Page 1
11
NATURE AND SCOPE OF FINANCIAL
MANAGEMENT
Unit Structure:
1.0 Learning Objectives
1.1 Introduction
1.2 Meaning and Definition of Financial Management
1.3 Importance of Financial Management in Business
1.4 Scope of Financial Management
1.5 Goals / Objectives of Finance Management
1.6 Qualities of a Successful Finance Manager
1.7 Functions of Financial Contro ller
1.8 Exercises
1.0 LEARNING OBJECTIVES
The present chapter attempts to:
Provide familiarisation with financial objectives and goals of a firm.
Develop conceptual framework of financial management.
Focus on nature, and scope of financial management.
Explaining the role of finance function.
Discuss the role of finance manager.
1.1 INTRODUCTION
Finance touches every aspect of our life and holds the key to all
activities. It has been described as the life blood of any business. The
blood in our body ne eds to be regulated to ensure smooth circulation for
healthy survival. Management of finance in an optimal manner is
inevitable for success of any business. The finance function has been
defined differently by different writers and differently over time.
According to G.L. Jones, the simplest way of understanding finance is to
say that finance is what finance does. L.J. Gitman has defined finance as
the art and science of managing money. The only conclusion one may
make with respect to finance is that it has a marvellous ability to evoke
different concepts in the minds of men.munotes.in
Page 2
21.2 MEANING AND DEFINITION OF FINANCIAL
MANAGEMENT
Financial management means money management. Financial
management is concerned with the planning and controlling of the
financia l resources of the business firm. The term financial management
has emerged from the generic discipline of management. As an academic
discipline, the subject of financial management has undergone radical
changes in relation to its scope, functions and obje ctives. In the past, the
financial management was confined to rising of the funds and its
procedural aspects. In the broader sense, it is now concerned with the
optimum use of financial resources in addition to its procurement.
Therefore, financial managem ent is that part of management which is
concerned mainly with:
1. Fund Raising: raising the right type of funds in the most economic and
suitable manner.
2. Use of Funds: using the funds in the most profitable and safest possible
manner.
According to James Van Horne,
“Financial management connotes responsibility for obtaining and
effectively utilizing funds necessary for the efficient operation of an
enterprise.”
According to I.M. Pandey:
“Financial management is that managerial activity which is
concerned with the planning and controlling of the firm’s financial
resources”.
Financial management provides the best guide for future resource
allocation by the firm. It performs facilitation, reconciliation and control
function in an organisat ion. It permits and recommends investment where
the opportunity is greatest. Financial management produces relatively
uniform yardsticks for judging most of the enterprise’s operations and
projects. It is continually concerned with an adequate rate of retu rn on
investment which is necessary to assure the successful survival of an
enterprise. The problem of attracting new capital and providing funds for
capital needs is solved if the return on investments is adequate. Because it
Is continuing drawing attent ion to such matters, financial management is
essential to effective top management.
Definitions of Financial Management
The simple definition of Financial Management is `the ways and
means of managing money’. This statement can be further expanded to
define Financial Management: the determination, acquisition, allocation
and utilization of the financial resources with the aim of achieving the
goals and objectives of the enterprise.munotes.in
Page 3
3According to Archer and Ambrosia:
“Financial management is the applicatio n of the planning and Control
functions to the finance function”.
Joseph and Massie:
“Financial management is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for
efficient operation”.
Raymond Chambers:
“Financial management may be considered to be the management of the
finance function. It may be described as making decisions on financial
matters and facilitating and reviewing their execution. It may be used to
designate the field of s tudy which lie beneath these processes”.
1.3 IMPORTANCE OF FINANCIAL MANAGEMENT IN
BUSINESS
The importance of financial management is known from the
following aspects:
1. Applicability –The principles of finance is applicable wherever there is
cash flow. The concept of cash flow is one of the central elements of
financial analysis, planning, control and resource allocation decisions.
Cash flow is important because financial health of the firm depends on its
ability to generate sufficient amounts of cash to pay its employees,
suppliers, creditors and owners. Any organization, whether motivated with
earning of profit or not, having cash flow requires to be viewed from the
angle of financial discipline. Therefore, financial management is equally
applicable to all forms of business like sole traders, partnerships,
companies. It is also applicable to non profit organizations like trusts,
societies, governmental organizations, public sector ente rprises etc.
2. Chances of Failure –A firm having latest technology, sophisticated
machinery; high calibre marketing and technical experts etc. may fail to
succeed unless its finances are managed on sound principles of financial
management. The strength of business likes in its financial discipline.
Therefore, finance function is treated as primary, which enable the other
functions like production, marketing, purchase, personnel etc. to be more
effective in achievement of organizational goals and objectiv es.
3. Return on investment –Anybody invests his money will mean to earn a
reasonable return on his investment. The owners of business try to
maximize their wealth. It depends on the amount of cash flows expected to
be generated for the benefit of owners , the timing of these cash flows and
the risk attached to these cash flows. The greater the time and risk
associated with the expected cash flow, the greater is the rate of return
required by the owners. The Financial management study the risk -return
perce ption of the owners and the time value of money.munotes.in
Page 4
41.4 SCOPE OF FINANCIAL MANAGEMENT
All decisions that have monetary benefits come under the purview
of financial management. There are basically, two approaches for
understanding the scope of financial manag ement: one is traditional
approach and the second one is the modern approach.
1. Traditional approach: Traditional approach views the scope of finance
function in a narrow sense of arrangement of funds by business firm to
meet their financing needs. Hence , the following three inter -related
aspects of raising and administering financial resources were covered:
a)Arrangement of finance from institution;
b)Raising funds in the capital market through financial instruments
including the procedural aspects;
c)Legal and accounting aspects involved for raising finance for the firm.
The traditional approach was criticized for the reasons:
a)It emphasis only the issues relating to procurement of funds and
ignored the issues related to internal financial deci sions.
b)It focused only on the problems related to corporate entities ignoring
the non -corporate bodies. The scope of financial management was
confined only to a particular segment of business enterprises.
c)It laid more emphasis on the onetime events (episode) such as
promotion, incorporation, reorganization, etc., taking place in the
corporate life of the concern/ignoring the day -to-day financial
problems of the concern.
d)The focus was more on long term financing. Working capital
management was co nsidered to be outside the purview of finance
function.
According to Solomon, the traditional approach has ignored the central
issues of financial management which comprise the following:
i)Should the enterprise commit capital funds to certain purpose?
ii)Do the expected returns meet financial standards of performance?
iii)How should these standards be set and what is the cost of capital funds
to the enterprise?
iv)How does the cost vary with the mixture of financing methods used?
Therefore, the trad itional approach while ignoring the above
crucial aspects implied a very narrow scope for financial management.
These defects were taken care by the Modern approach.munotes.in
Page 5
52. Modern Approach: The traditional approach focused on sources of
funds and was too ofte n largely concerned with specific procedural details.
Experts pointed out the following two defects of traditional approach:
i)It does not recognize the relationship between financing mix and the
cost of capital and fails to solve the problems relating to optimum
combination of finance, and
ii)It also fails to deal with the problems relating to the valuation of the
firm and the cost of capital.
The modern approach aims at formulating rational policies for the
optimal use, procurement and allocation of funds; unlike the traditional
approach which has focused only on the sources of funds and their
procedural details. The modern approach apart for c overing the acquisition
of external funds; includes the efficient and wise allocation of funds for
various uses. Emphasis has shifted from a detailed analysis, of operating
procedures in the acquisition, custody and disbursement of funds to the
formulation of rational decisions on the optimal use and allocation of
funds. Financial decision making has become fully integrated in more
advanced companies with top management policy formulation via capital
budgeting, loan range planning, evaluation of alternate u ses of funds, and
establishment of measurable standards of performance in financial terms.
In the words of Solomon, a financial manager should know the following:
i)How large should an enterprise be and how fast should it grow?
ii)In what form should it hold its assets?
iii)What should be the composition of its liabilities?
Thus, the modern approach views the term financial management
in a broad sense and provides a conceptual and analytical framework for
financial decision making. Therefore, financ ial management, in the
modern sense of the term, can be related to three major decision making
areas. They are as follows:
1.Investment Decision i.e. Where to invest funds and in what amounts?
2.Financing Decisions i. e .Where to raise funds from and in what
amount?
3.Dividend Decisions i. e how much of profits should be paid by way of
dividends and how much should be retained in the business?
All the above three decisions contribute towards the goal of wealth
maximization.
1. Investment Decisions: Investment decisions involve identifying the
asset or projects in which the firms limited resources should be invested. It
involves the major task of measuring the prospective profitability ofmunotes.in
Page 6
6investment in assets of the company or in new projects. The de cisions
relating to acquisition of fixed assets investment are known as capital
budgeting decisions and the decisions relating to current assets investment
are known as working capital management decisions. Capital budgeting
decisions relate to selection o f an asset or investment proposal or course of
action which have hot long term implications on the cash flows and
profitability of such investment. It helps in judging whether it is financial
feasible to commit funds in future. An important aspect of worki ng
capital, the profitability would be adversely affected, whereas with too
inadequate working capital, it would be unable to meet its financial
commitment on time and thereby invite the risk of insolvency. The
investment in the fixed assets of the company determines the production
capacity of the company. The production should be sufficient to demand
in the market. Production should not fall short or be too excessive in
relation to the demand for the product in the market. Further, the fixed
assets must be productive enough to ensure the returns expected from such
investment. This should be supported by sufficient investment in the
working capital assets. The working capital assets should be adequate
enough to maintain sufficient liquidity to augment the sa les level.
Investment decisions yield returns in future. Future performance is subject
to uncertainty and risk. Therefore, investment decisions require careful
analysis before substantial amounts are committed in fixed assets. The
investment decisions havi ng long term implications and affects the cash
inflows in the years to come. Hence any wrong decision taken in the initial
year, would adversely affect the future profitability and growth. Hence
appropriate techniques need to be adopted for proper evaluati on of
investment decisions.
2. Financing Decisions: Financing decisions involve deciding on the most
cost effective method of financing the chosen investments. Financing
decisions relate to the financing pattern of the firm. It involves in deciding
as to when, where and how to acquire the funds to meet the firm’s
investment needs. Different sources of finance have different advantages
with different degree of risks. Hence it becomes imperative to decide as to
how much finance is to be raised and from which sources. The prime
objective of financing decisions is to keep the cost of finance at the
minimum with maximum utilization of funds. Primarily, there are two
main sources of finance: one is the owned funds and second is the
borrowed funds. Owned funds are the shareholder’s monies on which
dividend are paid. Dividend payment depends upon the profitability of the
company and is not binding. There is no commitment involved in the
shareholders funds. On the other hand, borrowed funds involve fixed
commitments; their repayments are secured by a charge created on the
assets and interest payments are obligatory irrespective of the profits or
losses of the company. Hence, it increases the financial risk of the
company. The borrowed funds are relatively cheaper, but entail a certain
degree of risk, therefore, due prudence must be exercised while
determining the mix of owned and borrowed funds.munotes.in
Page 7
73. Dividend Decision: Dividend Decisions involve the decisions as
regards what amount of profits earned should be distributed by way of
dividends and what amount should be retained in the business. Dividend
policy is to be decided having regard to its implicate on the sharehol der
wealth in the firm. The aim is to decide an optimum dividend policy which
would maximize the market price of shares. This is a crucial decision as it
determines the reputation of the management of the company and
therefore, the market value of the shar es. If the management decides to
retain profits, it should be able to generate adequate returns (by investing
such retained profits), which should be much more that what the,
shareholders could have got, had they received the dividends and invested
the amo unt elsewhere. If the management is not able to generate adequate
returns on reinvestment of retained profits, then it should prefer to pay
dividends rather than retaining the profits. Therefore, the two important
factors which affect the dividend decision s are: firstly, the investment
opportunities available to the firms and secondly, the opportunity rate of
return of the shareholders. The topic has been dealt in more details in the
subsequent chapters of this book.
1.5 GOALS / OBJECTIVES OF FINANCE
MANAG EMENT
Many of the well -known authors on the subject have highlighted the
following two important goals of financial management. They are as
follows:
1. PROFIT MAXIMIZATION:
The objective of making profit is a commercial imperative. Profit
generation is e ssential for survival and growth of the business. Profit
generation is also regarded as a measure of success of the business. Profit
is an important yardstick for measuring the economic efficiency of any
firm. Any business would be making the use of econom ic and human
resources available to generate profits. The cost of these resources is
required to be met from the revenue generated from the use of these
resources and the surplus remaining would be needed for the growth and
expansion of the company. It is only an efficiently run business which can
afford to meet the cost of resources and generate profits. Therefore, the
survival and growth of any business depends upon its ability in earnings
profits. It is therefore contended that profit maximization is one of the
primary goals of the organization without which the survival of the
organization itself is threatened.
THE DRAWBACKS OF THE GOAL OF PROFIT
MAXIMIZATION
Although profit is an important yardstick for measuring the
economic efficiency of any firm, ye t it has got certain limitations which
are listed below:munotes.in
Page 8
81. It ignores the risk which is associated with the investment in such
profitable ventures. It ignores the risk or uncertainty of expected returns or
benefits. Risk is defined as the chance that the actual outcome of a
decision may differ from the expected outcome and in finance; risk
investment is one whose potential returns are expected to have a high
degree of variation or volatility. Some investments with high profits
potential, having a high deg ree of risk associated with it. When profit
maximization is aimed as the main objective, all profitable investment
projects are accepted without having regard to the risk factor. An
investment may have profit potential but may not be worth the risk.
2. Th e objective of profit -maximization assumes the existence of perfect
market conditions in which various resources are efficiently managed.
However, modern markets suffer from many imperfections. It leads to
inequitable distribution of income and wealth.
3.It ignores the time value of money without having any regard to the
timings of costs and returns. It takes into account only the size of the
profits without considering the timings of the prospective earnings.
4. Profit maximization as an objective is considered to be vague and
ambiguous. It does not define adequately as to what profits are what
profits to be considered, whether from the point of view of funds
employed or from the shareholders point of view, or short term or long
term profits etc.
5. Profit maximization as an objective ignores other important aspects of
financing e.g. borrowing capacity etc.
6. The objective of profit maximization focuses on interests of the owners
alone and ignores the interes t of other interested parties such as
employees, consumers, government and society in general.
7. The perception of the management as regards profit maximization
substantially differs from the perception of the shareholders.
Another variant of profit max imization is to consider the rate of
return on investment. If the rate of return on investment is higher than the
cost of funds, then such investment opportunities can be undertaken.
2. Wealth Maximisation:
According to this objective, the owners of the c ompany i.e. the
shareholders are more interested in maximizing their wealth rather than in
profit maximization. Maximization of the wealth of the shareholders
means maximizing the net worth of the company for its shareholders. This
reflected in the market price of the shares held by them. Therefore, wealth
maximization means creation of maximum value for company’s
shareholders which mean maximizing the market price of the share.
Wealth maximization refers to the gradual increase in value of the net
assets o f the organization. Profit generation adds to the increase in themunotes.in
Page 9
9value of the net assets of the organization. With greater profits, the EPS
(earnings per share) goes up; resulting in an increase in the value of the net
assets belonging to the shareholders of the company.
The market price of the shares is an important indicator of the
wealth maximization of the organization. Wealth maximization is the net
present value of a financial decision. Net present value is the difference
between the gross present value of the revenue generated from such
decision and the cost of such decision. A financial action with a positive
net present value creates wealth and therefore is desirable. The total cash
inflows over the years in terms of present value must be greater the
outflows of cash invested for generating such cash inflows. This results in
financial advantage leading to increase in the value of net assets. The
increase in the value of net wealth should in turn help in generating greater
volume of profits. This a ction results in financial gains to the shareholders
increasing the earnings per share.
Prof. Solomon has suggested wealth maximization as the best
criterion. According to him “Wealth or net present worth is the difference
between gross present worth and the amount of capital investment
required to achieve the benefits. Any financial action which creates wealth
or which has a net present worth above zero is a desirable one and should
be undertaken. Any financial action which does meet this test should be
rejected”.
Solomon states that wealth maximization provides an
unambiguous measure of what financial management should seek to
maximize in making investment and financing decisions.
Future earnings of a company are subject to uncertainties and
exposed to risk. Financial decisions for which the consequences are
known at a later date may either result in increasing or decreasing the net
wealth of the shareholders. Unforeseen economic and social conditions
may adversely affect the company. Hence the process of wealth generation
is a difficult task.
Therefore, the goal of wealth maximization implies a long term
perspective of the goal. The interest of the management in maximizing the
market price of the share is compatible with that of the shareholders’
interest. This helps the management in allocating the resources in the best
possible manner balancing the risks and the returns.
THE MERITS OF THE GOAL OF WEALTH MAXIMIZATION
ARE AS FOLLOWS:
1.It is a very effective and meaningful criterion to measure the
performance of the company.
2.The objective of wealth maximization is consistent with the objective
of maximization of the shareholders’ economic welfare.munotes.in
Page 10
103.The objective is also consistent with the objective of perpetual survival
of the company and its long term profitability.
4.It is operationally feasible and logical.
5.It includes the motive of profit maximization as it emphasis on
maximization of long term profitability and ensures maximum return
on owners’ investment.
6.The objectives allow for timings of profits and also consider the
timings of perspective benefits.
7.It ensures fait return on the investments, and takes into account the
uncertainty of the benefit also.
8.It offers rational guidelines for effective use of the resources available.
THE DRAWBACKS OF THE GOAL OF WEALTH
MAXIMIZATION
i)The basic assumption is that there an efficient capital market wherein
the market price of the share is truly reflected. This assu mption seldom
holds in real practice.
ii)The market price is influenced by various economic and political
factors which are difficult to anticipate and judge.
iii)The various parties having their stake in the company have conflicting
interests and ther efore difficult to reconcile their divergent views.
3.OTHER GOALS OR OBJECTIVES OF FINANCIAL
MANAGEMENT:
i)To ensure adequate returns to the shareholders which should be fair in
the given market conditions.
ii)To contribute to the operational efficiency of all other areas of
management.
iii)To infuse financial discipline in the organization.
iv)To build up a strong financial base so that the enterprise can fall back
upon its reverses during lean years and with stand the shocks of the
business.
1.6 QUALITIES OF A SUCCESSFUL FINANCE
MANAGER
The job of a finance manager is full of duties and responsibilities.
He has to perform various duties connected with finance. In order to
perform the finance duties successfu lly, a finance manager should be
competent. He should possess the following qualities:
1. Personality is the sum total of physical and mental qualities. A finance
manager should have a pleasing personality. Good height, good physique,munotes.in
Page 11
11good appearance woul d be an asset to a finance manager. He should be
physically and mentally healthy enough to bear the strain of finance in an
organization.
2. The job of a finance manager involves analytical work. He should have
a high degree of intelligence to understand the finance problems
immediately. An intelligent finance manager can control the finance
properly.
3. A finance manager should take initiative in performance of work. He
should do the job at his own i.e. without being told by others.
4. A finance manage r should have vast fund of power of imagination to his
credit. He should have a research mind which is very creative. He should
be able to bring innovation in financial management of an organization.
5. A finance manager should have self confidence to face the challenges
involved in his job.
6. A finance manager is a leader of financial administration. He should
have an effective Communication Skill. He should understand the
problems of his subordinates an d communicate instructions to solve them.
7. The job of a finance manager involves decision making. He has to take
various decisions which have financial implications on the working of the
organization. He should have the quality to judge the situation an d take
right decision accordingly.
8. He should be honest in his job. Finance requires utmost honesty on the
part of the manager and the subordinates also.
9. He should have an administrative skill to administer the finance
function. He should be able to plan, organize, direct, control and
coordinate the activities of the finance area. He has to see that the financial
decisions are properly implemented.
10. A finance manager should be self -disciplined. He should be able to
enforce discipline in the organ ization.
11. A finance manager should have patience. He should not take hasty
decisions which have adverse impact on the financial health of the
organization. He should listen to the views of others.
1.7 FUNCTIONS OF FINANCIAL CONTROLLER
The important f unctions of a financial controller in a large business
firm consist of the following:munotes.in
Page 12
121. Provision of Capital –To establish and execute programmes for the
provision of capital required by the business.
2. Investor Relations –To establish and maintain a n adequate market for
the company’s securities and to maintain adequate liaison with investment
bankers, financial analysis and shareholders.
3. Short -term Financing –To maintain adequate sources for company’s
current borrowing from commercial banks and other lending institutions.
4. Banking and Custody –To maintain banking arrangement, to receive,
have custody of and disburse the company’s monies and securities.
5. Credit and Collections –To direct the granting of credit and the
collection of accounts due to the company, including the supervision of
required special arrangements for financing sales, such as time payment
and leasing plans.
6. Insurance –To provide insurance coverage as re quired.
7. Investments –To achieve the company’s funds required and to establish
policies for investment in pension and other similar trusts.
8. Planning for Control –To establish, coordinate and administer an
adequate plan for the control of operation s.
9. Reporting and interpreting –To compare performance with operating
plans and standards, and to report and interpret the results of operations to
all levels of management and to the owners of the business.
10. Evaluating and Consulting –To consult with all segments of
management responsible for policy or action concerning any phase of the
operation of the business as it relates to the attainment of objectives and
the effectiveness of policies, organization structure and procedures.
11. Tax Administ ration –To establish and administer tax policies and
procedures.
12. Government Reporting –To supervise or coordinate the preparation of
reports to government agencies.
13. Protection of Assets –To ensure protection of assets for the business
through internal control, internal auditing and proper insurance coverage.
14. Economic Appraisal –To appraise continuously economic, social
forces and government influences, and to interpret their effect upon the
business.
15. Managing Funds –To maintain suff icient funds to meet the financial
obligations.munotes.in
Page 13
1316. Measuring of Return –To determine required rate of return for
investment proposals.
17. Cost control –To facilitate cost control and cost reduction by
establishment of budgets and standards.
18. Price Setting –To supply necessary information for setting of prices of
products and services of the concern.
19. Forecasting Profits –To collect relevant data to make forecast of
future profit levels.
20. Forecast Cash flow –To forecast the sourc es of cash and its probable
payments and to maintain necessary liquidity of concern.
1.8 EXERCISES
1. Define the scope of financial management. What role should the
financial manager plan in the modern enterprise?
2. How should the finance function of an enterprise be organized?
What functions are performed by the financial officers?
3. State the scope of Financial Management.
4. State and explain the main functions of a finance manager.
5. Explain the role of finance manager in a large corporate ent erprise.
6. What are the functions of Financial Management?
7. “The goal of profit maximization does not provide us with an
operationally useful criterion.” Comment on this statement.
8. What is objective of profit maximization pool? How is its differen t
from objective of profit maximization?
9. How does the modern finance manager differ from the traditional
finance manager?
10. Discuss the contents of modern finance functions.
11. Discuss the nature and scope financial management.
12. Discuss the na ture of financial management as a staff of line
functions?
13. Describe the functions of finance. In what ways, are these functions
related to possible finance objectives of a company?
14. Explain the nature and scope of finance function. What are the basic
objectives of decision -making in corporate finance?
15. Discuss the functions of a Chief Financial Officer.munotes.in
Page 14
14Multiple Choice Questions
1)The investment decisions should aim at investm ent in assets only when
they are expected to earn a return greater than a minimum acceptable
return is termed as …………………….
a)Interest rate c)growth rate
b)Hurdle rate d)internal rate of return
(2) The traditional view of financial management lo oks at:
a)Arrangement of short -term and long -term funds from financial
institutions.
b)Mobilization of funds through financial instruments.
c)Orientation of finance functions with accounting function.
d)All of the above
3)The modern approach t o financial management view:
a) the total funds requirement of the firm
b) the assets to be acquired
c) the pattern of financing the assets.
d) All of the above
4)The financing of long -term assets should be made from:
a) Short -term fund c)long-term funds
b) Debt funds d)equity funds
5)In fund raising decisions, one should keep in view:
a)Cost of various funds and financial risk.
b)Advantages and disadvantages of debt component in capital mix.
c)Impact of taxation on EPS
d)All of the above.
6)The financial health of the firm depends on its ability to generate
sufficient _____ to pay its employees, suppliers, creditors and owners:
a)Profit c)growth
b)Cash d)wealth
7)Liquidity and profitability are _______ goa ls for the Finance manager.
a)Different c)competing
b)Separate d)finance
8)Wealth maximization means maximizing the ____ of a course of
action.
a)NPV c)profit
b)IRR d)growth
9)_________ maximization objective considers the risk and time value
of money.
a)Profit c)value
b)Wealth d)growth
munotes.in
Page 15
152
CONCEPTS IN VALUATION
Unit Structure:
2.0 Objectives
2.1 Introduction
2.2 Time Value of Money
2.3 Basic Concepts
2.4 Time Value of Money Relationship
2.5 Future Value of Single Amount
2.6 Future Value of Annuity
2.7 Doubling Period
2.8 Present Value of an Uneven Series of Payments
2.9 Present Value of Annuity
2.10 Net Present Value
2.11 Mathematical Tables
2.12 Bond Valuation
2.13 Exercise
2.0 OBJECTIVES
After going through this chapter, you will able to:
Understand the concept of time value of money
Compute the time value of money
Calculate the future value as well as the present value of money
Understa nd the concept of present value and future value of annuities
2.1 INTRODUCTION
In our economics life, money is not free. Money has time value.
Interest rates give money its time value. If the investor has some spare
cash or funds, he can invest it in sav ings deposit in a bank and receive
more money later. If the investor wants to borrow money, he must repay a
larger amount in the future due to interest. The result is that Rs. 100 in
hand today, is worth more than Rs. 100 to be received a year from now.
This is because Rs. 100 today can be invested to provide Rs. 100 plus
interest after a year. The interest rates in the economy provide money with
its time value. There are two types of decisions which require some
consideration of time value. The first decis ion involves investing moneymunotes.in
Page 16
16now in order to receive future cash benefits. The other decision involves
borrowing now to take current expenditure at a cost of having less money
in the future. The intelligent investor requires familiarity with the concepts
of compound interest.
2.2 TIME VALUE OF MONEY:
In the world of finance and investment, time does have a value, Rs.
100 today are more valuable than Rs. 100 a year later. This is because
capital can be employed productively to generate positive returns. Again,
individuals normally prefer current consump tion to future consumption.
Even in case of inflation, Rs. 100 today represents greater real purchasing
power as compared to Rs. 100 one year later. The longer the term of a
loan, the greater will be the amount that must be paid due to interest.
Bonds are worthless to an investor, if the maturity is longer. Therefore,
this makes sense under the general framework of the time value of money.
2.3 BASIC CONCEPTS:
a)PRESENT VALUE: A present value is the discounted value of one or
more future cash flows.
b)FUTURE VALUE: A future value is the compounded value of a
present value.
c)DISCOUNT FACTOR: The discount factor is the present value of a
rupee received in the future.
d)COMPOUNDING FACTOR: The compounding factor is the future
value of a rupee.
Discount and compounding factors are functions of two things:
(i) the interest rate used, and (ii) the time between the present value and
the future value. The discount factor decreases as time increases. The
discount factor also decreases as in terest rate increases.
2.4 TIME VALUE OF MONEY RELATIONSHIP:
The basic time value of money relationships are presented in the
following equations:
(1) PV = FV x DF
(2) FV = PV XCF
Whereas, PV = Present value
FV = Future value
DF = Discounting factor =1
1RtCF = Compounding factor = (1 + R) t
R = Rate of interest
T = time in years.munotes.in
Page 17
172.5 FUTURE VALUE OF SINGLE AMOUNT:
The future value of an amount invested or borrowed at a given rate
of int erest can be calculated if the maturity period is given. Suppose, a
deposit of Rs. 5,000 gets 10 percent interest compounded annually for a
period of 3 years, the future value will be:
PV X CF = 5,000 (1.10)3 = 5,000 x 1.331 = Rs. 6,655.
Illustration 1:
Mr Shashikant deposit Rs. 1,00,000 with a bank which pays 10 percent
interest compounded annually, for a period of 3 years. How much amount
he would get a maturity?
Solution
FV =P VXC F
= 1,00,000 x (1.10)3
= 1,00,000 x 1.331
= Rs. 1,33,100
Mr.Shash ikant will get ₹1,33,100 after 3 years.
2.6 FUTURE VALUE OF ANNUITY :
An annuity is a series of payments of a fixed amount for a
specified number of periods. When payments are made at the end of each
year, it is called ordinary annuity. On the other han d when the payments
are made at the beginning of the year, it is called an annuity due.
Normally, it is assumed that the first annuity payment occurs at the end of
the first year.11RtFVa AR
Where A = Periodic cash payments
R = Annual interest rate
T = time in years / duration of annuity
The value of11RtRcan be determined by using the Time value of
money tables.
The Future va lue Interest Factors (FVIFA) for various years are a
shown in table:munotes.in
Page 18
18
Illustration 2:
Four equal annual payments of Rs. 5,000 are made into a deposit account
that pays 8 percent interest per year. What is the fut ure value of this
annuity at the end of 4 years?
Solution
The future value of annuity11RtFVa AR
= Rs. 5,000 x FVIFA @ 8%
= Rs. 5,000 x 4.5061
= Rs. 22530.50.
2.7 DOU BLING PERIOD
Sometimes, investor should know how long it will take to double
his money at a given rate of interest. In this case, a rule of thumb called
the rule of 72, can be used. This rule works pretty well for most of the
interest rates. The rule of 72 says that it will take seventy -two years to
double your money at 1 percent interest. You can calculate the doubling
by dividing 72 by the interest rate. You can also estimate the interest rate
required to double your money in the given number of years by dividing
number of years into 72.
For example, if the interest rat e is 12 percent, it will take 6 years to
double your money (72+23). On the other hand, if you want to double
your money in 6 years, the interest rate should be 12 percent (72+6).
A more accurate method used for doubling your money is using
the rule of 69. According to this rule, the doubling period of an investment
is = 0.35 + 69 Thus the doubling period of Interest rate investment of
different rates of interest can be determined as follows :munotes.in
Page 19
19As per rule of 69, the doubling period will be
1)Interest rate 12%690.35 0.35 5.75 6.112years
2)Interest rate 15%690.35 0.35 4.60 4.9515years
Illustration 3:
If the interest rate is 10%, what is the doubling pe riods of an
investment at this rate?
Solution
a)As per rule of 72, the doubling period will be
727.210years
b)As per the rule of 69, the doubling period will be690.35 0.35 6.9 7.2515years
PRESENT VALUE:
Many times, investors like to know the present value which grows
to a given future value. Suppose you want to save some money from your
salary to buy a scooter after 5 years. You should know how much money
should be put into bank now in order to get the fu ture value after 5 years.
The present value is simply the inverse of compounding used in
determining future value. The general relationship between future value
and present value is given in the following formula:
11PV FV DF FVR
Illustration 4:
Find the present value of Rs.50,000 to be received at the end of four
years at 12 percent interest compounding quarterly.
PV=FV 1
PV=FV x PVIF at 12%
=Rs. 50,000 x 0.623
=Rs. 31,150
2.8 PRESENT VALUE OF AN UNEVEN SERIES OF
PAYMENTS:
The annuity includes the constant amount in which cash flows are
identical in every period. Many financial decisions involve constant cash -
flow, however, some important decisions are concerned with unev en cashmunotes.in
Page 20
20flows. For example, investment in shares is expected to pay an increasing
series of dividends over time. The capital budgeting projects also do not
normally provide constant cash flows.
In order to deal with uneven payment streams, we have to mu ltiply
each payment by the appropriate PVIF and then sum these products to
obtain the present value of an uneven series of payments.
Illustration 5:
Mr Shah has invested Rs. 50,000 on Xerox machine on 1stJan. 2002. He
estimates net cash income from Xerox machine in next 5 years as under.
At the end of 5thyear Machine will be sold at Scarp value of Rs.
5,000. Advice him whether his project to viable, considering interest rate
of 10% p.a.
Solution:
Calculation of Present Value of Future Cash Flows :
Note: It is assumed that the net cash income is received at the end of the
year.
Considering 10% interest rate, the net present value of all future
cash flows is Rs. 75,635 which is higher than present net cash flow of Rs.
50,000. Thus, the project is viable.
2.9 PRESENT VALUE OF ANNUITY:
Many times investors want to know the present value which must
be invested today in order to provide an annuity for se veral future periods.
For example, A grandfather wants to deposit enough money today to meet
the tuition fees of his grand -son for the next three years. The interest ratemunotes.in
Page 21
21is 8%. The present value of this annuity is the sum of the present values of
all the future inflow of the annuities. The present value of an annuity can
be expressed in the following formula:
11 1111 2 1 111
1PVA ARR RRt
RR t
Where PVA1 = Present value of an annuity with a duration of ‘t’ periods
A = Constant periodic flow
R = Interest Rate
The present value interest factors for an annuity (PVIF) can be
determined by using the Time Value of Money Tables. The (PVIF) for
various years are given below :
For all positive interest rates, PVIFA for the present value of an
Annuity is always less than the number of periods the annuity runs,
whereas FVIFA for the future value of an annuity is equal to or greater
than the number of periods.
Illustration 6:
What is the present value of a 4 years annuity of Rs.8,000 at 12%
interest?
Solution:111RtPVA ARR t
The value of111RtRR tas per table is 3.0373
= Rs. 8,000 x PVIF at 12%munotes.in
Page 22
22= Rs. 8,000 X 3.0373
= Rs. 24,298
2.10 NET PRESENT VALUE:
Net Present Value (NPV) is the most suitable method used for
evaluating the capital investment project s. Under this method, cash inflow
and outflows associated with each project are worked out. The present
value of cash inflows is calculated by discounting the cash flows at the
rate of return acceptable to the management. The cash outflows represent
the in vestment and commitments of cash in the project at various points of
time. It is generally determined on the basis of cost of capital suitably
adjusted to allow for the risk element involved in the project. The working
capital is taken as a cash outflow in the initial year. The cash inflow
represents the net profit after tax but before depreciation. A depreciation is
a non -cash expenditure hence it is added back to the net profit after tax in
order to determine the cash inflows. The Net Present Value of cas h
inflows and the present value of cash outflows. If the NPV is positive the
project is accepted, and if it is negative, the project is rejected.
Discounted cash flow is an evaluation of the future net cash flows
generated by a project. This method cons iders the time value of money
concept and hence it is considered better for evaluation of investment
proposals. If these are mutually exclusive projects, this method is more
useful. The Net Present Value is determined as follows:
NPV = Present value of fu ture cash inflows –Present value of cash
outflows.
Illustration 7:
An investment of Rs. 40,000 made on 1/4/2002 provides inflows as
follows:
Which alternative would you prefer in the investor’ s expected
return is 10%? Give reason(s) for your preference.
Solutionmunotes.in
Page 23
23Calculation of Present Values:
Alternative I
Alternative II
The net present value of all fu ture cash flows is Rs. 40,789 in case
of ‘alternative I’ and Rs. 39,962 in case of ‘alternative II’. The NPV in
case of ‘alternative I’ is higher at 10% discounting factor. Hence,
‘alternative I’ is preferred for investment.
Illustration 8:
A Finance c ompany has introduced a scheme of investment of Rs.
40,000. The returns would be Rs. 8,000, Rs. 10,000, Rs. 11,000 and Rs.
12,000 in the next five years. The indicated rate of interest is 10%
Compute the present value of the investment and advise regard ing the
investment.
Solution:
i)Present value of investment = Rs. 40,000.
ii)Present value of returns:munotes.in
Page 24
24
iii)Present value of investment is Rs. 37,188 which is lower than
investment of Rs. 40,000. The net p resent value (i.e. 37,188 -40,000 = Rs.
2,812) is negative. Hence the investment is not profitable at 10% interest.
Illustration 9:
The share of Ridhi Ltd (F.V. of Rs. 10) was quoted at Rs. 102 on
01.04.2002 and the price rose to Rs. 132 on 01.04.2005. Dividends were
received at 10% on 30thJune each year. Cost of funds was 10%. Is it a
worth -while investment, considering the time value of money? (Present
value factor at 10% were 0.909, 0.826 and 0.751)
Solution
Calculation of Present Value of Cash inflows:
Considering the time value of money, the NPV is negative, hence,
it is not a wise investment.
Illustration 10:
XYZ & Co. is considering investing in a project requiring a capital
outlay of Rs. 2,00,000. Forecast for annual income after tax is as follows:munotes.in
Page 25
25
Evaluate the project on the basis of Net Present Value taking 14%
discounting factor and advise whether XYZ & Co. should invest in the
project or not ? The Present value of Re. 1 at 14% discounting rate are
0.8772, 0.7695, 0.6750 , 0.5921 and 0.5194.
Depreciation = 20% of 2,00,000 = Rs. 40,000
Profit after tax is given.
The cash inflow after tax (CFAT) = Profit After Tax (PAT +
Depreciation.
Net Present Value is positive; hence X YZ & Co should invest in
the project.
Illustration 11:
Find out the present value of a debenture from the following :
Face value of debenture Rs. 1,000
Annual Interest Rate 15%
Expected return 12%
Maturity Period 5y e a r s
(Present values of Re. 1 at 12% are, 0.8929, 0.7972, 0.7118, 0.6355 and
0.5674)
Solution
PV =I( P V A F )+F( D F )
=I(PVAF 12% for 5 years) + F (DF 12% for 5 years)munotes.in
Page 26
26=150 (3,6048) + 1,000 (0.5674)
=Rs. 540.72 + 567.40
=Rs. 1108.12
Illustration 1 2:
Mr Vishwanathan is planning to buy a machine which would
generate cash flow as follows:
If discount rate is 10%, is it worth to invest in machine?
Solution:
Calculation of Net Present Value
As the NPV is positive, it is worth investing in the machine.
Illustration 13:
A machine cost Rs. 80,000 and is expected to produce the
following cash flows:
If the cost of capital is 12 percent, is it worth buying the machine?munotes.in
Page 27
27Solution:
Calculation of Net Present Value
As the Net Present Value is negative, it is not worth buying the
machine.
Illustration 14:
Find the compounded value of annuity where three equal yearly
payments of Rs.2000 are deposited into an account that yields 7%
compound interest.
Solution
The fu ture value of annuity FVa = A11RtR=Rs. 2,000 (FVAFA @ 7% for 3
years)
=Rs. 2,000 x 3.215
=Rs. 6,430
Illustration 15:
Calculate the compound value when Rs. 10,000 are invested for 3 years
and the interest on it is compounded at 10% p.a. semi annually.
FV = PV x CF
FV = PV x (1 + R)t
=10,000 X1012 32
=10,000 (1.05) 6
=Rs. 10,000 x 1.340
=Rs. 13,400munotes.in
Page 28
282.11 MATHEMATICAL TABLES
Tale A -1Present Value of Re. 1:
11PVIFKn
munotes.in
Page 29
29Table A -1 (continued)
munotes.in
Page 30
30Table A -2Present Value of an Annuity of Re. 1 per period for n periods.
11
111kkn
PVIFk
munotes.in
Page 31
31Table A -2 (continued)
munotes.in
Page 32
32Table A -3 Future Value of Re. 1 at the end of n Periods.
PVIF = (1 + k) n
munotes.in
Page 33
33Table A -3 (continued)
Table A -4Sum of an Annuity of Re. 1 per period of n Periods :munotes.in
Page 34
34111
1n n
k tkPVIFAk
Table A -4 (continued)munotes.in
Page 35
35
2.13 BONDS VALUATION
What is Bond?
Bonds are financial instrument which represents the borrowings of
the issuing authority and pays a fixed amount of interest at a rate specified
at the time of issue. From an investors point of view it is a fixed return
earning instruments.
Terms related t o Bondsmunotes.in
Page 36
36a.Principal Value or Face Value: It is the nominal or principal value
of the Bond. It is the price printed on the face of the Bonds issued by
the company.
b.Interest rate or Coupon rate: A coupon rate is the specific interest
rate which is paid at spec ific intervals to the bond holders.
c.Maturity Period: It the total time period for which a bond is issued.
d.Net Proceeds: It is the total amount of funds raised by the company
by the issue of the bonds.
e.Redemption: It is the repayment of the amount to the bo nd holders at
the time of maturity.
f.Redemption Value: It is the total amount that is paid to the holders
of the bond at the time of maturity.
Valuation of Bonds:
The bond is to be valued based on the present value of the
expected cash inflows from such bonds in the form of Principal amount
repayment and interest received over the life time of the bonds.
V = I (PVIFA r, n) + P (PVIF r, n)
Where,
V=value of the bond
I=Annual interest payable on the bond
P=Principal amount of the bond repayable at the time of maturity (at
Par/Premium/Discount)
r=Discount rate or expected rate of return
n=maturity period of the bond.
PVIFA = Present Value Annuity F actor
PVIF = Present Value Interest Factor
Alternatively one can use table to find the value of the Bonds:
Statement showing Valuation of Bond
A B C=AxB
Year (n) Cash Inflow DF @ r%
1 XX (I) X XXX
2 XX (I) X XXX
3 XX (I) X XXX
4 XX (I) X XXX
5 XX (P + I) X XXX
Value of the Bond (Sum of Column ‘C’) XXX
I = Annual interest payable on the bondmunotes.in
Page 37
37P = Principal amount of the bond repayable at the time of maturity (at
Par/Premium/Discount)
r = Discount rate or expected rate of return
n = maturity period of the bond.
Illustration 1:
A bond having par value of ₹100 bears a coupon rate of 14% and
has maturity period of 5 years. The required rate of return on the bond is
12%. What should be the value of the bond?
What will be the answer if the required rate of return if?
a. 12%
b. 14%
b. 16%
Solution:
a. V = I (PVIFA r, n) + P (PVIF r, n)
V = 14(3.6048) +100(0.5674)
V = 50.47 + 56.74
V = 107.21
OR
a.
Year Cash Inflow DF @ 12%
1 14 0.8929 12.50
2 14 0.7972 11.16
3 14 0.7118 9.97
4 14 0.6355 8.90
5 114 (100 + 14) 0.5674 64.68
Value of the Bond 107.21
b. V = I (PVIFA r, n) + P (PVIF r, n)
V = 14(3.4332) +100(0.5194)
V = 48.06 + 51.94
V = 100.00
OR
b.
Year Cash Inflow DF @ 14%
1 14 0.8772 12.28
2 14 0.7695 10.77
3 14 0.6750 9.45
4 14 0.5921 8.29
5 114 (100 + 14) 0.5194 59.21
Value of the Bond 100.00
c. V = I (PVIFA r, n) + P (PVIF r, n)munotes.in
Page 38
38V = 14(3.2744) + 100(0.5194)
V = 45.84 + 47.61
V = 93.45
OR
c.
Year Cash Inflow DF @ 16%
1 14 0.8621 12.07
2 14 0.7432 10.40
3 14 0.6407 8.97
4 14 0.5523 7.73
5 114 (100 + 14) 0.4761 54.28
Value of the Bond 93.45
Illustration 2:
Lion Ltd. has issued a debenture with face value of Rs.100 bearing
coupon @ 10% p.a. maturing after 6 years at par. The expected rate of
return of investor is 15%. Should investor buy the debentures if the current
market price of debenture is Rs.85? (TYBAF, May 2016 (Adapted))
Solution:
Statement showing Valuation of Bond:
Year Cash Inflow DF @ 15% Amount
1 10 0.8696 8.70
2 10 0.7561 7.56
3 10 0.6575 6.58
4 10 0.5718 5.72
5 10 0.4972 4.97
6 110 (100 + 10) 0.4323 47.55
Value of the Debentures 81.08
The value of the Bond is 81.08 and it is priced at Rs.85 in the
market, so it is overpriced and therefore the investor is advised not to buy
the debentures .
Illustration 3
Darshan Ltd. wants to issue debentures redeemable after 7 years at
a premium of 10%. Face value of debentures is Rs.1,000. The company
proposes to issue so as to yield a return of 12% p.a. to the investor. The
coupon rate for the first three years will be 13% p.a. which will be
increased by 2% p.a. for the remaining life. As CFO of the company
advice the issue price of the debenture. (TYBA F, Nov 2016)
Solution:munotes.in
Page 39
39Statement showing Valuation of Bond
Year Cash Inflow DF @ 12%
1 130 0.8929 116.08
2 130 0.7972 103.64
3 130 0.7118 92.53
4 150 0.6355 95.33
5 150 0.5674 85.11
6 150 0.5066 75.99
7 1,250 (1,100 + 150) 0.4523 565.38
Value of the Bond 1,134.05
Redemption at Premium: 1,000 + 100 (1,000 x 10% Premium.)
Kindly Note:
1. When the interest is fluctuating, we should use Table based format.
Illustration 4:
Sanjana Ltd. has issued bonds with face value of Rs. 1,000
bearing interest @ 24% p.a. payable half yearly maturing after 5 years at
par. The expected rate of return o f an investor is 12%. Should the investor
buy the bonds if the current price of bond listed in the market is Rs.
1,000? (Adapted TYBAF Nov. 2016).
Solution:
Statement showing Valuation of Bond
Year Cash Inflow DF @ 6**%
1 120* 0.9434 113.21
2 120 0.8900 106.80
3 120 0.8396 100.75
4 120 0.7921 95.05
5 120 0.7473 89.68
6 120 0.7050 84.60
7 120 0.6651 79.81
8 120 0.6274 75.29
9 120 0.5919 71.03
10 1,120 (1,000 + 120) 0.5584 625.41
Value of the Bond 1,441.62
* Coupon Rate: 24% p.a. therefore 12% for 6 months
** Interest Rate: DF @ 12% p.a.
Illustration 5:munotes.in
Page 40
40Credit unlimited Ltd. has issued fully convertible bonds with face
value of Rs. 100 with coupon rate of 16% p.a. which will convert in 10
equity shares of Rs.10 each at the end of 6 years. Find out the value of
debentures if the expected rate of return of an investor is 20% p.a. and
expected market price of one share after 6 years is Rs.28.50. Interest on
debentures will be paid on half yearly basis. (TYBAF Nov. 2016)
Solution:
Statement showing Valuation of Bond
Year Cash Inflow DF @ 10%
1 8 0.9091 7.27
2 8 0.8264 6.61
3 8 0.7513 6.01
4 8 0.6830 5.46
5 8 0.6209 4.97
6 8 0.5645 4.52
7 8 0.5132 4.11
8 8 0.4665 3.73
9 8 0.4241 3.39
10 8 0.3855 3.08
11 8 0.3505 2.80
12 293* 0.3186 93.35
Value of the Bond 145.31
*Cash Inflow in Last Year = (10 Shares x Rs.28.50(Converted Value of
Debentures + 8)
Yield to Maturity:
Yield to Maturity (YTM) (alternatively referred as redemption or
book yield )is the speculative rate of return or inte rest rate of a fixed -rate
security, such as a bond . The YTM is based on the belief or understanding
that an investor purchases the security at the current market price and
holds it until the security has matured (reached its full value), and that all
interest and coupon payments are made in a timely fashi on. In simple
words ‘Yield to Maturity’ is the rate of return, mostly annualised, that an
investor can expect to earn if they hold the bond till maturity.
Where,
I = Interest
R.V. = Redemption Value
N.P. = Net Proc eeds/Market Value
n = no of years/periods
Illustration 1:munotes.in
Page 41
41Cairo Ltd.’s bond with a par value of Rs.500 is currently traded at
Rs.435. The coupon rate is 12% and it has a maturity period of 7 years.
What is yield to maturity?
Solution:
YTM =
YTM = 14.82%
Illustration 2:
What is YTM of each bond? Which bond will you recommend for
investment?
Bond Coupon Rate Maturity Price/ ₹100 Par Value
Bond X 11% 10 years Rs.76
Bond Y 12% 7y e a r s Rs.69
(TYBAF Nov. 2019)
Bond X Bond Y
.. .... . 1 0 0.. ..
2RV N PInterestnYTMRV N P 100 761110100100 76
2
13.41008815.23
100 69127100100 69
2
16.4310084.519.44%
Duration of Bond
The concept of duration is straightforward. Duration is nothing but
the average time taken by an investor to collect his/her investment. If an
investor receives a part of his/her investment over the time on specific
intervals before maturity, the investmen t will offer him the duration which
would be lesser than the maturity of the instrument. Higher the coupon
rate, lesser would be the duration.
It measures how quickly a bond will repay its true cost. The longer
the time it takes the greater exposure the b ond has to changes in the
interest rate environment.
Illustration 3:munotes.in
Page 42
42Calculate the duration of Bond from the following details.
Face Value = Rs. 1,000
Coupon Rate (payable annually) = 13 %
Years to Maturity = 5 years
Redemption value = Rs. 1,000
Current Market Price = Rs. 1036
Yield to Maturity = 12% (TYBAF. Apr. 2019).
Statement showing calculation of Duration of Bond
1 2 3 4=2x3 5=1x4
Year Interest @ 13%YTM @
12%PVCFYear x
PVCF
1 130 0.8929 116.08 116.08
2 130 0.7972 103.64 207.28
3 130 0.7118 92.53 277.59
4 130 0.6355 82.62 330.48
5 1130 0.5674 641.16 3,205.80
1,036.03 4,137.23
Duration of Bond = ∑Year x PVCF
∑PVCF
= 4,137.23
1,036.03
Duration of Bond = 3.99 Years
Illustration 4:
The following data is available for a bond. Face value is Rs. 100,
Coupon rate is 14%, years to maturity is 5 years, and redemption value is
Rs. 100. YTM is l5%. Calculate duration of bond.
(TYBAF, Nov. 2019)
Statement showing calculation of Duration of Bond
1 2 3 4=2x3 5=1x4
Year Interest @ 14% DF @ 15% PVCFYear x
PVCF
1 14 0.8696 12.17 12.17
2 14 0.7561 10.59 21.17
3 14 0.6575 9.21 27.62
4 14 0.5718 8.01 32.02
5 114 0.4972 56.68 283.40
96.65 376.39munotes.in
Page 43
43Duration of Bond =∑Year x
PVCF
∑PVCF
376.39
96.65
Duration of Bond = 3.89 Years
2.13 EXERCISES
1.What do you understand by time value of money?
2.What are the possible reasons that must have time value despite not
being put to use?
3.What do you understand by future value and present value of money?
4.What are annuities? And why such values are calculated/
5.How do you determine the equated monthly installments?
1)Indicate the right answer with your reasoning:
a)Which provides money its time value?
i)Investment
ii)Interest Rates
iii)Market Rates
iv)Call Rates
b)In approximately, how many year s would you expect to double
your money at 8% per annum?
i)8y e a r s
ii)12 years
iii)9y e a r s
iv)10 years
c)When payments are made at the end of each year, it is known as
________ annuity.
i)Annuity due
ii)Ordinary annuity
iii)Perpetuity
iv)Fixed annuity
d)When compounding is done more frequently than annually, the
effective rate of interest is ___________.
i)greater than the nominal rate of interest.
ii)lower than the normal rate of interest.
iii)equal to nominal rate of interest.
v)normal
Hint (Ans (a) –ii, (b) –iii, (c) –ii (d) –i)
2)Ramesh deposited Rs. 2,000 for 3 years period at 12% interest which
is credited at the end of every six months. What will be the total
amount credited t o Ramesh’s Account at the end of 3 years?munotes.in
Page 44
443)Mohan plan to send his son for higher studies in America after 5 years.
He expects the cost of the study to be Rs. 4,00,000. How much should
he save annually to have a sum of Rs. 4,00,000 at the end of 5 years .I f
the interest rate is 9%
4)A bank promises to give you Rs. 5,000 after 10 years in exchange of
Rs. 2,000 today. What is the interest rate involved in this offer?
5)Mukesh deposits Rs. 2,00,000 in Saraswati Co -op Bank which pays 10
per cent intere st. How much he withdraw annually for a period of 15
years?
6)Avinash wants to invest @ 8% p.a. compound interest, such amount as
will amount to Rs. 50,000 at the end of three years. How much should
he invest? (Ans. 39,642)
7)A company has advertised for deposits from the public. If you deposit
₹1,000 now, you would receive Rs. 1,464 at the end of 4 years or Rs.
1,611 at the end of 5 years. What rates of interest is the company
paying? (Ans. 10%)
8)Four equal annual payments of Rs. 4000 are made into a deposit
account that pays and per cent interest per year. What would be the
future value of this annuity at the end of 6 years?
(Ans. Rs. 29,342)
9)You can save Rs. 20,000 a year for 5 years and Rs. 9,000 and Rs.
3,000 a year for 10 years thereafter. What will these saving cumulate
to al the end of 15 years if the rate of interest is 10 percent? (Ans.
1,69,913)
10)What is the present value of the following ca sh stream if the discount
rate is 12%?
(Ans. Rs. 31,479)
11)Find out the present value of debenture from the following:
Face Value of debentures Rs. 1000
Annual interest rate 12%
Expected Return 10%
Maturity pe riod 5 years
12)A Bank advertise that it will pay a lump sum of Rs. 45,740 at the end
of 8 years to the investors who deposit annually Rs. 4,000 for 8 years
what is the interest rate bank is paying?
munotes.in
Page 45
453
LEVERAGES
Unit Structure :
3.0 Objectives
3.1 Introduction
3.2 Meaning of Leverage
3.3 Types of Leverages
3.4 Significance of Leverages
3.5 Exercises
3.0 OBJECTIVES
After studying the unit the students will:
The meaning of leverage
Business risk & financial risk
Sources of financing
Type s of leverages
Importance of leverages
3.1 INTRODUCTION:
A company can raise funds required for investment either by
increasing the owners’ claims or creditors’ claims. The claims of the
owners increase when a company raises funds by issuing equity shares.
The claims of the creditors increase when the funds are raised by
borrowings. Thus, the various means used to raise the funds represent the
capital structure o f the company. The capital structure decision is of great
importance for the management because it influences the debt -equity mix
of the company which affects the shareholders’ return and risk. If the
borrowed funds are more in the capital structure of a c ompany, it results in
an increase in shareholders’ earnings together with increase in their risk. It
is because the cost of borrowed funds is less than that of the shareholders’.
The costs on account of borrowed funds are allowable as a deduction for
incom e-tax purpose. However, the borrowed funds carry a fixed rate of
interest which has to be paid whether the company is earning profit or not.
Thus, the risk of the shareholders increases in case there are a high
proportion of borrowed funds in the total cap ital of a company. If the
proportion of the shareholders’ funds is more than the proportion of the
borrowed capital, the return as well as the risk of the shareholders will be
less. The effect of financing or debt -equity mix on the shareholder’s
earnings a nd risk can be examined by using the concept of leverage.munotes.in
Page 46
463.2 MEANING OF LEVERAGE:
The term leverage refers to a relationship between two interrelated
variables. It represents the influence of one financial variable over some
other related financial var iable. Leverage is used to describe the firm’s
ability to use fixed cost assets or funds to magnify the return to its owners.
James Horne defined Leverage as “the employment of an asset or
funds for which the firm pays a fixed cost or fixed return.” Lev erage
results when a firm employs an asset or source of funds which has a fixed
cost. There will be no leverage, if a firm is not required to pay a fixed cost.
The fixed cost or return has to be paid or incurred irrespective of the
volume of output or sale s, the size of such cost or return has considerable
influence on the amount of profits available for the shareholders. When
the volume of sales changes leverage helps in quantifying such influence.
Thus, leverage can be defined as “relative change in profi ts due to a
change in sales.” A high degree of leverage means large change in profits
due to a relatively small change in sales. Thus, higher the leverage, higher
is the risk and higher is the expected return.
3.3 TYPES OF LEVERAGE:
There are three com monly used measures of leverage in financial
analysis. These are as follows:
3.3.1 OPERATING LEVERAGE:
The operating leverage is defined as the employment of an asset
with a fixed cost in the hope that sufficient revenue may be generated to
cover all th e fixed and variable costs. It can also be defined as “the
tendency of the operating profit to vary disproportionately with sales.” It
exists when the firm has to pay fixed cost regardless of volume of output
or sales. Thus, operating leverage is a functio n of three factors:
i)Fixed amount of cost.
ii)Variable contribution margin.
iii)Volume of sales.
The operating leverage can be calculated by using the following
formula:ContributionOperating leverage =Operating profitC=EBIT
Contribution = Sales -Variable Cost.
Operating profit means Earnings before Interest and Taxes (EBIT).
Operating leverage is the ratio of net operating income before fixed
charges to net operating income after fixed charges.munotes.in
Page 47
47Degree of Operating Levera ge:
The degree of operating leverage may be defined as a percentage
change in the profits resulting from a percentage change in the sales. It can
be put in the form of a formula as follows:Percentage change in net operating incomeDOL =Percentage change in sales
Operating leverage is directly proportional to business risk. It
indicates the impact of change in sales on operating income. If a firm has a
high degree of operating leverage a small change in sales will have a large
effect on operating incom e. The operating profits of such a firm will
increase at a faster rate than the increase in sales. Similarly, the operating
profits of such a firm will suffer a greater loss as compared to reduction in
its sales. Generally, the firms should not operate und er conditions of a
high degree of operating leverage because it is a very risky situation where
a small decline in sales will affect its profits.
Illustration 1:
A company produces and sells 10,000 calculators. The selling
price per calculator is Rs. 50 0. Variable cost per calculator is Rs. 200 and
fixed operating cost is Rs. 20, 00,000. You are required to calculate:
a)Operating leverage.
b)If sales are up by 10%, what is its impact on EBIT?
Solution:
a)Statement of Profitability:
ContributionOperating leverage OL =EBIT
30,00,000== 3 T i m e s10,00,000
b)If sales are up by 10%:
%Δ in EBITOL =%Δ insales31030%XX
munotes.in
Page 48
48Thus, if sales are up by 10% the EBI T will increase by 30% (10
x3) which is checked as follows:
3,00,000Increase in EBIT = 10010,00,000
3.3.2 FINANCIAL LEVERAGE:
The financial leverage can be defined as “the tende ncy of the
residual net income to vary disproportionately with operating profit. It
may also be defined as the use of funds with a fixed cost in order to
increase earnings per share of the company.” The financial leverage
indicates the change that takes pl ace in the taxable income as a result of
change in the operating income. It signifies the existence of fixed interest
bearing securities in the capital structure of the company. Financial
leverage induces the use of funds obtained at a fixed cost in the ho pe of
increasing the return to he equity shareholders. The financial leverage can
be computed using the following formula:EBITFinancial leverage =EBT
Where, EBIT is the Earnings before Interest and Taxes.
EBT is the Earnings before Tax.
Degree of Financial Leverage (DFL) is the ratio of the percentage
change in earning before tax to the percentage increase in operating profit
i.e. EBIT. This can be put in the following formula:Percentage change in taxable incomeDFL =Percentage change in the operating income
According to Gitman, “financial leverage is the ability of a firm to
use fixed financial charges to magnify the effects of changes in EBIT on
the company’s earning per share.” Thus, the financial leverage ind icates
the percentage change in earning per share in relation to a percentage
change in EBIT. Accordingly, the degree of financial leverage can be
calculated as per the following formula:Percentage change in EPSDFL =Percentage change EBITmunotes.in
Page 49
49There will be no financial leverage if the result of the above
equation is less than 1.
Financial leverage is also termed as ‘Trading on Equity’. The
concept of trading on equity states that the company uses equity capital as
well as borrowed capital while deciding its capital structure. The objective
of the term trading on equity is to provide a higher return to the
shareholders of the company. However, trading on equity should b e used
for the term financial leverage only when the financial leverage is
favourable. The financial leverage has potentiality of increasing the return
to equity shareholders but at the same time it cerates additional risk for the
shareholders also.
Illustration 2:
Z Ltd. has given the following details:
It has borrowed Rs. 10,00,000 @ 15% p.a. and its equity share
capital is Rs.10,00,000
You are required to calculate:
a)Operating leverage.
b)Financial l everage.
Solution:
a)Income Statement:
ContributionOperating leverage OL =EBIT
24,00,000=12,00,000=2 Times
munotes.in
Page 50
50b)EBITFinancial leverage =EBT
12,00,000=10,50,000
1.14Times
3.3.3 COMBINED LEVERAGE:
Combined leverage expresses the relationship between revenue on
account of sales and the taxable income. It may be defined as “the
potential use of fixed costs, both operati ng and financial which magnifies
the effect of sales volume on the earnings per share of a company.” Thus,
degree of combined leverage is the ratio of percentage change in earning
per share to the percentage change in sales. It indicates the effect of the
change in sales on earning per share.
Operating leverage and financial leverage are closely concerned
with the firm’s capacity to meet its fixed costs, both opera ting and
financial. If both the leverages are combined, the result obtained will
disclose the effect of change in sales over change in taxable profit.
Combined leverage can also be called as composite leverage. It helps to
find out the resulting change in taxable income due to change in sales. The
following formula can be used to find out combined leverage:
Combined leverage = Operating Leverage x Financial Leverage =Contribution EBIT=EBIT EBTContribution=EBT
The degree o f combined leverage can also be calculated as follows:Percentage change in EPSDCL =Percentage change in sales
Degree of combined leverage indicates the effect of change in sales
on the earning per share.
Illustration 3:
The Income Statement of CRL Ltd. is given below: You are
required to calculate
a)Operating leverage,
b)Financial leverage, and
c)Combined leverage.
Income Statement for the year ended 31 -12-2008munotes.in
Page 51
51
Solution:
Income Statement for the year ended 31 -12-2008
a)Operating LeverageContribution=EBT6,00,000=5,00,0001.2 Timesb)Financial Leverage =EBITEBT5,00,0003,60,0001.39 Timesc)Combined LeverageContribution=OL FL=EBT6,00,0001.2 1.393,60,0001.673.4 SIGNIFICANCE OF LEVERAGE:
Leverages are the tools used by the financial experts to measure
the return to the owner s. The financial leverage is considered to be
superior of these tools. Financial leverage focuses the attention on themunotes.in
Page 52
52market price of the share. The management of a company always tries to
increase the market price of the shares by increasing the net wort h of the
company. Therefore, the management resorts to trading on equity in order
to increase EBIT and then the corresponding increase in the price of the
equity shares.
A company has to keep the balance between the two leverages
because they have got t remendous effect on EBIT and EPS. A right
combination between the two leverages is a very big challenge for the
company managements. A proper combination of both operating and
financial leverages is a blessing for the company’s growth. However, an
improper combination may prove to be a curse. Financial or operating
leverages exist only when the result of the calculation is more than one.
A high degree of operating leverage together with a high degree of
financial leverage makes the position of the compan y very risky. In this
case, a company employs excessively assets for which it has to pay fixed
costs and at the same time it uses a large amount of debt capital. The fixed
costs for using assets and fixed interest charges bring a greater risk to the
compan y. If the earnings fail, the company may not be in a position to
meet its fixed costs. Greater fluctuations in earnings are likely to occur on
account of the existence of a high degree of operating leverage. The
existence of high degree of operating levera ge will result in a more than
proportionate change in operating profits even on account of small change
in sales. The presence of a high degree of financial leverage causes more
than proportionate changes in EPS even on account of a small change in
EBIT. T hus, a company having a high degree of financial leverage and a
high degree of operating leverage has to face the problems of inadequate
liquidity or even insolvency in one or the other way. However, lower
leverages indicate the cautious policy of the mana gement but the firm may
be losing many profit -earning opportunities. Therefore, a company should
make all possible efforts to combine the operating and financial leverage
in a way that suits the risk -bearing capacity of the company. Thus, a
company with hi gh operating leverage should have low financial leverage
so that the combined leverage may be ideal. Similarly, a company having
a low operating leverage will stand to gain by having a high financial
leverage provided it has enough profitable opportunities for the
employment of borrowed funds. Low operating leverage and a low
financial leverage is considered to be an ideal situation for the
maximization of the profits with minimum of risk.
3.5 SOLVED PROBLEMS
Illustration 4:
‘B’Ltd. has the following balance sheet and income statement:munotes.in
Page 53
53Balance Sheet as on 31 -3-2009
Income statement for the year ended 31 -3-2009
Required:
a)Determine the degree of operating, financial and combined leverages
at the current sales level, if all operating expenses other than depreciation
are variable costs.
b)If total assets remain at the same level, but sales:
i)increase by 20 per cent and
ii)decrease by 20 per cent.
iii)What will be the earnings per share at the new sales levels?
Solution:
a)
Income Statementmunotes.in
Page 54
54
i)Operating leverageContribution=EBIT5,00,0004,40,0001.14 Timesii)Financial leverageEBIT=EBT4,40,0003,40,0001.29 Timesiii)Combined leverage = OL x FL
= 1.14 x1.29
= 1.47
Alternatively (CL)C=EBT5,00,0003,40,0001.47 Times
b)Earning per share at the new sales level:munotes.in
Page 55
55
Illustration 5:
Calculate the Operating Leverage, Financial Leverage and
Combined Leverage from the following data under situation I and II and
Financial Plan A and B:
Solution:munotes.in
Page 56
56a)Income statement:
Comments: Operating leverage under situation II is higher than situation
I. Financial leverage of plan A is higher than Situation II. Combined
leverage of Plan A is also higher in situation I. Hence, the financial
leverage is higher than operating leverage. Financial plan A is riskier in
both the situations.
Illustration 6:
The capital structure of Prakash Industries Ltd. consists of an
ordinary share capital of Rs. 10 lakhs (Rs . 10 each) and Rs. 10 lakh of
10% Debentures. Sales increased by 20% from 1,00,000 units to 1,20,000
units. The selling price is Rs. 10 per unit, variable cost amounts to Rs. 6
per unit and fixed expenses amount to Rs. 2,00,000. The income tax rate is
30%. You are required to calculate the following:
i)The degree of operating leverage.
ii)The degree of financial leverage.
iii)The percentage increase in earning per share at 1,00,000 units and
1,20,000 units.munotes.in
Page 57
57You are also required to comment on the behaviour of operating
and financial leverages in relation to increase in production from 1,00,000
units to 1,20,000 units.
Solution:
Income Statement
% increase in EPS = 1.26 –0.70 = 0.56
0.53100 80%0.704,00,000 4,80,000Operating leverage =2,00,000 2,80,00021 . 7 12,00,000 2,80,000Financial leverage =1,00,000 1,80,0002Times TimesTimes
1.56TimesComments: On account of increase in sales from 1 lakh units to 1,20,000
units, the EPS has increased by 80%. While the opera ting leverage has
come down from 2 times to 1.71 times and financial leverage has also
declined from 2 times to 1.56 times. There is a significant decrease in both
the business risk and the financial risk of the company on account of
reduction in both the leverages.
Illustration 7:munotes.in
Page 58
58A firm has sales of Rs. 75 lakhs, variable cost of Rs. 42 lakhs and
Fixed cost of Rs. 6 lakhs. It has a debt of Rs. 45 lakhs @ 9% and equity of
Rs. 55 lakhs.
i)What is the firms’s ROI?
ii)Does it have favourable financial leverage?
iii)If the firm belongs to an industry whose asset turnover is 3, does it
have a high or low asset leverage?
iv)What are the operating, financial and combined leverages of the
firm?
v)If the sales drop of Rs. 50 lakhs, what will be the EBIT?
vi)At what level of EBT of the firm will be equal to zero?
Solution:
Income Statement
1)Return of Investment (ROI)EBIT= 100Capital Employed
27,00,0001001,00,00,00027% 2)The return on investment at 27 % is higher than the interest payable on
debt at 9%. Thus, the firm has a favourable financial leverage.
3)Assets TurnoverNet Sales=Total Sales75,00,0001,00,00,0000.75The industry average is 3. Hence, the firm has a low asset average.munotes.in
Page 59
594)(i)Operating LeverageContribution=EBIT33,00,00027,00,0001.22 Timesii)Financial LeverageEBIT=EBT27,00,00022,95,0001.1764 Timesiii)Combined LeverageContribution=EBT33,00,00022,95,0001.438 Times5)If the sales drop to Rs. 50 lakhs, fr om Rs. 75 lakhs, the fall is by
33.33%. Hence, the EBIT will drop by 40.66 % (33.33 -1.22). Hence,
the new EBIT will be Rs. 27,00,000100 - 40.66%100 Rs. 16,02,180.
6)EBT to become zero means 100% reduction in EBT. The combined
leverage is 1.438. Hence, sales have to drop by 100/1.438 i.e. 69.54%.
The new sales will be Rs. 75,00,000100 - 69.54%100 Rs. 22,84,500.
Illustration 8:
Prepare income statements from the data given below for P, Q and
R companies:
munotes.in
Page 60
60Compute net profit (after tax) rate for all the three companies.
Offer your comments on the leverages a nd profitability position of all the
three companies.
Solution:
Income Statement
Comments:
1)Leverage
Combined leverage: 5 x4 = 20 4 x5 = 20 7 x6 = 42
Very high Very high Very very high
2)Profitability: Good Satisfactory Poor
3)Working: Calculation of sales for ‘P’
i)DFLEBIT 4=EBT 1Interest is Rs. 45,000EBIT –EBT = Rs. 45,0004E B T=E B I T4E B T –EBT = 45,0003 EBT = 45,000EBT45,000=. 1 5 , 0 0 03RsEBIT = 15,000 x 4 = Rs. 60,000munotes.in
Page 61
61ii)DOLContribution=EBIT5 Contribution=1 60,000Contribution 5 60,0003,00,000
iii)Variable cost as a percentage of sales = 50%
Contribution is Rs. 3,00,000Variable cost is also Rs. 3,00,000Sales = Rs. 6,00,000
Illustration 9:
From the following information available for four companies,
calculate:
i)EBIT
ii)EPS
iii)Operating leverage
iv)Financial leverage
(ICU A/Inter Dec.1996)munotes.in
Page 62
62Solution:
Income Statement
Illustration 10:
The Balance sheet of International Trade Ltd. as on 31stMarch,
2008 is as under:
munotes.in
Page 63
63The income assets turnover ratio of the company is 3, its fixed
operating cost is 1/6 of sales and variable operating cost is 50% of sales.
The corporate tax rate is 35%.
You are required to calculate:
a)The operating, financial and combined leverage s.
b)The market price of the share if the P/E multiple is 2.5.
c)The level of EBIT if the EPS is (a) Rs. 15 and (b) Rs. 25.
Solution:
Workings:
1)Total assets turnover is 3.Total Assets TurnoverNet Sales=Total assets
3Net Sales=300lakhsNet Sales = 3 x 300
= Rs. 900 lakhs.Fixed operating cost =19006lakhs
= Rs. 150 lakhsVariable operating cost = 50 % of Net sales
= 50 % of 900 lakhs
= Rs. 450 lakhs
2)
Income Statement
munotes.in
Page 64
64a)i)Operating leverageContribution=EBIT450=3001.5Timesii)Financial leverageEBIT=EBT300=2881.04Timesiii)Combined leverageContribution=EBT450=2881.56 1.5 1.04Times
b)Calculation of Market Price of the share
P/E RatioMarket Price=EPSMarket price= P/E Ratio xEPS
= 2.5 x20.78
= Rs. 51.95
c)Calculation of the level of EBIT if the EPS i s Rs. 15 and Rs. 25:
Income Statement for EPS:
EPS Rs. 15 Rs. 25No. of shares 9 lakhs 9 lakhsPAT 135 lakhs 225 lakhs
Tax @ 35% 72.69 121.15PBT 207.69 lakhs 346.15 lakhs
Interest 12.00 12.00EBIT 216.69 358.15
3.7 EXERCISES:
1)Choose the right answer with your reasoning:
a)The __________ is the percentage change in operating income that
results from a percentage change in sales:
i)Degree of operating leverage
ii)Degree of financial leverage
iii)Degree of combined leveragemunotes.in
Page 65
65b)A highly leveraged firm is __________ risky than its peers.
i)Less
ii)More
iii)Same
c)An advantage of Debt financing is ____________.
i)Lowers the cost of capital
ii)Increases the cost of capital
iii)Dilutes owners earnings
d)Combined leverage is the percentage change in relationship between
sales and ___________.
i) Operating income
ii) Operating leverage
iii) Earning per share
e)If interest expenses for a firm rise, we know that the firm has taken on
more __________.
i)Financial leverage
ii)Operating leverage
iii)Combined leverage
2)Define operating leverage and financial leverage. How these leverages
are measured?
3)What is combined leverage? Explain its significance in financial
planning of a firm.
4)A firm has sales of Rs. 75 lakhs variable cost of Rs. 42 lakhs and fixed
cost of Rs. 6 lakhs. It has a debt of Rs. 45 lakhs at 9% and equity of
Rs. 55 lakhs.
a)What is its ROI?
b)Does it have favourable financial leverage?
c)What are the operating, financial and combined leverages of the
firm?
d)If the sales drop to Rs. 50,00,000, what will be the new EBIT?
5)The Balance Sheet of a company is as under:
6)
Balance sheet as on 31.12.2008
munotes.in
Page 66
66The company’s total assets turnover is 3.00, its fixed operating
costs are Rs. 10,00,000 and variable operating costs ratio is 40%. The
income tax rate is 30%.
Calculate:
a)Operating, financial and combined leverages.
b)Determine the likely level of EBIT if EPS is (a) Rs. 10 (b) Rs. 30 and
(c) Rs. zero.
6)Calculate the degree of operating leverage degree of financial leverage
and degree of combined leverage for the follo wing companies and
interpret the results.
(7) Find out the financial leverage from the following:
8)A and B are two companies competing with each other. Their revenue
statements are given below:
With the help of leverages, comment on the business risks of the
two companies.munotes.in
Page 67
679)The following particulars relate to X and Co. Ltd.
Using the concept of combined leverage, by what percentage will
earnings per share increase, if sales increase by 10%? Verify your answer
by calculating earnings per share.
10)From the following data prepare income statement of A, B and C
companies.
munotes.in
Page 68
684
TYPES OF FINANCING
Unit Structure :
4.0 Objectives
4.1 Meaning of Finance
4.2 Need for Finance
4.2 Sources of Finance
4.3 Exercises
4.0 OBJECTIVES
After studying this unit you will understand:
Meaning of finance
Need and Importance of Finance
Sources of long term finance
Sources of short term finance
4.1 MEANING OF FINANCE
Finance is a broa d term that describes activities associated with
banking, leverage or debt, credit, capital markets, money, and
investments. Basically, finance represents money management and the
process of acquiring needed funds. Finance also encompasses the
oversight, c reation, and study of money, banking, credit, investments,
assets, and liabilities that make up financial systems. It is necessary to
raise finance from various sources for implementation of the project. The
schemes of finance will be determined after cons ideration of various
aspects attached to different sources of finance as following:
a)Share capital –preference shares and equity shares
b)Debentures
c)Term loan from financial institutions
d)Unsecured loan -banks, promoters, others.
4.1.1 Promoters Contribution
The persons who are involved in implementation of a project are
known as promoters .An entrepreneur who promotes the project is also
required to participate in the scheme of finance of the project. The extent
of promoter’s contribution in the project is a sign of interest of the
promoters in the project. Promoter’s contribution indicates the extent of
their involvement the in the project. The promoters contribution can bemunotes.in
Page 69
69provided in the form of subscribing to equity and preference shares issued
by the comp any unsecured loans ,seed capital assistance and internal
accrual of funds .The bank and financial institution normally participate in
the scheme of project finance and they ask the promoters to bring in a
certain portion of funds required which is normall y between 25% to 50%
of the cost of the project into the equity share capital of the company .The
promoters contribution can be arranged from outside sources like friends
and relatives. For eligibility of the project financing the financial
institution may stipulate minimum promoter’s contribution which is to be
arranged by the promoters.
4.1.2 Margin money
The banks and financial institutions maintain a margin while
financing the project cost. They asked the borrowers to bring a certain
amount of the cost of the project cost as margin money to safeguard from
the changes in the value of assets that are being financed and provided as
a security. The quantum of margin money to depend upon the
creditworthiness of the borrower and nature of security provided to the
institution. Margin money is one of the important factors which are
evaluated by the financial institutions while considering the project for
financial assistance. The margin money required for working capital will
be provided in the project cost .The RBI guidelines provide the amount of
capital brought by the promoters in project financing.
4.1.3 Capital Structure
Capital structure refers to the mix of a firm’s capitalization and
includes long -term source of fund such as debentures, preference shares,
equity share, and retained earnings. The decision regarding the forms of
financing their requirements and their relative proportions in total
capitalization are known as capital structure decision. A firm has the
choice t o raise capital for financing its project from different sources in
different proportions as follows:
(a)exclusive use of equity capital
(b)Use of equity and preference capital
(c)Use of equity and debt capital
(d)Use of equity, preference and debt capital
(e)Use of a c ombination of debt, equity and preference capital in
different proportions.
The choice of combination of these sources is called capital
structure mix.
4.1.4 Optimum Capital Structure:
The theory of optimal capital structure deals with the issue of right
mix of debt and equity in the long term capital structure of a firm. This
theory states that if a company takes on debt the value ofthe firm
increases up to a point, beyond that point i f debt continues to increases
then the value of the firm will start to decrease. if the company is unable
to repay the debt within the specified period, then it will affect themunotes.in
Page 70
70goodwill of the company in the market . Therefore, the company should
select it s appropriate capital structure with due consideration to the factors
of debt and equity.
4.1.5 Trading on Equity
The term ‘trading on equity’ is derived from the fact that debts are
contracted and loans are raised mainly on the basis of equity capital. Th e
concept of trading on equity provides that the capital structure of a
company should include equity as well as debt. Again the proportion of
debt in the capital structure should also be optimal. Those who provide
debt have a limited share in the firm’s e arnings and hence want to be
protected in term of earning and values represented by equity capital.
Since fixed charges do not vary with the firm’s earnings before interest
and tax, a magnified effect is produced on earning per share. The
determination of optimal level of debt is a formidable task and is a major
policy decision .EBIT -EPS analysis is a widely used tool to determine the
level of debt in a firm.
4.2NEEDS AND IMPORTANCE OF FINANCE
What is the main purpose of business finance? or Wh y is finance so
important?
1. Establishment of Business Enterprises:
The promotion of any establishment or any type of enterprise
basically requires finance.
Finance is required at every stage of the business establishment
like
a. During registration of t he company,
b. At the incorporation stage,
c. For obtaining the certificate for starting the business and
d. also for obtaining various permissions
Besides, expenditure on these requirements, finance is required for
arranging the Assets such as working place, plant and machinery, and
furniture and equipment, for short term items like working material,
furnishing and salaries of the employees.
Thus, finance is required to complete the initial activities of the
business enterprise.
2.Proficient Operat ion of Business
Operations of business cannot be efficiently operated without
finance. The activities such as purchase of raw materials, sending of
products to the consumers, conversion of raw materials into finished
product and sale cannot be done without efficient finance.munotes.in
Page 71
713. Development and Expansion of Business
Finances are required for the overall development and extension of
all business activities in compatibility with advance technology. With
finances, various commodities can be upgraded with the p urchases or sold
or produced. Besides, finance (capital) is also required for the purchasing
of techniques, machinery, and equipment, the establishment of
Laboratories, etc.
4. Sound Business Position
Finance is an important measure by which the position o fa
business is measured i.e. whether it is strong or weak, Few examples of
business transactions like payments to the suppliers, remuneration and
facilities to the Employees and payment of principal amount and interest
can be paid to the lender within due date only when sufficient funds are
available.
5. Surviving in the Competition Era
One of the biggest threats to any business units are their
competitors. Performing with an aim to meet the expectations of the
customers and having edge over the competito rs requires finance. To gain
such edge one organisation has to look in many aspects. So there should
be proper policies and allocation of required funds towards relating
advertisement and publicity, production and distribution of commodities
and services, incentives to the consumers, sale promotion, providing
services and commodities at a fair price are required, to face present -day
competitors.
6. Infrastructural Facilities:
Finance is also required for arranging infrastructural facilities
which are essen tial for any business entrepreneurship. The volume of
finance required depends upon the nature of the business organisation i.e.
Proprietary business, may be high or low, according to the coverage of
various Enterprises. Substantial capital is required fo r all infrastructural
facilities, place, land, office site, plant installation for the establishment of
industries, place for conversion of raw materials into finished products,
water, electricity, telephone, etc.
7. Modernization of Business
In this era there dynamism and ever changing technologies, there
is always need for upgradation. Finances are required for technical know -
how, research and development, new techniques, new machinery, various
new products, and computerization, which are essential for t he
upgradation, modernization and operation of the business.
8. Labour Welfare and Social Security
For the success of any business or enterprise, human relations
between employers and workers should be cordial. In order to ensure the
same, entrepreneurs s hould essentially safeguard the interests of the
employees and workers. Employer should proper facilities like –that of
housing, primary treatment, health, education, libraries, and readingmunotes.in
Page 72
72rooms, travel, etc. In addition, they are also to be provided pro vident fund,
gratuity, pension, old age, personal or group insurance and accidental
insurance, etc. All these need a substantial volume of finance.
4.3 SOURCES OF FINANCE
The sources from which a business meets its financial
requirements can be clas sified on the basis of time, ownership and source
of generation as explained in Figure 4.1.
Figure 1
4.3.1 Long Term Sources of Finance
Long -term financing means capital requirements for a period of
more than 5 years to 10, 15 or 20 years or maybe more depending on other
factors. Capital expenditures in fixed assets like plant and machinery, land
and building etc. of a business are funded using long -term sources of
finance. Part of working capital which permanently stays with the
business is also financed with long -term sources of finance. Long term
financing sources can be in form of any of them:munotes.in
Page 73
73(a)Equity Shares.
(b)Preference Shares.
(c)Debentur es
(d)Bonds.
(e)Term Loans.
(f)Venture Funding
(g)Assets Securitization
(h)International Financing
(a)Equity Shares
Equity share is a main source of finance for any company giving
investors rights to vote, share profits and claim on assets. We call it stock,
ordinary share, or shares, all are one and the same. Normally, a company
is started with equity finance as its fi rst source of capital from the owners
or promoters of that company. The company then finds an investor in the
form of friends, relatives, venture capitalists, mutual funds, or any such
small group of investors and issue fresh equity shares to these investo rs.A
point comes where the company reaches a very big level and requires
huge capital investment for business growth. It then offers its equity share
to the general public. This is called Initial Public Offer (IPO). More such
issues in future are called F ollow -on Public Offer (FPO).
They are categorized under long -term sources of finance because
legally they are irredeemable in nature. For an investor, these shares are
certificate of ownership in the company by virtue of which investors are
entitled to sh are the net profits and have a residual claim over the assets of
the company in the event of liquidation. Investors have voting rights in the
company and their liability to the company is limited to the amount of
investment.
Types of Equity Shares
There a re various types of equity shares classified based on
various things:
iAuthorized Share Capital: It is the maximum amount of capital which
can be issued by a company. It can be increased from time to time.
Some fee is required to be paid to legal bodies acc ompanied with
some formalities.
iiIssued Share Capital: It is that part of authorized capital which is
offered to investors.
iiiSubscribed Share Capital: It is that part of Issued capital which is
accepted and agreed by the investor.
ivPaid Up Capital: It is the part of subscribed capital, the amount of
which is paid by the investor.
Normally, all companies accept complete money in one shot and
therefore issued, subscribed and paid capital becomes one and the same.
Conceptually, paid up capital is the amount of money which is actually
invested in the business.munotes.in
Page 74
74There are other types of equity shares discussed below:
iRights Share: These are the shares issued to the existing shareholders
of a company. Such kind of shares is issued to protect the owne rship
rights of the investors.
iiBonus Share: These are the type of shares given by the company to its
shareholders as a dividend. There are various advantages and
disadvantages of bonus shares like dividend, capital gain, limited
liability, high risk, fluct uation in the market, etc.
iiiSweat Equity Share: These shares are issued to an exceptional
employees or directors of the company for their exceptional job in
terms of providing know -how or intellectual property rights to the
company.
Various Prices of Equit y Shares
iPar or Face Value: It is the value of a share of which it is accounted in
books of accounts.
iiIssue Price: It is the price at which the equity share is actually offered
to the investor. Normally, the issue price and face value of a share are
same i n the case of new companies.
iiiShare Premium and Share at Discount: When a share is issued at a
price higher than face value, the excess amount is called premium.
Contrary to it, if the share is issued at a price lower than face value, it
is said to be issue d at a discount.
ivBook Value: It is the ratio of the total of paid -up capital and reserves
and surplus divided by total no. of shares. This is the balance sheet
value of shares.
vMarket Value: In the case of companies listed on stock exchanges, the
market va lue of the share is the price at which they are sold currently
sold in the market.
Investing and Financing Angle of Equity Shares
When talking about equity shares, there are two angles. One is an
investor’s angle wherein the investor invests in equity sha res and second
financing angle where a company accepts the finance in the form of
equity. There are pros and cons of both of these as described below.
ADVANTAGES
iDividend: An investor is entitled to receive a dividend from the
company. It is one of the tw o main sources of return on his
investment.
iiCapital Gain: The other source of return on investment apart from
dividend is the capital gains. Gains which arise due to rise in market
price of the share.
iiiLimited liability: Liability of shareholder or inves tor is limited to the
extent of the investment made. If the company goes into losses, the
share of loss over and above the capital investment would not be borne
by the investor.
ivExercise control: By investing in the company, the shareholder gets
ownership in the company and thereby he can exercise control.
vClaim over Assets and Income: An investor of equity share is themunotes.in
Page 75
75owner of the company and so is the owner of the assets of that
company. He also enjoys a share of the incomes of the company.
viRights Shares : Whenever companies require further capital for
expansion, growth, entering into new areas etc., they tend to issue
‘rights shares’. By issuing such shares, ownership and control of
existing shareholders are preserved and the investor receives
investment priority over other general investors.
viiBonus Shares: At times, companies decide to issue bonus shares to its
shareholders. It is also a type of dividend. Bonus shares are free shares
given to existing shareholders and many times they are given in lieu of
dividends.
viiiLiquidity: The shares of the company which is listed on stock
exchanges have the benefit of any time liquidity. The shares can very
easily transfer ownership.
ixStock Split: Stock split means splitting a share into parts. How should
an investor be benefited by this? By splitting of share, the per -share
price reduces in the market which eventually increases the readability
of share. At the end, stock split results in higher volumes with a
number of investors leading to high liquidity of the share.
Disadvantages
iDividend: The dividend which a shareholder receives is neither fixed
nor controllable by him. The management of the company decides
how much dividend should be given.
iiHigh Risk: Equity share investment is a risky share compared to any
other in vestment like debts etc. The money is invested based on the
faith an investor has in the company. There is no collateral security
attached with it.
iiiFluctuation in Market Price: The market price of any equity share has
a wide variation. It is always very di fficult to book profits from the
market. On the contrary, there are equal chances of losses.
ivLimited Control: An equity investor is a small investor in the
company, therefore, it is hardly possible to impact the decision of the
company using the voting rig hts.
vResidual Claim: An equity shareholder has a residual claim over both
the assets and the income. Income which is available to equity
shareholders is after the payment of all other stakeholders’ viz.
debenture holders etc.
(b) Preference shares:
Prefer ence Shares: Preference shares are one of the special types
of share capital having fixed rate of dividend and they carry preferential
rights over ordinary equity shares in sharing of profits and also claims
over assets of the firm. Preference shares are l ong-term source of finance
for a company. They are neither completely similar to equity nor
equivalent to debt. The law treats them as shares but they have elements
of both equity shares and debt. For this reason, they are also called ‘hybrid
financing ins truments’.munotes.in
Page 76
76Features of Preference Shares Similar to Debt
iFixed Dividends: Like debt carries a fixed interest rate, preference
shares have fixed dividends attached to them. But the obligation of
paying a dividend is not as rigid as debt. Non -payment of a dividend
would not amount to bankruptcy in case of preference share.
iiPreference over Equity: As the word preference suggests, these type
of shares get preference over equity shares in sharing the income as
well as claims on assets. Alternatively, pref erence share dividend has
to be paid before any dividend payment to ordinary equity shares.
Similarly, at the time of liquidation also, these shares would be paid
before equity shares.
iiiNo Voting Rights: Preference shares holders normally does not have
anyvoting rights. They are similar to debenture holders and do not
have any say in the management of the company.
ivNo Share in Earnings: Preference shareholders can only claim two
things. One agreed on percentage of dividend and second the amount
of capital in vested. Equity shares are entitled to share the residual
earnings and residual assets in case of liquidation which preference
shares are not entitled.
vFixed Maturity: Just like debt, preference shares also have fixed
maturity date. On the date of maturity, the preference capital will have
to be repaid to the preference shareholders. A special type of shares
i.e. irredeemable preference shares is an exception to this. They do not
have any fixed maturity.
Features of Preference Shares similar to Equity Share s:
iDividend from PAT: Equity share dividend is paid out of the profits
left after all expenses and even taxes and same is the case with
preference shares. The preference dividend is paid out of the divisible
profits of the company. Out of the divisible pro fits, the preference
dividend would be paid first and the remaining profits can be utilized
for paying any dividend to equity shareholders.
iiManagement Discretion over Dividend Payment: The payment of
preference dividend is not compulsory and is a decision of the
management. Equity shareholders also do not have any right to ask for
dividends, the dividends are paid at the discretion of the management
of the company. Unlike debt, the nonpayment of a dividend of
preference shares does not amount to bankruptcy.
iiiNo Fixed Maturity: The maturity of a special variant of preference
share is not fixed just like equity shares. This variant is popularly
known as irredeemable preference shares.
Types of Preference Shares
There are various Types of Preference Shares with differences in
their structure. Some of these are cumulative, non -cumulative,
participating, non -participating, redeemable, irredeemable, convertible,
non-convertible, callable, adjustable rate preference shares.
iConvertible and Non -Convertible Preferenc e Shares
Convertible preference shareholders possess an option or rightmunotes.in
Page 77
77whereby they can be converted into an ordinary equity share at some
agreed terms and conditions. Non -convertible simply does not have this
option but has all other normal characteristi cs of a preference share.
iiRedeemable and Irredeemable Preference Shares
Redeemable preference share is very commonly seen preference
share which has a maturity date on which date the company will repay the
capital amount to the preference shareholders and discontinue the
dividend payment thereon. Irredeemable preference shares are little
different from other types of preference shares. It does not have any
maturity date. However after introduction of Companies Act, 2013, no
irredeemable preference shares c an be issued and even the existing
irredeemable preference shares have to be redeemed.
iiiCumulative and Non -Cumulative Preference Shares
If the shares are cumulative preference shares, the dividends are
cumulated and therefore paid when the company makes th e profit. In
short, a dividend of cumulative preference shares will have to be paid as
long as the company earns the profit in any year. Whereas, for non -
cumulative preference shares, a company can skip the dividend in the
year, the company has incurred lo sses.
ivPreference Shares with Callable Options
These are another innovative preference shares in which the
company has an option to buy the share at a predetermined price and on or
before a certain date.
vAdjustable Rate Preference Shares
These are some of the innovative types of instruments where the
rate of dividend is not fixed and is formulated based on some calculations
relating to the current interest rates etc.
BENEFITS OF PREFERENCE SHARE
There are several benefits of a preference share from the po int of
view of a company which is discussed below:
iNo Legal Obligation for Dividend Payment: There is no legal
compulsion for payment of preference dividend. This dividend is not a
fixed liability like the interest on the debt which has to be paid in all
circumstances.
iiImproves Borrowing Capacity: Preference shares become a part of net
worth and therefore reduces debt to equity ratio. This is how the
overall borrowing capacity of the company increases.
iiiNo dilution in control: Issue of preference share does not lead to
dilution in control of existing equity shareholders because the voting
rights are not attached to the issue of preference share capital. The
preference shareholders invest their capital with fixed dividend
percentage but they do not get control rights with them.
ivNo Charge on Assets: While taking a term loan security needs to be
given to the financial institution in the form of primary security andmunotes.in
Page 78
78collateral security. There are no such requirements and therefore, the
company gets the required mo ney and the assets also remain free of
any kind of charge on them.
DISADVANTAGES OF PREFERENCE SHARES
iCostly Source of Finance: Preference shares are considered a very
costly source of finance which is apparently seen when they are
compared with debt as a source of finance. The interest on the debt is
at a x -deductible expense whereas the dividend of preference shares is
paid out of the divisible profits of the company i.e. profit after taxes
and all other expenses.
iiSkipping Dividend Disregard Market Image : Skipping of dividend
payment may not harm the company legally but it would always create
a dent on the image of the company.
iiiPreference in Claims: Preference shareholders enjoy a similar situation
like that of an equity shareholder but still gets a prefe rence in both
payment of their fixed dividend and claim on assets at the time of
liquidation.
(c) Debentures:
A debenture is a debt instrument used by the companies to raise
money for medium to long term at a specified rate of interest. It consists
of a w ritten contract specifying the repayment of the principal and the
interest payment at the fixed rate. Generally, a debenture is not secured by
any collateral and is only backed by the reputation of the issuer.
FEATURES / ATTRIBUTES OF DEBENTURES:
Trust In denture
It is an agreement which has to be entered into by the ‘Issuing
Company’ and the ‘Trust’ which is involved in taking care of the interest
of the general investors. Normally the trustee is a bank or a financial
institution who is appointed by a debe nture trust deed.
Coupon Rate
It is the rate of interest which is promised by the company to pay
to the debenture holder on a regular interval which may vary from case to
case. The rate of interest may be fixed or floating.
Tax Benefit
Most important ele ment from the company point of view is that
the interest paid is a tax deductible expense. Effectively, the company will
get the tax benefit because the taxable income will be reduced by the
extent of interest paid. Due to this, the effective cost of borro wing gets
reduced.
Date of Maturity
For all the debentures, the issuing company has to issue repayment
to the debenture holders on the date of maturity. This date is also
mentioned on the certificatesmunotes.in
Page 79
79Security
Here, we should classify debentures into two –secured debentures
and unsecured debentures. Secured debentures are secured by some or
other immovable assets of the company whereas the unsecured assets are
issued based on the general credit of the company. The general legal
prefere nce of debt is available to all types of debentures i.e. in the event of
liquidation debenture will stand prior to preference shares and ordinary
equity shares.
Convertibility
Certain types of debentures are issued with the option of
conversion into equity . The ratio of conversion and the time period after
which conversion will take place is mentioned in the agreement of
debenture. Debentures may be fully or partly convertible in nature.
Credit Rating
Normally, an investor would not go and check the credib ility and
the risk involved with the debentures. Credit rating agencies are given this
task and they rate the debentures and the overall company. Involving a
rating agency is compulsory for the issuing company normally in every
country.
A debenture is the primary source of long -term capital for
companies to fulfill their financial requirements. Other instruments to
raise long term capital are bank loans, bonds, and equity shares. Though
all these instruments are used widely in different combinations, they differ
from each other in many ways. The article clarifies how debenture is
different from the bank loan, equity shares, and bonds respectively.
Types of Debentures:
There are various types of debentures like redeemable,
irredeemable, perpetual, convert ible, non -convertible, fully, partly,
secured, mortgage, unsecured, naked, first mortgaged, second mortgaged,
the bearer, fixed, floating rate, coupon rate, zero coupon, secured
premium notes, callable, puttable, etc.
Redeemable and Irredeemable (Perpetu al) Debentures:
Redeemable debentures carry a specific date of redemption on the
certificate. The company is legally bound to repay the principal amount to
the debenture holders on that date. On the other hand, irredeemable
debentures, also known as perpet ual debentures, do not carry any date of
redemption. However after introduction of Companies Act, 2013, no
irredeemable debentures can be issued and even the existing irredeemable
debentures have to be redeemed.
Convertible and Non -Convertible Debentures
Convertible debenture holders have an option of converting their
holdings into equity shares. The rate of conversion and the period after
which the conversion will take effect are declared in the terms and
conditions of the agreement of debentures at the t ime of issue. On themunotes.in
Page 80
80contrary, non -convertible debentures are simple debentures with no such
option of getting converted into equity. Their state will always remain of a
debt and will not become equity at any point of time.
Fully and Partly Convertible De bentures
Convertible Debentures are further classified into two –Fully and
Partly Convertible. Fully convertible debentures are completely converted
into equity whereas the partly convertible debentures have two parts.
Convertible part is converted into e quity as per agreed rate of exchange
based on an agreement. Non -convertible part becomes as good as
redeemable debenture which is repaid after the expiry of the agreed
period.
Secured (Mortgage) and Unsecured (Naked) Debentures
Debentures are secured in t wo ways. One when the debenture is
secured by the charge on some asset or set of assets which is known as
secured or mortgage debenture and another when it is issued solely on the
credibility of the issuer is known as the naked or unsecured debenture. A
trustee is appointed for holding the secured asset which is quite obvious as
the title cannot be assigned to each and every debenture holder.
Registered Unregistered Debentures (Bearer) Debenture
In the case of registered debentures, the name, address, and other
holding details are registered with the issuing company and whenever
such debenture is transferred by the holder; it has to be informed to the
issuing company for updating in its records. Otherwise, the interest and
principal will go the previous ho lder because the company will pay to the
one who is registered. Whereas, the unregistered commonly known as
bearer debenture. can be transferred by mere delivery to the new holder.
They are considered as good as currency notes due to their easy
transferabi lity. The interest and principal are paid to the person who
produces the coupons, which are attached to the debenture certificate. and
the certificate respectively.
Fixed and Floating Rate Debentures
Fixed rate debentures have fixed interest rate over the life of the
debentures. Contrarily, the floating rate debentures have the floating rate
of interest which is dependent on some benchmark rate say LIBOR etc.
Secured Premium Notes / Debentures
These are secured debentures which are redeemed at a premium
over the face value of the debentures. They are similar to zero coupon
bonds. The only difference is that the discount and premium. Zero coupon
bonds are issued at the discount and redeemed at par whereas the secured
premium notes are issued at par and rede emed at the premium.
Callable and Puttable Debentures / Bond:
Callable debentures have an option for the company to buyback
and repay to the investors whereas, in the case of puttable debentures, the
option lies with the investors. Puttable debenture hold ers can ask the
company to redeem their debenture and ask for principal repayment.munotes.in
Page 81
81(d)Bonds:
Bond is a financial instrument whereby the issuer of the bond
raises (borrows) capital or funds at a certain cost for certain time period
and pays back the princ ipal amount on maturity of the bond. Interest paid
on bonds is usually referred to as coupon. In simple words, a bond is a
loan taken at a certain rate of interest for a definite time period and repaid
on maturity.
From a company’s point of view, the bond or debenture falls under
the liabilities section of the balance sheet under the heading of Debt. A
bond is similar to the loan in many aspects however it differs mainly with
respect to its tradability. A bond is usually tradable and can change many
hands b efore it matures; while a loan usually is not traded or transferred
freely.
Common features of bonds and the financial terms related to bonds.
1.Issuer: The entities that borrow money by issuing bonds are called as
issuers.
2.Face Value: Every bond that is issued has a face value; which is
usually the principal amount that is borrowed and returned on
maturity. In layman’s term, it is the value of the bond on its maturity.
3.Coupon: The rate of interest paid on the bond is called as a coupon.
4.Rating: Every bond is usually rated by credit rating agencies; higher
the credit rating lower will be the coupon required to pay by the issuer
and vice versa.
5.Coupon Payment Frequency: The coupon payments on the bond
usually have a payment frequency. The coupon s are usually paid
annually or semi -annually; however, they may be paid quarterly or
monthly as well.
6.Yield: The effective return that the investor makes on the bond is
called as a return. Assuming a bond was issued for a face value of ₹
1000 and a coup on rate of 10% on initiation. The Price at a later date
may rise or fall and hence the investor who invests at a rate other than
₹1000 will still receive a coupon payment of ₹100 (1000 * 10%) but
the effective earning shall be different since investment a mount is not
₹1000. That effective return in layman’s term is called as the yield. If
the holding period is considered for a year this is referred to as current
yield and if it is held to maturity it is referred to as yield to maturity
(YTM).
DIFFERENT T YPES OF BONDS
Plain Vanilla Bonds
A plain vanilla bond is a bond without any unusual features; it is
one of the simplest forms of bond with a fixed coupon and a defined
maturity and is usually issued and redeemed at the face value. It is also
known as a s traight bond or a bullet bond.
Zero Coupon Bonds
A zero coupon bond is a type of bond where there are no coupon
payments made. It is not that there is no yield; the zero coupon bonds aremunotes.in
Page 82
82issued at a price lower than the face value (say ₹950) and then pay the
face value on maturity ( ₹1000). The difference will be the yield for the
investor. These are also called as discount bonds or deep discount bonds if
they are for longer tenor.
Deferred Coupon Bonds
This type of bond is a blend of a coupon -bearing bo nd and a zero
coupon bond. These bonds do not pay any coupon in the initial years and
thereafter pay a higher coupon to compensate for no coupon in the initial
years. Such bonds are issued by corporates whose business model has a
gestation period before th e actual revenues start. Examples of a company
which may issue such type of bonds include construction companies.
Convertible Bonds
Convertible bonds are a special variety of bonds which have an
inbuilt feature of being converted to equity shares at a spe cified time at a
pre-set conversion price.
Foreign currency convertible Bonds
Foreign currency convertible bond is a special type of bond issued
in the currency other than the home currency. In other words, companies
issue foreign currency convertible bon ds to raise money in foreign
currency.
Difference between Debentures & Bonds
Debenture and bond are used often as interchangeable terms.
However, there are subtle and noteworthy differences between the two
instruments:
•Security: A bond is a more secure instrument than a debenture. A
debenture does not have any collateral backing; whereas a bond will
always have collateral attached.
•Rate of Interest: Debenture holders are entitled to a higher rate of
interest in comparison to bond hold ers. The reason is that debenture is
an unsecured loan and therefore, is riskier than a bond.
•Liability: In a case of a bankruptcy, the company is liable to pay
bondholders on priority, whereas debenture holders are paid later.
•Periodical Payments: Deb enture holders are paid periodical interest on
their loan and the principal is paid back at the completion of the entire
term. Bondholders, on the other hand, are not paid any periodical
payments. They receive the accrued interest and the principal upon th e
term completion at one go.
(e)Term Loan:
A term loan provides borrowers with a lump sum of cash upfront
in exchange for specific borrowing terms. Term loans are normally meant
for established small businesses with sound financial statements. In
exchang e for a specified amount of cash, the borrower agrees to a certain
repayment schedule with a fixed or floating interest rate. Term loans may
require substantial down payments to reduce the payment amounts and the
total cost of the loan.munotes.in
Page 83
83Types of Term Loan s
Term loans come in several varieties, usually reflecting the
lifespan of the loan. These include:
Short -term loans: These loans are generally for a period of less than a 12
months.
Intermediate -term loans: These loans are generally for a period of one to
three years.
Long -term loans: These loans last anywhere above three to twemty five
years.
(f)Venture Funding:
Venture funding is a funding process in which the venture funding
companies manage the funds of the investors who want to invest in new
businesses which have the potential for high growth in future. The venture
capital funding firms provide the funds to start ups in exchange for the
equity stake. Such a startup is generally one that possesses the ability to
generate high returns. However, the risk for venture capitalists is high.
There are five stages of venture funding. They are as follows:
Stage 1: Seed Capital
Stage 2: Startup Capital
Stage 3: Early Stage / Second Stage Capital
Stage 4: Expansion Stage
Stage 5: Bridge / Pre IPO Stage
Stage 1: Seed Capital
In this first stage of venture funding, the venture or the startup company in
need of the funds contacts the venture capital firm or the investor. The
venture firm shall share its idea of business with the investors and
convince them to in vest in the project. The investor or venture capital firm
shall then conduct research on the business idea and analyze its future
potential. If the expected returns in future are good, the investor (Venture
capitalist) shall invest in the business.
Stage 2: Startup Capital
Startup capital is the second stage of venture funding. If the venture is
able to attract the investor, the idea of the business of the venture is
brought into reality. A prototype product is developed and fully tested to
know the actual potential of the product. Generally, a person from the
venture capital firm takes a seat in the management of the business to
monitor the operations regularly and keep a check that every activity is
done as per the framed plan. If the idea of business mee ts the requirement
of the investor and has sufficient market in the trail run, the investor
agrees to participate in the future course of the business.
Stage 3: Early Stage / Second Stage Capital
After the startup capital stage comes the early/first/secon d stage capital. In
this stage, the investor significantly increases the capital invested in the
venture business. The capital increase is mainly towards increasing themunotes.in
Page 84
84production of goods, marketing or other expansion say building a network
etc. The compa ny with higher capital inflow moves towards profitability
as it is able to reach a wide range of customers.
Stage 4: Expansion Stage
This is the fourth stage of venture funding. In this stage, the company
expands its business by way of diversification and differentiation of its
products. This is possible only if the company is earning good profits and
revenue. To reach up to this stage the company needs to be operational for
at least 2 to 3 years. The expansion gives the venture new wings to enter
into unt apped markets.
Stage 5: Bridge / Pre IPO Stage
This is the last stage of venture funding. When the company has
developed substantial share in the market with its products, the company
may opt for going public. One main reason for going public is that the
investors can exit out of the company after earning profits for the risks
they have taken all the years. The company mainly uses the amount
received by way of IPO for various purposes like merger, elimination of
competitors, research and development, etc.
(g)American Depository Receipt
American Depository Receipt represents the shares of a foreign company
issued by U.S bank which can be traded in U.S. equity markets.
Meaning of American Depository Receipt
American Depository Receipt (ADR) is a certified negotiable instrument
issued by an American bank suggesting the number of shares of a foreign
company that can be traded in U.S. financial markets. American
Depository Receipts provide US investors with an opportunity to trade in
shares of a foreign compan y.
American Depository Receipt Process
The domestic company, already listed in its local stock exchange, sells its
shares in bulk to a U.S. bank to get itself listed on U.S. exchange.
The U.S. bank accepts the shares of the issuing company. The bank keeps
the shares in its security and issues certificates (ADRs) to the interested
investors through the exchange.
Investors set the price of the ADRs through bidding process in U.S.
dollars. The buying and selling in ADR shares by the investors is possibl e
only after the major U.S. stock exchange lists the bank certificates for
trading.
The U.S. stock exchange is regulated by Securities Exchange
Commission, which keeps a check on necessary compliances that need to
be complied by the foreign company.
Adva ntages of American Depository Receiptmunotes.in
Page 85
85The American investor can invest in foreign companies which can fetch
him higher returns.
The companies located in foreign countries can get registered on
American Stock Exchange and have its shares trades in two diff erent
countries.
The benefit of currency fluctuation can be availed.
It is an easier way to invest in foreign companies as there are no
restrictions to invest in ADR.
ADR simplifies tax calculations. Trading in shares of foreign company in
ADR would lead to tax under US jurisdiction and not in the home country
of company.
The pricing of shares of foreign companies in ADR is generally cheaper.
Hence it provides additional benefit to investors.
Disadvantages of American Depository Receipt
Even though the transactions in ADR take place in US dollars, still they
are exposed to the risk associated with foreign exchange fluctuation.
The number of options to invest in foreign companies is limited. Only few
companies feel the necessity to register themselves th rough ADR. This
limits the choice available to US investor to invest.
The investment in companies opting for ADR often becomes illiquid as
investor needs to hold the shares for long term to generate good returns.
The charges for entire process of ADR are mostly transferred on investors
by the foreign companies.
Any violation of compliance can lead to strict action by Securities
Exchange Commission.
Conclusion:
ADRs provide the US investors with ability to trade in foreign companies
shares. ADR makes it easier and convenient for the domestic investors in
US to trade in foreign companies shares. ADR provides the investors an
opportunity to diversify their portfolio by investing in companies which
are not located in America. This eventually leads to investo rs investing in
companies located in emerging markets, thereby leading to profit
maximization for investors.
(h)Global Depository Receipt
Global Depository Receipt (GDR) is an instrument in which a company
located in domestic country issues one or more o f its shares or
convertibles bonds outside the domestic country. In GDR, an overseas
depository bank i.e. bank outside the domestic territory of a company,
issues shares of the company to residents outside the domestic territory.munotes.in
Page 86
86Such shares are in the for m of depository receipt or certificate created by
overseas the depository bank.
Issue of Global Depository Receipt is one of the most popular ways to tap
the global equity markets. A company can raise foreign currency funds by
issuing equity shares in a f oreign country.
Global Depository Receipt Example
A company based in USA, willing to get its stock listed on German stock
exchange can do so with the help of GDR. The US based company shall
enter into an agreement with the German depository bank, who shal l issue
shares to residents based in Germany after getting instructions from the
domestic custodian of the company. The shares are issued after
compliance of law in both the countries.
Global Depository Receipt Mechanism
The domestic company enters into a n agreement with the overseas
depository bank for the purpose of issue of GDR.
The overseas depository bank then enters into a custodian agreement with
the domestic custodian of such company.
The domestic custodian holds the equity shares of the company.
On the instruction of domestic custodian, the overseas depository bank
issues shares to foreign investors.
The whole process is carried out under strict guidelines.
GDRs are usually denominated in U.S. dollars
Advantages of GDR
The following are the advantages of Global Depository Receipts:
GDR provides access to foreign capital markets.
A company can get itself registered on an overseas stock exchange or over
the counter and its shares can be traded in more than one currency.
GDR expands the globa l presence of the company which helps in getting
international attention and coverage.
GDR are liquid in nature as they are based on demand and supply which
can be regulated.
The valuation of shares in the domestic market increase, on listing in the
international market.
With GDR, the non -residents can invest in shares of the foreign company.
GDR can be freely transferred.munotes.in
Page 87
87Foreign Institutional investors can buy the shares of company issuing
GDR in their country even if they are restricted to buy shares of foreign
company.
GDR increases the shareholders base of the company.
GDR saves the taxes of an investor. An investor would need to pay tax if
he purchases shares in the foreign company, whereas in GDR same is not
the case.
Disadvantages
The followin g are the disadvantages of Global Depository Receipts:
Violating any regulation can lead to serious consequences against the
company.
Dividends are paid in domestic country’s currency which is subject to
volatility in the forex market.
It is mostly beneficial to High Net -Worth Individual (HNI) investors due
to their capacity to invest high amount in GDR.
GDR is one of the expensive sources of finance.
(i) Public Fixed Deposits:
Public deposits refer to the unsecured deposits invited by companies f rom
the public mainly to finance working capital needs. A company wishing to
invite public deposits makes an advertisement in the newspapers.
Any member of the public can fill up the prescribed form and deposit the
money with the company. The company in r eturn issues a deposit receipt.
This receipt is an acknowledgement of debt by the company. The terms
and conditions of the deposit are printed on the back of the receipt. The
rate of interest on public deposits depends on the period of deposit and
reputati on of the company.
A company can invite public deposits for a period of six months to three
years. Therefore, public deposits are primarily a source of short -term
finance. However, the deposits can be renewed from time -to-time.
Renewal facility enables c ompanies to use public deposits as medium -
term finance.
Public deposits of a company cannot exceed 25 per cent of its share
capital and free reserves. As these deposits are unsecured, the company
having public deposits is required to set aside 10 per cen t of deposits
maturing by the end of the year. The amount so set aside can be used only
for paying such deposits.
Thus, public deposits refer to the deposits received by a company from the
public as unsecured debt. Companies prefer public deposits becaus e these
deposits are cheaper than bank loans. The public prefers to deposit moneymunotes.in
Page 88
88with well -established companies because the rate of interest on public
deposits is higher than on bank deposits. Now public sector companies
also invite public deposits. Publ ic deposits have become a popular source
of industrial finance in India.
Merits of Public Deposits:
1. Simplicity:
Public deposits are a very convenient source of business finance. No
cumbersome legal formalities are involved. The company raising depos its
has to simply give an advertisement and issue a receipt to each depositor.
2. Economy:
Interest paid on public deposits is lower than that paid on debentures and
bank loans. Moreover, no underwriting commission, brokerage, etc. has to
be paid. Inter est paid on public deposits is tax deductible which reduces
tax liability. Therefore, public deposits are a cheaper source of finance.
3. No Charge on Assets:
Public deposits are unsecured and, therefore, do not create any charge or
mortgage on the comp any’s assets. The company can raise loans in future
against the security of its assets.
4. Flexibility:
Public deposits can be raised during the season to buy raw materials in
bulk and for other short -term needs. They can be returned when the need
is ov er. Therefore, public deposits introduce flexibility in the company’s
financial structure.
5. Trading on Equity:
Interest on public deposits is paid at a fixed rate. This enables a company
to declare higher rates of dividend to equity shareholders during periods
of good earnings.
Public deposits enable a company to build up contacts with a wider
public. These conta cts prove helpful in the sale of shares and debentures
in future.
Demerits of Public Deposits:
1. Uncertainty:
Public deposits are an uncertain and unreliable source of finance. The
depositors may not respond when economic conditions are uncertain.
More over, they may withdraw their deposits whenever they feel shaky
about the financial health of the company.
Depositors are entitled to withdraw their deposits at any time after giving
prior notice to the company. During times of financial tightness or dis tress
the depositors may get panicked and wish to withdraw their deposits.
Moreover, if a large number of depositors simultaneously withdraw their
deposits during slump, the company may find it difficult to repay a hugemunotes.in
Page 89
89sum at once. Therefore, public dep osits are described as ‘fair weather
friends’.
2. Limited Funds:
A limited amount of funds can be raised through public deposits due to
legal restrictions.
3. Temporary Finance:
The maturity period of public deposits is short. The company cannot
depend upon public deposits for meeting long -term financial needs.
4. Limited Appeal:
Public deposits do not appeal as a mode of investment to bold investors
who want capital gains. Conservative investors may also not like these
deposits in the absence of proper security.
5. Unsuitable for New Concerns:
New companies lacking in sound credit standing cannot depend upon
public deposits. Investors do not like to deposit money with such
companies.
(j) Concept of Securitization:
Securitization is a structured process by which a pool of loans and other
receivables are packaged and sold in the form of asset -backed securities to
the investors to raise the required funds from them. By this process
relatively illiquid assets are converted into securities . Securitization falls
under the broad category termed as structured finance transactions.
Structured finance refers to securities where the promise to repay the
investors is backed by the value of the underlying financial asset or the
credit support of a third party to the transaction or some combination of
the two. Thus, securitization is nothing but liquefying assets comprising
loans and receivables of an institution through systematic issuance of
financial instruments.
(i) The process of securitization starts with identification by the company
(the originator) the loans or bills receivable in its portfolio, to prepare a
basket or pool of assets to be securitized.
(ii) The pool of assets so identified is then sold to a specific purpose
vehicle (SPV) or trust. Usually an investment banker performs the task of
an SPV, which is also called an issuer, as it ultimately issues the securities
to investors.
(iii) Once the assets are acquired by SPV, the same are split into
individual shares/securities which are reimbursed by selling them to
investors. These securities are called ‘Pay or Pass Through Certificates’
(PTC) which are so structured as to synchronize for redemption with the
maturity of the securitized loans or bills.munotes.in
Page 90
90(iv) Repayments under the securiti zed loans or bills keep on being
received by the originator and passed on to the SPV. To this end, the
contractual relationship between the originator an d the
borrowers/obligates is allowed to subsist in terms of the pass through
transaction; alternativel y a separate agency arrangement is made between
the SPV (Principal) and the originator (agent).
(v) Although a PTC could be with recourse to its originator, the usual
practice has been to make it without recourse. Accordingly, a PTC holder
takes recourse to the SPV and not the originator for payment to the
principal and interest on the PTCs held by him. However, a part of the
credit risk, as perceived (and not interest risk), can be absorbed by the
originator, by transferring the assets at a discount, enab ling the SPV to
issue the PTCs at a discount to face value.
(vi) The debt to be securitized and the PTC issues are got rated by rating
agencies on the eve of the securitization. The issues by the SPV could also
be guaranteed by external guarantor -institut ions to enhance creditability of
the issues. The PTCs, before maturity, are tradable in a secondary market
to ensure liquidity for the investors.
(h)Long term financial institution:
Long term loans are provided by specify financial institutions in India.
The following are the specialised financial institution:
(i)The industrial financial corporation in India.
(ii)Industrial development bank of India.
(iii)Industrial Reconstruction Corporation inIndia.
(iv)Small industries development bank of India.munotes.in
Page 91
91(v)Life insurance Corporation of India.
(vi)State financial corporation.
(vii)Exime book.
Term loans are provided by these institutions at deferent rate of interest
under scheme of financial institution. it is also to be repaid according to a
stipulated repayment schedule these institution stipulate a number of
condition management and certain and other financial policy of a
company .
Term loan represent secured borrowing. It is the most important source of
finance for new project. They generally carry a rate of interest inclusive
interest tax depending on the credit rating of the borrower, the perceived
risk of lending. The loan are generally repayable over a period of 60 to 10
years in annul, half yearly or quarterly installment. For last scale project
all India financial institution provides the bulk of term finance either
singly or in consortium with other financial institution.
(b)Loan from commercial banks:
The banks’ in India also provide term loans to the companies .banks
normally provides term loans to projects in the small and medium scale
sectors . The primary role of commercial banks is to cater to the short
term requirement of the industry. However banks have started taking an
interest on term financing of indu stries in several ways. The proceeds of
the term loan from banks are generally used for fixed assets or for
expansion of plant capacity. Their repayment is scheduled over a period of
time. Term loans proposals involve an element of risk because of changes
in the conditions affecting the borrowers. The bank making such a
proposal has to access the situation to make a proper appraisal. The
decision in such a situation would depend upon various factors affecting
the conditions of the industry concerned and the earning potential of the
borrower.
(c)Retained earnings:
Retained earnings are the profits retained in the business. Every company
retains certain portion every year in the form of reserve. Even the balance
of profit after declaration of dividend is also ca rried forward in the
balance of sheet. It is known as ploughing backs of profits. Such funds
belong to the ordinary shareholder’s and increase the net worth of
company. a public limited company has to plough back a reasonable
amount of profit every year ke eping in view the legal requirements and its
own expansions plans. However, retained earnings can be used by existing
and financially sound companies. A new company or a loss making
company cannot follow this method. Retained earnings are used as a long -
term capital without any cost.
4.3.2 Short Term Source of Finance
Short -term financing deals with raising of money required for periods
varying from a few days to one year. It may sometimes exceed for a
period above one year but still be called as short -term finance.munotes.in
Page 92
921. Trade Credit
Trade credit is credit received by an business organisation from the
manufacturers or wholesalers or suppliers. It is also known as mercantile
credit. The usual duration of this credit ranges from 30 to 90 days. It is
granted to the company or firm on “Open account” without any security
except that of the goodwill and financial standing of the buyer. Trade
credit does not provide the cash but it facilitates the purchase of materials
without immediate payment. Usually no interest i s charged on trade
credits. Trade credit depends upon the buyer’s need for it and also the
willingness of the supplier and factors such as:
The financial resources of the supplier.
His eagerness to dispose of his stock.
Degree of competition in the market .
Credit worthiness of the firm.
2. Consumer Credit or Customer Advance
Many times the manufacturers or the suppliers insist on, advance by the
customers particularly in case of special orders or big orders. The
customer advance forms part of the price of the products ordered by him.
Sometimes, the customer also tenders the full price. This is an interest free
source of finance. The period of such credit depends upon the time taken
to deliver the goods. The availability of this credit also depends on the
following factors:
Competitive conditions in the market
Customs of the trade and usage.
Reputation of the supplier.
3. Installment Credit
This is also called consumer credit. Retailers for selling consumer durable
generally use it. Here, however, we use t he term “Installment credit” to
denote the facility provided by the equipment suppliers on easy
installments as this serves to provide capital to a firm in kind. Installment
includes interest on unpaid sums and is suitably spread so as to enable the
purcha sing company to meet them out of current cash flows. Commercial
banks and financial institutions, now -a-days provide this form of credit on
liberal terms. Hire purchase system is also a modified form of the
installment credit. In the hire purchase system, the title over the
machinery or equipment remains with the supplier until the full price
amount is settled.
4. Factoring
Under this method, a financing company purchases the account
receivables from the customers or money is advanced on the security of
the accounts receivable. In financial accounting, it is denoted as Trade
Debtors, and this item appears on the asset side of the Balance Sheet.
Since credit sales are unavoidable in trading transactions, every trader has
always a larger amount locked up in t he form of Account Receivables.munotes.in
Page 93
93This account receivable is a right to property and a right to collect the
amount from the client.
5. Short -term Loans
Commercial banks also provide loans to the business concern to meet the
short -term financial requirements . When a bank makes an advance in
lump sum against some security it is termed as loan. Loan may be in the
following form:
(a) Cash credit: A cash credit is an arrangement by which a bank allows
his customer to borrow money up to certain limit against the s ecurity of
the commodity.
(b) Overdraft: Overdraft is an arrangement with a bank by which a current
account holder is allowed to withdraw more than the balance to his credit
up to a certain limit without any securities.
MONEY MARKET INSTRUMENTS IN INDIA
1. Treasury Bills
T-bills are one of the most popular money market instruments. They have
varying short -term maturities. The Government of India issues it at a
discount for 14 days to 364 days. These instruments are issued at a
discount and repaid at par a t the time of maturity. Also, a company, firm,
or person can purchase TB’s. And are issued in lots of Rs. 25,000 for 14
days & 91 days and Rs. 1,00,000 for 364 days.
2. Commercial Bills
Commercial bills, also a money market instrument, works more like the
bill of exchange. Businesses issue them to meet their short -term money
requirements. These instruments provide much better liquidity. As the
same can be transferred from one person to another in case of immediate
cash requirements.
3. Certificate of Depo sit
Certificate of deposit or CD’s is a negotiable term deposit accepted by
commercial banks. It is usually issued through a promissory note. CD’s
can be issued to individuals, corporations, trusts, etc. Also, the CD’s can
be issued by scheduled commercial banks at a discount. And the duration
of these varies between 3 months to 1 year. The same, when issued by a
financial institution, is issued for a minimum of 1 year and a maximum of
3 years.
4. Commercial Paper
Corporates issue CP’s to meet their short -term working capital
requirements. Hence serves as an alternative to borrowing from a bank.
Also, the period of commercial paper ranges from 15 days to 1 year. The
Reserve Bank of India lays down the policies related to the issue of CP’s.
As a result, a co mpany requires RBI‘s prior approval to issue a CP in the
market. Also, CP has to be issued at a discount to face value. And the
market decides the discount rate.munotes.in
Page 94
94Denomination and the size of CP:
Minimum size –Rs. 25 lakhs
Maximum size –100% of the issue r’s working capital
5. Call Money
It is a segment of the market where scheduled commercial banks lend or
borrow on short notice (say a period of 14 days). In order to manage day -
to-day cash flows. The interest rates in the market are market -driven and
hence highly sensitive to demand and supply. Also, the interest rates have
been known to fluctuate by a large % at certain times.
4.4 EXERCISES:
1 Which of the following is a liability of a bank?
(a) Treasury Bills
(b) Commercial Papers
(c) Certificate of Deposits
(d) Junk Bonds
2. Commercial paper is a type of
(a) Fixed coupon bond
(b) Unsecured short -term debt
(c) Equity share capital
(d) Government bond
3. In India, Commercial Papers are issued as per the guidelines issued by
(a) Sec urities and Exchange Board of India
(b) Reserve Bank of India
(c) Forward Market Commission
(d) None of the above
4.Commercial paper are generally issued at a prices
(a) Equal to face value
(b) More than face value
(c) Less than face value
(d) Equal to r edemption value
5. Which of the following is not applicable to commercial paper?
(a) Face Value
(b) Issue Price
(c) Coupon rate
(d) None of the above
6. Which of the following is true with respect to commercial paper (CP)?
(a) These are issued in multiples of 1 lakh
b) The minimum amount to be invested by a single investor is 5 lakhs
(c) The minimum maturity period is 30 days
(d) The issuer cannot buy back these instruments
(e) These can be raised up to the extent of 80% of working capital limitmunotes.in
Page 95
957. Which of the following statements is/are true with respect to Short -
term bank finance
i) Under the cash credit arrangement the customer is permitted to
borrow up to a limit called the cash credit limit
ii) Cash credit account ope rates against security in the form of pledge
of shares and securities.
iii) Under letter of credit agreement the bank assumes the risk and also
provides the credit
(iv) Security in the form of hypothecation is limited to movable
properties
(a) Only (ii) a bove
(b) Only (iv) above
(c) Both (i) and (iv) above
(d) Both (ii) and (iii) above
8. Which of the following statements is not true with respect to
Commercial Papers (CPs)
(a) These are short -term usance promissory notes with a fixed maturity
period
(b) It is also referred to as Corporate Paper
c) is mostly used to finance the current transactions of a company
(d) it helps to meet the seasonal need for funds
(e) it cannot be issued by body corporate
9. which of the following statements is tru e with regard to public
deposit to a company?
(a) The procedure involved in raising public deposit is fairly complex
(b) A public deposit with maturity period of less than 1 year is also
treated as long term liability
(c) After -tax cost of public deposi ts will be much less than the after -tax
cost of bank borrowing
(d) Security is offered in the case of public deposit
(e) Public deposit will have restrictive covenants in respect of dividends
payments appointment of senior executives
10. The type of co llateral (security) used for short -term loan is
(a) Real estate
(b) Plant and Machinery
(c) Stock of good
(d) Equity share capital
Solution
1. C 6. B
2. B 7. C
3. B 8. C
4. C 9. D
5. D 10. Emunotes.in
Page 96
961.What are the sources of long -term finance?
2.Explain the concept of financial feasibility of a Project?
3.Explain the advantages of equity financing?
4.What is debenture (debt) financing? Why debentures are considered
cheaper than equity as a source of long -term finance?
5.Write short notes on the followin g:
(a)Trading on equity
(b)Promoter’s contribution.
(c)Preference Shares
(d)Money Market Instruments
(e)Loan syndication.
munotes.in
Page 97
975
COST OF CAPITAL
Unit Structure:
5.0 Objectives
5.1 Introduction
5.2 Definition of Cost of Capital
5.3 Measurement of Cost of Capital
5.4 Cost of Debt
5.5 Cost of Bonds
5.6 Cost of Preference Shares
5.7 Cost of Equity
5.8 Cost of Retained Earnings
5.9 Weighted Average Cost of Capital (WACC)
5.10 Exercises
5.0 OBJE CTIVES
After studying this chapter you will be able to:
Understand the concept of Cost of Capital
Understand the different sources of capital
Understand the cost of employing each of these sources of capital
Know the concept of weighted average cost of capital
The importance of cost of capital in financial management
5.1 INTRODUCTION
The financing decision relates to the composition of relative proportion of
various sources of finance. The sources are;
1.Owned Capital -i.e. Equity Share Capital, Preference Share Capital,
Accumulated profits.
2.Borrowed Capital -: Debentures, loans from financial institutions.
The financial management weighs the merits and demerits of different
sources of finance while ta king the financing decisions.
Whether the companies choose shareholders funds or a combination of
both, each type of fund carries a cost.
The cost of equity is the minimum return the shareholders would have
received if they had invested elsewhere. Borrow ed fund cost involves
interest payment.munotes.in
Page 98
98Both types of fund incur cost and this is the cost of capital to the
company. This means, cost of capital is the minimum return expected by
the company.
Whenever funds are to be raised to finance investments, capital structure
decision is involved.
A demand for raising funds generates a new capital structure since a
decision has to be made as to the quantity and forms of financing.
5.2 MEANING OF COST OF CAPITAL
In simple terms cost of capital refers to the discount rate that is used in
determining the present value of the estimated future cash flows of the
business/new project and eventually deciding whether the business/new
project is worth undertaking or not.
It is also the minimum rate of return that a firm must earn on its
investment which will maintain the market value of shares at its current
level.
It can also be stated as the opportunity cost of an investment, i.e. the rate
of return that comp any would otherwise be able to earn at the same risk
level as the investment that has been selected. For example, when an
investor purchases a stock in a company, he/she expects to see a return on
that investment. Since the individual expects to get back m ore than his/her
initial investment, the cost of capital is equal to this minimum return that
the investor expects to receive which is termed as investor’s opportunity
cost.
The cost of each source of capital is called specific cost of capital. When
these specific costs are combined for all the sources of capital for a
business, it is termed as overall cost of capital for a business.
5.3 MEASUREMENT OF COST OF CAPITAL
The first step in the measurement of cost of capital of the firm is the
calculation of the cost of individual sources of raising funds. From the
viewpoint of capital budgeting decisions, the long term sources of funds
are relevant as they constitute the major sources of financing the fixed
assets. In calculating the cost of capital, therefor e, the focus on long -term
funds which are: -
i.Long term debt (including debentures)
ii.Preference shares
iii.Equity Capital
iv.Retained Earningsmunotes.in
Page 99
995.4 COST OF DEBT
The calculation of the cost o f debt is relatively easy. A debt may be in the
form of Bond or Debenture. A Bond is a long term debt instrument or
security. Bonds are issued by the government. Therefore, they do not have
any risk of default. The government honours obligations on its Bon ds.
Bonds of the public sector companies in India are generally secured, but
they are not free from the risk of default.
The private sector companies also issue bonds, which are called as
Debentures in India. A company in India can issue secured or unsecu red
debentures.
5.4.1 COST OF DEBENTURES
The cost of debentures and long term loans is the contractual interest rate
adjusted further for the tax liability of the company. For a company, the
higher the interest charges, the lower the amount of tax payable by the
company. The interest on debentures or bonds is debited to the profit and
loss account. Therefore, the taxable profit of the company is reduced. It is
an indirect saving to the company. Therefore the cost of debt capital is
reduced to the extent of the tax liability.
Illustration 1: Two companies X and Y are having their capital structure
as follows;
Company X Company Y
Earnings before interest and taxes (EBIT) 100 100
(Rs. In lakhs)
Interest (I) (12% ) - 40
Profit before tax (PBT) 100 60
Tax (T) @ 35% 35 21
Profit after Tax (PAT) 65 39
The tax rate applicable to the company is 35 percent.
Solution:
Cost of Debt = (I -t) where I = interest rate and t = tax rate
Cost of debt of X = 0, there is no debt.
Cost of debt of Y = (I -T)= (12 -35%) =12 -4.2 = 7.8%
The important point to remember, while calculating the average cost of
capital, is that the post -tax cost of debt should be used and not the pre -tax
cost of debt.
5.4.2 COST OF IRREDEEMABLE DEBENTURES
Cost of debentures not r edeemable during the life time of the company.
where,munotes.in
Page 100
100Kd=cost of debt after tax
I=Annual interest payment
NP=Net proceeds of debentures
t=Tax rate
Illustration 2
A company issues 1,000 15% debentures of the face value of ₹100 each
at a discount of ₹5. The under -writing and other costs are ₹5000 / -for
the total issue. . The interest per annum is ₹15,000. The income tax rate
is 40%. Calculate the cost of Debt.
Solution
The net proceeds of the debenture = 1000 x 95 = ₹95,000
₹95,000 -₹5,000 = ₹90,000
Net proceeds per debenture = 90,000/1,000 = ₹90
Though the interest on debenture is 15%, the net cost of debenture is 10%.
5.4.3 Cost of Redeemable debentures
If the debentures are redeemable after the expiry of a fixed period, the cost
of debenture s would be:
where,
I = Annual interest payment
NP = Net proceeds of debentures
RV = Redemption values of debentures
t =T a xr a t e
n = Life of debentures
Illustration 3:
A company issued 10,000, 10% debentures of Rs 100 each on 1.4.2007 to
be matured on 1.4.2012. If the market price of the debenture is Rs.80.
Compute the cost of debt assuming 35% tax rate.
Solution :
munotes.in
Page 101
101
Illustration 4
Five years ago, Sonata Limited issued 12 per cent irredeemable
debentures at Rs. 103, at Rs. 3 premium to their par value of R s 100. The
current market price of these debentures is Rs. 94. If the company pays
corporate tax at a rate of 35 per cent what is its current cost of debenture
capital?
Solution:
Kd= 12/94 = 12.8 per cent
Kd(after tax) = 12.8 x (1 -0.35) = 8.3 per cent
5.5 COST OF BONDS
It is easy to find out the present value of a bond since its cash flows and
the discount rate can be determined easily. If there is no risk of default,
then there is no difficulty in calculating the cash flows associated with a
bond. The expected cash flows consist of annual interest payments plus
repayment of principal. The appropriate capitalization or discount rate
would depend upon the risk of bond. The risk in holding the government
bond is less than the risk associated with a debentu re issued by a
company. Therefore, a lower discount rate would be applied to the cash
flows of the government bond and a higher rate to the cash flows of the
company debenture.
5.6 COST OF PREFERENCE SHARES
The cost of preference share capital is the dividend expected by its
holders. Though payment of dividend is not mandatory, non -payment may
result in exercising of voting rights by them.
The payment of preference dividend is not adjusted for taxes as they are
paid after taxes and is not deductible.
The cost of preference share capital is calculated by dividing the fixed
dividend per share by the price per preference share.munotes.in
Page 102
102Illustration 5:
Suzlo n Energy has issued preference shares at Rs. 100 per share, with a
stated dividend of Rs. 12% and a flotation cost of 3% what is the cost of
preference share?
Solution
pPreference DividendK=Market Price of Preference Share 1-flotation costRs.12= 12 / 97 12.37%Rs.100 1-0.03
5.6.1 COST OF IRREDEEMABLE PREFERENCE SHARES
Cost of irredeemable preference sharesPDPO
Where,
PD = Annual preference dividend
PO = Net proceeds in issue of preference shares.
Cost of irredeemable pre ference shares where Dividend Tax is paid over
the actual dividend payment1PD DtPO
Where,
PD = Annual preference dividend
PO = Net proceeds in issue of preference shares
Dt = Tax on preference dividend
Illustration 6:
X Ltd. issued 2,000 10% preference shares of Rs 100 each at Rs. 95 each.
Calculate the cost of preference shares.
Solution
5.6.2 COST OF REDEEMABLE PREFERENCE SHARES:
If the preference shares are redeemable after the expiry of a fixed period
the cost of preference shares would be:/2pPD RV NP NKRV NPmunotes.in
Page 103
103Where ,
PD = Annual Preference Dividend
RV = Redemption value of Preference Shares
NP = Net proceeds on issue of Preference Shares
N = Life of Preference Shares
However, since dividend of preference shares is not allowed as deduction
from income for e tax p urposes, there is no question of tax advantage in
the case of cost of preference shares.
The cost of redeemable preference share could also be calculated as the
discount rate that equates the net proceeds of the sale of preference shares
with the present value of the future dividends and principal payments.
Thus, in the case of debt as well a s preference shares, cost of capital is
calculated by reference to the obligations incurred and proceeds received.
Illustration 7:
Y Ltd. issued 2,000 10% preference shares of Rs 100 each at Rs 95 each.
The company proposes to redeem the preference shares at the end of 10
years. Calculate the cost of preference shares.
Solution :/2pPD RV NP NKRV NP
10 100 9510
100 95
2
0.10710.7%pK
approx
5.7 COST OF EQUITY
It may prima facie appear that equity capital does not carry any cost. But
this is not true. The market share price is a function of return that equity
shareholders expect and get. If the company does not meet their
requirements, it will have an adverse ef fect on the market share price.
Also, it is relatively the highest cost of capital. Since expectations of
equity holders are high, higher cost is associated with it.
In simple words cost of equity capital is the rate of return which equates
the present va lue of expected dividends with the market share price. In
theory the management strives to maximize the position of equity holders
and the effort involves many decisions.munotes.in
Page 104
104Different methods are employed to compute the cost of equity capital.
a)DIVIDEND PRICE APPROACH
Here, cost of equity capital is computed by dividing the current dividend
by average market price per share. However, this method cannot be used
to calculate cost of equity of units suffering losses.
This dividend price ratio expresses the cost of equity capital in relation to
what yield the company should pay to attract investors.10eDKP
Where,
Ke= Cost of equity
D1= Annual dividend
P0= Market price of equity
This model assumes that dividends are paid at a constant rate to
perpetuity. It ignores taxation.
Earnings and dividends do not remain constant and the price of equity
shares is also directly influenced by the growth rate in divi dends. Where
earnings, dividends and equity share price all grow at the same rate, the
cost of equity capital may be computed as follows:
Ke=( D 1/P0)+G
Where,
D1=[ D 0(1+G)] i.e. next expected dividend
P0= Current Market price per share
G= Constant Growth Rate of dividend
Cost of newly issued shares, Kn , is estimated with the constant dividend
growth model so as to allow for flotation costs.
Kn=(D 1/P0-F) + G
Where,
F = Amount of flotation cost per share
Illustration 8:
A company has paid a dividend of Rs 1 per share (of face value of Rs 10
each) last year and it is expected to grow @10% next year. Calculate the
cost of equity if the market price of share is Rs 50.munotes.in
Page 105
105Solution
11 0 . 1 00.10500.12 12%eDGKPor
Ke= D + G
b)EARNING/PRICE APPROACH:
This approach co -relates the earnings of the company with the market
price of its share.
The cost of ordinary share capital would be based upon the expected rate
of earnings of a company. The argument is that each investor expects a
certain amount of earnings, whether distributed or not from the company
in whose shares he invests.
If an inves tor expects that the company in which he is going to subscribe
for shares should have at least a 20% rate of earning the cost of ordinary
share capital can be construed on this basis Suppose the company is
expected to earn 30%, the investor will be prepare d to pay Rs 150 Rs30 x
100 for each share of Rs 100.
So, cost of equity will be given by:/20eEPK Ke= (E/P)
where,
E= Current earnings per share
P= Market share price
Since earnings do not remain constant and the price of equity shares is
also directly influenced by the growth rate in earning, we need to modify
the above calculations with an element of growth.
So, cost of equity will be given by:
Ke=( E / P )+G
where,
E = Current earnings per share
P = Market share price
G = Annual growth rate of earnings
The calculation of ‘G’ (the growth rate) is an important factor in
calculating cost of equity capital. The past trend in earnings and dividends
may be used as an appr oximation to predict the future growth rate if the
growth rate of dividend is fairly stable in the past.munotes.in
Page 106
106G = 1.0 (1+G)nwhere n is the number of years
The Earning Price Approach is similar to the dividend piece approach;
only it seeks to nullify the effe ct of changes in the dividend policy.
c)REALIZED YIELD APPROACH:
According to this approach, the average rate of return realized in the past
few years is historically regarded as ‘expected return’ in the future. The
yield of equity for the year is:11ttt
tDPYP
where,
Yt= Yield for the year t
Dt= Dividend for share for end of the year t
Pt= Price per share at the end of the year t
Pt-1= Price per share at the beginning and at the end of the year t
This approach provides a single mechanism of calculating cost of equity.
It has unrealistic assumptions. If the earnings do not remain stable, this
method is not practical.
d)CAPITAL ASSET PRICING MODEL APPROACH (CAPM):
CAPM model describes the risk -return trade -off for securities. It describes
the linear relationship between risk and return for securities. The risks to
which a security is exposed are divided into two groups, diversifiable and
non-diversifiable.
The diversifiable risk can be eliminated through a portfolio consisting of
large number of well diversified securities.
The non -diversifiable risk is attributable to factors that affect all
businesses. Such risks are: -
Interest r ate changes
Inflation
Political changes etc.
Thus, the cost of equity capital can be calculated under this approach as:
Ke=R f+b( R m-Rf)
where,
Ke= Cost of equity capital
Rf= Rate of return on security
b = Beta coefficient
Rm= Rate of return on mar ket portfolio
Therefore, required rate of return = risk free rate + risk premiummunotes.in
Page 107
107The idea behind CAPM is that investors need to be compensated in two
ways -time value of money and risk.
The time value of money is represented by the risk -free rate in the formula
and compensates the investors for placing money in any investment over a
period of time.
The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk. This is
calculated by taking a risk measure (beta) which compares the returns of
the asset to the market over a period of time and compares it to the market
premium.
Illustration 9:
Calculate the cost of equity capital of Shanthi ltd, whose risk free rate of
return equals 10%. The firm’s beta equals 1.75 and the return on the
market portfolio equals to 15%.
Solution
Ke=R f+b( R m-Rf)
Ke= 0.10 + 1.75 (0.15 –0.10)
= 0.10 + 1.75(0.05)
= 0.1875
=18.75%
5.8 COST OF RETAINED EARNINGS
Like other sources of fund, retained earnings involve cost. It is the
opportunity cost of dividends f orgone by shareholders.
The given future depicts how a company can either keep or reinvest cash
or return it to the shareholders as dividends. If the cash is reinvested, the
opportunity cost is the expected rate of return that shareholders could have
obtained by investing in financial assets.
There are two approaches to measure this opportunity cost. One approach
is by using discounted cash flow (DCF) method and the second approach
is by using capital asset pricing model.
a)by DCF :1
0SDGKP
where,
D1= Dividend
Po= Current market price
G = Growth rate
b)By CAPM : K S=R f+b( R m–Rf)munotes.in
Page 108
108where,
Ks= Cost of equity capital
Rf= Rate of return on security
b= Beta coefficient
Rm=R a t e of return on market portfolio
Illustration 10: A Ltd provides the following details:
D0= Rs 4.19 P0= Rs 50 G= 5%
Calculate the cost of retained earnings based on DCF method.
Solution :
1
0
0
01.4 . 1 9 1 . 0 5 0 . 0 5.50
0.088 0.05
138
13.8%SDGKP
DGGP
Rs
Rs
Illustration 11: C Ltd provides the following details:
Rf= 7% b = 1.20 Rm=13%
Calculate the cost of retained earnings based on CAPM method.
Solution
Ks=R f+b( R m–Rf)
= 7% + 1.20(6%)
= 7% + 7.20
Ks= 14.2%
5.9 WEIGHTED AVERAGE COST OF CAPITAL
(WACC)
WACC (Weighted Average Cost of Capital) represents the investors’
opportunity cost of taking on the risk of putting money into a company.
Since every company has a capital structure i.e. what percentage of fund s
comes from retained earnings, equity shares, preference shares, debt and
bonds, so by taking a weighted average, it can be seen how much
cost/interest the company has to pay for every rupee it borrows/invest.
This is the weighted average cost of capital.munotes.in
Page 109
109The weighted average cost of capital for a firm is of use in two major
areas: -
1.In consideration of the firms position;
2.Evaluation of proposed changes necessitating a change in the firm’s
capital. Thus, a weighted average technique may be used in a quasi -
marginal way to evaluate a proposed investment project, such as the
construction of a new building.
Thus, weighted average cost of capital is the weighted average after tax
costs of the individual components of firm’s capital structure. That is, the
after tax cost of each debt and equity is calculated separately and added
together to a single overall cost of capital.
K0= % D(mkt) (K i)( 1–t) + (% Psmkt) K p+ (Csmkt) K e
where,
K0= Overall cost of capital
Ki= Before tax cost of debt
1–t=1 –Corporate tax rate
Kp= Cost of preference capital
Ke= Cost of equity
% Dmkt = % of debt in capital structure
% Psmkt = % of preference share in capital structure
% Cs = % of equity share in capital structure
The cost of weighted average method is pref erred because the proportions
of various sources of funds in the capital structure are different. Therefore,
cost of capital should take into account the relative proportions of
different sources of finance.
Illustration 12:
Calculate the WACC using the f ollowing data
(a) Book value weights Basis
(b) Market value weights Basis
The capital structure of the company is as under:
Rs. Debentures (Rs 100 per debenture)
5,00,000
Preference shares (Rs 100 per share)
5,00,000
Equity shares (Rs 10 per share)
10,00,000
The market prices of these securities are:
Debenture Rs 105 per debenture
Preference Rs 110 per preference share
Equity Rs 24 eachmunotes.in
Page 110
110Additional information:
1)Rs 100 per debenture redeemable at par, 10% coupon rate, 4%
flotation costs, 10 y ear maturity.
2)Rs 100 per preference share redeemable at par, 5% coupon rate, 2%
flotation cost and 10 year maturity.
3)Equity shares have Rs 4 flotation cost.
The expected dividend is Rs 10 with annual growth of 5%. The firm has a
practice of paying all earnings in the form of dividend.
Corporate tax rate is 30%.
Solution
Cost of equity =100.0520eK
= 0.05 + 0.05
= 0.10
= 10%
Cost of Debt =100 9610 1 0.310
100 962dK
7 0.42196
0.0755
7.55%
Cost of preference shares =25101982pK5.2
990.05355.35%
a)Calculation of WACC using book value weights
Source of capital Book value Specific cost (K%) Total cost
10% Debentures 5,00,000 5.55 27,500
5% preference shares 5,00,000 5.3 26,500
Equity shares 10,00,000 10.0 1,00,000
Total 20,00,000 1,54,000munotes.in
Page 111
1110.1,54,000. 20,00,000RsKRs0.0777.7%
b)Calculation of WACC using market value weights;
5.10 EXERCISES
1.Indicate whether the following statements are true or false :
a)Cost of capital is the cost of borrowing funds.
b)Retained earnings do not have explicit cost.
c)Cost of Preference Share capital is higher than the cost of equity
capital.
d)The higher is the corporate tax rate, the higher is the cost of debt.
e)Overall cost of capital decreases on payment of ent ire long term
debt.
(Answers: a -False, b -True, c -False, d -False, e -False)
2.What is cost of capital? Explain the problems faced in determining
cost of capital.
3.Explain the different approaches to the calculation of cost of equity
capital.
4.What is weighted average cost of capital? Explain the rationale behind
the use of weighted average cost of capital.
5.Explain the approach to determine the cost of retained earnings.
6.A company has the following specific cost of capital along with t he
indicated book and Market Value weights’ :munotes.in
Page 112
112
Calculate the weighted average cost of capital using book value and
market value weights. (Answers : Ko = 9.5%, 9.9% )
7.Two companies, A and B are in the same bus iness and hence similar
operating risks. However, the capital structure of each of them is different.
The following are the details :
Assume that current levels of dividends are generally expected to continue
indefinitely and the income tax rate is 35 percent. Compute the weighted
Average Cost of capital of each company. (Answers : 19%, 17%)
munotes.in