accompanied by a demand draft for fees payable under the Act.
(b) The applications should be accompanied by a true copy of the letter of
intent/industrial license, whichever is necessary, or registration with the Director
General of Technical Development (DGTD) for the project.
(c) In respect of companies registered under the MRTP Act, they should ensure that the
requisite approval under the said Act has been obtained before making an application to
the SEBI. Documentary evidence of the foregoing should invariably be submitted with
the application.
(d) A certificate duly signed by the secretary and/or director of the company stating that
the information furnished is complete and correct should be annexed to the application.
Similarly, a certificate from the auditors of the company stating that the information in
the application has been verified by them and is found to be true and correct to the best
of their knowledge and information, be furnished.
Merits of Preference Shares
(i) These shares are preferred by people who do not like to risk their capital completely
and yet want an income which is higher than that obtainable on debentures and other
creditorship securities.
(ii) These shares have the merit of not being a burden on finances because dividend on
these will be paid if profits are available;
(iii) These shares are particularly useful if its assets are not acceptable as collateral
security for creditorship securities such as debentures, bonds etc.,
(iv) These shares can well save it from the higher interest which will have to be paid by it
in case it wishes to issue debentures against assets which are already mortgaged;
(v) The property need not be mortgaged as in the case of debentures if these shares are
issued;
(vi) Preference shares bear a fixed yield and enable the company to declare higher rates
of dividend for the equity shareholders by trading on equity;
(vii) The promoters can retain control over the company by issuing preference shares to
outsiders because these shareholders can vote only where their own interests are
affected ;
(viii) In the case of redeemable preference shares, there is the advantage that the
amount can be repaid as soon as the company gets more funds out of profits.
Evaluation of Preference Shares as a Source of Finance
The exact role of preference shares in meeting the financial requirements is debatable.
The attitude of financial managers towards preference shares seems to vary widely. This
divergence is probably explained by the 'in-between' nature of this type of ownership
security. In creating some sort of obligation to pay a fixed dividend, the company
assumes a risk to its credit rating and shareholders relations.
Reasons to issue preference shares are:
(a) it is desirable to enlarge the sources of funds for the business. Certain financial
institutions (and even individual investors) that can buy equity shares can not invest in
preference issues. The yield premium over debt is attractive to these and other investors
who wish to assume the risk of equity shareholders;
(b) the sale of preference shares may be an economical way of raising funds. If earnings
of assets exceed the dividend rate and the preference shares are non-participating, this
economy is obvious;
(c) the sale of preference shares makes it possible to do business with other peoples
money without giving them any participation in the affairs of management;
(d) Preference shares can be considered a type of semi-permanent equity financing;
(e) Preference share carries less risk than debt.
From the investor's viewpoint, preference share is safer than equity share within the
same company. Because of the priority over equity shares in the receipt of dividends and
repayment of capital, preference shareholders believe themselves to be in a stronger
position than equity shareholders. However, this advantage is somewhat offset by the
fact that preference shareholders can usually receive only a limited return on their
investment. In other words, preference shareholders sacrifice income in return for
expected safety.
Please use headphones
The limitations attached with preference shares are quite obvious:
(1) Those who doubt the usefulness of preference shares point out that it is too
expensive to use under the present tax structure. While the yield to investor on
preference shares is not much higher than on debt issues, the cost to the company is
more than double. It is so because the company cannot deduct this dividend on its tax
return; this fact is the principal drawback of preference shares as a means of financing.
In view of the fact that interest obligations on debt are deductible for tax purpose, the
company that treats to preference share dividend as a fixed obligation, finds the explicit
cost to be rather high.
(2) Critics of preference shares also argue that while no legal obligations exist to pay
dividends, the passing of preference dividends and accumulation of arrears can have an
adverse effect upon the credit of the company.
REVIEW QUESTIONS
1. What are the characteristics of equity shares?
2. Critically evaluate equity shares as a source of finance both from the point of (i) the
company and (ii) the investing public.
3. What do you understand by no-par shares? State the advantages claimed by such
shares.
4. What are Right Shares? What is its significance for financial management?
5. What do you mean by Bonus Shares? State the guidelines for issue of such shares.
6. Explain essential characteristics of preference shares.
7. State and explain the various kinds of preference shares.
8. State the conditions to which the issue of redeemable preference share is subjected to
in India.
9. Explain the merits and demerits of preference shares as a source of industrial finance
both from the point of (i) the company and (ii) investing public.
10. What are the relevant factors, necessary to be kept in mind by a corporate financial
controller in recommending the issue of (i) Bonus shares and (ii) Cumulative
Convertible Preference Shares?
SUGGESTED READINGS
1. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi, Tata
McGraw Hill Co.
2. Kulkarni, P.V.: Corporate Finance Bombay, Himalaya Publishing House.
3. Saravanavel, P.: Financial Management, New Delhi, Dhampat Rai & Sons.
- End of Chapter -
LESSON - 15
DEBENTURES AND BONDS
Learning Objectives
After reading this lesson you should be able to:
Understand the features of debentures
Detail the types of debentures
Distinguish between fully convertible and partly convertible debentures
Evaluate debentures as a source of finance
Know the SEBI guidelines to issue debentures
Lesson Outline
Features of Debentures
Type of Debentures
Advantages and Limitations of Debenture Finance
Procedure for the issue of Debentures
Suggestions to develop Debenture Market
A debenture is a document issued by the company as an evidence of debt. It is the
acknowledgement of the company's indebtedness to the debenture holders. Debentures
and bonds are called as creditorship securities. In the United States of America, only
unsecured bonds are termed as debentures. But in Britain, no distinction is made
between debentures and bonds. In India, the words 'debentures' and 'bonds' are used
interchangeably.
The Companies Act, 1956 has not defined as to what a debenture means. It simply states
that a "debenture includes debenture stock, bonds and any other securities of a
company whether constituting a charge on the assets of the company or not [Sec.
2(12)]." Thus, the Act only states that it is a kind of security that constitutes a charge by
way of security on issuing debentures. In other words, debenture is a long-term
promissory note that usually runs for duration of not less than ten years.
FEATURES OF DEBENTURES
Debenture financing has the following features:
(1) Debenture is a credit instrument: The debentureholder is a creditor of the
issuing company: Debenture is the promise by the company that it owes a specific sum
of money (debt) to the holder.
(2) Provision for a trustee: When the debenture issue is floated as a private
placement, the issuing company and the debenture buyers are the only parties to the
issue. When a debenture issue is sold to the investing public, there are three parties to
the issue: the issuer, the debentureholders, and the trustee.
(3) Debentureholders are entitled to periodical payment of interest at an agreed
rate.
(4) Debentureholders are also entitled to redemption of their capital as per the
agreed terms.
(5) Priority in case of liquidation: In the event that the issuing company is
liquidated, debentureholders' claims are honoured ahead of the shareholders' claims.
When more than one debenture issue must be retired, the priorities among the
debenture issues are contained in the indenture like the pari passu (meaning, with an
equal step) clause.
(6) Debentureholders have no voting rights. Under Section 117 of the Companies
Act, 1956, debentures with voting rights cannot be issued.
(7) Usually debentures are secured by charge on or mortgage of the assets of the
company.
(8) Debentureholders have the right to sue the company for any unpaid dues.
(9) They can enforce their claimover the security by the sale in case of default.
(10) They can apply for foreclosure or even for winding up of the company to
safeguard their interests.
TYPES OF DEBENTURES
There are several types of debentures. A brief analysis about the different types of
debentures is given below.
1. Registered Debentures: Registered debentures are those which are recorded with
a Register of Debentureholders with full details about the number, value and types of
debentures held by each of them. The payment of interest and the repayment of capital
is made to those whose names are registered with the company and duly in the Register
of Debentureholders. Registered debentures are not negotiable. Transfer of ownership
of these debentures cannot be valid unless the regular instrument of transfer, duly
stamped and signed both by the owner (transferor) and the transferee, is passed by the
Board of Directors. The transfer of such debentures is recorded in the Register of the
company.
2. Bearer Debentures or Unregistered Debentures: These debentures are
payable to the bearer of the debentures. The names of the debentureholders are not
recorded in the Register of debenture holders. They are negotiable instruments by
custom. So they are transferable by mere delivery. Registration of transfer is not
necessary.
3. Secured Debentures or Mortgage Debentures: These debentures are secured
fully or partly by a charge on the assets of the company. The charge may be either a fixed
charge or a floating charge.
4. Unsecured Debentures or Naked Debentures: These debentures are not
secured either fully or partly by a charge on the assets of the company. The general
solvency of the company is the only security for the debentureholders. Here, the
debentureholder is treated as an unsecured creditor.
5. Redeemable Debentures: These debentures are repayable after a certain period.
Sometimes they can be redeemed by the company on demand by the holders or at the
discretion of the company.
6. Irredeemable Debentures: These debentures are also known as "perpetual
debentures". These debentures are not repayable during the life-time of the company.
Such debt becomes due for redemption only when the company goes into liquidation or
when interest is not regularly paid as and when accrued.
7. Equitable Debentures: These debentures are secured by deposit of title deeds of
the property, with a memorandum in writing creating a charge.
8. Legal Debentures: These debentures are those in which the legal ownership of the
property of the corporation is transferred by a deed to the debentureholders as security
for the loans.
9. Preferred Debentures: Preferred debentures are those which are paid first in the
event of winding up of the corporation.
10. Ordinary Debentures: Also known as "second debentures", these debentures are
paid only after the preferred debentures have been redeemed.
11. Convertible Debentures: Holders of these debentures are given the choice to
convert their debenture holdings into equity shares of the company at stated rates after
a specified period. Thus these debentureholders get an opportunity to become
shareholders and take part in the company management at a later stage. On the basis of
convertibility, they can be classified into
(a) Non-Convertible Debenture (NCDs): These debentures cannot be
converted into equity shares and will be redeemed at the end of the maturity
period.
ICICI offered for public subscription for cash at par 20,00,000 16% unsecured
redeemable bonds (debentures) of Rs. 1000 each. These bonds are fully non-
convertible and interest paid half yearly on June 30 and December 31 each year.
The company proposes to redeem these bonds at par on the expiry of 5 years from
the date of allotment i.e. the maturity period is 5 years. But ICICI has also allowed
its investors the option of requesting the company to redeem all or part of the
bonds held by them on the expiry of 3 years from the date of allotment, provided
the bond holders give the prescribed notice to the company.
(b) Fully Convertible Debentures (FCDs): These debentures are converted
into equity shares after a specified period of time either at one stroke or in
installments. These debentures may or may not carry interest till the date of
conversion. In the case of a fully established company with an established
reputation and good, stable market price, FCDs are very attractive to the investors,
as their bonds are getting automatically converted into shares that may at the time
of conversion be quoted much higher in the market compared to what the
debentureholders paid at the time of FCD issue.
Recently three reputed companies, Apple Industries Limited, Arvind Polycot
Limited and Jindal Iron and Steel Company Limited have come out with the issue
of zero percent FCDs for cash at par. Let us take a look at the Jindal issue...
The total issue was for 3,01,72,080 secured zero-interest FCDs. Of these,
1,29,30,000 FCDs of Rs. 60 each were offered to the existing shareholders of the
company on Rights basis in the ratio of one FCD for every one fully paid equity
share held as on 30.03.93. The balance of 1,72,42,080 secured zero-interest FCDs
were offered to the public at par value of Rs. 100 each. The terms of conversion
were as follows: Each fully paid FCD will be automatically and compulsorily
converted into one equity share of Rs. 10 each at a premium of Rs. 90 per share
credited as fully paid up. Conversion into equity shares will be done at the end of
12 months from the date of allotment.
(c) Partly Convertible Debenture (PCDs): These are debentures, a portion of
which will be converted into equity share capital after a specified period, whereas
the non-convertible (NCD) portion of the PCD will be redeemed as per the term of
the issue after the maturity period. The non-convertible portion of the PCD will
carry interest right upto redemption, whereas the interest on the convertible
portion will be only upto the date immediately preceding the date of conversion.
Let us look at the Ponni Sugars and Chemicals in greater detail. The company is
offering PCDs worth Rs.2205 lakhs, of which Rs.605 lakhs is being offered to the
existing shareholders. The issue is for 14,70,000 16% Secured Redeemable PCDs
of Rs. 150 each. Out of this, 4,06,630 PCDs are by a of Rights Issue, in the ratio of
one PCD for every ten equity shares held. The balance 10,63,370 PCDs are offered
to the public. Of the total face value of Rs. 150, the convertible portion will have a
face value of Rs.60 and the non-convertible portion a face value of Rs.90. A
tradable warrant will be issued in the ratio of one warrant for every 5 fully paid
PCDs. Each such warrant will entitle the holder to subscribe to one equity share at
a premium that will not exceed Rs.20 per share within a period of 3 years from the
date of allotment of the PCDs. This is not included in the conversion at the rate of
1:10. The tradable warrants will also be listed in stock exchanges to ensure
liquidity. Interest at 16% on the paid-up value of the PCD allotted shall accrue
from the date of allotment, but interest on the convertible portion of the PCD will
be paid only up to the date immediately preceding the date of conversion. The
non-convertible portion of the PCD will be redeemed in the stages at the end of the
6th, 7th and 8th years from the allotment of the PCD.
(d) Secured Premium Notes (SPNs): This is a kind of NCD with an attached
warrant that has recently started appearing in the Indian Capital Market. This was
first introduced by TISCO which issued SPNs aggregating Rs.346.50 crores to
existing shareholders on a rights basis. Each SPN is of the face value of Rs.300. No
interest will accrue on the instrument during the first 3 years after allotment.
Subsequently, the SPN will be repaid in 4 equal installments of Rs.75 each from
the end of the fourth year together with an equal amount of Rs.75 with each
installment. This additional Rs.75 can be considered either as interest (regular
income) or premium on redemption (capital gain) based on the tax planning of the
investor.
The warrant attached to the SPN gives the holders the right to apply for, and get
allotment of one equity share for cash by payment of Rs. 100 per share. This right
is to be exercised between one and one-and-half years after allotment, by which
time SPN will be fully paid up. The instrument was first issued by IDBI, later
followed by SIDBI. The above bond issued by IDBI had a face value of Rs. 1 lakh
but was at a 'deep discounted' price of Rs. 2700. This bond appreciates to its face
value over the maturity period of 25 years. But a unique advantage of this bond is
that it gives the investor an option of contracting upto maturity or seek
redemption at the end every 5 years with a given deemed face value. These bonds
can be sold by the investor in the stock exchange and the difference between the
sale price and original cost acquisition will be treated as capital gain. The bond has
been assigned AAA rating by CRISIL, indicating the highest safety with regard to
payment of interest and principal.
The face value of SIDBI's Deep Discount Bond is also Rs. 1 lakh, but the initial
investment required is only Rs.2,500. These bonds have got AA rating from
CRISIL indicating high safety with regard to timely payment of principal and
interest.
Please use headphones
REASONS FOR ISSUING CONVERTIBLE BONDS
The management inserts conversion feature in bond indenture for four main reasons,
viz., to sweeten the issue, to eliminate debt with unduly restrictive conditions, to defer
the sale of equity stock and prevent dilution of earnings available to current
stockholders, and to reduce cost of financing. It is generally believed that convertible
bonds enjoy high marketability because of three-fold benefits available to bondholders.
Thus, a convertible bondholder has the advantage of certainty of income, the priority of
claim as to income and assets, and the opportunity of sharing in the profits if the
company prospers. Management uses conversion method to extinguish debt which is
unduly restrictive in terms, hampering the progress of the organisation, and to get rid of
burden of fixed obligation. Frequently, when there is a slump in stock market and
acquisition of capital through equity stock possess a great problem or the company has
been caught temporarily in financial trouble or due to poor cash dividend policy, it is felt
that the new stock-issue will elicit poor response from investors, then the management
may decide to defer the stock issue and float convertible bonds with an intention to
convert them in near future when, it is believed, earnings of the company will improve
substantially and market conditions will change. Furthermore, cost consideration also
motivates the management to issue convertible bonds. The underwriting cost of a
convertible bond is lower than common stock or ordinary bonds because of the fact that
the former is more appealing to the investor and hence easier to sell.
Another factor, which has made convertible bond more popular with the management,
is lower interest rate. Because of conversion privilege investors may forego higher
interest rate.
FEATURES OF CONVERTIBLE SECURITIES
There are four important features of convertible securities:
(i) Conversion Ratio : The conversion ratio is the ratio in which the convertible
security can be exchanged for equity stock. The conversion ratio may be stated by
indicating that the security is convertible into a certain number of shares of equity stock.
In this situation, the conversion ratio is given, and in order to find the conversion price,
the face value of the convertible security is divided by the conversion ratio. An example
of this case is given here.
Example: A corporation has outstanding a convertible security issue - a debenture with
Rs. 1,000 face value convertible into 25 shares of equity stock. The conversion ratio for
the bond is 1:25. From this, the conversion price for the bonds is arrived at as Rs.
1,000/25 shares = Rs.40
Sometimes, instead of the conversion ratio, the conversion price is given. In that case,
the conversion ratio can be obtained by dividing the face value of the convertible by the
conversion price. This case can be explained with the following example.
Example: A corporation has an outstanding convertible bond with a face value of
Rs.1,000. The bond is convertible at Rs.50 per share into equity stock. From this
information, the conversion ration is calculated at 1:20 (Rs. 1000 / Rs. 50) = Rs. 20.
(ii) Conversion Period : Convertible bonds are often convertible only within or after
a certain period of time. Sometimes, conversion is not permitted until a certain period
has passed. In another instance, conversion is permitted only for a limited number of
years after its issuance. Sometimes, bonds may be convertible at any time during the life
of the security. Time limitations on conversion are imposed by the corporation to suit its
long-run financial needs.
(iii) Conversion Value : It is the value of the security measured in terms of the
market value of the security into which it may be converted. Since convertible bonds are
convertible into equity stock, the conversion value can generally be found simply by
multiplying the conversion ratio by the current market price of the corporation's equity
stock.
Example: A corporation has an outstanding Rs.1016 bond which is convertible into
Rs.31.25 a share. The current market price of the equity stock is Rs.32.50 per share. The
conversion ratio is therefore (Rs.1000 / Rs.31.25) = 32.
The current market price of the equity stock is Rs.32.50 per share. The conversion value
of the bond is (Rs.1016 / 31.25) x Rs. 32.50 = Rs.1056.
(iv) Conversion Premium : The conversion value depends on the market value of
shares at the time of issue of convertible bonds. Normally, the market price of the
convertible security will be higher than the conversion value at the time of issue. The
difference between the two is conversion premium. So, it is this difference between the
market price of the shares and the low conversion value that acts as an incentive for the
public to invest in convertible debentures.
Where the difference between the face value and the market price is high, companies
put a premium on shares at the time of conversion and when the difference is not high,
there is normally no premium and the shares are aliened at par.
The conversion premium is the percentage difference between the current price and
conversion price. The actual size of the premium depends largely on the nature of the
company. If the companys stock is not expected to appreciate greatly, a low premium
will be used. The convertible premium given to a convertible security can greatly affect
the future success of the security. This can be explained by the following example.
Example: A corporation has issued a Rs. 1,000 convertible bond. The bond is
convertible into 20 shares of the corporation's equity stock at a price of Rs.50 per share.
The corporation's equity stock is currently selling at Rs.45 per share. From this
information, it is clear that the conversion premium is Rs.50 - Rs.45 = Rs.5 per share or
Rs.5 x 20 shares = Rs. 100. Conversion premium in this case is (Rs.5 / Rs.45) x 100 =
11.11 percent.
UTILITY OF CONVERSION METHOD
The conversion privilege of the bond is very appealing to the issuer as well as to
investing community. It enables the issuing company to attract savings of investors even
though the company's current position does not favour issue of stock.
Furthermore, this provides a convenient and relatively easy way of getting rid of bonded
indebtedness and the fixed interest charges attached thereto. Without making any cash
payment and simply by further dividing the ownership, the company can extinguish
indebtedness.
To investors who at the moment are not prepared to invest in stocks but who are not
content to continue indefinitely as creditors, conversion privilege has great value
because it would give safety of principal and a certain ratio of income and a right to
convert it for stock in case the company prospered so that its stock paid at a high rate
gets reasonably secured. Thus, the purchase of convertible bonds gives investors the
opportunity to have their cake and eat it too. Such bonds also appeal to speculators who
are interested more in capital appreciation than income. They could borrow on their
bond to make a large percentage of appreciation on their investment.
However, convertible bonds may be said to have adversely affected, though to a limited
extent, the investment position of the company's stock. In the event of depression the
consequences may be serious. Further, conversion injures the market position of the
bonds that remain unconverted. The value of such bonds will be very low.
ADVANTAGES OF DEBENTURE FINANCE
Debenture finance has its own importance and significance in company finances:
1. The company is able to secure capital without giving any control to the
debentureholders.
2. In every country and in every section of society there are investors who want to
do secured investment with an attractive rate of interest. But they are not
prepared to expose their money to risk. Debentures very much suit their
investment pattern.
3. Debentures are less risky securities from the investors' point of view. Hence, the
company is able to raise capital through the issue of debentures at relatively
lesser cost.
4. Debentureholders pay to the company for a specific period and cannot withdraw
their money before the expiry of that period. In this way there is certainty about
the availability of finance for a specific period and plans can be made accordingly.
5. The company has the scope for 'trading on their equity' by raising the bulk of its
capital in the form of debentures with fixed rate of interest. The equity
shareholders are thus enabled to get maximum possible return out of the residual
profits, during boom period.
6. Since debentures are generally issued on redeemable basis, the company can
avoid over-capitalisation by refunding the debt when the financial needs are no
longer there.
7. Issue of debentures reduces the dependence of the company on uncertain sources
of finance such as deposits, commercial banks etc.
8. In case the company has already incurred a number of small debts of short
duration, it may be costlier for it to maintain them. Under such circumstances,
they may be converted into a single issue of debentures which will prove less
costly.
9. Debentures have a great market response during depression or when the
possibilities of inflationary profits are rare.
LIMITATIONS OF DEBENTURES
In spite of the fact that the debentures offer several advantages mentioned above, it is
found that in practice they have several limitations:
1. Debenture interest has to be paid to the debentureholders whether the
corporation earns profit or not. It becomes a great burden on the finances of the
corporation.
2. When assets of the company get tagged to the debentureholders, the
creditworthiness of the company in the market comes down and in some cases
even the banks refuse loans to that company.
3. If the capital structure is heavily loaded with debentures, the major part of the
company's earnings is absorbed in servicing the debts, and little is left for
distribution of dividends. This lowers the value of shares of such company.
4. If the company has already raised large amount through the issue of debentures,
it has to offer higher rates of interest to market its subsequent issue of
debentures.
5. From the investors' point of view, safety of capital is likely to be vitiated by lack of
control over the company's affairs. The speculative ventures, overtrading and
mismanagement of the company would harm the interest of debentureholders
and weaken the safety of their capital.
6. The proportion of fixed assets to total assets is an important determining factor
for the issue of debentures. A corporation with low proportion of fixed assets to
total assets will not find itself under congenial conditions for the issue of
debentures because it has no substantial security to offer to debentureholders.
Mostly the trading enterprises and concerns dealing in consumer goods belong to
such category.
7. There is a ceiling imposed by financial institutions on the maximum debt-equity
ratio of a company which in turn limits the quantum of funds that can be
mobilised from this source.
8. Since financing by way of debentures increases the financial risk of the company,
the equity shareholders tend to demand a higher rate of return to compensate for
the additional risk assumed.
9. The debenture contract can have several protective covenants which restrict the
financial flexibility of the company.
LAW RELATING TO ISSUE AND REDEMPTION OF DEBENTURES
Procedure for the issue of Debentures:
1. A resolution authorising the issue has to be passed by the Board of Directors of
the Company at a meeting of the Board.
2. There must be a provision in the Articles for issue of debentures.
3. Consent of the SEBI has to be obtained for the issue of debentures.
4. Consent of the shareholders has to be obtained at a meeting of the shareholders if
the borrowings under the debenture, together with any money already borrowed
by the company (apart from temporary loans obtained from the company's
bankers in the ordinary course of business) are going to exceed the aggregate of
the company's paid up capital plus free reserves in the case of public and their
subsidiaries.
5. Sanction of the shareholders by ordinary resolution is also necessary if the whole
or substantial part of the company's undertaking is proposed to be charged
against the debentures by use of mortgage.
6. The particulars of the charge created by the debentures have to be filed with the
Registrar of Companies within 30 days after the execution of the deed containing
the charge. A Certificate of Registration has to be obtained from the Registrar and
a copy of the certificate has to be endorsed on every debenture certificate.
Particulars of the debentures have also to be entered in the company's Register of
Charges.
7. Where the debentures are offered to the public, then a Debenture Prospectus has
to be filed with the Registrar on the same date on which the said prospectus is
issued. If prospectus is not issued, then a statement in lieu of prospectus has to
be filed with the Registrar at least 3 days before the first allotment of debentures.
The prospectus shall state the name of the stock exchange or exchanges to which
the application will be made. Before the 10th day after the issue of the prospectus,
the company should apply for permission from the stock exchange(s). If the
permission is not applied for within the 10th day after the first issue of the
prospectus, then the allotment becomes void. Even if such permission was
applied for within ten days, but permission is not granted within ten weeks from
the date of the closing of the subscription lists even by one of the stock exchanges,
the allotment becomes void. If the application has not been disposed of within
the time limit stated above, it shall be deemed that the application has not been
granted.
8. If the allotment becomes void, the money received from the applicants must be
repaid within eight days after expiry of ten days (where permission was not
applied for within stipulated time) or ten weeks (where permission was refused
or the period of ten weeks has expired) as the case may be. If the money is not
repaid within eight days after the company becomes liable to repay it, the
Directors of the company will be jointly and severally liable to repay that money
with interest at the rate of 12% per annum from the expiry of the eighth day,
unless such Directors prove that the default was not because of their misconduct
or negligence.
9. An appeal against the decision of the stock exchange refusing permission for the
proposed debentures may be preferred under Section 22 of the Securities
Contracts (Regulation) Act. If such an appeal has been preferred then the
allotment is not considered void until the appeal has been dismissed.
10. If permission has been granted by a recognised stock exchange or exchanges to
deal with the debenture issue, the excess money received on application must be
forthwith returned without interest to the applicants and where the money is not
repaid within eight days from the date of allotment, an interest at the rate of 12%
per annum on the refundable amount accrues and penal consequences follows for
default. All moneys received from the applications for debentures must be kept in
a separate bank account in a scheduled bank. If a prospectus has been issued, the
allotment of debentures should be made after 5th day from the issue of the
prospectus.
11. It is not necessary to file a return of allotment with the Registrar after the
allotment of debentures. However, within three months of the allotment, the
debentures must be completed and made ready for delivery. After the allotment,
the name of the debentureholder with his/her address, occupation, number of
debentures held by him/her, and the date of allotment of the debentures, must be
entered in the Register of Debentureholders. In case the number of
debentureholders exceeds fifty, then, the names of the debentureholders should
be entered in the Index of Debentureholders.
FORMS OF DEBENTURES
Its principal contents are:
(a) Date when the principal is to be repaid by the company;
(b) Rate of interest;
(c) Dates on which the interest is to be repayable;
(d) A statement that the undertaking of the company is charged with such payments;
and
(e) A statement that the debenture is issued subject to "conditions".
Debenture cannot be issued to a foreigner or non-resident Indian without prior
permission of the Reserve Bank of India under the Foreign Exchange Regulation Act
and Rules made thereunder.
Debentures Stock Certificates must be completed and ready for delivery within two
months after allotment, or after Lodging of Transfer, unless the conditions of issue
otherwise provide (Section 113 of the Companies Act, 1956). A contract to take up
debenture may be enforced by specific performance (Section 112 of the Companies Act).
Issue of Debentures at Commission or Discount: (S.129) Where any
commission, allowance or discount has been paid, or from holders having bonds of not
more than Rs. 40,000 face value in each case.
Guidelines for issue of Fully Convertible Debentures (FCDs)/Partially
Convertible Debentures (PCDs)/Nonconvertible debentures (NCDs):
The guidelines issued by the Securities and Exchange Board of India (SEBI) on 11th
June, 1992 are as follows:
1. Issues of FCDs having a conversion period of more than 36 months will not be
permissible, unless conversion is made optional with "put and call" option.
Put option is an option to sell a fixed amount of stocks/shares/debentures on a certain
fixed day and at a fixed price.
Call option is an option to buy a fixed amount of stocks/shares/debentures on a certain
fixed day and at a fixed price.
Put and call option is a double option to buy or sell a fixed amount of
stocks/shares/debentures on a certain fixed day and at a fixed price.
2. Compulsory credit rating will be required if conversion is made for FCDs after 18
months.
3. Premium amount on conversion, time of conversion in stages, if any, shall be
predetermined and stated in the prospectus. The interest rate for above debentures will
be freely determinable by the issuer.
4. Issue of debentures with maturity of 18 months or less are exempt from the
requirement of appointment of debenture trustees or creating a Debenture Redemption
Reserve (DRR). In other cases, the names of the debenture trustees must be stated in
the prospectus and DRR will be created in accordance with guidelines for protecting the
interest of the debentureholders. The trust deed shall be executed within 6 months of
the closure of the issue.
5. Any conversion of debentures will be optional at the will of the debentureholder if the
conversion takes place at or after 18 months from the date of allotment, but before 36th
month.
6. In case of NCDs/PCDs, credit rating is compulsory where maturity period is more
than 18 months.
7. Premium amount at the time of conversion for the PCDs shall be predetermined and
stated in the prospectus. Redemption amount, period of maturity, yield on redemption
for the PCDs/NCSs shall be indicated in the prospectus.
8. The discount on the non-convertible portion of the PCDs in case they are traded, and
the procedure for their purchase on spot-trading basis must be disclosed in the
prospectus.
9. In case, the non-convertible portions of the PCDs or NCDs are to be rolled over
(renewed), a compulsory option should be given to those debentureholders who want to
withdraw from the debenture programme and encash. Roll over shall be done only in
cases where debentureholders have sent their positive consent and not on the basis of
'no negative reply received from them.
10. Before rollover of any NCDs or non-convertible portion of the PCDs, fresh credit
rating shall be obtained within a period of 6 months prior to the due date of redemption.
11. A letter of information regarding rollover shall be vetted by SEBI with regard to the
credit rating, debenture-holder's resolution, option for conversion, and such other items
which SEBI may prescribe.
12. The disclosures relating the debentures will contain amongst other things:
(i) the existing and future equity and long-term debt ratio;
(ii) servicing behaviour on existing debentures;
(iii) payment of due interest on due dates on term loans and debentures;
(iv) certificate from a financial institution or banker about their 'no objection' for a
second or parri passu charge being created in favour of the trustees to the proposed
debenture issues.
REVIEW QUESTIONS
1. Define the word 'debenture' and bring out its salient features.
2. What are the different types of debentures that may be issued by a company?
3. What are the advantages and disadvantages of debenture finance to industries?
4. Explain briefly the law relating to issue and redemption of debentures in India.
5. Summarise the guidelines for issue of debentures by public limited companies in
India.
6. Account for the increasing popularity of convertible debentures with the investing
public and companies in India.
7. Are debentures becoming popular with public sector enterprises in India? State
reasons for your answer.
8. What suggestions would you offer to develop further the corporate debenture
market in India?
SUGGESTED READINGS
1. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi, Tata
McGraw Hill Co.
2. Khan, M Y and Jain, P K: Financial Management, New Delhi, Tata McGraw Hill Co.
3. Pandey, I M: Financial Management, New Delhi, Vikas Publishing House.
4. Saravanavel P: Financial Management, New Delhi, Dhanpat Rai & Sons.
- End of Chapter -
LESSON -16
UNDERWRITING OF SECURITIES
Learning Objectives
After reading this lesson you should be able to:
Understand the concept of underwriting of securities
Recognise the need for underwriting
Detail the different forms of underwriting
Examine the legal provision and regulations relating to underwriting
Evaluate Merchant Bankers as underwriters
Lesson Outline
Meaning and Types of Underwriting
Who can Underwrite - Authorised Merchant Bankers
Choosing an Underwriter
SEBI Guidelines for Underwriting
Government Guidelines for Underwriting
Underwriting Agreement
Payment of Underwriting Commission
Future of Underwriting business in India
In terms of Section 69 of the Companies Act, 1956, no allotment shall be made of any
share capital of a company for subscription to the public unless the minimum amount to
be subscribed, as stated in the prospectus, has been subscribed, and the application
money has been received by the company in cash or by cheque or other instrument and
paid. If the minimum subscription mentioned in the prospectus is not subscribed within
120 days from the date of opening of issue, all the application moneys are forthwith
liable to be refunded by the company within 128 days with interest for delay beyond 78
days from the date of closure of the issue as per Section 73 of the Companies Act, 1956.
In view of the far-reaching consequences of failure to raise the "minimum subscription"
there is need to ensure that this subscription is procured. Hence, there is need for an
insurance against under-subscription. This is obtained from reliable persons who
undertake to procure/subscribe in the event of the failure to evoke adequate response
from the public. Such an arrangement is called "Underwriting" and the person who
undertakes is called "Underwriter".
MEANING OF UNDERWRITING
Underwriting is an act of providing a guarantee (undertaking a guarantee) of buying the
shares offered to the public in the event of non-subscription or under-subscription of
the shares by the public. For this purpose, the shares issuing company may enter into an
agreement with an underwriter or with a number of underwriters or with an institution,
for underwriting the issue of shares to the public.
TYPES OF UNDERWRITINGS
There are four types of underwriting agreements:
1. Firm Commitment Underwriting: An underwriter guarantees the sale of all
shares offered to the public at an agreed price. The underwriter may agree to
purchase all the shares outright from the issuing company and arrange to sell the
stock to the public themselves.
2. Standby Underwriting: The underwriter guarantees to buy the unsold shares
offered in the stock issue.
3. Sub-underwriting: After entering into underwriting agreement with the
issuing company, the underwriter may invite other underwriters or underwriting
firms to join in with him and share the risk in mutually agreed proportions.
4. Syndicate Underwriting: The issuing company enters into underwriting
agreements with multiple underwriters to underwriters a large issue. They agree
with the company to share the joint responsibility in an agreed ratio. The issuing
company has to mention the name of the underwriters and the number of shares
underwritten by him in the prospectus as prescribed in the Companies Act, 1956.
Please use headphones
WHO CAN UNDERWRITE?
Underwriting is generally undertaken by:
1. Public Financial Institutions,
2. Banks,
3. Investment Companies, or
4. Trusts of appropriate standing or experience.
Members of the recognised stock exchange are prohibited from entering into
underwriting or getting into agreements related to floating of new issues, unless they
have got permission of the stock exchange of which they are members. Such permission
is granted subject to certain conditions, like, the members cannot undertake
underwriting commitments of more than 5% of the public issue; the underwriting of
issues should be widely distributed amongst the members of stock exchange in such a
way that no single member of the stock exchange is allowed to underwrite substantial
portion of the issue; new members are permitted to share the responsibility subject to
their financial position.
Authorised Merchant Bankers
The Securities and Exchange Board of India (SEBI) registers the organisations to carry
out merchant banking activities. SEBI classifies its authorisation into 4 categories,
namely Category I, Category II, Category III and Category IV merchant bankers. Only
Category I, II and III merchant bankers (with capital adequacy of Rs. 1 crore, Rs. 50
lakhs and Rs. 20 lakhs respectively) are permitted to take up underwriting business.
Whenever a merchant banker is acting as the lead manager, it has to mandatorily
underwrite the issue. The mandatory underwriting is limited to 5% of the public issue or
Rs. 25 lakhs whichever is lower.
Limitations
This traditional system has many limitations. Some of the limitations pertain to:
(i) Capital adequacy,
(ii) Control,
(iii) Recovery procedure, and
(iv) Legal procedure, etc.
(i) Capital Adequacy: Of the above categories of underwriters, only the All India
Development Financial Institutions, the All India Investment Institutions and Banks
have sufficient capital adequacy, whereas members of the stock exchange and most
merchant bankers do not have enough capital. Capital or networth is very important in
the event of issue not getting subscribed fully. When an issue does not get fully
subscribed, it devolves on the underwriters. If they do not have enough capital, they will
not be able to take up their portion of risk or fulfill their commitment. Authorised
merchant bankers of Categories I, II, and III are permitted to underwrite capital issues
subject to the limit that outstanding commitments of any such individual merchant
banker at any point of time should not exceed five times his networth (paid-up capital
and free reserves minus revaluation reserves). They must send a monthly report to SEBI
and to the regional stock exchanges where the merchant bankers are located, regarding
their underwriting activities and commitments.
(ii) Control: Members of the stock exchanges, as on date, are controlled by the
respective stock exchanges. Members of the stock exchange control their stock exchange
through an elected Governing Board. Wherever there is a default by a member, there is
not strict enforcement on him by the stock exchanges.
(iii) Recovery Procedure: In the event of development of an issue, recovery from the
members of stock exchanges becomes very difficult. There are quite a few instances
where brokers backed out of their commitment.
CHOOSING AN UNDERWRITER
In choosing an underwriter the potential issuer usually considers such factors as the
reputation of the investment bank, its past experience in doing equity issues for
companies similar to the issuer, and, more importantly, its placement power, i.e., its
ability to distribute successfully the issue on the basis of the price and other agreed
conditions. Underwriters should be at least as selective in choosing clients as clients are
in choosing them because one of the prime assets of an investment bank is its
reputation, and the clients of an investment bank and its success in placing issues are
major factors in their reputation. Obviously, an unsuccessful underwriting damages the
reputation of the investment bank.
SEBI GUIDELINES FOR UNDERWRITING
The Securities and Exchange Board of India (SEBI) has issued guidelines for issue of
capital by companies. The guidelines pertaining to underwriting are enumerated
hereunder:
a. Underwriting is mandatory for the full issue and the minimum requirement of
90% subscription is also mandatory for each issue of capital to public. Number of
underwriters would be decided by the issuing company.
b. If the company does not receive 90% of issued amount from public subscription
plus accepted devolvement of underwriters within 120 days from the date of
opening of the issue, the company shall refund the amount of subscription. In
case of disputed devolvement, the company should refund the subscription if the
above conditions are not met.
c. The Lead Manager(s) must satisfy themselves about the networth of the
underwriters and the outstanding commitments and disclose the same to SEBI.
d. The underwriting agreement may be filed with the stock exchanges.
Underwriting should be only for issue to the public, and will exclude
reserved/preferential allotment to reserved categories. In other words, underwriting is
mandatory only to the extent of net offer to the public.
Minimum subscription clause is applicable for both the public and rights issue with a
right of renunciation.
The intention is that the lead manager should satisfy himself in whatever manner he
deems fit about the ability of the underwriters to discharge their underwriting
obligations. There is no need for lead manager(s) to furnish any certificate to SEBI in
this behalf. A statement to the effect that in the opinion of the lead managers, the
underwriters' assets are adequate to meet their obligations should be incorporated in
the prospectus.
GOVERNMENT GUIDELINES FOR UNDERWRITING
Government has issued guidelines relating to the underwriting of capital issues to be
followed by the stock exchanges, merchant bankers and other agencies associated with
the management of the public issues of capital. These should be read along with SEBI
guidelines:
i. The stock exchanges will satisfy themselves that the company's securities being
underwritten would be officially quoted on a recognised stock exchange;
ii. Members of the stock exchange desiring to underwrite will satisfy themselves
that the company has duly complied with the listing regulations;
iii. The Governing Bodies of recognised stock exchanges shall have the discretion to
refuse permission or impose such conditions in respect of the underwriting of
securities by members of stock exchanges as they may deem necessary in the
special circumstances of any given case;
iv. The underwriting of the public issues should be distributed amongst the
members of the stock exchanges as widely as possible;
v. No member should be allowed to undertake an underwriting commitment of
more than 5 per cent of the public issue; and
vi. The stock exchanges should prescribe procedures for advance action to the
companies, merchant bankers, etc., for making underwriting arrangements, so as
to ensure that all relevant information is furnished in the draft prospectus
submitted to the stock exchanges for approval.
UNDERWRITING AGREEMENT
It is an agreement entered into between the company and the underwriters agreeing to
underwrite the proposed issue of the company. The agreement should provide the
amount of the issue agreed to be underwritten by the underwriters in case of under-
subscription and the commission payable for such undertaking. It should also stipulate
that in the event of under-subscription, the underwriters or their nominees would take
up the shares for which they are liable or at least that quantity of issue which would
make up the minimum subscription, within three to four weeks of the closing of
subscription list. The agreement should provide that the underwriters would be
discharged of their underwriting obligations to the extent of applications bearing their
stamps.
In order to avoid unfair discrimination between the underwriters, the company should
ensure that application forms supplied and distributed among the members of stock
exchanges do not bear the stamp of any underwriter.
PAYMENT OF UNDERWRITING COMMISSION
The provisions of Section 76 of Companies Act are to be complied with while paying the
underwriting commission. Section 76 (1) states that a company may pay a commission
to any person in consideration of:
(a) his subscribing or agreeing to subscribe, whether absolutely or conditionally, for any
shares in or debentures of the company, or
(b) his procuring or agreeing to procure subscription whether absolute or conditional for
any shares in or debentures of the company, if the following conditions are fulfilled:
(i) payment of the commission is authorised by the articles;
(ii) the commission paid or agreed to be paid does not exceed, in the case of
shares, 5% of the price at which the shares are issued or the amount or rate
authorised by the Articles, whichever is lesser, and in the case of debentures, 21%
of the price at which the debentures are issued or the amount or rate authorised by
the Articles, whichever is lesser;
(iii) the amount or rate of commission is disclosed in the Prospectus or Statement
in lieu of Prospectus, as the case may be, or in a statement filed with the Registrar
before the payment of the commission.
(iv) the number of shares or debentures which persons have agreed to subscribed
should be disclosed in the Prospectus, and
(v) a copy of the contract relating to the payment of the commission should be
delivered to the Registrar.
(vi) no underwriting commission can be paid if the issue is privately placed. In
other words, underwriting commission is payable only on such shares or
debentures as are offered to the general public [(Section 76 (4A)]
Stock Exchange Division of the Department of Economic Affairs, Ministry of Finance
issued guidelines dated 7-5-1985 for payment of underwriting commission.
The rates of underwriting commission are in force as follows:
On amounts devolving on the
underwriters (%)
On amounts subscribed
by the public (%)
(A) Equity Shares 2.5 2.5
(B) Preference shares / convertible and non-convertible debentures
(a) For amounts upto
Rs.5 lakhs
2.5 1.5
(b) For amounts in
excess of Rs. 5 lakhs
2 1
Notes:
(i) The above underwriting commissions are maximum ceiling rates within which any
company will be free to negotiate with the underwriters.
(ii) Underwriting commission will not be payable on the amounts taken up by the
promoter's group, employees, directors, their friends, and business associates.
(iii) The underwriter gets commission at the above rates on shares, debentures
undertaken by him irrespective of the number of shares & debentures subscribed by the
public. Even if the issue is fully subscribed by the public, he will get commission at the
above rates on all shares & debentures paid by him.
FUTURE OF UNDERWRITING BUSINESS IN INDIA
With the introduction of free pricing of securities, underwriting business is undergoing
metamorphic changes. Gone are the days when the underwriting business was taken less
seriously by the parties involved. There are already reports of under-subscription of
quite a few public issues and consequent devolvement on underwriters. Capital
adequacy assumes significance for fulfilling underwriting obligations in the event of
devolvement. Only Financial Institutions and Commercial Banks have enough capital
adequacy to meet such obligations. Merchant Bankers' foremost task is, therefore, to
enhance their capital base.
Moreover, companies are also not happy with the situation. Bulk holdings with
underwriters also expose them to a takeover bid. There has, in fact, been a reported
instance of a major underwriter taking over a company whose issue was
undersubscribed.
Further, with mega issues coming in large numbers, it becomes essential to go in for
syndicate approach. There is already a forceful demand from underwriters associations
for upward increase in underwriting commission. In the free pricing scenario, a liberal
free market driven fee structure is likely to emerge sooner or later. Brokers are also
demanding that bank finance be made available to them to carry on the business of
underwriting.
Merchant bankers / underwriters will also have to develop a large investor base and
network throughout India since they would be required to approach the investor directly
and would also have to provide efficient secondary market services.
Lastly the merchant bankers / underwriters will have to be selective in new floatations.
The fundamental strengths of the companies will, therefore, come under sharper focus
and there will be increasing demand for more and more financial information and
disclosures about the performance of the companies. The underwriters will have to
develop their own assessment network for critical appraisal of projects. The market
driven forces will, therefore, help the capital market to attain greater depth and maturity
in the coming years.
REVIEW QUESTIONS
1. What is underwriting of securities? State the guidelines issued by Government of
India and SEBI in this connection.
2. Explain the legal provisions and regulations regarding payment of underwriting
commission.
3. Explain the salient features of underwriting of securities by merchant bankers.
SUGGESTED READINGS
1. Pandey, I.M.: Financial Management, New Delhi, Vikas Publishing House.
2. Rathnam, P. V.: Financial Advisor, Allahabad, Kitab Mahal.
- End of Chapter -
LESSON - 17
TERM-LOANS
Learning Objectives
After reading this lesson you should be able to:
Understand the concept of term-loan
Identify the purposes of term-loans
Detail the features of term-loans
Explain the covenants of term-loan agreement
Evaluate term-loan as a source of finance
Lesson Outline
Concept of Term-Loans: Term Lending institutions
Purposes of Term-loans
Distinctive Features of Term-Loans
Appraisal of Term-Loan Proposal: Feasibility Studies
Terms & Conditions of Term-Loan Agreement
Equity Kicker
Since 1950s, the role of term-loans has considerably increased and in many cases
greater reliance is being placed on term-loans vis-a-vis the owned funds, because of the
growth of term-lending institutions and growing participation by commercial banks in
term-lending.
CONCEPT OF TERM-LOANS
The term 'Term-Finance' relates to the money, required either for setting up a new unit
or financing the expansion/diversification/ modernisation of a project in terms of land,
building, plant and machinery or permanent addition to current assets, with a duration
that may extend beyond 3 years up to 10 years or even more in certain cases. Thus,
'Term-Loan' is a debt instrument that has a longer maturity providing a specific large
amount of financing, and contains a repayment schedule (typically in annuity form) that
requires the borrower to make regular principal and interest payments. Term-loans are
a type of trading on the equity and thus increase the borrower's financial leverage.
Term-loan is a business project-oriented medium- or long-term loan with a maturity of
more than 3 years. Commercial banks and various financial institutions constitute the
hard core of the term-financing in India. Specialised financial and investment
institutions were established in India as an integral part of the capital market. Such
institutions are known as Development Banks or Term Finance Corporations, for
example, The Industrial Development Bank of India (1964), the Industrial Finance
Corporation of India (1948), the Industrial Credit and Investment Corporation of India
(1955), the State Financial Corporation (1951), the National Small Industrial
Corporation Limited (1955), the Industrial Reconstruction Bank of India (1971), the Unit
Trust of India (1964), Small Industries Development Bank of India (SIDBI) 1990 etc.
The terms and conditions usually vary from institution to institution and also depending
upon the purpose of loan.
PURPOSES OF TERM-LOANS
Some of the important purposes for which term-loans are sought are given below:
(a) An undertaking might be interested in installing new plants, for which it might
need term-loan in the hope that installed capacity will enable the firm to repay the loans
quickly.
(b) It may need money for the purchase of permanent assets and additions in the
property which already it has.
(c) Due to repaid industrialisation many undertakings might need loans to take
advantage of industrialisation process.
(d) Some undertakings might need term-loans for modernisation of their plants.
(e) Loans sometimes become unavoidable for refinancing of funded debts.
(f) Some of the firms might be paying heavy interests on bond issues. Such loans can go
a long way in reducing the bond interest burden. Obviously it is a major relief.
(g) A term-loan can also help in rearranging of maturities, elimination of restrictive
provisions of the bond issues and in returning redeemable preference shares.
DISTINCTIVE FEATURES OF TERM-LOANS
Term-loans are negotiated directly between the borrower and the lender. As a result, the
provisions contained in the loan agreements can differ widely. Because the loan is
obtained directly from the lender, term-loans can be viewed as a form of private
placement except the registration requirements.
a. Purposes: Term-loans are granted for purposes such as expansions,
diversification, modernisation and renovation schemes. Sometimes they may also
be granted for liquidation of prior debts.
b. Security (Collateral): The security cover for term-loans comprises the existing
(fixed) assets as well as those to be acquired from such loans. Usually, first legal
mortgage on such assets is created in favour of the creditor. Besides, personal
guarantees of the promoters, directors etc., are also obtained to ensure continuity
of the interests of the sponsors of the project.
c. Project-Oriented approach: The approach of the term-lending institution is
project-oriented. The underlying theory of term-loan is that the ability of the
borrower to repay the loan is judged by the flow of anticipated income from the
project rather than from the liquidity of his assets. The term-lending institutions
thoroughly examine the viability and profitability of the project in order to assess
the repaying capacity and feasibility of project from economic, technical,
commercial, managerial, financial and social point of view.
d. Period (Repayment schedule): Generally, term-loans are repayable in semi-
annual installments over a period of 3 to 15 years, including an initial grace
period.
e. Interest rate: The rate of interest on term-loans is usually 1 -2 points above the
bank's advance rate, but the development banks charge a rate of interest lesser on
short period loans.
f. Refinance: Term-loans are eligible for refinance facilities from the Industrial
Development Bank of India, Small Industries Development Bank of India, Export
Import Bank of India, etc.
g. Consortium approach: Where the total term-loan required by an industrial
unit is too large for a single bank, some form of participation arrangement is also
made on the part of different financial institutions. Such a consortium approach
is known as co-financing or joint financing of projects.
h. Follow-up measures: As the term-loan spreads over a number of years,
several post-sanction measures are undertaken e.g. the assisted concern is
required to submit regular progress reports about the project under construction.
The term-lending institution also sends its officials to inspect the progress of the
project.
i. Commitment Charge: The lending institution also charges a nominal
commitment charge of 1 to 2 % per year on the un-utilised portion of loan from a
stipulated date. With effect from 1990-91 financial institutions have decided to
replace commitment charge with upfront charge or frontend charge as is the
practice internationally.
j. Nominee Director: It is not uncommon for a creditor institution to nominate
its representation in the board of directors of the borrowed unit.
k. Convertibility Clause: Recently the term-lending institution insists for
conversion of whole or part of loans into equity by inserting the convertibility
clause in the Loan Agreement itself. This convertibility clause enables the
creditor to participate in the prosperity of a successful project.
l. Bridge Loans: Sanctioning and disbursement of term-loans requires some
time. In the meantime borrowing units require funds to meet their immediate
needs. The borrowing unit makes an arrangement with the commercial banks or
lending financial institutions for temporary but short-term loans from them for
the purpose, which are known as bridge loans. Such loans are granted normally
on the personal guarantee given by promoters or directors and repaid
immediately after sanctioning of the term-loan.
m. Covenants: Term-loans contain both affirmative and negative covenants.
Affirmative covenants require the borrower to keep the lender informed of its
financial position by submitting periodical financial statements - actual and
projected - or any event that have or could have a significant impact on the
borrower's financial position. Negative covenants restrict or prohibit the
borrower from specified actions such as increasing its dividend payments, make
sure the minimum liquidity is maintained, and impose capital structure changes.
Please use headphones
APPRAISAL OF TERM-LOAN PROPOSAL: FEASIBILITY STUDIES
There are broadly six aspects of appraisal of term-lending proposals. They are:
(i) Technical feasibility
(ii) Economic feasibility
(iii) Commercial viability
(iv) Managerial competence
(v) Financial feasibility
(vi) Social considerations
An appraisal for all the six factors in aggregate will certainly help the financier to decide
the viability of the proposal for finance.
(i) Technical feasibility: The examination of this aspect requires a thorough
assessment of the various requirements of the actual production process and includes a
detailed estimate of the goods and services needed for the project - land, machinery,
trained labour or training facilities, raw-materials, transportation, fuel, power, water
etc. Where these resource factors are not domestically available and are to be imported,
conditions in the foreign market and the Government policy at home are to be reviewed
vis-a-vis the availability of the foreign exchange in the country. For certain projects,
foreign experts of foreign training of local staff may be necessary. Another important
feature of technical feasibility relates the types of technology to be adopted for the
project. In case new technical processes are adopted from abroad, attention is to be paid
to the differences in conditions. The lending banks should employ technocrats or
consultants to study the projects on their technical aspects.
(ii) Economic (Marketing) feasibility: This aspect of an appraisal relates to the
earning capacity of the project. Earning of the project depends on the volume of sales.
Therefore, it is highly pertinent to determine how much output of the new unit or the
additional production from an existing unit can be absorbed by the market at given
prices. In other words, it takes into account the total output of the product concerned
and the existing demand for it in order to establish whether there is an unsatisfied
demand for the product. Two general indicators of the existence of dissatisified demand
are 'price level' and 'prevalence of controls'. When demand is greater than the available
supply and there are no controls, prices would be much higher than the production cost,
yielding abnormal profits to producers. On the other hand, where price controls exist,
like rationing, it is prima facie that the entire demand is not being met by current
production.
Possible future changes in the volume and pattern of supply and demand will have to be
estimated in order to assess the long run prospects of the industry as well as earning
capacity of the unit. In calculating the future demand, the lending bank has to take into
consideration the potentialities of the export market, the changes in incomes and prices,
multiple uses of the product, probable expansion of the industries using such goods, and
growth of new industries requiring them. On the supply side, several factors which affect
supply position, such as the competitive position of the unit in question, existing and
potential competitors, the extent of capacity utilisation, units cost advantages and
disadvantages, structural changes, and technological innovation bringing substitution
into the market, should also be scrutinised.
(iii) Commercial viability: The appraisal of commercial aspects of a project involves
a study of the proposed arrangements for the purchase of raw materials and sale of
finished products etc. The basic question to be asked in this respect are whether
adequate arrangements have been made for buying the materials and services needed to
construct the facility, and when the construction is finished, for obtaining power, labour
and raw materials to operate the plant and market its product. The problems are much
the same for all projects during the construction phase. The main objective is to see that
the proposed arrangements ensure that the best value is obtained for the money spent.
In the operating phase, commercial problems vary considerably from sector to sector. In
industry, the likely terms of purchase of the ingredients of production and of the sale of
products need careful examination, since these terms may have an important bearing on
the amount of working capital required. Where the concern proposes to appoint sole
selling agents, the same should be examined in the interest of the concern and from the
public policy angle.
(iv) Managerial competence: To a large extent, the lending bank's confidence in the
repayment prospects of a loan is conditioned by its opinion of the borrowing unit's
management. Where the technical feasibility, economic feasibility, and financial
feasibility are well established, but the integrity and resourcefulness of the management
is doubtful, the proposal is worth leaving where it is. Thus it has been aptly remarked
that appraisal of management is the touchstone of term-credit analysis. The calibre of
the people with whom he is dealing can be judged with reference to their knowhow of
the business as reflected in their purchase, production, sales, labour, personal credit,
and financial policies.
(v) Financial feasibility: The financial position of the concern has to be examined
during the running of the loan. For having a proper perspective of the financial position,
it is not sufficient to consider a single year's performance as revealed in the Balance
Sheet and Profit & Loss Account. On the other hand, a dynamic view has to be taken og
the organisation in next few years. The basic data required for a financial analysis can be
grouped under the following heads:
(a) Cost of the project (whether additional or new) - The cost of the project
should normally includes study of land (including development expenses),
building, machinery and plant (including spare parts, insurance, freight, duty,
transportation to site, and erection charges), technical knowhow (including
consulting and engineering fees), preliminary expenses, pre-operative expenses
(up to start of normal production, interest during construction, allowance for
unseen costs), and net working capital requirements. The usual sources of finance
are share capital, debenture capital, reserves and surplus, retained earnings, long-
term borrowing and deferred payments.
(b) Cost of the production and profitability - The profitability of an
enterprise depends on the total cost of production and aggregate sale price of the
output. In calculating the total cost of production, the data regarding each
element/component of cost of the product are essential. The tendency to
underestimate the cost of production should be avoided. Before estimating sale in
money terms, it is necessary to estimate the sales likely to be made, not only for
one year, but during each of the next three or four years. The volume of sales is
influenced by a variety of factors, including the quality of the product, its price and
the general market conditions. The cost of production and sales estimates is also
useful in working out the "breakeven" point which would indicate to the banker
the ability of the industry to face a difficult situation.
(c) Cash flow estimates (sources and application of funds) during the currency
of the loan-Cash-flow estimates are obtained for the future period (of years)
during which the term-loan will be outstanding. These estimates are necessary to
ascertain as to when the project will need money for different purposes, and what
different sources for such funds are available. Repayment of installments of loans
is arranged according to the cash accruals shown in cash-flow statement. The cash
flow estimates in respect of a new concern will have to be prepared on the basis of
the prospects for the project under consideration. For an existing concern,
however, the estimates would take into account the cash flow arising from its
current business as well as from the expansion under consideration.
(d) Projected working capital requirement
(e) Projected Profit & Loss Account and Balance Sheet at the end of each
financial year during the period of the loan - The Balance Sheets and Profit and
Loss Accounts for the past three to five years can be studied as a first step in
financial appraisal of existing concerns. The second step would be the preparation
of estimates of the cash flow statements for the next four to five years. The third
step would be the preparation of the projected balance sheets for a similar period.
The figures in the cash-flow statements would provide a link between the balance
sheet of one year and the next. For a new project all the necessary figures must
come from the cash flow estimates. The proforma will reflect the projected
financial position of the concern in the future years.
As a pre-sanction measure, the lending bank should depute an officer to verify the
correctness of the information furnished by the borrower, and supplement it if
necessary through investigation. The valuation of the assets and the depreciation policy
adopted by the concern has also to be checked. After sanctioning a term loan and
disbursing it, the lending bank has to make post-sanction inspection to ensure whether
the amount borrowed has been actually used for the purpose for which it was borrowed
and whether terms and conditions of the loan have been complied with. The value of the
security, production, sales, position regarding insurance and defaults in repayment, if
any, should be reviewed at regular intervals.
(vi) Social Consideration: The social objectives of the project are also considered
keeping in view the interests of the general public. The projects offering large
employment potential, which channelise the income of the agricultural sector for
productive use, or projects located in totally less developed areas, or projects which will
stimulate small industries or the growth of ancillary industries, are given special
considerations.
Energy Management and Ecological Aspects
Along with economic and social appraisal, ecological considerations are also kept in
view and given due weight. It is ensured that the applicant concern has made adequate
provision for treatment of effluents so that the environmental pollution remains under
control. In the context of high priority and significance given to conservation and use of
alternative sources of energy, term-financing institutions have been attaching
considerable importance to 'energy management' while financing industrial projects.
For this purpose, the steps proposed to be taken for the conservation of energy or use of
alternate sources of energy is now examined in depth while appraising a project.
Balancing of Various Factors
While it is necessary to look into all the above aspects of appraisal, the extent of
investigation and the importance to be attached to each aspect depend upon the
circumstances of individual projects. Not all term-loan proposals may require full-scale
appraisal of all aspects. For instance, in the case of a project that is obviously profitable,
a general consideration of the unit's position with reference to its cash-flow should
suffice. Again, where the product has an assured market, a laborious market analysis is
needless. In the ultimate analysis, however, the skills lie in identifying and sorting out
strong points and weak points, and arriving at a final view on the project. Weakness
located in certain areas may be offset by strengths in other areas. Possibly, sound
management and bright economic outlook may outweigh mediocre caliber of
management and doubtful economic prospects. In some cases, negative factors may
dominate; managerial competence may be so much below par so as to off-set all other
considerations. In this way, a large number of variations and combinations are possible.
Thus, the crucial responsibility of the lending bank lies in balancing judiciously different
considerations for arriving at a proper decision. There cannot be readymade formulae,
by using which a term-loan proposal can be pronounced as acceptable or otherwise.
Nevertheless, scientific approach helps considerably in arriving at proper decisions.
There is no mechanical substitute for a banker's judgment. Decision-making in this area
calls for full appreciation of all relevant factors and sound judgment based on
experience.
TERMS & CONDITIONS OF TERM-LOAN AGREEMENT
Term-loans attract several restrictive terms and conditions other than those related to
creation of charges. Different lending institutions stipulate different kinds of conditions
depending on the nature of the project, the borrower, etc. The commercial banks
stipulate only a minimum number of conditions, whereas the financial institutions apply
a large number of more comprehensive conditions. By-and-large, the main clauses of a
term-loan are as follows:
(a) Government clearance: The loan agreement stipulates the borrowing company
to obtain all relevant government clearances as may be applicable. Sanctioning of the
loan must not be construed to be lifting of any other restrictive barrier by the
government such as licensing, MRTP clearance, capital goods clearance for imported
machines, import license, FERA, RBI clearance, clearance from the SEBI for security
issues, etc.
(b) Consent of other lenders: Usually for a consortium loan, a condition an
institution stipulates is that for other parts of the loan, the borrower should be able to
satisfy other lending institutions separately.
(c) Repayment: Repayment of any existing loan or long-term liabilities is to be made
in concurrence with the financial institutions.
(d) Additional loans: Any additional loans to be taken by the Company, the interest
to be paid and repayment of the principal are, usually, subject to the financial
institution's consent.
(e) Capital structure: The term-loan agreement may stipulate the equity and/or
preference shares that the company must issue in order to support the project. It may
also stipulate changing of proportionate shareholding between the various owner
groups, mainly between the Indian and the overseas entrepreneurs.
(f) Dividend declaration: As long as there is a loan outstanding, and declaration of
dividend beyond certain percentage is made subject to the lender's approval.
(g) Directorship: Usually, a term lending institution may reserve the right to
nominate one or more directors (called Nominee Directors) to the Board of the
borrowing company to indicate the institution's views to the management. Any
intervention by the institutions is usually done through the nominee directors.
(h) Commercial agreement: Usually any major commercial agreement such as any
orders for equipment, consultancy, collaboration agreement, selling agency agreement,
agreement with senior management personnel, etc., needs the concurrence of the term-
lending institutions if they are entered into after the loan agreement has been signed.
(i) Restriction to expand: Any further expansion plan would need to be cleared by
the institutions, as it may have an adverse impact on the future cash flow of the
company. No expansion plan can be contemplated without the knowledge of the
institutions once the loan agreement has been signed.
(j) Restriction to create further charge: The borrower is usually not allowed to
create any further charge on the assets without the knowledge of the financial
institutions.
(k) Information: The borrower must agree to furnish any information which the
institution may consider to be relevant, as and when they are asked for, within a
reasonable time.
(l) Organisation: Depending on the nature of the project, the financial institutions
may insist on appointing suitable personnel in the organisation to their satisfaction.
This could be in the area of marketing, R & D, design or production, depending on the
nature of project.
(m) Shareholding: The institutions, usually, stipulate that the promoters cannot
dispose of their shareholdings without the consent of the lending institutions. This is
made with a view to keeping the promoters involved as long as the institutions remain
involved.
(n) Convertibility: Any large loans from all-India financial institutions (usually above
Rs. 50 lakhs) attract a convertibility clause, as in debentures. The institutions normally
ask for 20 percent convertibility, and sometimes accept a firm allotment of shares in lieu
of such a convertibility clause. In an era of liberalisation, the convertibility condition has
been dispensed w.e.f. April 1991.
(o) Additional clause: Usually, the term-loan agreement carries a clause where by
the financial institution can insert any other restrictive clause at a later date at their
option. The purpose of this clause is to bolster the security in case any future unforeseen
developments weaken the security.
(p) Project finance: Usually, the term-loan agreement puts one or more clauses, like
the borrower would make arrangements to raise the other part of the project finance to
the satisfaction of the particular lending institution. This clause safeguards an
institution against any unforeseen happening by which the other participating
institutions back out, but it is unable to do so just because the sanction letter has been
issued earlier.
EQUITY KICKER
Lenders also may require so called "equity kickers". For example, a commercial bank
lender may require the borrower to pay an agreed percentage on any profits generated
from the loan. An insurance company may use an equity kicker in the form of options,
like warrants, which allow the insurance company to purchase a specified number of
equity shares directly from the borrower at a price set below the borrower's current
market share price.
REVIEW QUESTIONS
1. What is term-financing? Explain the major sources of term-finance in India.
2. What are the special features of term-loans? Discuss the disadvantages attached
with term-loans.
3. What precautions will be taken by term-lending institutions while granting term-
loans?
4. What are the broad aspects of appraisal of term-loan proposals in India?
5. Explain the terms and conditions usually found in term-loan agreements.
SUGGESTED READINGS
1. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi, Tata
McGraw Hill Co.
2. Khan, M.Y. and Jain, P.K.: Financial Management, New Delhi, Tata McGraw Hill Co.
3. Pandey, I.M.: Financial Management, New Delhi, Vikas Publishing House.
4. Rathnam, P.V. : Financial Advisor, Allahabad, Kitab Mahal.
5. Saravanavel, P.: Financial Management, New Delhi, Dhanpat Rai & Sons.
- End of Chapter -
LESSON - 18
LEASE FINANCE
Learning Objectives
After reading this lesson you should be able to:
Understand the concept of leasing
Identify the equipment suitable for teasing
Know the kinds of lease
Distinguish between lease financing and debt financing
Ascertain which is better - Lease vs Purchase or Lease vs Hire Purchase
Specify the advantages and disadvantages of lease.
Lesson Outline
Lease Transaction
Equipment suitable for leasing
Kinds of Leases - Financial Lease, Operating Lease
Maintenance, Non-Maintenance and Net Leases
Lease versus Buy
Lease Financing versus Debt Financing
Lease versus Hire-Purchase
Income-Tax Implications of Leasing
Advantages & Disadvantages of Leasing Finance
Hire Purchase Finance
Concept of Lease
A lease is an agreement whereby a lessor (one who leases out) conveys to the lessee (one
to whom something has been leased out) the right to use an asset for an agreed period of
time in return for rent. The essential features of a lease are:
(i) It is an agreement between the lesser and lessee,
(ii) The agreement is for a stipulated time period,
(iii) The lessor conveys to the lessee the right of using an asset owned by him,
(iv) The lessee pays the rental in exchange for the right of using the asset.
When the lessor and lessee belong to two different countries it is known as 'Cross-
Border Leasing'.
Lease Transaction: Leasing is a method of financing equipment, where the lessee
(the user of the equipment) selects the equipment, acquires it on lease and is allowed the
use the equipment during the period of lease, which may be spread over the entire
economic life of the asset, by paying a predetermined lease rental, while the ownership
in legal terms continues to rest with the lessor (who finances the cost of the equipment
and gives it out on lease). The lessor may or may not be the manufacturer of the
equipment. In case the lessor is the manufacturer, he will have to capitalise it in his
books, fund it as a capital asset and give it out on lease to the lessee. If the lessor is a
leasing company and not the manufacturer, which is usually the case, the lessor would
purchase the equipment from the manufacturer by paying for the cost (including duties
and taxes) using his own finances, thereby becoming its owner, capitalise it in his books,
and give it out on lease to the lessee.
Thus, there are basically three parties involved in a leasing transaction - the leasing
company (lessor) that finances the transaction, the manufacturer or supplier from
whom the leasing company purchases the equipment, and the party who needs the
equipment (lessee) who will possess and use the equipment, for which it will pay a
periodic lease rental to the lessor. In this manner, the lessee is able to exploit the
economic value of the equipment by using it as if he owned it without having to pay for
the capital cost (for which he possibly may not have the necessary long-term funds),
borrowing capability or cash flow. Lease rentals can be conveniently paid over the lease
period out of profits earned from the use of the equipment and the rental is 100% tax
deductible.
Equipment suitable for leasing: Generally high value and technology oriented
products are most suitable for leasing, though there are no restrictions. Further, as
mentioned earlier, imported equipment at present would not lead itself to leasing.
Typical items that could be leased are computers, transport vehicles, machine tools,
diesel generators, earth-moving equipment, printing presses, textile machinery, air-
conditioning equipment, agricultural equipment, hotel equipment, pumps, quarry
equipment, compressors, containers, hospital equipment, locomotives and rolling
stocks, etc.
Solvency of parties: It is very essential for the leasing company to evaluate the
financial position and cash flow of the lessee to determine the ability of the lessee to pay
the rentals over a long period. If the lessee goes bankrupt, the leasing company will rank
only as a creditor in the winding-up. In certain cases, collaterals, or bank acceptances or
guarantees may have to be obtained from the lessee. On the other hand, the lessee must
also evaluate the financial standing of the leasing company since the lessee's unlimited
right to use the equipment can get seriously affected if the leasing company becomes
insolvent, and the assets have to be called back on winding up.
Kinds of Leases
There are basically two kinds of leases - financial lease and operating lease.
1. Financial Lease : A Financial Lease (also called Finance Lease, Capital Lease or
Full Pay-out Lease) is generally a long-term lease, where leasing is used as the method
of financing the capital expenditure. The lessee selects the equipment, settles the price
and terms of sale, arranges with a leasing company to buy it, takes it on lease by
entering into an irrevocable (non-cancellable) contractual agreement with the leasing
company for a fixed long-term period, pays the lease rentals to the leasing company on a
periodic basis over the period of lease, uses the equipment exclusively, maintains it,
insures and avails of the after-sales service and warranty backing it.
The lessee also bears the risk of obsolescence as he stands committed to pay the rental
for the entire lease period even though equipment may become obsolete during the
period of lease. A finance lease, as is evident from the above explanation, transfers
substantially all the risks and rewards linked to its ownership. Such a lease can be split
up into two or three periods over the life of the equipment. The lease during the first
period is called the primary lease which is for a pre-determined period of say, five
years (during which the leasing company recovers the complete cost of the equipment
along with the cost of capital and profit) followed by a perpetual lease on nominal
terms / token rental for the remaining life time of the asset.
Primary lease of five years can alternatively be followed by a secondary lease of
another 3 to 4 years thereafter followed by a perpetual lease, and the lease rental will
accordingly stand during the primary lease period. In fact, there is a fair degree of
flexibility possible, and packages can be tailor-made to suit the needs of the lessee. The
lease agreement can stipulate that at the end of pre-determined lease period the
equipment will be sold / scrapped and the proceeds received will accrue to the lessee or
the lessor as agreed, and the lease rent will be adjusted accordingly. Such a financial
lease would be wi thout the purchase option, and at best, the lessee may be entitled
to buy the equipment at the then prevailing market value at the end of the lease.
The financial lease could also be wi th pur chase option, wherein, at the end of the
pre-determined lease period, the lessee has the right to buy the equipment at a pre-
determined value or at a nominal value, and the lease rental will be adjusted
accordingly. However, there is a view that a lease with purchase option is construed to
be a hire-purchase transaction and, therefore, the lease rentals will, for tax purposes, be
split into principal and interest, and only the interest portion, and not the entire lease
rental, will be allowed as a deduction.
The rate of rental would be fixed based on the kind of financial lease taken, the period of
lease, the periodicity of rental payment and the rate of depreciation and other tax
benefits available.
The periodicity of lease rental could be monthly, quarterly or half yearly.
Normally, an advance of three months rental is taken by the leasing company and is
adjusted at the end of the lease period. The leasing company also charges nominal
service charges/management fees to cover legal and other costs, and it may also insist
on collaterals or bankers' guarantees in individual cases.
2. Operating Lease : An Operating Lease (also known as Maintenance Lease or
Service Lease) is a short-term lease. The lease period is insignificant as compared to the
life of the equipment and the lease is usually cancellable. The lessor insures and
maintains the equipment and the lease rental takes all these costs into account. The risk
of obsolescence lies with the lessor, who gives it out on lease to one lessee after another
for short periods. In such a lease, substantially all the risks and rewards incidental to
ownership are not transferred to the lessee.
The important characteristics that distinguish an operating lease from a finance lease
are given below:
i. The cost of the asset is not received by the lessor from a single lessee;
ii. The lease term is not for the duration of economic life of the asset;
iii. The type of assets leased out are "general purpose" and not "special purpose"
assets. Such assets are usual and needed by many;
iv. The lessor is responsible for repairs and maintenance and other support
services to the lease;
v. The risk of obsolescence is borne by the lessor.
The chart prepared by the secretariat of IASC illustrates the classification of lease into
Finance Lease and Operating Lease.
Fig. 18.1 Distinction between Financial lease and Operating lease
Sale and Leaseback
A sale and leaseback transaction involves the sale of an asset to the lender (leasing or
finance company) and the leasing of same asset back from the lender. The transaction
may be with respect to new equipment or second hand equipment which the seller has
been already using. The rentals and sale price are usually interdependent and may not
represent fair values. This method has a great advantage in that the vendor has the
uninterrupted use of equipment and of the same time it helps him to expand his
business with the funds released by the sale. The vendor also makes a profit if the fair
value is more than the depreciated value, and this helps to improve his net worth. The
transaction is completed on paper without any physical movement of assets which stay
where there are i.e., in the organisation which continues to use them as before without
any interruption.
In the sale and lease back method there are only two parties to the transaction instead of
three, as the supplier of the equipment and its lessee are the same person, and the other
party is the leasing company. Charging a higher sale price on the sale of the assets to the
leasing company is not necessarily an advantage to the organisation selling them for
leaseback, since the supplier and lessee are the same, and the leasing company only
playing the role of a financier. If the sale price received by the selling organisation is
high, it also has to shell-out a higher lease rental, and if the sale price received is low, the
rental paid out is also correspondingly reduced.
In fact, if the sale price is low the sale tax payable on the sale to the leasing company is
also reduced. In certain circumstances, perhaps, no sales tax may be payable. The sale
and lease back technique is popular abroad, and is likely to gain immense popularity in
India as well, on account of its advantages.
Maintenance, Non-maintenance, and Net Leases
Based on leasing contracts, leases may also be classified into three types: maintenance,
non-maintenance and net. The maintenance lease provides that the lessor pays a
complete upkeep of the equipment. The type of lease frees the lessee from maintenance
headaches and from worries over equipment breakdowns; if the equipment cannot be
readily repaired, the lessor usually furnishes a replacement. In non-maintenance
lease, the full cost of maintaining the equipment or property is in the hands of the
lessee and he incurs all taxes. For net lease, the lessor makes arrangements for
purchasing the equipment, delivery, and financing as a little more than an agent for the
lessee. However, such a lessor has nothing to do with maintenance and repair of the
equipment.
In lease financing, the nature of the obligations of the lessor and the lessee are specified
in the lease contract. This contract contains:
(i) the basic period during which the lease is non-cancellable,
(ii) the timing and amounts of periodic rental payments during the basic lease period,
(iii) any option to renew the lease or to purchase the asset at the end of the basic lease
period, and
(iv) provision for the payment of the costs of maintenance and repairs taxes, insurance,
and other expenses. With a 'net lease' the lessee pays all of these costs. Under a
'maintenance lease', the lessor maintains the asset and pays the insurance cost.
Please use headphones
Lease Financing versus Debt Financing
Conceptually, leasing is quite similar to borrowing, so leasing provides financial
leverage. In fact, a lease is a type of debt. Whether lease financing or debt financing is
favoured will depend upon the pattern of cash-outflows for each financing method and
upon the opportunity of funds. Several methods are used to compare the two
alternatives. The important ones are:
1. Present Value Analysis
2. Internal Rate of Return Analysis
3. Bower-Herringer-Williamson Method
The decision to lease or borrow can be made on the basis of which alternative has the
lowest present value of cash outflows or lowest after-tax internal rate of return. Because
the latter does not require specifying a discount rate, it is preferred by a number of
theorists. If the Present Value method is used, the after-tax cost of debt, perhaps, the
risk-free rate should be employed as the discount rate. Another method of analysis calls
for the separation of difference in explicit financing costs from differences in taxes, with
the two methods of financing compared according to their present values.
All the above methods, usually, indicate the answer that borrowing generally will be the
preferred alternative because the interest cost typically is somewhat lesser than leasing.
As long as the interest cost is lower, debt financing will be superior to lease financing. It
is important to stress that in the absence of economic advantages, such as taxes, and/or
market imperfections, lease financing will not be superior to debt financing.
Lease versus Buy (Purchase) Decision
A lease versus buy (purchase) decision should be evaluated in each case especially where
funds are not a constraint. Various factors such as the rental charge, prevailing rates of
interest on borrowed funds, availability of funds, tax rates applicable to the lessee
organisation, depreciation rate, and availability of other tax benefits such as additional
depreciation, investment allowance on the capital cost of the equipment, have to be
taken into consideration. The tax benefits based on the ownership and capital cost of the
equipment are available to the leasing company (lessor) and not to the lessee who, on
the other hand, is entitled to a complete tax deduction for rentals paid.
On balance, therefore, while it may be better to 'buy' in one case, it may be better to
'lease' in another. Further, certain caution has to be exercised before entering into a
leasing agreement and all the legal aspects should be carefully considered. At present,
while there is a law governing hire purchase transactions and while lease of immovable
property is covered by the Transfer of Property Act 1882, there is no specific enactment
in respect of equipment leasing, and as a result, different laws are to be construed to
interpret legalities involving equipment leasing.
Lease versus Hire-Purchase
A leasing transaction must be distinguished from a hire-purchase transaction or
transaction of payment by installments. In the case of payment by installments, the user
actually purchases the capital equipment himself and merely makes the payment in
periodic installments over a specified period, and becomes the owner at the very outset.
In a hire-purchase transaction, a sizable down payment is made and balance amount is
payable over a specified period as installments comprising of principal and interest, and
ownership in the property passes to the person taking the equipment at the end of the
period when the last payment is made.
The main advantage of buying assets on hire purchase is that the business is able to use
the earnings (by employing the asset) to pay the hire-purchase charges as they fall due.
The asset must normally have a longer expected life than the length of the hire-purchase
agreement, and the value should also be in excess of the amount outstanding on the
agreement.
The main disadvantage of hire-purchase financing is that the interest rates are usually
high (more than 15%). As this rate is applied to total amount involved (i.e. the initial
balance) the effective rate charged on the balances outstanding will tend to double the
actual rate charged. Due to this grave disadvantage, this method is not always favoured.
In spite of its expensiveness, this method is more particularly used by those business
houses whose work necessitates their expenses and profits to be spread over a lengthy
period e.g. the building construction industry.
Thus, in installment and hire-purchase transactions, the user gets vested with
ownership and custody of the equipment, as against a lease transaction where the user
(lessee) has only the custody and usage of the equipment while the ownership vests in
the lessor.
Income-Tax Implications of Leasing
The income-tax implications of leasing need to be clearly understood as they play an
important role in the lease transaction. While the tax treatment for the leasing company
is more intricate, it is simple for the manufacturer or lessee. In the case of the
manufacturer, the transaction of sale to the leasing company is like a sale to any other
customer, and income tax will be payable on the profit earned through the sale. On the
other hand, the lessee is entitled to a 100 percent tax deduction for the lease rental paid,
but it may be noted that, as stated earlier, there is a view that if the lease is with the
purchase option, the transaction may be regarded as hire-purchase, in which case the
lease rental will be split between principal and interest, and only the interest element
will be allowed as a tax deduction.
Advantages of Leasing Finance
There are numerous advantages of obtaining equipment on lease, which must be taken
into account in evaluating a lease versus buy decision. These are as follows:
1. It has a tremendous cash flow advantage as it enables one to acquire a capital asset
even though he does not have the ability to immediately generate cash resources to meet
the cost of the capital expenditure for buying the asset. As long as the user has the ability
to pay the rentals through profits generated from utilisation of the equipment or from
profits of the other activities or otherwise, leasing enables the user to use the equipment
for his business. Thus, if the lessee does not have the ability or desire to raise equity or
has used all his borrowing capability and cannot borrow any further under the norms of
banks and financial institutions, leasing comes to the rescue and enables the borrower
to acquire and use the asset.
2. Even if the user has borrowing power and can borrow funds, he may need such
borrowed funds for other equipment or activities. Leasing again comes to the rescue as
it keeps the borrowing powers intact.
3. The sale and lease back technique comes in very handy when the borrower has limited
or no borrowing powers and wishes to borrow for a specific project or for working
capital needs. This may be particularly true in the case of a growing organisation where
working capital needs would also be growing, but the organisation is unable to obtain
higher borrowing, as its long term funds base is fixed and cannot itself be increased for
various reasons. In such a situation, the sale and leaseback technique enables the
organisation to make higher borrowings to meet the growing working capital
needs without having to bring in any additional equity.
Leasing is, therefore, also called "off balance sheet financing", as it finances new capital
assets without bringing them on the balance sheet, and also has the advantage of taking
existing capital assets 'off balance sheet' without disrupting their user.
4. Even where the organisation has borrowing power, it may prefer to adopt leasing as
the mode of financing its capital assets instead of resorting to borrowings on account of
the strings attached to borrowing, and restrictions imposed on the borrower. Financial
institutions in India impose a lot of onerous conditions on the borrower. However, lease
finance is free from restrictive covenants of borrowing.
5. The leasing alternative provides "off balance sheet financing" and therefore, there
is scope for the lessee to escape asset based restrictions impose by the authorities (e.g.
under the MRTP Act, etc.). Under the I (D & R) Act, however, the Government has
issued a notification that the value of assets obtained on lease is to be taken into
account.
6. Leasing provides 100% finance, as the lessee does not have to provide any margin
money. The entire cost of the equipment is financed by the lessor.
7. Leasing avoids raising of equity and thereby prevents change in the
shareholding pattern, which is important from the stand point of control over
management.
8. The leasing transaction can be completed swiftly as against the time-consuming
and procedure-bound approval and disbursement process of loans. In fact, in many
cases, the delay in sanction of loans results is an over-run of expenditure apart from
other hardships.
9. Leasing can take care of urgent non-budget additions expeditiously, as it does
not upset the capital expenditure funding plans.
10. Though a pseudo advantage, in most cases, it is easier to obtain internal
sanctions for acquiring assets on lease as against incurring capital expenditure
through purchase.
11. Lease rental is entitled to a 100 percent tax exemption. Thus, if the rate of
income tax payable by the lessee is say 60% and the lease rental is say 30% p.a.,
effectively the lessee has to pay a rental of only 12% p.a. post-tax (i.e. 40% of 30%).
12. Acquiring equipment on lease provides a hedge against inflation, as the lessee pays
for today's equipment in tomorrow's currency, as against outright purchase, where the
buyer pays entirely in today's currency.
13. A lease rental package can be tailor-made to suit the needs of the lessee, and as it is a
contract of mutual convenience. Rentals can be fixed to suit the cashflow of the
lessee. Though lease rentals normally commence from the date of delivery, a holiday of
lease rentals for a specified number of months can be considered in individual cases.
The terms relating to onus of insurance and maintenance, period of lease, rate of rental,
frequency of rental payment, etc. can be mutually agreed upon.
14. Apart from advantages to the lessee, leasing is also beneficial to the
manufacturers and suppliers of equipment since it helps in boosting the sale of
their equipment which is made available on lease. In fact, manufacturers stand to gain
by having tie-ups with leasing companies in order to push sales of their products in the
markets.
Disadvantages of Lease
Because the lease obligation generally is not disclosed in the balance sheet as a
liability, but rather treated as a footnote to the financial statement, certain creditors and
investors may not recognise the full implications of this contractual commitment. To the
extent that it is not recognised, the ability of the firm to raise additional funds may seem
better if the asset were purchased and financed out of the debt.
One of the principal disadvantages of lease financing is that the lessee does not own the
asset; any residual value after the basic lease period goes to the lessor.
Another major disadvantage is that the interest cost of lease financing usually is higher
than the interest cost of borrowing.
Also, long term leasing of assets is generally more expensive to the lessee.
Miscellaneous expenses have often to be borne by the lessee.
When a lease is long-term and non-cancellable, there is no chance for the lessee to shift
the danger of obsolescence to the lessor.
REVIEW QUESTIONS
1. Explain the meaning of the term 'leasing' and state the different types of leases.
2. Leasing is often called "off balance sheet" financing. Explain reasons for agreeing or
disagreeing with this characterisation.
3. A sale and lease-back arrangement may be thought of as a special type of financial
lease. How?
4. Is leasing an investment decision or a financing decision? How does lease financing
provide for financial leverage?
5. What are the major differences between (i) financial lease and operating lease, (ii)
financial lease and sale-and-lease-back arrangement?
6. Distinguish between service lease and financial lease. Would you be more likely to
find a service lease employed for a fleet of trucks or for a manufacturing plant?
7. How will you evaluate lease financing versus debt financing decisions?
8. Explain the advantages and disadvantages of a lease as a source of finance.
9. Discuss the similarities and differences, if any, between a lease and a hire purchase
agreement.
10. Explain the following: (a) Maintenance lease, (b) Net lease, (c) Primary lease, (d)
Perpetual lease, (e) Tax implications of leasing.
SUGGESTED READINGS
1. Rathnam, P V: Financial Advisor, Allahabad, Kitab Mahal
2. Saravanavel, P: Financial Management, New Delhi, Dhanpat Rai & Sons.
- End of Chapter -
LESSON - 19
DIVIDEND POLICY
Learning Objectives
After reading this lesson you should be able to:
Understand the scope of management of earnings
Identify the determinants of dividend policy
Ascertain different kinds of dividend policies
Distinguish between stock dividend and stock split
The rules as to payment of dividend
Lesson Outline
Management of Earnings - Sources of Profits - Profit Gear
Dividend Policy - Determinants of Dividend Policy
Kinds of Dividend Policies
Forms of Dividends - Stock Dividend and Stock Split
Companies Act and Payment of Dividend
Procurement of adequate amount of capital is not the be-all-and-end-all of the entire
duties of management. As a matter of fact, the dexterity of management lies more in the
management of earnings than in the procurement of capital. After obtaining the
necessary amount of capital, the next important function is to invest and utilise the
procured capital in such a way that the investors may get an adequate return on their
investments and the capital too may remain intact. Procurement of capital is
comparatively an easier task and it depends more on the condition of the money market.
But efficient utilisation of the capital and the management of earnings are delicate
issues which depend upon the internal administration of enterprises. The procured
capital is usually invested in the further procurement of men, machines, and materials,
and the ultimate result of this investment is either profit or loss, which in turn depends
upon the earning capacity of the company. The more the earning capacity of the
company, the higher would be the profits.
MANAGEMENT OF EARNINGS
In the words of Gerstenberg, "Management of income in its broadest sense includes the
management of each phase of the companys business because each activity of business
usually involves income or expenditure." Creation of ill-planned reserves, unsound
depreciation policy and absence of scientific internal financial control are symbols of
defective administration of income and may lead to liquidation. Hence, rational
management of earnings is considered as an important tool of financial administration.
The scope of management (or maximization) of earnings are:
(i) Increasing the level of profits of the company through capital-gear and profit-gear,
(ii) Management of dividends, and
(iii) Management of reserves and surpluses.
Level of Profit of the Company and its Significance
1. Correct financial performance reporting to the shareholders.
2. Dividend declaration depending upon the determination of profit.
3. Intensive use of capital can be ascertained by the earning capacity.
4. Ascertaining the operating efficiency of the company.
5. Future expansion and diversification of the company.
6. Ease in obtaining loan or creating public response to further issue of securities.
7. Determining the correct basis of merger or consolidation.
8. Correct taxation planning is possible.
9. Ascertaining the importance of the industry in national economy.
10. Inter-firm and intra-firm comparison are made effective.
Sources of Profits
The principal sources of earning for a company may be classified into three groups:
1. Income from the main business : Internal financing or ploughing back of profits
depends mainly on the income from this main source. The higher the profits, the heavier
would be the reserve of retained earnings.
2. Income from Other Sources : Any other income, besides the main source, falls
under this head. The term 'other sources' refers to those sources which are allied to the
main objective. Such income is separately shown in the accounts of the company.
3. Income from Investment : More often, the surplus funds of a company are
invested in the purchase of securities of other companies. Such investment may be
permanent or temporary. Certain companies are legally bound to invest a part of their
capital in government securities, e.g., banks and insurance companies. Income from
investments is also separately shown in the Profit and Loss account/Balance Sheet of a
company.
Advantages of Stable Earnings
Although there is no direct correlation between the stability of earnings and the
profitability of a business over a complete business cycle, stability of revenues is one of
the aims of business.
(i) The stable flow of income simplifies the task of management by facilitating long-term
planning and enabling it to control the performance efficiently
(ii) It permits the enterprise to maintain its organisation
(iii) It also helps in building a sound capital structure
(iv) Forecasting and business budgeting can be done successfully on proper lines
(v) Stable dividend policy depends considerably on stable earnings
(vi) It increases the credit-worthiness of a company, which can get the company
adequate loans at a reasonable rate of interest
(vii) Stable earnings also help in keeping the price steady, which is beneficial from the
standpoint of consumers.
Hence, all possible efforts be taken to keep the earnings of a company stable.
Factors Affecting the Stability of Earnings
Generally speaking, the stability of gross earnings depends upon the following four
elements:
1. Nature of business: It is a notable fact that enterprises dealing in basic and
essential services, low-priced commodities, non-durable goods, or consumer
goods have more stable earnings than those dealing in luxurious, high-priced or
novelty goods, heavy goods and raw materials.
2. Size of business: Mere size of business has a salutary effect in keeping
revenues steady, where size is a result of product diversification. Enterprises
characterised by large scale production, upto a certain point at least, have a wide
margin of profit when compared with smaller concerns, and can withstand
temporary losses better than the small companies.
3. Possession of elements of a monopoly: Other things being equal, a concern
that enjoys some elements of monopoly will have steadier revenues than one that
is subject to intense competition. The monopoly benefits may arise on account of
patents, copyrights, particular locational site etc.
4. Profit gear: The profit derived by some tactical policies i.e., by taking proper
advantage of a situation may be termed as tactical profit. Profitability may be
improved at least temporarily by some management tactics apart from routine
policies and plans. The tactical profit has special significance in the total profit.
The relation of such tactical profit with the routine profit may be Profit Gear. The
higher the Profit Gear the greater is the importance of such tactical policies. In a
period when there is no occasion to take tactical decision to increase profit or if
wrong policies are followed, the profitability may be substantially affected. Thus
tactical decisions may be taken up as profit-boosters. Even moderate dose of
over-trading may boost up the profit.
Similarly, timely action may act as loss-breaker or loss-absorber. Special sales drive may
result in extra contribution and reduction in loss. Timely closure of seasonal factory like
a sugar mill will result in avoiding loss by avoiding avoidable daily expenses. That is, in
difficult days, loss minimisation, rather than profit maximisation may be the suitable
objective. In the case of reduction of loss by tactical decision, the profit gear may be
calculated by finding out the ratio of loss avoided with usual loss.
DIVIDEND POLICY
Dividend policy, as intimately related to retained earnings, refers to the policy
concerning quantum of profits to be distributed as dividend. This is probably the most
important single area of decision making for the finance manager. Action taken by the
management in this area affects growth of the firm. An erroneous dividend policy may
land the firm in financial predicament and capital structure of the firm may become
unbalanced. Progress of the firm may be hamstrung owing to death of resources, which
may result in fall in earnings per share. Stock market is very likely to react to this
development and share prices may tend to, sag leading to decline in the total value of
the firm. Extreme care and prudence on the part of the policy framers is, therefore,
inevitable.
If strict dividend policy is formulated to retain larger share of earnings, plenty of
resources would be available to the firm for its growth and modernisation purposes.
This will give rise to business earnings. In view of the improved earnings position and
financial health of the enterprise, the value of shares will increase and a capital gain will
result. Thus, shareholders earn capital gain in lieu of dividend income, the former in the
long-run and the latter in the short-run. The reverse holds true if liberal dividend policy
is followed to pay out higher dividends to shareholders. Consequently, the stockholders'
dividend earnings will increase but the possibility of earning capital gains is reduced.
Investors desirous of immediate income will greatly value shares with high dividend.
The stock market may, therefore, respond to this development and value of shares may
zoom.
It is, thus, evident that retention of earnings lies on capital gains. Distribution of
income, on the other hand, increases dividend earnings. Owing to varying notions and
attitudes of shareholders due to difference in respect of age, tax bracket, security
income, habits, preferences and responsibilities, some shareholders are primarily
concerned with the short-run returns, others think in terms of long-range returns, and
still others seek a portfolio which balances their expectations over time. The above
analysis lead us to conclude that dividend decision materially affects the stockholder's
wealth and the valuation of the firm. However, financial scholars have not been
unanimous on this issue.
Determinants of Dividend Policy
The payment of dividend involves some legal as well as financial considerations. It is
difficult to determine a general dividend policy which can be followed by different firms
at different times because the dividend decision has to be taken considering the special
circumstances of an individual case. The following are the important factors which
determine the dividend policy of a firm:
1. Legal Restrictions : Legal provisions relating to dividends as laid down in sections
93, 205, 205A, 206 and 207 of the Companies Act, 1956 are significant because they lay
down a framework within which dividend policy is formulated. These provisions require
that dividend can be paid only out of current profits or past profits after providing for
depreciation or out of the money provided by Government for the payment of dividends
in pursuance of a guarantee given by the Government. The Companies Act, further,
provides that dividends cannot be paid out of capital, because it will amount to
reduction of capital, adversely affecting the security of its creditors.
2. Magnitude and Trend of Earnings : The amount and trend of earnings is an
important aspect of dividend policy. It is rather the starting point of the dividend policy.
As dividends can be paid only out of present or past year's profits, earnings of a
company fix the upper limits on dividends. The dividends should generally be paid out
of current year's earnings only, as the retained earnings of the previous years become
more or less a part of permanent investment in the business to earn current profits. The
past trend of the company's earnings should also be kept in consideration while making
the dividend decision.
3.Desire and Type of Shareholders : Although, legally, the discretion as to whether
to declare dividend or not has been left with the Board of Directors, the directors should
give due importance to the desires of shareholders in the declaration of dividends, as
they are the representatives of the company. Desires of shareholders for dividends
depend upon their economic status. Investors, such as retired persons, widows and
other economically weaker persons view dividends as a source of funds to meet their
day-to-day living expenses. To benefit such investors, the companies should pay regular
dividends. On the other hand, a wealthy investor in a high income tax bracket may not
benefit by high current dividend incomes. Such an investor may be interested in lower
current dividends and high capital gains. It is difficult to reconcile these conflicting
interests of the different types of shareholders, but a company should adopt its dividend
policy after taking into consideration the interests of its various groups of shareholders.
4. Nature of Industry : Nature of industry, to which the company is engaged, also
considerably affects the dividend policy. Certain industries have a comparatively steady
and stable demand irrespective of the prevailing economic conditions. For instance,
people used to alcohol continue to buy it both in boom as well as recession. Such firms
expect regular earnings and hence, can follow a consistent dividend policy. On the other
hand, if the earnings are uncertain, as in the case of luxury goods, conservative policy
should be followed. Such firms should retain a substantial part of their current earnings
during boom period in order to provide funds to pay adequate dividends in the recession
periods. Thus, industries with steady demand of their products can follow a highest
dividend payout ratio while cyclical industries should follow a lower payout ratio.
Please use headphones
5. Age of the Company : The age of the company also influences the dividend
decision of a company. A newly established concern has to limit payment of dividend
and retain a substantial part of earnings for financing its future growth and
development, while older companies which have established sufficient reserves can
afford to pay liberal dividends.
6. Future Financial Requirements: In addition to desires of the shareholders,
future financial requirements of the company also must be taken into consideration
while making a dividend decision. The management of a concern has to reconcile the
conflicting interests of shareholders and the company's financial needs. If a company
has highly profitable investment opportunities it can convince the shareholders that
there is a need to limit dividend payment in order to increase the future earnings and
stabilise the company's financial position. But when profitable investment opportunities
do not exist, then the company may not be justified in retaining substantial part of its
current earnings. Thus, a concern having few internal investment opportunities should
follow high payout ratio as compared to one having more profitable investment
opportunities.
7. Government's Economic Policy: The dividend policy of a firm has also to be
adjusted to the economic policy of the Government, as was the case when the
Temporary Restriction on Payment of Dividend Ordinance was in force. In 1974 and
1975, companies were allowed to pay dividends not more than 33.33 per cent of their
profits or 12 per cent on the paid-up value of the shares, whichever was lower.
8. Taxation Policy: The taxation policy of the Government also affects the dividend
decision of a firm. A high or low rate of business taxation affects the net earnings of a
company (after tax) and thereby its dividend policy. Similarly, a firm's dividend policy
may be dictated by the income-tax status of its shareholders. If the dividend income of
shareholders is heavily taxed being in high income bracket, the shareholders may forego
cash dividend and prefer bonus shares and capital gains.
9. Inflation: Inflation acts as a constraint in the payment of dividends. Profit arrived
from the Profit & Loss account on the basis of historical cost has a tendency to be
overstated in times of rise in prices due to over-valuation of stock-in-trade and writing-
off depreciation on fixed assets at lower rates. As a result, when prices rise, funds
generated by depreciation would not be adequate to replace fixed assets, and hence to
maintain the same assets and capital intact, substantial part of the current earnings
would be retained. Otherwise, imaginary and inflated book profits in the days of rising
prices would amount to payment of dividends much more than warranted by the real
profits out of the equity capital resulting in erosion of capital.
10. Control Objectives: When a company pays high dividends out of its earnings, it
may result in the dilution of both control and earnings for the existing shareholders. As
in case of a high dividend pay-out ratio, the retained earnings are insignificant and the
company will have to issue new shares to raise funds to finance its future requirements.
The control of the existing shareholders will be diluted if they cannot buy the additional
shares issued by the company. Similarly, issue of new shares shall cause increase in the
number of equity shares and ultimately cause lower earnings per share and their price in
the market. Thus, under these circumstances to maintain control of the existing
shareholders, it may be desirable to declare lower dividends and retain earnings to
finance the firm's future requirements.
11. Requirements of Institutional Investors: Dividend policy of a company can be
affected by the requirements of institutional investors such as financial institutions,
banks, insurance corporations, etc. These investors usually favour a policy of regular
payment of cash dividends and stipulate their own terms with regard to payment of
dividend beyond certain percentage on equity shares.
12. Stability of Dividends: Stability of dividends is another important guiding
principle in the formulation of a dividend policy. Stability of dividends simply refers to
the payment of dividend regularly. Shareholders generally prefer payment of such
regular dividends. Some companies follow a policy of constant dividend per share while
others follow a policy of constant payout ratio, while there are some others who follow a
policy of constant low dividend per share plus an extra dividend in the years of high
profits. A policy of constant dividend per share is most suitable to concerns whose
earnings are expected to remain stable over a number of years or those who have built
up sufficient reserves to pay dividends in the years of low profits. The policy of constant
payout ratio, i.e., paying a fixed percentage of net earnings every year may be supported
by a firm because it is related to the firm's current ability to pay dividends. The policy of
constant low dividend per share plus some extra dividend in years of high profits is
suitable to the firms having fluctuating earnings from year to year.
13. Liquid Resources: The dividend policy of a firm is also influenced by the
availability of liquid resources. Although, a firm may have sufficient available profits to
declare dividends, yet it may not be desirable to pay dividends if does not have sufficient
liquid resources. Hence, the liquidity position of a company is an important
consideration in paying dividends.
Kinds of Dividend Policies
There are a wide variety of dividend policies followed by companies. Selection of a
particular dividend policy is decided by the management after considering several
factors. The possible policies are :
(a) Policy of no Immediate Dividends: Payment of dividends is desirable from the
company's and shareholders' point of view, but it is not compulsory. The Board of
Directors may decide to pay no dividend, even though the earnings are substantial and
available for the purpose. A company following this policy may justify it under the
following conditions:
(i) The company is new and growing
(ii) The needed capital cannot be raised except at very high cost and earnings,
therefore, must be ploughed back in the business
(iii) The shareholders are willing to wait for a return on their investment, and in
the meantime, are content to have their holdings appreciate in value (capital
gains).
The no dividend policy must be used with great caution as it may cause dissatisfaction to
shareholders because of non-payment of current dividends. After a period of no
dividends while the surplus is increasing, it may be a good policy to issue bonus shares
(stock dividend) so that the net worth of the company is not affected.
(b) Stable Dividend Policy: A stable dividend policy is one that maintains regularity
in paying some dividend regularly even though the amount of dividend may fluctuate
from year to year and may not be related with earnings. More precisely, stability of
dividends refers to the amount paid out regularly. Stability of dividends can take three
forms:
i. Constant dividend per share, i.e., paying a fixed amount per share as
dividend every year irrespective of the fluctuations in the earnings.
ii. Constant percentage of net earnings, i.e., paying a fixed percentage of net
earnings every year (here, the amount of dividend will fluctuate in direct
proportion of earnings), and
iii. Small constant dividend per share plus extra dividend.
Generally, when we refer to a stable dividend policy, we refer to the first form of paying
constant dividend per share. A stable dividend policy, therefore, does not mean an
inflexible policy, but one that involves payment for a fair rate of returns after taking into
consideration the gradual growth of the business and the gradual evolution of external
values.
Merits of Stable Dividend Policy: Stable dividend policy brings various benefits to
the company and shareholders.
(1) It helps in long-term financing. If a company anticipates having to raise
additional funds some time in the future, it must keep in mind that today's
operations will be part of the record that investors would like to examine critically
in deciding whether to buy the company's securities. A stable dividend policy, in
that event, would make financing easier.
(2) It improves the company's credit and enhances the market value of securities.
(3) It creates shareholder's confidence in the management and reduces investor's
uncertainty. Dividends have informational value a company can make statements
about its expected earnings growth to inform shareholders in order to create a
favourable impression on them.
(4) The benefits outlined above would bring a great relief to the management in
formulating long-term planning for the company.
From what has been said above, one should not get an erroneous impression that the
stable dividend policy is without any drawback. The greatest danger associated with a
stable dividend policy is that once it is adopted by the firm, it cannot be changed easily.
It is, therefore, prudent that the dividend rate is fixed at a lower level so that it can be
maintained even in years with reduced profits.
(c) Policy of Regular and Extra Dividends: This policy carries out the intention of
regular (stable) dividend rate, and at the same time allows shareholders to have a share
of additional earnings through extra dividends. It is not an unusual practice for
companies to pay extra year-end dividends if the results of business operations indicate
their justifiability. In order to avoid any possible misunderstanding, it is always
advisable to clearly indicate to shareholders the amount of regular and extra dividends.
In future if extra dividend is not paid, then the shareholders would not get disillusioned
with the company. Large companies, usually, number their dividends and label them as
regular or extra.
(d) Policy of Regular Stock Dividends: A stock dividend policy refers to the
distribution of shares in lieu of (or in addition to) cash dividend (known as bonus shares
in India) to the existing shareholders. Such a policy results in increasing constantly the
number of outstanding shares of the company. The policy to pay regular stock dividends
is justified when:
(i) there are earnings available with the company but the need is to retain cash in
the business, and
(ii) companies have modernisation and extension programmes, which need to be
financed immediately.
The policy of regular stock dividends is not generally advisable. The policy can apply
only temporarily, however, the constant cutting up of the corporate ownership into a
large number of shares may prove harmful in periods of reduced earnings. Also, the
value of shares may fall below a desirable range from the stand-point of later financing.
Those shareholders who have a strong preference for cash dividends would feel totally
disillusioned with the company.
(e) Policy of Regular Dividends and Stock Dividends: The company using this
dividend policy pays regular (stable) dividend in cash and extra dividend in stock. This
dividend policy is adopted when a company:
(i) wants to continue its records of regular cash payments,
(ii) has reinvested earnings that it wants to capitalise, or
(iii) wants to give shareholders a share in the additional earnings but cannot afford
to use up its cash.
(f) Policy of Irregular Dividends: This policy is based upon an attitude that
shareholders are entitled to as much dividends as the earnings and financial condition
of the company warrant. Having this policy of declaring dividends is entirely
appropriate for a company that has highly unstable earnings. If this dividend policy is
adopted by a company with stable earnings, it will have disastrous consequences for the
company and shareholders.
Forms of Dividends
1. Annual or Regular Cash Dividends: It is the dividend being paid annually by the
company. It is also known as final dividend. When annual accounts of the company
have been finalised and audited, the directors recommend the rate of dividend which
can be distributed on the capital of the company. When approved by the shareholders at
an annual general meeting, the dividend is paid within 42 days from the date of
declaration by the company. It is generally paid in cash and as a percentage of the paid-
up capital, e.g. 10% or 15% of the face value of the share. Though in some cases,
dividend per share can also be distributed.
2. Interim Dividends: When companies have heavy earnings during a year and
directors wish to pay them to the shareholders but at same time, they do not wish
shareholders to regard the amount as a precedent for later years, they can distribute
interim dividend. So, it is an extra dividend paid during the year. Such dividends are
immediately paid after the recommendation of the Board of Directors, as there is no
need of shareholders' approval. Interim dividends are also cash dividends.
3. Scrip Dividends: Scrip dividends are used when earnings justify a dividend, but the
company's cash position is temporarily weak. So, shareholders are issued transferable
promissory notes, which may or may not be interest bearing.
4. Bond Dividends: In rare instances, dividends are paid in Bonds or Notes that have
a long enough term to fall beyond the current liability group. Except that the date of
payment is postponed, the effect is the same as that of paying dividends in scrip. The
shareholders become a secured creditor if the bond has a lien on assets.
5. Property Dividends: Property dividends involve a payment with non-cash assets.
Such a distribution may be made whenever these are assets that are no longer necessary
in the operation of the business. The investment held by the company also can be
distributed by the company in the form of property dividends.
However, it is important to note that only cash dividends and stock dividends (i.e.,
bonus shares) are permissible in India; other types of dividends are not allowed. The
Indian Companies Act, 1956 governs the declaration and payment of dividends.
6. Stock Dividends: It is a form of dividend in which the surplus of company is
transferred to capital account and shareholders are given the dividend in the form of
shares rather than cash. Such shares are called bonus shares. This dividend is
declared to only Equity Shareholders and it may take two forms:
(i) converting the partly paid equity shares into fully paid up without asking for
cash from the shareholders, or
(ii) issuing and allotting shares to existing equity shareholders in a definite
proportion out of reserves and surpluses.
Thus, the shareholders receive stock or share certificate for the dividend. This process is
also known as 'capitalisation of profits'. Stock dividend does not alter the cash position
of the company. It serves to commit the retained earnings to the business as a part of its
fixed capitalisation.
Objects of Stock Dividend: Stock dividends may be issued to serve one or more of
the following objectives:
1. Conservation of Cash: By issuing bonus shares, a company gives profits of its
prosperity to the shareholders without giving away cash. Hence, distribution of
dividends "in kind" conserves the cash in the business.
2. Lowering the rate of dividend: Stock dividend is a remedy for under
capitalisation too. Under-capitalised enterprise having a high rate of earnings on
the capital employed lowers the rate of dividend by increasing their
capitalisation. The increase in the number of shares is intended to reduce the rate
of dividend per share.
3. Transferring the formal ownership of surplus and reserves to the
shareholders: The existence of huge accumulated profits and other reserves
may provide temptation to the corporate management to indulge in speculative
activities and to manipulate the market value of the company shares. But once
these reserves are capitalised by issuing bonus shares, the scope for the above
activities is reduced.
4. Widening the share market: A company desiring wider ownership of its
shares may issue bonus shares. Some of the old shareholders might sell their new
shares. Moreover, the probable reduced value of the share prices may fall within
the buying range of more number of investors.
5. Financing the expansion programs: The expansion and modernisation
programme of a company can easily be financed by utilising the corporate savings
through the issue of bonus shares. Bonus shares become the permanent part, of
the capital structure of a company.
6. Enhanced prestige: Bonus shares tend to increase the credit-standing of the
issuing company. Its borrowing capacity goes high in the eyes of lending
institutions. It can arrange loans at a reasonable cost.
7. True depiction of earning capacity : If the revenues are not capitalised, a
false idea about the rate of profits is created because shares capital is left
unchanged while profits continue to accumulate.
8. Tax advantage: Bonus shares are sometimes issued to reap the benefit of a
higher rate of deduction allowed on paid-up capital than on the reserves under
the Payment of the Bonus Act, 1965.
Advantages of Stock Dividends
1. Maintenance of liquidity position: By issuing bonus shares a company can
maintain its liquidity position, as cash dividends are not paid to the shareholders;
only bonus shares are issued.
2. Satisfaction of shareholders: By the issue of bonus shares, the number of
equity shareholders in the company increases and they gain by the increased
confidence of investors in the soundness of the corporation. Hence, shareholders
can be satisfied by issuing bonus shares.
3. Remedy for under-capitalisation: In under-capitalised enterprises, the rate
of dividend is high. By issuing bonus shares, the rate of dividend per share can be
reduced, and a company can be saved from the negatives of wider-capitalisation.
4. Economical issue of securities: The issue of bonus shares is the most
economical issue of securities, because other types of securities cannot be issued
at this minimum cost.
5. There is conservation of control, and internal financing is available to the
company.
6. Tax Saving: Bonus shares are issued to take the benefit of a higher rate of
deduction allowed on paid up capital than on the reserves under the Payment of
the Bonus Act, 1965.
7. Increase in their equity: By issuing bonus shares, the equity of the
shareholders increases in the company. For example, A is the owner of 20 equity
shares of Rs. 100 each. Now the company issues four bonus shares to him i.e.,
one bonus share for every 5 shares held. In the beginning, his equity was Rs.
2000 in the company, but now his equity increased upto Rs. 2,400 in the
company.
8. Increased marketability of shares: When a company issues bonus shares,
some of the old shareholders sell their new shares to the other persons. Hence, by
issuing bonus shares the marketability of shares is increased.
9. Increase in income: In the long-run the income of the shareholders is also
increased. But it will be possible only when company is able to maintain the same
rate of dividend as before on the increased capital also.
Disadvantage of Bonus Shares Issue
(1) It leads to an increase in the capitalisation of the corporation which cannot be
justified until and unless there is a proportionate increase in the earning capacity of the
company.
(2) It throws more liability in respect of future dividend on the company.
(3) It excludes the possibility of new investors coming in contact with the company.
(4) The market value of existing shares goes down.
(5) Some shareholders may not like bonus shares; they might prefer only cash
dividends. Such investors may be disappointed. It lowers the market value of the
existing shares too.
Stock Split-ups
A corporation may issue stock split-ups to its shareholders. A stock split-up increases
the number of shares of the outstanding stock. There is no change in the total stated
value of the stock or in the surplus. It has no effect on shareholders equity. Its effect is
solely to repackage the evidence of ownership in small units. Stock split-ups are issued
with the following objectives:
a. To increase the number of outstanding shares for the purpose of effecting a
reduction in their unit market price and obtaining an orderly distribution of
shares;
b. To conceal the distribution of large profits by reducing the rate per share;
c. To provide a broader and more stable market for the stock;
d. To prepare for corporate mergers;
e. To please shareholders, since stock split-ups are viewed as bullish by the market
and stockholders take split-ups as on indicator of the financial success of a
corporation;
f. To facilitate manipulation by insiders;
g. To precede new financing.
Comparison of Stock Dividend and Stock Split
Stock Dividend Stock Split
1
The par value of the stock is
unchanged
The par value of the stock
reduces
2 A part of reserves is capitalized
There is no capitalization of
reserves
In a nutshell, a stock-split is similar to a bonus issue from the economic point of view,
though there are some differences from the accounting point of view.
COMPANIES ACT AND PAYMENT OF DIVIDEND
Provisions of Companies Act relating to Declaration and Payment of Dividend:
Declaration and payment of dividend is an internal matter of the company and is
governed by its Articles. The power regarding appropriation of profits is given to the
Board of Directors. The Directors are to follow Table A or provisions of Articles and the
provisions of the Companies Act 1956 in this regard. These are the rules regarding
declaration and payment of dividend:
1. Dividend on Paid up Capital : A company may, if so authorised by its Articles, pay
dividend on the paid up value of shares (section 93 of the Companies Act).
2. Provisions of Articles of Association (Rules 85 to 94 of Table A)
(a) A company may declare dividend in its General Meeting provided it does not exceed
the amount recommended by the Board of Directors,
(b) The Board of Directors may, from time to time, pay to the members such interim
dividends as appears to be justified by the profits of the company,
(c) Notice of dividend should be given to those who are entitled to receive it,
(d) The Directors may transfer any amount they think proper to the Reserve Fund,
which may be utilised for any contingencies, and
(e) When a dividend has been declared, it becomes a liability of the company towards
the shareholders from the date of its declaration, but no interest can be claimed on it.
3. Dividends only out of Profit (Sec. 205 (i))
(a) Dividends can only be declared or paid out of
i. the current profits of the company,
ii. the past accumulated profits, or
iii. money provided by the Central or State Government for the payment of
dividends in pursuance of a guarantee given by that government.
No dividend can be paid out of capital. Director responsible for payment of dividend out
of capital shall be personally liable to make good such amount to the company.
(b) Companies are not entitled to pay any dividend unless present or arrears of
depreciation have been provided for out of the profits, and an amount of 10% of profits
has been transferred to the Reserve. However, Central Government may allow any
company to declare or pay dividends out of profits before providing for any
depreciation.
(c) Capital Profits may also be utilised for the declaration of dividend provided
i. there is nothing in the Articles prohibiting the distribution of dividend out of
capital profits,
ii. they have been realised in cash, and
iii. they remain as profits after revaluation of all assets and liabilities.
(d) Dividend cannot be paid out of accumulated profits unless current losses are made
good.
4. Payment of Dividend only in Cash (Sec. 205(iii))
Dividends are to be paid in cash only except
(a) by capitalising the profits by issue of fully paid bonus shares if Articles so permit,
provided all legal formalities have been satisfied in respect of issue of bonus shares, and
(b) by paying up any unpaid amount on partly paid up shares.
5. Payment of Dividend to Specified persons (Sec. 206)
Dividend shall be paid only to those whose names appear on the Register of members on
the date of declaration of dividend or to the holders of dividend warrants if issued by the
company.
6. Payment of Dividend within 42 days (Sec. 207)
Dividend must be paid within 42 days of its declaration except in the following
circumstances:
(a) by operation of law of insolvency,
(b) in compliance of the directions of the shareholders,
(c) where right to receive dividend is pending decision,
(d) where it is not due to the default of the company, and
(e) if the company lawfully adjusts the amounts against any debt due from the
shareholder.
Any director in default shall be liable to punishment of seven days of simple
imprisonment or fine or both.
7. Payment of Interim Dividend:
The directors of a company can pay interim dividend, subject to the provisions of
Articles. Interim dividend can be paid at any time between the two AGMs (annual
general meetings) taking into full year's accounts and after providing full year's
depreciation on fixed assets.
8. Transfer of Unpaid Dividend to a Special Bank Account (Sec. 205 (A))
According to section 205 A, newly inserted by the companies (Amendment) Act 1974,
where a company has declared a dividend but has not posted the dividend warrant in
respect thereof within 42 days to the shareholders entitled to it, such unpaid dividends
shall be transferred to a special account to be opened by the company in the behalf in
any Scheduled Bank to be called 'Unpaid Dividend Account of. Co. Ltd.' If the unpaid
dividends are not so transferred, the company shall pay an interest at 12% p.a.
9. Transfer of Unclaimed Dividend to Central Government:
Any amount transferred to the unpaid dividend account which remains unpaid or
unclaimed for 3 years from the date of such transfer, shall be transferred to the Investor
Protection Fund by the company along with a statement giving full particulars in respect
of the sums so transferred and the last known addresses of the persons entitled to
receipt and such other particulars as may be prescribed. The company is entitled to a
receipt for such transfer from the Reserve Bank of India.
If a company fails to comply the above said provisions (given in Para 8 and 9 above), the
company and every officer of the company who is in default shall be punishable with a
fine which may extend to Rs. 500 for every day during which default continues.
REVIEW QUESTIONS
1. Explain the significance of dividend decisions in financial management.
2. Outline and analyse the fundamental issues concerning corporate dividend policy.
3. Explain the various external and internal factors which influence the dividend
decision of a firm.
4. What are the different types of dividends that can be paid by a company?
5. Explain (i) Constant-Pay-out Ratio Policy (ii) Constant Rupee Policy, and (iii)
Regular-Extra dividend Policy. What are the ramifications of these policies?
6. What are the advantages and disadvantages of stock dividend to the company and to
the shareholders? Explain.
7. As a firm's financial manager, which policy would you recommend to the Board of
Directors that the firm should adopt - a stable dividend payment per share policy or a
stable pay-out ratio policy?
8. Write a short note on Pay-out Ratio. What is its importance in dividend decisions?
9. What are Bonus Shares? Explain in brief the provision of Company Law relating to
them and the guidelines issued by SEBI.
10. Describe the various provisions of Companies Act, 1956 governing the declaration
and payment of dividend.
SUGGESTED READINGS
1. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi, Tata
McGraw Hill Co.
2. Pandey, I.M.: Financial Management, New Delhi, Vikas Publishing House.
3. Saravanavel, P.: Financial Management, New Delhi, Dhanpat Rai & Sons.
- End of Chapter -
LESSON 20
RELEVANCE AND IRRELEVANCE OF DIVIDEND DECISION
Learning Objectives
After reading this lesson you should be able to:
Recognise the controversies as to relevance of dividends
Understand the different models - dividend theories
Lesson Outline
Dividend Theories
Walter's Model
Gordon's Model
M.M. Model
M.M. Theory Criticisms
Illustrative Examples
Several theories studying relationship between dividend and value of the firm have been
advanced. Broadly speaking, these theories can be grouped into two categories, viz.
(a) Theories relating to relevance of dividend decision in valuation of firm, and
(b) Theories concerning irrelevance of the dividend decision.
The former set of theories, with which James E. Walter, Myron Gordon, John
Linter and Richardson are associated, hold that there is a direct relationship between
dividend policies of the firm and its market valuation of earnings, since the investor is
concerned about how the earnings are split up between dividends and retention.
The irrelevance approach of dividend decision was propounded by Merton Miller and
Franco Modigliani. According to these scholars, dividend decision is irrelevant and
does not affect share values as investors are basically indifferent to whether they get
returns in the form dividends or in the form of capital gains.
DIVIDEND THEORIES
I. Walter's Model : The basic emphasis of Walter's model is "maximisation of wealth
for the shareholders". Professor Walter brings about the importance of the relationship
between a firm's internal rate of return and its cost of capital in determining a dividend
policy.
Walter's model is based on the following assumptions:
1. All investment opportunities are financed by retained profits.
2. The firm's Internal Rate of Return (IRR) and its Cost of Capital (CoC) are constant.
3. All the profits are immediately either distributed as dividends or re-invested
internally.
4. The firm has a very long and continuous life.
The value of earnings per share (EPS), and dividend per share (DPS) may be varied to
determine the results, but any given values of EPS and DPS are assumed to be constant
forever for determining a given value.
The model is as follows:
DPS IRR (EPS DPS)/CoC
MPS = --------- + -----------------------------
CoC CoC
where,
MPS = Market Price Per Share
DPS = Dividend Per Share
EPS = Earnings Per Share
IRR = Internal Rate of Return
CoC = Cost of Capital
The above can be written as:
IRR
DPS + -------- (EPS DPS)
CoC
MPS = ------------------------------
CoC
From the above we are able to conclude that the two major factors influencing the
market price of a share are
(1) the dividend per share, and (2) the relationship between IRR and CoC.
One can visualise mathematically three kinds of relationship between IRR and CoC.
IRR > CoC (Growth firms)
IRR = CoC (Normal firms)
IRR < CoC (Declining firms)
Let us take an example and find out the optimal dividend policy for the first cases: IRR
> CoC
Assuming, CoC = 15% and EPS = Rs. 10. Since IRR > CoC, let us take IRR = 20%. Then,
if dividend payout is 0 (i.e., DPS = 0),
It is seen clearly that the optimal policy for a growth firm is to have dividend payout at
zero, since its Market Price goes down as the dividend is increased.
Similarly it can be established for a normal firm (IRR = CoC) that MPS is not affected by
the payout ratio, and as such there is no optimum policy.
For a declining firm (IRR < CoC), optimal policy would be to have the dividend pay-out
at 100%
Criticism: Walter's Model is criticised for the following:
1. There is no external financing,
2. The IRR is constant, and
3. The cost of capital is also constant.
In practice the IRR and CoC can never be constants as they change from time to time.
Please use headphones
II. Gordon's Model
This model is also called Dividend Capitalisation Model. Here, the market value of
share is equated to the present value of an infinite stream of dividends to be received by
the shareholder.
The Model is as follows:
DPS = Dividend Per Share
K = Appropriate discount rate (Cost of Capital)
In this model, the dividend rate is assumed to grow in future when earnings are
retained. Assuming a growth percentage of 'g' the above model can be re-looked at as
follows:
When the above is solved, the equation reduces itself to:
The following are the assumptions of the Gordon Model:
1. The firm is an all equity firm.
2. No external finance is assumed. All retained earning is used for further expansion.
3. The IRR is constant and also the appropriate discount rate (k) or cost of capital is also
constant.
4. Corporate taxes do not exist.
5. The earnings are continuous.
6. The proportion of retained earnings is constant and the discount rate (cost of capital)
is greater than the growth rate (k > g).
The Gordon Model can be restructured from the assumptions. Since the proportion of
retained earnings is always constant, dividend will be always constant. Dividend will
always be (1 - RE%). If total earnings in a period is E, then dividend will be (1 - RE%)
and earning would grow at a constant IRR.
We can substitute the above assumptions and study the results for various
characteristics of the firm.
As seen before, MPS = D1 / (k - g) = E1 (1 - RE) / (k - RE x IRR) in case of a normal
firm,
Since k = IRR the above can be simplified as,
MPS = E1 (1 - RE) / (k - RE x k)
= E1 (1 - RE) / k (1 - RE)
= E1 / k
So, MPS = E1 / k
E1 is a return on assets, and hence the MPS will be equal to book value of assets as long
as the return equals the discount rate or cost of capital. Hence, we find that MPS is a
function of E1/k or Return on Assets r/k.
The relationship can be established for r > k, r = k, and r < k, as we did in Walters
Model. You will find that the optimal policy does not change by analyzing the same with
example given under Walter's Model.
III. Miller and Modigliani (MM) Theory
While the earlier two theories - Walter's Model and Gordon's Model - laid emphasis on
maximization of shareholders' wealth, Miller and Modigliani (MM) assert that given the
investment decision of the firm, the dividend payout ratio does not affect the wealth of
the shareholders. Their contention is that the value of firm is solely determined by the
firm's investment policy and earning power on its assets, and that the split-up between
dividend and retained earnings is irrelevant and has no significance.
The critical assumption of MM is that the rate of return 'r' for a share which is
purchased at time '0' is equal to the dividend received at time 1 plus the capital
gain/losses on the same. Converting into an equation, we get:
r = D1 + (P1 - P0)
P0
where,
r = Internal Rate of Return
D1 = Dividend at the end of period 1
P1 = Market price per share at period 1
P0 = Initial purchase price
Reclassifying the above, we get
r x P0 = D1 + P1 - P0
r x P0 + P0 = D1 + P1
P0 (1 + r) = D1 + P1
P0 = (D1 + P1) / (1 + r)
Since IRR (r) is equal to the cost of capital (CoC) under the assumptions, we can say
that,
P0 = (D1 + P1) / (1 + CoC)
The above is the value for one share. If the firm has 'n' number of shares, we get the total
value of the shares of the firm as,
V = nP0 = n(D1 + P1) / (1 + CoC)
One of the basic assumptions in both Walter's and Gordon's Models is that no external
financing is envisaged. But MM theory allows external financing. The crux of the MM
theory is that the effect of dividend payment on shareholders' wealth is offset exactly by
other means of financing. When the firm has made its investment decision, it must
decide whether to retain earnings or to pay dividends or sell new shares in order to
finance the investments. The decline in market price of share on account of increased
shares offsets the payment of dividend exactly.
Let us see how this is brought out by the MM model:
nP0 = n(D1 + P1) / (1 + CoC)
If the firm decides to issue 'm' new shares at time 1 at a price P1, the total value of shares
then will become nP0 + mP1.
If we want to know the value of the new shares at time 0, then the value = nP0 + mP1/(1
+ CoC)
This value is to be equated to the overall value at time 1.
At time 1, the number of shares are (n + m), and the dividends paid would have been
only for 'n' shares. The overall equation then will be:
mP1 nD1 + (n+m) P1
nP0 + ------------ = -----------------------
(1 + CoC) (1 + CoC)
Simplifying, we get value as,
nD1 + (m+n)P1 - mP1
nP0 = -----------------------------
(1 + CoC)
The additional investment can be either financed by retained earnings or by new shares
or by both, as per MM's assumptions. The amount of new shares mP1 will then be equal
to (Investment - Retained earnings) or,
mP1 = I1 - (X1 - nD1), where X1 = profits, I1 = Investment
mP1 = I1 - X1 + nD1
Substituting for mP1 in the previous equation, we get,
nD1 + (m+n)P1 - (I1 - X1 + nD1)
nP0 = ------------------------------------------
(1 + CoC)
(m+n)P1 - (I1 - X1)
nP0 = ------------------------
(1 + CoC)
From the above, we find that the term D1 cancels out. MM assumes that the other terms
X1, I1, (n + m) P1 and CoC are assumed to be independent of D1.
MM Model thus concludes that the current value of the firm is independent of its
current dividend policy. What is gained by the shareholder in increased dividend is
offset exactly by the decline in the terminal value of share. The Model also concludes
that nP0 is unaffected not only by current dividend decisions but by future dividend
decisions as well. Thus the shareholders are indifferent between retention of earnings
and the payment of dividends in all future periods.
MM Model also asserts that the dividend irrelevance is not affected even if the firm
raises external funds by issuing debt instead of shares, as the real cost of debt is the
same as the real cost of equity financing. In case of debt financing, their conclusion is
the same with regard to leverage. Even when the assumption of complete certainty is
dropped, they still conclude that dividend policy continues to be irrelevant, as they
attribute it to the familiar arbitrage argument. The shareholders' wealth is unaffected by
current and future dividend decisions. It depends entirely upon the expected future
earnings stream of the firm.
Criticism: MM Theory of dividend irrelevance works out well under a set of
theoretical assumptions. But these are hardly valid and unrealistic in practice, especially
in the Indian context. We find the capital markets hardly perfect. MM theory loses the
relevance here. Internal and external financing are not equivalent and dividend policy
does affect the perception of shareholders. The following are the major criticisms leveled
against the MM theory:
1. Taxes: The assumption that taxes do not exist, is only a theoretical possibility. In
India complicated tax laws exist. From the viewpoint of the shareholder, capital gains is
preferable than dividend income because: (i) the capital gains tax is lower than the tax
on dividends, and (ii) capital gains arise only when the shares are actually sold. The
value of the share goes up if the entire profits are retained rather than getting external
financing.
2. Existence of floatation and transaction Costs: MM's assumption is that the
wealth of shareholders does not change whether the firm uses internal financing or
external financing. But in practice there are always underwriting and brokerage costs
when new shares are issued, whereas there are no such costs when the profits are
retained. Similarly, the shareholder has to pay a brokerage fee when he decides to sell
the shares.
3. The discount rate 'r' and Cost of Capital 'CoC' are assumed to be equal. In
reality, both differ and investors would always like to maximise their earnings by going
in for different set of portfolios.
4. MM contends that the dividend policy continues to be irrelevant whether
the market is certain or uncertain. This has been contradicted by Gordon. He
asserts that uncertainty increases with time span. This implies that risk increases as well
as the discount rate. As such, shareholders would prefer immediate dividends than a
future stream of dividends to avoid risk.
5. The last criticism is about the informational content regarding dividends; MM
assumes that this does not affect their contention of irrelevance. But the fact is that
information regarding dividends does have an impact on the share prices because they
communicate information regarding the profitability of the firm. If a firm which has a
stable dividend policy, deviates and changes the ratio, then the shareholders and
investors might believe that the management is announcing a change in the expected
future profitability of the firm. Accordingly, the price of the share might change.
Illustration 1: The earnings per share of a company are Rs. 8 and the rate of
capitalisation applicable to the company is 10%. The company has before it an option of
adopting a payout ratio of 25% or 50% or 75%. Using Walter's formula of dividend
payout, compute the market value of the company's share if the productivity of retained
earnings is (i) 15% (ii) 10%, and (iii) 5%.
Solution:
Given EPS = 8, CoC = 10%
Market value of the company's share under different payout options:
(i) If productivity of retained earnings is 15% (IRR = 15%)
For payout ratio 0f 25% (DPS = 25% of EPS = 25% x Rs.8 = Rs.2),
Market Value of Share, MPS
IRR 0.15
DPS + -------- (EPS DPS) 2 + ------ (8 - 2)
CoC 0.10
= -------------------------------------- = ---------------------------- = 11 / 0.10 =
Rs.110
CoC 0.10
For payout ratio 0f 50% (DPS = 50% of EPS = 50% x Rs.8 = Rs.4),
Market Value of Share, MPS
IRR 0.15
DPS + -------- (EPS DPS) 4 + ------ (8 - 4)
CoC 0.10
= --------------------------------------- = -------------------------- = 10 / 0.10 =
Rs.100
CoC 0.10
For payout ratio 0f 75% (DPS = 75% of EPS = 75% x Rs.8 = Rs.6),
Market Value of Share, MPS
IRR 0.15
DPS + -------- (EPS DPS) 6 + ------ (8 - 6)
CoC 0.10
= -------------------------------------- = -------------------------- = 9 / 0.10 =
Rs.90
CoC 0.10
(ii) If productivity of retained earnings is 10% (IRR = 10%)
For payout ratio 0f 25% (DPS = 25% of EPS = 25% x Rs.8 = Rs.2),
Market Value of Share, MPS
IRR 0.10
DPS + -------- (EPS DPS) 2 + ------ (8 - 2)
CoC 0.10
= -------------------------------------- = -------------------------- = 8 / 0.10 =
Rs.80
CoC 0.10
For payout ratio 0f 50% (DPS = 50% of EPS = 50% x Rs.8 = Rs.4),
Market Value of Share, MPS
IRR 0.10
DPS + -------- (EPS DPS) 4 + ------ (8 - 4)
CoC 0.10
= ------------------------------------- = --------------------------- = 8 / 0.10 =
Rs.80
CoC 0.10
For payout ratio 0f 75% (DPS = 75% of EPS = 75% x Rs.8 = Rs.6),
Market Value of Share, MPS
IRR 0.10
DPS + -------- (EPS DPS) 6 + ------ (8 - 6)
CoC 0.10
= -------------------------------------- = --------------------------- = 8 / 0.10 =
Rs.80
CoC 0.10
(iii) If productivity of retained earnings is 5% (IRR = 5%)
For payout ratio 0f 25% (DPS = 25% of EPS = 25% x Rs.8 = Rs.2),
Market Value of Share, MPS
IRR 0.05
DPS + -------- (EPS DPS) 2 + ------ (8 - 2)
CoC 0.10
= ------------------------------------ = ------------------------- = 5 / 0.10 = Rs.50
CoC 0.10
For payout ratio 0f 50% (DPS = 50% of EPS = 50% x Rs.8 = Rs.4),
Market Value of Share, MPS
IRR 0.05
DPS + -------- (EPS DPS) 4 + ------ (8 - 4)
CoC 0.10
= ------------------------------------- = ------------------------- = 6 / 0.10 = Rs.60
CoC 0.10
For payout ratio 0f 75% (DPS = 75% of EPS = 75% x Rs.8 = Rs.6),
Market Value of Share, MPS
IRR 0.05
DPS + -------- (EPS DPS) 6 + ------ (8 - 6)
CoC 0.10
= --------------------------------- = ---------------------------- = 7 / 0.10 = Rs.70
CoC 0.10
Illustration 2: Textool Ltd. has 80,000 shares outstanding. The current market price
of these shares is Rs.15 each. The company hopes to make a net income of Rs.2,40,000
during the year ending on March 31, 1995 and it belongs to a risk class for which the
appropriate capitalisation rate has been estimated to be 20%. The company's board is
considering a dividend of Rs.2 per share for the current year that began on April 1, 1995.
Assuming no taxes, answer questions listed below on the basis of the Modigliani-Miller
dividend valuation model:
(a) What will be the price of the share at the end of March 31, 1995 (i) if the dividend is
paid, and (ii) if the dividend is not paid?
(b) How many new shares must the company issue if the dividend is paid and the
company needs Rs. 5,60,000 for an approved investment expenditure during the year?
Solution:
Given, n = 80,000 shares; P0 = Rs.15; X1 = Rs.2,40,000; CoC = 20%; D1 = Rs.2 per
share
(a) (i) If the dividend is paid
According to MM Model, current market price per share P0 = (D1 + P1) / (1 + CoC)
15= (2 + P1) / (1 + 0.20)
15 (1.2) = 2 + P1
P1 = 18 - 2 = Rs.16 = Price of the share at the end of the period, ending March 31, 1995
(a) (ii) If the dividend is not paid
15= (0 + P1) / (1 + 0.20)
15 (1.2) = P1
P1 = Rs.18
(b) Dividend is paid, and price of the new share is Rs. 16
Given P1 = Rs.16, Investment I1 = Rs. 5,60,000 and Net income X1 = Rs.2,40,000
According to MM Model, the total value of new shares,
mP1 = I1 - (X1 - nD1), where m is the number of new shares issued
m x Rs.16 = 5,60,000 - (2,40,000 - (80,000 shares x Rs.2))
16m = 4,80,000
m = 3000 shares
REVIEW QUESTIONS
1. What are the various theories of dividend policy?
2. Critically evaluate MM theory. What do you feel about the relevance of the theory in
the Indian context?
3. Compare and contrast dividend theories for (a) growth firm (b) normal firm, and (c)
declining firm
4. What are the assumptions which underly Gordon's model of dividend effect? Does
dividend policy affect the value of the firm under Gordon's model?
5. What is the informational content of dividend payments? How does it affect the share
value?
PRACTICAL PROBLEM
1. The earnings per share of the face value of equity Rs.100 of PQR Ltd. is Rs.20. It has
an internal rate of return of 25% of EPS. Capitalisation of its risk class is 12.5%. If
Walter's model is used,
(a) What should be the optium payout ratio?
(b) What would be the market price per share if the payout ratio is zero?
(c) How shall the market price of the share be affected if more than zero payout is
employed?
(d) Suppose the company has a payout of 25% of EPS, what would be the price per
share?
[Ans: (a) zero, (b) Rs. 320, (c) The optimum payout ratio for growth firm is zero. For a
normal firm one dividend policy is as good as the other. The optimum payout ratio for
declining firm is 100%, (d) Rs. 280]
SUGGESTED READINGS
1. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi, Tata
McGraw Hill Co.
2. Khan, M.Y. and Jain, P.K.: Financial Management, New Delhi, Tata McGraw Hill Co.
3. Pandey, I.M.: Financial Management, New Delhi, Vikas Publishing House.
4. Rathnam, P.V.: Financial Advisor, Allahabad, Kitab Mahal.
5. Saravanavel, P.: Financial Management, New Delhi, Dhanpat Rai & Sons.
- End of Chapter -
LESSON - 21
RETAINED EARNINGS
Learning Objectives
After reading this lesson you should be able to:
Know the significance of retained earnings
Understand the factors affecting size of relative earnings
Detail the various kinds of reserves and surplus
Ascertain the financial significance of depreciation funds/polices
Lesson Outline
Retention of Earnings
Factors Affecting Size of Retained Earnings
Advantages and Disadvantages
Reserves and its kinds
Surplus and its main classes
Financial Significance of Depreciation Funds/Policies
From the financial viewpoint, the earnings of a business enterprise for any one year are
channelised into three main directions:
(i) The government's share in the profits through income tax,
(ii) The portion to the shareholders as cash dividends; and
(iii) The residual amount retained in the business.
Dividend and retained earnings are controlled by the decisions of corporate
management. They decide how much profit should be paid to shareholders in the form
of dividend and how much to be retained in the business. The higher the dividend rate,
the lower the quantum of profits retained in the business. The management has to strike
a balance between the decision in such a manner that neither the continuous flow of
business operations is interrupted nor the shareholders' requirements of steady
dividend payment remain unsatisfied.
RETENTION OF EARNINGS
Business enterprises try to save a part of their current earnings for meeting future
financial needs of expansions, modernisation, rationalisation and replacement
programmes. The main feature of retained earnings is that it is an internal source of
finance and emanates from profits not distributed to shareholders as dividends. The
other names of retained earnings are 'internal financing', 'self-financing' or 'ploughing
back of profits'. The process of creating savings in the form of reserves and surpluses for
its utilisation in the business is technically referred to ploughing back of profits.
Features and Significance of Retained Earnings
(i) The main feature of retained earnings is that it is an internal source of finance. This
method of financing avoids any long-term debt and does not dilute the ownership.
(ii) Retained earnings for expansion, modernisation etc. is an ideal arrangement from
the point of view of corporate management because there is no immediate pressure to
pay a return on this portion of the funds, though it does have a cost which the firm has
to bear. Also this source can be used without creating charge on assets of the company.
(iii) Retained earnings augment the capital base of the business. This puts the company
in a better position to borrow more funds.
(iv) Retained earnings can be utilised for purposes of paying-off the old debts of the
company and paving a way for greater amount of new funds.
(v) Decision to retain earnings has direct and indirect advantages for the shareholders.
Retention of earnings offers the benefit of tax-saving to shareholders. With increased
retention of earnings, the shareholder's equity magnifies. Better creditworthiness of the
business leads to higher share prices and future growth prosperity.
(vi) Greater reliance on the use of retained earnings also helps reducing the burden on
the financial system of the country.
Factors Affecting Size of Retained Earnings
The amount of earnings that may be retained in the business is affected by many factors,
such as the characteristics of the industry and company, level of profits of the company,
management policies about depreciation, dividends policy, and taxation policy.
(i) Characteristics of industry and company: The policy relating to retention of
earnings varies not only between industries, but even among companies within the same
industry, and sometimes within a company from time to time. Growth industries and
growth companies are usually characterised with low payout and high retention rates.
The reasons are obvious. The more rapid the growth, the greater the demand for
additional funds for expansion. The higher the profitability, the greater the temptation
to retain funds, but this is with the basic dividend policy.
(ii) Level of profits of the company: Notwithstanding anything else, larger the level
of profits, greater the amount of earnings available for retention. However, the size of
profits is a function of factors such as the demand of product, cost of production and
distribution, price, structure of the products, degree of competition in the market,
general price level etc.
(iii) Management policy regarding depreciation: At the very outset, it may be
categorically specified that depreciation is not a source of funds, however, the inclusion
of depreciation expense in the profit and loss statement reduces the net income and
hence the income tax and to that extent the funds are available with the business. This is
because in the present face of ever-rising prices, larger amount of depreciation in initial
years will have greater time value. This is possible with the adoption of the accelerated
depreciation policy. The straight line method of depreciation, on the other hand, does
not make available larger amounts of funds with the business in the initial life of the
asset but charges it uniformly.
(iv) Dividend policy: One of the vital factors affecting the magnitude of retained
earnings is the dividend policy followed by the management. There is an inverse
relationship between the payout ratio and retention of earnings. A liberal dividend
policy would reduce the amount of retained earnings.
(v) Taxation Policy: The higher the rate of corporate tax (corporate tax rate is fixed,
but the rates are different for different companies), the smaller the amount of funds
available for retention. The rate of corporate tax is higher in case of closely held
companies, and is also called the 'rate of distribution of profit'. Such companies,
therefore, are in a less privileged position to retain bigger amount of earnings. At
present, there exists no provision to encourage retention of corporate earnings except
the provision of depreciation being allowed as tax deductable expense.
ADVANTAGES of Retained Earnings
The advantage of retention of earnings or self-financing for the convenience of study,
can be classified under three groups
(i) The Corporation,
(ii) The Shareholders, and
(iii) The Country
(i) Advantages to the Corporation
a. Provides a cushion to absorb the shocks of business vicissitudes
b. Ease in financing schemes of rationalism
c. No dependence on fair-weather friends
d. Helps in stabilizing the dividend policy
e. Deficiencies of depreciation can be made good
f. Easy retirement of bonds or debentures
(ii) Advantages to the Shareholders
a. Safety of investment
b. Rise in the market value of securities
c. Profit by retaining the shares
d. Evasion of super tax
(iii) Advantage to the Country
a. Aids in capital formation
b. Greater, better and cheaper production is facilitated
c. Smooth and continuous functioning of enterprises
d. Quick financing of rationalization schemes
DANGERS / DISADVANTAGES of Excessive Retention of Earnings
The proceedings description might give the impression that retention is always
beneficial to shareholders, company and the nation. This is not to so. Excessive
retention of earnings and their reckless utilization is detrimental to the interest of all:
(i) To Shareholders
a. It results in foregoing dividends for a long period and to a large extent
b. The corporate management may enjoy the accumulated earnings to finance the need
of the company in which they are interested even though shareholders may have interest
in them, thus bringing little or no gain to them. Shareholders are benefited out of this
source only when management invests the amount of retained earnings in projects
contributing to their wealth, i.e., the return on projects is greater than the cost involved
in retained earnings.
(ii) To the Company
a. If the accumulated earnings are indiscriminately used for the issue of bonus shares, it
may result in over-capitalisation of the company, with its negative consequences like
reduced future dividends, reduced share prices, manipulation etc. The company's
financial stability may be threatened.
b. Excessive retention of earnings by one company in relation to its competitors may,
over a long period of time, result in occupying monopoly position in the market. Like
over-capitalisation, monopoly position has its own evil consequences for consumers and
society.
c. Excessive retention of earnings also increases the manipulative powers of the
company management. For instance, the management may manipulate share prices. By
reducing the rate of dividend, in the first instance, it may cause downfall of prices in the
market and using this opportunity to buy shares at reduced prices. Subsequently, a
higher rate of dividend may be declared causing an increase in share prices and then
using the same opportunity to sell them at increased prices.
(iii) To the Nation
Excessive retention of earnings may not do any social good also. Retained earnings will
not be used for capital formation and in socially profitable investments. Use of retained
earnings for manipulative purposes will certainly upset the financial system of the
country.
RESERVES
Meaning: "Precaution is better than cure" is a common sense maxim. On the same
principle, 'provisions' should be made in business also for all possible contingencies.
According to Companies Act 1956, the expression 'provision' shall mean "any amount
written-off or retained by way of providing for depreciation, renewals or diminution in
value of assets, retained by way of providing for any known liability of which the amount
cannot be determined with substantial accuracy".
The term 'reserves' has not been specifically defined in the Act, but it refers to "that
amount which has been provided for any purpose other than those mentioned above". It
has been stated that any amount retained by way of providing for any known liability is
in excess of the amount which, in the opinion of the directors, is reasonably necessary
for the purpose, and the excess shall be treated for this purpose as a reserve and not as a
provision.
Kinds: Reserves may be general or specific.
General Reserve is that part of the profits of the company which is set aside for
meeting any future emergency. Its various purposes may be;
(i) to stabilise the economic condition of the company,
(ii) to meet the increasing demands of the business,
(iii) to meet casual losses, or
(iv) to conceal the real profits of the company.
In the last case they are known as 'Secret Reserves'.
Specific Reserves are usually created out of profits of capital nature. Such reserves
cannot be utilised for dividend distribution; their main objective is to stabilise the
economic condition of the company.
Reserve can be classified into three categories:
(i) Valuation Reserves
(ii) Liability Reserves, or
(iii) Proprietary reserves.
Valuation Reserves are used to restore the integrity of investment when assets have
suffered a loss in value. They are also known as 'specific reserves'.
Proprietary Reserves comprise a number of reserve accounts like reserve for
dividends and general reserve.
Liability Reserves are provided to take into account the liabilities arising out of
current operations like reserve for taxes or reserve for pensions, etc.
Liability reserve is more like valuation reserve than proprietary reserve. Valuation
reserve is a matter of necessity while proprietary reserve is usually a matter of financial
prudence. Valuation reserve is a charge against P & L account while proprietary reserve
is an appropriation of profits. Proprietary reserves help in increasing the equity of the
shareholders in the company.
Please use headphones
SURPLUS
The term 'surplus' represents the undistributed earnings of the company, i.e., the
balance of profits that remain after paying the dividends. Surplus is regarded as a
welcome sign by the management. It reflects upon the sound earning capacity of the
company. Surplus can be divided into three main classes:
(a) Earned Surplus: It is created by the net profits from operations after meeting all
the expenses therefrom. Sometimes, past accumulated profits are also transferred to
earned surplus account. Different revenue reserves are also, sometimes, transferred to
such surplus account.
(b) Capital Surplus: Such surplus is that which is created out of capital gains and
non-recurring receipts. It is also known as 'paid-in-surplus'.
(c) Revaluation Surplus: These surpluses arise from revalution of assets. The
appreciation in the value of fixed assets can be transferred to this surplus account. This
is particularly done in the periods of rising prices or when the outlook for future is
bright.
Uses of Surplus: The accumulated surpluses can be utilised by the company for a
variety of purposes / uses, for example,
(i) for reducing the value of fixed and working capital,
(ii) for writing-off intangible assets like goodwill, preliminary expenses, reorganisation
expenses, etc.,
(iii) for equalising the rate of dividend payment but it is possible only if
they are actually realised in cash,
they are not likely to affect the liquidity position of the company adversely,
they remain after revaluation of all assets and liabilities of a company, and
the Articles of Association of the company permit such distribution.
(iv) for absorbing the shocks of business cycles,
(v) for making up the deficiencies of loss,
(vi) for financing schemes of betterment. For instance, obsolescence may be more rapid
than anticipated or the deteriorated economic conditions may prevent the collection of
debts. Under such circumstances, the deficiency can be made good out of accumulated
surplus.
Financial Significance of Depreciation Funds/Policies
The significance of depreciation funds can be discussed with reference to certain
management's decisions:
(i) Internal Investment Decision: The provision of depreciation in accounting
reports does not in any way affect investment decision implied by the replacement of an
asset. Depreciation is taken into consideration indirectly by comparing the cash
proceeds generated by asset with the cost thereof.
(ii) Measuring Performance: As the performance is generally measured by either
income or return on investment, both of which depend on the method of depreciation
accounting. The straight line depreciation gives reasonably good measure of income in
case the revenues and maintenance requirements are constant throughout the life of the
asset, but it distorts the return on investment, which would increase with a decrease in
the book value of the asset due to depreciation.
(iii) Fund generation: Generally, it is thought that depreciation is a source of funds.
It is not the function of depreciation accounting to provide funds for replacement; funds
must come from the revenues of the business. The charge for depreciation neither
increases nor decreases the amount available to, say, purchase equipment. Even the
making of charges to income and setting up of reserves for depreciation give no
assurance regarding the availability of funds for replacement, unless they are in some
way earmarked for the purpose.
(iv) Make or Buy Decisions: In a make or buy decision, a relevant cost would one
that could be avoided if the part was not made but bought. It would not be relevant cost
if it would be incurred irrespective of the decision of making or buying. The depreciation
of the factory building cannot be avoided by the elimination of one phase of production
and so it would not be relevant in the make or buy decision.
(v) Pricing Decisions: A firm is expected to produce at a point where its marginal
cost equals marginal revenue, and to fix a price equal to the average revenue that will
sell the appropriate quantum of output. In this context, depreciation is not taken into
account in arriving at decisions regarding price fixation. In spite of the fact that the
manager may set the price as dictated by competition, he is bound to recover not only
the fixed costs but also make a profit, if he is skilful in market manipulations through
timely pricing decisions.
Factors Complicating Depreciation Policy:
A decision regarding depreciation method becomes complex due to the following
considerations:
(a) Tax implication: In India the Income Tax law prescribes a method of depreciation
i.e., the Diminishing Balance Method. If a company adopts the Straight Line method
then it will have to declare a different income for taxation purposes as opposed to the
income reckoned for accounting purposes.
(b) Impact on dividend distribution: The company cannot pay dividends except
out of profits. Profit means the surplus left after providing for depreciation under any of
the recognised methods. If the management chooses the straight line method, the
distributable surplus in the earlier years would be larger. This would enable the
management to declare dividend more easily than if they follow the diminishing balance
method.
(c) The cash flow implication: Cash flow is the difference between sales revenue
and cash cost. If the depreciation figure is less, the quantum of profit would be more,
and vice versa. Thus the profit plus depreciation has its influence on the quantum of
distributable profit, and hence on the quantum of dividends. It has already been stalled
that the quantum of cash flow from operations is not to be affected by a change in the
method of depreciation.
(d) Depreciation and changing price levels: Depreciation is the process of
allocation of the historical cost over a period of years. Another objective of depreciation
is building up of adequate funds to replace the asset at the end of its full service. If
depreciation is calculated on the estimated replacement cost of the asset, then this
important objective could be met. But this would lead to arbitrary and highly volatile
depreciation charges in each year.
Factors that Affect the Choice of Method:
The most widely used methods of providing for depreciation are the Straight Line
Method and the Reducing Balance Method, but the factors that affect the choice of
methods are as follows:
(a) The passage of time - predominantly recognised by the Straight Line Method.
(b) The use of the asset - predominantly recognised by the Product Method.
(c) The rapid deterioration of assets as, for example, loose tools, where the Revaluation
Method may be used.
(d) The effect of associated procedures, such as costing methods which can aid the
calculation of depreciation by, for example, the Production Method.
(e) The possible onset of obsolescence and, therefore, the early write-off of the major
portion of cost by using, for example, the Reducing Balance Method.
(f) Company Connection Influence: The Sum-of-Years Digits method is rarely used in
Great Britain but widely used in America. A subsidiary in this country may be required
to follow the American practice.
(g) The Effect of Maintenance Expenditure: To equalise product costs, an attempt may
be made to match low maintenance costs with high depreciation or vice versa in any one
accounting period.
(h) The intention to provide funds for the business at the end of the anticipated asset
life, as a result of setting aside the depreciation provision, e.g., use of the Sinking Fund
or Endowment Policy Method.
(i) The need to recognise that funds invested in the asset should be providing a return,
e.g., use of the Annuity Method.
(j) The effect of taxation: For tax computation, the rates used for tax purposes may be
adopted by the company.
It is important to choose a method which results in a fair allocation to the accounting
period and to product cost. It is possible, for example, to have misleading product cost
data, if two identical products are produced on two different machines, and one
machine is fully depreciated while the other machine is not. In this situation, a different
depreciation allocation may be made in the costing records from the one adopted for the
financial accounts. Alternatively, the depreciation may be treated as a fixed cost and
excluded from product cost, e.g., where marginal costing is used.
REVIEW QUESTIONS
1. What is meant by Reserves and Surplus?
2. Why are reserves created and how do they serve in stabilising profits and value of
the firm?
3. What are the factors affecting size of retained earnings?
4. State the advantages of retained earnings as a source of finance viz. Self financing
from the view of a nation, shareholders and the company.
5. What are the dangers inherent in excessive retention of earnings?
6. "The success of a business concern depends in no small a measure upon the way
in which its earnings are computed, distributed and retained" - Comment.
7. Write an essay on the correct policy about allocation of a company's earnings to
depreciation reserves and dividends.
8. Explain the financial significance of depreciation policies and methods.
SUGGESTED READINGS
1. Pandey, I. M.: Financial Management, New Delhi, Vikas Publishing House.
2. Saravanavel, P.: Financial Management, New Delhi, Dhanpat Rai & Sons.
- End of Chapter -
LESSON - 22
MERGERS AND ACQUISITIONS
Learning Objectives
After reading this lesson you should be able to:
Understand the meaning of merger, take-over, etc.
Know the different kinds of mergers.
Identify the circumstances which influence merger of companies.
Specify the regulations/guidelines for take-over and merger.
List out recent mergers and acquisitions in India.
Lesson Outline
Concept of Merger and Acquisition
Classification of Mergers - Operating Mergers versus Financial Mergers
Circumstances which influence merger of Companies - Financial and Non-
financial factors
Major Mergers in Indian Corporate Sector
Regulation of Mergers/Take-overs by SEBI
Role of Financial Institution in Mergers and Take-overs
Acquisitions of Companies in Indian Corporate Sector
Tender Offer - Defensive Strategies
Issues to be considered in Mergers and Acquisitions.
Leveraged Buy-Out
Illustrative Examples
CONCEPT OF MERGER AND ACQUISITION
A company may grow internally, or it may go externally through acquisitions. The
objective of the firm in either case is to maximise existing shareholders' wealth. A
company can acquire another company through merger, take-over, consolidation etc. A
merger is a combination of two companies where only one survives. The merged
company goes out of (corporate) existence, leaving its assets and liabilities to the
acquiring corporation. Consider the merger of Tata Fertilizers Ltd (TFL) with Tata
Chemical Limited (TCL), the promoting company. Under the scheme of merger, TFL
shareholders were offered 17 shares of TCL (market value per share was Rs. 114), for
every 100 shares of TFL held by them. Further, TFL's cumulative convertible preference
(CCP) shareholders, who may not want to accept shares in exchange, were given the
option of cash payment of Rs. 15 for every share they held. In this merger, TCL is an
acquiring company, which survives after the merger, whereas TFL is being the acquired
company, which ceases to exist after the merger.
A merger is different from a consolidation or amalgamation, which involves the
combination of two or more companies, whereby an entirely new company is formed.
All the old companies cease to exist, and their equity shares (common stock) are
exchanged for shares of the new company. For example, Hindustan Computer Ltd
(HCL), Hindustan Instruments Ltd (HIL), Indian Software Company Ltd (ISCL) and
Indian Reprographics Ltd (RFL) were amalgamated in April 1986 into a new company
called HCL Ltd. In this amalgamation, all the four amalgamated companies lost their
corporate identities and formed a new company known as HCL Ltd. When two
companies of about same size combine, they usually consolidate; on the other hand,
when the two companies differ significantly in size, usually a merger is involved.
Though it is important to understand the distinction, the terms 'merger' and
'consolidation' tend to be used interchangeably to describe coming together /
combination of two companies.
The termtake-over means the acquisition by one person or group of persons or a
company of sufficient shares in another company to give the purchaser control of that
other company. A take-over in this sense differs from merger, as the company which is
taken-over by the purchaser remains in existence, while in merger one of the two
companies goes out of existence. Thus, take-over tends to denote the situation where
one business offers to buy out the ownership of another, often against the wishes of the
Board of Directors or groups of shareholders. The dividing line between the two is
indistinct. A number of situations which are presented as mergers are effectively take-
over bids. The Directors of the taken-over company, being unable to control effectively
the course of events in their business, are glad that the other business is willing to
preserve their self-esteem by presenting the take-over operation as merger.
The primary motivation for mergers is to increase the value of combined enterprise. If
companies A and B merge to form company C, and if C's value exceeds that of A and B
taken separately, then synergy is said to exist. Synergistic effects can arise from three
sources:
(i) Operating economies resulting from economies of scale in production or distribution,
(ii) Financial economies, including a higher Price-Earnings ratio or a lower cost of debt,
or both, and
(iii) Increased market power due to reduced competition.
Operating and financial economies are socially desirable, but mergers that reduce
competition are both undesirable and illegal.
CLASSIFICATION OF MERGERS
Economists classify mergers into three groups:
(a) Horizontal Mergers: When two or more companies producing the same goods or
offering the same services decide to merge, it becomes a horizontal merger. The
horizontal merger involves reduction in the number of competing companies in the
effected markets; for example, the emergence of Associated Cement Companies (ACC)
Limited when small cement plants all over the country decided to merge into one
company; the National Textile Corporation (NTC) resulting from the merger of several
sick units manufacturing textile products into one corporation; merger of Sundaram
Clayton Limited's (SCL) moped division with TVS Suzuki Limited (TSL); and take-over
of Universal Luggage Company by Blowplast Company are other examples for
horizontal mergers.
(b) Vertical Mergers: A vertical merger or integration is a merger between two
companies manufacturing different products but having customer-supplier relationship,
wherein the product of one company is used as raw materials by the other company. The
merger between Tata Iron and Steel Company Ltd and Indian Tube Company Ltd is a
vertical merger.
(c) Conglomerate Mergers: Pure conglomerate merger occurs where one company
takes over another company in a completely different industry, with no important
common factors between them in production, marketing, research and development or
technology. Such mergers result in no reduction in competition in the industries
concerned. An example of this type of merger is between Mahindra and Mahindra
Limited and Indian Aluminum Company Limited.
Operating Mergers versus Financial Mergers
From the standpoint of financial analysis, there are two basic types of mergers:
1. Operating mergers, in which the operations of two companies are integrated with the
expectation of operating economies for obtaining synergistic effects. The primary
benefit from an operating merger is high expected profits. For example, the combined
company may be able to reduce overheads and thereby increase profits.
2. Pure financial mergers, in which the merged companies will not operate as a single
unit, and from which no operating economies are expected. The expected benefits of
financial mergers are more varied. In one case, the target company may have no
financial leverage, so the acquiring firm may plan to buy the company, pay for it by
issuing debt, and gain market value from the capital structure change. In another
instance, one of the firms may be so small that its stock is illiquid, and its Price-Earnings
ratio is low. In such a case the stock will have a low value, and it may represent a bargain
purchase for the acquirer value. In other instances, one firm may have excessive
liquidity, large annual cash flows, and unused debt capacity, while another firm may
need financial resources to take advantage of growth opportunities.
In any type of merger, parties such as the shareholders of the company, the creditors,
the employees, the government through monopoly commissions, the lending financial
institutions, the stock exchange, high courts etc., get involved. In a decision to allow
merger of public limited companies, the interest of minority shareholders and the public
interest in general should always be considered before the necessary permission to
merge is granted by the authorities concerned. These parties should evaluate the
proposal of merger in proper perspective considering carefully the following factors
affecting the mergers:
(i) Capacity to influence its market share,
(ii) Efficiency of the merged enterprise,
(iii) Regional imbalance and the employment,
(iv) Effects on balance of payment, and
(v) Public interest.
Financial and Managerial Considerations
Amalgamation is the blending of two or more existing undertakings, the shareholders of
each company becoming substantial shareholders in the company which is to carry on
the blended undertakings. The term 'amalgamation' has not been defined in the
Companies Act. It is an arrangement whereby the assets of two or more companies
become vested in or under the control of one company. Amalgamation comes into play
when two companies are joined to form a third company or one is absorbed into or
blended with another. Amalgamation generally takes place between companies which
are associated with one another in some form or other e.g. common shareholders, unity
of management, common line of business, location of activities etc. But amalgamation
between two companies which have nothing in common can also take place and this has
become equally popular in the present emphasis on diversification and insulation
against economic, socio-political vicissitudes besides uncertainties of nature. The overall
considerations of business and the needs of socio-economic changes including of scale,
industrial and trade policies of the state may also influence the merger of companies
with a view to achieving long term economic and financial benefit, both for the
companies concerned and the shareholders.
CIRCUMSTANCES THAT INFLUENCE MERGERS
(a) Gap between corporate objectives and achievements: Despite reasonable
internal growth, management might find a clear gap between expectations and
realisations either due to time constraint, want of special managerial skills, productive
capacity, technology, research and development etc. Merger of companies may facilitate
companies to grow from a higher take-off point and record incremental sales volume,
marshall effectively the available resources and ensure optimum returns.
(b) The need for diversification: With a view to ensuring greater stability in the
earnings and working capital management and to get over the limitation of managerial
know-how, product and production technology, marketing skills and other key factors,
amalgamation may provide the answer for exchange of all the readymade skills of the
companies concerned, so that the new emerging management may adopt them to
advantage. With the transplanting of new skills, the new management will also be
revitalised and the company poised for further accelerated growth.
(c) Spreading the risk: A small company is exposed to relatively more risk in
embarking upon a new product line. Initial and potential losses may be top high when
compared to capital base. Combination with a larger company would spread the risk.
(d) Elimination of unhealthy competition: Two companies running identical
businesses can merge together to avoid competition and save huge money on
competitive advertisements.
(e) Related lines of business: Where activities of companies are complimentary to
one another, merger can help reduce cost of products. Different companies dealing with
product at different stages of production, all of which ultimately result in the production
of one or more major items or products can also merge together under a common
ownership.
(f) Long gestation period: A capital intensive company with a long gestation period
can advantageously increase its debt capacity by merging with another non capital
intensive company, especially when the latter company is a cash rich company and the
idle cash can be profitably invested.
(g) Shareholder's net worth: Shareholders of a closely held company can reasonably
expect a better return upon the company merging with a widely held company besides
ensuring enough liquidity and feasibility of altering their investment portfolio. Further
the earning per share of the amalgamating company is bound to improve and future
earnings ensured.
(h) Tax benefits: The various tax benefits that accrue from amalgamation form
additional incentives.
(i) Non-financial factors: Apart from the financial factors, the following non-
financial factors have also to play a part in merger proposals:
a. Role and compensation of the earlier management over the new or
amalgamated company,
b. Continuation and promotion of the existing products,
c. Opportunity to enter new markets,
d. Bargaining capacity after merger,
e. Safeguards for future growth,
f. Other gains to the amalgamating company,
g. Other gains to the amalgamated company
(j) Qualitative factors: In a merger proposal, the amalgamated company not only
takes over the physical assets and liabilities of the amalgamating company but also its
experience, organisation, proven performance, skilled staff, goodwill etc.
(k) Other circumstances:
a. Seasonal or cyclical companies can merge with either non-seasonal or other
companies for various reasons like funds management etc.
b. For sick companies, perhaps, amalgamation with a successful company is a practical
proposition.
c. For successful companies, amalgamation would help securing certain potential tax
incentives apart from providing for external expansion.
d. Small companies can merge with other small companies if they have necessary
managerial talent and competence in addition to ensuring funds flow.
e.Closely held companies may merge with widely held companies in order to take
advantage of the tax benefits. Even foreign companies can merge and make the
amalgamated company an Indian company to ensure the tax benefits, by first converting
the foreign branch into an Indian company as a subsidiary of the foreign company,
which in turn can be merged with an Indian company, subject to the restriction imposed
by other legislations like MRTP., FERA, etc.
Illustration
Firm A is studying the possible acquisition of Firm B by way of a merger. The following
data is available:
Firm A:
After-tax earnings = Rs. 10,00,000
No. of equity shares = 2,00,000
Market price per share = Rs.75
Firm B:
After-tax earnings = Rs. 3,00,000
No. of equity shares = 50,000
Market price per share = Rs.60
(i) If the merger goes through by exchange of equity shares and the exchange ratio is set
according to the current market prices, what is new earning per share for Firm A?
(ii) Firm B wants to be sure that its earning per share is not diminished by the merger.
What exchange ratio is relevant to achieve the objective?
Solution:
(i) According to current market prices, B's position will be as follows:
Value of B's shares will be equal to value of A's shares, when 5 shares of Firm B @ Rs.60
are matched with 4 shares of Firm A:
5 x Rs.60 = 4 x Rs.75 = Rs.300
i.e. for every 5 shares of B, 4 shares of A will be exchanged.
In total, the Firm B will get (50,000 shares x Rs. 4 / Rs.5) = 40,000 shares of A
New EPS = Rs.10,00,000 + Rs. 3,00,000
2,00,000 shares + 40,000 shares
= Rs. 5.417 = Rs. 5.42
(ii) By adopting the above method, B's EPS will come down to Rs. 5.42
Present EPS of B is Rs. 3,00,000 = Rs.6
50,000 shares
Present EPS of A is Rs. 10, 00,000 = Rs. 5
2,00,000 shares
Hence, B should get 6 shares for every 5 shares of A, i.e.
(50,000 shares x Rs. 6 / Rs. 5) = 60,000 shares of A
New EPS of B will be Rs. 10,00,000 + Rs.3,00,000 = Rs. 5 per share.
2,00,000 shares + 60,000 shares
Firm B, by getting 60,000 shares of A as against its own 50,000 shares, the objective
achieved is:
60,000 x 5 = Rs. 30, 00,000
EPS = Rs. 3,00,000 = Rs. 6
50,000 shares
Source: Economic Times, July 15, 1993.
Merger Process in India: The process of amalgamation is regulated by the
Companies Act, 1956. The following procedure for the amalgamation is normally
followed:
Examination of object clause
Intimation to Stock Exchange
Approval of Amalgamation Draft
Making Application in the High Court
Drafting of notice and explanatory statements, and its dispatch
Filing an affidavit in court
Holding of meeting of shareholders and creditors
Petition to the court for confirmation
Passing of orders by High Court
Transfer of the assets and liabilities
Issue of shares and debentures
Historical Perspective: In India, the whole business of mergers and takeovers till the
1970s was at a low key, though profitable affair: discussions were generally conducted
across the board and negotiated settlements reached amongst the parties concerned. In
the negotiated settlement, shareholders other than the controlling interests had no real
say, though in the case of mergers they were required to vote for or against the merger
resolution. The enormous clout wielded by the financial institutions came to light when
the famous raid of DCM Ltd. and Escorts Ltd. was launched by Swaraj Paul in the early
1980s. Given the enormous amount of floating short term funds held by institutions,
industrialists realised that an institutional vote could make or mar their future.
Consequently, a demand was made to curtail their power.
Though the role of financial institutions in take-over battles is rightly interpreted as
connivance between political powers and industrialists, it must be borne in mind that
financial institutions are vested with the responsibility of moderating the stock
exchanges. Therefore, it is a matter for them to deal in large quantities of shares and
own large proportions of the share capital.
Financing the Acquisition (Method used in India)
The three widely adopted methods are:
(i) using asset based financials to finance the acquisition of a division,
(ii) buying of shares from the promoters by paying cash or paying through own shares,
and
(iii) paying own shares in exchange for the company.
REGULATION OF TAKE-OVERS
Basically the framework for regulating takeovers must seek to:
(i) impart transparency to the process,
(ii) protect the interest of the shareholders, and
(iii) facilitate the realisation of economic gains.
(i) Transparency of the Process: A takeover affects the interests of many parties
and constituents, such as the contending acquirers, shareholders, employees,
customers, suppliers, and others. Hence, it should be conducted in an open, transparent
manner. If the process is transparent, take-overs will be viewed favourably by all
concerned and regarded as a legitimate device in the market for corporate control.
(ii) Interest of Shareholders: In a take-over, the 'controlling block', which often
tends to be between 10 percent and 40 percent, is usually acquired from a single seller
(occasionally it may be acquired from many sellers through market purchases).
Typically the 'controlling block' is bought at a 'negotiated' price, which is higher than the
prevailing market price. The Securities and Exchange Board of India (SEBI) has come
out with some guidelines on Corporate Takeovers. The essential thrust of these
guidelines is to make takeovers as transparent as possible in order to protect target
companies and individual shareholders. As per the guidelines, if a person who holds
shares in a company has agreed to acquire further shares through negotiations, which
when taken together with the shares already held by him, would carry more than 10% of
the voting capital, he has to make a public announcement of an offer to the remaining
shareholders of the company, before he acquires those additional shares.
(iii) Realisation of Economic Gains: The primary economic rationale for take-
overs should be to improve the efficiency of operations and promote better utilisation of
resources. In order to facilitate the realisation of these economic gains, the acquirer
must enjoy a reasonable degree of latitude for infusion of funds, restructuring of
operations, liquidation of non-viable division, widening of product range, redeployment
of resources, etc.
ROLE OF FINANCIAL INSTITUTIONS
Financial institutions, thanks to their substantial equity holding in a large number of
companies, often hold the balance of power. Without their support, the acquirer may
not be able to enjoy control. Hence, they have a crucial role to play. Ideally, they should
serve as guardians of larger public interest and ensure that:
(a) the process of take-over is open and transparent,
(b) the potential acquirers operate on level ground,
(c) the take-over is likely to produce economic gains,
(d) the interest of shareholders and other constituents is reasonably protected, and
(e) no undue concentration of market power arises as a sequel of take-over.
TENDER OFFER
A tender offer is a formal offer to purchase a given number of a company's shares at a
specific price. In a tender offer, a company wants to acquire another company and asks
the shareholders of the target company to "tender" their shares in exchange for a
specific price. The price is generally quoted at a premium i.e., above the market price, in
order to induce the shareholders to tender their shares. Tender offer is one of the ways
of acquiring control of another company.
Tender offer can be done in two circumstances:
First, it can be negotiated directly through the management. The acquiring company
requests the management of the target company to get its approval. When the
management of the target company does not oblige, then the acquiring company can
request directly the shareholders by means of the tender offer.
Second, the acquiring company can directly request the shareholders of the target
company to "tender" their shares at a specific price. The shareholders are informed of
the offer through announcement in the financial press or through direct communication
individually.
In USA, the tender offers have been used for a number of years, but the pace has been
intensified rapidly since 1955, whereas in India, there have been no such tender offers
till recently. In September 1989, Tata Tea Ltd. (TTL), the largest integrated tea company
in India, had made an open offer for controlling interest to the shareholders of the
Consolidated Coffee Ltd. (CCL). TTL's Chairman, Darbari Seth, offered one share in TTL
and Rs.100 in cash (which is equivalent of Rs. 140) for a CCL share, which was then
quoting at Rs. 88 on Madras Stock Exchange. TTL's decision is not only novel in the
Indian corporate sector but also a trend setter. TTL had notified in the financial press
about its intention to buyout some tea estates and solicited offers from the shareholders
concerned.
The exchange price for "tender" shares may be either purely cash or purely shares of the
acquiring company. Sometimes, the exchange consideration for tender shares may be
partly by cash and partly by shares of the acquiring company. In a number of cases, the
management of the target company resists such tender offers. There are many reasons
for this resistance:
(i) The acquiring firm may fail to understand the culture and problems of the target
company,
(ii) Future plans may not be in the interest of target company's shareholders,
(iii) Tender offer or exchange ratio is too low to accept, or
(iv) Acquiring company may replace the present management with a new management.
Defense Strategies
There are a number of tactics and devices to defend the tender offer and avoid being
taken over by another company. The important defensive tactics are:
a. Divestiture (spin off): The target company disposes some of its operations or part
of the business in the form of a newly created company.
b. Crown Jewels: Disposal of profitable divisions / asset coveted by the acquirer, thus
making the target unattractive.
c. Blank Check: Authorising issuance of new shares, usually preferred at the
discretion of the Board of Directors. Its purpose is to vote down a hostile take-over
attempt.
d. Poison Pill: Taking on a large debt, usually at exorbitant terms, making the
acquisition less attractive. Scorched earth is an extreme form of this tactic.
e. Pac-man: This is similar to the popular video game - each company tries to gobble
up the other. The target seeks to acquire the predator, adding to accounting and legal
confusion.
f. Shark Repellent: Amending the Memorandum or Articles to make a takeover
complex and costly, thereby discouraging it.
g. Green Mail: Threatening fight for control of the firm, but with the ultimate
objective of raising the market price of shares and selling them at a premium.
h. White Knight: Inducing a cash rich ally to out-bid the predator and avert a
takeover.
i. Gray Knight: Enlisting the services of friendly company to purchase the shares of
the predator, keeping him busy with defending his own company.
ISSUES TO BE CONSIDERED IN MERGERS AND ACQUISITIONS
From the above discussion, it is clear that the management of the company that is taking
over another company, should carefully examine the following aspects before a final
decision is made:
1. How does the merger help the parent company? Does it add to the existing strengths?
Does it provide an assured source of raw materials? Does it provide forward integration?
Does it help in optimal utilisation of the existing resources?
2. Why should they take over this particular unit, and not some other unit? What are its
unique features? How do they mesh-in with the existing features of the parent
company?
3. Why is the present management selling out? Is the unit inherently alright? Are there
any basic problems, which are not open to easy solution?
4. What kind of post-merger problems are likely to arise? Is the parent company fully
prepared to tackle them?
5. How would the financial institutions react to the proposal? What new conditions are
they likely to impose?
6. What would be the impact on the share prices of the parent company?
7. What would be the impact on sales turnover, and profitability of the parent company
after the take-over and merger?
8. What is the right price for the unit? How should it be paid? What should be the
exchange ratio between the shares of the parent company and the merger company?
Many merchant bankers have impressive shopping lists of companies available for sale.
Some of these bankers are extremely persuasive and sophisticated in their match-
making practices. Even when you are paying through your nose, you may be under the
illusion that it is a steal. Be careful and be on the alert when you are dealing with the
merchant bankers, specialising in take-over deals. It is possible that your company may
be raided by a hostile take-over specialist. In the West, merchant bankers have devised
schemes which help the existing managements to acquire another company.
LEVERAGED BUY-OUTS
During the 1980s, a new scheme of corporate restructuring became extremely popular in
the USA and the Western Europe. This new scheme came to be known as leveraged
buyout (LBO). As the name implies, an LBO has two major aspects:
(i) Using the LBO, the management buys out the entire shareholding of the company
from the public and gets it delisted.
(ii) For buying shares on such a massive scale, the management takes a loan and thus
leverages the transaction.
Please use headphones
The LBO package is usually designed and structured by investment or merchant
bankers. LBOs are a mixed bag with some advantages and disadvantages, as indicated
below:
Advantages:
1. If the public shareholders get a value higher than the market price (close to the
break-up value) they are benefited, at least, in the short run.
2. The owner-managers and/or the professional managers can run the companies
without any fear of losing control from a hostile take-over.
3. LBOs help to restructure the companies, basically weeding out inefficient and
incompetent managements.
Disadvantages:
1. As an LBO usually results in a very high proportion of debt, servicing of the debt
becomes a great financial strain for the company in the post-LBO period.
2. Since the management resorts to asset-stripping and jettisoning of the subsidiaries to
reduce the debt burden after an LBO, it might weaken the company in the long run.
3. Continuity and stability will be adversely affected when bankers and stock market
experts start running manufacturing enterprises. The management focus tends to shift
to short term.
Some Policy Issues: LBOs give rise to some major policy issues as listed below:
1. Joint-stock companies which go public and get listed on the stock exchanges promote
a wide dispersal of share ownership. LBOs tend to result in the reverse, namely,
concentration of share ownership and economic power.
2. LBOs involve considerable debt-financing which works both ways. When the
operational profits are high, a high debt-equity ratio results in high earnings per share.
When the operational profits are stagnating or low, a high debt-equity ratio is not in the
interest of the equity owners.
3. Financing an LBO transaction by way of so-called junk bonds (i.e. high-yield bonds)
may lead to reckless financing affecting the long-term stability of interest rate
structures. Default rates in junk bonds are quite high.
4. LBOs and junk bonds help managements as well as raiders. Thus they tend to disturb
the equilibrium by rocking the boat rather too often.
REVIEW QUESTIONS
1. Define 'Merger' and state the primary motives for mergers.
2. Distinguish between operating mergers and pure financial mergers.
3. Examine several recent mergers and point out the principal motives for merging in
each case.
4. Examine a recent merger in which at least part of the payment made to the seller
was in the form of stock. Use stock market prices to obtain an estimate of the gain from
the merger and the cost of the merger.
5. Explain the distinction between a tax-free and a taxable merger. State the
circumstances in which you would expect buyer and seller to agree to a taxable merger.
6. Do you have any rational explanation for the great fluctuations in aggregate merger
activity and the apparent relationship between merger activity and stock prices?
7. Explain the various issues to be considered in Mergers and Acquisitions decisions.
8. Give brief summary of SEBI guidelines on merger of companies in India.
9. What is a tender offer? State the defensive strategies adopted to defend the tender
offer.
10. What is meant by Leveraged Buy-out? State its advantages and disadvantages in the
present Indian context.
PRACTICAL PROBLEMS
1. Firm E is studying the possible acquisition of Firm F by way of merger. The following
data is available in respect of the firms.
Firm E Firm F
Earnings after tax (Rs.) 2,00,000 60,000
No. of Equity shares 40,000 10,000
Market value per share (Rs.) 15 12
(i) If the merger goes through by exchange of equity share and the exchanges ratio is
based on the current market prices, what is the new earnings per share for Firm E?
(ii) Firm F wants to be sure that its earnings available to the shareholders will not be
diminished by the merger. What should be the exchange ratio in that case?
[Ans.: (i) Rs. 5.42, (ii) 6 new shares for every 5 existing shares]
2. The following data concern companies A and B:
Company A Company B
Earnings after tax Rs. 1,40,000 Rs. 37,500
Equity shares outstanding 20,000 7,500
Earnings Per Share Rs.7 Rs. 5
Price Earnings Ratio 10 8
Market price Rs.70 Rs. 40
Company A is the acquiring company, exchanging its one share for every 1.5 shares of
Company B. Assume that Company A expects to have the same earnings and P/E ratios
after the merger as before (no synergy effect), show the extent of gain accruing to the
shareholders of two companies as a result of the merger. Are they better or worse off
than they were before the merger?
SUGGESTED READINGS
1. Brealey, R. and Myers, S.: Principles of Corporate Finance, New York, McGraw Hill
Co.
2. Scharf, Charles, A.: Acquisitions, Mergers, Sales & Takeovers: A Hand Book,
Eaglewood Cliffs, N.J., Prentice Hall Inc.
- End of Chapter -
LESSON - 23
BUSINESS FAILURES AND REVIVAL
Learning Objectives
After reading this lesson you should be able to:
know the meaning of incipient sickness, weak unit, and sick unit
understand the causes for sickness leading to business failures
detail the steps for rehabilitation of sick companies under S.I.C. Act
ascertain the objectives and activities of B.I.F.R.
Lesson Outline
The Traditional Sickness - Incipient Sickness
Weak Unit - Sick Unit - Sick Company
Reason for Industrial Sickness - Internal and External
Detection of Sickness - Early Warning Signals
Revival Measures - under S.I.C. Act
Role of B.I.F.R.
Industrial sickness is spreading very fast. There are over three lakh sick units in the
small scale industries sector and over 1,000 in the medium and large scale sector. Over
Rs. 10,000 crores of banks and financial institutions funds are being locked up in these
units. There are two common patterns of sickness in industrial units:
(a) The Traditional Sickness - Life Cycle Theory: Companies go through a life-
cycle with typical phases like entrepreneurial stage, growth stage, maturity stage and
decline stage. The old jute mills and textile mills became chronically sick followed this
life-cycle pattern. These mills were not modernised, technology was not upgraded. Due
to rising costs, the operations of these units became unviable. The units had no money
to replace their worn-out assets. Eventually the units became sick and some of them
were taken over by the Jute Corporation and National Textile Corporation. Successful
companies introduce new products and take up new projects at the maturity stage to
avoid the decline. Thus they introduce another growth cycle.
(b) Incipient Sickness: The second type of sickness hits the new projects, which are
not properly conceived, executed and managed. The unit struggles for three to four
years and then turns sick. Typically such a new project suffers from time overrun and
cost overrun. By the time the project is ready, the working capital margin is eroded
either partly or totally. Due to the problems of learning curves, the productivity is low in
the first one or two years. The market-seeding operation takes much more time than
originally planned. The company gets into a severe cashflow problem. Usually the
banker takes away his umbrella at this crucial time, and another corporate patient is
born.
Please use headphones
Industrial Sick Units
RBI Definition
According to the Reserve Bank of India, a unit may be considered sick, if it has incurred
cash losses for one year and; in the judgment of the Bank, it is likely to continue to incur
cash losses for the current year as well as the following year, and the unit has an
imbalance in its financial structure such as current ratio of less than 1:1 and worsening
debt-equality ratio, i.e., the ratio of total outside liabilities to net worth.
A small scale unit is sick when its account with banks are irregular continuously for six
to nine months, the erosion of capital takes place at a rate more than 10% per annum,
there is continuing default in the payment to the creditors and the unit has remained
closed for the previous six months.
The definition of sick units adopted by the term lending financial institutions is based
on the criterion of continuous cash losses, default in debt servicing requirements and
irregularities in meeting statutory and other liabilities.
Thus, an industrial unit is classified as sick by term-lending institutions after taking into
account the following symptoms:
(i) Continuous default in meeting four consecutive half-yearly installments of interest or
principal in respect of the institutional loans;
(ii) Continuous cash losses for a period of 2 years or continued erosion in the net worth
by 50% or more; and
(iii) mounting arrears on account of statutory or other liabilities for a period of one or
two years.
Weak Units
As against the SSI (small scale industry) units, there are categories of non-SSI sick units
which do not come under the purview of the Sick Industrial Companies (Special
Provisions) Act 1985. The Reserve Bank of India has advised the banks to take remedial
measures to facilitate the detection of sickness at an early stage for these units, when
they become 'weak', before they turn 'sick'. An industrial unit is called a weak unit at the
end of any accounting year, if it has:
(i) accumulated losses equal to or exceeding 50% of its peak net worth in the
immediately preceding five accounting years,
(ii) a current ratio of less than 1:1, and
(iii) suffered a cash loss in the immediately preceding accounting year.
Sick Industries (Special Provisions) Act 1985:
According to this Act, a sick unit means, "A company (being a company registered for
not less than 7 years) which has at the end of any financial year accumulated losses
equal to or exceeding its entire net worth and has also suffered cash losses in such
financial year and the financial year immediately preceding such financial year".
Reasons for Industries Sickness
When a unit succeeds, the management takes full credit. When a unit fails and becomes
sick, the management usually blames the environmental factors including the banks and
financial institutions. Objective analysis indicates the following reasons for industrial
sickness:
1. Internal Factors
(i) Inexperienced entrepreneurs
(ii) Disputes among the promoters' groups/partners
(iii) Wrong technology and obsolete technology
(iv) Antiquated (outdated) equipment
(v) Uneconomical size
(vi) Improper balancing of production facilities
(vii) Lack of adequate margins for working capital
(viii) Poor management practices
2. External Factors
(i) Limited market potential
(ii) Shrinking demand for the product manufactured
(iii) Cut-throat competition in the industry
(iv) Lack of assured supply of raw materials
(v) Militant trade unions and multiple unions
(vi) Unexpected levies and tax burdens
(vii) Power cuts, frequent load shedding
(viii) Heavy interest burden
(ix) Inadequate working capital facilities
(x) Competition from the unorganized sector
(xi) Erratic imports - Emergence of cheap substitutes
(xii) Dumping practices by foreign companies
(xiii) Change in macro-economic Policies.
Detection of Sickness
The old adage 'prevention is better than cure' is especially true in the case of industrial
sickness. The major problem in India is the sickness of a unit is detected at a very late
stage, when the net worth is eroded and rehabilitation becomes very difficult. Recent
studies on industrial sickness have showed that even six years before attaining the stage
of cash loss, the profitability index of the sick companies showed marginal decline,
followed by sustained decline during the period of 3 years preceding the cash loss
period, and then it showed continuous and significant cash loss during the subsequent
period. Thus, if the sickness is detected at early stages using some important ratios,
sickness can be prevented.
Early warning signals or Symptoms of a Sick Unit
These are some of the more important early warning signs of impending sickness in a
company:
Stagnant declining sales
Continuing losses
Erosion of working capital margins
Irregularity in bank working capital limits
High operating costs
Uneconomic levels of operations
Chronic cash shortages
Accumulation of non-moving inventories
Sticky debtors
Pressing creditors
Unsatisfactory financial ratios
Fall in share prices
Revival Measures
1. Pre-requisites for New Management
a. A New Chief: A chief brings a new perception of reality. He initiates the
development of new strategies and implementation of new methods. He tends to have
leadership and motivational skills. His ability to be flexible, to make rapid decisions, and
to work under stress, allows him to turn around the company. Above all, he brings a
vision.
b. Central Financial Control: Introduction of strong financial control through the
establishment of cash-flow forecasts, budgets, manufacturing overheads, and a tight
control over both capital and revenue expenditure are very crucial.
c. New Marketing Focus: If the company lacks competitiveness in one or more of its
product lines, it is time to rethink the overall product-market focus. Add (delete)
product lines; add (delete) customers and markets and begin a focused sales effort. New
focus includes eliminating unprofitable lines and customers, emphasising only the
profitable core. (If the core itself is not profitable, then recovery chances are slim).
d. Improved Marketing: Improved marketing begins with a detailed well executed
marketing plan, and recruiting new sales representatives, since this always leads to
increase in sales volume. It is possible that the present sales force is capable of doing
better with the right motivation and direction.
e. Pricing: Pricing is most important during a turnaround, because profits are more
sensitive to price. A given increase in price will have a greater impact on profit than the
same % increase in volume or reduction in cost. However prices must be increased when
the variable costs are not covered by the selling price. When firms see their sales volume
decreasing, they lower their prices. But as soon as the firm lowers its prices, the
competitor lowers theirs and thus no further sales volume can be obtained. Thus be
careful when lowering prices.
f. Asset Reduction: Integral part of a turnaround is asset reduction. In severe
financial crisis, asset reduction is the only viable alternative. A positive cash-flow is the
most important priority for survival. Reduction in working capital requirement is
possible through the reduction in the days the debtors are due, and in reduction of
inventory levels.
g. Cost Reduction: Cost reduction strategy must be aimed at improving the firm's cost
position vis-a-vis the competitors'. Studies have shown that in a loss making situation,
profits are more sensitive to cost-reduction than to price increases. Costs are also
reduced through control on purchases and plant utilisation.
h. Debt Re-Structuring: A firm that is in a turnaround situation and in a cash crisis
usually has a high level of debt to equity. Cash-flow generation strategies, particularly
asset reduction strategies, should be used to reduce borrowings. It is common for
companies to restructure debts by asking principal creditors, such as banks, to convert
interest and principal payments into equity. Convert short-term debt to long-term debt
or settling for a lower amount now, as a full and final settlement for all borrowings.
2. Cost-Reduction Strategies
a. Raw-Material Costs: The easiest way to do this is to reduce the amount used by
changing the manufacturing processes. For example, engineering companies study what
each component is supposed to do and whether there are substitutes and redundancies,
both in product and process engineering.
b. Labour Costs: In developed nations, accepting wage cuts is quite common. But in
India, it is even absurd to think that white- and blue-collar workers will accept this
temporary solution. Management has to rely on increased labour productivity for a
reduction in labour costs. Changes in management style, introduction of incentive
payout, and changes in production methods can increase productivity. Total labour
costs can be lowered by encouraging early retirement, voluntary retirement and not
hiring when persons leave. Cutting or reducing over-time and re-scheduling work and
paid holidays can lower labour costs. For white-collar workers, freeze all pay increases.
c. Reduction of overhead Costs: For reducing the manufacturing costs, reduce the
size of operation by eliminating a part of the process, and improve efficiency within the
existing operation. In summary, successful cost reduction is possible when there are
changes in established methods of operation, changes in the organisational culture and
attitude of management and staff.
d. Marketing and Revenue Improvement: The first thing to do is to make a list of
what you are selling - land, building, machinery, inventory, who is the potentially the
best type of purchaser and what is it worth to him. This exercise defines a direction that
the company will follow to sell its assets most profitably.
e. Reduce Inventories: Immediately stop new purchasing, cancel outstanding orders,
and return goods to suppliers. Instead of holding stocks, order more frequently. Deals
and other understandings between the suppliers and the purchase department
personnel often exist. It is wise to change suppliers and not rely on same old ones.
Surplus raw-materials could be sold and work-in-progress inventories should be
reduced through better scheduling, better manufacturing methods.
f. Reducing Debtors: Identify outstanding accounts and stop all deliveries to them.
Contact customers personally, rather than through the sales force. Check the solvency
and trading practices of your customers. An insolvent debtor could be the final blow for
the firm. Companies have been known to use bill discounting facilities and begin to
establish the same terms that the competitors are offering, not more, not less.
g. Delay Creditors: Delay the time in which creditors get paid. Try to persuade them
to continue to provide the firm with supplies and wait for payment.
h. Concentrate on Few Products and Markets: In a recovery situation, it is the
best to concentrate on few products and a few customers. Selecting products to
concentrate on should be those that provide a sales volume and have a good growth rate.
Products that offer a good contribution margin, and have short manufacturing time
should be selected. It is wise to limit the range of products offered during the
turnaround situation. If too many products are there, it is difficult to pay attention to all
of them, causing inventories to build-up and thus affecting cashflow.
Customers should be selected on the basis of profitability earned, and days outstanding
on the account. It is not always wise to focus on the largest customer. If volume is
required and the largest customer is profitable then it is alright, otherwise, he is also the
only one who is most capable of exploiting the firm's situation. Once the product and
customer decisions have been made, other marketing steps are taken.
Planning, monitoring each customer and salesperson, along with products and price
must be done. Evaluate and replace the sales reps if required. Assign profit centre
responsibility and develop an ongoing profit improvement plan to insure maximum
operational efficiency.
i. Changing Prices: Price increases means raising list prices, lowering discounts or
both. Price and profitability have a great relationship:
(a) Raising prices: Products that already have a high margin can stand a further
price increase more easily than products with lower margins. Infrequently
purchased consumer goods tend to be less price-sensitive. If there are fewer
sources of supply, there are fewer comparable products on the market, and thus
price increases are easier. Products with high switching costs and specialised
buyers also lead to price inelasticity. The Indian consumer is often used to price
increase due to high inflation. If prices have been steady for the past few months,
it is not unreasonable to raise prices. The greatest resistance against raising prices
comes, not from the customer, but from the sales force, because they have to work
harder with increased prices.
b) Discounts: Discounts work like magic for the wholesalers and retailers. It is
more important for a firm to have a competitive discount structure than a
competitive list price. Once a decision is made, communicate the importance to
the sales force and the need to change prices.
3. What the crisis manager should do: Gain Management Control
Appoint 2 new persons - good Finance Director and a good Chief Accountant. After that,
the crisis manager must spend time:
a) understanding all legal cases, formalities that the company has or will have to
face in the near future;
b) developing a cash-flow forecast - current month's, next quarter's and the whole
year's, and understand the current cash position. Receipts from debtors, amount
paid to creditors, amount of salary and wages, tax and dividend payments and
capital items (receipts and payments). Consideration must be given to loan
repayments, the next peak demand for cash, and the seasonal build of inventory.
c) doing inventory control - identify old or obsolete items and either dispose them
or write them off. Keep a firm control over purchases, and compare usage levels
before new purchases.
d) doing expenditure controls - make a policy that all capital expenditure over Rs.
X will require the manager's approval. Limit all revenue expenditures, like
temporary employment and the recruitment of staff. There should be no new
recruitment of labour. All pay increases shall be temporarily frozen and any price
increases from suppliers should be rejected. In this way revenue expenditure can
be controlled.
4. Communication with outsiders
a. Banks - Keep them informed at all times regarding new plans, actions taken and
results obtained. Restructure debt and/or obtain additional financing.
b. Unions - Meet the Union leaders and seek their cooperation. Urgency of situation
must be outlined clearly, win their confidence and support.
5. Assess Management Quality and replace if needed. As a rule, do not fire someone
from his job if the job is crucial for day-to-day operation and there is no competent
replacement available immediately.
6. Evaluate the Business
Remember Paretos 80:20 principles:
80% or all profits come from 20% of the products.
80% of the work is done by 20% of the employees.
80% of problems get created by 20% of the workers.
80% of the problems get solved by attending to 20% of the business.
a. Finance: Calculate the percentage of all expenditure to sales, financial ratios and
look for any trend. Compare the company with the industry standards; compare
historical cash-flows to determine how the firm has arrived in the current cash-flow
crisis.
b. Marketing: Undertake a sales analysis by product customer, for trends on sales
volume and seasonal patterns; profit-to-contribution for major selling products. Identify
positive and negative products or product lines. Customer analysis includes gross sales
for each customer, days outstanding, returns, complaints and profitability for individual
customers
c. Operational: Plant utilisation, departmental efficiency reports, breakdown and
maintenance reports are of great value to the crisis manager.
d. Personnel: A record of the name and designation of each employee - years worked,
legal costs for dismissal, qualification, background etc., is useful.
7. Improve the Budgetary System
The budget and forecasts as a vehicle for control sales forecasts must be developed and
properly monitored. The sales forecast must specify what product or product line will be
sold to which customer and in what geographical territory. Above all, solicit the co-
operation from the department heads during the process of development and
implementation of these forecasts.
Revival under Sick Industries Companies (Special Provisions) Act 1985
For providing an integrated approach to deal effectively with the problem of industrial
sickness, a special legislation called or Sick Industries Companies (Special Provisions)
Act (SICA) was passed in the year 1985. Under the SICA, Board For Industrial and
Financial Reconstruction (BIFR) was set up in the year 1987, as a body of experts for
timely defection of sickness in industrial companies and for expeditious determination
of preventive, ameliorative, remedial and other measures.
Objectives of BIFR
(i) To fully utilise the productive industrial assets,
(ii) To afford maximum protection of employment
(iii) To optimise use of investible funds locked up in sick units.
(iv) To realise the amounts of banks and financial institutions etc, from non-viable sick
units through liquidation in cases where there is no hope of revival.
Machinery Under SICA
The provisions of SICA arc sought to be implemented through BIFR which is the heart
and soul of SICA, assisted by an operating agency which acts as hand tool of BIFR by
carrying out investigations and preparing schemes for revival. BIFR acts as a quasi
judicial body, i.e. independent of executive influence. In addition to the above
mentioned authorities, Appellate Authority for Industrial and Financial Reconstruction
(AAIFR) is also constituted under SICA, which acts as a judicial body and hears appeals
against the orders of BIFR. SICA excludes the Civil Courts jurisdiction against any order
passed by BIFR or AAIFR i.e., any order passed by BIFR or AAIFR cannot be challenged
in any other civil courts. So AAIFR has been given exclusive jurisdiction as per SICA.
Operating Agency
Any public financial institution specified in Sec. 3 (1) of SIC Act i.e., (ICICI, IFCI, IDBI,
IRBI, SFCs, Banks etc.) can be appointed as an Operating Agency by BIFR.
Constitution of BIFR
BIFR consists of a chairman appointed by Central Government for a term of 5 years, and
not less than 2 or more than 14 members. A member must be qualified to be the judge of
High Court or persons of ability, integrity and standing who have special knowledge and
professional experience of not less than 15 years, in fields of science, technology,
banking, industry, law, economics, industrial finance, industrial reconstruction etc. The
first team of 6 members was formed on 12-1-1987 with Mr. R. Ganapathy, as its
Chairman.
Procedural Steps
1. Identification of a sick company : It may be either by reference or upon
information received from outside.
(a) The Act imposes responsibility on Board of Directors to intimate in a prescribed
format to BIFR within 60 days of finalisation of accounts, if it qualifies as Sick Company
as per definition of SICA.
(b) Reference to BIFR by State Government, Central Government, scheduled bank or
any public financial institution which has interest.
(c) Identification of a sick unit by BIFR itself.
2. Inquiry by BIFR : The inquiry by Operating Agency or BIFR must be completed in
60 days. For the purpose of conducting inquiry, BIFR has got the right to appoint
special directors, if necessary. As soon as the case is taken up for study, all the legal
proceedings and contracts (like winding up of company, execution of decree against
properties of company, etc.) stand suspended.
3. Consideration for revival of sick unit shall be decided on the basis of extensive
study of all the variables like management policies, labour unrest, availability of raw
materials, finance, etc.
4. After an indepth study, BIFR decides if there is any possibility of making the
company's networth positive in a reasonable time. If so, the company is given a
chance to make it positive, and has got the right to extend the time limit, if the company
requests for some more time and passes a fresh order.
5. If the company fails to do so, the Operating Agency prepares a scheme providing
either for ameliorative, remedial or other measures for revival of the company within 90
days of issue of order. There is freedom of action to the Operating Agency while framing
the scheme. The scheme may be reconstruction, rehabilitation or revival.
6. Finally, the revival package is sent by BIFR to the sick company and may
incorporate any changes as suggested by the sick company, if necessary.
7. Any scheme is sanctioned by BIFR after circulating a draft copy to all the persons
who have some interest in the company like Operating Agencies, creditors, transferee of
an industrial concern etc., before giving a final approval to it.
Sometimes, merger of a sick unit with a healthy unit may be resorted to, due to
synergistic advantages that may be available. Uneconomic divisions of a unit and
surplus assets may be sold in order to mobilise funds.
Where the unit is under a heavy financial burden, a package of reliefs and concessions is
worked out providing for adequate working capital.
Thus, by adopting various strategies, the BIFR attempts at reviving viable units, while
the unviable ones are allowed to die.
Difficulties encountered by BIFR
During its working of more than seven years, BIFR has experienced various difficulties
in the process of taking measures for rehabilitation of sick units referred to it. Some of
such difficulties are listed below:
(i) Although the promoters of the sick units are quite anxious to get their unit declared
as a sick industrial company to get protection against their creditors, they submit their
revival plans to BIFR/Operating Agencies with a lot of delay. Even after sanction of
revival schemes by BIFR, promoters, in many cases, do not comply with the envisaged
terms and conditions including induction of their contribution.
(ii) In case of units belonging to large industrial groups, BIFR has observed that the
financial institutions and the banks lack coordination amongst them and do not exert
requisite pressure on such groups to take care of their sick units. BIFR on its part insists
on larger promoter's contribution and keeps the reliefs within RBI parameters in such
cases.
(iii) One of the major obstacles in the smooth process of rehabilitation is the inadequate
cooperation extended by the State level financial institutions, foreign banks and private
banks. These agencies, in many cases, refuse to give even the normal reliefs and
additional assistance envisaged in the rehabilitation packages.
(iv) Several State governments, particularly the less industrialised ones, do not
cooperate in the required degree. They do not take decisions and seek repeated
adjournments of the BIFR hearings. They either do not send their representatives in the
hearings or send junior officers who are not able to commit on behalf of the State
governments.
(v) BIFR has observed that workers in most cases give maximum sacrifices when
compared to their intrinsic capacity. They also agree for rationalisation and wage freeze
if considered necessary for revival of the sick units. However, of late, tendency has been
noticed in some cases for labour to renege on the agreements and raise demands for
wage hikes, etc.
(vi) While the work of financial institutions as operating agency has been found by BIFR
to be, by and large, satisfactory, the designated commercial banks generally display
shyness to take up the operating agency work. Most of the commercial banks are not
fully equipped for multi-disciplinary approach required for conducting a techno-
economic study.
REVIEW QUESTIONS
1. Explain the causes for industrial sickness, leading to business failures.
2. What are the early financial and non-financial symptoms of sick units?
3. Explain (a) incipient sickness (b) weak units (c) chronic sickness
4. Suggest suitable revival measures for rehabilitating sick industrial concerns.
5. Explain role of and procedure for rehabilitating sick industrial company under BIFR
scheme of SIC Act, 1985.
SUGGESTED READINGS
1. Bidani S.N. and Mitra, P.K.: Industrial Sickness, New Delhi, Vision Books.
2. Saravanavel, P.: Management Control Systems, Bombay, Himalaya Publishing
House.
3. Srivastava, S.S. and Yadav, R.A.: Management and Monitoring of Industiral
Sickness, New Delhi, Concept Publishing Company.
- End of Chapter -
LESSON - 24
VALUATION OF SHARES
Learning Objectives
After reading this lesson you should be able to:
Know the different concepts of valuation
Understand the necessity for and relevance of valuator
Ascertain the general and specific factors influencing the valuation of shares
Explain and evaluate the different methods of valuation of shares.
Calculate fair market value of shares
Lesson Outline
Concept of Value
Valuation of Shares - Equity and Preference
Factors influencing the valuation of shares
Necessity for Valuation
Methods of Valuation - Asset Backing Method - Earning Capacity Method
Fair Market Value
As observed in Lesson 1, the objective of a firm is to maximise shareholder's wealth.
Further, it was explained that the shareholder's wealth is represented by the product of
number of shares and the current market price per share. Given the number of shares
that the shareholder owns, the higher the stock price per share, the greater will be the
shareholder's wealth. Thus, the financial objective of a firm is to maximise the market
value per share in the market. To maximise the stock price, we have to develop a
valuation model and identify the variables that determine the stock price. Generally
speaking, the value of the firm depends upon two things: (i) the rate of return and (ii)
the element of risk. As the return and risk characteristics of a firm are influenced by the
three financial decisions, namely, (i) Investment decisions, (ii) Financing decision, and
(iii) Dividend decision.
Valuation Concepts
The term 'value' has been used to convey a variety of meanings. The different meanings
of value are useful for different purposes. The various concepts of value are discussed
below:
1. Present Value: A business enterprise keeps or uses various assets because they
generate cash inflows. Value is the function of cash inflows and their timing and risk.
When cash inflows are discounted at the required rate of return to account for their
timing and risk, we get the value or the present value of the asset. In financial decision
making, such as valuation of securities, the present value concept is relevant.
2. Going Concern Value: In the valuation process the valuation of shares is done on
the going concern basis. In a going concern, we assess the value of an existing mixture of
assets which provide a stream of income. The going concern value is the price which a
firm could realise if it is sold as an operating business. The going concern value will
always be higher than the liquidation value. The difference between these two values
will be due to value of organisation, reputation etc. We may command goodwill if the
concern is sold as a going concern.
3. Liquidation Value: If a firm decides to go out of business it will sell its assets.
After terminating the business, the amount which will be realised from sale of assets is
known as liquidation value. Since the business will be terminated, the organisation will
be valueless and intangibles will not fetch any price. The liquidation value will be the
lowest value of a firm. Generally, the true value of the firm will be greater than the
liquidation value.
The liquidation value is useful from the creditors' point of view. If the concern is
running then creditors will be paid out of cash inflows. On the other hand if the concern
is terminated, the creditors will be paid out of the amount realised from various assets.
The creditors will try to ensure that the realisable value of the assets is more than their
claims so that they get fully paid.
4. Replacement Value: The assets are shown on historical cost in the balance sheet.
This cost may not be relevant in the present context. This problem may be solved by
showing assets on replacement value basis. Replacement value is the cost which a firm
will have to spend if it were to replace the assets under present conditions.
Though replacement value method is an improvement over book value concept but still
it has certain limitations. It is very difficult to ascertain the present value of similar
assets which the firm is using. It may so happen that this type of assets may no longer be
manufactured as present. This will create a problem of finding out the replacement cost
of the assets. Moreover, it is not certain that the assets of business would be worth its
replacement cost. The value of intangibles is also ignored in this method.
5. Market Value: The market value of an asset or security is the value at which it can
be sold at present. It is argued that actual market prices are appraisals of knowledgeable
buyers and sellers-who are willing to support their opinions with cash. Market price is a
definite measure that can readily be applied to a particular situation and it minimises
the subjectivity of other methods in favour of a known yardstick of value.
Please use headphones
6. Book Value: The book value of assets can be ascertained from the firm's balance
sheet which is prepared according to the accounting concepts and conventions. The
assets are shown in the balance sheet at cost less depreciation. No account is taken for
the real value of the assets, which may change with the passage of time. The assets are
generally recorded at cost. In case the convention of conservatism is used then assets are
shown at cost or market price whichever is less. The convention of conservatism is
followed for current assets only not for fixed assets. The value of intangibles is also
included in the assets. The debts are shown on the outstanding values and no account is
taken for interest or payment of principal amount. The book value' per share can be
determined by dividing the common shareholders' equity (capital plus reserves and
surpluses) by the number of shares outstanding.
Factors influencing the share value
The factors influencing the valuation of shares can be classified as general factors and
specific factors.
General Factors: These factors are those which have an overall effect on the price of
shares in general:
(i) Government's fiscal and monetary policies - Bank rate, direct and indirect taxes,
(ii) Political stability in the country,
(iii) Economic climate i.e., depression or boom,
(iv) Industrial Policy of the Government,
(v) International political and economic climate also influence the market value of
shares. No country's economy is so isolated that it is immune to changes in other parts
of the world.
Specific Factors : These factors are those which apply to the particular company and
to the industry in which the company is operating:
(i) The present position and future prospects of the industry of which the company is a
part.
(ii) The amount and trend of dividends paid and expected, future dividends, taking into
consideration the dividend cover and the yield compared with similar equity shares.
(iii) Announcement by companies themselves may affect prices, for instance, if a
company increases or does not pay interim dividend.
(iv) The capital structure of the company, which will lead to the study of financial
leverage i.e. the proportion of debt to equity.
(v) An analysis of the company's cash flow to determine its ability to service fixed
charges.
(vi) The amount and trend of the company's profits and the net earnings i,e, the profits
available for distribution to the equity shareholders' after meeting all prior charges,
expressed as a percentage of the market value of the equity share capital.
(vii) The set up of the management to ensure that the company has got a competent and
broad-based, board of directors and also has within it persons of sufficient standing with
adequate technical, financial and business experience.
(viii) The net assets according to the balance sheet of the company
(ix) Whether there is an active market in the equity shares and the amount of the "turn"
i.e. the difference between the higher and lower prices as quoted on the stock exchange.
(x) The possibility of bonus or rights issues.
Necessity for valuation
The necessity for valuation of shares arises inter alia in the following circumstances.
(i) Assessments under the Wealth Tax or Gift Tax Acts.
(ii) Purchase of a block of shares which may or may not give the holder thereof a
controlling interest in the company.
(iii) Purchase of shares by employees of the company where the retention of such shares
is limited to the period of their employment.
(iv) Formulations of schemes like amalgamation, absorption, etc.
(v) Acquisition of interest of disentitling shareholders under a scheme of reconstruction.
(vi) Compensating shareholders on the acquisition of their shares by the Government
under a scheme of nationalisation.
(vii) Conversion of shares, say preference share, debentures/loan into equity.
(viii)Advancing a loan on the security of shares.
(ix) Resolving a deadlock in the management of a private limited company on the basis
of the controlling block of shares being given to either of the parties.
(x) Valuation of securities for Balance Sheet of trust and finance companies.
Relevance of Valuation
Valuation by expert is generally called for when parties involved in the transaction/deal,
etc., fail to arrive at a mutually acceptable value or the agreements or Articles of
Association, etc., do not provide for valuation by experts. For isolated transactions of
relatively small-blocks of shares which are quoted on the stock exchanges, generally, the
ruling stock exchange price provides the basis. But valuation by valuer becomes
necessary when: (i) Shares are unquoted, (ii) Shares relate to private limited companies,
(iii)Courts so direct, (iv) Articles of Association or relevant agreements so provide,
(v)Large blocks of shares is under transfer, and (vi) Statutes as require (like Wealth Tax,
Gift Tax Act).
Limitation of Stock Exchange Prices as a Basis for Valuation: Stock exchange
is a place where shares and stocks are exchanged by the process of purchase and sale,
generally through brokers, who transact the business on a commission basis on behalf of
their clients. It may be stated that stock exchange price is a price pure and simple and
not a value based on valuation. Stock exchange price is, basically, determined on the
interactions of demand and supply and business cycles and may not reflect a reasoned
valuation on principal considerations of yield and safety of capital.
METHODS OF VALUATION
The different methods of valuing shares may be broadly classified into
1. Asset backing method,
2. Earning capacity valuation method.
3. Imputed Market price of shares.
1. Asset Backing Method : This method is concerned with the asset backing per share
and may be based either (a) on the view that the company is a going concern, or (b) on
the fact that the company is being liquidated.
(a) Company as a going concern: If this view is accepted, there are two approaches
(i)to value the shares on the net tangible assets basis (excluding the good will) (ii) to
value the shares on the net tangible assets plus an amount for goodwill.
Net Tangible Assets Backing (excluding the Goodwill): Under this method, it is
necessary to estimate net tangible assets of the company (Net Tangible Assets=Assets-
Liabilities)in order to value the shares. In valuing the figures by this method care must
be exercised to ensure that the figures representing the assets are sound that intangible
assets and preliminary expenses are eliminated and all liabilities are taken into account.
Where both types of shares are issued by a company, the shares would be valued as
under:
(1) If preference shares have priority as to capital and dividend, then the preference
shares are to be valued at par.
(2) After the preference shareholders are paid, die net tangible assets are divided by the
number of equity shares to calculate the value of each shares. If at the time of valuation
there is an uncalled capital, then the uncalled equity share capital be added with the net
tangible assets in order to value the shares fully paid up. The valuation of shares for the
shareholder who have calls in arrears will be valued as a percentage on their paid up
value with the nominal value of shares.
(3) If the preference shares are non-participating and rank equally with the equity
shares, then the value per share would be in proportion of the paid up capital.
Illustration 1
The following is the summarised Balance Sheet of XYZ Company Ltd. as at December
31, 1994.
For purposes of valuation of shares fixed assets are to be depreciated by 10 per cent and
investments are to be revalued at Rs. 10,80,000. Debtors will realise Rs.12, 14,000.
Interest on Debentures is accrued due for 9 months and preference dividend for 1994 is
also due; neither of these has been provided for in the Balance Sheet. Calculate the value
of each Equity Share.
Solution
Valuation of Shares of XYZ Company Ltd. By the Net Assets Method
Asset Backing (including Goodwill):
In many cases goodwill may be worth the figure at which it is stated in the, balance sheet
or if there is no book value for goodwill, it may nevertheless exist. Further even if there
is a book value, the actual value of goodwill may be considerably higher than the book
value. It is generally considered that the value of fixed assets of the company depend on
their ability to earn profits i.e., on the goodwill attaching to them. In such a case
goodwill should be included with other tangible assets for valuation purposes. The
various methods of valuing the goodwill are:
i. Capitalisation of expected future net profits or earning
ii. Assessment based on turnover,
iii. Super Profits method, and
iv. Annuity Method.
Illustration 2
Calculate Goodwill as per (a)Annuity Method(b)Five Years purchase of Super Profits
method; and (c) Capitalisation of super profits methods from the details hereunder
The profits included non-recurring profits on an average basis of Rs. 1,000. Out of
which it was deemed that even non-recurring profits had a tendency of appearing at the
rate of Rs.600 p.a.
Solution
Normal rate of profit 10% of 1,50,000 = Rs. 15,000
Average net profit for 5 years
= (14,400+15,400+16,900+17,400+17,900) 5 = Rs.16,400
Super Profit = 1 6,400-600(non-recurring)= 15,800
15,800-15,000 = Rs. 800
Value of goodwill
(a) Annuity Method = Rs.800 x 3.78(present value factor) =Rs.3,024
(b) Five years purchase of super profits=800 x 5 = Rs.4,000
(c) Capitalisation of supper profit method:
Weakness of Assets Based Approach:
This method has its own weaknesses:
1. There is no uniform method for assessing book value of assets. Such a value is
influenced by policies of the companies on the one hand and accounting practices on the
other.
2. There is no uniformity in assessing depreciation which is an essential ingredient of
valuation of assets.
3. Goodwill and patents count a lot in valuation but in so far as accounting practice goes,
there is considerable lack of standardisation in this regard,
4. It is usually very difficult or rather impossible to exactly bring at par and compare the
value of securities of one company with another.
5. Every company has certain conventions about valuing assets rather than following
any logic and this influences valuation.
6. Usually the understandings do not take fixed assets at current value, but at old costs
which is quite deceptive.
7. This approach also does not give any real idea about earning power of the assets
which is another consideration in valuation.
Advantages of the approach:
This approach has certain advantages as well.
This approach has proved very useful in so far as investing companies, insurance
companies and banks are concerned and in the case of such companies whose assets are
largely liquid, provided such an approach is not exclusively expanded upon.
(1) Asset backing where company is being liquidated (Realisable Value
Approach)
Asset backing method is sound if liquidation is contemplated though realisable value
should be taken into account. When realisation is imminent, it is desirable to construct a
statement of affairs supported, by independent valuations of the fixed assets such as
land and buildings, plant and goodwill. Provision should also be made for the cost of
liquidation and thus some indication may be obtained as to how much per shares may
be payable to members.
(2) Earning Capacity Valuation Method
Capitalisation of earnings approach for valuation of shares is based on the assumption
that a shareholder values earning power on the one hand and income rather than
physical assets on the other. This method is also known as the Yield method. Under
this method, the valuation depends upon the comparison of the company's earning
capacity and the normal rate of interest or dividend that is current on outside
investment. The Earning capacity or yield basis of valuation may take any of the
following two forms: (i) valuation based on rate of return, and (ii) valuation based on
productivity factor.
(i) Valuation based on Rate of Return: The term rate of return refers to the returns
which a share holder earns on his investment. It may further be classified as (a) rate of
return and (b) rate of earnings. To ascertain the value of shares based on profit earning
capacity future maintainable profits and rate of interest at which the profits are to be
capitalised must be fixed. In arriving at the profit to show the normal earning capacity
generally the following adjustment are made: (i) Non-recurring items should be allowed
for, (ii)Income tax charges should be appropriated to the particular year in which they
are paid, and (iii) allocation to reserve.
The main purpose for adjustment of profit is the determination of future annual
maintainable profit which must be capable of distribution as dividend. The rate of
interest for capitalising the average normal profit is fixed upon by the circumstances of a
particular case. In practice a rate of 10% or more may be reasonable.
The following steps may be followed for calculating the value of shares according to
yield method:
i. Calculation of average expected future profits.
ii. Calculation of expected return by the following equation:
Expected Return = Expected Profits x 100
Equity Capital
iii. Calculation of yield value of share as under:
Value of share= Expected Rate x Paid up value of share
Normal Rate
Conclusion: Of course earning approach has its own advantages, but it cannot be
denied that such an approach has own limitations It is primarily because profits are
influenced by many factors. Even due to various reasons, the companies having same
span of work, working under same conditions might show different profits. Accordingly
this method determining the value of shares has its own inherited problems.
(ii) Valuation based on Productivity Factor: Productivity factor represents the
earning power of the company in relation to the value of the assets employed for such
earning. The factor is applied to the net worth of the company on the valuation date to
arrive at the projected earnings of the company. The projected earnings after necessary
adjustments are multiplied by the appropriate capitalisation factor to arrive at the value
of the companys business. Total value is divided by the number of equity shares to
ascertain the value of each share. The productivity factor-based valuation is merely a
method for ascertaining a reliable figure of future profits. The steps involved in such a
method of valuation can be enumerated as follows:
(a) Average net worth of the business is ascertained by taking a number of years whose
results are relevant to the future. It will be appropriate to determine the average net
worth of each year on the basis of net worth of the business at the commencement and
at close of each of the accounting years under consideration. The average net worth of
the business of the period under study would be calculated on the basis of the average
net worth calculated as above for each of the accounting years.
(b) Net worth of the business on the valuation date is ascertained.
(c) Average profit earned for the period under consideration is ascertained on ihe basis
of the profits earned by the business during the period by. simple or weighted average
method as may be considered appropriate.
(d) The productivity factor is found out as follows:
Average profit x 100
Average net worth
(e) The productivity factor calculated as above is applied to the net worth of the business
in future.
(f) The projected income so calculated is adjusted further by making of appropriations
for replacement, tax, rehabilitation of plant and equipments, underutilisation of
productive capacity, effects of restriction on monopoly and divided on preference
shares. Thus, the profits available for the equity shareholders are ascertained.
(g) The normal rate of return for the company is ascertained keeping in view nature and
size of the undertaking.
(h) Appropriate capitalisation factor or multiplier based on normal rate of return is
ascertained, as explained earlier
i. The capitalisation factor obtained as above is applied to adjusted projected profit
available for the equity shareholders to ascertain the capitalised value of the
undertaking.
Illustration 3
The following figure relate to a company which has Rs. 10,00,000 in Equity Shares and
Rs. 3,00,000 in 9 per cent Preference Shares, all of Rs. 100 each:
Average Net Worth Adjusted Taxed
(excluding
investment) Profit
1992 Rs. 18,60,000 Rs. 1,90,000
1993 21,50,000 2,10,000
1994 21,90,000 2,50,000
The company has investments worth Rs 2.80,000 (at market value) on the valuation
date, the yield in respect of which has been excluded in arriving at the adjusted tax profit
figures. It is customary for similar types of companies to set aside 25 percent of taxed
profit for rehabilitation and replacement purposes. On the valuation date, the net worth
(excluding investments) amounts to Rs. 22,50,000. The normal rate of return expected
is 9 percent. The company has paid dividends consistently within a range of 8 per cent
to 10 per cent on equity shares over the previous seven years and it expects to maintain
the same.
You are required to ascertain the value of each equity share on the basis of productivity,
applying suitable weighted averaging.
Solution
Computation of Productivity Factor
(Profit as a percentage of Capital employed)
(3)Valuation of Shares on the basis of Actual Market Price
Market price method is one of the old methods for the valuation of shares. In fact there
are many economists and analysts who attach more importance to this rather than any
other method. According to them, valuation of share is related to actual market price
and the prices at which transactions take place in the market indicate the value of the
shares. The real value is the verdict of the market.
Those who support this are of the view that this price is determined by the investors and
as such can be depended upon. Being a readily available measure can also be applied to
a particular situation. It is this method which minimises subjectivity, which is the
characteristic of other methods.
But the approach has its own problems as well. It is difficult to assess the market
because there are many fluctuations in its market and market is linked with many
factors. Sometimes fluctuations can be both violent as well as extreme, which might
disturb the whole system. Under such a situation it becomes doubtful whether at all it is
desirable to depend on this method, which is so undependable. Then another problem
with this method is that much of the speculative activity is going on in the market which
disturbs share valuation. Those who are working in the market manipulate share prices
in a manner which suits their convenience.
There are other problems involved in so far as market price is concerned. One sucp
important problem is that for many shares market quotations are not available and as
such their value is not listed in the share market. In the case of such companies it
becomes difficult to find out value of the shares. Trading in such shares becomes rather
deceptive both for the buyers as well as the investors. If any undertaking decides to
release some additional shares then in the case of any such share, share market will
suddenly come down, as it shall not he-possible for the market to bear its pressure.
Still another difficulty with this method is that in many cases market price is influenced
not by real but by artificial means and when the market is under the influence of such
means then there is bound to be deception. Then comes the problem of shares of closely
held company. Obviously the shares of such a company are not reflected through the
market. In many cases shares of such companies in the market might go up or come
down when the members of the family themselves begin to trade in the market and
purchase or sell shares to attract or detract the attention of some others concerned with
it.
Fair Market Value: There are many problems in so far as market value is concerned.
Though the method might seem very acceptable, yet it is not because it is linked with
many problems. In order to avoid some of the problems the idea of Fair Market Value,
has been evolved. This value is based on the assumption that there are both willing
buyers as well as sellers in the market and that each is quite well informed. It is also
believed that each such buyer and seller is quite rational. Accordingly, under this notion
it is believed that whole market will smoothly and rationality work. But as we know such
an idea is difficult to follow in practice because in the market there are neither ready
buyers nor ready sellers and equally also in the market all the buyers and sellers are not
rational or quite well informed.
Illustration 4
Mr.Ram Nath intends to invests Rs.66,000 in Equity Shares of a limited Company and
seeks your advise as to the maximum number of shares he can expect to acquire based
on a fair value of the shares to be determined by you. The following information is
available:
Average net profit of the business is Rs. 1,50,000. Expected normal yield is 8% in case of
such equity shares. It is observed that net assets on revaluation are worth Rs. 1,40,000
more than the amount at which they are stated in the books. Goodwill is to be calculated
at 5 years purchase of super profits, if any. Ignore taxation.
Solution
1. Value on Yield basis:
Normal yield is 8%
Value of Equity Share = 1 .20 x 100 = Rs. 15
8
or
Actual Yield = 1.20 x 100= 12%
10
Value of Equity Share = 12% x Rs.10 per share = Rs,15
8%
No. of Equity Shares that he can acquire = 66,000 = 4,400 Shares
15
2. Intrinsic Value including goodwill;
Rs.
3. Fair Value = 15.00 + 13.20 = 14.10
2
No. of Equity Shares that he can acquire = 66,000 = 4,680 Shares
14.10
Illustration 5
You are asked to value shares as on 31st March 1995 of a private Company engaged in
engineering business, with a view to floating it as a Public Company. The following
information is extracted from the audited accounts:
The audited Balance Sheet as at 31st March, 1995 showed the following position.
In lieu of salary to Managing Director, the Public Company would incur director's fees of
Rs.l8,000 per annum. Income Tax may be assumed at 60%.
You are required to value shares.
Solution
Valuation of Equity shares on net assets basis:
Valuation of Preference Shares
In India preference shares have a priority as to payment of dividend and repayment of
capital over equity shares in the event of company's winding up. They are taken as
cumulative but non-participating unless otherwise stated. Their valuation is generally
on "Dividend Basis" according to the following formula:
Paid-up value x Average maintainable Dividend rate
Normal rate of return
For example, if the paid-up value of a preference share is Rs.80, average dividend rate
12 per cent, normal rate of return 10 per cent the value of a preference share would be
Rs. 96 (m i.e. Rs. 80 x 12/10).
In case the dividend on cumulative preference shares is in arrears, the present value of
such arrears of dividend (if there is a possibility of their payment) should be added to
the value of a preference share calculated as above.
The dividend basis for valuation of preference shares is useful only in those cases where
the preference share capital does not has adequate assets backing and the company is a
going concern. In case the preference share capital does not have adequate assets
backing or the company is going into liquidation it will be appropriate to value
preference shares according to the net assets method.
In case of participating preference shares of companies in liquidation, it will be
appropriate to take into account the share in the surplus assets remaining after payment
to the equity shareholders.
Illustration 6
A company has net assets of Rs 1 lakh before payment to the shareholders. The share
capital consists of 5,000 equity shares of Rs. 10 each and 2,000 preference shares of Rs,
10 each. The preference shares are entitled to share 25 per cent of the surplus assets
remaining after payment to the equity shareholders. Calculate the value of a preference
share.
Solution
Illustration 7
The following figures are extracted from the books of M/s Prosperous Limited.
On a fair valuation of all the assets of the company it is found that they have an
appreciation of Rs. 75,000.
The articles of association provided that, in case of liquidation the preference
shareholders will have a further claim to the extent of 10 per cent of the surplus assets.
Ascertain the value of each preference and equity share, assuming liquidation. Ignore
expenses of winding up.
Solution
Valuation of Preference and Equity Shares of M/s Prosperous Ltd.
Note: It is to be noted that values in the question are to be determined assuming
liquidation. In such a case the surplus is to be distributed among the equity
shareholders according to the nominal value of the shares held by them (equal in this
case). Uncalled capital is an asset of the company and, ii one presumes that uncalled
money has been called up the truth of the statement made above will be self-evident. It
will be incorrect to distribute the surplus in the ratio of paid-up amounts.
REVIEW QUESTIONS
1. Briefly discuss some of the important purposes and methods of valuation of shares.
2. What do you understand by asset based approach to valuation? What are the main
problems involved in this approach?
3. Critically evaluate capitalisation of earnings approach for the valuation of shares.
4. Explain the method of valuation of shares on the basis of actual market price. State
the main objections to this method.
5. Describe two methods of valuation of shares and discuss which method in your view,
most appropriate in valuing a minority and majority shareholding.
6. What are facts that influence the valuation of shares for the purpose of
amalgamation/merger of companies? Discuss with illustrations.
PRACTICAL PROBLEMS
1. From the following figures calculate the value of a share of Rs yield on capital
employed basis and (ii) dividend basis, the market expectation being 12 %
2. Mr. Ashok wants to invest Rs. 32,000 in equity shares of a Company, The following
particulars are available:
The company is three years old and has earned an aggregate net profit of Rs. 9lakhs. The
equity shares may yield 15%, If the net assets are re-valued, the value thereof is Rs.
1,40,000 more than the value stated in the books. What is the maximum number of
shares Mr. Ashok can purchase based on fair value of the shares?
[Ans.: Fair value = Rs. 14, No of shares to be purchased on the basis of fair value 2,286
Equity Shares]
3. Mr. X, who desires to invest Rs. 33,000 in equity shares in public limited company,
seeks your advice as to the fair value of the shares. The following information is made
available:
Issued and Paid-up Capital Rs.
6 per cent Preference shares of Rs. 100 each 5,50,000
Equity shares of Rs. 100 each 3,50,000
9,00,000
Average net profit of the business in Rs. 75,000. Expected normal yield is 8 per cent in
case of such equity shares. It is observed that the net assets on revaluation are worth Rs.
70,000 more than the amounts at which they are stated in the books. Goodwill is to be
calculated at 5 year's purchase of the super profits, if any, (Ignore income-tax).
Give your working of the fair value of equity shares and determine the number of shares
which Mr. X should purchase.
[Ans. Goodwill Rs. 42,000; Intrinsic value Rs. 13.20; Value on yield basis: EPS based
Rs. 15 and Rate of Earnings basis Rs. 12.50 No. of shares to be purchased 2,340]
4. The Balance Sheets of two companies A Ltd. and B Ltd. as on 31 March, 1994 are:
(Rs.
Lakh)
A Ltd. proposes to take over B Ltd. For this purpose the assets were revalued as:
Fixed Assets Rs. 6.15 lakhs
Stock 1.00 lakhs
Debtors 1.05 lakhs
The additional factor to be considered is that B Ltd. is an industry which is not licensed
under the current policy of the Government. Hence, there is an advantage as an existing
unit. For this premium of Rs. 5 lakhs is assessed.
Calculate and suggest a share valuation of B for the takeover and suggest a fair exchange
ratio of shares.
[Ans. Break-up value of both more or less the same; Exchange Ratio 1:1]
SUGGESTED READINGS
1. Chowdhury : Management Accounting, Ludhiana. Kalyani Publishers.
2. Rathnam, P.V. : Financial Adviser, Allahabad, Kitab Mahal.
3. Saravanavel, P. : Financial Management,New Delhi, Dhanpat Rai & Sons
- End Of Chapter -