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Finance Functions The finance functions can be divided into three broad
categories: (1) investment decision, (2) financing decision, and (3) dividend
decision. In other words, the firm decides how much to invest in short-term
and long-term assets and how to raise the required funds.
Shareholders Wealth Maximisation (SWM) In making financial decisions,
the financial manager should aim at increasing the value of the shareholders
stake in the firm. This is referred to as the principle of Shareholders
Wealth Maximisation (SWM).
Wealth Wealth is precisely defined as net present value and it accounts for
time value of money and risk.
Agency Problem and Agency Costs Shareholders and managers have the
principal-agent relationship. In practice, there may arise a conflict between
the interests of shareholders and managers. This is referred to the agency
problem and the associated costs are called agency costs. Offering
ownership rights (in the form of stock options) to managers can mitigate
agency costs.
Financial Manager The financial manager raises capital from the capital
markets. He or she should therefore know-how the capital markets function to
allocate capital to the competing firms and how security prices are determined
in the capital markets.
Chief Financial Officer A number of companies in India either have a
finance director or a vice-president of finance as the Chief Financial Officer
(CFO). Most companies have only one CFO. But a large company may have
both a treasurer and a controller, who may or may not operate under the CFO.
Treasurer and Controller The treasurers function is to raise and manage
company funds while the controller oversees whether funds are correctly

Finance Functions
Investment or Long Term Asset Mix Decision

Financing or Capital Mix Decision

Dividend or Profit Allocation Decision
Liquidity or Short Term Asset Mix Decision

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Finance Managers Role

Raising of Funds
Allocation of Funds

Profit Planning
Understanding Capital Markets

Financial Management, Ninth Edition I M Pandey

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Financial Goals
Profit maximization (profit after tax)
Maximizing Earnings per Share

Shareholders Wealth Maximization

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Profit Maximization
Maximizing the Rupee Income of Firm

Resources are efficiently utilized

Appropriate measure of firm performance
Serves interest of society also

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Objections to Profit Maximization

It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment profit
maximization is regarded as

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Maximizing EPS
Ignores timing and risk of the expected benefit
Market value is not a function of EPS. Hence

maximizing EPS will not result in highest price

for company's shares
Maximizing EPS implies that the firm should
make no dividend payment so long as funds
can be invested at positive rate of return
such a policy may not always work

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Shareholders Wealth Maximization

Maximizes the net present value of a course

of action to shareholders.
Accounts for the timing and risk of the
expected benefits.
Benefits are measured in terms of cash flows.
Fundamental objectivemaximize the
market value of the firms shares.

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Risk-return Trade-off
Risk and expected return move in tandem;

the greater the risk, the greater the expected

Financial decisions of the firm are guided by
the risk-return trade-off.
The return and risk relationship:
Return = Risk-free rate + Risk premium
Risk-free rate is a compensation for time and
risk premium for risk.
Financial Management, Ninth Edition I M Pandey
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Organisation of the Finance Functions

Reason for placing the finance functions in

the hands of top management

Financial decisions are crucial for the survival of

the firm.
The financial actions determine solvency of the
Centralisation of the finance functions can result in
a number of economies to the firm.

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Status and Duties of Finance Executives

The exact organisation structure for financial

management will differ across firms.

The financial officer may be known as the
financial manager in some organisations,
while in others as the vice-president of
finance or the director of finance or the
financial controller.

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Role of Treasurer and Controller

Two more officersthe treasurer and the

controllermay be appointed under the

direct supervision of CFO to assist him or her.
The treasurers function is to raise and
manage company funds while the controller
oversees whether funds are correctly applied.

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Time Value for Money Individual investors generally prefer possession of a
given amount of cash now, rather than the same amount at some future time.
This time preference for money may arise because of (a) uncertainty of cash flows,
(b) subjective preference for consumption, and (c) availability of investment
opportunities. The last reason is the most sensible justification for the time value
of money.
Risk Premium Interest rate demanded, over and above the risk-free rate as
compensation for time, to account for the uncertainty of cash flows.
Interest Rate or Time Preference Rate Rate which gives money its value,
and facilitates the comparison of cash flows occurring at different time periods.
Required Interest Rate A risk-premium rate is added to the risk- free time
preference rate to derive required interest rate from risky investments.
Compounding Compounding means calculating future values of cash flows at
a given interest rate at the end of a given period of time.
Sinking Fund An annuity to be deposited for n periods at i rate of interest to
accumulate to a given sum. The following equation can be used:
Discounting Discounting means calculating the present value of cash flows at a
given interest rate at the beginning of a given period of time..
Capital Recovery determining annual cash flows to be earned to recover a
given investment.
Wealth or Net Present Value It is defined as the difference between the
present value of cash inflows (benefits) and the present value of cash outflows
(costs). Wealth maximisation principle uses interest rate to find out the present
value of benefits and costs, and as such, it considers their timing and risk.
Multi-period Compounding When interest compounds for more than once in a
given period of time, it is called multi-period compounding. If r is the nominal
interest rate for a period, the effective interest rate (EIR) will be more than the
nominal rate r in multi-period compounding since interest on interest within a
year will also be earned, EIR is given as follows:
where m is the number of compounding in a year and n is number of years.
Internal Rate of Return (IRR) IRR is the rate, which equates the present
value of cash flows to the initial investment. Thus in operational terms, in the
present value equation, all variables are known except r; r can be found out by
trial and error method.

Time Preference for Money

Time preference for money is an

individuals preference for possession of a

given amount of money now, rather than the
same amount at some future time.
Three reasons may be attributed to the
individuals time preference for money:

preference for consumption
investment opportunities

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Required Rate of Return

The time preference for money is generally

expressed by an interest rate. This rate will be

positive even in the absence of any risk. It may
be therefore called the risk-free rate.
An investor requires compensation for assuming
risk, which is called risk premium.
The investors required rate of return is:
Risk-free rate + Risk premium.

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Present Value
Present value of a future cash flow (inflow or

outflow) is the amount of current cash that is

of equivalent value to the decision-maker.
Discounting is the process of determining
present value of a series of future cash flows.
The interest rate used for discounting cash
flows is also called the discount rate.

Financial Management, Ninth Edition I M Pandey

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Present Value of a Single Cash Flow

The following general formula can be employed to

calculate the present value of a lump sum to be

received after some future periods:
Fn (1 i ) n
(1 i )
The term in parentheses is the discount factor or

present value factor (PVF), and it is always less

than 1.0 for positive i, indicating that a future amount
has a smaller present value.

Fn PVFn,i

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Suppose that an investor wants to find out

the present value of Rs 50,000 to be

received after 15 years. Her interest rate is
9 per cent. First, we will find out the present
value factor, which is 0.275. Multiplying
0.275 by Rs 50,000, we obtain Rs 13,750 as
the present value:
PV = 50,000 PVF15, 0.09 = 50,000 0.275 = Rs 13,750

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Net Present Value

Net present value (NPV) of a financial

decision is the difference between the

present value of cash inflows and the present
value of cash outflows.


+ k )t


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Present Value and Rate of Return

A bond that pays some specified amount in

future (without periodic interest) in exchange for

the current price today is called a zero-interest
bond or zero-coupon bond. In such situations,
you would be interested to know what rate of
interest the advertiser is offering. You can use
the concept of present value to find out the rate
of return or yield of these offers.
The rate of return of an investment is called
internal rate of return since it depends
exclusively on the cash flows of the investment.
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Internal Rate of Return

The formula for Internal Rate of Return is

given below. Here, all parameters are given

except r which can be found by trial and


1 (1 + r )


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Discount Rate being the rate of return that investors expect from securities of
comparable risk.
Bonds or Debentures are debt instruments or securities. In case of a
bond/debenture the stream of cash flows consists of annual interest payments
and repayment of principal. These flows are fixed and known.
The Value of the Bond can be found by capitalising cash flows at a rate of
return, which reflects their risk. The market interest rate or yield is used as the
discount rate in case of bonds (or debentures).
Yield to Maturity A bonds yield to maturity or internal rate of return can be
found by equating the present value of the bonds cash outflows with its price in
the above equation.
Zero-Interest Bonds (called zero-coupon bonds in USA) do not have explicit
rate of interest. They are issued for a discounted price; their issue price is much
less than the face value. Therefore, they are also called deep-discount bonds.
The basic discounting principles apply in determining the value or yield of these
Preference shares have a preference over ordinary shareholders with regard
to dividends. The preference dividend is specified and known. Similarly, in the
case of redeemable preference share the redemption or maturity value is also
known. Preference share value can be determined in the same way as the bond
value. Here the discount rate will be the rate expected by the preference
shareholders given their risk. This risk is more than the risk of bondholders and
less than the equity shareholders.
Value of the Share (General) Cash flows of an ordinary (or equity) share
consist of the stream of dividends and terminal price of the share. Unlike the
case of a bond, cash flows of a share are not known. Thus, the risk of holding a
share is higher than the risk of a bond. Consequently, equity capitalisation rate
will be higher than that of a bond.

Return on a Security consists of two parts, the dividend and capital gain.
Expected Rate of Return on a Security is the sum of the products of possible
rates of return and their probabilities.
Dispersion When the expected rate of return (also called average rate of
return) deviate from the possible outcomes (rates of return), this is referred to
as dispersion.
Variance and Standard Deviation Dispersion can be measured by
variance and standard deviation of returns of a security. Variance (2) or
standard deviation () is a measure of the risk of returns on a security.
Treasury Bills Government issued bonds with guarantees which offers riskfree
rate, as they do not have risk of default.
Risk Premium The difference between the (long-term) average share return
and (long-term) return on government bonds or treasury bills is the risk
Risk Preferences of Investors Investors have different risk preferences.
Investors may be risk averse, risk seeker or risk neutral. Most of them are,
however, risk averse.
Normal Distribution is a smoothed, symmetric curve. It best describes the
mean-variance (or standard deviation). We generally assume that returns on
shares are normally distributed.
Return on a Security consists of the dividend yield and capital gain.
Expected Rate of Return on a Security is the sum of the products of possible
rates of return and their probabilities.
Variance or standard deviation is a measure of the risk of returns on a security.
Portfolios Generally, investors in practice hold multiple securities.
Combinations of multiple securities are called portfolios.
Expected Return on a Portfolio is the sum of the returns on individual
securities multiplied by their respective weights (proportionate investment).
That is, it is a weighted average rate of return.
Covariance is the product of the standard deviations of individual securities
times their correlation coefficient.

Portfolio Risk is not a weighted average risk. Securities included in a portfolio

are associated with each other. Therefore, the portfolio risk also accounts for the
covariance between the returns of securities.
Magnitude of Portfolio Risk will depend on the correlation between the
securities. The portfolio risk will be equal to the weighted risk of individual
securities if the correlation coefficient is +1.0. For correlation coefficient of less
than 1, the portfolio risk will be less than the weighted average risk. When the
two securities are perfectly negatively correlated, i.e., the correlation coefficient
is 1.0, the portfolio risk becomes zero.
Minimum Variance Portfolio is called the optimum portfolio.
Investment or Portfolio Opportunity Set represents all possible
combinations of risk and return resulting from portfolios formed by varying
proportions of individual securities. It presents the investor with the risk-return
Mean-Variance Criterion for a given risk, an investor would prefer a portfolio
with higher expected rate of return. Similarly, when the expected returns are
same, she would prefer a portfolio with lower risk. The choice between high risk
high return or low risklow return portfolios will depend on the investors risk
preference. This is referred to as the mean-variance criterion.
Efficient Portfolio is one that has the highest expected returns for a given
level of risk. The efficient frontier is the frontier formed by the set of efficient
Optimum Risky Portfolio and Separation Theorem is the market portfolio
of all risky assets where each asset is held in proportion of its market value. It is
the best portfolio since it dominates all other portfolios. An investor can thus mix
her borrowing and lending with the best portfolio according to her risk
preferences. She can invest in two separate investmentsa risk free asset and a
portfolio of risky securities. This is known as the separation theorem.
Unsystematic Risk can be eliminated through diversification. It is a risk
unique to a specific security. When individual securities are combined, their
unique risks cancel out.
Systematic Risk cannot be eliminated through diversification. It is a marketrelated
risk. It arises because individual securities move with the changes in the
market. Investors are risk averse. They will take risk only if they are
compensated for the risk, which they bear. Since systematic risk can be
eliminated through diversification, they will be compensated for assuming
systematic risk.

Capital Market Line the market prices securities in a manner that they yield
higher expected returns than the risk-free securities. The risk-averse investors
can be induced to hold risky securities when they are offered risk premium. The
capital market line (CML) defines this relationship.
Capital Asset Pricing Model (CAPM) the model explaining the risk-return
relationship is called the capital asset pricing model (CAPM). It provides that in
a well-functioning capital market, the risk premium varies in direct proportion
to risk.
Securitys Beta CAPM provides a measure of risk and a method of estimating
the markets risk-return line. The market (systematic) risk of a security is
measured in terms of its sensitivity to the market movements. This sensitivity is
referred to the securitys beta.
Beta reflects the systematic risk, which cannot be reduced. Investors can
eliminate unsystematic risk when they invest their wealth in a well-diversified
market portfolio. A beta of 1.0 indicates average level of risk while more than 1.0
means that the securitys return fluctuates more than that of the market
portfolio. A zero beta means no risk.
Characteristics Line a line that is called the characteristics line can represent
the relationship between the security returns and the market returns. The slope
of the characteristics line is the sensitivity coefficient, which, as stated earlier, is
referred to as beta.
Expected Return on a Security (Security Market Line (SML)) is given by
the following equation:
E(Rj ) Rf (Rm Rf )b j

where Rf is the risk-free rate, Rm the market return and the measure of the
securitys systematic risk. This equation gives a line called the security market
line (SML).
Arbitrage Pricing Theory (APT) the differences of securities returns may not
be fully explained by their betas. The arbitrage pricing theory (APT), resulting
from the limitations of CAPM, assumes that many macro-economic factors may
affect the system risk of a security (or an asset). Thus, APM is a multi-factor
model to explain the return and return of a security. The factors influencing
security return may include industrial production, growth in gross domestic
product, the interest rate, inflation, default premium, and the real rate of return.
Price-to-book-value ratio and size have also been found to explain to the
differences in the security returns.

Securitys Beta The market or systematic risk of a security is measured in
terms of its sensitivity to the market movements. This sensitivity is referred to
the securitys beta.
Determinants of Beta The beta of a firm depends on a number of factors. The
three most important factors are: (a) nature of business, (b) operating leverage
and (c) financial leverage. Beta increases with the degree of operating and
financial leverage.
Market Portfolio may be approximated by a well-diversified share price index
such as the Bombay Stock Exchanges National Index or Sensitivity Index
Accounting Beta A cyclical firm would have higher beta. If we relate the
cyclical firms earnings with the aggregate earnings, we would obtain accounting
beta. Higher the accounting beta, higher the market beta.
Asset Beta and Equity Beta The calculated beta of a firm is the beta of its
equity. In case of a firm that does not employ debt; the equity beta is the same as
the firms asset beta. However, in case of a firm with debt, the asset beta is the
weighted average of the equity beta and the debt beta. Since debt is less risky,
the debt beta would be less than the equity beta.
Cost of Equity The firm uses capital supplied by shareholders. Alternatively,
shareholders could invest their funds in securities in the capital market. Thus,
they would require firm to earn a return equal to the expected rate of return on
security of the equivalent risk. Hence, the cost of equity is equal to the expected
rate of return, and can be calculated using SML. The risk-free rate and market
premium is common to all firms; betas of firms would be different.
Option is a contract that gives the holder a right, without any obligation, to buy
or sell an underlying asset at a given exercise (or strike) price on or before a
specified expiration period. The underlying asset (i.e., asset on which right is
written) could be a share or any other asset.
Call Option is a right to buy an asset. A buyer of a call option on a share will
exercise his right when the actual share price at expiration (St) is higher than
the exercise price (E), otherwise, he will forgo his right.
Put Option is a right to sell an asset. The buyer of a put option will exercise his
right if the exercise price is higher than the share price; he will not exercise his
option if the share price is equal to or greater than the exercise price.

American Option can be exercised at expiration or any time before expiration

while European options can be exercised only at expiration.
Value of a Share Option There are five factors that affect the value of a share
option: (1) the share price, (2) the exercise price, (3) the volatility (standard
deviation) of the share return, (4) the risk-free rate of interest, and (5) the
options time to expiration.
Value of a Call At expiration the maximum value of a call option is:
Value of call option at expiration = Max [(St E), 0]

Call Options Value will increase with increase in the share price, the rate of
interest, volatility and time to expiration. It will decline with increase in the
exercise price.
Value of Put Option at expiration is:
Value of put option at expiration = Max [(E St), 0]

Put Options Value will increase with increase in the exercise price, volatility
and time to expiration. It will decrease with increase in the share price, and the
rate of interest.
Several Trading Strategies (Hedged Position) An investor can create a
hedged position by combining a long position in the share with a long position in
a protective puta put that is purchased at-the-money (exercise and current
share prices being the same).
Straddle The investor can also create a portfolio of a call and a put with the
same exercise price. This is called a straddle.
Spread If call and put with different exercise price are combined, it is called a
Put-Call Parity There is a fixed relationship between put and call on the same
share with similar exercise price and maturity period. This relationship, called
put-call parity, is given as follows:
Value of put + value of share = value of call + PV of exercise price

Option in Case of an Ordinary Share There is a hidden option in the case of

an ordinary share that arises because of the limited liability of the shareholders.
Shareholders have a call option on the firm with an exercise price equal to the
required payment for debt. Shareholders will exercise their option to keep the
firm (by making required payment to debt-holders) if the value of the firm is
higher than the debt payment.


Discounted Cash Flow (DCF) Technique NPV, IRR and PI are the
discounted cash flow (DCF) criteria for appraising the worth of an investment
Net Present Value (NPV) method is a process of calculating the present value
of the projects cash flows, using the opportunity cost of capital as the discount
rate, and finding out the net present value by subtracting the initial investment
from the present value of cash flows.
Under the NPV method, the investment project is accepted if its net present
value is positive (NPV > 0). The market value of the firms share is expected to
increase by the projects positive NPV. Between the mutually exclusive projects,
the one with the highest NPV will be chosen.
NPV methods account for the time value of money and are generally consistent
with the wealth maximisation objective.
Internal Rate of Return (IRR) is that discount rate at which the projects net
present value is zero. Under the IRR rule, the project will be accepted when its
internal rate of return is higher than the opportunity cost of capital (IRR > k).
IRR methods account for the time value of money and are generally consistent
with the wealth maximisation objective.
NPV and IRR NPV and IRR give same accept-reject results in case of
conventional independent projects. Under a number of situations, the IRR rule
can give a misleading signal for mutually exclusive projects. The IRR rule also
yields multiple rates of return for non-conventional projects and fails to work
under varying cost of capital conditions. Since the IRR violates the valueadditivity
principle; since it may fail to maximise wealth under certain
conditions; and since it is cumbersome, the use of the NPV rule is recommended.
Profitability index (PI) is the ratio of the present value of cash inflows to
initial cash outlay. It is a variation of the NPV rule. PI specifies that the project
should be accepted when it has a profitability index greater than one (PI > 1.0)
since this implies a positive NPV.
NPV and PI A conflict of ranking can arise between the NPV and PI rules in
case of mutually exclusive projects. Under such a situation, the NPV rule should
be preferred since it is consistent with the wealth maximisation principle.
Payback is the number of years required to recoup the initial cash outlay of an
investment project. The project would be accepted if its payback is less than the
standard payback. The greatest limitations of this method are that it does not
consider the time value of money, and does not consider cash flows after the
payback period.

Discounted Payback considers the time value of money, but like the simple
payback it also ignores cash flows after the payback period. Under the conditions
of constant cash flows and a long life of the project, the reciprocal of payback can
be a good approximation of the projects rate of return.
Accounting Rate of Return is found out by dividing the average profit aftertax
by the average amount of investment. A project is accepted if its ARR is
greater than a cut off rate (arbitrarily selected). This method is based on
accounting flows rather than cash flows; therefore, it does not account for the
time value of money. Like PB, it is also not consistent with the objective of the
shareholders wealth maximisation.
Following table provides a summary of the features of various investment
I. Discounted Cash Flow Methods
1. Net present value (NPV): The difference between PV of cash flows and PV of
cash outflows is equal to NPV; the firms opportunity cost of capital being the
discount rate.
Acceptance rule
Accept if NPV > 0 (i.e., NPV is positive)
Reject if NPV < 0 (i.e., NPV is negative)
Project may be accepted if NPV = 0

Merits Demerits
Considers all cash flows.
Requires estimates of cash flows which is a
tedious task.
True measure of profitability.
Requires computation of the opportunity cost
of capital which poses practical difficulties.
Based on the concept of the time
Sensitive to discount rates.
value of money.

Satisfies the value-additivity

principle (i.e., NPVs of two or
more projects can be added).
Consistent with the shareholders
wealth maximisation
(SWM) principle.
2. Internal rate of return (IRR): The discount rate which equates the present
value of an investments cash inflows and outflows is its internal rate of
Acceptance rule
Accept if IRR > k
Reject if IRR < k
Project may be accepted if IRR = k
Merits Demerits
Considers all cash flows.
Requires estimates of cash flows which is a
tedious task.
True measure of profitability.
Does not hold the value-additivity principle
(i.e., IRRs of two or more projects do not add)
Based on the concept of the time
At times fails to indicate correct choice between
value of money. mutually exclusive projects.
Generally, consistent with wealth
At times yields multiple rates.
maximisation principle.
Relatively difficult to compute.
3. Profitability index (PI): The ratio of the present value of the cash flows to the
initial outlay is profitability index or benefit-cost ratio:
Acceptance rule
Accept if PI > 1.0
Reject if PI < 1.0
Project may be accepted if PI = 1.0
Merits Demerits
Considers all cash flows. Requires estimates of the cash flows which
is a tedious task.
Recognises the time value of At times fails to indicate correct choice between
money. mutually exclusive projects.

Relative measure of profitability.

Generally consistent with the
wealth maximisation principle.
II. Non-Discounted Cash Flow Criteria
4. Payback (PB): The number of years required to recover the initial outlay of
the investment is called payback.
Acceptance rule
Accept if PB < standard payback
Reject if PB > standard payback
Merits Demerits
Easy to understand and compute Ignores the time value of money.
and inexpensive to use.
Emphasises liquidity. Ignores cash flows occurring after the
payback period.
Easy and crude way to cope with risk. Not a measure of profitability.
Uses cash flows information. No objective way to determine the
standard payback.
No relation with the wealth maximisation
5. Discount payback: The number of years required in recovering the cash outlay
on the present value basis is the discounted payable period. Except using
discounted cash flows in calculating payback, this method has all the
demerits of payback method.
6. Accounting rate of return (ARR): An average rate of return found by dividing
the average net operating profit [EBIT (1 T )] by the average investment.
Average investment
Average net operating profit after tax
Acceptance rule
Accept if ARR > minimum rate
Reject if ARR < minimum rate

Merits Demerits
Uses accounting data with which Ignores the time value of money
executives are familiar.
Easy to understand and calculate.
Does not use cash flows.
Gives more weightage to future
No objective way to determine the
receipts. minimum acceptable rate of return.
Net present value (NPV) method is the most superior investment criterion as it is always
consistent with the wealth maximisation principle.
Cost of Capital to a firm is the minimum return, which the suppliers of capital
require. In other words, it is a price of obtaining capital; it is a compensation for
time and risk.
The cost of capital concept is of vital significance in the financial decisionmaking.
It is used: (a) as a discount, or cut-off, rate for evaluating investment
projects, (b) for designing the firms debt-equity mix and (c) for appraising the
top managements financial performance.
Firms obtain capital for financing investments in the form of equity or debt or
both. Also, in practice, they maintain a target debt-equity mix. Therefore, the
firms cost of capital means the weighted average cost of debt and equity.
Cost of Debt includes all interest-bearing borrowings. Its cost is the yield
(return), which lenders expect from their investment. In most cases, return is
equal to annual contractual rate of interest (also called coupon rate). Interest
charges are tax deductible. Therefore, cost of debt to the firm should be
calculated after adjusting for interest tax shield:
kd (1 T)

where kd is before-tax cost of debt and T is the corporate tax rate.

Cost of Equity Equity has no explicit cost, as payment of dividends is not
obligatory. However, it involves an opportunity cost.
The opportunity cost of equity is the rate of return required by shareholders on
securities of comparable risk. Thus, it is a price, which the company must pay to
attract capital from shareholders.
In practice, shareholders expect to receive dividends and capital gains.
Cost of Retained Earnings When a company issues new share capital, it has
to offer shares at a price, which is much less than the prevailing market price.

Therefore, the cost of retained earnings will be less than the cost of new issue of
Weighted Average Cost of Capital Three steps are involved in calculating the
firms weighted average cost of capital (WACC). First, the component costs of
debt and equity are calculated. Second, weights to the each component of capital
are assigned according to the target capital structure. Third, the product of
component costs and weights is summed up to determine WACC. The weighted
average cost of new capital is the weighted marginal cost of capital (WMCC).
Divisional or Projects Cost of Capital A firm may have several divisions or
product lines with different risks. Therefore, the firms WACC cannot be used to
evaluate divisions or projects.
Profits vs. Cash Flows Cash flows are different from profits. Profit is not
necessarily a cash flow; it is the difference between revenue earned and expenses
incurred rather than cash received and cash paid. Also, in the calculation of
profits, an arbitrary distinction between revenue expenditure and capital
expenditure is made.
Incremental Cash Flows Cash flows should be estimated on incremental
basis. Incremental cash flows are found out by comparing alternative investment
projects. The comparison may simply be between cash flows with and without
the investment proposal under consideration when real alternatives do not exist.
The term incremental cash flows should be interpreted carefully. The concept
should be extended to include the opportunity cost of the existing facilities used
by the proposal. Sunk costs and allocated overheads are irrelevant in computing
cash flows. Similarly, a new project may cannibalise sales of the existing
products. The projects cash flows should be adjusted for the reduction in cash
flows on account of the cannibalisation.
Components of Cash Flows Three components of cash flows can be identified:
(1) initial investment, (2) annual cash flows, and (3) terminal cash flows.
Initial Investment Initial investment will comprise the original cost (including
freight and installation charges) of the project, plus any increase in working
capital. In the case of replacement decision, the after-tax salvage value of the old
asset should also be adjusted to compute the initial investment.
Net Cash Flow Annual net cash flow is the difference between cash inflows and
cash outflows including taxes. Tax computations are based on accounting profits.
Care should be taken in properly adjusting depreciation while computing net
cash flows.

Change in Net Cash Flow from Operations Depreciation is a non-cash item,

but it affects cash flows through tax shield.
Free Cash Flows In practice, changes in working capital itemsdebtors
(receivable), creditors (payable) and stock (inventory)affect cash flows. Also,
the firm may be required to incur capital expenditure during the operation of the
investment project.
Free Cash Flows and the Discount Rate Free cash flows are available to
service both the shareholders and the debt holders. Therefore, debt flows
(interest charges and repayment of principal) are not considered in the
computation of free cash flows. The financing effect is captured by the firms
weighted cost of debt and equity, which is used to discount the projects cash
flows. This approach is based on two assumptions: (1) the projects risk is the
same as the firms risk, and (2) the firms debt ratio is constant and the projects
debt capacity is the same as the firms.
Terminal Cash Flows are those, which occur in the projects last year in
addition to annual cash flows. They would consist of the after-tax salvage value
of the project and working capital released (if any). In case of replacement
decision, the foregone salvage value of old asset should also be taken into
Terminal Value of a New Product may depend on the cash flows, which could
be generated much beyond the assumed analysis or horizon period. The firm
may make a reasonable assumption regarding the cash flow growth rate after
the horizon period.
Inflation and NPV The NPV rule gives correct answer to choose an investment
under inflation if it is treated consistently in cash flows and discount rate. The
discount rate is a market-determined rate and therefore, includes the expected
inflation rate. It is thus generally stated in nominal terms. The cash flows
should also be stated in nominal terms to obtain an unbiased NPV.
Alternatively, the real cash flows can be discounted at the real discount rate to
calculate unbiased NPV.
Complicated Investment Decisions A firm in practice faces complicated
investment decisions. The most common situations include choosing among
investments with different lives, deciding about the replacement of an existing
asset or timing of an investment and evaluating investments under capital
rationing. The NPV rule can be extended to handle such situations.
Annual Equivalent Values (AEVs) AEV is the NPV of an investment divided

by the annuity factor given its life and risk-free discount rate.
Capital Rationing occurs because of either the external or internal constrain
on the supply of funds. In capital rationing situations, the firm cannot accept all
profitable projects. Therefore, the firm will aim at maximising NPV subject to
the funds constraint.
In simple one-period capital rationing situations, the profitability index (PI)
rule can be used. PI rule breaks in the case of multi-period funds constraints and
project indivisibility.
A more sophisticated approacheither linear programming or integer
programmingcan be used to select investment under capital rationing.
However, two factors limit the use of these approaches in practice. First, they
are costly, and second, they assume investment opportunities as known. Also,
large companies in reality hardly face the real capital shortage situations.
Mostly it arises on account of the internal constraints imposed by the
management for control purposes.
Risk arises in the investment evaluation because the forecasts of cash flows can
go wrong. Risk can be defined as variability of returns (NPV or IRR) of an
investment project.
Decision-makers in practice may handle risk in conventional ways. For
example, they may use a shorter payback period, or use conservative forecasts of
cash flows, or discount net cash flows at the risk-adjusted discount rates.
Statistical techniques are used to measure and incorporate risk in capital
budgeting. Two important statistics in this regard are the expected monetary
value and standard deviation.
Expected Monetary Value is the weighted average of returns where
probabilities of possible outcomes are used as weights.
Sensitivity Analysis It is a method of analysing change in the projects NPV
for a given change in one variable at a time. It helps in asking what if
questions and calculates NPV under different assumptions.
Scenario Analysis considers a few combinations of variables and calculates
NPV for each of them. It is a usual practice to calculate NPV under normal,
optimistic or pessimistic scenario.
Sensitivity or scenario analysis forces the decision-maker to identify underlying
variables, indicates critical variables and helps in strengthening the project by
pointing out its weak links. Its limitations are that it cannot handle a large

number of interdependent variables and at times, fails to give unambiguous

Simulation Analysis The analyst specifies probability distributions for
variables and computer generates several hundred scenarios, probability
distribution for the projects NPV along with the expected NPV and standard
deviation. It overcomes the limitations of sensitivity or scenario analysis.
Decision Tree Analysis Another technique of resolving risk in capital
budgeting, particularly when the sequential decision-making is involved, is the
decision tree analysis. The decision tree provides a way to represent different
possibilities so that we can be sure that the decisions we make today, taking
proper account of what we can do in the future.
To draw a decision tree, branches from points marked with squares are used to
denote different possible decisions, and branches from points marked with
circles denote different possible outcomes. In a decision tree analysis, one has to
work out the best decisions at the second stage before one can choose the best
first stage decision.
Decision trees are valuable because they display links between todays and
tomorrows decisions. Further, the decision-maker explicitly considers various
assumptions underlying the decision. The use of decision tree is, however,
limited because it can become complicated.
Utility Theory One important theory, which provides insight into risk handling
in capital budgeting, is the utility theory. It aims at including a decision-makers
risk preferences explicitly into the capital expenditure decision. The underlying
principle is that an investor prefers a higher return to a lower return, and that
each successive identical increment of money is worth less to him than the
preceding one. The decision-makers utility function is derived to determine the
decisions utility value.
The direct use of the utility theory in capital budgeting is not common. It is very
difficult to specify utility function in practice. Even if it is possible to derive
utility function, it does not remain constant over time. Problems are also
encountered when decision is taken by group of people. Individuals differ in their
risk preferences.
Important Aspects of Capital Budgeting Process are
Identification of investment ideas is the most critical aspect of the
investment process, and should be guided by the overall strategic
considerations of a firm. It needs appropriate managerial focus. Each
potential idea should be developed into a project.

Development A company should have systems for estimating cash flows of

projects. A multi-disciplinary team of managers should be assigned the task
of developing cash flow estimates.
Evaluation Once cash flows have been estimated, projects should be
evaluated to determine their profitability. Evaluation criteria chosen should
correctly rank the projects.
Authorisation Once the projects have been selected they should be
monitored and controlled to ensure that they are properly implemented and
estimates are realised. Proper authority should exist for capital spending.
The top management may supervise critical projects involving large sums of
money. The capital spending authority may be delegated subject to adequate
control and accountability.
Control A company should have a sound capital budgeting and reporting
system for this purpose. Based on the comparison of actual and expected
performance, projects should be reappraised and remedial action should be
Companies are increasingly using DCF techniques, but payback remains
universally popular for its simplicity and focus on recovery of funds and
liquidity. In practice, judgement and qualitative factors also play an
important role in investment analysis. A number of companies pay more
attention to strategy in the overall selection of projects.
Strategic Investments Decisions are large-scale expansion or diversification
projects, and they involve either by their nature or by managerial actions
valuable options. Such options include right to expand, right to abandon, right to
delay, right to build new businesses, or right to disinvest or harvest.
Real Options create managerial flexibility and commitment. In principle, they
can be valued in the same way as financial options are valued. But in practice, it
is difficult to get all input parameters for valuing real options. Since large
numbers of real assets are not traded in the market, it is quite difficult therefore
to get information on the value of the underlying assets and the volatility.
Since real options are valuable, managers must identify them, value them,
monitor them and exercise them when it is optimal to do so. Managers generally
strive to create flexibility and commitment by building real options into
investment projects.
Capital Structure The debt-equity mix of a firm is called its capital structure.
The capital structure decision is a significant financial decision since it affects
the shareholders return and risk, and consequently, the market value of shares.

Financial Structure The term financial structure, on the other hand, is used
in a broader sense, and it includes equity and all liabilities of the firm.
Financial Leverage or Trading on Equity The use of the fixed-charges
capital like debt with equity capital in the capital structure is described as
financial leverage or trading on equity.
The main reason for using financial leverage is to increase the shareholders
return. Consider an example. Suppose you have an opportunity of earning 20 per
cent on an investment of Rs 100 for one year. If you invest your own money, your
return will be 20 per cent. On the other hand, you can borrow, say, Rs 50 at 10
per cent rate of interest from your friend and put your own money worth Rs 50.
You shall get total earnings of Rs 20, out of which you will have to pay Rs 5 as
interest to your friend. You shall be left with Rs 15 on your investment of Rs 50,
which gives you a return of 30 per cent. You have earned more at the cost of your
Financial leverage, on the one hand, increases shareholders return and on the
other, it also increases their risk. For a given level of EBIT, EPS varies more
with more debt. Consider a simple example. Let us assume that a firms expected
EBIT is Rs 120 with a standard deviation of Rs 63. This implies that earnings
could vary between Rs 57 to Rs 183 on an average. Suppose that the firm has
some debt on which it pays Rs 40 as interest. Now the shareholders expected
earnings will be: Rs 120 Rs 40 = Rs 80 (ignoring taxes) and standard deviation
will remain unchanged. Shareholders earnings will, on an average, fluctuate
within a range of Rs 17 and Rs 143. If EBIT is less than Rs 40, the earnings of
shareholders will be negative. In the extreme situation if the firm is unable to
pay interest and principal, its solvency is threatened.
In the insolvency, shareholders are the worst sufferers. Thus, we find that
financial leverage is a double-edged sword. It increases return as well as risk. A
trade-off of between return and risk will have to be struck to determine the
appropriate amount of debt.
Earnings Per Share (EPS) A firm determines the advantage of financial
leverage by calculating its impact on earnings per share (EPS) or return on
equity (ROE).
where EBIT is earnings before interest and taxes, INT is interest charge which
is given by the product of interest rate (i) and the amount of debt (D), T is
corporate tax rate and N is number of shares. If the firms overall profitability is
more than interest rate, EPS increases with debt. With increasing EBIT, EPS
increases faster with more debt.
Degree of Operating Leverage (DOL) EBIT depends on sales. A change in
sales will affect EBIT. The variability in EBIT due to a change in sales is
affected by the composition of fixed and variable costs.
Degree of Combined Leverage (DCL) DOL and DFL can be combined to see
the effect of total leverage on EPS.


Capital Structure Decision of the firm can be characterised as a choice of that
combination of debt and equity, which maximises the market value of the firm.
Modigliani and Millers Theory According to MMs proposition I, the firms
market value is not affected by capital structure; that is, any combination of debt
and equity is as good as any other. Firms borrow by offering investors various
types of securities. In M-Ms world of perfect capital market, because of same
borrowing and lending rates for all investors and no taxes, investors can borrow
at their own. Why should they pay a premium for a firms borrowing? M-M
accept that borrowing increases shareholders return, but, they argue, it also
increases risk. They show that increased risk exactly offsets the increased
return, thus leaving the position of shareholders unchanged. This is MMs
proposition II.
Interest tax shield and the value of the firm One unrealistic assumption of
MMs hypothesis is that, they assume no existence of taxes. When corporate
taxes are assumed, firms can increase earnings of all investors through
borrowing which results in interest tax shield.
Traditionalists argue that market imperfections make borrowing by individual
investors costly, risky and inconvenient. Thus the arbitrage envisaged by MM
will not work, and investors may be willing to pay a premium for shares of
levered firms. But thousands of the levered firms would have already satisfied
the demand of investors who like their shares. Therefore, a firm changing its
debt policy is unlikely to influence the market value of the firm.
Miller Theory incorporating both Corporate and Personal Income
Taxes In practice, we do not find all firms using high amounts of debt. One
explanation for this behaviour could be personal income taxes. Miller has
propounded a theory incorporating both corporate and personal income taxes.
According to him, the advantage of interest tax shield is offset by the personal
taxes paid by debt-holders on interest income. Interest income is tax-exempt at
corporate level while dividend income is not. Interest income is taxed at personal
level while dividend income may largely escape personal taxes. Thus companies
can induce tax paying investors to buy debt securities if they are offered high
rate of interest. But after a stage it will not be possible to attract investors in the
high-tax brackets. This point establishes the optimum debt ratio for the
individual firms.
Financial Distress There is another factor which reduces the tax advantage of
borrowing. It is financial distress, which is costly. It includes cost of inflexibility,
inconvenience and insolvency. Thus the value of a levered firm is:
Vl Vu TD PV of financial distress

The value will reach optimum value where marginal advantage of corporate

borrowing, TD, equals marginal present value of costs of financial distress

Capital Structure Decision The advantage of debt is that it saves taxes since
interest is a deductible expense. On the other hand, its disadvantage is that it
can cause financial distress. Therefore, the capital structure decision of the firm
in practice should be governed by the trade-off between tax advantage and costs
of financial distress. Financial distress becomes costly when the firm finds it
difficult to pay interest and principal. From this point of view, both debt ratio
and EBITEPS analysis have their limitations. They do not reflect the debtservicing
ability of the firm.
Debt Capacity means the amount of debt which a firm should use given its
cash flows. Cash flow analysis indicates how much debt a firm can service
without any difficulty. A firm does not exhaust its debt capacity at once. It keeps
reserve debt capacity to meet financial emergencies. The actual amount of debt
also depends on flexibility, control and size of the firm in terms of its assets.
Other factors, which are important when capital is actually raised, include
timing (marketability) and flotation costs.
Discount Rate We need estimate of the discount rate to determine the net
present value of a project. The discount rate depends on the projects business
risk and financial risk. Under CAPM, the equity beta captures both the business
risk and the financial risk. Financial risk arises when the firm uses debt.
Opportunity Cost of Capital Following the MM proposition I, the
opportunity cost of capital can be calculated as the pre-tax weighted average cost
of capital.
Asset Beta a reflects the business risk of the firm or the project. Thus, under
CAPM the firms or the projects opportunity cost of capital is given by the riskfree
rate plus the product of the risk premium and the asset beta.
You can estimate the equity beta and the debt beta from the market data and
then estimate the asset beta.
Equity Beta and the asset beta of an all-equity (unlevered) firm will be same.
In practice, the interest tax shields depend on the firms profitability, which
fluctuates randomly. Therefore, the interest tax shields may not reduce the
systematic risk.
Free Cash Flows Approach The most popular method of the project
evaluation is to discount the free cash flows at the firms weighted average cost
of capital (WACC)
The free cash flow approach adjusts the effect of the interest tax shields in the

discount rate (WACC) rather than the projects cash follows. This approach is
based on the assumption that the capital structure (debt ratio) is constant over
time. It also assumes that the projects and the firms risk and capital structures
are the same. Hence, this approach will not work if the projects and the firms
risk and capital structure are different, and where the projects capital structure
is not constant.
Equity Cash Flow (ECF) Approach is similar to the FCF approach and it is
based on the same assumptions. In the ECF approach the equity cash flows,
which are residual cash flows available to the equity shareholders, are
discounted by the levered cost of equity.
Capital Cash Flow (CCF) Approach is much easier to use when the projects
debt amount is fixed and the capital structure does not remain constant. CCFs
are calculated as the free cash flows plus the interest tax shields, and they are
discounted by the projects all-equity or opportunity cost of capital. The projects
opportunity cost of capital depends on its business risk and is not affected by the
capital structure. In the CCF approach the effect of the interest tax shields are
adjusted in the cash flows rather than the discount rate.
Adjusted Present Value (APV) Approach is an alternative approach for the
projects evaluation. It is a flexible approach that unbundled the projects value
into several parts. It separates the operational part from the financing effects.
The base-case NPV is calculated by discounting the free cash flows at the
projects opportunity cost of capital. The present values of the financing effects
are calculated separately using the discount rates appropriate to the risk of
these effects. For example, the interest tax shields are treated as risky as debt.
Hence, the interest tax shields are discounted at the cost of debt. APV is the sum
of the base-case NPV and the value of financing effects:
APV = Base NPV + value of interest tax shields + value of other financing
APV is a useful approach in the project financing where the debt is fixed and
there are several other financing effects like issue costs, investment incentives
and special tax benefits.
Adjusted Cost of Capital (or Discount Rate) Use it to discount the free cash
flows (perpetual):
The concept of the adjusted cost of capital is based on the MM tax-corrected
hypothesis. Two critical assumptions are that the cash flows are perpetual and
the amount of debt is fixed. In case of the fixed debt ratio, which implies
rebalancing of debt, the adjusted cost of capital can be estimated using the
Value of the Firm The use of the DCF techniques can be extended to value a
business firm. In the valuation of a firm a financial analyst usually assumes a
constant debt ratio.

The firm can be valued using FCFs and WACC. Further, the analyst assumes a
horizon period for analysis and calculates the horizon value at the end of the
horizon period. Horizon value depends on the growth prospects of the firm after
the horizon period.
The value of equity is obtained by subtracting the outstanding amount of debt
from the value of the firm. The value of equity divided by the number of
outstanding shares gives the equity value per share.
Walters Model Price per share is the sum of the present value of the infinite
stream of constant dividends and present value of the infinite stream of
capital gains.
Gordons Model Market value of a share is equal to the present value of an
infinite stream of dividends to be received by shareholders.
Bird-in-the-hands Argument Investors are risk averters. They consider
distant dividends as less certain than near dividends. Rate at which an
investor discounts his dividend stream from a given firm increases with the
futurity of dividend stream and hence lowering share prices.
MM Model According to MM, under a perfect market situation, the
dividend policy of a firm is irrelevant as it does not affect the value of the firm.
They argue that the value of the firm depends on firm earnings which results
from its investment policy. Thus when investment decision of the firm is
given, dividend decision is of no significance.
Information Content In an uncertain world in which verbal statements can
be ignored or misinterpreted, dividend action does provide a clear cut means of
making a statement that speaks louder than a thousand words.
Market Imperfections Tax DifferentialLow Payout Clientele, Flotation
Cost, Transaction and Agency Cost, Information Asymmetry, Diversification,
UncertaintyHigh Payout Clientele, Desire for Steady Income, and No or Low
Tax on Dividends:
Forms of Dividends Dividends may take two forms: cash dividend and bonus
shares (stock dividend). In India, bonus shares cannot be issued in lieu of cash
dividends. They are paid with cash dividends. Bonus shares have a psychological
appeal. They do not increase the value of shares.
Target Payout Ratio Companies generally prefer to pay cash dividends. They
finance their expansion and growth by issuing new shares or borrowing. This

behaviour is based on the belief that shareholders are entitled to some return on
their investment. Most companies have long-term payment ratio targets. But
they do not apply target payout ratios to each years earnings. They try to
stabilize dividend payments by moving slowly towards the target payout each
year. Also, they consider past dividends and current as well as future earnings
in determining dividend payment. Investors recognize this. Any extreme changes
are read as signals of managements expectations about the companys
performance in future. Thus dividends have information contents.
Stable Dividend Policy Companies like to follow a stable dividend policy since
investors generally prefer such a policy for the reason of certainty. A stable
dividend policy does not mean constant dividend per share. It means reasonably
predictable dividend policy. Companies determine dividend per share or
dividend rate keeping in mind their long-term payout ratio.
Firms Ability to Pay Dividend depends on its funds requirements for growth,
shareholders desire and liquidity. A growth firm should set its dividend rate at a
low level (because of its high needs for funds) and move towards its target
Practical consideration Financial Need of company, Shareholders
Expectations, Closely/Widely Held Company, Constraints on Paying Dividends,
Legal Restrictions, Liquidity, Borrowing Capacity, Access to the Capital Market,
Restrictions in Loan Agreements.
Efficient Capital Markets Capital market deal with financial assets or
securities. Securities will be fairly priced in the capital markets if they are
efficient. Capital markets are considered to be efficient if the prices of securities
reflect the available information. Depending on the extent of the information
being impounded in the security prices, capital markets may be efficient in
weak, semi-strong or strong form.
Indias Capital Market includes primary, secondary, OTC and derivatives
segments. As a consequence of the growing economy and the governments policy
of liberalisation and deregulation, the various segments of capital market in
India have grown at phenomenal rates. The first stock exchangethe Bombay
Stock Exchangewas established in 1875. Now there are 23 stock exchanges in
India. The number of shareholders has increased to about 3040 million. There
are about 9000 listed companies. Both the market capitalisation and volume of
trades have shown general growth, although they have fluctuated over years.
Stock exchanges in India have well-developed procedures for listing, trading,
settlement etc. The recent changes include shortening of the trading and
settlement period, rolling settlement, index-based price bands, dematerialised
share etc. A number of systems and rules exist for the regulation of the stock
exchanges. The Securities and Exchange Board of India (SEBI) is the central

regulatory authority regulating capital markets in India.

Primary Capital Market Companies raise new capital in the primary markets
either through public issues, rights issues or private placement. In India new
issues market has shown phenomenal growth after the eighties. A number of
companies are able to raise substantial amount from the capital market. The
corporate sectors dependence on the financial institutions for their funds
requirements is declining with the development of the new issues market. We
can also witness new financial instruments such as convertible securities, zerocoupon
debentures, warrants, special premium notes etc. being issued by
companies for raising capital. Yet another significant development is the free
pricing of the new issues by companies. Within the norms prescribed by SEBI, a
company can decide the issue price of its securities. Now companies are also
allowed book-building. In book-building investors make price bids for shares.
This leads to price discovery and the issuing company can assess the demand
based on different prices.
Secondary Capital Market Secondary market deals with securities that have
been previously issued. The over-the-counter market and the derivatives market
are other two forms of the secondary market.
OTC Market is an informal market where negotiated deals take place.
Derivatives Market deals in future and options; it is basically a market for
future delivery and payment. Options provide right, but not obligations to buy or
sell securities. Therefore, in option market delivery is conditional. In the
derivatives market options and future may include individual securities or
Merchant Bankers play the role of intermediaries in the capital market in
India. They help companies in the total management of issues of securities.
Therefore, they are called issue managers. As members of stock exchange,
underwriters of new issues and book builders, the help to make market, and
hence, are known as market makers also. Merchant bankers cannot undertake
the pure fund-based activities.
Mutual Funds provide a mechanism for collective investment. Generally they
mobilise funds from individual investors and invest the collected funds in
portfolios of securities. There are two basic types of mutual funds: open-ended
and close-ended. An investor can buy and sell units or shares of open-ended
funds at the market price continuously. In close-ended funds, the net asset value
per share or unit is determined based on the total value of investment. Within
these two broad categories, mutual funds may offer income funds, growth funds,
balanced funds, tax-savings funds etc. Mutual funds companies also offer index
funds and hedged funds to investors. Index funds invest investors money in
combination of securities in a general index like Sensex or in some sector index.
Hedged funds are broad based and may include foreign exchange market also.

They combine several investment strategies and try to maximise investors

returns. Mutual funds have several advantages to investors: simplicity,
diversification, professional expertise, affordability and flexibility. They do have
certain limitations: high brokerage, ownership risk, or no opportunity of making
extra-ordinary profit.
Securities Ordinary share, preference share and debentures are three
important securities used by the firms to raise funds to finance their activities.
Ordinary Shares provide ownership rights to ordinary shareholders. They are
the legal owners of the company. As a result, they have residual claims on
income and assets of the company. They have the right to elect the board of
directors and maintain their proportionate ownership in the company, called the
pre-emptive right.
Pre-Emptive Right of the ordinary shareholders is maintained by raising new
equity funds through rights offerings. Rights issue does not affect the wealth of a
shareholder. The price of the share with rights-on gets divided into ex-rights
price and the value of a right. So what the shareholder gains in terms of the
value of right he loses in terms of the low ex-rights price. However, he will lose if
he does not exercise his rights.
Debenture or Bond is a long-term promissory note. The debenture trust deed
or indenture defines the legal relationship between the issuing company and the
debenture trustee who represents the debenture holders. Debenture holders
have a prior claim on the companys income and assets. They will be paid before
shareholders are paid anything. Debentures could be secured and unsecured and
convertible and non-convertible. Debentures are issued with a maturity date. In
India, they are generally retired after 7 to 10 years by instalments.
Preference Share is a hybrid security as it includes some features of both an
ordinary share and a debenture. In regard to claims on income and assets, it
stands before an ordinary share but after a debenture. Most preference shares in
India have a cumulative feature, requiring that all past outstanding preference
dividends be paid before any dividend to ordinary shareholders is announced.
Preference shares could be redeemable, i.e., with a maturity date or
irredeemable, i.e., perpetual, without maturity date. Like debentures, a firm can
issue convertible or non-convertible preference shares.
Term Loans are loans for more than a year maturity. Generally, in India, they
are available for a period of 6 to 10 years. In some cases, the maturity could be
as long as 25 years. Interest on term loans is tax deductible. Mostly, term loans
are secured through an equitable mortgage on immovable assets. To protect
their interest, lending institutions impose a number of restrictions on the

borrowing firm.
Convertible Security is either a debenture or a preference share that can be
exchanged for a stated number of ordinary shares at the option of the investor.
Companies offer convertible securities to sweeten debt and thereby make it
attractive. It is a form of deferred equity financing, and provides low cost funds
during the early stage of investment project. The valuation of convertible
securities depends on its value as a straight, non-convertible security
(investment value) and its value if converted into ordinary shares. It generally
sells for a premium; that is, its market price exceeds the higher of its investment
or conversion value.
Warrant is an option to buy a specified number of ordinary shares at an
indicated price during a specified period. A detachable warrant is bought and
sold independent of the debenture to which it is associated. Warrants are
generally used to sweeten a debt to make it marketable and lower the interest
costs. When warrants are exercised, the firm obtains additional cash. The
market value of warrants depends primarily on the ordinary share price.
Warrants generally sell above their minimum, theoretical value. The difference
between the market price and theoretical value of warrants is the premium.
Zero-Interest or Deep-Discount Bonds or Debentures with Option Such
debentures are issued at a price much lower than their face value. Thus, there is
an implicit rate of interest. A company may also issue debentures redeemable at
premium and/or with warrants attached. These features are added to make the
issue of debentures attractive to the investors.
Lease is an agreement for the use of the asset for a specified rental. The owner
of the asset is called the lessor and the user the lessee. Two important categories
of leases are: operating leases and financial leases. The most compelling reason
for leasing equipment rather than buying it is the tax advantage of depreciation
that can mutually benefit both the lessee and the lessor. Other advantages
include convenience and flexibility as well as specialised services to the lessee.
In India, lease proves handy to those firms, which cannot obtain loan capital
from normal sources.
Operating Leases are short-term, cancellable leases where the risk of
obsolescence is borne by the lessor.
Financial Leases are long-term non-cancellable leases where any risk in the
use of the asset is borne by the lessee and he enjoys the returns too.

Equivalent Loan Financial lease involves fixed obligations in the form of lease
rentals. Thus it is like a debt and can be evaluated that way. Given the lease
rentals and tax shields, one can find the amount of debt which these cash flows
can service. This is equivalent loan. If equivalent loan is more than the cost of
the asset, it is not worth leasing the equipment.
Net Advantage of Lease You can also approach lease evaluation by calculating
the net advantage of lease (NAL).
Hire Purchase Arrangement like in a lease, the hire purchaser is able to
avoid the payment for the purchase of the asset now, and instead pays hire
purchase instalments (either monthly or quarterly or any other agreed period)
over a specified period and time. The hire purchaser becomes the owner of the
asset once he had paid all instalments. Unlike the leasee, he is entitled to claim
depreciation as well as the salvage value of the acquired asset. Hire purchase
arrangement differs from instalment sale arrangement in terms of the
ownership. Under hire purchase, ownership passes to the hire purchaser on the
payment of the last instalment, while under instalment sale ownership is
transferred once the agreement has been made between the buyer and the seller.
Project Financing is yet another asset-based financing arrangement. It is the
financing of a project as an independent economic unit, where the project itself
forms a direct security, and its cash flows are used to service the debt or equity
provided by the project sponsor. Project financing is the most common method of
financing large infrastructure projects. Project financing involves considerable
risk in the form of completion risk, market risk, foreign exchange risk, political
risk etc. Therefore, generally the project sponsors seek guarantees from the host
governments and use various risk mitigation arrangements. Usually, the risk
will be distributed among owners, contractors, suppliers of inputs, customers,
government etc. Project finance may take the form of a simple loan, or may
involve a more complex arrangement like BOOT , BOO etc.
Build-Own-Operate-Transfer In a BOOT arrangement, the project sponsor
builds a project, operates it for a long period of time to earn a reasonable return,
and then transfers it to the host government or its agency.
Build-Own-Operate In BOO arrangement, the project is not transferred to the
host government, rather the owner divests its stake in the capital markets. In a
build-lease-transfer arrangement, the owner transfers the project to a lessee for
operational purposes, but keeping ownership intact.
Venture Capital is risk financing available in the form of equity or quasiequity.
A venture capitalist also provides management support and acts as a
partner and adviser to the entrepreneur. Thus, he is different from a banker

and an investor of the shares of an enterprise. Venture capital is available as

early stage financing, expansion financing and acquisition financing.
Venture capital activity in developed countries has been encouraged because
of a large number of tax incentives available to venture capital firms and
investors, well-developed avenues for buying and selling shares of the small
scale enterprises and favourable social climate and government policy for
encouraging entrepreneurial activities.
Venture Capital in India There are about a dozen venture capital
organisations in India, mainly started by central and state-level financial
institutions and commercial banks. A few private sector venture capital funds
have also been established. Venture capital is available in three forms in
India: equity, conditional loans and income notes. Conventional loans are also
made available by venture capital firms. Income notes are hybrid securities,
combining the features of both conventional and conditional loans. Overall, in
India the focus in venture capital is still on debt financing. India has yet to
develop reasonable mechanisms of disinvestment. The OTC market has
started functioning, and hopefully, it would provide an impetus to venture
capital activity. India lacks sufficient tax incentives to encourage venture
capital activity. There is need for separate tax concessions for developing
venture capital in India
Balance Sheet is a statement of a firms assets, liabilities and equity on a
specific date.
Assets are economic resources that help generating revenues.
Liabilities are the firms obligations to creditors.
Equity is the investment made by owners in the firm.
Statement of Changes in Financial Position Both the balance sheet and the
profit and loss statement do not explain the changes in assets, liabilities and
owners equity. The statement of changes in financial position is prepared to
show these changes. Two common forms of such statement are: (a) the funds
flow statement, and (b) the cash flow statement.
Fund can be defined at least in three ways: It may mean (i) cash, (ii) working
capital (the difference between current assets and current liabilities), or
(iii) financial resources (arising from both current and non-current items).
Funds Flow Statement provides an analysis of changes in the firms working
capital position.

Cash Flow Statement is prepared to analyse changes in the firms cash

position. Both these statements can be recast to incorporate additional financial
information that does not affect cash or working capital but influences the
financing and asset mix of the firm. Funds flow and cash flow statement are
important managerial tools for financial analysis. They help the firm to know its
liquidity position, capital expenditures incurred, dividend paid and extent of
external financing.
Projected Funds or Cash Flow Statement plan the matching of inflow and
outflow of funds or cash.
Funds/Cash from Operations The main source of fundsworking capital or
cashis the firms operations. Funds from operations are calculated by
adjusting the figure of net profit for non-fund or non-cash items such as
depreciation. Depreciation is added to net profits to arrive at funds from
operation. To determine cash from operations, changes in current assets and
current liabilities are also adjusted in net profits. Increase in current assets and
decrease in current liabilities reduce cash while decrease in current assets and
increase in current liabilities increase cash. Other sources of working capital or
cash include sale of fixed assets, issue of share capital and borrowings. The
typical examples of uses of funds are: acquisition of fixed assets, repayment of
debt and payment of cash dividend.
Financial Ratio is a relationship between two financial variables. It helps to
ascertain the financial condition of a firm.
Ratio analysis is a process of identifying the financial strengths and
weaknesses of the firm. This may be accomplished either through a trend
analysis of the firms ratios over a period of time or through a comparison of the
firms ratios with its nearest competitors and with the industry averages. The
four most important financial dimensions, which a firm would like to analyse,
are: liquidity, leverage, activity and profitability.
Liquidity Ratios measure the firms ability to meet current obligations, and
are, calculated by establishing relationships between current assets and current
Leverage Ratios measure the proportion of outsiders capital in financing the
firms assets, and are calculated by establishing relationships between borrowed
capital and equity capital.
Activity Ratios reflect the firms efficiency in utilising its assets in generating
sales, and are calculated by establishing relationships between sales and assets.

Profitability Ratios measure the overall performance of the firm by

determining the effectiveness of the firm in generating profit, and are calculated
by establishing relationships between profit figures on the one hand, and sales
and assets on the other.
Ratio analysis is a very useful tool to raise relevant questions on a number of
managerial issues. It provides clues to investigate those issues in detail. However,
caution needs to be applied while interpreting ratios as they are calculated from the
accounting numbers. Accounting numbers suffer from accounting policy changes,
arbitrary allocation procedures and inflation.
Strategic Planning Companys strategy establishes an effective and efficient
match between its resources, opportunities and risks. It provides a mechanism of
integrating goals of multiple stakeholders.
Financial Planning of a company has close links with strategic planning.
Financial plan should be developed within the overall context of the strategic
planning. It is a process of identifying a firms investments and financing needs,
given its growth objectives. It involves trade-off between various investment and
financing options. A financial plan may be prepared for a period of three or five
Steps in Financial Planning:
Past performance Analysis of the firms past performance to ascertain the
relationships between financial variables, and the firms financial strengths
and weaknesses.
Operating characteristics Analysis of the firms operating
characteristicsproduct, market, competition, production and marketing
policies, control systems, operating risk etc. to decide about its growth
Co rporate strategy and investment needs Determining the firms
investment needs and choices, given its growth objective and overall strategy.
Cash flow from operations Forecasting the firms revenues and expenses
and need for funds based on its investment and dividend policies.
Financing alternatives Analysing financial alternatives within its
financial policy and deciding the appropriate means of raising funds.
Consequences of financial plans Analysing the consequences of its

financial plans for the long-term health and survival to firm.

Consistency Evaluating the consistency of financial policies with each other
and with the corporate strategy.
Financial Forecasting is an integral part of financial planning. Forecasting
uses past data to estimate the future financial requirements. A simple approach
to financial forecasting is to relate the items of profit and loss account and
balance sheet to sales.
Financial Modelling facilitates financial forecasting. It makes forecasting
easy. A financial model has three components: input current financial
statement and growth forecasts; model a system of equations based on the
relations between financial variables; output projected financial statements.
Financial models a large company can be very complicated when more details
are considered. In practice, companies focus on the most crucial decisions and
variables and keep the model simple.
Sustainable Growth Sometimes companies will like to achieve growth that
their current financial policies could sustain. Sustainable growth is the annual
percentage growth in sales that is consistent with the firms financial policies
(assuming no issue of fresh equity).
Gross Working Capital refers to the firms investment in current assets.
Net Working Capital means the difference between current assets and current
liabilities, and therefore, represents that position of current assets which the
firm has to finance either from long-term funds or bank borrowings.
Operating Cycle is defined as the time duration which the firm requires to
manufacture and sell the product and collect cash. Thus operating cycle refers to
the acquisition of resources, conversion of raw materials into work-in-process
into finished goods, conversion of finished goods into sales and collection of sales.
Larger is the operating cycle, larger will be the investment in current assets. In
practice, firms are acquire resources on credit. To that extent, firms need to
raise working finance is reduced.
Net Operating Cycle is used for the difference between operating cycle (or
gross operating cycle) and the payment deferral period (or the period for which
creditors remain outstanding).
The Manufacturing Cycle is conversion of raw material into work-in-process
into finished goods, is a component of operating cycle, and therefore, it is a major
determinant of working capital requirement. Manufacturing cycle depends on
the firms choice of technology and production policy.

Credit Policy of the firm is another factor which influences the working capital
requirement. It depends on the nature and norms of business, competition and
the firms desire to use it as a marketing tool.
Investment in Current Assets involves a trade-off between risk and return.
When the firm invests more in current assets it reduces the risk of illiquidity,
but loses in terms of profitability since the opportunity of earning from the
excess investment in current assets is lost. The firm therefore is required to
strike a right balance.
Financing of Current Assets also involves a trade-off between risk and
return. A firm can choose from short- or long-term sources of finance. If the firm
uses more of short-term funds for financing both current and fixed assets, its
financing policy is considered aggressive and risky. Its financing policy will be
considered conservative if it makes relatively more use long term funds in
financing its assets. A balanced approach is to finance permanent current assets
by long-term sources and temporary current assets by short-term sources of
finance. Theoretically, short-term debt is considered to be risky and costly to
finance permanent current assets.
Trade Credit creates debtors (book debts) or accounts receivable. It is used as a
marketing tool to maintain or expand the firms sales. A firms investment in
accounts receivable depends on volume of credit sales and collection period.
Credit Policy The financial manager can influence volume of credit sales and
collection period through credit policy. Credit policy includes credit standards,
credit terms, and collection efforts. The incremental return that a firm may gain
by changing its credit policy should be compared with the cost of funds invested
in receivables. The firms credit policy will be considered optimum at the point
where incremental rate of return equals the cost of funds. The cost of funds is
related to risk; it increases with risk. Thus, the goal of credit policy is to
maximise the shareholders wealth; it is neither maximisation of sales nor
minimisation of bad-debt losses.
Credit Standards are criteria to decide to whom credit sales can be made and
how much. If the firm has soft standards and sells to almost all customers, its
sales may increase but its costs in the form of bad-debt losses and credit
administration will also increase. Therefore, the firm will have to consider the
impact in terms of increase in profits and increase in costs of a change in credit
standards or any other policy variable.
Credit Terms The conditions for extending credit sales are called credit terms
and they include the credit period and cash discount.

Cash Discounts are given for receiving payments before than the normal credit
period. All customers do not pay within the credit period. Therefore, a firm has
to make efforts to collect payments from customers.
Collection Efforts of the firm aim at accelerating collections from slow-payers
and reducing bad-debt losses. The firm should in fact thoroughly investigate
each account before extending credit. It should gather information about each
customer, analyse it and then determine the credit limit. Depending on the
financial condition and past experience with a customer, the firm should decide
about its collection tactics and procedures.
Average Collection Period and Aging Schedule are methods to monitor
receivables. They are based on aggregate data for showing the payment
patterns, and therefore, do not provide meaningful information for controlling
Collection Experience Matrix Receivables outstanding for a period are
related to credit sales of the same period. This approach is better than the two
traditional methods of monitoring receivables.
Factoring involves sale of receivables to specialised firms, called factors.
Factors collect receivables and also advance cash against receivables to solve the
client firms liquidity problem. For providing their services, they charge interest
on advance and commission for other services..

Inventories Companies hold inventories in the form of raw materials, work-inprocess
and finished goods. Inventories represent investment of a firms funds.
The objective of the inventory management should be the maximisation of the
value of the firm. The firm should therefore consider: (a) costs, (b) return, and (c)
risk factors in establishing its inventory policy.
Transaction Motive to Hold Inventory for facilitating smooth production
and sales operation.
Precautionary Motive to Hold Inventory to guard against the risk of
unpredictable changesin usage rate and delivery time.
Speculative Motive to Hold Inventory to take advantage of price

Ordering Costs requisition, placing of order, transportation, receiving,

inspecting and storing and clerical and staff services. Ordering costs are fixed
per order. Therefore, they decline as the order size increases.
Carrying Costs warehousing, handling, clerical and staff services, insurance
and taxes. Carrying costs vary with inventory holding. As order size increases,
average inventory holding increases and therefore, the carrying costs increase.
Economic Order Quantity (EOQ) The firm should minimise the total cost
(ordering plus carrying). The economic order quantity (EOQ) of inventory will
occur at a point where the total cost is minimum.
Optimum Inventory Policy The value of the firm will be maximised when the
marginal rate of return of investment in inventory is equal to the marginal cost
of funds. The marginal rate of return (r) is calculated by dividing the
incremental operating profit by the incremental investment in inventories, and
the cost of funds is the required rate of return of suppliers of funds.
Reorder Point The inventory level at which the firm places order to replenish
inventory is called the reorder point. It depends on (a) the lead time and (b) the
usage rate. Under perfect certainty about the usage rate, and instantaneous
delivery (i.e., zero lead time), the reorder point will be equal to: Lead time
Usage rate.
Safety Stock In practice, there is uncertainty about the lead time and/or usage
rate. Therefore, firms maintain safety stock which serves as a buffer or cushion
to meet contingencies. In that case, the reorder point will be equal to: Lead time
Usage rate + Safety stock. The firm should strike a trade-off between the
marginal rate of return and marginal cost of funds to determine the level of
safety stock.
Selective Control System A-B-C Analysis A firm, which carries a number
of items in inventory that differ in value, can follow a selective control system. A
selective control system, such as the A-B-C analysis, classifies inventories into
three categories according to the value of items: A-category consists of highest
value items, B-category consists of high value items and C-category consists of
lowest value items. More categories of inventories can also be created. Tight
control may be applied for high-value items and relatively loose control for lowvalue
Total Quality Management (TQM) System Large numbers of companies
these days follow the total quality management (TQM) system which requires
companies to adopt JIT and computerised system of inventory management.

Transaction Motive for Holding Cash A firm needs cash to make payments
for acquisition of resources and services for the normal conduct of business.
Precautionary Motive for Holding Cash A firm keeps additional funds to
meet any emergency situation.
Speculative Motive for Holding Cash Some firms may also maintain cash
for taking advantages of speculative changes in prices of input and output.
Optimum Balance of Cash A firm should hold an optimum balance of cash,
and invest any temporary excess amount in short-term (marketable) securities.
In choosing these securities, the firm must keep in mind safety, maturity and
marketability of its investment.
Management of Cash involves three things: (a) managing cash flows into and
out of the firm, (b) managing cash flows within the firm, and (c) financing deficit
or investing surplus cash and thus, controlling cash balance at a point of time. It
is an important function in practice because it is difficult to predict cash flows
and there is hardly any synchronisation between inflows and outflows.
Cash Budget Firms prepare cash budget to plan for and control cash flows.
Cash budget is generally prepared for short periods such as weekly, monthly,
quarterly, half-yearly or yearly. Cash budget will serve its purpose only if the
firm can accelerate its collections and postpone its payments within allowed
limits. The main concerns in collections are: (a) to obtain payment from
customers within the credit period, and (b) to minimise the lag between the time
a customer pays the bill and the time cheques etc. are collected. The financial
manager should be aware of the instruments of payments, and choose the most
convenient and least costly mode of receiving payment. Disbursements or
payments can be delayed to solve a firms working capital problem. But this
involves cost that, in the long run, may prove to be highly detrimental.
Therefore, a firm should follow the norms of the business.
Receipts and Disbursements Method is employed to forecast for shorter
periods. The individual items of receipts and payments are identified and
analysed. Cash inflows could be categorised as: (i) operating, (ii) non-operating,
and (iii) financial. Cash outflows could be categorised as: (i) operating,
(ii) capital expenditure, (iii) contractual, and (iv) discretionary. Such
categorisation helps in determining avoidable or postponable expenditures.
Adjusted Income Method uses proforma income statement (profit and loss
statement) and balance sheet to work out cash flows (by deriving proforma cash
flow statement). As cash flows are difficult to predict, a financial manager does
not base his forecasts only on one set of assumptions. He or she considers

possible scenarios and performs a sensitivity analysis. At least, forecasts under

optimistic, most probable and pessimistic scenarios can be worked out.
Concentration Banking and Lock-Box System methods followed to expedite
conversion of an instrument (e.g., cheque, draft, bills, etc.) into cash.
Marketable Securities The excess amount of cash held by the firm to meet its
variable cash requirements and future contingencies should be temporarily
invested in marketable securities, which can be regarded as near moneys. A
number of marketable securities may be available in the market. The financial
manager must decide about the portfolio of marketable securities in which the
firms surplus cash should be invested.
Baumol Model of Cash Management considers cash management similar to
an inventory management problem.
where C* is the optimum cash balance, c is the cost per transaction, T is the
total cash needed during the year and k is the opportunity cost of holding cash
balance. The optimum cash balance will increase with increase in the per
transaction cost and total funds required and decrease with the opportunity cost.
Miller-Orr Model If the firms cash flows fluctuate randomly and hit the upper
limit, then it buys sufficient marketable securities to come back to a normal level
of cash balance (the return point). Similarly, when the firms cash flows wander
and hit the lower limit, it sells sufficient marketable securities to bring the cash
balance back to the normal level (the return point).


Short-Term Sources of Financing Trade Credit, Deferred Income and
Accrued Expenses, and Bank Finance. Two alternative ways of raising shortterm
finances in India are: factoring and commercial paper.
Spontaneous Sources of Working Capital Finance Trade Credit and
Deferred Income and Accrued Expenses are available in the normal course of
business, and therefore, they are called spontaneous sources of working capital
finance. They do not involve any explicit costs.
Non-Spontaneous or Negotiated Sources of Working Capital Finance
Bank Finances have to be negotiated and involve explicit costs. They are called
non-spontaneous or negotiated sources of working capital finance

Trade Credit refers to the credit that a buyer obtains from the suppliers of
goods and services. Payment is required to be made within a specified period.
Suppliers sometimes offer cash discount to buyers for making prompt payment.
Buyer should calculate the cost of foregoing cash discount to decide whether or
not cash discount should be availed.
A buyer should also consider the implicit costs of trade credit, and particularly,
that of stretching accounts payable. These implicit costs may be built into the
prices of goods and services. Buyer can negotiate for lower prices for making
payment in cash.
Accrued Expenses and Deferred Income also provide some funds for
financing working capital. However, it is a limited source as payment of accrued
expenses cannot be postponed for a long period. Similarly, advance income will
be received only when there is a demand-supply gap or the firm is a monopoly.
Bank Finance is the most commonly negotiated source of the working capital
finance. It can be availed in the forms of overdraft, cash credit,
purchase/discount of bills and loan. Each companys working capital need is
determined as per the norms. These norms are based on the recommendation of
the Tandon Committee and later on, the Chore Committee. The policy is to
require firms to finance more and more of their capital needs from sources other
than bank. Banks are the largest providers of working capital finance to firms.
Commercial Paper is an important money market instrument for raising
short-term finances. Firms, banks, insurance companies, individuals etc. with
short-term surplus funds invest in commercial papers. Investors would generally
invest in commercial paper of a financially sound and creditworthy firm. In
India, commercial papers of 91 to 180 days maturity are being floated. The
interest rate will be determined in the market. The yield on commercial paper
can be calculated as follows:
CP yield = [Face value Sale price/Sale price] [360/Days to maturity]
Merger is the combination of two or more firms into one of the firms. Merger
could be horizontal, vertical or conglomerate. A merger results into an economic
advantage when the combined firms are worth more together than as separate
entities. Merger benefits may result from economies of scale, economies of
vertical integration, increased efficiency, tax shields or shared resources. Merger
should be undertaken when the acquiring companys gain exceeds the cost. Cost
is the premium that the buyer (acquiring company) pays for the selling company
(Target Company) over its value as a separate entity. Discounted cash flow
technique can be used to determine the value of the target company to the
acquiring company. Merger and acquisition activities are regulated under
various laws in India. The objective of the laws as well as the stock exchange
requirements is to make merger deals transparent and protect the interest of all

Horizontal Merger is the combination of two or more firms in the same stage
of production/distribution/area of business.
Vertical Merger is combination of two or more firms involved in different
stages of production or distribution.
Conglomerate Merger is the combination of firms engaged in unrelated lines
of business. Acquisition or takeover means a combination in which the acquiring
company acquires all or part of assets (shares) of the target company. In
acquisition, there exists willingness of the management of the target company to
be acquired while this may not be so under takeover.
Leveraged Buy-Out (LBO) In a leveraged buy out a company is bought by
raising most funds through borrowings. When the company is boughtout by its
own managers, it is called management buyout (MBO). After acquisition, the
LBO generates lot of profits and creates high value. Lenders get high return by
converting their loans into equity or using warrants buying the companys
Pooling of Interest Method In the pooling of interest method, assets and
liabilities are combined at book values.
Purchase Method In the purchase method, the assets and liabilities are
revalue and then combined. The difference between book values of assets and
liabilities and their revaluation is shown as goodwill or capital reserve.

Derivatives are instruments that derive their value and payoff from another
asset, called underlying asset. Derivatives include options, forward contracts,
futures contracts and swaps. Investors, including firms, are risk averse. They
aim at reducing risk by hedging through derivatives.
Hedging helps to (i) reduce costs of financial distress, (ii) isolate the effects of
changes in external factor like interest rates and foreign exchange rates on
profitability, and (iii) allow managers to focus on improving operating efficiency
rather worrying about changes in factors on which they have no control.
Forward Contract is an agreement between two parties, called counterparties,
to buy and sell an asset at a future date at a price agreed upon today. There is
no immediate flow of cash. Cash is paid or received on the due date. Forward

contracts are obligations. They are not traded on organised exchanges.

Futures Contract is like a forward contract. But, unlike forward contracts,
futures contracts are traded on organised exchanges. Thus, they are liquid. Yet
another feature of futures contract is that they are marked to market. Prices
differences every day are settled through the exchange clearing house. The
clearinghouse pays to the buyer if the price of a futures contract increases on a
particular day. The seller pays money to the clearing house. The reverse will
happen if the prices decrease.
Swaps are arrangements to exchange cash flows over time.
Currency Swap The agreement provides for exchanging payments
denominated in one currency for payments in another currency over a period of
Interest Rate Swap one type of interest payments, say, fixed-rate payments, is
exchanged for another, interest payments, say, floating-rate payments. The
floating interest rates may be tied to LIBOR.
International Financial Management The guiding principle for international
financial management, like domestic financial management, is the shareholder
wealth maximisation. International financial management, however, differs
from domestic financial management, as it has to deal with multiple currencies,
interest rates, inflation rates and foreign exchange and political risks. There are
a number of ways in which an international company can finance its foreign
operations. It should strive to reduce its risk and minimise cost. It should take
advantages of government subsidies and tax asymmetries.
Foreign Exchange Rate is the price of one currency in terms of the other
Spot Rate is the current exchange rate, and is used for immediate delivery of
currency (which is two business days).
Forward Rate is the price determined today for delivery in the future.
International Parity Conditions There exists a definite relationship between
interest rates, inflation rates and exchange rates. These relationships are called
international parity conditions.
Interest Rate Parity The difference between the current exchange rate and the
forward rate results from the differences in the interest rates of two countries.
This is referred to as the interest rate parity.

where rF is interest rate of country F (say, the foreign country), rD is interest rate
of country D (say, domestic country), sF/D is the spot exchange rate between the
countries F and D and fF/D is the forward rate between the countries F and D.
Expectation Theory of Exchange Rates A forward exchange rate should be
what the foreign exchange market participants expect the future spot rate to be.
This is the expectation theory of exchange rates.
Purchasing Power Parity The expected future spot rate deviates from the
current spot rate because of the difference in the expected inflation rates in two
countries. This notion is based on the law of one price. The price of similar goods
should be same in foreign currency equivalent. This is known as purchasing
power parity. Nominal interest rates reflect the expected inflation rates.
International Fisher Effect In a perfect capital market, real rates will be
same in all countries. This is the international Fisher effect.
Foreign Exchange Risk An international company expecting to receive or pay
cash flows in future in foreign currency is exposed to foreign exchange risk. To
avoid the foreign exchange risk of borrowing, a company can borrow a mix of
currencies local as well as foreign. It can hedge against the risk of its
liabilities if it creates assets in those currencies. We can distinguish between
three types of foreign exchange risk: transaction exposure; economic exposure
and translation exposure. There are three alternatives available to hedge the
foreign exchange risk: forward contract; currency options; money market
Transaction Exposure Risk involves the possible exchange loss (or gain) on
existing foreign currency-denominated transactions due to change in the
exchange rate.
Economic Exposure Risk refers to change in the value of the firm caused by
the unexpected changes in the exchange rate.
Translation Exposure Risk is caused when for translating the assets and
liabilities of subsidiaries of a multinational company, the exchange rate at the
end of the accounting period is different from the exchange rate at the beginning.
Forward Contract A company can take a forward contract. It can either buy or
sell a currency forward at a known forward rate.
Currency Option The company can buy a currency option. A call option is the
right to buy and a put option is the right to sell currency at a predetermined
exchange rate. The company will exercise its option only when it is
advantageous to do so. Currency options allow the company to hedge against
risk and gain from favourable change in the exchange rate.

Money Market Operations The company can also hedge its foreign exchange
exposure through money market operations; that is, borrowing and investing in
the money markets.
International Capital Budgeting Decisions like domestic capital budgeting
decisions, require estimates of cash flows and an appropriate discount rate. The
cash flows can be estimated either in the domestic currency or in the foreign
currency. The financial managers should forecast the foreign exchange rates
assuming the parity conditions. The opportunity costs should be appropriately
modified, reflecting the interest rate of the country in whose currency cash flows
are estimated.
Eurocurrency Loans or Eurobonds A number of companies access funds in
the Eurocurrency markets either through borrowing from banks or by issuing
Eurobonds. Eurocurrency loans or Eurobonds are issued in countries other than
the country in whose currency they are denominated. Eurocurrency markets are
free from government regulations. Some companies also issue foreign bonds in
foreign domestic capital markets.
Depository Receipts A number of companies, particularly developing
countries, also raise funds through depository receipts. Depository receipts,
representing claims on the shares of a company, are issued by a depository,
usually an international finance firm to investors in developed countries.
Depository is an intermediary between the company and depository receipt
holders. He receives dividends from the company and then converts it into
receipt holders currency and distributes to them.
American Depository Receipts (ADRs) Depository receipts issued to
investors in the US are called American Depository Receipts (ADRs).
Global Depository Receipts (GDRs) Depository receipts issued to investors in
many countries are called Global Depository Receipts (GDRs).
Corporate Strategy A firms strategy establishes an effective and efficient
match between its competences and opportunities and environmental risks. It
provides a mechanism integrating the goals of its multiple consistencies.
Financial Policy In practice, financial policy of a company is closely linked
with its corporate strategy. Financial policies of the firms should be developed in
context of its corporate strategy. Within the overall framework of the firms
strategy, there should be consistency between financial policiesinvestment,
debt and dividend. For example, a firm can sustain a high-growth strategy only
when its investment projects generate high profits and it follows a policy of low
payout and high debt.

Economic Profit Growth should lead to the enhancement of the shareholder

value. This will happen when the firm is economically profitable; that is, when
the firms return on equity (ROE) is higher than its cost of equity (ke). Value is
created when ROE > ke; value is maintained when ROE = ke; and value id
destroyed when ROE < ke. Alternatively, ROCE can be compared with WACC.
Value is created when ROCE > WACC.
Economic Value Added The amount of EVA is the difference between aftertax
PBIT and the charges for capital employed or invested capital:

Performance of Government Companies Like the private sector companies,
the government companies also aim at profitability and value creation. But they
focus much more on non-financial and social objectives A very few government
companies make profits and declare dividend. In 200203, 81 companies, out of
118 profit making companies paid about 36 percent of their net profits as
Finance Function in Government Companies The organization of finance
function of the government companies is evolving over the years, and it has
become now a specialized function with a decentralized structure in case of
multi-divisional and multi-product companies. The scope of finance function in
the government companies is as extended as in the case of the private sector
companies. It includes the funds management, budgeting, cost control, assets
management and security etc.
Investment Decisions of Government Companies The basic principle of
value creation governs the investment decisions of the government companies.
But these companies also use economic return and the social impact criteria in
choosing projects. The authority for investment expenditure goes beyond the
management of the company. Government departments and ministries play
important role in authorizing investment expenditures beyond certain specified
limits. Most government companies are dependent on the government funding
for financing their expansion and growth. The government funding is available
either as equity or debt. Hence, the issue of capital structure is considered
redundant as the source of the debt and equity is the same, that is, the tax
payers money allocated by the government.
Current Assets in Government Companies Government companies have
huge investment in current assets. Hence, working capital management
assumes for greater importance. A number of companies (e.g., BHEL, NTPC)
have well-established policies and practices of managing working capital.
However, a large number of companies have inadequate working capital
management. The Boards of the companies hardly discuss the working capital

management issues and lay down policies and procedures.

Financial Controls in Government Companies are more stringent then in
the private sector companies. They are subjected to internal audit, statutory
audit and audit by controller and Auditor General. An additional feature of
performance evaluation and control in government companies is Memorandum
of Understanding (MoU). Performance budgeting and zero-base-budgeting (ZBB)
are special budgeting control tools used by government companies.
Memorandum of Understanding (MoU) is a performance contract between
the government and the company management. It specifies the performance
targets as well as explicitly states the autonomy and accountability of
management in meeting financial and non-financial objectives and targets. The
emphasis is only reducing the close control of the government and the day-to-day
interference in the management of companies.
Performance Budgeting is a flexible system of aligning organizational
mission, goals and objectives with budgeted funds and expected results. It takes
a comprehensive, policy oriented approach, rather than a short term mechanical
approach of preparing budgets.
Programme Budgeting Performance budgeting may be extended to each
specific programmes, and it is referred to Programme budgeting.
Zero-base budgeting is based on the notion that each activity or Programme
and its funding must be justified each time afresh.