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Chapter 1 Introduction to Financial Management

1.1 Meaning of financial management

1.2 Scope of financial management
1.3 Traditional Vs Modern concept of finance function-
1.4 Objectives/ goals of financial management
1.5 How is Financial Accounting related with Financial Management?
1.6 Profit and loss account and finance topics

Chapter 2 Financial Planning

2.1 Meaning Of Financial Planning.

2.2 Estimating Capital Requirements
2.3 Meaning of Fixed capital.
2.4 Assessment of fixed capital requirements.
2.5 Management of fixed capital.
2.6 Meaning of Working Capital.
2.7 Factors Determining Working Capital.
2.8 Estimation different Components of Working Capital.
2.9 Methods of Working Capital Forecasts

Chapter 3 Capitalization

3.1 Meaning of Capitalization

3.2 Theories of capitalization
3.3 Meaning of Over-capitalisation
3.4 Causes of Over-capitalization
3.5 Corrections for Over-capitalization
3.6 Meaning of Under capitalization-
3.7 Causes of Under capitalization
3.8 Remedies of Under capitalization
3.9 Under capitalization Vs. Overcapitalization
3.10 Distinction between capitalization and share capital

Chapter 4 Leverage

4.1 Concept of Leverage

4.2 Types of Leverages
4.2.1 Operating Leverage. Degree of Operating Leverage.
4.2.2 Financial Leverage. Favorable and Unfavorable Financial Leverage- Requirements or Conditions for Trading on Equity Degree of Financial leverage
4.3 Total Leverage

Chapter 5 Capital Structure

5.1 Meaning and factor influencing Capital Structure

5.2 Net Income (NI) Approach
5.3 Net Operating Income (NOI) Approach
5.4 Traditional Theory
5.5 Modigliani-Miller (M.M.) Theory
5.6 The pecking-order theory of capital structure
5.7 EBIT / EPS Comparison

Chapter 6 Cost of Capital

6.1 Meaning of cost of capital

6.1.1 Concept of Cost Of Capital
6.2 Importance Of Cost Of Capital
6.3 Components Of Cost Of Capital
6.4 Types Of Cost Of Capital
6.5 Approaches Of Cost Of Capital
6.6 Measurement Of Cost Of Capital
6.7 Determining Component Cost Of Capital
6.7.1 Cost of Debt
6.7.2 Cost of Preference Shares
6.7.3 Cost of Equity Capital
6.7.4 Cost of retained Earnings
6.8 Weighted Average Cost of Capital
6.9 Cost of Equity and Risk

Chapter 7 Working Capital Management

7.1 Meaning of Working Capital Management

7.2 Need of Working Capital Management
7.3 Types of Working Capital
7.4 Factors determining Working Capital Requirement
7.5 Working Capital Policies
7.6 Methods for Estimating Working Capital Requirements
7.7 Financing of Working Capital
7.8 Control of Working Capital
Chapter 8 Management of Earnings

8.1 Introduction
8.2 Scope of Management of Earnings
8.2.1 Determination of Profits
8.2.2 Surplus: Meaning and Importance Kinds and Sources of Surplus Uses of Surplus Manufacturing of Surplus Hiding Of Surplus
8.2.3 Reserves
8.2.4 Meaning And Concept Of Ploughing Back Of Profits The Necessity of Ploughing Back of profits
8.3 Cost of Retained Earnings
8.4 Dividend Policy
8.4.1 Earnings capitalisation model
8.4.2 Walter's Model
8.4.3 Gordon's Model (continuing dividend growth valuation model)
8.4.4 Graham & Dodd Model
8.5. Company - Specific Policies and Procedures
8.5.1 Stability
8.5.2 Liquidity
8.5.3 Control
8.5.4 Shareholding pattern
8.5.5 Timing of investment opportunities
8.5.6 Legal constraints
8.5.7 Legal provisions in the Indian context
8.5.8 Procedural aspects
8.5.9 Bonus Shares
8.6 Dividend Policies In Practice

Chapter 9 Management of Long Term Funds

9.1 Introduction
9.2 Term loan appraisal
9.3 Security against term loans


10.1 Kinds of Share Capital

10.2 Equity Shares
10.2-1 Advantages and Disadvantages
10.3 Rights Issues
10.3.1 Reasons for a Rights Issue
10.3-2 Advantages of Rights Issue
10.3-3 Procedure of Making Rights
10.3-4 Rights Offer Ratio
10.4 Preference shares
10.4.1 Types of Preference Shares
10.4-2 Advantages and Disadvantages
10.5 Deferred/Founders Shares
10.6 Non voting shares (NVS)
10.6-1 Advantages and Disadvantages
10.7 Sweat Equity Shares
10.8 Stock Options
10.9 Stock Splits
10.10 Buy Back of Shares (Shares Repurchase)
10.10.1 Reasons for Buy-back
10.11 Debentures
10.12 Kinds of Debentures
10.13 Convertible Debentures (CDs)
10.14 New Debt Instruments
10.15.1 Secured Premium Notes (SPN)
10.15.2 Deep Discount Bond (DDB)
10.15.3 Debt for Equity Swap
10.15.4 Multi-option Secured Redeemable Convertible Debentures
10.15.5 Callable Bond
10.15.6 Option Tender Bonds
10.15.7 Guaranteed Debentures
10.15.8 Subordinated Debentures
10.15.9 Floating Rate Bonds
10.15.10 Junk Bonds
10.15.11 Indexed Bonds
10.15.12 Stepped-up Debentures

Chapter 11 Sources of Finance

(Financial Institutions and Term Lending)
11.1 Types of Sources of Finance
11.2 The, Role 0f Commercial Banks in India in long-term Financing 0f Industry
11.3 General Insurance Companies (GIC)
11.4 Life Insurance Corporation of India (LICI) :
11.5 Unit Trust of India:
11.6 Long-term Finance and Governmental Agency’s:
11.7 Credit Guarantee Scheme of the Reserve Bank of India:
11.8 National Small Industries Corporation (NSIC):
11.9 Central and State Finance Corporations:
11.10 The Industrial Finance Corpora/ion of India (lFCI) :
11.11 The Industrial Credit & Investment Corporation of India (I,C.I.C.I.)
11.12 The National Industrial Development Corporation (NIDC):
11.13 The Industrial Development Bank of India (IDBI):
11.14 Industrial Rehabilitation Bank of India
11.15 State Financial Corporation:
11.16 Foreign Financial Participation:
11.17 Foreign Private Loans:
11.18 The World Bank.
11.19 The International Finance Corporation.
11.20 Other Foreign Sources.
11.21 Sale & Leaseback.
Chapter 12 Lease financing

12.1 Introduction
12.2 Lease, Hire-purchase and Installment Sale:
12.3 Types of Lease Arrangements
12.4 Lease Versus Buy: The Basic Decision
12.5 Evaluation of Lease-buy Decision:
12.6 Lease Financing-Leassor’s View Point:

Chapter 13 Mergers and Acquisitions

13.1 Concept of Mergers and Acquisitions

13.2 Mergers And Acquisitions: Types
13.3 Defence against Tender Offer and Hostile Take-over Bids:
13.4 Motives and Reasons Behind Mergers:
Chapter 1- Introduction to Financial Management

1.2 Meaning of financial management

Finance is the life blood of any business or industrial undertaking. It is a pre-requisite for starting and
running of the business. Financial management is concerned with the proper management of funds. It
involves managerial decisions relating to the procurement long term and short-term funds and their proper
utilization in the most productive and effective manner and also to framing of dividend policy.
According to J.F Bradley-“financial management is the area of business management devoted to the
judicious use of capital and careful selection of sources of capital in order to enable spending unit to
move in the direction of reaching its goals”. The main objective of financial management is
a) maximization of profits and assuring better returns on capital by employing funds most
b) procurement of funds at reasonable costs whenever needed
c) Coordinating the activities of the finance department with other departments to ensure timely
meeting of financial needs.

In his book the theory of financial management Ezra Soloman has defined the finance function as the
study of the problems involved in the use and acquisition of funds by a business. its main concern is
to find a rational basis for answering three questions
a) What total value of funds should be invested in the business? That is what size and growth rate
should the business aim to achieve?
b) What specific assets should the business acquire? That is in what form the assets be held?
c) How should the required funds be financed? Alternatively, how should the liability side of the
balance sheet be financed?

Lets look at this definition one by one

a) Investing capital- it relate to the careful selection of viable and profitable investment proposals ,
allocation of funds to the investment proposals with a view to obtain net present value of the
future earnings of the company and to maximize its value .
b) Acquiring capital- it is the responsibility of the financial manager to estimate his firms need for
outside capital and then to raise this capital from the financial market. In fund raising decision,
he should keep in view the cost of funds from various sources.
c) Managing capital- finally, the financial manager has the primary day to day operating
responsibility for company’s current assets. In addition to determining the size of the company’s
investment in these assets, the financial manager is also responsible for administering these
resources efficiently.

1.2 Scope of financial management

Financial management is broadly concerned with the acquisition and use of funds by a business firm.
Its scope may be defined in terms of the following questions:

a) how large should the firm be and how far should it grow ?
b) What should be the composition of the firms assets?
c) What should be the mix of firm’s financing?
d) How should the firm analyse, plan and control the financial affairs?

While the first three questions express Ezra soloman’s conception of financial management as
discussed in his classic work. The theory of financial management the fourth question represents an
addition that I feel is very relevant in the light of the responsibilities shouldered by financial
managers in practice.

1.3 Traditional Vs Modern concept of finance function-

There are two approaches to the finance function. These approaches have the differences because of
time during which these are being adopted. These approaches are
a) Traditional approach
b) Modern approach
Traditional approach- under the traditional approach the function of financial management was
simply the procurement of funds by corporate enterprises to meet their financing needs. Procurement
means the whole gamut of raising funds externally. The financial manager of a business firm will
1) Arrangement of short term and long-term funds from financial institutions.
2) Mobilization of funds through financial instruments like equity shares, preference shares,
debentures, bonds etc.
With the increase in the complexity of modern business situations the role of a financial manager is
not just confined to procurement of funds, but his area of functioning is exaggerated to efficient use
of funds available to the firm and expectation of the provider of the funds.
Modern approach- In view of modern approach, the finance manager is expected to analyse the firm
and to determine the total requirement of the firm. The assets to be acquired and the pattern of
financing the assets. According to modern approach, the finance manager of a modern business will
generally involve the following three types of decisions-
a) Investment decision
b) Finance decision
c) Dividend decision
Investment decision- Investment decision is the most important of the firms three major decisions. It
relate to the careful selection of viable and profitable investment proposals with a view to obtain net
present value of the future earnings of the company and to maximize value
“Investment decision involve identifying the assets or projects in which the firms limited financial
resources should be invested”
Investment decision can be broken down into
a) Capital budgeting decisions (Relating to fixed assets)
b) Working capital management (relating to current assets)
Capital budgeting decision is concerned with designing and carrying out through a systematic
investment programme. According to Charles T Horngren- “ Capital budgeting is long term planning
for making and financing proposed capital outlays”
Working capital management deals with the management of current assets of the firm .By optimizing
the investment in current assets and by reducing the level of current liabilities, the company can
reduce the locking up of funds in working capital thereby it can improve the return on investment in
the business.

Financing decision- financing decisions involve deciding on the most effective method of financing
the chosen investments. Should debt or equity finance be used or perhaps a mix of both. Basically
there are two main sources of finance for any firm, the shareholder fund and the borrowed funds.
Shares represent ownership right in the firm. Buyers of the share are known as shareholder. Legally
they are owners of the firm. Shareholder may get dividend and capital gains in the return of the
invested capital. Shareholders can be of two types – equity and preference shares
a) Equity shares- Equity shares are ordinary shares that do not carry any preferential right in
respect of dividend or repayment of capital. Dividend on them is payable after preference shares.
b) Preference shares- preference shares are those that enjoy preferential rights over equity shares in
matter of payment of dividend at a fixed rate, as well as the return of capital when the company is
wound up. However preference shareholders do not have a voting right except when dividend has
not been paid for more than two years in the case of cumulative preference shares and for more
than three years in the case of non-cumulative preference shares.
Another important source of securing capital is creditors or lenders. Lenders are not owners of the
company. The return on loans or borrowed funds is called interest. Payment of interest is a legal
Financing decision involve formulation and designing of capital structure. The process entails
deciding about the form or pattern of capital structure and also fixing the relative proportion between
various types of funds from different sources proposed to induct in the capital structure. The total
funds collected should represent the ideal mix of cheaper and costlier funds. So the average cost of
overall capital for the company is kept at the minimum level. Some corporations face financial
problems due to wrong financing decisions. There are the corporations having high debt equity ratio
in the capital structure. In bad day it will be very difficult for the company to bear a burden of interest
which makes the company in the sick condition so it is very important for the company to take
financing decision carefully for the growth of the company.
Dividend decision- dividend decision involves deciding how much of the firms earning should be
paid out to shareholders in the form of shareholders in the form of dividends in return for their
investment in the firm and how much should be retained to finance the firm’s future investment plans.
All firms whether small or big have to decide how much of the profits should be reinvested back in
the in the business and how much should be distributed in the form of dividends. The finance
manager is required to take various decisions regarding distribution of profit as dividends; the finance
manager has to look into the fund requirement of the firm and the shareholders interest.
1.4 Objectives/ goals of Financial management
Financial management provides a framework for optimal decision-making. Financial management is
concerned with financing of a firm and with designing a method of operating the investment. The
objective of a company must be to create value for its shareholders. Value is represented by market price
of the company’s common stock. There are two broadly classified objectives of financial management in
terms of approaches:
a) Profit maximization approach
b) Wealth maximization approach
Profit maximization as decision criterion- According to this approach, action that increase profits should
be undertaken and those that decreases are to be avoided. In specific operational terms as applicable to
financial management, the profit maximization criterion implies that the investment, financing and
dividend policy decisions of a firm should be oriented to the maximization of profits. Profit maximization
would imply that a firm should be guided in financial decision making by one test. Select assets, projects
and decisions that are profitable and reject those, which are not the rationale behind profitability
maximization as a guide to financial decision making is simple. It provides the yardstick by which
economic performance can be judged. Finally it ensures maximum social welfare. The profit
maximization criterion is criticized in the following grounds:
 Ambiguity
 Timing of benefits
 Quality of benefits
I) Ambiguity – this approach does not have any precise connotation. The profit as a criterion is a vague
and ambiguous concept. It is amenable to different interpretation by different people. For example profit
may be short tern or long term , it may be total profit or rate of profit; it may be before tax or after tax, it
may be return on capital employed or total employed or total assets or shareholders equity and so on.
Timing of benefit-this approach does not take into consideration the time value of money while working
out profitability “the bigger the better” principle is adopted.
Time pattern of profits
Period Reliance(crore) Tata(crore)
I 5000
II 1000 1000
III 3000 6000
IV 2000 3000
It can be seen from the above table that the profits associated with Reliance and Tata are same. If the
criterion is profit maximization both would be equally ranked. We can see that reliance provides higher
return in the earlier years in comparison to Tata whereas the return from Tata is larger in later years. If we
will take into consideration the TVM the reliance is superior because a basic doctrine of financial
planning is the earlier the better.
II) Quality of benefits- here the quality means the degree of certainty with which benefits are expected.
As a rule, the more certain the expected return, the higher is the expected benefits; the lower is the quality
of benefits. It is in practice that investors want to avoid or at least minimize risk.

Wealth maximization- it is also known as value maximization or net present worth maximization
approach. It takes into consideration the time value of money. As a decision criterion profit maximization
has three shortcomings, it does not take into account of risk, Time value of money and it is ambiguous,
due to these reasons value maximization has replaced ‘profit maximisation’as operational criterion.
Wealth maximization means maximizing the NPV of a course of action. The NPV of a course of action is
the difference between the present value of its benefits and the present value of its cost. A financial action,
which has a positive NPV, creates wealth and accepted whereas negative NPV should be rejected. This
can be expressed through the following formula

Npv = net present value A1 + A2 + A3 + A - C
2 3 n
A1, A2, A3and An are the NPV= (1+r) future
streams of expected (1+r)
cash (1+r)
inflows (1+r)
for different years .
R = discount rate
C = total of present value of the cash outflows.
It can be seen that value maximization is taking into considerations the tvm and handling of the risk as
measured by the uncertainty of the expected benefits is an important part. It would be noted that the focus
of financial management is on the value to the owners or suppliers of equity capital. The wealth of owners
is reflected in the market value of shares so wealth maximization implies the maximization of the market
price of shares.

1.5 How is Financial Accounting related with Financial Management?

Financial accounting Financial management
1)Share capital Capital structure
Equity & cost of capital
Reserve and surplus
Secured loans

2)current liabilities Working capital financing

trade creditors policy
unsecured loans
(short term)
loans and advances

3)fixed assets (net) Capital budgeting

gross assets
less depreciation

4)Investments Security analysis and portfolio


5)cash and bank Receivables Cash management

Inventories Receivables management
Inventory management

1.6 Profit and loss account and finance topics

Net sales Revenue risk
Gross profit Gross profit margin
Depreciation Depreciation policy
Earning before int and tax Business risk
Interest Financial risk
Tax Tax planning
Profit after tax Return on equity
Dividends Dividend policy

Test Questions:
Q1. Define financial management? What are its characteristics? Discuss
Q2. What are the vital aspects of finance function in a business?
Q3. Explain wealth maximization and value maximization objectives of financial management?
Q4. Write a note on traditional VS modern concept of finance function?
Chapter 2 Financial Planning
2.1 Meaning Of Financial Planning.
Funds requirement decision and the financing decision are two major areas of financial decision-making.
Funds requirement decision is concerned with the estimation of the total funds or capital requirements for
the business enterprise, while the financing decision is concerned with the sources from which the funds
are to be raised. In order that the business enterprise get the funds required at reasonable cost, it is also
necessary to raise the funds at the proper time. It is, therefore, necessary that the promoters or the persons,
responsible for the management of the business enterprise take care of all these aspects right at the time of
formation of the company by having a proper financial planning. .
Financial Planning, therefore, includes:
(i) Estimating the amount of capital to be raised.
(ii) Determining the form and proportionate amount of securities.
(iii) Laying down the policies as to the administration of the financial plan.

MEANING OF FINANCIAL PLAN “Financial planning results in the formulation of the financial plan.
It is primarily a statement estimating the amount of capital and determining its composition.
It states:
(i} The quantum of finance, i.e., the amount needed for implementing the business plans.
(ij) The patterns of financing, i.e., the form and proportion of various corporate securities to be issued to
raise the required amount.
(iii)The policies to be pursued for the floatation of various corporate securities, particularly regarding
the time of their floatation.
Principles governing a Financial Plan .
The financial plan should be prepared keeping in view the following principles:
(1) Simplicity. The financial plan should envisage a simple financial structure capable of being
managed easily. The types of securities should be minimum, since securities of various types win- give
rise to unnecessary suspicion in the minds of the investing public and create avoidable complications.
(2).Long-term view. The financial plan should be formulated and conceived the promoters /management
keeping in view the long-term needs of the corporation rather than finding out the easiest way of
obtaining the original capital. This is because the original financial plan would continue to operate for a
long period even after the formation of the company.
(3) Foresight. The financial plan should be prepared keeping in view the future requirements of capital
for the business. Of course, it is a difficult task since it requires making of accurate forecast regarding the
future scale of operations of the company. Technological improvements demand forecast, resource
availability and other secular changes should be kept in view while drafting the financial plan. A plan
visualized without foresight may bring disaster for the company in case It fails to meet the requirements
for both fixedand working capital.
(4) Optimum use. The financial plan should provide for meeting the genuine needs of the company. The
business should neither be starved of funds nor it should have unnecessary spare funds. Wasteful use of
capital is as bad as inadequate capital. A proper balance should be maintained between the long- term and
the short-term funds since the surplus of one would not be able to offset a shortage of the other.
(5) Contingencies. The financial plan should keep in view the requirements of funds for contingencies
likely to arise. It does not, however, mean that capital should be kept unnecessarily idle for unforeseen
contingencies. Promoters' foresight will considerably reduce this risk.
(6) Flexibility. The financial plan should have a degree of flexibility also. Flexibility is helpful in making
changes or revising the plan according to pressure of circumstances with minimum possible delay.
(7) Liquidity. Liquidity- is the ability of the enterprise to make available the ready cash whenever
required to make disbursement. Adequate liquidity in the financial plan gives it a degree of flexibility too.
It could act as a shock absorber in the event of business operations deviating from normal course. This
will help in avoiding embarrassment to management and loss of goodwill of the company among the
(8) Economy. The cost of raising the required capital should be the minimum. It should not impose
disproportionate burden on the company. This is possible by having a proper debt-equity mix.

2.2 Estimating Capital Requirements

The capital requirements of a business enterprise can broadly be classified into two main categories. They
(i) Fixed capital requirements, and
(ii) Working capital requirements.

2.3 Meaning of Fixed capital.

It means the capital, which is meant for meeting the permanent or long-term needs of the business. In
other words fixed capital is required for the acquisition of those assets that are to be used over a long
Fixed capital is required for acquisition of the following assets:
(i) Tangible assets such as land, buildings, plant and machinery, furniture and fittings, etc. -
(ii) Intangible assets such as goodwill, patents, copyrights, promotion, cost, etc.
It should be noted that the fixed assets couldn’t be withdrawn from the business without disturbing the
normal working of the undertaking. It is, therefore, necessary that sufficient funds are raised for
acquisition of fixed assets. These funds are required not only while establishing a new enterprise but also
for expanding, diversifying and maintaining intact the existing enterprise.

2.4 Assessment of fixed capital requirements.

The assessment of fixed capital requirements for preparing a list of the fixedassets needed by the
business can make a business. Having compiled a list of the fixed assets required for the business, it will
not be difficult to ascertain the total funds required for purchase of fixed assets. The price of land can be
found out from the property agents, the information regarding the estimated cost of construction of
building can be obtained from the building contractors, the suppliers of machines can be asked to give
quotations for the plant and equipment to be installed. Similarly, the amounts to be paid for patents, trade
marks, goodwill etc. can also be ascertained.
Factors determining fixed capital. The amount of fixed capital requirements of a business depends
basically on the following factors:
(i) Nature of the business. The nature of the business to a great extent determines the amount of fixed
capital required by the business. For example, public utility concerns like electricity supply companies,
water supply under- t~ or railway companies would reqmre heavy investment in fixed assets; on the other
hand, a trading concern would require relatively much less invest- ment in fixed assets.
(ii) Size of the business. Size of the business has also its impact on the fixed capital requirements of the
business. It can generally be said that larger the size of the business, the heavier would be the investment
in fixed capital.
(iii) Types of products. A company manufacturing simple consumer articles like soap, oil etc., will
require a smaller amount of fixed capital as compared to a company manufacturing complicated industrial
goods such a heavy machinery, tractors, etc.
(iv) Diversity of production lines. More fixed capital will be required in case of companies which have
diversity of production lines as compared to companies which do not have much of diversification. For
example, a company producing ancillary products or by-products together with main products will require
greater amount of fixed capital as compared to companies which
manufacture only main products.
(v) Method of production A company manufacturing each part of a finished product by itselfrequires a
greater amount of fixed capital as compared to a company which gets the parts manufactured from
outside and merely assembles them in its own factory.
(vi) Method of acquisition of ed assets. A company which purchases fixed assets against immediate cash
payment or ownership basis requires a greater amount for fixed capital as compared to a company which
acquires , fixed assets on hire-purchase system or lease system.

2.5 Management of fixed capital. Management of fixed capital is concerned with the raising of required
fixed capital at minimum cost and its effective utilisation. The following principles should be observed in
order to have an efficient management of fixed capital:
(i) Generally only such fixed assets should be purchased which are likely to increase the earning capacity
of the business.
(ii) Wherever feasible, fixed assets should be purchased on rental or hire purchase system. This would
result in releasing pressure on bulk funds.
(iii) Obsolete or outmoded fixed assets should not be bought even though they may be available at lower
(iv) There should not be any idle capacity. This would increase the overhead burden. In other words, new
fixed assets should be bought only when there is already full utilisation of the existing fixed assets.
(v) Fixed assets should be maintained properly. Periodical inspection, overhaul and scheduled repairs
would considerably increase the working life of the assets.
(vi) Proper depreciation should be provided out of profits to enable timely replacement of the fixed assets.
(vii) Investment in fixed assets should have a proper relationship with sales and profits. Fixed assets
turnover ratios for different years can be found out to determine whether investment in fixed assets has
been judicious or not. (viii) The requirements of fixed capital should be met out of long-term, funds such
as share capital, debentures, loans from financial institutions, etc.

2.6 Meaning of Working Capital.

The term working capital refers to the capital required for day-to-day operations of a business enterprise.
It is represented by excess of current assets over current liabilities. It is necessary for any organisation to
run successfully its affairs, to provide for adequate working r capital. Moreover, the management should
also pay due attention in exercising proper control over working capital. Schall has correctly observed it
and Haley that "managing current assets require more attention than managing plant and equipment
expenditure. Mismanagement of current assets can be costly. Too large an investment in current assets
means tying up capital that can be used productively elsewhere. On the other hand, too little investment
can also be expensive. For example, insufficient inventory may mean those sales are lost since the goods
that a customer wants to buy are not available. The result is that Financial Manager spends a large
percentage of his time in managing current assets because these assets vary quickly and a lack of attention
paid to them may result in appreciably lower profits for the firm.

All this indicates that proper estimation of the working capital requirements is a must for running the
business efficiently and profitably. The forecasts regarding working capital are made keeping this factor
in view. However, the requirements of working capital depend on a number of factors. These factors have
been explained below.

2.7 Factors Determining Working Capital.

(i) Production policies. The production policies pursued by the management have a significant effect on
the requirements of working capital of the business. The production schedule has a great influence on the
level of inventories. The decision of the management regarding automation, etc., will also have its effect
on working capital requirements. In case of labour-intensive industries the working capital requirements
will be more. While in case of a highly automatic plan, the requirements of long-term funds will be more.
(ii) Nature of the business. Working capital also depends upon the nature of the business. The public
utility concerns like railways, electricity, etc., have very little need for working capital since most of their
transactions are on cash basis and, moreover, they do not require large inventories. On the other hand,
ordinary manufacturing and trading concerns require sufficient working capital since they have to invest
substantially in inventories and debtors. (
(iii) Length of the manufacturing process. Longer the manufacturing process, the higher will be the
requirements of working capital and vice versa. This is because of the reason that highly capital-intensive
Industries require a large amount of working capital to run their sophisticated and long production
process. On the same principle, a trading concern requires a much lower working capital than a
manufacturing concern.
(iv) Credit policy. A company which allows liberal credits to its customer may have higher sales but will
need more working capital as compared to a company which has efficient debt collection machinery and
observing strict credit terms. This is because in the case of the former company, a substantial amount of
its funds will get tied up in its sundry debtors. The working capital requirements can also be affected by
the Credit facilities enjoyed by the company. A company enjoying liberal credit facilities from its
suppliers will need lower amount of working capital as compared to a company, which does not enjoy
such credit facilities.
{v) Rapidity of turnover. There is a high degree of correlation between the quantum of working capital
and the speed with which the sales are affected. A company having a high rate of turnover will need lower
amount of working capital as compared to a company, which has a low turnover. For example, in case of
jewelers, the turnover is very slow. Not only they have to maintain a high inventory of jewellery of
different types but also the movement of inventory is slow. Thus, the working capital requirements of a
jeweler will be higher than those of a grocer.
(vi) Seasonal fluctuations. A number of industries manufacture and sell goods only during certain
seasons. For example, the sugar industry produces practically all the sugar between December and April
and hence the working capital requirements of this industry will be higher during this period as compared
to any other period. Similarly, the woolen textile industry makes its sales generally m winter; hence its
working capital requirements during this period would be large.
(Vii} Fluctuations of supply. Certain companies have to obtain and maintain large reserves of raw
materials due to their irregular sales and intermittent supply. This is particularly true in case of companies
requiring special kind of raw materials available only from one or two sources. In such a case large
quantity of raw materials has to be kept in store to avoid any possibility of the production process coming
to a dead halt. Thus, the working capital requirements in case of such industries would be large.
Thus, there are several factors affecting the working capital requirements. However, as a general rule, it
can be concluded that in most cases the period, which elapses between the purchase of materials and the
receipt of sale, proceeds of the finished goods will determine the working capital requirements of any

2.8 Estimation different Components of Working Capital.

Since working capital is excess of current assets over current liabilities, the forecast for working capital
requirements can be made only after estimating the amount of different constituents of working capital.
The procedure for estimating each of the constituents and the information required for the purpose is
discussed below:
1. Inventories. The term 'Inventories' includes stock of raw material, work-in-progress and finished
goods. The estimation of each of them will be made as follow:
(a) Stock of raw material- The average amount of raw materials to be kept in stock will depend upon the
quantity of raw materials required for production during a particular period and the average time taken in
obtaining a fresh delivery. Suitable adjustments may have to be made to provide for contingencies and
seasonal factors. For example, if the total quantity of raw materials required in a year amounts to 1,200 kg
and one month is taken in obtaining a fresh delivery, it means a minimum stock of 100 kg of raw
materials must be kept. This may have to be further increased on the basis of likely delays and other
considerations. The quantity of stock multiplied by the price will give the amount of working capital
required for holding stock of raw materials.
(b) Work-in-progress. The cost of work-in-progress includes raw materials, wages and overheads. In
determining the amount of work-in progress, the time period for which the goods will be in the course of
production process is most important.
(c) Finished goods. The period for which the finished goods have to remain in the warehouse before sales
is an important factor for determining the amount locked up in finished goods?
2. Sundry Debtors. The amount of funds locked up in Sundry Debtors will be computed on the basis of
credit sales and the time lag in collecting payment.
3. Cash and Bank Balances. The amount of money to be kept as cash in hand or cash at bank can be
estimated on the basis of past experience. Every businessman knows the amount that he will require for
meeting his day-today payments.
4. Sundry Creditors. The lag in payment to suppliers of raw materials, goods, etc., and the likely credit
purchases to be made during the period will help in estimating the amount of creditors.
5. Outstanding Expenses. The time-lag in payment of wages and other expensive will help in estimating
the amount of outstanding expenses.
Having determined the amount of various current assets and current liabilities, the amount of working
capital can be calculated by any of the following two methods:
(i) By considering the total amount of current assets and current liabilities.
(ii) By considering only the cash cost of current assets and an1ount current liabilities.

2.9 Methods of Working Capital Forecasts

The assessment of working capital requirements for the future can be made according to anyone of the
following methods:
1. By determining the amount of current assets and current liabilities. The assessment of working
capital requirements can be made on the basis of the current assets required for the business and the credit
facilities available for the acquisition of such current assets, i.e., current liabilities.
2. By determining the cash costs Of current assets and current liabilities. It has already been stated
that the working capital is the difference between current assets and the current liabilities. In order to
estimate the requirements of working capital. One has to forecast the amount of current assets and the
current liabilities. However, in case of certain current assets, the cash costs involved are much less than
the value of the current assets. Many experts, therefore, calculate the working capital requirements by
taking into account only the cash cost blocked in sundry debtors, stock of work in progress and finished
goods. According to this approach, the debtors are computed not as a percentage of sales but as a
percentage of cash costs. Similarly the finished goods and work-in-progress are valued according to cash
Test Questions
Q1. What is financial planning? Explain the principles governing a sound financial plan?
Q2. How will you assess the working capital requirement of your company?
Q3 What factor determines the size of investment in the working capital of a business enterprise?

Chapter 3 Capitalization
3.1 Meaning of Capitalization

Capitalization is an important constituent of the financial plan. In common parlance, the term
capitalization means the total amount of capital employed in a business. However, like the broader
concept of capital, there is no universally accepted definition of capitalization. To note the variety of its
meaning, one authority defines' capitalization' as "the sum of the par value of the stocks and bonds
outstanding. This concept of capitalization given by Guthmann and Dougall excludes surplus and
reserves from the ambit of capitalization while they are an integral part of it. A. S. Dewing defines it as
follows: "The term capitalization or the valuation of the capital, includes the capital stock and debt;" But
it is also one-sided point of view. A good definition of capitalisation has been given by E. E. Lincoln,
which runs as follows:
"Capitalization is a word ordinarily used to refer to the sum of the outstanding stocks and funded
obligations... which may represent wholly fictitious values".
According to Gerstenberg: "For all capital purposes capitalization means the total accounting value of all
the capital regularly employed in the business".
Thus, the practical meaning of capitalization is the computation, appraisal or estimation of present value.
The value of the total assets employed in a business at a point of time is the figure obtained by the
valuation concept at a given rate of normal return. Thus, in capitalization the emphasis is placed upon the
amount of capital. The same thought is generally present in legal usage of the term also. Whenever a new
business is promoted, an existing business is expanded or two or more businesses are merged into one, the
problem of capitalization arises frequently. In brief, the term' capitalization' is generally used in the sense
of meaning the long- term financial structure and it embraces the composition of the structure in general
and the value of the structure in particular. So, when we decide what types of securities are to be issued, it
is a financial decision relating to the capital structure and knowing the relative amounts of various
securities to be issued is the problem of capitalization. As a matter of fact, the decisions relating to the
capital structure and capitalization are not altogether different. They are one and the same. Management
prepares an integrated plan to collect the required funds from a variety of sources.
Capitalization of a New Concern - The capitalization of a newly promoted concern has some typical
problems. A new enterprise operates at great disadvantage in the raising of capital because there is no
gauge of the risk involved. Promoters of a new company in the absence of sound background because
beggars instead of choosers of capital. The significance of capitalization is also weakened once the project
is put into operation because the early stages are in any respects a discounting of future possibilities.

3.4 Theories of capitalization

To determine the amount of capitalization of a newly promoted concern, two theories have been
(1) The Earning Theory, and
(2) The Cost Theory.

(1) The Earning Theory of Capitalization. Basically, a business concern is a profit earning institution
and earnings as a test of the amount of capitalization have its own significance. Under this method, the
probable earnings are forecast and then they are capitalized at a normal representative rate of return. The
forecast or projection of earnings is made on the basis of the study of demand of the product to be
produced, the expected competition and future prospects. On the one hand, the commitment of new
capital to a new venture is warranted only when a fair rate of return appears to be feasible. To project the
income, the Performa income statement is prepared and then this earning figure is capitalised at a normal
rate of return. This normal rate of return is the expectation of investor on a similar type of investment. The
management should very carefully decide both these variables. On the other hand, the profit levels should
be no higher than a reasonable amount and the rate of capitalization also should not be abnormally low or
(2) The Cost Theory of Capitalization. In this theory the capitalization is regarded as the equivalent of
the cost actually incurred in setting up the business. The original out-of- pocket investment in land and
buildings, plant and machinery, patents, etc., is estimated and added together. Reasonable provision is
made for future as well as for current needs. Obviously, the use of initial cost facilitates the calculation of
the amount of capital to be raised but it cannot take care of future earning capacity. This approach gives
us only a momentary value of the capital, which would in no way reflect future changes. Not only it is
possible for the capital equipment to become obsolete, but. in addition, true worth is also dependent
primarily upon earnings.
Comparison of both approaches while making a comparison of both approaches, we come to the
conclusion that no approach is self-sufficient. Upon first thought, the cost principle may appear to give
assurance that the capitalisation would at least be representative of the value of the enterprise. But this
hope proves to be momentarily. Original cost is static in character and does not reflect future changes. On
the other hand, the earning approach is also incomplete in itself. A new enterprise has no past or present.
Future earnings cannot be forecast exactly and they depend to a large extent on such external factors
beyond the control of the management. So while taking any final decision, the management should test
the figure with the other approach too. Moreover, there is no final verdict possible as regards to the
capitalisation. As a general rule it will be desirable to allow for a comfortable margin of contingency and
changes in capitalization
3.5 Meaning of Over-capitalisation
The term 'over-capitalisation' is generally used to convey the sense of overstatement of the value of
properties held by the concern or a redundancy of capital. Gerstenberg defines" it as follows:
- A corporation is overcapitalized when its earnings are not large enough to yield a fair return on the
amount of stock and bonds that have been issued or when the amount of securities outstanding exceed the
current value of the assets. -
In the words of Gilbert Harold: -When a company has consistently been unable to earn the prevailing
rate of return on its outstanding securities, considering the earnings of similar companies in the same
industry and the degree of risk involved, it is said to be over capitalized.
Thus, from the above said definitions it is clear that overcapitalization is an economic irregularity
experienced in the long-term and caused by the inability of management in reading the future carefully. It
connotes the situation of issuing excess shares, debentures, bonds, etc. by the company than that is
required. Hence, there is a fall in the dividend rate as the earnings will be insufficient to pay suitably to
the investors. Over-capitalization does not imply a surplus of funds. It is quite possible that a company
may have more funds and yet have low earnings. Often funds may be inadequate. and the earnings, too,
may be low. In both situations, there is over-capitalization.

3.4 Causes of Over-capitalization

(1) Stock Watering- When overcapitalization exists on the basis of deficient offsetting values, the
condition is commonly known as 'watered stock'. When a going concern is purchased or promoters
transfer their property to the proposed business at a higher price or their services or goodwill, etc., are
over-valued, the result is stock watering. It creates the situation of overcapitalization eventually
(2) High Cost of Promotion- If cost of promotion is high the balance sheet of new company will show
fictitious assets in larger amounts resulting into overcapitalization.
(3) Excessive Capital- If management of a company collects funds too much without their need, it will
be naturally overcapitalization. The arrangement will not be able to pay suitable return on it.
(4) Over estimation of Earnings- If the projection of earnings is not correct and they are estimated at a
high level, the company after some time will be overcapitalized.
(5) Capitalization at a Lower Rate-If the normal rate of return is taken to be low, the capitalized value
of earnings will be automatically high. It will make the company overcapitalized .
(6) High Cost of Debt Financing-If company is highly geared and major portion of its earnings goes to
meet interest and other obligations of debt financing, the shareholders will , naturally receive lesser
amount by way of dividend and company will experience overcapitalization.
(7) Defective Depreciation Policy-If management does not provide the proper depre- ciation on its assets
the book value of assets in the long-run will be excessively high than that of their actual value. The
earning capacity of the concern will go down and the company will be overcapitalized.
(8) Liberal Dividend Policy-The management adopts a liberal dividend policy in the beginning and they
do not build surplus and reserves, etc. So the internal net worth base of the company is not sound and
after sometime the features of overcapitalization come forth.
(9) Promotions During boom Period -The companies promoted during boom period are overcapitalized
when there is normal price level. During boom period the assets are paid at a high price and this price
does not verify their earning capacity.
(10) High Rate of Taxation-If there is an increase in the corporate taxation rates, a major portion of
company earnings is utilised in paying taxes resulting into a lower rate of dividend. When company is
unable to pay a suitable dividend for long time the value of its shares will go down.
(11) Practice of Under Capitalization-If any company follows the practice of under' capitalization for a
long time and uses the debt financing on an increasing scale,-it will be over capitalized after some time.
The reason for it is that each debt increases the net burden of interest on company and shareholders get
less by way of dividends.

3.5 Corrections for Over-capitalization

(1) Redemption of Preference Shares-If Company has issued redeemable preference shares and they are
fully paid up, they can be redeemed.
(2) Adjustment in Debt Capital-If capital is sufficient for operations, some portion of debts can be
redeemed and the burden of interest may be lessened.
(3) Ploughing Back of Profits- If the overcapitalization is in initial stages; company can follow a rigid
dividend policy and may make reserves. Reserves and surpluses have no explicit cost so the dividend rate
can be increased on equity shares.
(4) Recapitalization-If condition has become serious the recapitalization should be adopted and financial
structure of the company should be re-organized. It is a complicated and legal affair and it requires the
consent of shareholders too.

3.6 Meaning of Under capitalization-

In the quantitative sense, under capitalization exists when insufficient provision is made for funds to
operate on the most productive basis or sometimes under capitalization is said to take place when there is
understatement of the real economic value of net assets. Sometimes, this is brought about by a deliberate
desire to start operations on limited scale and to expand as the opportunity arises. At other times, the
supply of capital is restricted because of an inability to obtain it on a reasonable basis from the investment
market. When a company is undercapitalized, the rate of dividend on its equity shares goes up and
company experiences the shortage of ready funds to exploit market opportunities. The market value of
equity shares goes high and high encouraging speculators to buy them.

3.7 Causes of Under capitalization

The following are the important causes of under capitalization:
(1) Underestimation of Earnings - If at the time of promotion the expected earnings are under estimated
and afterwards there is an enormous increase in earnings, the company will be in a position to declare and
pay bumper dividends.
(2) Conservative Asset Management Policy-A conservative and overcautious management may write
down the value of the assets below their fair value for the purpose of creating secret reserves. Equivalent
adjustment of surplus or stock is then a necessity. Such practice may be motivated by a strong desire to
build an ultra safe financial position but at the same time it leads to under capitalization.
(3) Unforeseeable Increase in Earnings - If there is an unforeseen increase in earnings due to high
turnover of working capital, high level of efficiency or exemptions granted by Government in corporate
taxation, it also leads to under capitalization.
(4) Conservative Dividend Policy-A conservative dividend policy can also lead under- capitalization in
the long run. A sound reserves and surplus base encourages the management to pay higher dividends.
(5) Trading on Equity - If company follows the policy of trading on equity for a long time and the debt
capital is available to the company on suitable terms and conditions and comparatively at a lower rate, the
company will be undercapitalized after some time.
(6) Promotions during Depression Period- If a company has been promoted during depression period,
the acquisition cost of the assets of such company will be low in comparison to normal times price level.
(7) Forced Scarcity of Capital-Sometimes, the supply of capital is restricted because of an inability to
obtain it on a reasonable basis from the capital market. In such circumstances, the problem of the shortage
of ready funds can create under capitalization.
(8) Ploughing Back of Profits -Sometimes, companies retain a major portion of earnings
and ploughs it back in the business, the company earns handsome amount on it also. It enhances the rate
of dividend to equity shareholders.
(9) High Level of Efficiency-If a company is working on a high level of efficiency, it can work even with
a meager amount of capital and the continuous practice of such type leads to under capitalization.

3.8 Remedies of Under capitalization

(1) Splitting-up Shares-If shares of large denomination are divided into the shares of low denomination;
the problem can be solved to a possible extent. Now the dividend per share can be distributed on a large
number of shares.
(2) Increase in the Par Value of Shares-If it is possible the par value of shares outstanding may be
increased equal to the total market value of those shares and amount required for it can be utilized from
reserves and surplus account.
(3) Capitalization of Earnings- Retained earnings has no explicit costs. They should be capitalized and
then they will also be part of cost bearing capital. It will bring down the dividend rate at a reasonable
(4) Fresh Issue- If additional funds are needed, fresh unissued shares may be issued to the public and
total capital can be increased.

3.9 Under capitalization Vs. Overcapitalization

Under capitalization and overcapitalization both are economic irregularities relating to the capitalization
of a company. Over-capitalization is a more common phenomenon and under capitalization has rare
occurrence. However,' both are detrimental to the interests of the society. We may compare them in terms
of their effect on investors, on company and on the society in general.
Serial no Basis Over-capitalisation Under-capitalisation
1. Rate of dividend or It is lower. It is higher.
rate of earning per
2. Possibility or nature Income is uncertain or Income is sure and
of income irregular regular.
3. Value of shares Capital value of shares Capital value of shares
decline. increases.
4. Real worth of shares Real worth of shares is Real worth of shares
reduced. increases.

3.10 Distinction between capitalization and share capital

No. Capitalisation Share capital
1 It is the sum total of all long- It is the sum total of shares
term securities issued by a issued by the company
company and the surpluses not
meant for distribution.
2 Capitalization = share capital Share capital = equity share
+ irredeemed bond and capital + preference share
debentures + outstanding long capital
term loans + reserves and
3 At the time of valuation, par or Here paid up value of share
face value of the securities are are taken into account.
taken into account

Test Questions
Q1. Explain the meaning of capitalization. How would you estimate the capital requirements of a
newly promoted corporation?
Q2. Define capitalization and discuss the theories of capitalization?
Q3. What do you mean by over capitalization? Critically discuss its causes and disadvantages. What
will you do for controlling the over capitalization?
Q4. What do you mean by under capitalization? Explain its causes and effects. Give the suggestion to
overcome them.
Q5. “Under capitalization leads to over capitalization “ do you agree with this statement? Give
Q6. Write a short note on ‘watered capital’?

Chapter 4 Leverage

4.1 Concept of Leverage

A business firm obtains capital from two major sources: by the issue of ownership securities and by the
issue of creditor ship securities. These two sources are frequently referred to as 'Owned Capital' and 'Debt
Capital'. 'Owned Capital' is the amount contributed by the owners of the business: on the other hand, debt
is the amount owned by the creditors. An average business firm utilises three types of debt in its financing
process: Short-term, medium- term and long-term. Trade credit, accounts payable, promissory notes are
frequent examples of short-term credit. Medium-term loans and public deposits are important examples of
medium-term debt capital. Long-term debt may be obtained either through the issuance of formal debt
instruments to the public such as debentures, bonds, or long-term loans from public financial institutions.
The main motive of using debt capital in the financial structure of business firms is two-fold: to maximize
the return to its equity-holders and lowering down the average cost of capital. There are certain obvious
advantages of using debt capital. They are: (i) getting funds without sharing in control and management,
(ii) advantage of tax shield, (iii) creating flexibility in capital structure and economy in raising funds etc.
One important feature of debt finance is its fixed cost of capital. It affects to a large extent the profitability
of the enterprise, earnings per share and finally the market price of shares. Leverage is the most crucial
and useful instrument to measure the impact of debt capital on the three variables.
Meaning of Leverage
The dictionary meaning of the term leverage refers to "an increased means of accomplishing some
purpose " In mechanics, leverage means the instrument that helps us in lifting heavy objects, which may
not be otherwise possible. However, in the area of finance, the term leverage has a special meaning. It is
used here to describe the firm's ability to use fixed cost funds to magnify the return of its owners. The tax
deductibility and low rate of interest prompt the management to use borrowed funds in capital or financial
structure of firms and "the use of the fixed charge sources of funds, such as debt and preference capital
along with the owner's capital in the capital structure is described as financial leverage"
According to Solomon Ezra, "Leverage is the ratio of the net rate of return on shareholders' equity and the
net rate of return on total capitalisation."
In the words of James E. Walter, "Leverage may be defined as percentage return on equity to percentage
return on capitalisation".
According to Weston and Brigham, "In general usage, the leverage is defined as the ratio of total debt to
total assets"2
James Van Home has defined leverage as "the employment of an asset or funds for which the firm pays a
fixed cost or fixed return". Thus, according to him, leverage results as a result of the firm employing an
asset or source of funds, which has a fixed cost of capital. The former may be termed as "fixed operating
cost", while the latter may be as "fixed financial cost". It should be noted that fixed cost or return is the
fulcrum of leverage. If a firm is not required to pay fixed cost or fixed return, there will be no leverage.
Since fixed cost or return has to be paid or incurred irrespective of the volume of output or sales, the size
of such cost or return has considerable influence over the amount of profits available for the shareholders.
When the volume of sales changes, leverage helps in quantifying such influence. It may, therefore, be
defined as relative change in profits due to a change in sales. A high degree of leverage implies that there
will be a large change in profits due to a relatively small change in sales and vice versa. Thus, higher the
leverage, higher is the risk and higher is the expected return.
4.2 Types Of Leverages
In the literature of finance, there are three types of leverages: (i) Operating leverage, (ii) Financial
leverage and (iii) Composite leverage.

4.2.1 Operating Leverage.

The first type of leverage is operating leverage. It may be defined "as the tendency of the operating profit
to vary disproportionately with sales. " It is said to exist when a firm has to pay fixed cost regardless of
volume of output or sales. This results in a disproportionately higher change in the net income,
consequent to change in the level of sales. The firm is said to have a high degree of operating leverage if
it employs a greater amount of fixed costs and a small amount of variable costs. On the other hand, a firm
will have a low operating leverage when it employs a greater amount of variable costs and a smaller
amount of fixed costs. Thus, the degree of operating leverage depends upon the amount of fixed elements
in the cost structure.
Operating leverage in a firm is a function of three factors :
1. The amount of fixed costs.
2. The contribution margin.
3. The volume of sales.
Of course, there will be no operating leverage, if there are no fixed operating costs.

Computation of Operating Leverage. The operating leverage can be calculated by the

Following formula with the assistance of break-even technique:
Operating Leverage = Contribution C
Operating Profit OP
Here, Contribution means sales less variable cost, and Operating Profit means "Earning before Interest
and Tax" (EBIT)
Operating leverage may be favourable or unfavourable. In case the contribution exceeds the fixed cost,
there is favourable operating leverage. In a reverse case the operating leverage will be termed as
unfavourable. Thus, operating leverage results when fluctuations in sales revenue produce wide
fluctuations in operating profit. High operating leverage involves a very risky situation because margin of
safety is very low. A low operating leverage, on the other hand, gives enough cushions to the management
providing a high margin of safety against the fluctuations in sales. Degree of Operating Leverage.

The degree of operating leverage may be defined as percentage change in the profits resulting from a
percentage change in the sales. It may be put in the form of following formula:
Degree of Operating Leverage = % change in operating profit
% change in sales

4.2.2 Financial Leverage.

The Financial1everage is also known as capital leverage. It may be defined as the tendency of the residual
net income to vary disproportionately with operating profit. It measures the effect of fixed charges
payable on long-term funds on the earnings belonging to the shareholders and indicates the change that
takes place in the taxable income as a result or change in the operating income. It signifies the existence
of fixed interest/fixed dividend bearing securities in the total capital structure of the company. Thus, the
use of fixed interest/dividend bearing securities such as debt and preference share capital along with the
owners' equity in the total capital structure of the company is described as financial leverage. Where in
the capital structure of the company, the fixed interest/dividend bearing securities are greater compared to
the equity capital, the leverage is said to be larger. In a reverse case the leverage will be said to be smaller.
Weston Holt opines "financial leverage may be defined either by the ratio of total debt to net worth or by
the ratio of total debt to total assets." According to this definition financial leverage may be called capital
leverage also. and Unfavourable Financial Leverage- Financial leverage may be favour- able or
unfavourable depending upon whether the earnings on total capital employed exceeds the explicit fixed
cost of funds or not. The leverage will be considered to be favourable so long the firm earns more on
assets purchased with the funds than the fixed costs of their use. Unfavourable or negative leverage
occurs when the firm does not earn as much as the fund's cost. or Conditions for Trading on Equity The following are the important
requirements for successful operation of this policy:
(1) Stable Earnings-The permanent borrowing should be undertaken only when a reasonable stability of
income makes the required payment of interest to the debenture-holders fairly certain. A company whose
earnings are reasonably stable may be justified in trading on equity. But if the earnings are subjected to
violent fluctuations, borrowings should be resorted to on a limited scale.
(2) Large Investment in Fixed Assets-Large amounts of fixed property constitute a valuable adjunct for
borrowing money, since they give the lender a feeling of security and an assurance that the company will
not vanish overnight. Generally, stable earnings and large fixed assets accompany each other. The public
utility services provide such unique combination; hence, they are in a position to benefit from this policy.
(3) Well Defined and Established Field of Enterprise- Third requirement for satisfactory trading on the
equity is that the field of enterprise be well defined and established. The new and untried ventures should
be invariably financed with the equity shares.
(4) Cost of Borrowings-The next condition on this policy is the increasing cost of borrowings. As the
proportion of funds borrowed from debentures increases, increased investment risk tends to increase the
rate of interest to be paid. But this check is operative in a perfect money market only where tenders are
thoroughly competent to measure the risks involved.
(5) Custom or Usage-The next important restriction on this policy is of a practical character. It is the
custom or usage of the industry concerned which builds the general standard beyond which neither
issuing company nor the purchasing institutions would like to go. "Although custom will neither gain
universal observance nor guarantee certain safety, it nevertheless plays an extremely useful part in the
world of finance." I Trading on Equity and Financial Leverage. Financial leverage is also some times
termed as "trading on equity". However, most of the authors on Financial Management are of the opinion
that the term trading on equity should be used for the financial leverage only when the financial leverage
is favourable. The company resorts to trading on equity with the objective of giving the equity
shareholders a high rate of return than the general rate of earning on capital employed in the company, to
compensate them for the risk that they have to bear. For example, if a company borrows Rs. 100 at 8 %
interest per annum, and earns a return of 12 %, the balance of Rs. 4 per annum after payment of interest
will belong to the shareholders and, thus, they can be paid a higher rate of return than the general rate of
earnings of the company. But in case, the company could earn a return of only 6 % on Rs. 100 employed
by it, the equity shareholders will lose Rs. 2 per annum. Thus, the financial leverage is a double- edged
sword. It has the potentiality of increasing the return to equity shareholders, but at the same time creates
additional risk for them. Mr. Waterman in his 'Essays on Business Finance' has beautifully described the
role of financial leverage in the following words: "the role of financial leverage suggests a lesson in
Physics, and there might be some point to considering the rate of interest paid as the fulcrum used in
applying forces through leverage. At least it suggests consideration of pertinent variables; the lower the
interest rate, the greater will be the profit and less the chances of loss. The less the amount borrowed, the
lower will be the profit or loss; also a greater the borrowing the greater the risk of unprofitable leverage
and greater the chances of gain. Often corporate management in its enthusiasm to maximise the return on
equity shares, follows a policy of high degree of leverage. It is dangerous. The limitations of the policy of
trading on equity must always be kept in mind. "Financial leverage is like a structure which requires a
solid foundation. This foundation is provided by the low operating leverage. Mere dependence on high
financial leverage without paying adequate attention to operating leverage results in a lop-sided capital
structure." So, this policy must be adhered to only when the requirements of trading on equity are well
satisfied. A mere dependence on high leverage without paying adequate attention to operating leverage
results into a lop-sided capital structure, high burden of fixed capital costs, low profits, low market price
of equity shares and ultimately early winding up of the company. Debt is just like consumption of fat,
which is good for a healthy living for a healthy person who is capable of digesting .it. Computation of Financial leverage It takes place as follows:
Financial Leverage = EBIT = EBIT
EBIT stands for earning before interest and tax
INT stand for interest on borrowed capital
PBT stands for profit before tax Degree of Financial leverage

The degree of financial leverage can be computed by measuring percentage change in profits caused by a
given percentage change in EBIT. This can be expressed as follows:
DFL= % Change in sales
% Change in EBIT
DFL stands for degree of financial leverage
PBT for profits before tax
EBIT for earning before interest and tax

Examples of Leverage

Measures the change in ebit for a given change in sales; caused by fixed operating costs
Remember breakeven analysis?



%  SALES - 50% BASE +50%

SALES (UNITS) 1000 2000 3000

SALES 10000 20000 30000
LESS: VC -5000 -10000 -15000
LESS: FC -5000 -5000 -5000

EBIT 0 5000 10000

%  EBIT -100% BASE +100%


%  SALES - 50% BASE +50%

SALES (UNITS) 1000 2000 3000

SALES (Rs) Rs10000 Rs20000 Rs30000
LESS: VC (Rs4.50) -4500 -9000 -13500
LESS: FC -6000 -6000 -6000
EBIT -500 5000 10500

%  EBIT -110% BASE +110%

DOL = %  EBIT




%  EBIT - 100% BASE +100%

EBIT Rs0 Rs 5000 Rs10000

LESS: INTEREST -1000 -1000 -1000
PROFIT B4 TAX -1000 4000 9000
LESS: TAX@ 40% +400 -1600 -3600
PROFIT AFTER TAX -600 2400 5400
STOCK DIVIDENDS -400 -400 -400

SHAREHOLDERS -1000 2000 5000

EPS OF(1000
shares) =  EPS
%-Rs1.00 Rs2.00 Rs5.00
%  EPS -150% BASE +150%
4.3 Total Leverage

Combines Effects Of Using Fixed Operating And Financial Costs To Magnify Impact Of Changes In
Sales On Eps











Test Questions And Problems

I. Explain operating and financial leverage and briefly discuss the implications of each one of them?
2. What is financial leverage? Can all types of companies afford to maintain a high financial leverage in
their capital structures? Explain giving reason.
3. What is the combined impact of operating and financial leverages? Illustrate your answer by taking a
suitable example.
4. "Operating leverage plays an important role in capital budgeting decisions and long-term profit-
planning:' Do you agree? Give reasons in support of your answer.
5. Examine the importance of conducting the financial leverage analysis for a financial executive in
corporate profit and financial structure planning.
6. "Financial leverage acts as a lever to magnify the influence of fluctuations in operating income on
earning per share:' Comment on this statement with suitable examples.
7. Examine the dangers of high financial leverage. What are the limitations of Trading on Equity? 8.
Distinguish between operating leverage and financial leverage. Do you think they are related to capital
9. "While considering the various alternative financing plans, it is imperative that a financial manager
must keep in mind the firm's degree of financial leverage:' Explain this statement n the light of positive,
negative and indifferent (neutral) financial leverage.
10. Assuming that other variables remain unchanged evaluate the impact of the following changes on the
degree of combined leverage on the firm: (i) EBIT level of the firm increases, (ii) Firm's fixed costs
increases, (iii) sales price per unit of the firm decreases, and (iv) the variable costs per unit of the firm
11. The capital structure of the Progressive Corporation consists of an ordinary share capital of Rs.
10,00,00) (shares of Rs. 100 par value) and of Rs. 10,00,00) of debentures @ 10%. Sales increased by
20% from 1,00,00) units to 1,20,00) units; the selling price is Rs. 10 per unit, variable costs amount to Rs.
6 per unit and fixed costs amount to Rs. 2,00,00). The rate of tax for the corporation is 50%.
You are required to compute (i) the degree of financial leverage at 1,00,00) units and 1,20,00) units, (ii)
the degree of operating leverage at 1,00,00) units and 1,20,00) units of output, and (iii) the impact of
combined leverage at both the levels of output.

Chapter 5 Capital Structure

5.1 Meaning and factor influencing Capital Structure

There are only two ways in which a business can make money:
 The first is debt. The essence of debt is that you promise to make fixed payments in the future
(interest payments and principal repayment). If you fail to make those payments, you lose control of
your business. For a publicly traded firm, debt can take the form of bonds, in addition to bank loans.
 The other is equity. With equity, you get whatever cash flows are left over after you have made debt
payments. For a publicly trade firm, equity takes the form of common stock.
Capital structure decisions are about how much debt and how much equity will be used in a firm. Does
the amount of debt used have an effect on firm value? Or in other words, is there an optimal debt-equity
ratio that maximizes the shareholders’ wealth or the firm’s value?

Our presentation starts with an ideal, prefect and frictionless world. In this world:
 There are no taxes.
 There are no transaction costs.
 There is no default risk associated with the use of debt.
 There are no agency costs, either between shareholders and bondholders, or between shareholders
and managers.

There is no uncertainty about cash flows generated in the future.

Debt-equity mix in the total capitalization of a firm is determined by a variety of qualitative and
quantitative considerations already discussed in the preceding chapter. The main considerations are
concerned with income, control, risk and value of the firm. A capital structure, which minimizes the
weighted average cost of capital and maximizes EPS and thus the value of the firm can be called an
optimum capital structure. Truly speaking there is much divergence of views about the term optimum
capital structure. According to one view a change in capital structure (leverage or debt-equity mix) causes
a corresponding change in the EPS and the value of the firm. The other view contends that the value of a
firm has nothing to do with change in capital structure or debt-equity mix. The value of a firm is not
dependent on capital structure; but on the risk perception by investors; who assess the value on the basis
of overall capitalisation rate; irrespective of its debt- equity mix. These are two extreme views and the
other approaches in fact try to balance these two theories.
The various theories in this regard are based on three basic variables. These are earnings, cost of capital
and financial risk. A decline in earnings may cause a crisis before a highly leveraged firm and thus may
make the position of equity shareholders very risky; causing a decline in their EPS and a fall in the market
prices of their shares. Additional doses of leverage in the capital structure are likely to reduce the overall
cost of capital (Ko) of the firm, because cost of debt (Ki) is a cheaper source of capital due to tax
advantage. But this is possible upto a certain point beyond which the cost of debt (Ki) may rise and be
equal to overall cost of capital (Ko). Financial risk may change due to variability in earnings of equity
shareholders and also due to the possibility of probable insolvency caused by cash inadequacy to meet
even the non-discretionary obligations or payments. All the approaches or theories of capital structure try
to analyze inter-relationship between debt- equity mix (capital structure) cost of capital and the value of
the firm. The four theories of capital-structure are:
1. Net Income Approach
2. Net Operating Income Approach
3. Traditional Appr0ach
4. Modigliani-Miller (MM) Approach.
Before discussing the above theories, it would be more appropriate to mention certain common terms and
symbols and the underlying assumptions.
NI = Net Income available to equity shareholders.
NOI = Net Operating Income or (0)
I = Interest amount on long-term debt,
B = Total market value of debt
S = Total market value of equity
V = Total market value of the firm.
Symbols used to express costs of various funds are as follows: . Interest
KI = Cost of Debt = Interest __________
Market Value of Debt
Ke = Cost of equity = ______NI_________
Market value of equity
Ko = Overall cost of capital or weighted average cost of capital can be computed as below:

Ko = Ki ___b____ + Ke ____S______
(B+S) (B+S)
Ko = EBIT + I+NI

V == Net Operating Earnings______ = O

Total market value of the firm V

Whenever debt-equity mix (leverage) changes the relative total values of debt (B) and equity (S) also
change; which ultimately causes change in Ki (cost of debt), Ke (cost of equity) and Ko (overall cost of
capital). Thus, the analysis of the various approaches is mainly based on changes in Ki, Ke and Ko on
account of changes in degree of financial leverage.
The underlying assumptions are as follows:
1. There are no income taxes. This implies that use of debt capital does not attract tax benefit. This
assumption is only for the sake of simplifying the analysis.
2. Dividend payout ratio is kept 100 per cent. This means that the entire earnings available to equity-
holders are distributed as cash dividend and nothing is kept in the form of retained earnings.
3. There are only two sources of capital- bonds (debt) and equity share capital.
4. Operating profits (EBIT) remain constant. This implies that probability distribution of EBIT is known
and the mean values of each years EBIT distribution is constant.
5. Operating risk (business risk) is constant and on the basis of this assumption the effects of financial risk
are isolated and analysed.
6. Total capitalisation remains constant. This means that the firm can make changes in leverage (debt-
equity mix) either by selling equity shares and using the proceeds to repay bonds or debt; or by selling
bonds and using the proceeds to repurchase equity shares (reduce stock).

5.2 Net Income (NI) Approach

The exponent of this theory is David Durand. According to this approach capital
structure decisions regarding leverage or debt-equity mix exercise an important impact on the value of the
firm. An increase in the degree of leverage or debt in the capital structure will bring down the overall cost
of-capital (Ko) of the firm (given a constant EBIT) and will increase the total market value (V) of the
firm; resulting in raising the market price of equity shares. On the contrary, given the same EBIT, if ratio
of debt to total capitalisation is brought down (by issuing additional equity shares and utilising the
proceeds for retiring bonds or making repayment of debt of equal amount) then this will increase the
overall cost of capital (Ko) for the firm and. will bring down the total value of the firm causing a decrease
in the market price per equity share.
The inter-relationship between financial leverage, cost of capital and the value of the firm hold good with
certain assumptions.
Firstly, there are no taxes on income.
Secondly, the rate of interest on debt (Ki) is lower than rate of return on equity or equity-capitalisation
rate (Ke).
Thirdly, the investors (shareholders and lenders) perceive no change in financial risk. In other words, cost
of debt (Ki) and cost of equity (Ke) remain unchanged or constant. In case these assumptions hold true,
then the financial manager of a firm can try to attain an optimum capital structure through an ideal debt-
equity mix, which will minimise the overall, cost of capital (Ko) and maximise the total market value (V)
of the firm. The approach can be explained better by taking an example.
it can be said that Net Income (NI) Approach explains that higher leverage in capital structure lowers
overall cost of capital (Ko) and increases total value of the firm (V). It focuses attention to the fact that if
financial leverage is favourable (i.e., Ke> Ki) then increase of debt ratio to total capitalisation will
maximise the total value of the firm as well as the market value of its equity shares.
On the contrary, Net-income theory also suffers from certain shortcomings, as it is not based on practical
or realistic considerations or assumptions. It ignores the fact that increase of leverage in capital structure
also increases risk perception of equity-holders who rightly expect a higher return on their equity, which
raises Ke (in contrast to a constant Ke as assumed in NI theory). Similarly, the theory assumes a constant
EBIT and a constant Ki which in actual practice cannot be realistic.

5.3 Net Operating Income (NOI) Approach

NOI approach is extremely opposite to NI approach. Net operating income (NOI) theory was also
promulgated by David Durand. According to this approach, the overal1 cost of capitalisation (Ko)
remains constant. That is why it is also known as a fixed capitalization rate theory. It has no relation to
capital structure, which means that overall capitalisation rate (Ko) is independent of changes in capital
structure through variation in debt-equity mix. Investors determine the total value of the firm on the basis
of overall capitalisation rate (Ko). It is not necessary to split up total capitalisation into equity and debt
and aggregate their capitalised values (on the basis of a fixed Ki and Ke as is done under NI approach) in
order to determine the total market value of the firm.
The NOI theory contends that Ko remains as a constant percentage for firms operating in similar line of
activity and having similar risk perception. The net operating income is thus capitalised at a constant rate
of capitalisation (Ko) to calculate the total market value (V) of the firm.
This follows that the market computes or evaluates the value of the firm as a whole by dividing operating
profit (EBIT) by Ko (capitalisation rate) as given below: EBIT 0
V = EBIT or O
K0 K0
In this way the overall capitalisation rate (Ko) can be considered as an important factor in evaluating the
value of the firm. The market value of a firm has, thus, no relevance to changes in capital structure
through increase or decrease in degree of leverage (ratio of debt to total capital). The value of a firm as a
whole will remain constant irrespective of its debt-equity mix (of course given a constant EBIT or
operating income) a change in the degree of leverage will not cause a corresponding change in the total
market value of the firm.
As contrary to NI approach (in which Ke was considered to be constant) the equity capitalisation rate
(Ke) is not constant under NOI approach and will increase with every increase in financial leverage;
because of increased financial risk for equity-holders. it does not compensate the existing shareholders for
enhanced risk (due to an increase in the higher rate of return on their equity capital. This raises the cost of
equity share capital, which implies that the equity capitalisation rate (Ke) goes up substantially. In case
the firm does not compensate the existing shareholders for enhanced risk (due to an increase in leverage)
then the shareholders may start selling their shares and this will bring down market price per share. In
other words the price-earnings ratio will go down so as to counter balance the increase in leverage.
The cost of debt (Ki) has two manifestations.
One is the explicit cost, which is represented by the rate of interest on debt. The other is the implicit cost
of debt which may be termed as an indirect or hidden cost. The increase in.Ke (cost of equity capital) due
to increase in leverage as explained in the preceding paragraph) in a way is the implicit cost of debt
Therefore. it -would-be more appropriate to say that the benefit of a constant explicit cost of debt (Ki) is
off-set by a corresponding rise in its implicit cost (as represented by the increased Ke).
The above description leads to conclude that Net Operating Income (NOI) approach totally ignores the
role of debt-equity mix changes in capital structure of a firm. This virtually means that changes in the
degree of leverage will not make any change in the total market value of the firm or the market price of its
equity shares and thus financing decision pertaining to variation in debt-equity ratio in the capital
structure is a matter of indifference for the investors. Any capital structure can thus be an optimum capital
structure so far as the overall capitalisation rate (Ko) remains constant (which is one of the basic
assumptions under this approach) and on the basis of this Ko the market continues to determine the total
value of the firm.

Net Operating Income (NOI) Approach: An Appraisal NOI approach is extremely opposite to NI
approach. Net operating income (NOI) theory was also presented by David Durand. According to this
approach the overall cost of capital (Ko) is not dependent on debt-equity mix in capital structure.
Investors (both equity-holders and lenders) determine the total value of the firm as a whole. It is not
necessary to split up total capitalisation of a firm into debt and equity and then aggregate the total values
of debt and equity to find out the total value of the firm.
The NOI theme contends that the net operating income is capitalised by the market at a constant rate of
overall capitalisation to ascertain the total market value of a firm. The overall capitalisation rate (Ko) is
assessed by investors operating in the capital market as a fixed percentage for firms in similar line of
business and with similar risk perception. Thus, Ko remains constant under this approach and that is why
this theory is called as fixed Ko approach. The market capitalises the value of a firm as a whole by
dividing EBIT by Ko (overall capitalisation rate for firms in the category) as follows:
In this way the rate of overall capitalisation can be considered a key-determinant in ascertaining the total
value of a firm. This follows that a firm has no relevance to changes in capital structure. The total value of
a firm will remain constant irrespective of its degree of leverage or ratio of debt to equity. In other words,
it can be said that given a constant EBIT and a constant rate of overall capitalisation, a change in degree
of leverage or debt- equity ratio will not make any change in the total market value of the firm.
As contrary to NI approach (in which Ke was deemed to remain constant) cost of equity (Ke) does not
remain constant under NOI approach. Thus, an increase in degree of financial leverage increases financial
risk for equity shareholders; which raises their expectations and they expect a high return on their
investment with a view to counter-balance the increased risk. In this way cost of equity (Ke) goes up with
every increase in financial leverage. Moreover with a higher debt or increase in the degree of leverage the
cost of debt (Ki) also does not remain constant. With higher doses of debt the lenders certainly perceive a
higher risk. However they do not press on an increase in explicit cost of debt 1. But there is a hidden cost
of debt, which can be called as implicit cost of debt. Although the explicit cost of debt remains the same
with increase in leverage in capital structure; yet the implicit cost goes up. This follows that the benefit of
a constant Ki (explicit cost of debt) is offset by a corresponding rise in its implicit cost (as represented by
increase in Ke).
The above account leads one to conclude that NOI approach accords no role to capital structure planning
decisions. According to it, any capital structure can be optimum as the total market value of a firm is not
related to degree of financial leverage. According to this logic financing decision-making pertaining to
debt-equity mix is a matter of indifference for investors in the capital market as they capitalise NOI at a
fixed Ko (overall rate of capitalisation) to determine the total market value of a firm. The following
illustrations will make the analysis more clear.

5.4 Traditional Theory

NI approach and NOI approach (discussed above) represent two extreme themes to analyse inter-
relationship between capital structure decisions, the value of the firm (V) and the overall cost of capital
(Ko). The basic contention under NI approach is that changes in capital structure (through variation in
debt-equity ratio) always affect Ko and V, The NOI theme, on the other hand assumes that changes in
capital structure in the form of increase or decrease in leverage do not exercise any impact on V and Ko
which are totally independent and not related to financing decisions.

The traditional theory of capital structure is an intermediary approach, which reconciles NI, and NOI
approaches. This theory assumes that (a) there is relevance of capital structure and through proper
increase in leverage or debt-equity mix a firm can have an optimum capital structure in which the total
market value (V) of the firm will be maximum and overall cost of capital (Ko) minimum. The optimum
capital structure for firm will be at that level of debt-equity mix at which the marginal real cost of debt
(both explicit and implicit) is equal to the real cost of equity. (b) The overall cost of capital' (Ko) is
affected 'by capital structure decisions. (c) Beyond a particular point increase in leverage causes rise in
equity capitalisation rate (Ke) at a rapid rate. That is why this theory is also known as 'varying Ke at
varying leverage theory'. (d), Beyond a certain critical point cost of debt (Ki) also shows tendency to rise;
although such increase is not rapid.

The traditional theory assumes that as financial leverage goes up on its path from 0 to 1, three distinct
phases can be perceived. These are:
I. The First Phase is the initial stage in which there is increase in total market value of the firm (V) and
decrease in overall capitalisation rate (Ko) along with increase in leverage. The Ke, no doubt, shows signs
of increase, but the rise in Ke is too moderate and too insignificant to neutralize the benefit of additional
debt, which is a cheaper source of capital.
2. The Second Phase is characterised by a constant V and constant Ko. During this phase the total market
value of the firm (V) and the overall cost of capital (Ko) remain almost constant as degree of leverage in
capital structure rises. This is because the benefit of using debt (at cheaper Ki) is neutralized by a
corresponding higher rise in equity capitalisation rate (Ke).

3. The Third Phase is characterised by a decrease in total market value of the firm (V) and increase in
overall cost of capital (Ko) with every increase in financial leverage beyond a critical level. Beyond this
critical point increase in rate of debt to total capitalisation causes substantial increase in risk and as a
result both Ke (equity capitalisation rate) and Ki (rate of interest on debt) show a rapid increase.

5.5 Modigliani-Miller (M.M.) Theory

M. M. theory of capital structure has been named after Franco Modigliani and Merton H. Miller.' This
approach closely resembles NOI approach so far as' the theme of irrelevance of capital structure in
determining V and Ko /1le concerned. Both the approaches contend that cost of capital (Ko) is
independent of the degree of leverage in capital structure and hence the value of the firm (V) also is not
affected by financing decisions. M.M. approach, however, goes a step further and provides a 'rational'
explanation and operational justification (which is lacking in NOI approach) for the independence or
irrelevance of the degree of financial leverage in the valuation of a firm and in computing its Ko. NOI
approach, no doubt, assumes that there is no inter-relationship between cost of capital (Ko) and the debt-
equity ratio; but does not give any behavioural or operational justification for such a contention. This has
been explained by M.M. approach in a rational manner.
Modigliani and Miller in their approach have given certain simplified assumptions and have also provided
three basic propositions. These have been summarised below.

Simplified Assumptions M.M. approach develops its theme on the basis of the following four

I. The Capital Markets are perfect. This implies that the investors in the capital market think and behave
in a rational manner and can sell and purchase securities without any restrictions, The capital market has a
perfect information system which means that the required information is made available to each investor
promptly and without any cost. The securities traded in the market are divisible infinitely and the
borrowing facilities are freely available to investors on similar terms and conditions; at a risk- free
interest rate.
2, There are no transaction costs (stamp duty, commission, brokerage, etc.) involved in or attached to sale
and purchase of securities.

3. All the firms can be classified into 'equivalent risk class or group' and that the extent of risk is equal for
firms in a particular equivalent risk class or 'homogeneous risk category'. The values of probability
distribution of estimated future operating earnings are the same for firms within the homogeneous or
equivalent risk category.
4. There are no taxes on corporate income-an assumption, which was subsequently removed by
Modigliani and Miller. It is' also assumed that the firms pay 100% of their earnings as dividend and thus
do not retain any earnings in business.
Basic Propositions
1. The total market value of a firm (V) and its overall cost of capital (ko) are not dependent on the degree
of leverage in their capital structure and remain constant irrespective of any level of debt-equity mix.
2. The cost of equity (Ke) is equal to the rate of capitalisation of pure equity earnings stream plus a risk-
premium. This implies that a risk-premium is added to the pure equity capitalisation rate in order to
ascertain the total cost of equity (Ke). The risk-premium can be defined as the difference between the
pure equity capitalisation rate (Ke) and Ki multiplied by the ratio of debt to equity (that is Ke-Ki x B/S).
In this way increase in Ke exactly offsets the increased risk on account of the use of debt, which is a
cheaper source of funds.
3. For investment purpose the cut-off rate or the hurdle rate is independent of the manner in which an
investment is actually financed.
In the present context of exploring a behavioral justification for the irrelevance of financing decisions in
the valuation of a firm, Proposition 1 is relevant and needs a detailed treatment.
Basic Proposition I

This proposition under M.M. approach presents an operational justification for the argument that total
market value of firms (of course within the homogeneous risk-category) remains constant irrespective of
the degree of financial leverage. Accordingly, the overall cost of capital (Ko) and the market price of
equity shares are the same; no matter what the debt-equity ratio of the firm may be.
It may be pointed out that the entire M.M. theme is built-up on the process known as 'arbitrage'.
Therefore, before explaining the practical implications of the basic Proposition No. I, it would be most
appropriate to explain the meaning of 'arbitrage'. In security market terminology arbitrage is known as
"simultaneous purchase and sale of the same or equivalent security in. order to profit from price
discrepancies." In other word the process of arbitrage balances the discrepancies and restores equilibrium
in 'V' and Ko of the two firms (belonging to the same risk equivalency class). In case the V of a levered
firm is higher and its Ko is lower as compared to an unlevered firm (whose V is lower and Ko is higher)
the rational investors will start selling their proportionate share in the levered firm (using debt in capital
structure) borrow funds proportionate to the debt of the levered firm at the same rate of interest (in the
terminology used M.M the rational investors will substitute home made leverage or personal leverage for
corporate leverage and purchase equivalent share in the equity of the unlevered firm (not using debt, in its
capital structure). By doing so the rational investors (or arbitragers) will be having the benefit of the same
return after arbitrage as they were having before such arbitrage at lower outlay and at the same time with
lower risk. Such arbitrage operations will continue till a state of equilibrium is restored in the market
value (V) and overall cost of capital,. (Ko) of the levered and unlevered firms.

The M.M. theory advocates that in a perfect capital market discrepancies in V and Ko of two equivalent
risk category are temporary and in the long run tend to square up on account of arbitrage operations.
(1) Modigliani and Miller (MM) irrelevance theorems

Financial Structure before and after leverage

All Equity Levered
Debt 0 4000
Shares outstanding 400 200
Price/share 20 22
Equity 8000 4400
Assets 8000 8400
Interest rate 10% 10%
The company plans to borrow Rs 2000 to retire 200 shares outstanding, making the previous all-equity
firm become a levered firm.

Let’s assume the change in capital structure has a positive effect on the stock price: stock price rises from
Rs20/share to Rs22/share, and correspondingly, the total assets increase from Rs8000 to Rs 8400. We will
show this change creates an arbitrage opportunity.

First, Let’s look at the earnings per share (EPS) before and after the capital structure change:
Unlevered Equity
Recession Normal Expansion
Earnings 400 1200 2000
EPS (unlevered) 1 3 5

Levered Equity
Recession Normal Expansion
Earnings before interest 400 1200 2000
Interests 400 400 400
Earnings after interest 0 800 1600
EPS (levered) 0 4 8

Then, we examine two investment strategies:

Strategy A: Buy 100 shares of the levered equity.
Strategy B: Borrow Rs2,000 and use the borrowed proceeds plus your own investment of Rs2000 to buy
200 shares of unlevered equity at Rs20/share.

The results for the two strategies are shown below:

Strategy A: Buy 100 shares of Levered Equity
Recession Normal Expansion
EPS of levered equity 0 4 8
Earnings for 100 shares 0 400 800
Initial cost 2200

Strategy B: Homemade leverage

Recession Normal Expansion
EPS of unlevered equity 1 3 5
Earnings for 200 shares 200 600 1000
(-)Interests on Rs2000 200 200 200
Net Earnings 0 400 800
Cost of stocks for 200 shares 4000
(-)Amount borrowed 2000
Initial cost 2000

The two strategies produce the same returns whatever the scenario is, but Strategy A is more expensive.
Rational investors will use Strategy B rather than Strategy A; they will borrow on their personal account
to buy more shares of unlevered firm. This strategy is often called homemade leverage, meaning
investors can duplicate the effects of corporate leverage on their own. Price of levered firm will decline
and price of unlevered firm will increase, till they become equal. Similarly, if value of levered firm is less
than value of unlevered firm, equilibrium will force them to be equal. This proves:

MM Proposition I (no taxes): Other things equal, the value of the levered firm is the same as the value of
the unlevered firm.

The implication is straightforward: there exists no optimal capital structure. The capital structure
decisions have no effect on the real operations of a firm, and thus no effect on firm’s value and
shareholders’ welfare. Capital structure decisions determine only how the pie is sliced.
From the above tables, we see EPS for the levered equity is more variable than EPS for the unlevered
equity, implying levered equity is more risky than unlevered equity, and so should have a higher required
return. We have:

MM Proposition II (no taxes): Cost of equity (required return on equity) rises with leverage. More
rS  r0   (r0  rB )
where rS is the cost of equity, or required return on equity or stock
rB is the cost of debt
r0 is the weighted average cost of capital (WACC), or cost of equity for an otherwise identical all-
equity firm
B is market value of the firm’s debt
S is the market value of the firm’s equity or stock

In an MM no-tax world, what will be changed by capital structure decisions?
 Risk of equityrequired return for equity (cost of equity)

What will not be changed?

 Firm value
 Equity value / stock price per share
 Cost of capital for the assets, or WACC.

(2) Introducing corporate taxes into MM: The benefits of debt

We relax the first assumption about MM world. Here, companies are levied corporate taxes. In this case,
debt represents one of its benefits over equity. Unlike dividends, payments to bondholders, interest
payments, are deductible from corporate taxes. The annual tax savings (called tax shield from debt) from
use of debt is equal to:
TC  rB  B
where TC is corporate tax rate
rB is interest rate of the debt
B is the total amount of debt
For simplicity, assume the tax shield is perpetual, then the present value of tax shield is:
TC  rB  B
 TC  B
MM Proposition I (with corporate taxes): The value of levered firm rises with leverage, with the
increase in value equal to the present value of tax shield from debt. More specifically,
EBIT  (1  TC ) TC  rB  B
VL    VU  TC  B
r0 rB

where VL is the value of levered firm

VU is the value of unlevered firm
r0 is the cost of equity (required return to equity) for an otherwise identical all-equity firm.

What is the implication of this proposition on the optimal capital structure for a firm? The more debt
used, the better. Is the implication consistent with the reality?

Hypothesis I: Other things equal, the higher the marginal tax rate of a firm, the more debt it will have in
its capital structure; As tax rates increase over time for a firm, debt ratio will also go up as well.

The effect of leverage on cost of equity persists under MM world with corporate taxes, but somewhat
abated, because the tax savings from debt make the equity less risky.

MM Proposition II (with corporate taxes): Cost of equity (required return on equity) rises with
leverage. More specifically,
rS  r0   (1  TC )  (r0  rB )
where rS is the cost of equity, or required return on equity or stock
rB is the cost of debt
r0 is the cost of equity for an otherwise identical all-equity firm
TC is corporate tax rate
B is market value of the firm’s debt
S is the market value of the firm’s equity or stock

The weighted average of cost of capital (WACC) under MM world with corporate tax will become:
rWACC   rB  (1  TC )   rS
In an MM world with no taxes, WACC does not change with leverage. But in an MM world with
corporate taxes, WACC will typically decrease with leverage. The intuition is that the increase in firm
value from debt use will make the capital the firm employs less risky, leading to decrease in cost of

In an MM world with corporate taxes, what will be changed by the use of leverage?
 Risk of equityrequired return for equity (cost of equity): increase
 Risk of the firmcost of capital (WACC): decrease
 Firm value: increase
 Equity value / stock price per share: increase

What will not be changed by use of leverage?

(3) Introducing Bankruptcy costs, agency costs: The costs of debt

MM Propositions with corporate taxes, imply that the optimal capital structure is 100% debt, and no
equity should be used. This is obviously not the case in reality. Where did we miss? Let’s be closer to the
reality and relax some other assumptions underlying MM conclusions.

(A) Bankruptcy costs

First, as we know, heavy use of debt subjects a firm to financial distress (default risk or bankruptcy). Two
types of cost are involved in bankruptcy proceedings:
 Direct costs: legal and administrative costs
 Indirect cost: impaired ability to do business: customers, suppliers and financiers will be reluctant
to do business with the bankrupt firm.

Hypothesis II: Other things equal, the greater the indirect bankruptcy cost and/or probability of
bankruptcy, the less debt the firm can afford to use. For example, firms producing products that require
long-term servicing and support (e.g., personal computer manufacturer or copier producer) generally
should have lower leverage.

(B) Agency costs

Agency costs of debt result from conflicts between shareholders and bondholders. Thus, we are relaxing
the fourth assumption underlying MM world. Bondholders care about the safety of their promised
payments, while shareholders as the residual claimant, only care about the cash flows beyond the
promised debt payments. Agency costs of debt may take the following forms:
 Risk shifting: Shareholders and managers tend to take on much riskier projects than
bondholders expect them to, especially when the financial distress is imminent. Shareholders
could expropriate wealth from the bondholders by taking high-risk projects, even though
these projects may decrease the total value of firm.

Under investment: In case of possible financial distress, shareholders and managers may choose to give
up some positive NPV projects, because increase in value from these projects

 Milking the property: Firms tend to pay out extra dividends and other distributions in times
of financial distress, leaving less for the bondholders.

Of course, bondholders are smart enough to expect the perverse behaviors of the shareholders. To protect
their own interests, bondholders may (1) build the expectation into bond prices by demanding much
higher interest rates on debt; or (2) write protective covenants to restrict the flexibility enjoyed by the
firm. Both actions by bondholders force extra cost on shareholders, meaning the ultimate assumers of
agency costs of debt are shareholder themselves. Part of solution to agency costs of debt is financing by
issuing convertible bonds, one of the hybrid securities with features of both debt and equity. We will talk
about it in the topic “options in corporate finance”.

Hypothesis III: Other things equal, the greater the agency problems associated with lending to a firm, the
less debt the firm can afford to use. For example, regulated utility companies have little chance to take
high-risk projects, so they can afford to use high level of debt. Pharmaceutical companies have
historically maintained low debt ratios, possibly because their projects are basically long-term ones and
follow unpredictable paths, making monitoring by bondholders relatively unlikely.

(4) Discipline function of debt

We now discuss another possible source of benefits of debt, in addition to the tax benefits. We now
consider the agency costs of equity resulting from separation of ownership and management in corporate
form of business. Managers of companies with large amount of free cash flow tend to waste the resources
by taking on negative NPV projects. Including more debt in financial structure can reduce agency costs,
because, unlike dividend distribution for equity, payments of interests and repayment of debt principal are
mandatory and inflexible, and failure to pay the promised cash flows will subject the firm to bankruptcy.
Thus, the use of debt could discipline managers to better use the firm’s resources, boosting firm value and
shareholders’ wealth.

Hypothesis 4: Other things equal, the greater the agency problems between shareholders and managers
in a firm, the more debt the firm tends to use. For example, a private firm, for which there exits no
separation of ownership and management, should use less debt, according to this hypothesis.

(5) The trade-off theory of capital structure

Combining the above section (2)-(4), an optimal debt-equity ratio could be established for an individual
firm, based on the arguments of benefits and costs associated with use of debt. The benefits include the
tax shield and the reduction of agency costs of equity; the costs include the bankruptcy costs and agency
costs of debt. Initially, firm value increases with leverage, but at the level of debt, the risk of financial
distress will rise due to heavy use of debt, and bankruptcy costs and agency costs begin to dominate the
benefits of debt, leading to declining of firm value. The optimal debt ratio occurs at the point of change
this line of interpretation of the optimal financial structure in reality is called trade-off theory of capital

5.6 The pecking-order theory of capital structure

It is conceivable that managers of a firm know more about their company than financial market /
investors: a case of information asymmetry. When a company decides to issue stock or bond, financial
market tends to infer that the stocks and bonds of the company are overvalued, and accordingly, investor
do not want to pay much for the issues. Thus, the decision of equity or debt issuance is a signal of
overvaluation of the company’s securities, even if the firm’s securities are actually not overvalued (market
simply cannot distinguish the good companies from bad companies).

Due to information asymmetry and the resultant signaling of equity or debt financing, a firm tends to use
internal retaining earnings firstly when it comes to financial its new projects, because doing so does not
depend on whether markets are pricing its securities correctly, in addition to floatation costs can be
avoided. Only when the internal resources are exhausted, it turns to financial market for outside
financing. Since mispricing of equity is likely to be much greater than debt, and so information
asymmetry is more severe in the case of equity, the firm will typically use debt first, and equity is last
resort. Such an interpretation of financial structure using the different degree of preference over different
financial vehicles is called pecking-order theory of capital structure. Retained earnings  low-risk
debt  high-risk debt (e.g. convertibles)  equity. Pecking-order theory seems to be practically
relevant. See the following survey results:
Ranking Sources Reasons Cited Score
1 Retained Earnings None 5.61
2 Straight Debt Maximize Stock Prices 4.88
3 Convertible Debt Cash Flow & Survivability 3.02
4 External Common Equity Avoiding Dilution 2.42
5 Straight Preferred Stock Comparability 2.22
6 Convertible Preferred None 1.72

Implications of pecking-order theory:

 There is no target amount of leverage. A firm chooses its leverage based on its financing
 Profitable firms use less debt.
 Companies like financial slack by hoarding cashes for potential good projects.

(7) Capital structure in case of personal taxes: Miller Model

MM Propositions with corporate taxes override the conclusion that debt is irrelevant to firm value. But by
introducing also personal taxes, Miller argued that the debt irrelevance theorem could be resuscitated
even in the presence of corporate taxes if taxes on the dividends and interest income individuals receive
from firms were factored into the analysis.
 (1  TC )  (1  TS ) 
V L  VU  1  B
 (1  TB ) 
where VL is the value of levered firm
VU is the value of unlevered firm
TC is corporate tax rate
TS is personal tax rate on equity distributions (dividends or capital gains)
TB is personal tax rate on interest income
B is the amount of debt

If TS = TB, then we have: V L  VU  TC  B , the same result as MM proposition with corporate taxes. But
in reality, companies often distribute earnings through stock buyback, because tax rate on capital gain is
traditionally lower than tax rate on ordinary income such cash dividends or interest income. In this case,
TS < TB, so the tax benefits of debt will reduce. If further, (1  TC )  (1  TS )  1  TB , then we have
V L  VU , the tax benefits are eliminated completely, and debt irrelevance result remains. This means the
lower corporate taxes for a levered firm are exactly offset by higher personal taxes on interest income.
This is a possibility, however. Another force that works against tax shield of debt is the limited tax
deductibility of debt, because firm can deduct interest only to the extent of profits. This implies that the
first unit of debt should increase firm value more than the last unit, because the interest on later units may
not be deductible. In economic term, the marginal benefits of debt are declining. When marginal benefits
of debt is equal to the marginal disadvantages of debt (such as bankruptcy costs, or disadvantaged
treatment of tax on interest income relative to the tax on capital gains), an optimal capital structure

5.7 EBIT / EPS Comparison

One of the objectives of capital management is to find the right mixes of capital. A comparison of Earnings
Before Interest Taxes (EBIT) with Earnings per Share (EPS) under different financing plans can help determine
which type of financing is most advantageous - debt financing or equity financing. Since debt has little effect on
EBIT, we start our analysis with EBIT. We simply want to calculate what EPS will be under each financing
plan. Both the debt and equity financing plans are plotted on a graph. Depending upon what we expect EBIT to
be, the graph can tell us which financing plan will give us the highest EPS.
At a level of Rs 2 million EBIT, EPS is the same under either the equity or debt-financing plan. If we expect
EBIT to be below Rs 2 million, then we would favor the equity plan since it yields a higher EPS. If we expect
EBIT to be above Rs 2 million, then debt would be preferred over equity after considering the increased risk.

Example 1 - EBIT / EPS Comparison

ABC Corporation wants to raise Rs 4 million in capital for production facilities. ABC can
issue stock (200,000 shares @ Rs 20) or issue bonds at 10% interest. ABC's tax rate is 45%.
ABC's projected EBIT is Rs 6.5 million and it has long-term capital consisting of Rs 2
million in debt @ 8% and 100,000 shares of equity.

Calculate EPS (Earnings per Share) under different financing plans:

100% equity 100% debt 50 / 50 Mix

Expected EBIT Rs 6,500,000 Rs 6,500,000 Rs 6,500,000
Current Interest on Debt (160,000) (160,000) (160,000)
New Interest on Debt -0- (400,000) (200,000)
Earnings before Tax 6,340,000 5,940,000 6,140,000
Less Taxes @ 45% (2,853,000) (2,673,000) (2,763,000)
Earnings to Shareholders 3,487,000 3,267,000 3,377,000
Shares Outstanding 300,000 100,000 200,000
Earnings per Share (EPS) Rs 11.62 Rs 32.67 Rs 16.89

The returns or EPS under a 100% debt Plan is much higher than other plans. If ABC expects
an EBIT of Rs 6.5 million, it can easily service higher levels of debt.

In the above example, it is quite clear that ABC can benefit from the use of more debt. However, suppose ABC
expects EBIT to fall dramatically over the next few years.

The minimum level of EBIT needed to cover fixed financing charges (debt and preferred shares) under 100%
equity Plan.

1. The minimum level of EBIT needed to cover fixed financing charges (debt and preferred share) under
100% debt Plan.

2. The Indifference Point where EPS is the same under the 100% equity Plan and the 100% debt Plan. The
following formula can be used to calculate the Indifference Point:

EPS = ((EBIT - I) (1 - TR) - PD) / number of shares outstanding

EPS: Earnings per Share EBIT: Earnings Before Interest Taxes TR: Tax Rate
PD: Preferred Dividends

Example 2 - Calculate Graph Points for EBIT / EPS Comparison

If we refer back to Example 1, we can determine that the minimum level of EBIT under the
two financing plans is as follows:
100% equiity: Minimum EBIT to service fixed obligations is Rs 160,000 (Rs 2 million of
existing debt x 8% interest rate)

100% debt: Minimum EBIT to service fixed obligations is Rs 560,000 (Rs160,000 + Rs


We need a third intersection point or indifference point where EPS is the same under the two
financing plans (100% equity and 100% debt). We can solve for the EBIT where EPS is the

100% equity 100% debt

(EBIT - Rs160,000) (1 - .45) = (EBIT - Rs560,000) (1 - .45)

300,000 shares 100,000 shares

.55 EBIT - Rs 88,000 = .55 EBIT - Rs 308,000

300,000 100,000

(.55 EBIT - Rs 88,000) 100,000 = (.55 EBIT - Rs 308,000) 300,000

55,000 EBIT - Rs 8,800,000 = 165,000 EBIT - Rs 92,400,000

110,000 EBIT = $ 83,600,000

EBIT = Rs 760,000

At an EBIT of Rs 760,000, we are indifferent to the two financing plans since EPS is the
same. If EBIT were to fall below Rs 760,000, we would favor the equity Plan. If EBIT is
expected to be above Rs 760,000, we would favor the debt Plan. The following calculation
confirms the indifference point:

100% Stock 100% Bonds

Indifference EBIT Rs 760,000 Rs 760,000
Existing Interest (160,000) (160,000)
Interest on New Debt -0- (400,000)
Earnings before Tax 600,000 200,000
Less Taxes @ 45% (270,000) ( 90,000)
Earnings to Shareholders 330,000 110,000
Shares Outstanding 300,000 100,000
Earnings Per Share (EPS) Rs 1.10 Rs 1.10

At an EBIT of Rs 760,000, we have an EPS of Rs 1.10.


One way to understand how to manage capital is to look at the various approaches that can be used for
finding the right capital structure. As we previously indicated, the right capital structure is that mix of
debt and stock that maximizes the value of the firm while at the same time maintains a relatively low
overall cost of capital. Two very different approaches to capital management are the Net Operating
Income Approach and the Net Income Approach.

Net Operating Income Approach: This approach to capital management concludes that it does not
matter how you mix the capital structure. The value of the business is not determined by how you
arrange the right side of the Balance Sheet. Additionally, the overall cost of capital will not change as
you change the mix of capital. Therefore, values are determined by the capitalization of operating
income or EBIT (Earnings Before Interest Taxes).

Example 3 - Calculate Market Value of Business under Net Operating Income Approach to Capital

XYZ Company has Rs 400,000 in outstanding debt at 7% interest. Norton's cost of capital is 12% and
expected operating income or Earnings Before Interest & Taxes (EBIT) is Rs120,000.

Earnings to Shareholders =Rs 120,000 -Rs 28,000 (7% interest on debt) = Rs 92,000.
Total Market Value = Rs 120,000 / .12 = Rs 1,000,000
Market Value of Stock = Rs 1,000,000 - Rs 400,000 = Rs 600,000
Cost of Equity = Rs 92,000 / Rs 600,000 = 15.3%

Net Income Approach: In contrast to the Net Operating Income Approach, the Net Income Approach
concludes that the capital structure of an organization has a major influence on the value of the
organization. Therefore, the use of leverage will change both the cost of capital and the value of the
firm. Net Income is capitalized in arriving at the market value of the firm.

Example 4 - Calculate Market Value of Business under Net Income Approach to Capital Management

Referring back to Example 3, we can calculate the following values:

Market Value of Stock = Rs 92,000 / 15.3% = Rs 601,307
Total Value = Rs 601,307 + Rs 400,000 = Rs 1,001,307
Overall Cost of Capital = Rs 120,000 / Rs 1,001,307 = 12%

Franco Modigliani and Merton Miller have provided some guidance between the Net Operating
Income Approach and the Net Income Approach. Modigliani and Miller concluded that capital
structure is not a major factor in the determination of values. Values are determined by the investment
and operating decisions that generate cash flows. It is cash flows that give rise to values. This approach
to valuation has become a mainstay within financial management. But what about capital structures?
Mike Jenson, founder of the Journal of Financial Economics, may have resolved the answer to this
question. Jenson noted that whenever a company makes a change in its capital structure, it sends a
signal to investors. This signaling effect does in fact result in changes to valuations.

Jenson also noticed that managers have a tendency to guard capital and minimize the distribution of
dividends to shareholders. This follows with the so-called "pecking order" of financing whereby
managers prefer internal sources of capital to external sources of capital. The specific pecking order is
as follows:

1. Internal sources of capital - retained earnings / cash

2. External sources of capital - debt

3. External sources of capital - convertible securities

4. External sources of capital - preferred stock

5. External sources of capital - common stock

Consequently, capital structures can impact valuations due to the so-called signaling effect.
Additionally, the real source of values will reside in cash flows (more specifically free cash flows). Free
cash flows are the excess cash that can be withdrawn from a business after paying everything off. And
in order to generate free cash flows, management must generate returns in excess of the cost of capital.

Test Questions
I. Explain briefly the view of traditional writers on the relationship between capital structure and the value
of the firm,
2. Write a detailed note on Traditional vs. M.M. Approach to capital structure.
3. Explain the position of M.M. theory on the issue of an optimal capital structure. Show as to how home-
made leverage by an individual investor can replicate the same risk and return as provided by the
leveraged .
4. "The basic controversy between 'Traditional Theory' and 'M.M. Theory' comes to an end when
corporate income taxes are assumed to exist:' Explain giving suitable arguments.
5. "The bases of MM Thesis for optimal capital structure are unrealistic assumptions:' Evaluate the
6. Explain clearly the concept of 'financial risk'. What is the relationship between leverage and cost of
capital? Explain.
7. "The total value of a firm remains unchanged regardless of variations in its financial mix. Discuss this
statement and point out the role of arbitraging and home-made leverage,

Chapter 6 Cost of Capital

6.1 Meaning of cost of capital

"Cost of Capital is the minimum rate of return which a firm requires as a condition for undertaking an
investment proposal."
6.1.1 Concept of Cost Of Capital
Minimum rate for evaluating projects opportunities is opportunity cost of capital = business cost of capital
Cost of capital = opportunity cost of capital
 The cost associated with different sources of funds is called the cost of capital. Cost of Capital
represents the rate a business must pay for each source of funds - debt, preferred shares, equity shares, and
retained earnings. Cost of Capital is an important element in taking capital investment decisions. Accurate
measurement of cost of capital is desirable on account of its serious implications on the over-all objective of a
firm, i.e., maximization of shareholders' wealth. Hence, the need for correct definition and measurement of cost
of capital is inevitable.

The term cost of capital refers to the price paid by a firm for obtaining funds from investors through
issuance of a specific type of security. It is, therefore, the minimum rate of return expected by investors.
Thus, in operational terms cost of capital refers to the minimum rate of return which a firm must earn on
its investment in order to satisfy the expectations of its investors and keep the market value of the concern
unchanged. In economic terms, the term 'Cost of Capital' may be defined as the cost of acquiring the
requisite funds, i.e., borrowing rate. Alternatively it may refer , to opportunity cost of funds. i.e., lending
rate. Practically, we use the borrowing rate to indicate the cost of capital. Since a firm borrows funds from
different sources at different rates, the cost of capital indicates the weighted average cost of each
component of capital. Some of the definitions of 'Cost of Capital' are as follows:
According to Solomon Ezra, "The cost of capital is the minimum rate of return or cut-off rate for capital
According to Hampton John J., "Cost of capital is the rate of return, the firm requires from investment in
order to increase the value, of the firm in the market rate."
According to Milton H. Spencer, "Cost of capital is the minimum rate of return which a firm requires as
a condition for undertaking an investment,"
According to James C. Van Horne, "The cost of capital represents a cut-off rate for the allocation of
capital to investment projects. It is the rate of return on a project that will leave unchanged the market
price of the stock,"
Pricewater house Coopers survey, 14 March 2000
Cost of capital for most Indian companies is generally regarded to be in the 15-20 per cent range. This
when compared with cost of capital for most US companies (believed to be in the 8-12 per cent range),
places Indian companies at a significant competitive disadvantage. The future could, however, see a
general reduction in cost of capital for Indian companies.
According to the survey, a majority of the respondents expect equity market risk premium and risk-free
rate to decline in India over the next three years. This decline, which would lead to a reduction in cost of
equity for Indian companies, is expected on account of improvement in corporate transparency, greater
maturity (thereby reduced volatility) of the equity market, reduction in fiscal deficit, market-determined
returns on government securities, fewer curbs on capital flow and lower transaction costs.
In a common Sense, "The cost of capital is any discount rate used to value cash streams."
Thus, cost of capital is the minimum rate of return from a project, which a firm is expected to earn in
order to discharge its obligations in respect of funds acquired from the investors.

 Some advantages to using shares are:

 No fixed payments are required to investors; dividends are paid only as earnings are available.

 No maturity date on the security, the invested capital does not have to be repaid.

 Improves the credit worthiness of the company.

 Some disadvantages to using shares are:

 Dilutes the earnings per share to shareholders.

 Issuance costs are higher than debt.

 Issuing more shares can increase the overall cost of capital.

 Dividend payments to shareholders are not tax deductible.

 Some advantages to using debt are:

 Interest payments are tax deductible.

 Does not dilute earnings per share or control within the company.

 Cost is fixed; interest and principal do not change.

 Expected returns to investors are usually lower than stock.

 Some disadvantages to using debt are:

 Fixed charges must be paid regardless of available earnings or cash flow.

 Adds more risk to the business.

 Has a maturity date and the capital invested must be repaid to investors.

6.2 Importance Of Cost Of Capital

The cost of capital comprises an important element in capital investment decisions. It is important not
only from the perspective of capital budgeting decisions but it also constitutes an integral part of capital
structure decisions. The concept of cost of capital is quite relevant in the following managerial decisions.
1. Capital Investment Decisions, The cost of capital represents the cut-off rate in investment decisions.
It is often used as the discount rate for computing the present value of cash in- flows associated with a
capital project. In case of different discounted cash flow methods, such as NPV Method. Profitability
Index Method, Terminal Value Method etc" the cost of capital is employed for discounting the future cash
inflows. In case of the Internal Rate of Return (IRR) Method, the computed lRR is compared with the
cost of capital. Thus, cost of capital constitutes the basis for capital investment decisions. It provides a
yardstick for evaluating capital expenditure proposals, and, thus, serves the role of accept-reject criterion.
Obliviously, the accept-reject rule requires the firm to select only such projects, which give a rate of
return higher than the cost of capital. The cost of capital, therefore, occupies a crucial significance in
capital budgeting decision in- so far as it provides a rational yardstick for making the optimum investment

2. Capital Structure Decisions. Besides an accept-reject decision criterion for capital investment
proposal, the cost of capital is also important in designing the balance and appropriate capital structure of
the firm. A firm may raise its financial resources in a number of ways including loans from banks and
other financial institution, public deposits, debts and debentures, equity shares, preference shares, retained
earnings, etc. The cost of capital is influenced by changes in financial leverage or capital structure. Since
the cost of capital has a direct bearing on the firms overall objective: of maximising shareholders' wealth,
the firm will logically attempt to have an optimum capital structure which will minimise cost of capital
and risks associated with raising funds from various sources. Keeping in view the varied costs and risks
involved in different sources of capital, it is inevitable to compute the cost of each type of capital so as to
have an optimum capital structure. Thus, the cost of capital plays a vital role in designing an appropriate
capital structure of a firm, which is absolutely necessary for attaining the firm's overall objective of
shareholders' wealth maximisation by minimising its overall cost of capital and the associated risks.
3. Optimum Resource Mobilisation. The concept of cost of capital is also useful in optimum
mobilisation of resources. A capable financial manager is always aware of the fluctuations in the capital
market, current rates of interest and dividend. This enables him to mobilise the requisite funds from
different sources in such a way as to minimize the composite cost of capital and risk while retaining the
control of the firm in the bands of the existing shareholders. Thus, cost of capital also plays an important
role in optimum mobilization of financial resources from different sources.
4. Evaluation of Expansion Projects and Financial Performance of Top Management. The cost of
capital can be used to evaluate the financial feasibilities of expansion projects. If the marginal rate of
return on investment is higher than the cost of capital, the expansion projects are accepted other wise
rejected. The cost of capital can also be used to evaluate the financial performance of the firm's top
executives. Such an evaluation will involve a comparison of actual profit abilities of the projects with the
projected composite cost of capital and also with the actual cost incurred in raising the required funds.
The cost of capital is also important in many other areas of decision-making, such as comparative study
of alternative financial resources, optimum allocation of financial resources, dividend policy decisions,
working capital management policies, capital budgeting and capital expenditure control, etc.

6.3 Components Of Cost Of Capital

The cost of capital of a firm comprises the following three components:
1. Return at Zero Risk. This refers to the projected rate of return on investment when the project does
not involve any business or financial risk.
2. Premium for Business Risk. Besides the normal rate of return at zero risk level, the cost of capital
also includes premium for business risk. Business risk refers to the changes in operating profit on account
of changes in sales. The projects involving higher risk than the average risk can be financed at a higher
rate of return than the normal rate. This is due to the fact that the supplier of funds for such projects will
expect a premium for increased business risk. The business risk is generally determined while taking
capital budgeting decisions.
3. Premium for Financial Risk. The cost of capital also include premium for financial risk arising on
account of higher debt content in capital structure requiring higher operating profit, to cover periodic
payment of interest and repayment of principal amount on maturity. Since the chances of cash Insolvency
of a firm with higher debt content in its capital structure are greater. The suppliers of funds would expect
a higher rate of return as a premium for higher risk.

6.4 Types Of Cost Of Capital

The cost of capital can be classified as follows:
1. Explicit and Implicit Cost. The explicit cost of any source of finance is the discount rate that equates
the present value of funds raised by the firm with the present value of its expected cash outflows. These
cash outflows may relate to interest payments, payment of principal or dividend. In other words, it is the
internal rate of return, the firm can afford for financing an investment proposal. The determination of the
explicit cost of capital is similar to the determination of the IRR with the difference that in case of explicit
cost of capital the cash inflows take place in the beginning followed by a series of cash outflows
subsequently. Thus, the explicit cost of capital is the annual cash outflows for several years.
The implicit cost of capital may be defined as the rate of return associated with the best investment
opportunity for the firm and its shareholders that would be foregone, if the project presently under
consideration by the firm were accepted. Thus, the concept of opportunity cost gives rise to the implicit
cost of capital; the cost of retained earnings is therefore, an opportunity cost or implicit cost of capital, in
the sense that it is the rate of return at which the shareholders could invested these funds, had these been
distributed to them as dividends. Likewise, other forms of capital also have implicit cost because implicit
costs arise when funds are used. The basic difference between explicit and implicit costs is that the
explicit costs arise when funds are raised whereas implicit costs arise when funds are used. However, for
purposes of capital investment decisions the explicit cost is considered as cost of capital.
2 Future Cost and Historical Cost. Future cost refers to the expected cost of capital financing an
investment proposal, while historical cost is the actual cost of capital already incurred in financing a
project. Historical costs are useful in projecting the future costs and appraising the past performance as
against predetermined standard or cost. However for purposes of capital budgeting decisions, the relevant
costs are future costs and not the historical costs.
3. Specific Costs and Composite Cost. The cost of each component of capital, such as equity shares,
preference shares, debentures, loans, etc., is known as specific cost. While composite cost refers to the
average cost of capital of a firm. In order to determine the average or composite cost of capita!, the
determination of cost of each specific source of capital becomes necessary. For purposes of investment
decisions, the composite cost of capital is treated as cost of capital.
4. Average Cost and Marginal Cost. The Average cost of capital refers to the weighted average of the
costs of each specific component of capital of a firm. The weights are in proportion of the share of each
component of capital in the capital structure of the firm. Conversely, marginal cost of capital is the
weighted average cost of new capital raised by the firm. For purposes of capital budgeting and financial
decision, the marginal cost of capital is considered as the most important factor.

6.5 Approaches Of Cost Of Capital

The concept of cost of capital is not only useful and has considerable practical utility in finance. But it is
also the most controversial topic in the theory of finance; a basic point of dispute regarding long-term
financing is whether a firm's cost of capital depends upon the method and level of financing or its capital
structure. There are two following important approaches in this regard:
1. Traditional Approach. This approach emphasises that a firm's cost of capital hinges upon its capital
structure, and it can change its overall cost of capital by changing its capital structure, i.e., increasing or
decreasing debt-equity ratio. Since the cost of debt capital is cheaper due to lower rate of interest and tax
saving as compared to the cost of equity capital involving relatively higher rate of dividend and foregone
tax benefit, the traditional theorists argue that the weighted average cost of capital will decrease with
every increase in debt content in the total capital structure. However, the debt content in the overall
capital structure should be maintained at a proper level because cost of debt is a fixed burden on the
profits of the firm, and may adversely affect the firm in periods of lower profitability. Further, if the debt
content in the total capital structure is raised beyond a certain point, the investors will expect a higher rate
of return on account of increase in business and financial risks.

2. Modigliani-Miller Approach. According to this approach, the cost is an independent factor and
remains unaffected by changes in the firm's capital structure. In other words, a change in capital structure
or debt-equity ratio does not affect the firm's total cost of capital. This approach is based on the reasoning
that each change ill the debt-equity ratio automatically offsets change in one with the change in the other
due to change in the expectation of equity shareholders. The Modigliani-Miller hypothesis, therefore,
suggests that the market value of the firm and cost of capital is the same for all the firms irrespective of
the proportion of debt included in the capital structure because of the arbitrage in the capital market.
Assumptions of the M.M. Approach. The Modigliani-Miller Approach is based on the following
1. Perfect Capital Market. This implies that the investors are rational persons and have full information
of the capital market. They are free to buy or sell securities. They can borrow without restrictions on the
same terms and conditions as the firm can, and there is no transaction costs.
2. Firms can be classified in Homogenous Risk Classes. Firm with identical risk characteristics may be
grouped in homogenous risk classes. Firms in each class are considered to have the same degree of
business and financial risk. All firms within an industry are assumed to be within the same risk class.

3. Same Expectations of Investors. All investors expect the same net operating income which is used in
evaluation of a firm. The firms distribute all of their net earnings to the shareholders.
4. No Taxes. In the original formulation of this hypothesis, Modigliani and Miller assumed that there are
no corporation taxes. This assumption has been removed later.
This approach is subject to criticisms on account of its basic assumption that capital markets are perfect.
This approach applies only in an equilibrium state, but it is unrealistic to assume the existence of
equilibrium position. Thus, the traditional approach is more realistic.
6.6 Measurement Of Cost Of Capital
As pointed out above, the cost of capital of a firm is the weighted average of the cost of each type of its
capital. If the capital of a firm consists of equity shares, preference shares, debentures, loans and retained
earnings, its cost of capital will be the weighted average of all this sources of financing. Thus, the first
stage in the measurement of a firm's cost of capital is the accumulation of the cost of each specific type of
capital, i.e.., debt capita!, preference share capital, equity share capital and retained earnings.
Once the cost of each specific source of capital is computed, weighted average of all these costs is
calculated to determine the overall cost of capital to the firm. The weight assigned to each type of capital
is the ratio of the market value of each specific component of capital to the market value of the total
capital structure of the firm. In other words, the weights, assigned to each specific component of capital
are in proportion to their respective shares in the total capital structure.
Before proceeding to the computation of cost of each specific component of a firm's capital and its overall
cost of capital, it is pertinent to review the conceptual and practical problems faced by the financial
manager in determining the cost of capital
Problems in determining the cost of capital are briefly summarised as follows:
1. Problem of Controversy regarding Cost Capital. There is a major controversy whether or not the
cost of capital is dependent upon the method and level of financing by the firm. While traditional theorists
maintain that a firm's cost of capital depends upon its capital structure and is subject to changes in its debt
equity mix, the modern theorists argue that the firm's total cost of capital is independent of its capital
structure and changes in debt-equity mix does not affect the firm's overall cost of capital.
1. Problem Regarding Quantification of Shareholders' Expectations. The determination of cost of
equity capital is another problem as it is considered to be the minimum rate of return expected by its
equity shareholders and which will maintain the present market value of the firm equity shares. This
means that the determination of the cost of equity share capital will require the quantification of the firm's
equity shareholders, which is a very difficult task because the equity shareholders value a firm's equity
shares on the basis of a number of factors.
3. Problem Regarding Computation of Cost of Retained Earnings and Depreciation Funds .Since
the cost of capital through these sources will depend upon the approach followed for computing the cost
of equity capital, the finance manager is confronted with the problem of selecting the appropriate
approach because of controversial view regarding cost of capital. .
4. Problem of Weights. Another problem in determining the cost of capital relates to the assignment of
appropriate weights to each component of capital. The finance manager has to make a choice between the
book values and the market values of each type of capital. The cost of capital will be different in each
5. Problem Regarding Type of Cost. It is argued that historical costs are not relevant for decision-
making purposes and only the future costs should be considered. This again creates the problem whether
to consider marginal cost of capital or the average cost of capital.
It is clear from the above discussion that it is quite difficult to determine the accurate cost of
capital. Since the cost of capital; is one of the most crucial factors in managerial decisions, it
should be estimated with a reasonable range of accuracy.
6.7 Determining Component Cost Of Capital

In the following pages we will discuss the methods of computing the component costs of three major
sources of capital: debt, preference shares and equity shares. The investors' required rate of return should
be adjusted for taxes in practice for calculating the cost of a specific source of capital to the firm. In the
investment analysis, net cash flows are computed on an after- tax basis, therefore, the component costs,
used to determine the discount rate, should also be expressed on an after-tax basis.

6.7.1 Cost of Debt

A company may raise debt in a variety of ways. It may borrow funds from financial institutions or public
either in the form of public deposits or debentures (bonds) for a specified period of time at a certain rate
of interest. A debenture or bond may be issued at par or at a discount or premium. The contractual rate of
interest forms the basis for calculating the cost of any form of debt.
Debt Issued at Par
The before-tax cost of debt is the rate of return required by lenders. It is easy to compute before-tax cost
of debt issued and to be redeemed at par; it is simply equal to the contractual (or coupon rate) of interest.
For example, a company decides to sell a new issue of 7-year 15 per cent bonds of Rs 100 each at par. If
the company realises the full face value of Rs 100 bond and will pay Rs 100 principal to bondholders at
maturity, the before-tax cost of debt will simply be equal to the rate of interest of 15 per cent. Thus:
kd = I= --------
where kd is the before-tax cost of debt, i is the coupon rate of interest, Bo is the issue price of the debt and
in the above Equation it is assumed to be equal to the face value (F), and INT is the amount of interest.
The amount of interest payable to the lender is always equal to:
Interest = Face value of debt x Interest rate

The before-tax cost of bond in the example is: Rs 15

kd = -------

We could arrive at same results as above by using Equation (1): cash outflow are Rs 15 interest per year
for 7 years and Rs 100 at the end of seventh year in exchange for Rs 100 now. Thus:
15 15 15 15 15 15 15 100
100 = ----------- + ------------ + ---------- + ----------- + ---------+ ------------- +----------- +-----------
(1 +kd) (1 +kd)2 (1 +kd)3 (1 +kd)4 (1 +kd)5 (1 + kd)6 (1 + kd)7 {I + kd)7

7 15 100
100 =  ------- +--------
t=1 (1 +Kd)t (1 + Kd)7
100 = 15(PVAF7 .kd) + 100(PVF7.kd)
By trial and error, we find that the discount rate (kd), which solves the equation, is 15 per cent:
100 = 15(4.160) + 100(0.376~ = 62.40 + 37.60 = 100
Clearly, the before-tax cost of bond is the rate, which the investment should yield to meet the outflows to

Debt Issued at Discount or Premium

The above mentioned Equations will give identical results only when debt is issued at par and redeemed
at par. Equation first can be rewritten as follows to compute the before-tax cost debt:
n INT Bn
B0 =  ------- +--------
t=1 (1 +Kd)t (1 + Kd)n

Where Bn is the repayment of debt on maturity and other variable as defined earlier. The above given
equation can be used to find out the cost of debt whether debt is issued at par or discount or premium,
Tax adjustment. The interest paid on debt is tax deductible. The higher the interest charges, the lower
will be the amount of tax payable by the firm. This implies that the government indirectly Jays a part of
the lender's required rate of return. As a result of the interest tax shield, the after-tax cost of debt to the
firm will be substantially less than the investors' required rate of return. The before-tax cost of debt, kd
should, therefore, be adjusted for the tax effect as follows:
After-tax cost of debt = kd(1 - T)
Where T is the corporate tax rate. If the before-tax cost of bond in our example is 16.5 per cent, and he tax
rate is 35 per cent,2 the after-tax cost of bond will be:
kd(1 - T) = 0.1650(1 - 0.35) = 0.1073 or 10.73%
It should be noted that the tax benefit of interest deductibility would be available only when the finn s
profitable and is paying taxes. An unprofitable firm is not required to pay any taxes. It would not gain my
tax benefit associated with the payment of interest, and its true cost of debt is the before-tax cost.
It is important to remember that in the calculation of the average cost of capital, the after-tax cost Jf debt
must be used, not the before-tax cost of debt.

ILLUSTRATION 1 A 7-year Rs 100 debenture of a firm can be sold for a net price of Rs 97.75. The
coupon rate of interest is 15 per cent per year, and b0nd will be redeemed at 5 per cent premium on
maturity. The firm's tax rate is 35 per cent. Compute the after-tax cost of debenture.
The annual interest will be: F x i = Rs 100 x 0.15 = Rs 15, and maturity price will be: Rs 100 (1.05) = Rs
105. We can use Equation (3) to compute the after-tax cost of debenture:
n INT Bn
B0 =  ------- t +-------- n
t=1 (1 +Kd) (1 + Kd)
By trial and error, we find kd = 16%:
15(4.038) + 105(0.354) = 97.75
The after-tax cost of debenture will be:
kd(1 - T) = 0.16(1 - 0.35) = 0.104 or 10.4%
Cost of the Existing Debt

Sometime a firm may like to compute the "current" cost of its existing debt. In such a case, the cost of
debt should be approximated by the current market yield of the debt. Suppose that a firm has 11 per cent
debentures of Rs 100,000 (Rs 100 face value) outstanding at December 31, 19XI to be matured on
December 31, 19X6. If a new issue of debentures could be sold at a net realisable price of Rs 80 in the
beginning of 19X2, the cost of the existing debt, using short-cut method, will be:

11+1/5(100-80) 15
kd = ------------------------ = ------------ = 0.167 or 16.7%
½(100-80) 90

If T = 0.43, the after-cost of debt will be: .

kd(1 - T) = 0.167(1 - 0.43) = 0.095 or 9.5%

6.7.2 Cost of Preference Capital

The measurement of the cost of preference capital poses some conceptual difficulty. In the case of debt,
there is a binding legal obligation on the firm to pay interest, and the interest constitutes the basis to
calculate the cost of debt. However, in the case of preference capital, payment of dividends is not legally
binding on the firm and even if the dividends are paid, it is not a charge on earnings; rather it is a
distribution or appropriation of earnings to preference shareholders. One may be, therefore, tempted to
conclude that the dividends on preference capital do not constitute cost. This is not true.
The cost of preference capital is a function of the dividend expected by investors. Preference capital is
never issued with an intention not to pay dividends. Although it is not legally binding upon the firm to
pay dividends on preference capital, yet it is generally paid when the firm makes sufficient profits. The
failure to pay dividends, although does not cause bankruptcy, yet it can be a serious matter from the
ordinary shareholders' point of view. The nonpayment of dividends on preference capital may result in
voting rights and control to the preference shareholders. More than this, the firm's credit standing may be
damaged. The accumulation of preference dividend arrears may adversely affect the prospects of ordinary
shareholders for receiving any dividends, because dividends on preference capital represent a prior claim
on profits. As a consequence, the firm may find difficulty in raising funds by issuing preference or equity
shares. Also, the market value of the equity shares can be adversely affected if dividends are not paid to
the preference shareholders and, therefore, to the equity shareholders. For these reasons, dividends on
preference capital should be " paid regularly except when the firm does not make profits, or it is in a very
tight cash position.
Irredeemable preference share The preference share may be treated as a perpetual security if it is
irredeemable. Thus, its cost is given by the following equation:
kp = ----------
where kp is the cost of preference share, PDIV is the expected preference dividend, and Po is the issue
price of preference share.

ILLUSTRATION 2 A company issues 10 per cent irredeemable preference shares. The face value per
share is Rs 100, but the issue price is Rs 95. What is the cost of a preference share? What is the cost if the
issue price is Rs 105?
We can compute cost of a preference share as follows:
Issue price Rs 95:
kp = ---------- = ----- = 0.1053 or 10.53%
Po 95
Issue price Rs 105:
kp = --------- = ------ =0.0952 or 9.52%
Po 105
Redeemable preference share Redeemable preference shares (that is, preference shares with finite
maturity) are also issued in practice. A formula similar to Equation (3) can be used to compute the
cost of redeemable preference share:
n INT Pn
P0 =  ------- +--------
t=1 (1 +Kp)t (1 + Kp)n
The cost of preference share is not adjusted for taxes because preference dividend is paid after the
corporate taxes have been paid. Preference dividends do not save any taxes. Thus, the cost of preference
share is automatically computed on an after-tax basis. Since interest is tax deductible and preference
dividend is not, the after-tax cost of preference is substantially higher than the after-tax cost of debt.

6.7.3 Cost of Equity Capital

Firms may raise equity capital internally by retaining earnings. Alternatively, they could distribute the
entire earnings to equity shareholders and raise equity capital externally by issuing new shares. In both
cases, shareholders are providing funds to the firms to finance their capital expenditures. Therefore, the
equity shareholders' required rate of return will be the same whether they supply funds by purchasing new
shares or by foregoing dividends which could have been distributed to them. There is, however, a
difference between retained earnings and issue of equity shares from the firm's point of view. The firm
may have to issue new shares at a price lower than the current market price. Also, it may have to incur
flotation costs. Thus, external equity will cost more to the firm than, the internal equity.

Is Equity Capital Free of Cost?

It is sometimes argued that the equity capital is free of cost. The reasons for such argument is that it is not
legally binding for firms to pay dividends to ordinary shareholders. Further, unlike the interest rate or
preference dividend rate, the equity dividend rate is not fixed. It is fallacious to assume equity capital to
be free of cost. As we have discussed earlier equity capital involves an opportunity cost; ordinary
shareholders supply funds to the firm in the expectation of dividends (including capital gains)
commensurate with their risk of investment. The market value of the shares determined by the demand
and supply forces in a well functioning capital market reflects the retum required by ordinary
shareholders. Thus the shareholders' required rate of return, which equates the present value of the
expected dividends with the market value of the share, is the cost of equity. The cost of external equity
could, however. be different from the shareholders' required rate of return if the issue price is different
from the market price of the share.
In practice, it is a formidable task to measure the cost of equity. The difficulty derives from two factors:
First, it is very difficult to estimate the expected dividends. Second, the future earnings and dividends are
expected to grow over time. Growth in dividends should be estimated and incorporated in the
computation of the cost of equity. The estimation of growth is not an easy task. Keeping these difficulties
in mind, the methods of computing the cost of internal and external equity are discussed below.

6.7.4 Cost of Retained Earnings

The opportunity cost of the retained earnings (internal equity) is the rate of return on dividends foregone
by equity shareholders. The shareholders generally expect dividend and capital gain from their
investment. The required rate of return of shareholders can be determined from the dividend valuation
Normal growth As explained in Chapter 8, the dividend-valuation model for a firm whose dividends
are expected to grow at a constant rate of g is as follows: DIV)
Po = --------
ke - g

where, DIV1=DIVo(l + g).

The Above equation can be solved for calculating the cost of equity k, as follows:
ke = -------- + g
The cost of equity is thus, equal to the expected dividend yield (DIV/P 0) plus capital gain rate as reflected
by expected growth in dividends (g). It may be noted that above equation is based on the following
. The market price of the ordinary share (Po) is a function of expected dividends.
. The initial dividend, DIV1, is positive (i.e. DIV1 > 0).
. The dividends grow at a constant rate g, and the growth rate (g) is equal to the return on equity (ROE)
times the retention ratio (b) (i.:e. g = ROE x b).
. The dividend payout ratio [i.e. (1 - b)] is constant.

The cost of retained earnings determined by the dividend-valuation model implies that if the firm would
have distributed earnings to shareholders, they could have invested it in the shares of the firm or in the
shares of other firms of similar risk at the market price (Po) to earn a rate of return equal to ke. Thus, the
firm should earn a return on retained funds equal to k, to ensure growth of dividends and share price. If a
return less than k, is earned on retained earnings, the market price of the firm's share will fall. It may be
re-emphasised that the cost of retained earnings will be equal to the share- holders' required rate of return.

ILLUSTRATION 3 Suppose that the current market price of a company's share is Rs 90 and the
expected dividend per share next year is Rs 4.50. If the dividends are expected to grow at a constant rate
of 8 per cent, the shareholders' required rate of return is:
ke = -------- + g
Rs 4.50
ke = --------------+0.80 = 0.05 + 0.08 = 0.13 or 13%
Rs 90

If the company intends to retain earnings, it should at least earn a return of 13 per cent on retained
earnings to keep the current market price unchanged.

Supernormal growth Dividends may grow at different rates in future. The growth rate may be very high
for a few years, and afterwards, it may become normal indefinitely in the future. The dividend- valuation
model can also be used to calculate the cost of equity under different growth assumptions. For example, if
the dividends are expected to grow at a super-normal growth rate g" for n years and thereafter, at a
normal, perpetual growth rate of gn beginning in year n + 1, then the cost of equity can be determined by
the following formula:

n DIV0 (1+gs)t Pn
P0 =  ------------------ +------------
t=1 (1 +Ke)t (1 + Ke)n
P n is the discounted value of the dividend stream, beginning in year n + 1 and growing at a constant,
perpetual rate gn' at the end of year n, and therefore it is equal to:

Pn= -----------
When we multiply Pn by 1/(1 + ke )n we obtain the Present value of P in Year O. Substituting
The above two Equations, we get:

n DIV0 (1+gs)t DIVn+1 1

P0 =  ------------------ + ------------  ---------
t=1 (1 +Ke)t Ke-gn (1 + Ke)n

The cost of equity, ke can be computed by solving the above Equation by trial and error.

ILLUSTRATION 4 Assume that a company's share is currently selling for Rs 134. Current dividend,
DIVo are Rs 3.50 per share and are expected to grow at 15 per cent over the next 6 years and then at a rate
of 8 per cent foreve. The company's cost of equity can be found out as follows:

6 3.50 (1.15) t DIV7 1

134 =  ------------------ + ------------  ---------
t=1 (1 +Ke)t (Ke-0.08) (1 + Ke)6
4.03 4.63 5.33 6.13 7.05 8.11 8.11 (1.08) 1
= ---------- + ---------- + ------------ + ------------ + ------------ + ------------ + -------------- * ------------
(1 + ke) (1 + ke)2 (1 + ke)3 (1 + ke)4 (1 + ke)5 (1 + ke)6 (ke - 0.08) (1 + ke)6
= 4.03(PVF1..ke) + 4.63(PVF2..ke) + 5.33(PVF 3..ke) + 6..13(PVF4..ke) + 7.05(PVF5..ke) +8.11 (PVF6..ke)
+ 8.76 . (PVF6..ke)
(ke - 0.08)
By trial and error, we find that k~ = 0.12 or 12 percent:
134 = 4.03(0.893) + 4.63(0.797) + 5,33(0.712) + 6.13(0.636) + 7.05(0.567) + 8.11 (0.507) + ------------ (0.507)
0.12 -0.08

Zero-growth In addition to its use in constant and variable growth situations, the dividend valuation
model can also be used to estimate the cost of equity of no-growth companies. The cost of equity of a
share on which a constant amount of dividend is expected perpetually is given. as follows:
ke = ---------
The growth rate g will be zero if the firm does not retain any of its earnings; that is, the firm follows a
policy of 100 per cent payout. Under such case, dividends will be equal to earnings, and therefore
Equation (13) can also be written as:
ke = -----------
which implies that/in a no-growth situation, the expected earnings-price (EJP) ratio may be used as the
measure of the firm's cost of equity.

Cost of External Equity

The minimum rate of return, which the equity shareholders require, on funds supplied by them by
purchasing new shares to prevent a decline in the existing market price of the equity share is the cost of
external equity. The firm can induce the existing or potential shareholders to purchase new shares when it
promises to earn a rate of return equal to:
ke= ---------- + g

Thus, the shareholders' required rate of return from retained earnings and external equity is the same.
The cost of external equity is, however, greater than the cost of internal equity for one reason. The selling
price of the new shares may be less than the market price. In India, the new issues of ordinary shares are
generally sold at a price less than the market price prevailing at. the time of the announcement of the
share issue. Thus, the formula for the cost of new issue of equity capital may be written as follows:

ke= ---------- + g
where Io is the issue price of new equity. The cost of retained earnings will be less than the cost of new
issue of equity if Po> Io.
ILLUSTRATION 5 The share of a company is currently selling for Rs 100. It wants to finance its
capital expenditures of Rs 1.00,000 either by retaining earnings or selling new shares. If the company
sells new shares the issue price will be Rs 95. The dividend per share next year, DIV 1 is Rs 4.75 and it is
expected to grow at 6 per cent. Calculate (i) the cost of internal equity (retained earnings) and (ii) the cost
of external equity (new issue of shares).

Rs 4.75
ke = ---------- +0.06=0.0475+0.06=0.1075 or 10.75%
Rs 100
The cost of external equity can be calculated as follow:
Rs 4.75
ke= ----------+0.06=0.05+0.06=0.11 or 11%
Rs 95
It is obvious that the cost of external equity is greater than the cost of internal equity because of
the under pricing (cost of external equity = 11 % > cost of internal equity = 10.75%).

6.8 Weighted Average cost of Capital

 After we have calculated each component cost of capital, we will calculate a weighted average based
on the relative market values of each component. The following example will illustrate how weighted average
cost of capital is calculated.

Illustration – Calculate Weighted Average Cost of Capital

Jindal cement has the following capital structure

Capital Component Book Value Cost of Capital

Long Term Debt (5,000 debts) Rs. 5,000,000 5.4%
Equity shares (62,500 shares) Rs. 2,500,000 13.9%
Preference shares (20,000 shares) Rs. 500,000 12.5%
Retained Earnings Rs. 750,000 12.0%

Market prices are Rs. 1,050 for debts, Rs. 65.00 for equity shares, and Rs. 35.00 for
preference shares. Total market values are calculated as follows:

Long Term Debt = 5,000 x Rs. 1,050 Rs. 5,250,000

Equity shares = 62,500 x Rs. 65.00 Rs. 4,062,500
Preference shares = 20,000 x Rs. 35.00 Rs. 700,000

Since retained earnings have a market value closely tied to equity shares, we will allocate the
equity shares market value between equity shares and retained earnings based on book

Equity shares = Rs. 4,062,500 x (Rs.2,500,000 / Rs.3,250,000) = Rs. 3,125,000

Retained Earnings = Rs. 4,062,500 x (Rs.750,000 / Rs.3,250,000) = Rs. 937,500

Weighted Average Cost of Capital is calculated as follows:

Capital Component Market Values Mkt% x C of Cp = Wgh C of Cp
Long Term Debt Rs. 5,250,000 52% 5.4% 2.8%
Equity shares Rs. 3,125,000 31% 13.9% 4.3%
Preference shares Rs. 700,000 7% 12.5% .9%
Retained Earnings Rs. 937,500 10% 12.0% 1.2%
Weighted Average Cost of Capital 9.2%

 Our overall cost of capital is calculated as a weighted average based on the relative market values of
each component of capital. If market values are not available, use %’s derived from the targeted or forecasted
capital structure. If worse comes to worse, you can fall back on book values. In any event, the weighted average
cost of capital is the overall cost of capital that will be used to evaluate capital investments.

6.9 Cost of Equity and Risk

 The Cost of Equity is the rate of return required by those who invest in equity securities. The expected
return can be broken down into two components - Risk Free Rate and Risk Premium. A good benchmark for
establishing the Risk Free Rate is the rate paid on 30 year U.S. Treasury Debts since the risk of default is
virtually non-existent. Understanding two forms of risk - Business Risk and Financial Risk, can establish the
Risk Premium. In the absence of debt, shareholders are confronted with one form of risk, business risk.
Business Risk is the risk of changes to operating income from numerous factors that influence business. When
we introduce debt, we have to include financial risk. Financial Risk is the risk of changes to earnings from the
use of increased debt. More debt results in higher interest payments, which impacts earnings. Consequently, the
Risk Premium consists of Business Risk + Financial Risk. The following graph summarizes these relationships:

 In the above graph, we have a total risk free rate of 5%. The addition of business risk increases the
required rate on shares to 10%. When we introduce debt, this adds financial risk and increases the required
return on stock. The final total rate of return on shares with all forms of risk climbs from 12% to 16% over a
range of Debt to Equity Ratios. Since the cost of capital represents the rate that must be paid to investors for the
use of long-term funds, higher risk to investors will increase the cost of capital.

1. What is Cost of Capital? What is meant by 'explicit cost' and 'real cost' of capital?
2. Define the concept of 'cost of capital'. State how would you determine the weighted average
cost of capital of a company?
3. What is meant by cost of capital for a firm and what relevance does it have in decision-
making? How is it calculated for different types of sources of capital funds? Why is the cost of
capital most appropriately measured on an after tax basis?
4. What is meant by Cost of Capital? What are the components of cost of capital? What is the cost
of retained earnings? How is the cost of new equity issue determined?
5. Explain the problems faced in determining the cost of capital. How is the cost of capital
relevant in capital budgeting decisions and capital structure planning?
6. Explain critically the different approaches to the calculation of cost of equity capital.
7. Explain the various approaches for computing the cost of equity. Discuss the merits and
demerits of each.. '
8. What is the weighted average cost of capital? Explain the rationale behind the use of weighted
average cost of capital.
9. Compare the advantages and disadvantages of using marginal as opposed to historical weights
for calculating weighted average cost of capital. Which of these weights are more consistent
with the company's goal of wealth maximisation?
10. Some people regard retained earnings as a source of capital without any cost. Do you agree
with this view? State how.the cost of retained earnings should be determined.
11. 'Equity capital has also a cost.' Explaining, it discuss the methods of measuring the cost of
equity capital.
12. ABCLtd. wishes to issue 1,000,7% debentures ofRs. 100 each for which the expenses of issue
would be Rs. 5 per debenture. Find out the cost of debenture. [Ans. 7.37%]
13. A company has issued 6% debentures of Rs. 100 each at a discount of 10% repayable after 10
years. Find out the cost of debenture capital. [Ans. 7.37%]
14. rallis Ltd. has issued 1,000 equity shares of Rs. 100 each as fully paid. It has earned a profit of
Rs. 10,000 after tax. The market price of the shares is Rs. 160 per share. Find out the cost of
equity capital. [Ans. 6.25%]

Chapter 7 Working Capital Management

7.1 Meaning of Working Capital Management

The total investment in a business may be classified into two parts viz. (i) fixed capital and (ii) working
capital. Fixed capital refers to that part of the total capital invested, which is for the acquisition of fixed
assets e.g. land, buildings, plant, machinery, furniture etc.
Working capital refers to that part of the total capital employed which has been invested for the financing
of current assets e.g. inventories, debtors, cash and bank balances, bills receivable, prepaid expenses etc.
That is, total of all current assets is working capital.
Working Capital is often classified as Gross working capital and Net working capital. Gross working
capital is the total of all current assets. Net, working capital is the difference between the total current
assets and total current liabilities. As per the general practice net working capital is referred to simply as
Working Capital.

Current Assets:

(1) Stocks (Raw-materials, Stores & Spares, work-in-progress finished goods)

(2) Sundry debtors- (less provision for bad debts),
(3) Loans and advances
(4) Cash and bank balances.
Current liabilities:
(I) Sundry Creditors
(2) Advance and deposits
(3) Bank over-drafts, Bank loan.
From the management viewpoint gross working capital deals with the problems of managing individual
current assets as it represents the total value of the current assets. It enables the management to examine
the profit earning capacity of the current assets and ensures that the capacity is not less than the cost of
borrowing funds. On the other hand, net current assets help the management in arriving at the
requirements of funds from permanent sources. For' the purposes of planning for Working capital,
consideration only the net working capital is therefore, relevant.
Working Capital Requirements:
We know that a business undertaking requires funds for two purposes. . Funds are required to create
productive capacities through purchase of fixed assets etc., and to finance a part of the capital required for
day to day running of the business.
Funds are also required to invest in stocks, sundry debtors, cash and other current assets. Suppose a
company has a certain amount of cash. It will need raw materials. Some raw material would be available
on credit but cash will have to be paid out for the other part immediately. Then he has to pay labour costs
and incur factory overheads. These three combined will constitute work in progress (WIP). After the
production cycle is over, WIP will get converted into the finished product. The finished product when
sold on credit gets converted into sundry debtors. Sundry Debtors are realized in cash after expiry of the
credit period. This cash can again be used for financing raw materials, WIP etc. Thus, there is a complete
cycle from cash to cash wherein cash gets converted into work in progress, finished goods, sundry debtors
and, finally, cash again. Short-term funds are essentially required to meet the requirements of funds
during this period. This time period is dependent upon the length of time within which the original cash
gets converted into cash again.
It is obvious that a certain amount of funds is always tied up in raw material inventories, work in
progress, finished good, consumable stores, sundry debtors and day-to-day cash requirements.
However, the business also enjoys credit facilities from his suppliers who may give the raw
materials on credit. Similarly, a businessman may not pay immediately for many expenses. The
labourers are also paid only periodically. Therefore, a certain amount of funds is automatically
available to finance' the current asset requirements. However, the requirements for current assets
are usually greater than the amount of funds available through current liabilities. In other words,
the current assets are to be kept at a higher level than the current liabilities. This difference is
known as working capital.
Working capital has been defined as "the capital representing the excess of current assets over current
The working capital cycle may be depicted as follows:

Working Capital Cycle


Debtors Raw Materials

Finished Goods Work In Progress

7.3 Need of Working Capital Management

Working capital is just like the heart of business. It becomes weak; the business can hardly prosper and
survive. It is an index of the solvency of a concern. Its proper circulation provides to the business the right
account of cash to maintain regular flow of its operations. The following are a few advantages of adequate
working capital funds in the business:
(1) Cash Discount - If proper cash balance is maintained the business can avail of the cash discounts
facilities offered to it by the suppliers.
(2) Liquidity and Solvency - The proper administration of working capital enhances the: liquidity in
funds, solvency and credit-worthiness of the concern.
(3) Meeting Unseen Contingencies-It provides funds for un1ieen emergencies so that a business can
successfully sail through the periods of crisis.
(4) High Morale-The provision of adequate working capital improves the morale of the executives and
their efficiency leads it to higher climax.
(5) Good Bank Relations-Good relations with banks can also be maintained. The enterprise by
maintaining an adequate amount of working capital is able to maintain a sound bank credit; trade credit
and can escape insolvency
(6) Fixed Assets Productivity is Increased-Fixed assets of the firm also cannot work without proper
amount of working capital. Without it-fixed assets are like guns, which cannot shoot as there are, no
cartridges. Somebody has aptly commented that the fate of large-scale investment in fixed assets is
largely determined by the manner in which its current assets are managed.
(7) Research and Innovation Programmes-No research programme, innovation and technical
developments are possible to be undertaken without sufficient amount of working capital.
(8) Expansion Facilitated - The expansion programme of a firm is highly successful, if it is financed
through own working capital.
(9) Profitability Increased-The profitability of a concern also depends, in no small measure, on the right
proportion of fixed assets and current assets. Every activity of the business directly or indirectly affects
the current position of the enterprise; hence, its nee4is should be properly estimated and calculated.

7.3 Types of Working Capital

Working capital can be classified either on the basis of its concept or on the basis of periodicity of its
(A) On the 'Basis of Concept. On the basis of its concept, it may be either gross working capital or net
working capital. Gross working capital is represented by the total current assets. The net working capital
is the excess of current assets over current liabilities.
(i) Gross Working Capital = Total Currents Assets t (ii) Net Working Capital = CA-CL
(B) On the Basis of Requirement. According to Gerstenbergh, the working capital can be classified into
two categories on the basis of time and requirement:
(i) Permanent Working Capital. It refers to the minimum amount of investment, which should always
be there in the fixed or minimum current assets like inventory, accounts receivable, or cash balance etc.,
in order to carry out business smoothly. This investment is of a regular or permanent type and as the size
of the firm expands, the requirement of permanent working capital also increases. Tandon Committee has
referred to this type of working capital as "hard core working capital."
(ii) Variable Working Capital. The excess of the amount of working capital over permanent working
capital is known as variable working capital. The amount of such working capital keeps on fluctuating
from time to time on the basis of business activities. It may again be sub-divided into seasonal and special
working capital. Seasonal working capital is required to meet the seasonal demands of busy periods
occurring at stated intervals. On the other hand, special working capital is required to meet extra-ordinary
needs for contingencies. Events like strike, fire, unexpected competition, rising price tendencies or
initiating a big advertisement campaign require such capital.

The following diagram illustrates the difference between permanent and variable working
7.4 Factors determining Working Capital Requirement

There is no set universally applicable rule to ascertaining working capital needs of a business
organization. The factors which influence the need level are discussed below:

* Nature of business: If we look at the Balance sheet of any trading organization, we find major part of
the resources is deployed on current assets, particularly stock-in-trade. Whereas in case of a transport
organization major part of funds would be locked up in fixed assets like motor vehicles, spares and work
shed etc. and the working capital component would be negligible. The service organizations or public
utilities need lesser working capital than trading and financial organizations. Therefore, the requirement
of working capital depends upon the nature of business carried by the organization. .
*Manufacturing Cycle: Time span required for conversion pf raw materials into finished goods is a
block period. The period in reality extends a little before and after the work-in-pr6gress. This cycle
determines the need of working capital.
*Business Cycle Fluctuation: This is another factor which determines the need level. Barring
exceptional cases, there are variations in the demand for goods/services handled by any organization.
Economic boom or recession etc., have their influence on the transactions and consequently on the
quantum of working capital required.
* Seasonal Variations: Variation apart, seasonality factor creates production or even storage problem.
Muster and many other oil seeds are Rabi crops. These are to be purchased in a season to ensure
contu1UOuS operation of oil plant. Further there are woolen garments, which have demand during winter

blockage during off-season.

*Scale of Operations: Operational level determines working capital demand during a given period.
Higher the scale, higher will be the need for working capital. However, pace of sales turnover (Quick or
slow) is another factor. Quick turnover calls for lesser investment in inventory while low turnover rate
necessitates larger investment.
*Credit Policy: Credit Policy of the business organization includes to whom, when and to what extent
credit may be allowed. Amount of money locked up m account receivables has its impact on working
capital. In good many cases, account receivables are sterile and sticky and thereby they have forfeited the
right to be classified as current assets. In view of such situation in ascertaining quick ratio instead of
deducting stock-in-trade we find it worthwhile to deduct sundry debtors. The other component is credit
policy of the suppliers, their terms and conditions of credit. Trade credit has its historical presence in the
trading world. Availability of normal credit supplies as well as trade credit facilitates working capital
supply and reduces the need for bank finance.
*Accessibility to Credit: Creditworthiness is the precondition for assured accessibility to credit.
Accessibility in banks depends on the flow of credit i.e., the level of working capital.
*Growth and Diversification of Business: Growth and diversification of business call for larger volume
of working fund. The need for increased working capital does not follow the growth of business
operations but precedes it. Working capital need is in fact assessed in advance in reference to the business
*Supply Situation: In easy and stable supply situation, no contingency plan is necessary and
precautionary steps in inventory investment can be avoided. But in case of supply uncertainties, lead-time
may be longer necessitating larger basic inventory, higher carrying cost and working capital need for the
purpose. No aggressive approach can gain foothold in such situation.
"' '
*Environment Factors: Political stability in its wake brings in stability in money market and trading
world. Things mostly go smooth. Risk ventures are possible with enhanced need for working capital
finance. Similarly, availability of local infrastructural facilities - road, transport, storage and market etc.,
influence business and working capital need as well.

7.5 Working Capital Policies

There are three basic approaches for determining the working capital financing mix:
(A) The Hedging Approach. According to this approach, the maturity of source of funds should match the
nature of assets to be financed. That's why~ it is also known as 'Matching Approach'. It divides total
working capital requirements in two categories- permanent and temporary. The permanent working
capital requirements should be financed by long-term funds while the temporary or seasonal working
capital requirements should be financed out of short-term funds.
(B) The Conservative Approach. This approach emphasizes upon safety. According to this approach, all
requirements of working capital funds should be met from long-term sources. The short-tenn sources
should be used only during emergency times. This approach is less risky but more costly as compared to
hedging approach. It is a 'low risk, low profits' approach.
(C) Trade off Approach. Trade off approach is a mid way between the two extremes-hedging as well as
conservative approaches. However, the level of such trade off will differ from case to ease depending
upon perception of the risk by the persons involved in financial decision-making. However, one way of
determining the trade off is by finding the average of the minimum and the maximum requirements of
working capital during a period. The average working capital so obtained may be financed by long-term
funds and die balance of working capital may be financed by short-term sources.

7.6 Methods for Estimating Working Capital Requirements

There are many popular methods available for estimating the working capital requirements, which are as
(1) Cash Forecasting Method. In this method the position of cash at the end of the period is shown after
considering the receipts and payments to be made during that period. Its form assumes more or less a
summary of cashbook. This shows the deficiency or surplus of cash at the definite point of time.
(2) The Balance Sheet Method. In the balance sheet method of forecasting, a forecast is made
of the various assets and liabilities of the business. Afterwards, the difference between the two is
taken which will indicate either cash surplus or cash deficiency.
(3) Profit and Loss Adjustment Method. Under this method the forecasted profits are adjusted on cash
(4) Per Cent-of-Sales Method. Having determined the sales accurately, steps can be taken to forecast
the working capital of concern. It is a traditional and simple method " of determining the volume of
working capital and its components, sales being a dominant factor. In this method, working capital is
determined as a per cent of forecasted sales. It is decided on the basis of past observations. If over the
year, relationship between sales and working capital is found to be stable, then this relationship may be
taken as a standard for the determination of working capital in future also. This relationship between sales
m and working capital and its various components may be c;xpressed in three ways: (i) as number of
days of sales; (ii) as turnover; and (iii) as percentage of sales,
The per cent-of-sales method of determining working capital is simple and easy to understand and is
useful in forecasting the working capital requirements, particularly, in the short-term. However, the
greatest drawback of this method is the assumption of linear relationship between sales and working
capital. Therefore, this method cannot be recommended for universal application. It may be found
suitable by individual companies in m specific situations.
(5) The Operational Cycle Method. This method of working capital forecast is based on the operational
cycle concept of working capital. The operational cycle refers to m the period that a business enterprise
takes in converting cash back into cash. In the case of a manufacturing concern, the duration of time
needed to complete the chain of events from cash to production and back to cash is termed as the
"operating cycle". As an example, a manufacturing firm uses cash to acquire inventory of materials that is
converted into semi-finished goods and then into finished goods. When finished goods are disposed of to
customers on credit, accounts receivable are generated. When cash is collected from customers, we again
have cash. At this stage one operating cycle is completed. Thus, a circle from cash back to cash is called
the 'Operating Cycle'. Each of the above operating cycle stage is expressed in terms of number of days of
relevant activity and requires a level of investment to support it. The sum total of these stage-wise
investments will be the total amount of working capital of the firm.
The following formula may be used to express the framework of the operating cycle:
t = (r - c) + w + f + b
Where, t stands for the total period of the operating cycle in number of days;
r stands for the number of days of raw material and stores consumption requirements held in raw
materials and stores inventory; .
c stands for the number of days of purchases in trade creditors;
w stand for the number of days of cost of production held in work-in-progress;
f stands for the number of days of cost of sales held in finished goods inventory; and
b stands for the number of days of sales in book debts.

The computations may be made as under:

r = Average inventory of raw materials and stores
Average per day consumption of raw materials and stores
c = Average trade creditors
Average credit purchases per day
w = Average work-in-progress
Average cost of production per day
f = Average inventory of finished goods
Average cost of sales per day
b =Average book debts
Average sales per day
The average inventory, trade creditors, work-in-progress, finished goods and book debts can be computed
by adding the opening and closing balances at the end of the year in the respective accounts and dividing
the same by two. The average per day figures can be obtained by dividing the concerned annual figures
by 365 or the number of days in the given period.
The operational cycle method of determining working capital requirements gives only an average figure.
The fluctuations in the intervening period due to seasonal or other factors and their impact on the working
capital requirements cannot be judged in this method. To identify these impacts, continuous short- run
detailed forecasting and budgeting exercises are necessary.
(6) Regression Analysis Method. The regression technique is a very useful statistical technique of
working capital forecasting. In the sphere of working capital management, it helps in making projection
after establishing the average relationship in the past years between sales and working capital (current
assets) and its various components. The analysis can be carried out through the graphic portrayals (scatter
diagrams) or through mathematical formula.
The relationship between sales and working capital of various components may be simple and direct
indicating complete linearity between the two or may be complex in differing degrees involving simpler
linear regressions; or simple curvi-linear regression, and multiple regression situations.
This method with the range of technique suitable for simple as well as complex situations is an
undisputed refinement on traditional approaches of forecasting and determining working capital
requirements. It is particularly suitable for long-term forecasting.

7.7 Financing of Working Capital

Permanent working capital should be financed in such a manner that the enterprise may have its
uninterrupted use for a sufficiently long period. There are five important sources of permanent or long-
term working capital.
1. Shares. Issue of shares is the most important-source for raising the permanent or long-term capital. A
company can issue various types of shares as equity shares, preference shares and deferred shares.
According to the Companies Act, 1956, however, a public company cannot issue deferred shares.
Preference shares carry preferential rights in respect of dividend at a fixed rate and in regard to the
repayment of capital at the time of winding up the company. Equity shares do not have any fixed
commitment charge and the dividend on these shares is to be paid subject to the availability of sufficient
profits. As far as possible, a company should raise the maximum amount of permanent capital by the issue
of shares.
2. Debentures. A debenture is an instrument issued by the company acknowledging its debt to its holder.
It is also an important method of raising long-term or permanent working capital. The debenture-holders
are the creditors of the company. A fixed rate of interest is paid on debentures. The interest on debentures
is a charge against profit and loss account. The debentures are generally given floating charge on the
assets of the company. When the debentures are secured they are paid on priority to other creditors. The
debentures may be of various kinds such as simple, naked or unsecured debentures, secured or mortgaged
debentures, and redeemable debentures. Irredeemable debentures, convertible debentures and non-
convertible debentures. The debentures as a source of finance have a number of advantages both to the
investors and the company. Since interest on debentures has to be paid on certain predetermined intervals
at a fixed rate and also debentures get priority on repayment at the time of liquidation, they are very well
suited to cautious investors. The f1rm issuing debentures also enjoys a number of benefits such as trading
on equity, retention of control, tax benefits, etc.
3. Public Deposits. Public deposits are the fixed deposits accepted by a business enterprise directly from
the public. This source of raising short term and medium-term finance was very popular in the
absence of banking facilities. In the past, generally, public deposits were accepted by textile
industries in Ahmedabad and Bombay for periods of 6 months to 1 year. But the business houses
accept now-a-days even long-term deposits for 5 to 7 years. Public deposits as a source of
finance have a large number of advantages such as very simple and convenient source of finance,
taxation benefits, trading on equity, no need of securities and an inexpensive source of finance.
But it is not free from certain dangers such as; it is uncertain, unreliable, unsound and inelastic
source of finance. The Reserve Bank of India has also laid down certain limits on public
deposits. Non-banking concerns cannot borrow by way of public deposits more than 25% of its
paid –up capital and free reserves.
4. Ploughing Back of Profits. Ploughing back of profits means the reinvesnnents by concern of
its surplus earnings in its business. It is an internal source of finance and is mot suitable for an
established firm for its expansion, modernization and replacement etc. This method of finance
has a number of advantages as it is the cheapest rather cost-free source of finance; there is no
need to keep securities; there is no dilution of control is; it ensures stable dividend policy and
gains confidence of the public. But excessive resort to ploughing back a: of profits may lead to
monopolies, misuse of funds, over capitalization and speculation, etc.
5. Loans from Financial institutions. Financial institutions such as Commercial Banks, Life Insurance
Corporation, Industrial Finance Corporation of India, State Financial Corporations, State Industrial
Development Corporations, Industrial Development Bank of India, etc. also provide short-term, medium-
term s and long-term loans. This source of finance is more suitable to meet the medium-term demands of
working capital. Interest is charged on such loans at a fixed rate and the amount of the loan is to be repaid
by way of installments in a number of years.

The main sources of short-term working capital are as follows:

1.Indigenous Bankers

2. Trade Credit
3. Installment Credit
4. Advances
5. Accounts Receivable Credit or Factoring
6. Accrued Expenses
7. Deferred Incomes
8. Commercial Paper
9. Commercial Banks

1. Indigenous Bankers
Private moneylenders and other country bankers used to be the only source of fmance prior to the
establishment of commercial banks. They used to charge very high rates of interest and exploited the
customers to the largest extent possible. Now a day with the development of commercial banks they have
lost their monopoly. But even today some business houses have to depend upon indigenous bankers for
obtaining loans to meet their working capital requirements.
2. Trade Credit
Trade credit refers to the credit extended by the suppliers of goods in the normal course of business. As
present day commerce is built upon credit, the trade credit arrangement of a firm with its suppliers is an
important source of short-term fmance. The credit-worthiness of a firm and the confidence of its suppliers
are the main basis of securing trade credit. It is mostly granted on an open account basis whereby supplier
sends goods to the buyer for the payment to be received in future as per terms of the sales invoice. It may
also take the form of bills payable whereby the buyer signs a bill of exchange payable on a specified
future date.
When a firm delays the payment beyond the due date as per the terms of sales invoice, it is called
stretching accounts payable. A firm may generate additional short-term finances by stretching accounts
payable, but it may have to pay penal interest charges as well as to forgo cash discount. If a firm delays
the payment frequently, it adversely affects the credit worthiness of the f1rDl and it may not be allowed
such credit facilities in future.
The main advantages of trade credit as a source of short-term finance include:
(i) It is an easy and convenient method of finance.
(ii) It is flexible as the credit increases with the growth of the firm.
(iii) It is informal and spontaneous source of finance.
However, the biggest disadvantage of this method of fmance is charging of higher prices by the suppliers
and loss of cash discount.
3. Instalment Credit
This is another method by which the assets are purchased and the possession of goods is taken
immediately but the payment is made in installments over a pre-determined period of time. Generally,
interest is charged on the unpaid price or it may be adjusted in the price. But, in any case, it provides
funds for sometime and is used as a source of short-term working capital by many business houses, which
have difficult fund position.
4. Advances
Some business houses get advances from their customers and agents against orders and this source i
short-term source of finance for them. It is a cheap source of finance and in order to minimize their
investment in working capital, some firms having long production cycle, specially the firms
manufacturing industrial products prefer to take advances from their customers.
5. Factoring or Accounts Receivable Credit
Another method of raising short-term finance is through accounts receivable credit offered I commercial
banks and factors. A commercial bank may provide finance by discounting the bills or invoices of its
customers. Thus, a firm gets immediate payment for sales made on credit. A factor is a financial
institution, which offers services relating to management and financing of debts arising out of credit sales.
Factoring becoming popular allover the world on account of various services offered by the institutions
engaged in it. Factors render services varying from bill discounting facilities offered by commercial banks
to a total take over of administration of credit sales including maintenance of sales ledger, collection of
accounts receivables, credit control and protection from bad debts, provision of fmance and rendering of
advisory services to their clients Factoring may be on a recourse basis, where the risk of bad debts is
borne by the client, or on a non-recourse basis, where the risk of credit is borne by the factor.
At present, only only a few financial institutions on a recourse basis render factoring in India. However,
the Report of the Working Group on Money Market (Vaghul Committee) constituted by the Reserve Bank
of India has recommended that banks should be encouraged to set up factoring divisions to provide
speedy finance to the corporate entities.
In spite of many services offered by factoring, it suffers from certain limitations. The most critical fallouts
of factoring include; (i) the high cost of factoring as compared to other sources of short-term finance, (ii)
the perception of financial weakness about the firm availing factoring services, and (iii) adverse impact of
tough stance taken by factor, against a defaulting buyer, upon the borrower resulting into reduced future
6. Accrued Expenses Accrued expenses are the expenses which have been incurred but not yet due and
hence not yet paid also. These simply represent a liability that a firm has to pay for the services already
received by it. The most important items of accruals are wages and salaries, interest, and taxes. Wages and
salaries are usually paid on monthly, fortnightly or weekly basis for the services already rendered by
employees. The longer the payment-period, the greater is the amount of liability towards employees or the
funds provided by them. In the same manner, accrued interest and taxes also constitute a short-term
source of fmance. Taxes are paid after collection and in the intervening period serve as a good source of
finance. Even income tax is paid periodically much after the profits have been earned. Like taxes, interest
is also paid periodically while a firm uses the funds, continuously. Thus, all accrued expenses can be used
as a source of finance.
The amount of accruals varies with the change in the level of activity of a firm. When the activity level
expands, accruals also increase and hence they provide a spontaneous source of fmance. Further, as no
interest is payable on accrued expenses, they represent a free source of fmancing. However, it must be
noted that it may not be desirable or even possible to postpone these expenses for a long period.
Provisions of law and practice in industry determine the payment period of wages and salaries. Similarly,
law governs the payment dates of taxes and delays may attract penalties. Thus, we may conclude that
frequency and magnitude of accruals is beyond the control of managements. Even then, they serve as a
spontaneous, interest free, limited source of short-term financing.

7. Deferred Incomes
Deferred incomes are incomes received in advance before supplying goods or services. They represent
funds received by a firm for which it has to supply goods or services in future. These funds increase the
liquidity of a firm and constitute an important source of short-term finance. However, firm having great
demand for its products and services, and those having good reputation in the market can demand
deferred incomes.
8. Commercial Paper
Commercial paper represents unsecured promissory notes issued by firm to raise short-term funds. It is an
important money market instrument in advanced countries like U.S.A. In India, the Reserve Bank of India
introduced commercial paper in the Indian money market on the recommendations of the Working Group
on Money Market (Vaghul Committee). But only large companies enjoying high credit rating and sound
financial health can issue commercial paper to raise short-term funds. The Reserve Bank of India has laid
down a number of conditions to determine eligibility of a company for the issue of commercial paper.
Only a company, which is listed on the stock exchange, has a net worth of at least Rs. 10 crores and a
maximum permissible bank finance of Rs. 25 crores can issue commercial paper not exceeding 30 per
cent of its working capital limit.
The maturity period of commercial paper, in India, mostly ranges from 91 to 180 days. It is sold at a
discount from its face value and redeemed at face value on its maturity. Hence, the cost of raising funds,
through this source, is a function of the amount of discount and the Reserve Bank of India provides the
period of maturity and no interest rate for this purpose. Investors including banks, insurance companies,
unit trusts and firm to invest surplus funds for a short period usually buy commercial paper. A credit
rating agency, called CRISIL, has been set up in India by ICICI and UTI to rate commercial papers.
Commercial paper is a cheaper source of raising short-term finance as compared to the bank credit and
proves to be effective even during period of tight bank credit. However, only large companies enjoying
high credit rating and sound fmancial health can use it as a source of fmance. Another disadvantage of
commercial paper is that it cannot be redeemed before the maturity date even if the issuing firm has
surplus funds to pay back.
9. Working Capital Finance By Commercial Banks
Commercial banks are the most important source of short-term capital. The major portion of working
capital loans is provided by commercial banks. They provide a wide variety of loans tailored to meet the
specific requirements of a concern. The different forms in which the banks normally provide loans and
advances ; are as follows:
(a) Loans
(b) Cash Credits
(c) Overdraft.,
(d) Purchasing and Discounting of bills.
(a) Loans. When a bank makes an advance in lump sum against some security it is called a loan. In case
of a loan, the bank to the customer sanctions a specified amount. The entire loan amount is paid to the
borrower either in cash or by credit to his account. The borrower is required to pay interest on the entire
amount of the loan from the date of the sanction. A loan may be repayable in lump sum or installments.
Interest on loans is calculated at quarterly rests and where repayments are stipulated in installments, the
interest i~ calculated at quarterly rests on the reduced balances. Commercial banks generally provide
short-term loans up to one year for meeting working capital requirements. But banks also provide now-a-
days term loans exceeding one year. The term loans may be either medium-term or long-term loans.
(b) Cash Credits. A cash credit is an arrangement by which a bank allows his customer to borrow money
up to a certain limit against some tangible securities or guarantees. The customer can withdraw from his
cash credit limit according to his needs and he can also deposit any surplus amount with him. The interest
in case of cash credit is charged on the daily balance and not on the entire amount of the account. For
these reasons, it is the most favourite mode of borrowing by industrial and commercial concerns. The
Reserve Bank of India issued a directive to all scheduled commercial banks on 28th March 1970,
prescribing a commitment charge, which banks should levy on the unutilized portion of the credit limits.
(c) Overdrafts. Overdraft means an agreement 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. There are no restrictions for
operation of overdraft limits. The interest is charged on daily overdrawn balances. The main difference
between cash credit and overdraft is that overdraft is allowed for a short period and is a temporary
accommodation whereas the cash credit is allowed for a longer period. Overdraft accounts can either be
clean overdrafts, partly secured or full secured.
(d) Purchasing and Discounting of Bills. Purchasing and discounting of bills is the most important form in
which a bank lends without any collateral security. Present day commence is built upon credit. The seller
draws a bill of exchange on the buyer of goods on credit. Such a bill may be either a clean bill or a
documentary bill, which is accompanied by documents of title to goods such as a railway receipt. The
bank purchases the bills payable on demand and credits the customer's account with the amount of bill
less discount. At the maturity of the bills, bank presents the bill to its acceptor for payment. In case the
bill discounted is dishonoure4 by non-payment, the bank recovers the full amount of the bill from the
customer along with expenses in that connection.
7.8 Control of Working Capital
The availability of bank credit to industry has been a subject-matter of regulation and control in the recent
years keeping in view the basic objective of ensuring its equitable distribution to various sectors of the
Indian economy. Reports submitted by four important committees are significant in this respect. They are
(i) Dehejia Committee Report, 1969.
(ii) Tandon Committee Report, 1975.
(iii) Chore Committee Report, 1980.
(iv) Marathe Committee Report, 1984.
(v) Chakravaty Committee Report, 1985
(vi) Kannan Committee Report, 1997

1. Dehejia Committee Report, 1969.

In order to determine "the extent to which credit needs of industry and trade are likely to be inflated and
how such trends could be checked" the National Credit Council constituted in 1968 a committee under the
chairmanship of Shri V.T. Dehejia. The committee submitted its report in September, 1969. The important
findings of this committee were as follows:
(i) There was a tendency on the part of industry generally to avail itself of short-term credit from banks in
excess of legitimate requirements.
(ii) There was also a tendency on the part of industry to divert short-term credit for acquisition of non-
current assets.
(iii) The present lending system of cash credit was found by the committee largely responsible for the
above two tendencies on the part of the industry.
Recommendations. The Committee made the following recommendations to bring about improvements
in the lending system:
(i) There should be appraisal of credit applications received by- the bankers with reference to present and
projected total financial position as shown by cash flow analysis and forecast submitted by borrowers.
(ii) The total cash credit requirements of the borrower should be segregated into two portions.
(a) "Hard Core" component, which would represent the minimum level of raw materials, finished
goods and stores which the industry was required to hold for maintaining a given level of
(b) The strictly short-term components representing the requirements of funds for temporary
purposes, such as short-term increase in inventories, tax, dividends and bonus Payments
The Committee suggested that the hard-core element in the cash credit borrowing should be
segregated and put on a formal term loan basis and subject to repayment schedule.
(iii) In order to avoid the possibility of double or multiple financing, the Committee suggested that a
customer should generally be required to confine his dealings to one bank only. However, in case of large
borrowers, the Committee recommended the adoption of "consortium arrangement."
2. Tandon Committee Report, 1975.
The recommendation of the Dehejia Committee regarding plugging the loopholes in the existing credit
system and change in the lending policy of the banks remained unimplemented. As a result banks
"oversold credit" and a large part of it remained unutilized. It was felt that there was an urgent necessity
to review the existing credit system. Changes were to be effected in a way that the borrower would plan
his credit needs and the banker also would be able to plan, having known the borrower's credit
requirements. A committee was, therefore, appointed by the Reserve Bank in July, 1974, under the
chairmanship of Shri P .L. Tandon.
Terms of reference. The terms of reference of the committee were as follows:
1. To suggest guidelines for commercial banks to follow up and supervise credit from the point of view of
ensuring proper end-use of funds and keeping a watch on the safety of advances.
2. To suggest the type of operational data and other information that may be obtained by banks
periodically from the borrowers and by the Reserve Bank from the lending banks.
3. To make suggestions for prescribing inventory norms for different industries both in the private and
public sectors and indicate the broad criteria for deviating from these norms.
4. To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to
5. To make recommendations regarding resources for financing the minimum working capital
6. To suggest whether the existing pattern of financing working capital requirements by cash
credit/overdraft system requires to be modified, if so, to suggest suitable modification.

Recommendations. The report submitted by the Tandon Committee is a landmark in the history of
financing of working capital by commercial banks in India. The report was submitted on 9th August 1975.
The report included recommendations covering all aspects of lending. The recommendations were
essentially based on three principles:
(i) A proper financial discipline has to be observed by the borrower. He should supply to the banker
information regarding his operational plans well in advance. The banker must carry out a realistic
appraisal of such plans.
(ii) The main function of a banker as a lender is to supplement the -borrower's resources to carry an
acceptable level of current assets. This has two implications: (a) the level of current assets must be
reasonable and based on norms and (b) a part of funds 'requirement for carrying out current assets must be
found from long-term funds.
(iii) The bank should know the end-use of bank credit so that it is used only for purposes for which it is
made available.
The salient features of the recommendations of the committee are being summarised below:
(1) Fixation or norms. An important feature of the Tandon Committee's recommendations relate to
fixation of norms for bank lending to industry. These norms can be divided into two categories.
(i) Inventory and receivables norms. The committee has suggested norms for 15 major industries. The
norms proposed represent the maximum level for holding inventories and receivables. They pertain to the
(i) Raw materials including stores and other items used in the process of manufacture.
(ii) Stocks in process.
(iii) Finished goods.
(iv) Receivables and bills discounted and purchased.
The norms have been worked out according to "the time element". Raw materials
are expressed as so many month's consumption. Stock-in-process are expressed as so many
months' cost of production. Finished goods and receivables are expressed as so many months' cost of
sales and sales respectively.
(ii) Lending norms. The recommendation of the Tandon Committee regarding the "lending norms" has
far-reaching implications. The lending norms have been suggested in view of this realization that the
banker's role as a lender is only to supplement the borrower's resources and not to meet his entire working
capital needs. In the context of this approach, the Committee has suggested three alternative methods for
working out the maximum permissible level of bank borrowings. Each successive method reduces the
involvement of short-term ba:1k credit to finance the current assets.
3. Chore Committee Report, 1980 Having implemented the recommendations of the Tandon
Committee, the Reserve" Bank of India in March, 1979, appointed another committee under the
chairmanship of Shri K.B. Chore. Chief Officer, Department of Banking Operations and Development,
Reserve Bank of India. This Committee was asked to review the working of cash credit system in recent
years with particular reference to the gap between sanctioned limits and the extent of their utilization, It
was also asked to suggest alternative type of credit facilities which should ensure greater credit discipline
and enable the banks to relate credit limits to increase in output or other productive activities.
Recommendations. The important recommendations of the Committee are as follows:
(i) Periodical review of limits. The existing system of three types of lending, namely cash credits, loans
and bills should continue. But wherever possible, the use of cash credit should be supplemented by the
use of loans and bills. The Committee further advised the commercial banks to streamline the existing
cash credit system and also undertake, invariably, a periodical review of the limits already in vogue under
the system. For this purpose, the bank should strictly ensure that review of all the borrower accounts
enjoying working capital credit limits of Rs. 10 lakhs and above from the banking system is made at least
once a year.
(ii) No bifurcation of cash credit accounts. The Reserve Bank's earlier instructions to banks to bifurcate
the cash credit accounts (as per recommendations of the Tandon Study Group) into demand loan
component and cash credit portion and to maintain differential interest rates between these two
components have been withdrawn.
(iii) Separate limits for peak level and non-peak level requirements. The banks have been asked to fix
separate credit limits wherever feasible for the normal non-peak level and for peak-level credit
requirements indicating the periods during which the separate limits would be utilized by the borrowers.
If, however, there is no pronounced seasonal trend, peak-level and normal requirements should be treated
as identical and limits should be fixed on that basis.
Within the limits sanctioned for peak-level/non-peak-level periods, the borrowers should indicate before
the commencement of each quarter the requirements of funds during that quarter (i.e., the operative limit).
The statement so submitted by the borrower should form the basis for quarterly review of the accounts.
The operative limit indicated by the borrower should virtually set the level of drawings in that quarter
subject to a tolerance limit of 10% either way. Excess or under utilization of the operative limit beyond
the tolerance level should be considered as an irregularity in the account indicative of defective planning
by the borrower and the banks should initiate necessary corrective steps, in concert with the borrowers, to
prevent the recurrence of such irregularities in future.
(iv) Submission of quarterly statements. The quarterly statements should be submitted by all borrowers
having working capital limits of Rs. 50 lakhs and above from the entire banking system in place of the
present limit of Rs. 1 crore. In case of default banks were permitted to char6~ penal interest of 1 % p.a. on
the total outstanding for the period of default.
(v) No frequent sanction of temporary limits. Borrowers should be discouraged from approaching
banks frequently for ad hoc or temporary limits in excess of sanctioned limits to meet unforeseen
contingencies. Request for such limits should be considered very carefully and should be allowed only for
predetermined short durations and given through separate demand loan "non-operable" cash credit
(vi) Reduction in overdependence of bank credit. The over dependence on bank credit by
medium/large borrowers is sought to be reduced by requiring them to enhance their contribution towards
working capital. For this purpose, in assessing the maximum permissible bank finance, banks should
hereafter adopt the second method of lending as recommended by the Tandon Committee, according to
which the borrower's contribution from his own funds and term finance to meet the working capital
requirements should be equal to at least 25 per cent of the total current assets.
4. Marathe Committee’s Report
This Committee was appointed by R.B.I. in October, 1982 to review the working of Credit Authorization
Scheme (CAS) from the point of view of operational aspects. The Committee submitted its report in July
1983, which was accepted by R.B.I. with some modifications w.e.f. April 1, 1984. The chief plank of the
recommendations is the concept of 'FAST TRACK' which implies that subject to fulfillment of some
conditions, as given below, the banks can release, without prior approval of R.B.I., 50% of the additional
credit required by borrowers, falling out of the ambit of the CAS, as a result the disbursement of credit is
faster or running on the 'FAST TRACK' than it would have been otherwise. The condition to be complied
with by a borrower is as follows:
(1) Reasonableness of estimate/projections in regard to sales, chargeable current ~ assets, current
liabilities (other than bank borrowings) and net working capital.
(2) Classification of current assets and current liabilities in conformity with the guidelines issued by
(3) Maintenance of minimum current ratio of 1.33 : 1.
(4) Prompt submission of operating statements.
It is to be ensured that the following periodical statements have been submitted: by the borrower during
the last six months within the prescribed time frame:
(i) Quarterly Information System: Form I. Estimates of current assets and current liabilities (including
short-term bank borrowings) for the ensuring quarter is to be submitted in the week preceding the
commencement of the quarter to which the statement relates.
(ii) Quarterly Information System: Form II. Statement showing the performance for the previous quarter
with current assets and current liabilities to be submitted within six weeks from the close of the quarter to
which the statement relates.
(iii) Half-yearly Operating and Funds Flow Statements: Form III. To be submitted " within two months
from the close of the half-year.
(5) Submission of annual accounts by the borrower to the bank regularly and promptly. Further the bank
is required to review the borrower's account at least once a year.
While forwarding the FAST TRACK cases to RBI, a certificate is to be forwarded by an officer of the
applicant bank.
5.Chakravarty Committee Report
The Reserve Bank of India appointed another committee under the chairmanship of Sukhamoy
Chakravarty to review the working of the monetary system of India. The committee submitted its
report in April 1985. The committee made two major recommendations in regard to the working
capital finance:
(i) Penal Interest for Delayed Payments
The committee has suggested that the government must insist that all public sector units, large
private sector units and government departments must include penal interest payment clause in
their contracts for payments delayed beyond a specified period. The penal interest may be fixed at
2 per cent higher than the minimum lending rate of the supplier's bank.
(ii) Classification of Credit Limit Under Three Different Heads
The committee further suggested that the total credit limit to be sanctioned to a borrower should
be Iii considred under three different heads: (1) Cash Credit I to include supplies to government,
(2) Cash Credit II to cover special circumstances, and (3) Normal Working Capital Limit to cover
the balance credit facilities. The interest rates proposed for the three heads are also different.
Basic lending rate of the bank should be charged to Cash Credit II, and the Normal Working
Capital Limit be charged as below:
(a) For Cash Credit Portion : Maximum prevailing lending rate of the bank.
(b) For Bill Finance Portion : 2% below the basic lending rate of the bank.
(c) For Loan Portion :The' rate may vary between the minimum and
maximum lending rate of the bank.
6. Kannan Committee Report
In view of the ongoing liberalization in the financial sector, the Indian Banks Association (IBA)

Constituted a committee headed by Shri K. Kannan, Chairman and Managing Director of Bank of Baroda
to examine all the aspects of working capital finance including assessment of maximum permissible bank
finance (MPBF). The Committee submitted its report on 25th February 1997. It recommended that the
arithmetical rigidities imposed by Tandon Commit Lee (and reinforced by Chore Committee) in the form
of MPBF computation so far been in practice, should be scrapped. The Committee further recommended
that freedom to each bank be given in regard to evolving its own system of working capital finance for a
faster credit delivery so as to serve various borrowers more effectively. It also suggested that line of credit
system (LCS), as prevalent in many advanced countries, should replace the existing system of
assessment/fixation of sub-limits within total working capital requirements. The Committee proposed to
shift emphasis from the Liquidity Level Lending (Security Based Lending) to the Cash Deficit Lending
called Desirable Bank Finance (DBF). The Reserve Bank of India with has already accepted some of the
recommendations of the committee suitable modifications. The important measures adopted by RBI in
this respect are given below:
(i) Assessment of working capital finallced based on the concept of MPBF, as recommended by Tandon
Committee, has been withdrawn. The banks have been given full freedom to evolve an appropriate system
for assessing working capital needs of the borrowers within the guidelines and norms already prescribed
by Reserve Bank of India.
(ii) The turnover method may continue to be used as a tool to assess the requirements of small borrowers.
For small scale and tiny industries this method of assessment has been extended up to total credit limits of
Rs. 2 Crore as against existing limit of 1 crore.

(iii) Banks may now adopt Cash Budgeting System for assessing the working capital finance in respect of
large borrowers.
(iv) The banks have also been allowed to retain the present method of MPBF with necessary modification
or any other system as they deem fit.

(v) Banks should Jay down transparent policy and guidelines for credit despensation in respect of each
broad category of economic activity.

(vi) The RBI's instructions relating to directed credit, quantitative limits on lending and prohibitions of
credit shall continue to be in force. The present reporting system to RBI under the Credit Monitoring
Arrangement (CMA) shall also continue in force.
A. Objective Type
1. Fill in the gaps:
(i) Net working capital is the excess of………. over ……….;
(ii) Working capital is also known as………….. or………….. , capital.
(iii) The gross working capital is…………. a concern concept.
(iv) The rate of return on investments…………. with the shortage of working capital.
(v) Greater the size of a business unit………… will be the requirements of working capital.
[Ans. (i) Current Assets. Current Liabilities; (ii) revolving. Circulating; (iii) going; (iv) falls; (v) larger]

2. State whether the following statements are true or false:

(i) Gross working capital refers to the capital invested in the total assets of an enterprise.
(ii) Net working capital is the excess of current liabilities over current assets.
(iii) Every business concern should have excessive working capital.
(iv) Longer the process period of manufacture. larger is the amount of working capital required.
(v) The fixed proportion of working capital should be generally financed from the fixed capital sources.
(vi) Commercial banks provide loans for working capital.
[Ans. (i) False; (ii) False; (iii) False; (iv) True; (v) True; (vi) True].
B. Short Answer Type
1. What is the concept of working capital?
2. Name the various kinds of working capital.
3. What are the principles of working capital management?
4. What are the sources of short-term working capital?
5. Write advantages and disadvantages of trade credit as a source of short-term finance. 6. What is
7. Write a brief note on commercial paper as a source of finance.
8. What is a letter of credit?
9. Differentiate between hypothecation and pledge.
10. Write a note on CAS.
11. What is working capital budget?
C. Essay Type
1. Define the term working capital. What factors would you take into consideration in estimating the
working capital needs of a concern ?
2. What do you understand by working capital? Explain the concepts of working capital? '.

1. Traders Ltd. are engaged in large scale retail business. From the following information. You are
requircd to forecast their working capital requirements :
Projected annual sales Rs. 130lakhs
Percentage of Net Profit on Cost of Sales 25%
Average credit period allowed to debtors 8 weeks
Average credit period allowed by creditors 4 weeks
Average stock carrying (in terms of sales requirements) 8 weeks
Add: 10% to computed figures to allow for contingencies.
[Ans. Rs. 26.40 lakhs]
2. The following information has been submitted by a borrower:
(i) Expected level of production 1,20.000 units
(ii) Raw materials to remain in stock on an average 2 months
(iii) Processing period for each unit of product 1 month
(iv) Finished goods remain in stock on an average 3 months
(v) Credit allowed to the customers from the date of dispatch 3 months
(vi) Expected ratios of cost to selling price :
(a) Raw materials-60% (b) Direct wages-IO% (c) Overheads -20%
(vii) Selling price per unit Rs. 10
(viii) Expected margin on sale 10'%
You are required to estimate the working capital requirements of the borrower.
[Ans. Rs. 7.50.000]
Chapter 8 Management Of Earnings

8.1 Introduction

The term management of earnings means how the earnings of a firm are utilised, i.e. how much i to the
shareholders in the form of dividends and how much is retained and ploughed back in the business way
the companies apportion their earnings between-dividends and retention is known as management of
In the words of Gerstenberg,'Management of income, in its broadest sense, includes the management of
each phase of the company’s business because, the minutest activity of the business usually involves in,
or expenditure."
Management of earnings is all important tool of business administration. In case of joint stock companies
where ownership and management are in different hands, management of earnings assumes special
importance, Companies, usually, do not distribute the entire amount of earnings to the shareholders in the
form of dividends, but retain a part of it for the future expansion and growth to bear the future risks. A
well established policy regarding management of earnings must be formulated to secure the maximum
benefits to the body corporate and its owners. The prime criterion in this regard is the effect of its policy
decision on the value of the firm, viz, the cost of capital, its growth and the market price of its shares. A
company that pays regular dividends and steadily arguments its future earnings capacity through retention
commands respectable position in the market, Creation of ill planned reserves, unsound depreciation
policy and absence of internal financial control measures are the symbols of defective management of
earnings and may lead to the liquidation of the firm.

8.2 Scope of Management of Earnings

Management of earnings includes:

1. (a) Determination of Profits,
(b) Determination of Surplus,
(c) Creation of Reserves.
2. Provision for Depreciation and Depreciation Policy.
3. Declaration of Dividend and Dividend Policy.
4. Retained Earnings or Ploughing-back of Profits (Self Financing).

8.2.1 Determination of Profits

The excess of revenues earned over expenses incurred for earning that revenue is known as profits,
Income statement or profit and loss account is prepared to determine the profits. The determination of
correct profits is of immense significance due to the following:
(i) for correct reporting to the shareholders;
(ii) for declaration of dividends, the amount and trend of earnings or profits is the starting point;
(iii) for ascertaining the operating efficiency of the company;
(iv) for deciding about the future expansion and growth ;
(v) for ascertaining the intensive use of capital ;
(vi) for determining creditworthiness of the firm ;
(vii) for payment of correct taxes;
(viii) for determining the basis of mergers and amalgamations; and
8.2.2 Surplus: Meaning and Importance

There are different views regarding the meaning and concept of surplus. According to one school of
thought, the balance remaining after deducting the liabilities and share capital from the total of assets is
known as 'surplus'. In the opinion of the other school, 'surplus' represents the 'undistributed earnings' of a
company, i.e., the balance of profits remaining after paying dividends to the shareholders. Still, there are
others in whose opinion 'surplus' is a left over which represents an addition to assets that is carried over
on the 'equity side'. But, surplus is solely equity of stock-holders and not an asset in any sense of the
word. In simple words, 'surplus' may be described as the net income of the company remaining after
payment of dividend and all other expenses. It is the difference between the book value of the assets and
the sum of liabilities and capital.
Surplus is considered to be a sort of a blanket covering of many corporate purposes. It is not merely a
source of dividend, but has various other functions as well. It is regarded as a welcome sign by the
management. It reflects upon the sound earning capacity of a firm. It enables a company to follow a stable
dividend policy. A company can pay stable dividends even in the years when there are no sufficient
profits. Surplus acts as a cushion to absorb the shocks of economy and business such as depression for the
company. A company with large surplus can withstand the shocks of trade cycles and the uncertainty of
the market with comfort, preparedness and economy. Kinds And Sources of Surplus

The various kinds of surplus and their sources are discussed as below:

1. Earned surplus. In the mind of a layman, surplus always implies earned surplus. The use of the term
surplus as accumulation of past earnings accounts for its common identification with earned surplus. The
main sources of earned surplus are:

(a) past accumulated profits;

(b) net profits from business operations at the close of each financial year;
(c) retained earnings including income from business operations as well as non-operational
incomes, such as profit on sale of fixed assets ;
(d) conversion of reserves which are no longer required; and
(e) non-operating income.
2. Capital surplus. Capital surplus is that part of the surplus which is not related directly to the operating
results of the business. It results from:
(a) an increase in assets without a corresponding increase in liability or capital; and
(b) a decrease in capital or liabilities without a corresponding decrease in assets.
3. Surplus from unrealised appreciation of asset. During periods of prosperity or boom, the value of
fixed assets may increase or intangible values may be added by accounting entries. Such a surplus is not
realised because the assets are not actually sold but the effect of an appreciated surplus is created when a
company appreciates its assets.
4. Surplus from realised appreciation of asset. The sale of assets at prices in excess of book values may
result in realised surplus.
5. Surplus from mergers, consolidations and reorganisations. In mergers and consolidations, stock
may be exchanged for stock and surpluses taken over by the new companies. Since mergers and
consolidations are generally accompanied by an upward valuation of assets, the resulting surplus may be
larger than the total of that resulting in an increase in surplus. Even unsuccessful companies may increase
their book surplus through a forced reduction in liabilities.
6. Surplus from reduction of share capital. In periods of adversity, companies may create a surplus by
reducing the liability of their stated capital. This process of creating a surplus involves a number of legal
formalities and a sanction of the creditors.
7. Surplus from secret reserves. A secret reserve is one which is not disclosed in the balance sheet. Such
a reserve may be created by:
(a) an understatement of income;
(b) an excessive depreciation;
(c) inflation of capital expenditure;
(d) an undervaluation of assets; and
(e) an overstatement of liabilities.
This method of creating a surplus is not encouraged because it does not represent a true and fair view of
the company's financial position and provides an opportunity to the management for manipulation and
misuse of the company's funds.
8. Paid-in surplus. It arises from the issue of shares at premium. Uses of Surplus

Surplus may be broadly classified as (i) earned surplus; and (ii) capital surplus. The uses of surplus have
been discussed below keeping in mind such classification:
1. Uses of Earned Surplus
The accumulated earned surplus can be utilised by the company for the following:
(a) reducing the value of fixed and working capital ;
(b) writing off intangible assets, such as, goodwill, preliminary expenses, etc.
(c) equalising the rate of dividend;
(d) financing schemes of expansion and growth ;
(e) absorbing the shocks of business cycles; and
(f) supplementing other reserves.
2. Uses of Capital Surplus
Capital surplus may be used for the following purposes:
(a) for expansion and growth ;
(b) for protecting investments against a decline in values.
(c) for providing funds for working capital ;
(d) for writing down of operating losses;
(e) for absorbing depreciation. Manufacturing of Surplus

Surplus can be manufactured by the following methods:

(i) Understatement of liabilities, by:

(a) omission of certain liabilities ;'
(b) providing inadequate depreciation; and
(c) providing insufficient taxes.
(ii) Overstatement of assets, by:
(a) over-valuation of certain assets, such as inventories;
(b) considering unrealised profits;
(c) not making a provision for bad and doubtful debts ;
(d) not taking into account the loss or shrinkage in the value of an asset Hiding Of Surplus

Sometimes the companies hide their surplus for the various reasons, such as:

(i) to prevent the shareholders from demanding the distribution of surplus;

(ii) to induce investors to sell their shareholdings to the management at less than its true value;
(iii) to preserve the management from the temptation of paying large dividend;
(iv) to save heavy taxation;
(v) to prevent competitors;
(vi) to delay payments to creditors by impressing upon them their inability to pay immediately.
The various methods that are generally employed to hide the surplus are as follows:
I. Undervaluation of assets by :
(a) charging excessive depreciation;
(b) charging capital expenses as revenue;
(c) writing off assets by charging against surplus.
2. Overstatement of liabilities by :
(a) showing a contingent liability as an actual liability ;
(b) use of fictitious liabilities; and
(c) providing excessive provision for taxation, etc.
8.2.3 Reserves

In general, the term 'reserve' refers to the amount set aside out of profits. The amount may be set aside
to cover any liability, contingency, commitment or depreciation in the value of assets. Reserves mean,
therefore, amounts, which belong to the owners over and above, the capital contributed by them. If
amounts equal to reserves are invested in outside investments, the reserve is called 'Reserve Funds'.
Technically speaking, the amount set aside out of profits may be either (i) a 'provision' or (ii) a’ reserve.
A 'provision' means amount set aside as a charge against profits to meet:
(a) depreciation, renewals or diminution in the value of assets; and
(b) any known liability the amount of which cannot be known as yet, e.g., provision for doubtful debts,
provision for repairs, etc.
The term 'reserve' also includes other surpluses, which are not designed to meet any known liability,
contingency, commitment or diminution in the value of assets. Such a reserve is not a charge against
profits, but an appropriation of profits. In the modem days, the term reserve is used only in connection
with a restriction on, or appropriation of retained earnings. Such an appropriation is made on account of
the following:
(i) to prevent the distribution of surplus in the form of dividends;
(ii) to provide additional capital, i.e., ploughing back of profits;
(iii) to provide for rainy days;
(iv) to enable equalisation of dividends; and
(v) to supplement other reserves

8.2.4 Meaning And Concept Of Ploughing Back Of Profits

The 'Ploughing Back of Profits' is a technique of financial management under which all profits of a
company are not distributed amongst the shareholders as dividend, but a part of the profits is retained or
reinvested in the company. This process of retaining profits year after year and their utilisation in the
business is also known as ploughing back of profits.
It is actually an economical step, which a company takes, in the sense, that instead of distributing the
entire earnings by way of dividend, it keeps a certain percentage of it to be re-introduced into the business
for its development. Such a phenomenon is also known as 'Self-Financing’; 'Internal Financing’; or
'Inter- Financing'. A part of profits is ploughed back or re-employed into the business and is regarded as
in ideal source of financing expansion and modernisation schemes as there is no immediate pressure to
pay a return on this portion of stockholders' equity. Under this method, a part of total profits is transferred
to various reserves such as General Reserve, Replacement Fund, Reserve Fund, and Reserve for Repairs
and Renewals, etc. Sometimes 'secret reserves' are also created without the knowledge of the
shareholders. From all the practices of financial management, this system of ploughing back of profits is
considered desirable as it helps in the financial and economic stablisation of the concern. The Necessity of Ploughing Back of profits

The need for re-investment of retained earnings or ploughing back of profits arises for the following
1. For the replacement of old assets, which have become obsolete.
2. For the expansion and growth of the business.
3. For contributing towards the fixed as well as the working capital needs of the company.
4. For improving the efficiency of the plant and equipment.
5. For making the company self-dependent of finance from outside sources.
6. For redemption of loans and debentures.
8.3 Cost of Retained Earnings

It is sometimes argued that retained earnings do not involve any cost because a firm is not required to pay
dividends on retained earnings. However, the shareholders expect a return on retained profits. Retained
earnings accrue to a firm only because of some sacrifice made by the shareholders in not receiving the
dividends out of the available profits. The cost of retained earnings may be obtained by investing the
after-tax dividends in alternative opportunity of equal qualities. It is, thus, the opportunity cost of
dividends foregone by the shareholders. Cost of retained earnings can be computed with the help of
following formula:

K = D + Gr
where, K, = Cost of retained earnings
D = Expected dividend
NP = Net proceeds of share issue
G = Rate of growth
Further, it is important to note that shareholders, usually, cannot obtain the entire amount of retained 1
profit by way of dividends even if there is 100per cent pay-out ratio. It is so because the shareholders are l
required to pay tax on their dividend income. So, some adjustment has to be made for tax. However, tax
adjustment in determining the cost of retained earnings is a difficult problem because all shareholders do
not I fall under the same tax bracket. Moreover, if the shareholders wish to invest their after-tax dividend
income in alternative securities, they may have to incur some costs of purchasing the securities such as
brokerage. Hence, the effective rate of return realised by the shareholders from the new investment will
be somewhat lesser than their present return from the firm. To make adjustment-in the cost of retained
earnings for tax and costs of purchasing new securities, the following formula may be adopted:

K = (D/NP + G) x (I-t) x (I-b)

where, K = Cost of retained earnings
D = Expected dividend
G = Growth Rate
NP = Net Proceeds of equity issue
t = Tax rate
b = Cost of purchasing new securities, or brokerage costs
8.4 Dividend Policy

WHAT IS DIVIDEND PROBLEM Dividend is the amount paid out to the shareholders out of the
earnings for equity shareholders. That part of the total earnings, which is not paid out as dividend, is the
retained earnings (RE), which is ploughed back or reinvested in the business. The higher the amount of
dividend, the lower the RE and vice versa. Retained profit increases the long-term capital base of the
company and thus increases the potential of future earning capacity. On the other hand, the higher the
dividend, the higher the earnings of the equity shareholders at present. The question is what is the trade-
off between present earnings and higher future earnings; what is the optimum dividend policy. As in other
matters, that dividend policy is optimum, which maximises the net wealth of equity shareholders. The
issue before dividend policy is to determine the best distribution of profit between dividend per share
(DPS) and retained earnings per share (RES). There are a number of models all of which revolve around
the question: how does dividend affect market value of equity shares. These are:
I) Earnings capitalisation model
2) Walter's model.
3) Gordon's model
4) Graham and Dodd model:
8.4.1 Earnings capitalisation model
Under the approach:
Market value (MY) per equity share = EPS or DPS + RES
ke ke
It is clear that under this approach, dividend has no effect on market value (MY) of equity shares as
shown in illustration 1 below.
Illustration 1. EPS = Rs. 4, ke = 10%, calculate market value per equity share under 3 dividend, payout
ratios (DP ratios) namely 25%, 50% and 75%.
Solution. . The required market values per share will be as follows:
(DP ratio 25%) MV per equity share = DPS + RES = Re. I + Rs. 3 = Rs.40
ke 10%

Thus under this model, dividend cannot affect market value of equity shares.

8.4.2 Walter's Model

This model slightly modifies the Earnings Capitalisation approach for valuation of equity shares as
Market value per equity share = DPS + (RES X AR/NR)

Where AR = actual capitalisation rate or actual rate of earnings.

NR = equity capitalisation rate or ke or normal rate of earnings.
The effect of this model on valuation of equity shares is shown in illustration 2.
Illustration 2 : D Ltd. has normal capitalisation rate of 10%, and EPS Rs. 4. Calculate its market price per
equity share under the three dividend payout ratios: 25%, 50% and 75% and the three actual capitalisation
rates of5%, 10% and 15%.
Solution: Market value of Equity Shares under Walter's Model
AR NR Dividend payout ratio
25% 50% 75%
5% 10% l.+ (3 x 5/10) 2 + (2 x 5/10) 3 + (1 x 5/10)
10% 10% 10%
= 25 = 30 =
35 .
10% 10% 1 + (3 x 10/10) 2 + (2 x 10/10) 3 + (1 x 10/10)
10% 10%
= 40% = 40% = 40%

15% 10% 1 + (3x 15/10) 2 + (2 x 15/10) 3 + (1x 15/10)

10% 10%
10% = 55 = 50 =45
From the above the following conclusions can be drawn:
(1) When AR = NR, increased equity dividend increases market value of equity shares.
(2) When AR = NR, dividend ceases to affect market value of equity shares; whatever be
the rate of dividend, market value per equity, share remains unchanged.
(3) When AR = NR, increased dividend reduces market value per equity share
(4) Behavioural explanation of the conclusions of Walter's model:
Market value of equity shares reflects the ultimate earnings of equity shareholders of the company
(including earnings of the company itself).
(4.1) When AR = NR, higher dividend has the effect of increasing total earnings of equity shareholders.
With increased dividend, shareholders get more cash as dividend and reinvest it in companies earning
normal rate actual rate of the company. So it increases total earnings of equity shareholders. Therefore,
market value per equity share increases.
(4.2) When AR = NR, whatever be the dividend payout ratio, it would have no effect on the market value
of equity shares because by reinvesting the cash received as dividend in other companies the equity
shareholders' earnings would not increase since the company is earning at the normal rate at which the
other company also earns. Thus market value of equity shares would remain unchanged.

(4.3) When AR = NR, higher dividend would have the effect of reducing the total earnings of the equity
shareholders. With increased dividend, the shareholders would get more cash as dividend and if they
reinvest it in the companies earnings normal rate actual rate of the company, it would reduce the total
earnings of the equity shareholders. Therefore, the market value per equity share decreases.
8.4.3 Gordon's Model (continuing dividend growth valuation model)
Under this model, market value per equity share is affected by:
(a) current dividend per share (DPS)
(b) expected increase in dividend per share.
This model regards that retained earnings, RE, is a growth factor i.e. RE invested now increases the future
DPS. RE by itself is not involved but only its expected future earnings affect DPS.
Definition of terms
(1) CR act or AR = actual capitalisation rate = E/P ratio
MV/equity share

(2) Growth factor = (CRact x RE%)

Illustration 3 :

Data available CRact RE%

5% 50%
10% 50%
10% 60%
Calculate the growth factors.
Growth factor (first case) = CRact (5%) x RE (50%) = 2.5%
Growth factor (second case) = 10% x 50% = 5%
Growth factor (third case) = 10% x 60% = 6%

Illustration 4: A company has 10% CR act dividend payout ratio = 50% and present dividend
per share = Re. 1. Normal capitalisation rate = 12%. Find the market value per equity share under
Gordon's model. :

Solution: Under Gordon's model, market value per equity share = Do

CRDnorm growth factor

where, Do = dividend per share this year
CRnorrn = Normal capitalisation rate growth factor CRact x RE %
Market value per equity share = 1 =1 = Rs.14.29
0.12-(0.1 x0.5) 1.07

8.4.4 Graham & Dodd Model

Under this model, market value per equity share = (DPS + 1/3 of EPS) x P/E ratio.

Illustration 5: X Ltd. has dividend per share of Rs. 1.50, earnings per share = Rs. 3, normal P/E ratio is
20. Find the market value per equity share.

Solution: Market value per equity share =(1.50+ 1/3x3)x20

= 2.50 x 20
= Rs. 50.
8.5. Company - Specific Policies And Procedures
Although the dividend payout ratio is a major aspect of the dividend policy, there are other aspects, which
may affect valuation, such as stability, issue of bonus shares and some legal and procedural constraints.
8.5.1 Stability
In addition to the percentage of dividend payout of a company over the long run, investors may value
stable dividends over this period. Other things being equal, the market price of the shares of a company
may be higher if it pays a stable dividend than if it pays a fixed percentage of its earnings, which may
fluctuate. A stable policy implies not only maintaining a percentage of dividend payout in relation to
earnings over the long run, but also the manner in which the actual dividend are paid. Rather than varying
the dividends directly with changes in EPS every year, dividend can be maintained. The accompanying
chart best explains the difference between the two policies.
There are many reasons why an investor may pay higher price for the share of a company which follows a
stable dividend policy. As mentioned in part I, dividend policy signals the financial health of a company
and its future prospects (information content). Many investment institutions and individual investors
prefer to include in their portfolio, shares of companies with a stable dividend policy in order to ensure
their own steady cash flow. Although the investor can sell a portion of his stock for income when the
dividend is not sufficient, such sales may have to be effected at a lower price, (consequent upon a lower
dividend declaration).
A number of well-managed companies follow a policy or a target dividend payout ratio over - the long
run. Dividends are adjusted to changes in earnings, but only with a time lag. When earnings slowly
increase year by year, dividends are increased only when the company is sure that the higher rate of
dividend can be maintained.
8.5.2 Liquidity
The liquidity of a company is an important consideration in many dividend decisions. A company that is
growing and profitable may not be liquid, because its funds may be locked up in fixed assets or
permanent working capital. As the company may like to maintain some liquidity cushion to give it
flexibility and protection against uncertainty, it may be reluctant to jeopardize this position in order to pay
a large dividend. However, if a firm has the ability to borrow at short notice, it may be flexible in its
dividend policy.
8.5.3 Control
If a company pays substantial dividends, it may have to raise capital at a later time to finance; profitable
investment opportunities. Such a course may sometimes lead to a dilution of management control, and for
this reason, the present management may like to use retained earnings as the principal source of finance.
However, this policy may act as a double-edged sword, and may actually harm the interest of the owner
group. A low dividend payout may motivate the small individual shareholders to sell their shares to a take
over tycoon, who may seize control by acquiring majority shares from the market.
8.5.4 Shareholding pattern
In many of the closely held companies, the promoter group keeps a close watch on the pulse of
the different shareholding groups and their preferences for dividends and/or capital gains. The dividend
policy is formulated based on a consensus.
8.5.5 Timing of investment opportunities
A company may formulate long-term plans, and identify profitable investment opportunities.
But if the proposed investment calls for funds after time lag of say, more than five years, it would be
worthwhile to opt for a higher dividend payout immediately and go in for fresh equity or rights issue
when the need for funds arises.
8.5.6 Legal constraints
Sometimes term loan agreements - especially those under the soft loan scheme for modernisation or as
part of a package of revival of sick undertakings, stipulate that dividends should not be declared above a
specified percentage for the stipulated period. Such a stipulation, in fact, helps the management in
convincing shareholders about a lower payout ratio.
8.5.7 Legal provisions in the Indian context
These are summarised below:
1. Companies can pay only cash dividends, except in case of bonus share.
2. Payment of dividend is governed by the companies Act which stipulates that dividends can be paid
only out of profits earned during the relevant year, after providing for depreciation, and after transferring
to reserves such percentages of profits as prescribed by law. Schedule XIV of the Companies Act
prescribes the rates of depreciation to be adopted. The transfer to reserves shall be as per the following
Proposed Dividend Percentage of current profits
(% of paid-up capital) to be transferred to reserve
More than but not less than Not less than
10% 12..5% 2..5%
12.5% 15% 5%
15% 20% 7.5 %
20% ------ 10%
3. Dividends may be paid out of accumulated profits of previous years, due to absence or inadequacy of
profits for the current year, and & such payment is governed by the Companies (Declaration of Dividends
out of Reserves) Rules. 1975. These rules provide that-
a) the rate of dividend shall not exceed the average dividend declared in the five years immediately
preceding the relevant year, or 10% of paid up capital, whichever is less.
b) the total amount to be drawn from accumulated profits earned in the previous years and transferred to
the reserves shall not exceed the amount equal to one - tenth of the sum of its paid up capital and free
reserves; the amount so transferred shall first be utilised to set off losses incurred in the financial year,
before any dividend can be declared in respect of preference or equity shares.

c) the balance of reserves after such drawl shall not fall below 15% of the paid up capital.
d) Dividends cannot be declared for past years for which accounts have been closed.
e) Dividends cannot be declared out of reserves created by revaluation of assets.
8.5.8 Procedural aspects
The payment of dividend requires the following procedural formalities:
a) Approval of the Board of Directors by a resolution in a formal meeting.
b) The resolution of the Board should be approved by the shareholders in the Annual General Meeting.
c) The dividend is payable only to members whose names appear in the Register of Members on the
record date.
d) Once the dividend is declared, the dividend warrants must be posted within 42 days. Within 7 days
after the expiry of 42 days, the unpaid dividends should be transferred to a special account opened with a
scheduled bank. Any amount remaining unpaid or unclaimed for three years from the date of transfer shall
be transferred to the general revenues of the central government, and such shareholders may prefer their
claim directly to the Government.
8.5.9 Bonus Shares
Bonus shares (or stock dividends in US parlance) are shares issued to existing shareholders as a result of
capitalisation of reserves (including share premium account). In the wake of a bonus issue, the
shareholders proportionate ownership remains unchanged. The book value per share. The EPS and the
market price per share will decrease, but the number of shares (stock outstanding) will increase.
The underlying reasons for issue of bonus shares are as follows:
a) The accumulated reserves created out of transfers from profits earned represent an increase in the
shareholder’s wealth, which legitimately, belongs to them.
b) The bonus issue tends to bring the market price per share within a realistic range.
c) It increases the number of shares outstanding, and promotes more active trading.
d) The nominal rate of dividend decreases, which dispels the impression of profiteering from the minds of
the public at large. ,
e) The bonus issue decision is taken consciously only when the management feels confident about
"servicing" the increased equity, i.e. maintaining the rate of dividend in the long run, and hence
shareholders regard the bonus issue as an indication of the financial health of the company.
t) The issue of bonus shares can be a prelude to issue of convertible debentures when the firm is ready
with attractive investment opportunities.
The important regulatory provisions governing the issue of bonus shares are as follows:
a) The bonus issue can be made only out of free resources built up out of genuine profits, or share
premium collected in cash.
b) The residual reserves after proposed capitalisation shall be at least 40% of the increased paid up
c) 30% of the average profits before tax of the company for the previous three years should yield a rate of
dividend on the expanded capital base of the company of not less than 10%.

8.6 Dividend Policies In Practice

To learn about the dividend policies of business firms, the author asked the chief finance executives of
twenty large-sized business undertakings, representing a wide cross-section of industries, the following
question: What is your dividend policy? The responses obtained are reproduced below (the lengthier ones
have been' paraphrased),
Nature of Response
Electrical "We try to maintain a ten per cent dividend rate, that is what the government expects
from us,"
Chemicals "Dividend policy is concerned primarily with the welfare of shareholders, When earnings
position permits we declare good dividends, Otherwise, we don't, We don't think Of
accumulating surplus and declaring bonus shares."
Tea "In the last ten years the parent company has not been insisting on any dividend rate,
whatever has been paid out is accepted, our payout has been 30 to 50 per cent,"
Fertilizer "Though we are a joint sector project, our dividend policy is governed by commercial
considerations. Of course, we are a bit conservative,"
Toothpaste "We believe in rewarding shareholders generously-both in dividends and bonus shares,
our payout has been very high,"
Aluminum "We pay dividend whenever w~ can afford it, When performance is poor or liquidity
unsatisfactory we skip dividend to preserve our financial strength."

Chemical "Our dividend policy is to pay a fixed rate of dividend and issue bonus shares when we
are eligible to. The purpose is to ensure that shareholders retain shares to enjoy capital
Automobile "We like to maintain a dividend rate of 15 per cent. This seems to be a fair return to
Shipping "In the past when the going was good, we paid good dividends and issued bonus shares
periodically. The last few years were rough. We had to suspend dividend for some time.
We are now recovering. We will try to follow the past policies, provided business
conditions are good."
Leasing "We would like to declare as high a dividend as we can. If share prices rise due to that,
we can raise relatively easily more funds by issuing convertible debentures."
Diversified "We regard shareholders as partners. They deserve handsome returns. We give good
dividend and periodic bonus issues."
Diversified "We have a very conservative dividend policy. Our dividend rate, which used to be 10 per
cent four years ago, has now been raised to 15 per cent. We won't probably consider a
change for the next few years." '.
Truck' "The company follows a conservative dividend policy which aims at protecting the
interests of the shareholders and the company by (a) providing a consistent and
reasonable return to the shareholders, and (b) ploughing back profits to take care of
contingencies and to improve the equity base."
Pharmaceuticals "We distribute about 30 per cent of our earnings. We maintain our dividend around 18
Percent. When the reserves position permits and the earnings potential justifies, we issue
bonus shares."
Diversified "We don’t have a specific dividend policy. When the profits are good and liquidity
satisfactory we give 12% to 15% as dividends."
Textiles "Due to drop in profits we have skipped dividends. We will try to restore it- when I don't
know." '
Storage "We have been paying steadily about 20 per cent as dividends. Batteries Of course, our
bonus record is poor. In the foreseeable future there may be very little change."
Diversified "The investor is the king. Unless he is rewarded, we can't get the funds for our growth.
So, we try to benefit him by dividends, bonus issues, and rights issue."
Consumer "We paid good dividends as profits were high, We will try to maintain the Electronics
same. Of course, profitability will be the key factor."
Diversified "We have, if you permit me to say, an obsession with 20 per cent dividend rate. We don't
want to raise it to 25 per cent or 30 per cent as this connotes super profits--but we would
like to' declare bonus shares. Our planning revolves around this compelling goal-
dominant goal."

Some Types.

On the basis of the above responses we find that most of the firms pursue three types of policies:

1. Generous Dividend and Bonus Policy Firms, which follow these policy reward shareholders
generously by stepping up total dividend payment over time. Typically, these firms maintain the dividend
rate at a certain level (15 to 25 per cent) and issue bonus shares when the reserves position and earnings
potential permit. Such firms naturally have a strong shareholder orientation.
2. More or Less Fixed Dividend Po/icy Some firms have a target dividend rate, which is usually in the
range 10 per cent to 20 per cent which they consider as a reasonable compensation to equity shareholders.
Such firms normally do not issue bonus shares. Infrequently, may be once in few years, the dividend rate
may be raised slightly to provide somewhat higher compensation to equity shareholders to match the
higher returns from other forms of investment.
3. Erratic Dividend Po/icy Firms, which follow this dividend policy, seem to be indifferent to the welfare
of equity shareholders. Dividends are paid erratically whenever the management believes that it will not
strain its resources.


A Objective Type Questions

1. State whether each of the following statements true or false:
(i) Management of earnings has nothing to do with ploughing back of profits.
(ii) Secret reserves are not shown in the balance sheet.
(iii) A reserve means cash.
(iv) Proprietary reserves are available for distribution as dividend.
(v) Capital reserves are built out of revenue profits.
[Ans. (i) False; (ii) True; (iii) False; (iv) True; (v) False]

2. Fill up the blanks:

(a) The process of.. ... .. . and their utilisation in the business is known as ploughing back of profits.
(b) Ploughing back of profits is also known as .. . or . . .. .. . .. ..
(c) The need for ploughing back of profits arises due to (i) (ii) and (iii) ....
(d) The tool of ploughing back of profits enables a company to adopt a . . .. ... ... ... . . dividend policy.
(e) Excessive Ploughing back of profits creates dissatisfaction among the. . . . . . . . . . . . . . .
(f) The part of profits distributed among the shareholders of a company is known as . . . . . . . . . . . . . . .

3. State whether the following are true or false:

(a) Ploughing back of profits is the same as self-financing.
(b) A new company can finance its assets by ploughing back of profits.
(c) Retained earnings provide a cushion to absorb the shocks of economy.
(d) Shareholders do not gain by the policy of ploughing back of profits.
(e) Ploughing back of profits results in dilution of ownership.
(f) Because of the merits of ploughing back of profits, a company should not pay any dividends.
(g) Earnings capacity of the company has nothing to do with the policy of ploughing back of profits.

B. Short Answer Type Questions

1. What is 'management of earnings’?
2. Where are the sources of profits?
3. What is the difference between 'Reserve and Reserve Fund’?
4. What are proprietary reserves?
5. Name the main kinds of reserves.
6. What do you understand by retained earnings?
7. What is the cost of retained earnings?
8. What is the need of Ploughing back of profits?
9. Enumerate the factors that influence the re-investment of profits.
C. Essay Type Questions
1. What do you understand by 'management of earnings? Discuss its scope.
2. What do you mean by ‘surplus’? Explain the various kinds and sources of surplus.
3. Define the term 'reserves' and explain briefly the various types of reserves.
4. Why do companies sometimes hide their surplus? How do they proceed with it?
5. Discuss the factors which are relevant for determining the payout ratio.
6. What is the difference between a policy of stable dividend payout ratio and a policy or stable dividends
or steadily changing dividends?
7. Why do firms follow a policy of stable dividends or gradually rising dividends?
8. What is the difference between the following approaches: (1) pure residual dividend policy approach,
(ii) fixed dividend payout ratio approach, and (iii) smoothed residual dividend approach.
9. What did Lintner's survey of corporate dividend behaviour reveal?
10. Discuss the important provisions of company law pertaining to dividends.
11. What are the keys regulatory provisions governing the issue of bonus shares in India?
12. Should a company borrow money to pay dividends? Discuss.
Chapter 9 Management of Long Term Funds

9.1 Introduction
assure itself that the anticipated rise in the income of the borrowing unit would materialise, thus providing
the necessary funds for repaying the loans according to the terms of amortization. The liquidity of term
loans depends not so much on the short-run sale ability of the goods and commodities as on the increased
Term loan income of borrowing units resulting from a higher level of utilisation of existing installed
capacity. For assessing the risks involved in term lending, the normal criteria used for judging the
soundness of short-term loans are often unreliable and inadequate. The methods of analysis and the
standard to be adopted for appraisal of term loans are more similar to investment decisions than to short-
term lending. Appraisal of term-loans requires a dynamic approach involving, inter alia, a projection of
future trends of output, sales, and estimates of costs, returns and flow of funds. Appraisal of term loans
depends to a large extent on estimates of forecasts. Its purpose is not to set down a categorical statement
of the long-range prospects of an industrial unit but only to provide broad guide outlines to the financial
The practice of making an appraisal of term loan applications on modern scientific lines has not made
much progress in India. This is partly due to the fact that mainly the larger banks give such loans to
highly credit-worthy constituents and hence no elaborate enquiry is considered necessary. The need for
such appraisals is now being increasingly felt with the expansion of term lending. There cannot be a fixed
or standardised approach to appraisal. Numerous and diverse elements enter into the process. It is difficult
to have a cut and dried formula with the help of which a loan proposal can be considered; straightaway as
acceptable or unacceptable. While the same set of factors is taken into consideration in the scrutiny of
individual applications. The weightage given to the several factors varies from case to case. The more
important factors among these are: the type of organisation and activity of the borrowing unit, the nature
of its' product and its market potentiality, its size, the quality of its management, soundness of financial
position, the amount and, term of the loan required and its repayment schedule.

Financial institutions are usually inclined to adopt the criterion of profitability rather than that of'
‘development' in extending term loans. In other words, they are concerned mainly with the commercial
profitability of a project as determined by the level of prospective profits and its ratio to invested capital
of the borrowing unit and not with its broad economic significance or importance in the development of
the resources of the economy. Commercial profitability could sometimes be more apparent than real. The
extent of State support and the manner in which it is made available in the form of import controls,
protective duties, subsidies, tax rebates and other concessions have I considerable bearing on the profit
prospects of certain industries. To the extent that the profitability of a project is conditional in the
continuance of such support, appropriate allowance has to be made by the lending institution in the
appraisal of the project. A number of other aspects of the State policy such as transport rates, prices and
wage limits, export promotion, exchange regulations require due attention of the lending institutions
while appraising term loam.

9.2 Term loan appraisal

There are four broad aspects of appraisal, namely, technical feasibility, economic feasibility, managerial.
Competence and financial or commercial feasibility. A brief account of each of these aspects follows.
Technical feasibility. The examination of this aspect requires an assessment of the goods and services
needed for the project-land, housing, transportation, raw materials, supplies, fuel, power, water, etc. The
financial institution has to satisfy itself that these requirements are available. Where they are not
domestically available and have to be imported, conditions foreign market as well as government policy
at home in terms of availability of foreign exchange calls for a review. The location of the project is
highly to its technical feasibility and hence special attention is paid to this feature. In fact, the
accessibility to the various resources has meaning only with reference to location. Another important
feature of technical feasibility relates to the type of technology to be adopted for the project. In case new
technical processes are adopted from abroad, attention is paid to the differences in conditions. The
dangers of hasty adoption of new techniques are quite substantial in an underdeveloped country. It is,
therefore, desirable for lending institutions to make use of the services of technical personnel.

Economic feasibility. This aspect relates to the determination of the extent of absorption of the output of
the new unit or the additional production from an established unit at given prices. In other words, it takes
account of the total output of the product concerned and the existing demand for it with a view to
establishing whether there is an unsatisfied demand for the product. Two general indicators of the
existence of unsatisfied demand are the price level and the prevalence of controls. It is necessary to know
specifically whether the unsatisfied demand is ephemeral or genuine. The study goes beyond immediate
prospects. Possible future changes In the volume and pattern of supply and demand will have to be
estimated in order to assess the long-run prospects of the industry as well as earning capacity of the unit.

Projection or forecasting of demand is a complicated matter though of vital importance. The demand for
a product is affected by a variety of factors and it may be difficult to take account of all these. If
information concerning the demand for a product in the past is available, projections of demand over a
period of years can be made on the basis of assumptions concerning future trend of all prices and
incomes, particularly in the case of consumer goods industry. The projection of demand for intermediate
goods (goods used as inputs for further production) and capital goods is more complicated because the
demand for such goods is affected by changes in incomes and prices only indirectly. Often intermediate
and capital goods have multiple uses, being needed in several lines of production, and hence it is
necessary to take into account inter-industry relationships also.
Estimations of demand can never be wholly accurate or absolutely reliable; they can at best be considered
as approximations.
Managerial competence. The confidence of the lending institution in repayment prospects of a loan is
largely conditioned by its opinion of the borrowing unit’s management. It has, therefore, been remarked
that appraisal of management is the touchstone of term credit analysis. Where the technical competence,
administrative ability, integrity and resourcefulness of the management are well established, the loan
application gets the most favorable consideration.

Financial feasibility. The financial appraisal, by and large, is designed to seek answers to the following:
(a) Whether the estimates of the cost of the project fully cover all items of expenditure and are realistic.
(b) Whether the sources of finance contemplated by the sponsors of the project will be adequate and the
necessary finance will be available during the period of construction as per their schedule. (c) What is the
likely impact of the project on the level of production, sales, net earnings, borrowings, costs, etc. of the
borrowing unit? Or, when can the project be expected to break-even (with offsetting expenditure) and
start yielding profit? (d) What time should be fixed for starting of repayment over a period to be
determined in the light of the financial capacity of the borrowers " arising from increased output and
The magnitude of the available surplus and other cash accruals to meet the interest and principal
repayments (called as debt service coverage) is an essential point for investigation in deciding the period
of amortization.
The financial position of the concern has to be examined during the currency of the loan. For having a
proper perspective of the financial position of the concern, it is not sufficient to consider a single year's
performance as revealed in the balance sheet and profit and loss account. On the other hand, a: dynamic
view has to be taken of the organisation in the next few years.
Term lending institutions follow different methods in obtaining the financial data. Some use
comprehensive application form calling for particulars of different aspects of the projects presented for
financing, others use a simple preliminary application form to judge whether the schedule of the
application is prima facie feasible and later on follow-up by a comprehensive form. Quite often, the
lending institutions adopt the interview method for eliciting as many details and particulars of the
schedule as possible.
The basic data required for a financial analysis can be grouped under the following heads:
1 Cost of the project (Exhibit I).
2 Cost of production and profitability (Exhibit 3).
3 Cash-flow estimates during the currency of loan (Exhibit 4).
4. Pro-forma balance sheets (Exhibit 2),
Term lending institutions have to critically analyse the data obtained from the borrowers with a view to
ensuring that: (i) the estimated cost of the project is reasonable and the project has a fair chance of
materialising; (ii) the financial arrangement is comprehensive without leaving any gaps and ensures cash
availabilities as and when needed; (iii) the estimates of earnings and operating costs are as realistic as
circumstances permit; and (iv) the borrower's repaying ability, as judged from the project operations,
exists with a reasonable margin of safety .
Exhibit 1 Cost of the Project Period Required for completion

Already incurred To be incurred
Rupees and
In In
In Rupee In Rupee Rupee
Rupees Rupees
equival equiva Equivalent
ent lent
of of
foreign foreig
exchan n
ge excha

Land (including
development expenses)
Machinery and Plant
Spare Parts
Insurance, freight
duty and
transportation to
Erection Charges
Technical know how/
consulting engineering fees
Preliminary expenses
Pre – operative expenses
(upto start of normal
Interest during construction
Allowance for unforeseen


Net working capital


Grand Total

Note:- (1) Details and / or supporting documents may be required to be furnished wherever possible.
Note:- (2) Information may be furnished on the phasing of the expenditure on the project over a period of
years in a separate statement, if necessary.
Exhibit 2 Pro – Forma Balance Sheet Estimates

Construction Operation
Second Third First Second Third
Year Year Year Year Year
(2) (3) (4) (5) (6)
Rs. Rs. Rs. Rs. Rs. Rs.

Capital and Liabilities

Share capital
Reserve and Surplus
Long – Term debt
Current Liabilities


Gross fixed assets
Less: Depreciation
Current assets
Intangible assets


Debt – equity ratio:

Current ratio:
Exhibit 3 Cost of Production and Profitability

Construction Operation
Second Third First
Year Year Year
(2) (3) (4)
Rs. Rs. Rs. Rs.

Production (grade and quantity) : (Production in the initial period

should be assumed at a reasonable rate of utilization of capacity.
Increasing gradually to attain estimated full capacity in subsequent

Raw materials (separately for each item of raw material indicating also
the quantity required per unit of finished product and price
at which it will be obtained)
Power and Fuel
Consumable Stores
Repair and Maintenance
Factory Supervision and Overheads
Administrative overheads (viz. office salaries, insurance, rent,
travelling and other expenses etc.)
Selling and advertising expenses

Interest – (Indicate also rates)

(a) On bank borrowings for working capital
(b) On medium – and long term borrowings
Depreciation (rates also should be given for all items)
Managing Agents / Managing Directors/ Secretaries and
Treasurers remuneration – (indicate also rate)
Other expenses

Cost of Production

Sales (including prices for each product line)

Other income

Operating profit

Net Profit

Ratio of sales to Total capital employed

Ratio of operating profit to sales
Ratio of profits (before taxes with interest on long – term debt
added back) to total capitalisation i.e. long – term plus equity
Note : Details and / or supporting documents should be supplied wherever possible and particularly
regarding the source and rate of raw materials, power, fuel etc. labourers and other personnel employed,
and the basis for the selling prices assumed. In the case of an existing company in operation, existing
sales, etc. will continue till new operations start.
Exhibit 4 Cash Flow Estimates(Quarterly /Half – yearly estimates may be given
during construction period)

Construction Operation
Second Third First
Year Year Year
(2) (3) (4)
Rs. Rs. Rs. Rs.

Source of funds:
Net Profit (before taxes with interest added back but
after depreciation and development rebate reserve)

Share capital increase

Increase in long – term borrowings

Increase in Short – term borrowings

Depreciation provisions

Development rebate reserves

Other (specify)

Application of Funds:
Fixed assets and capital expenditure
Current assets (such as book debts, closing stock,
bills receivable, etc).
Repayment of long – term borrowing s
(Including deferred payments)

Repayment of short term borrowings


Other assets


Other expenses
Opening balance of cash
Surplus / deficit between sources and application of
Closing balance of cash
Debt service coverage ratio

9.3 Security against term loans

Considerations of security form an important basis of lending. In fact, they constitute necessary adjunct to
financial appraisal. Lending institutions have to examine the loan proposals from the point of view of
nature and extent of security offered. Sometimes, there is a greater reliance on security due to inadequate
financial appraisal, which in its turn may be due to non-availability of the necessary data. The security
cover of the loan should, however, not be regarded as a substitute for an adequate financial assessment.
Security considerations are of particular importance in less developed countries like India where
information on the character, integrity and credit-worthiness of the borrowers is not readily available and
much ground work has yet to be done in the establishment of credit information bureaus. A prudent term
lending institution, therefore, secures its loan by adequate collateral and, where necessary, guarantees. It
also embodies in the loan agreement suitable protective and restrictive covenants such as maintenance of
certain minimum financial standards, supplying to the lender adequate financial information, earlier
repayment of loans under certain conditions, restriction on the payment of dividend and any other
payments like managing agency or selling agency commission. Taking of adequate security infuses the
necessary responsibility in the borrower. A general tendency exists among term lending institutions in
India to depend more on collateral for the repayment of loans than on the integrity and policy of
management and the borrowing concern's past and prospective earnings..
The types of security generally accepted by the term lending institutions are the existing industrial assets
as well as those to be acquired out of the granted loans. Most financial institutions also obtain, as a
measure of caution, the personal guarantees of the directors/ managing agents since the future of the
concern is largely dependent on the efficiency of management.
While approving an application for term loan, certain restrictions are incorporated in the loan agreement
with a view to protecting the interests of the lending institutions and ensuring the maintenance of
soundness of the financial position of a concern. The borrower may be required to agree that the loan in
question will receive the higher priority for repayment. Provision may be made that the borrower should
not borrow further sums on long-term basis without the consent of the lending institution. A statement
may also be made that debt- equity ratio should not exceed a specific limit. Sometimes, the agreement
specifies conditions regarding the maintenance of minimum working capital so as to possess enough
cushion for withstanding unexpected financial shocks such as fall in prices. At other times, in order to
ensure that the borrower is not short of funds for meeting the current obligations including the servicing
of the loans, it may be provided that the selling commission or the managing agency commission, if any,
will not be disturbed during the currency of the loan, except after meeting the interest on and instalments
of the loan. Similarly, the borrower may be required not to declare dividend for specified periods or
beyond an agreed rate. These restrictive covenants are considered necessary in case of term-loans, which
run over a period of years for giving protection to the lending institution.

Test Questions

Q1. Explain the procedure associated with a term loan.

Q2. What are the salient features of the equipment finance scheme?
Q3. Discuss the kinds of appraisal done by financial institutions.

10.1 Kinds of Share Capital

Section 86 of the Companies Act, 1956 provides that the share capital of a company limited by formed
after the commencement of this Act, or issued after such commencement, shall be of two kinds namely:
a Equity Share capital and b. Preference share capital
10.2 Equity Shares
An equity interest in a company may be said to represent a share of the company's assets and a share of
any profits earned on those assets after other claims have been met. The equity shareholders are the
owners of the business; they purchase shares, the company to buy assets uses the money, the assets are
used to earn profits, which belong to the ordinary shareholders.
After satisfying the rights of preference shares, the equity shares shall be entitled to share in the
remaining amount of distributable net profits of the company. The dividend on equity shares is not fixed
and ma from year to year depending upon the amount of profits available. The rate of dividend is
recommend by the Board of Directors of the company and declared by shareholders in the Annual
General Meeting. Equity shareholders have a right to vote on every resolution placed in the meeting and
the voting rights shall be proportion to the paid-up capital.
10.2-1 Advantages and Disadvantages - As a source of long-term finance, ordinary shares carry a
of both advantages and disadvantages for a company.
. Advantages
- There are no fixed charges attached to ordinary shares. If a company generates enough earnings be able
to pay a dividend but there is no legal obligation to pay dividends.
- Ordinary shares carry no fixed maturity.
- They provides a cushion against losses for creditors, thus the sale of ordinary shares rather than
securities increases the creditworthiness of the firm.
- Ordinary shares can often be sold more easily than debentures.
- Returns from the sale of ordinary shares in the form of capital gains are subject to capital gains tax
rather corporation tax.
. Disadvantages
- The sale of ordinary shares extend voting rights or control to the additional shareholders who are
brought into the company.
- More ordinary shares give more people the right to share with the existing owners in the company p
- The costs of underwriting and distributing new issues of ordinary shares are usually higher than
for underwriting and distributing preference shares or debentures.
- If the firm has more equity or less debt than is called for in the optimum capital structure the average
cost of capital will be higher than necessary.
- Dividends payable to ordinary shareholders are not deductible as an expense for the purpose of
corporation tax but debenture interest is deductible.
10.3 Rights Issues
If an existing company intends to raise additional funds, it can do so by borrowing or by issuing new
shares. One of the most common methods for a public company to use is to offer existing shareholders the
opportunity to subscribe further shares. This mode of rising finance is called ‘Rights issues'. The existing
shareholders have right to entitlement of further shares in proportion to their existing shareholding.
A shareholder who does not want to buy the Right shares, his right of entitlement can be sold to some one
else. The price of rights shares will be generally fixed above the nominal value but below the market price
of the shares. The issue of quoted shares at below the nominal value is not allowed, and it would be rare
for this to happen for unquoted shares. Section 81 of the Companies Act provides for the further issue of
shares to be first offered to the existing members of the company, such shares are known as ‘Ri ght shares'
and the right of the members to be so offered is called the 'right of pre-emption’.
10.3.1 Reasons for a Rights Issue - The main reasons to make a Rights issue by a company are as
* In times of inflation, the replacement costs of assets will be high, unless the company can retain cash
from substantial profits; the only alternative is to raise cash from a fresh issue of shares.
* For funding expansion projects, a company may make rights issue.
* If a company has a proportion of interest bearing loan capital, the company can suffer from a squeeze
on profits. The Company can improve the capital structure position by obtaining extra share capital.
* At a time when the share prices were relatively high, companies found it easy to persuade their
shareholders to subscribe cash for new issues with a view to expansion by takeover.
10.3-2 Advantages of Rights Issue
* To Companies: The company benefits from lower Issue costs, in that administration and underwriting
costs are lower and the issue is made at the direction of the directors rather than via a general meeting of
the company. This is because issues of equity through the stock exchange will alter the balance of
* To the shareholders: The main attraction of the rights issue for current shareholders is that they are able
to maintain their original proportion of share ownership. Further more, any transfer of wealth away from
them due to an equity issue being under priced, is avoided.
10.3-3 Procedure of Making Rights -In order to make a rights issue the company, when making the
offer, must detail the reasons for the issue, the terms of the offer; the capital structure of the company at
the time of issue, the future prospects for the company, and forecasts of future dividends.
10.3-4 Rights Offer Ratio - The number of shares needs to buy under the pre-emptive right by the
existing shareholders in proportion to their existing shares held is set by the Board of Directors. The ratio
is determined using a simple calculation.
N = Number of outstanding shares
Number of new shares to be offered

10.4 Preference shares

A preference share is a hybrid security because it has features of both ordinary shares and bonds.
Preference shareholders have preferential rights in respect of assets and dividends. In the event of
winding up the preference shareholders have a claim on available assets before the ordinary shareholders.
In addition, preference shareholders get their stated dividend before equity shareholders can receive any
The dividends on preference shares are fixed and they must be declared before a legal obligation exists to
pay them. The fixed nature of dividend is similar to that of interest on debentures and bonds. The
declaration feature is similar to that of equity shareholders dividends.
10.4.1 Types of Preference Shares - The general forms of preference shares are as follows:
. Cumulative and Non-cumulative Preference Shares The cumulative preference gives a right to
demand the unpaid dividend of any year, during the subsequent years when the profits are ample. All
preference dividends arrears must be paid before any dividends can be paid to equity shareholders. The
non-cumulative preference share carry a right to a fixed dividend out of the profits of any year. In case
profits are not available in a year, the holders get nothing, nor can they claim unpaid dividends in
subsequent years.
. Cumulative Convertible Preference Shares The cumulative convertible preference (CCP) share is an
instrument that embraces features of both equity shares and preference shares, but which essentially is a
preference share. Since the CCP shares capital would constitute a class of shares, distinct from purely
equity and purely preference share capital, the rights of the instrument holders must be stated either in a
general body resolution or in the articles or in the terms of issue in the offer document viz.,
prospectus/letter of offer.
. Participating and Non-participating Preference Shares Participating preference shares are those
shares which are entitled to a fixed preferential dividend and, in addition, carry a right to participate in the
surplus profits along with equity shareholders after dividend at a certain rate has been paid to equity
shareholders. Again, in the event of winding up, if after paying back both the preference and equity
shareholders, there is still any surplus left, then the participating preference shareholders get additional
share in the surplus assets of the company.
Unless expressly provided, preference shareholders get only the fixed preferential dividend and return on
capital in the event of winding up out of realised values of assets after meeting all external liabilities and
nothing more. The right to participate may be given either in the memorandum or articles or by virtue of
their terms of issue.

. Redeemable and Irredeemable Preference Shares Subject to an authority in the articles of association,
a public limited company may issue redeemable preference shares to be redeemed either at a fixed date or
after a certain period of time during the life time of the company. The Companies Act, 1956 prohibits the
issue of any preference share which is irredeemable or is redeemable after the expiry of a period of
twenty years from the date of issue.
10.4-2 Advantages and Disadvantages - The major advantages to the issuing company are:
- The obligation to pay fixed rate of interest on the security is not binding in the same way as it is with
- Preference shares enable the company to avoid dilution of equity capital which occurs when additional
ordinary shares are issued.
- They also permit a company to avoid sharing control through participation in Voting.
- Since many preference shares are irredeemable, they are more flexible than debentures.
The major disadvantage is that dividends paid to preference shareholders are not tax-deductible;
consequently the true cost to a company of preference shares is far greater than the cost of debentures.
As a hybrid security, the use of preference shares is favored by circumstances that fall between those
favouring the use of ordinary shares and those favouring the use of debentures. The costs of preference
share financing follow interest rate levels more than ordinary share prices; in other words, when interest
rates are low, the cost of preference shares is also likely to be low. Companies sell preference shares when
they seek the advantage financial gearing but fear the dangers of the fixed charges on debt in the face of
potential fluctuations in income. If debt ratios are already high or the costs of equity financing are
relatively high, the case for using preference shares will be strengthened.
10.5 Deferred/Founders Shares
A private company may-issue what are known as deferred or founder's shares. Promoters and directors of
the company normally hold such shares. That is why they are usually called founders shares. These shares
are usually of a smaller denomination, say one rupee each. However they are generally given equal voting
rights with equity shares which may be of higher denomination, say Rs. 10 each.
Thus, by investing relatively lower amounts, the promoters may gain control over the management of the
company. As regards the payment of dividends to holders of such shares, the articles usually provide that
these shares will carry a dividend fixed in relation to the profits available after dividends have been
declared on the preference and equity shares. It is because of this deferment of the dividend payment that
these shares are; also called deferred shares. The promoters, founders and directors tend to have a direct
interest in the success: of the company they will receive dividends on these shares only if the profits are
high enough to leave a balance of after paying dividends to preference and equity shareholders. Besides,
greater the profits of the company, the higher will be dividends paid on these shares. Non-voting Shares
10.6 Non voting shares (NVS) as an innovative instrument for raising funds, although prevalent in many
developed countries for years, it only recently introduced in our country by the new union budget 1996-
97. In India, the concept of NVS is not a novel idea. The Companies Bill, 1993 that was scrapped
subsequently, had proposed NVS instrument for raising funds. The Pherwani study group, Constituted by
the Government on 27-3-1991 strongly recommended the concept of NVS. ;
The non-voting shares are closely akin to preference shares, which do not carry any voting
rights, nor is the dividend payable pre-determined. However, unlike preference capital, non-
voting shares do not carry a predetermined dividend. The pay-off to the investor for the
assumption of higher risk levels and the compensation for loss of control is high rate of
dividends payable to them.
10.6-1 Advantages and Disadvantages - NVS can be found useful by companies, which are shy of
exposure over leveraged companies, new companies and closely held companies. It may find favour with
small investors, non-resident Indians, overseas corporate bodies, mutual funds etc. The investor gains in
terms of higher dividends purchase at advantageous low price, liquidity and capital appreciation.
10.7 Sweat Equity Shares
Under Section 79Aof the Companies Act, 1956,a company can issue sweat equity shares to its employees
or directors at discount or for consideration other than cash for providing know-how or making available
from rights in the nature of intellectual property rights or value additions etc. on the following conditions:
- Issue of sweat equity shares of a class of shares already issued.
- Such issue must be authorised by a special resolution passed by the company in General meeting.
- Not less than one year has, at the date of the issue, elapsed since the date on which the company was
entitled to commence business.
- The equity shares of the company must be listed in recognised stock exchange.
10.8 Stock Options
Stock options is defined as the right to buy a designated stock at the option of the holder at a>1y time
with a specified period at a determinable price. It can also represent the right to sell designated stocks
within an agreed period at a determinable price.
These options are often granted to management and key employees as a form of incentive compensation.
It is to be distinguished from stock right available to all shareholders. The' Stock option’ is used when the
rights are issued other than pro rata to all-existing shareholders.
10.9 Stock Splits
According to section 94 of the Companies Act, 1956 a company can alter its share capital by sub-division
of all or part of its capital into shares of small amounts. The following illustration will explain how the
stock split will have impact on the capital structure of a company.
10.10 Buy Back of Shares (Shares Repurchase)
Buy back is described as the procedure which enables a company to go back to the holders of its shares
and offer to purchase from them the shares that they hold.
Section 77(1) of the Companies Act provides that a company limited by shares or a company limited by
guarantee having a share capital cannot buy its own shares. The restriction is applicable to all companies
having share capital, whether public or private. However, the Companies (Amendment) Act, 1999 vide
sections 77A, 77AA and 77B and the guidelines issued by SEBI in this regard allow companies to
purchase their own shares or other securities subject to certain conditions.
10.10.1 Reasons for Buy-back - There are three reasons why a company would opt for buy-back:
* To improve shareholder value, since buy back provides a means for utilising the companies surplus
funds which have unattractive alternative investment options, and since a reduction in the capital base
arising from buy-back would generally result in higher earnings per share (EPS).
*It is used as a defense mechanism, in an environment where the threat of corporate takeovers has
become real; buyback provides a safeguard against hostile take-over by increasing promoter’s holdings.
* It would enable corporate to shrink their equity base thereby injecting much needed flexibility.
* It improves the intrinsic value of the shares by virtue of the reduced level of floating stock.
* It would enable corporate to make use of the buy-back shares for subsequent use in the process of
mergers and acquisitions without enlarging their capital basis.
*Buy-back of shares is used as a method of Financial Engineering.
* It is used for signaling the effect of buy-back on the share price.

10.11 Debentures
According to section 2(12) of the Companies Act, a "Debenture" includes debenture stock, bonds and any
other securities of a company, whether constituting a charge on the assets of the company or not. From
this definition it is not very clear what a debenture is. A debenture has been defined as "acknowledgement
of debt, given under the seal of the company and containing a contract for the repayment of the principal
sum at a specified date and for the payment of interest at fixed rate per cent until the principal sum is
repaid and it may or may not give the charge on the assets to the company as security of the loan. A
debenture is a kind of document acknowledging the money borrowed containing the terms and conditions
of the loan, payment of interest, redemption of the loan and the security offered (if any) by the company.
Debentures are bonds issued, by a company. Such bonds embody terms and conditions of loans, payment
of interest, and repayment of the loan etc.
10.12 Kinds of Debentures. Debentures may be of the following kinds:
Bearer Debentures: Bearer debentures are similar to share warrants in that they too are negotiable
instruments, transferable by delivery. The interest on bearer debentures is paid by means of attached
coupons. On maturity, the principal sum is paid to the bearers.
Registered Debentures: These are debentures which are payable to the registered holders i.e., persons
whose names appear in the Register of debenture holders. Such debentures are transferable in the same
way as shares.
Perpetual or Irredeemable Debentures: A debenture which contains no clause as to payment or which
contains a clause that it shall not be paid back is called a perpetual or irredeemable debenture. These
debentures are redeemable only on the happening of a contingency or on the expiration of a period,
however long. It follows that debentures can be made perpetual, i.e., the loan is repayable only on
winding up or after a long period of time.
Redeemable Debentures: These debentures are issued for a specified period of time. On the expiry of
that specified time the company has the right to pay back the debenture holders and have its properties
released from the mortgage or charge. Generally, debentures are redeemable.
Debentures Issued as Collateral Security for a Loan: The term collateral security or secondary security
means, a security which can be realised by the party holding it in the event of the loan being not paid at
the proper time or according to the agreement of the parties. At times, the lenders of money are given
debentures as a collateral security for loan. The nominal value of such debentures is always more than the
loan. In case the loan is repaid, the debentures issued as collateral security are automatically redeemed.
Naked Debentures: Normally debentures are secured by a mortgage or a charge on the company's assets.
However debentures may be issued without any charge on the assets of the company. Such debentures are
called 'Naked or unsecured debentures: They are mere acknowledgement of a debt due from the
company, creating no rights beyond those of unsecured creditors.
Secured Debentures: When any particular or specified property of the company is offered as security to
the debenture holders and when the company can deal with it only subject to the prior right of the
debenture holders, fixed charge is said to have been created. On the other hand, when the debenture
holders have a charge on the undertaking of the company i.e., on the whole of the property of the
company, both present and future, and when it can deal with the property in the ordinary course of
business until the charge crystallizes i.e., when the company goes into liquidation or when a receiver is
appointed, the charge is said to be a floating charge. When the floating charge crystallizes, the debenture
holders have a right to be paid out of the sale proceeds of the assets subject to the right of the preferential
creditor but prior to making any payment to unsecured creditors.
10.13 Convertible Debentures (CDs) - A company may also issue CDs in which case an option is given
to the debenture holders to convert them into equity or preference shares at stated rates of exchange, after
a certain period. Such debentures once converted into shares cannot be reconverted into debentures.
CDs may be fully or partly convertible. In case of fully convertible debentures, the entire face value is
converted into shares at the expiry of specified period(s).1n case of partly convertible debentures only the
convertible portion is converted into shares at the end of the specified period and non-convertible portion
is redeemed at the end of certain specified period. Non-convertible debentures do not confer any option
on the holder to convert the debentures into shares and are redeemed at the expiry of specified period(s).
CDs, whether fully or partly convertible, may be converted into shares at the end of specified period or
periods in one or more stages. The company should get a credit rating of debentures done by credit rating
agency. CDs are listed on stock exchanges.
The Partly Convertible Debentures (PCDs) offers more flexibility to both companies and investors. It has
been claimed to be better than fully convertible debentures as it does not automatically entail a large
equity base, particularly in case of new companies. Experience shows that servicing of a large base of
capital is not easy in case of new projects, especially if the company runs into rough weather due to
marketing difficulties. As such, the non-convertible portion of the debenture keeps the equity of a
company within manageable limits.
The instrument of PCD also has been usual advantages of a convertible debenture - the security offered
on the non-convertible portion as well as the prospects of capital appreciation and higher dividends on the
convertible portion. Further the non-convertible portion is unlikely to be quoted at a discount for a fair
part of the life of the debenture on account of the equity entitlement. Finally, the interest cover is lower
than normal debt on account of the debt is being reduced over time with conversion into equity.
10.14 New Debt Instruments
In the fast changing financial scenario, it has become imperative for the corporate sector to device new
debt instruments for raising funds from the market. A brief discussion is made here about the new
instruments of finance.
10.15 Zero Interest Bond (ZIB) - ZIB refer to those bonds which are sold at discount from their eventual
maturity value and have zero interest rate. These certificates are sold to the investors for discount. The
difference between the face value of the certificate and the acquisition cost is the gain to the investors.
The investors are not entitled to any interest and are entitled to only repayment of principal sum on the
maturity period.
The individual investors prefer ZIB because of lower investment cost and low rate of conversion to equity
if ZlBs are fully or partly convertible bonds. This is also a means of tax planning because the bonds do
not carry any interest, which is otherwise taxable. Companies also find ZIB quite attractive because there
is no immediate interest commitment. On maturity the bonds can be converted into equity shares or non-
convertible debentures depending on the requirement of capital structure of a company.
10.15.1 Secured Premium Notes (SPN) - The SPN is a tradable instrument with detachable warrant
against which the holder gets equity share(s) after a fixed period of time. The SPN have feature of
medium to long-term notes.
With each SPN, a warrant may be attached to it, which will give the holder the right to apply for and get
allotment of equity shares after certain period of time by which the SPN will be fully paid-up.
The investor can plan his tax affairs to minimise tax burden. It will be possible to spread interest income
evenly over the life of the investment and that the premium as capital gains. For example, those who
retire after fifth year of investment can opt for low premium to reduced tax liability.
10.15.2 Deep Discount Bond (DDB) - The IDBI for the first time issued Deep Discount Bond (DDB).
For a deep discount price of Rs. 2,700 an investor gets a bond with a face value of Rs. I lakh. The DDB
appreciates to its face value over the maturity period of 25 years. The unique advantage of DDB is the
elimination of investment risk. It allows an investor to lock-in the yield to maturity or keep on
withdrawing from the scheme periodically after five years by returning the certificate.
The main advantage of DDB is that the difference between the sale price and original cost of acquisition
will be treated as capital gain, if the investor sells the bonds on stock exchange. The DDB is safe, solid
and liquid; instrument. Investors can take advantage of these new instruments in balancing their mix of
securities to minimise risks and maximize returns. 16.15-5 Zero Coupon Convertible Note - It is an
instrument which can be converted into common stock of the issuer. If investor chooses to convert they
will be required to forego all accrued and unpaid interest. Zero coupon can generally be put to the issuer.
This allows the issuer to obtain the advantages of convertible debt without too much dilution of common
stock. Like any zero coupon bond the issuer gets a tax deduction for imputed interest, even though no
cash is paid until maturity. Investors are also benefited since they have the opportunity to participate in
the underlying stock appreciation. If the appreciation does not materialise investors still have the regular
scheme of interest income. There are risk considerations also in view of the fact that prices of zero
coupon bonds are much more sensitive ~o changing interest rates than coupon bonds. In case if the
proposal does not seem to be advantageous to convert, the investor will be left with a relatively low yield
to maturity. Since zero coupon convertibles often can be put to the issuer, the issuer may be forced to
refinance the debt at a disadvantageous time.
10.15.3 Debt for Equity Swap - This instrument is an offer from an issuer of debt securities to its debt
holders to exchange the debt for the issuer common or preferred stock. The issuer who wishes to offer
debt for equity swaps does so with a view to increasing equity capital for the purposes of improving its
debt-equity ratio and also enhances its debt raising capacity. It also helps issuers to reduce their interest
expenses and enables them to replace it with dividends on stock that are payable at their discretion.
Investors get attracted because of the potential appreciation in the value of the stock. There are risk
considerations in view of the fact swaps may dilute earnings per share of issuer. In addition, dividends are
not tax deductible while interest on tax securities is taxable. Further, potential appreciation in the value of
the stock may not materialise and in the process investors may have to suffer. Debt for swaps instrument
has not been used in Indian situations and there arc markets may be able to diversify and after they are
well established, the other instruments recommended by the Pherwani committee may find place in the
portfolios of the investors.
10.15.4 Multi-option Secured Redeemable Convertible Debentures - Where a debenture gives the
holder thereof two or more different options, it may be called a multi-option debenture. It is a species of
debenture. It is essentially a debenture in character and is secured redeemable and convertible into equity
shares. Its chief feature is the multi-options available to the investor.
10.15.5 Callable Bond - A callable bond is a bond, which the issuer has the right to call in, and payoff at
a price stipulated in the bond contract. The price the issuer must pay to retire a callable bond when it is
called is termed as 'call price'. The main advantage in callable bond is the issuers have an incentive to call
their existing bonds if the current interest rate in the market is sufficiently lower than the bond's coupon
rate. Usually the issuer cannot call the bond for a certain period after issue.
10.15.6 Option Tender Bonds - The option tender bonds are bonds with put option which give the
bondholders the right to sell back their bonds to the issuers normally at par. Issuers with puts are aimed
both at investors who are pessimistic about the ability of interest rates to decline over the long-term and at
those who simply prefer to take a cautious approach to their bond buying.
10.15.7 Guaranteed Debentures - Some businesses are able to raise long term money because their
debts are guaranteed, usually by their parent companies. In some instances the State Governments
guarantee the bonds issued by the State Government undertakings and corporation like Electricity Supply
Board, Irrigation Corporation etc.
10.15.8 Subordinated Debentures - A subordinated debenture is an unsecured debt which is junior to all,
other debts i.e., other debt holders must be fully paid before the subordinated debenture holders receives
of conversion into ordinary shares. Subordinated debt is often called Mezzanine finance because it ranks
between equity and standard debt.
10.15.9 Floating Rate Bonds - The interest paid to the floating rate bondholder’s changes periodically
depending on the market rate of interest payable on the gilt edged securities. These bonds are also called!
adjustable interest bonds or variable rate bonds.
10.15.10 Junk Bonds - Junk bonds are a high yield security which because a widely used source of
finance i in takeovers and leveraged buyouts. Firms with low credit ratings are willing to pay 3 to 5 per
cent more than the high-grade corporate debt to compensate for the greater risk.
10.15.11 Indexed Bonds - Fixed income and fixed sum repayments are uneconomic in times of rapid
inflation. Indexed bond is a financial instrument which retains the security and fixed income of the
debenture but which also provides some safeguard against inflation.
10.15.12 Stepped-up Debentures- The terms of issue of stepped up debenture contains that instead of
making I conversion at one go at the end of the tenure, it has designed the instrument in such a way that
the equity component is augmented gradually. For example, the stepped up debenture has been priced at
the face value of Rs. 50, with a coupon of 1896 p.a. (interest payable half yearly) and tenure of three
years. The debt component will be converted into equity in a phased manner over a period of three years
from the date of the issue. The conversion will be done at par value, at the rate of 2096 at the end of first
year and 4096 each at the end second and third years. As the scale of business increases, via funding
through borrowings, proportional increases in equity should also be brought in.
A debt instrument with interest rates that either ascends or descends, ratcheting up to the highest or lowest
level in the terminal year.

Test Questions

Q1 Write the advantages and disadvantages of equity financing.

Q2 In what senses, the preference shares are ‘preferred’? Explain the preference available to
these shareholders.
Q3 Critically examine the rights available to the equity shareholders.
Q4 What are the advantages and disadvantages of debenture as an instrument of financing from
the point of view of the company as well as the investors?
Q5 Write short notes on:
a) Voting Rights of Equity Shareholders.
b) Redeemable Preference Shares.
c) Zero Interest fully Convertible Debentures.
d) Optionally Convertible Debentures.
Chapter 11 Sources Of Finance
(Financial Institutions And Term Lending)

11.1 Types of Sources of Finance

The sources of finance available to industries may be considered under three board classifications:
(a) Long-term Sources;
(b) Short-term sources:
(c) Internal sources (self-financing).

Long-term sources include individual investors, corporate and institutional investors like banks, insurance
companies, investment trusts, Government agencies, financial corporation "Sales and Leaseback" and hire
purchase arrangements and international financing institutions.

Short-term sources include private firms and money-lending operative societies, mercantile creditors and
commercial banks.

Internal sources include plaguing back of profits and depreciation earned on assets used in the business.

Individual investors as owners or lenders of capital providing long-term source of finance:

In the case of proprietary concerns and partnership firms individual investors, as owners of the business,
have to provide a substantial portion of the long term finance required by these enterprises as the legal
forms of these organizations, greatly affect the sources and amounts of capital that can be attracted. In the
case of corporate form of organizations, individual investors contribute to the capital of companies by
subscribing to their stocks or shares. But subscribing to the issues of debenture bonds by companies, they
also lend capital for the long-term use of this corporate from of organisations.

11.2 The, Role 0f Commercial Banks in India in long-term Financing 0f Industry

Though commercial banks in India mainly finance trade and industry by short-term advances, in the
recent years they have participated in long-term financing of industry to some extent in the following
(a) Investment in shares and debentures companies;
(b) Grant of medium-terms loans (some banks in India are known to extend medium-term credits to
industries against the security of fixed assets).
(c) Underwriting the issues of shares and bonds;
(d) Indirectly by investing in financial corporations, such as, Industrial Finance Corporation, State
Financial Corporation, Industrial Credit and Investment Corporation etc. and by making advances against
corporate securities. The primary role of the commercial banks is to cater to the short-term requirements
of industry. Of late, however, banks have started taking an interest in term financing of industries in
several ways, though the formal term lending is, so far, small and are confined to major banks only.
Term lending by banks has become a controversial issue these days. It is argued that term loans do not
satisfy the canon of liquidity, which is the major consideration in all bank operations. According to the
traditional values, banks should provide loans only for the short periods and for operations, which result
in the automatic liquidation of such credits over short periods. On the other hand, it is contended that the
traditional concept of liquidity requires to be modified. The proceeds of the term loan are generally used
for what are broadly known as fixed assets or for expansion in plant capacity. Their repayment is usually
scheduled over a period of time. The liquidity of such loans is said to depend on the anticipated income of
the borrowers.
As a matter of fact, a working capital loan is more permanent and a longer term then a so called 'long
term loan.' This is because a term loan is always repayable on a fixed time schedule. A working capital
loan though "money at call" is hardly ever adjusted in practice.
Nationalised Banks:
These banks have also been extending medium-term loans in recent years. The facilities is given by these
banks to small-scale units are very significant. Loans are granted on term basis up to ten years for
investment of a capital nature in land and building or in machinery and equipment, to assist the
expansion, modernization of small scale units and also the setting up of new industrial units in the small-
scale sector.
Land Mortgage Banks:
Land Mortgage Banks are of two kinds:
(a) Central, and
(b) Primary (or village) banks,
Most of these banks in India are quasi-cooperatives. Central Land Mortgage Banks grant long-term loans
to agriculturists through primary Banks.
The purposes for which the loans may be granted are for:
(a) settlement of old debts, and
(b) making improvement of lands.
Loans are granted only to members on the mortgages of their lands up to 50 per cent of their values in
some states, or up to 30 times the land revenue payable on them in other states. A maximum limit to
individual members is fixed, which varies from state to state. The period of loans also varies in different
states up to maximum of 16.25, 20 Or 30 years, repayments being by equal annual installments of
principal and interest. The Central Land Mortgage Banks raise their funds mainly by issuing debentures
which are guaranteed by the State Governments in respect of repayment of principal and the payments of
interest. Other sources of their funds include share capital and deposits.

11.3 General Insurance Companies (GIC)

General Insurance Companies in. India also subscribes to or purchase shares and debentures and thus
contributes directly to the long-term needs of industry. By investing in shares and debentures of other
banking and financial institutions, they also indirectly participate in long-term financing of industries.

11.4 Life Insurance Corporation of India (LICI) :

The Life Insurance Corporation of India, which came into existence on 1st September, 1956 under the
Life Insurance Corporation Act, enjoys the exclusive right to carryon Life Insurance business in India. It
is one of the institutions in India which mobilizes a vast amount of personal savings. The Corporation
now occupies an important place in the Capital Market of India. The Corporation not only takes an active
interest in underwriting operations but also invests in shares and debentures of companies. The
Corporation is permitted to invest up to 30 per: cent of the subscribed share capital of a company. The
Corporation provides loan to co-operative sugar factories, industrial estates, and improvement trusts, State
Electricity Boards and companies on a long-term basis.
11.5 Unit Trust of India:
The Unit Trust of India, established under the Unit Trust Act, 1963, came to operation on 1st February
1964. It has an initial capital of Rs. 5 crores contributed by the Reserve Bank of India. The Life Insurance
Corporation of India. The State Bank of India and its subsidiaries, scheduled banks and other specified
financial institutions. With this capital, it has already built up a balanced portfolio of investment in
securities of diverse types giving an average yield of over 1 per cent. The Trust offers to small investors
the advantages of a reasonable return and expects management. The Trust enjoys exemption from
payment of income tax, and super tax other taxes on income. With the significant tax concessions and
other advantages offered to investors, the Unit Trust is expected to mobilize the financial resources of
numerous small investors and channelise them to the corporate sector.

11.6 Long-term Finance and Governmental Agency’s:

The State Aid to Industries Act is in operation in all the States. Loans may be granted under these Acts to
cottage and small-scale industries for pur poses, such as:
(a) for the purchase of land;
(b) for the construction of factory buildings or work sheds ;
(c) for the purchase of tools, equipment and machinery and for erecting machinery, and
(d) for subscribing towards the share capital of an industrial co-operative society.

The loans sanctioned for the purchase of tools, equipment and machinery are normally paid by the
Government directly to the suppliers of such machinery etc. ~very loan granted under these schemes is
secured by a mortgage upon specified assets of the business." The rates of interest charged on those loans
are very concessional ones. The period for the repayment of the loans may extend up to 22 years.

11.7 Credit Guarantee Scheme of the Reserve Bank of India:

The object of this scheme, which came into force on 1st July, 1960, is to enlarge the supply of
institutional credit to small-scale industrial units by ensuring a degree of protection to the lending
institutions against possible losses in respect of the advances granted by them to there small-scale
industries. The Reserve Bank of India may give guarantee under this Scheme to the approved credit
institution. Though, initially, such guarantees applied only to loans for periods not exceeding seven years,
this limitation has now been re]axed so that the period of the loans can extend beyond 7 years from the
date of the first disbursement of the advances.

11.8 National Small Industries Corporation (NSIC):

The National Small Industries Corporation Limited was set up by the Central Government with its
headquarters at Delhi. There are also three subsidiary corporations in the country. These corporations
arrange to supply machinery to small scale industries on hire purchase basis and also assist these
industries in marketing their produce and in obtaining orders from the stores purchasing departments of
the Government. The Corporation is empowered to guarantee loans made by banks to small scale units. It
also arranges raw materials for these units and engages in export of small industry products.
11.9 Central and State Finance Corporations:
With the increased tempo of industrialization in the country. a number of specialised financial institutions.
dedicate to promote large-scale industrial development and cater to the deeds of large scale industries in
the matter of their long-term financial requirements has been established in India after in- dependence,

11.10 The Industrial Finance Corpora/ion of India (lFCI) :

The Industrial Finance Corporation of India (IPCI) was incorporated in 1948 under the Industrial Finance
Corporation Act, 1948 with the object of "making medium and long-term credits more readily available to
industrial concerns in India, particularly in circumstances where the normal banking accommodation is
inappropriate or resource to capital issue methods is impracticable". Its primary role is to assist in the
private sector.

I.F.C.I. can extend financial assistance to any public limited company or co-operative society engaged in,
or proposing to engage in, one of the following activities:

(a) Manufacturing, preservation or processing of goods;

(b) Shipping;
(c) Mining;
(d) Hotel industry; and
(e) Generation or distribution of electricity and gas. I.P.C.I. finance is not available to:
(a) Small-scale industrial units; and
(b) Proprietary concerns, partnerships or private limited companies.

The assistance may take anyone or more of following forms.

(a) Granting of loans Or subscribing to debentures in rupee-currency repayable is not more than 25 years;
(b) Granting loans in foreign currency;
(c) Underwriting of equity, preference or debenture issues;
(d) Subscription to equity or preference capital;
(e) Guaranteeing deferred payments in respect of machinery imported from abroad or purchased in India;
(f) Guaranteeing loans raised from foreign banks or financial institutions in foreign currency; and
(g) Guaranteeing loans raised from scheduled banks or State Co-operative Banks or floated in the public
I.F.C.I. can sanction loans or other facilities to any extent, however that loans over Rs 1 Crore required
prior approval of the Central Government. I.F.C.I. as a matter of convention, entertains loan applications
only for amounts in excess of Rs. 10 lakhs. The purposes for which loans can be sanctioned are purchases
of new machinery, renovation or replacement of old machinery, construction of factory buildings,
purchase of land for factory sites and the like. It does not sanction loans for working capital or for
repayment of existing liabilities except in exceptional cases.
I.F.C.I. generally aims at a margin of 50% which means that it gives assistance to the extent of half of the
total capital cost. The loans are secured by a first legal mortgage of all fixed assets of the industrial
concern such as, land, building, plant and machinery. In certain exceptional cases and the case of co-
operative societies. I.F.C.I. may finance up to 65% of the capital cost of the project.
I.F.C.I. has an authorized capital of Rs. 10 crores. The other sources of financing available for its
operations are:
(a) Loans from Central Government and Reserve Bank of India;
(b) Borrowing by issue of bonds;
(c) Deposits from the public, State Government and local authorities;
(d) Loans in foreign currency; and
(e) Its own internal resources represented by retained earning and repayment of loans.
I.F.C.I. is authorized to (a) grant long term loans Or subscribe to debentures in rupee currency repayable
in not more than 25 years; (b) grant loans in foreign currency, (c) underwrite equity or preference or
debenture issues,(d) subscribe to equity or preference capital; (e) guarantee deferred payments in respect
of machinery imported from abroad or purchased in India; (f) guarantee loans raised in foreign currency;
and (g) guarantee loans raised from scheduled banks or state co-operative banks or floated in the public
As a rule, rupee loans up to Rs. 30 lakhs are sanctioned by the State Financial Corporation (SFC),
established in various States; loans in excess of this limit are sanctioned by the IFCI. IFCI also sanctions
loans of less than Rs. 30 lakhs where these are required in conjunction with other facilities, such as sub-
loans in foreign currencies, underwriting of shares and debentures, and &guarantees for deferred
payments for imported plant and machinery, or for foreign currency loans to be raised from foreign credit
institutions, particularly where the SFC concerned is not in a position to sanction the said facilities.
The Corporation has secured lines of credit in foreign exchange. It sanctions financial assistance for
productive purpose, such as purchase of new machinery, construction of factory building, and purchase of
factory land. Its finances are not available for the purchase of raw materials or for the repayment of
existing liabilities, save i~ exceptional cases. The IFCI provides financial assistance for setting up new
industrial enterprises as also for the renovation, modernization or diversification of existing ones.

Eligibility for financial assistance etc.:

Any public limited company ,or a co-operative society incorporated and registered in India which is
engaged in, or is proposing to engage in the manufacture, preservation or processing of goods, or in
shipping, mining, hotel industry or in the generation or distribution of electricity or any other form of
power, is eligible for financial assistance from the lFCI. Public sector projects which are set up as public
limited companies are also eligible for assistance by the IFCI on the same basis as projects in the private
sector, within the framework of Government policies.
In case of many projects, the Corporation undertakes joint financing with other all-India financial
institutions. For this purpose, they have an inter-institutional approach.
Terms for advancing loans:
The loans are generally secured by a first legal mortgage on the block, i.e., fixed assets of the industrial
concern, both existing and those to be acquired in future. In the case of projects which require joint
financing, pari passu charge on the mortgaged assets is conceded in favour of other institutions. Raw
materials, stocks in process, finished goods, and consumable store and book debts are not included in
IFCI's security. This is because the same can be pledged for working capital loans with the banks. In the
case of existing concerns which are undertaking schemes of expansion or renovation. IFCI's assistance is
up to about half the total capital cost of expansion and renovation or the written down value of the
existing block. In special cases, the IFCI may advance more than 5°% of the total cost. In the case of co-
operative enterprises, the IFCI may finance up to 65% of the capital cost of projects, provided the loans
are guaranteed by the Central State Government; similarly; a higher percentage of total cost can be given
as loans if the project is in a backward area.
The loans are normally repayable by semi-annual instalments over a period of 7 to 10 years. The
corporation generally allows a grace period of up to 3 years after the initial disbursement of the loan.
To remove regional imbalances in the economy, the Corporation extends sizeable financial assistance on
concessional terms to industrial undertakings in less developed State/areas. It also encourages the growth
of new entrepreneur- ship and special consideration is given to applications for financial assistance for
projects promoted by technocrats and professionally qualified persons. The Corporation is also extending
substantial assistance to industrial co-operatives.

11.11 The Industrial Credit & Investment Corporation of India (I,C.I.C.I.)

The Industrial Credit and Investment Corporation of India Limited (I.C.I.C.I.) was incorporated in 1655
as a privately-owned financial institution with the object of carrying on the business of assisting industrial
enterprises within the private sector of industry in India in general by :
(a) assisting in the creation, expansion and modernization of enterprises;
(b) encouraging and Promoting the participation of private capital, both internal and external in such
enterprises; and
(c) encouraging and promoting private industrial investments and the expansion of investment markets.
I.C.IC.I. extends financial assistance only to limited liability companies in the private sector. Its finance is
not available to:
(a) Public sector undertakings; and
(b) Proprietary or partnership enterprises.
The assistance takes anyone or more of the following forms:
(a) Underwriting public and private issues and offers of sale of industrial securities-ordinary shares,
debentures and debenture stock;
(b) Direct subscriptions to such security;
(c) Granting loans in rupees repayable over periods up to 15 years;
(d) Granting similar loans in foreign exchange for payment for imported capital equipment and technical

(e) Guaranteeing payments for credits made by others; and

(f) Furnishing managerial, technical and administrative advice and assisting in obtaining managerial
technical and administrative ser- vices for Indian Industry.
I.C.I.C.I. does not quote standard terms for loans and other financial assistance. These are considered on
the merits of each case in the light of the risks involved, the prevailing conditions and practices of
financial institutions, cost of I.C.I.C.I. own funds, its expenses and its need to build up reserves. Loans are
granted on proper security for periods up to 15 years. A period of grace is normally allowed before
repayment begins in order to enable the project to come into effective production.
I.C.I.C.I. has an authorized capital of Rs. 25 crores. The other sources of financing available to its
operation are:
(a) Borrowings from Government of India
(b) Lines of credit made available' by the Word Bank which can be used for purchase of capital goods
from any country which is a met11ber of the World Bank and from Switzerland;
(c) Lines of credit mad. available by the Development Loan Fund which can be used for purchase of
,capital goods from any country which is a member of the World Bank and Switzerland up to the value of
$ 1,00,000 and the balance only purchases from U.S.A. ;
(d) Other foreign borrowings;
(e) Its own internal resources represented by retained profits and repayments of loans.
The I.C.I.C.I. specialises in securing assistance for Indian Industries from foreign countries.
I.C.I.C.I. is a unique financial institution in many ways. It began its operations as a wholly privately
owned institution but with the nationalisation of life insurance business the L.I.C.I (a Government
Corporation) became a relatively large shareholder in it. Unlike other corporations, this one is inter-
national, both in its ownership and operations. Its share capital is subscribed by both Indian and foreign
investors from U.K. and US.A. and its operations include a sizeable proportion of foreign assistance. The
Corporation has been set up to assist, by various means industrial development in the private sector.
The Corporation aims at (a) assisting in the creation expansion and modernization of industrial units in
the private sector. (b) encouraging the inflow and participation of foreign capital in these units, and (c) the
expansion of the investment market in India.

The Corporation is authorised to undertake the following activities to achieve these objects: (i) granting
loans over a period of year. (ii) subscription to equity and preference share capital, normally in the form
of underwriting of public issues, (iii) guaranteeing of rupee payments required, for instance, in the case of
deferred payments, (iv) advancing loans in foreign technical and administrative assistance to Indian
industry. Generally, the Corporation treats Rs. 5 lakhs as the lower limit for its assistance. The upper limit
for assistance is Rs. 1 crore. In 1969, the Corporation decided to provide foreign currency loans to
partnership and proprietary firms also to strengthen entrepreneurship in small concerns.
11.12 The National Industrial Development Corporation (NIDC):
The National Industrial Development Corporation (NIDC) was incorporated in 1954 as a Private Limited
Company. Its primary objects are-"the promotion and establishment of industries for the manufacture and
production of plant, machinery, implements and goods of any description likely to promote industrial
development and to aid and assist any industrial undertaking owned by the private companies also, with
capital and other resources for establishing new industries or for running their business."
Therefore, it can render assistance to any type of industrial organisation, i.e., public or private sector
enterprise. Company, firm or individual. The assistance may also take any form such as providing capital,
credit, machinery and equipment, loans and advances, subscriptions to or underwriting of shares and
debentures and guaranteeing of loans and advances. The NIDC is intended mainly to be an agency of the
Government for developing industries with no profit motive.
The NIDC started with Rs. 10 lakhs of capital. Its financial requirements are met by the Government by
an annual grant for the purpose of study, investigation and formulation of projects and building up
technical and managerial staff. and by loans to be made as and when projects are taken up.
It undertakes financing of industries only in so far as it is incidental to such development. It gives priority
to establishments for the manufacture of capital goods, machinery and equipment for other industries. It
takes up the study and investigation of industrial schemes, and implementing them, tries to secure,
wherever possible, the maximum use of industrial equipment, experience; and skill available in the
private sector. In other case, it may itself set up industries which may, in their turn, lead to the growth of
ancillary industries in the private sector.
NIDC can render assistance to any type of industrial undertaking. The assistanced can be provided in the
shape of capital, credit, machinery, or any other type of facility. However, the Corporation has made slow
progress in the field of setting up new industries because it has been undertaking large projects
11.13 The Industrial Development Bank of India (IDBI):
The Industrial Development Bank of India was established under the Industrial Development Bank Act
1964. It is a wholly owned subsidiary of the Reserve Bank of India. The development Bank is enable to
finance all types of industrial enterprises both in the public and private sectors which incorporated under
the Companies Act or any other law.
The assistance that can be rendered by the Development Bank can take diverse forms. These may include-
(a) granting loans and advances;
(b) subscribing to, purchasing or underwriting the issue of stocks, shares, bonds or debentures;
(c) guaranteeing~ deferred payments due from industrial concerns, loans raised by them in the open
market or from scheduled banks etc.
(d) taking under writing obligations;
(e) accepting, discounting or rediscounting bonafide commercial bills or promissory notes of industrial
(f) refinancing;
(i) term-loans to industrial concerns repayable between 3 and 25 by I.F.C., the Financial Corporation and
other financial year’s institutions notified by the Government for the purpose;
(ii) term-loans repayable between 3 and 10 years given by schedule banks or State Co-operative Banks;
(iii) export credit maturing between 6 months and 10 years granted by the specified financial institutions;
(g) augmenting the resources of the I.F.C., State Financial Corporation and other financial institutions
notified for the purpose by subscribing to their stocks, shares, bonds or debentures.
The Act also makes provision for a separate "Development Assistance Fund" intended to provide
assistance for industries which may not be able to obtain funds in the normal course but may nevertheless
be of such importance as to justify special assistance. This fund is to be created out of an appropriate
initial grant from the Central Government supplemented by loans, gifts, grants, donations etc., from
Government and other sources. Assistance from this fund is subject to prior approval of the Central

The Development Bank can also undertake promotional activities such as marketing and investment
research, surveys and techno economic studies and provide technical and administrative assistance to
industrial enterprises for promotion, management or expansion.
To begin with, the Development Bank will have capital fund of Rs. 10 crores. It will be supplemented by
an interest free loan from the central Government of Rs. 10 crores for a period of I5years repayable in 15
equal annual installments. It can also borrow other funds from the Central Government and Reserve Bank
of India. It can also take loans foreign currency from any bank of financial institution in any other country
with the approval of Central Government.
The Refinance Corporation for Industry has since been merged with the Development Bank. As important
landmark in the history of industrial finance in the country was the establishment of the Industrial
Development Bank in July, 1964. The Bank is intended to serve as a reservoir from which the existing
financial institutions can draw. It seeks to cover the gaps left by the numerous State institutions working
in the field of industrial finance. The Bank has a measure of flexibility in its scope and operations which
is essential for the organisation of capital market on a sound footing. It promotes the establishment of new
enterprises especially in key industries and assists projects both in the private and the public sectors.
The Bank is expected to combine commercial promotion and re-financing activities. To the end, it
performs the following important functions:
(a) Refinancing: The Bank refinance: (i) loans for term between 3 and 25 years granted by the I.F.C., &
S.F.Cs., or other financial institutions. (ii) loans repayable between 3 and 10 years granted by any
schedule bank or state co-operative bank to an industrial concern, and (iii) export loans, given by any
schedule bank of state co-operative bank or any other approved institution, repayable between six months
and ten years.
(b) Short term accommodation: The Bank is empowered to accept, discount or re-discount commercial
paper (Bills of Exchange, Promissory Note etc.) of industrial concerns.
(c) Direct subscriptions: The Bank subscribes to Or buys stocks, shares bonds or debentures of the I. F.
C., S. F. Cs. or any other notified financial institution.
(d) Lending and underwriting: The Bank grants loans and advance to industrial concerns. It can also
underwrite the issue of shares or debentures by any industrial concern.

e) Guaranteeing: The Bank can guarantee deferred payment due from any industrial concern. It can also
guarantee loans floated by an industrial concern in the market or raised from a scheduled bank or I.F.C or
S.F.C., or any other financial institution.
(f) Formation: The Bank can arrange technical or administrative assistance for any industrial concern or
person for promotion, management or expansion of any industry. It will also plan, promote and develop
industries to cover the gaps in the existing capital structure.
(g) Miscellaneous: The Bank may undertake research and surveys for evaluation of dealing' with
marketing of investments. It can form subsidiaries for carrying out its functions and will do any other
kind of business which the Central Government on the recommendation of the Reserve Bank of India,
may authorise.
11.14 Industrial Rehabilitation Bank of India
The IRBI originated in April, 1971 as a public limited company was known as the Industrial
Rehabilitation Corporation of India Ltd. (IRCI). It was established as an adjunct to the development
institutions already functioning in the country. The need for setting up the IRCI was felt in the context of
the all round depression in industry arising from recession combined with adverse factors like
management, unsatisfactory labour relations and critical raw material position which led to the closure or
sickness of many industrial units. The position was particularly critical in West Bengal. The IRC[ was
established by the Reserve Bank of India at the instance of the Central Govt. with the object of reviving
and revitalizing the sick and closed industrial units. Though it is all-India insti- tuition, it has paid special
attention to West Bengal; this is because of the particularly serious condition of industry in that State. In
1984, IRCI was re-constituted as a subsidiary of IDBI to be known as Industrial Rehabilitation Bank of
India (IRBI), L.I.R.B.I. functions not merely as a lending institution, but as a reconstruction agency which
concerns itself with the diagnosis and the removal of the problems and shortcoming which might have led
the sick unit to its present unfortunate condition. It helps in the management by providing managerial
guidance, and acts as a catalyst in securing assistance for banks and financial institutions and government
The assistance given by IRBI has taken the form of soft loans and guarantees, Reconstruction loans are
granted for meeting essential capital expenditure and repayment of pressing liabilities as also for
providing liquid (i.e. cash) resources. In regard to working capital, the IRBI provides the margin money
on the strength of which the assisted units can obtain finance from banks. The margin money is essential
to have before a borrowing concern is able to get assistance from banks. It becomes a kind of security for
the advance taken.

Generally IRBI has been issuing guarantees to banks in respect of margin money for working capital.
However, in some cases It had to provide cash payment for the margin money.
Limited companies, co-operatives, partnership, or proprietary concerns are all eligible for assistance from
IRBI. In practice, however, IRBI generally suggests conversion of partnership and proprietary concerns
into limited companies. IRBI does not ordinarily assist cases where more than 50% shares are held by a
State or the Central Government.
Normally, it charges interest at 8i% p.a. with half yearly rests on its term loans. For units in the small-
scale group, the interest rate is 7%t and for units located in backward areas, a concessional rate of 7% is
charged by way of interest. For guarantees, charges are limited to I % per annum.
The repayment of loans normally depends upon the facts of each case. It has varied between 4 and 12
years. Moratorium periods of different durations have been granted with regard to payment to principal
and/or interest. This means that IRBI postpones its dues for a certain period over which the weak or sick
units will not be required to pay the principal or the interest. For providing reconstruction assistance, the
IRBI asks for a first charge on all the fixed assets of the assisted units.
11.15 State Financial Corporation:
State Government have been empowered by the State Financial Corporations Act, 1951 to establish
financial corporations in their respective States, Each of the States in India has got its own financial
corporation nearly all of them were established under the State financial Corporation Act, 1958 except the
one in Madras, which was established under the Companies Act.
State Financial Corporation can render financial assistance not only to private public limited companies
but also to limited companies partnership firms and proprietary concerns. The assistance can be in anyone
or more of the following forms:
(a) Granting loans or advances or subscribing to debentures Or industrial concerns, repayable within 20
(b) Guaranteeing loans raised by industrial concerns, on such terms and condition as may be mutually
agreed upon, which are repayable within 20 years; and
(c) Underwriting the stocks, shares, bonds and debentures subject to their being diposed of in the market
within 7 years.
They cannot, however, subscribe directly to the shares or stock of any limited liability company except
for underwriting purposes or grant any loan or advance on the security of their own shares. The loan or
advance granted to any single enterprise cannot exceed 10 per cent of the paid-up capital of the
Corporation or Rs. 10 lakhs, whichever is less. The loans are to be property secured by pledge, mortgage,
and hypothecation or otherwise. I
The capital structure of any State Financial Corporation may range between Rs. 50 lakhs and Rs. 5 crores.
They can issue bonds and debentures to supplement their financial resources and may accept deposits
from the public. They can also get medium-term credit facilities from the Reserve Bank of India.
To sum up, the State Financial corporations have been established in all the State under the Financial
Corporations Act, 1951, a central legislation, to serve the needs of medium and small-scale industries on a
regional basis. In Tamil Nadu, the Tamil Nadu Industrial Investment Corporation Ltd., functions on the
lines of a State Financial Corporation. In structure and mode of operation, SFCs are broadly, similar to the
Industrial Finance Corporation. They grant loans to corporate and non-corporate industrial units including
proprietary. and partnership concerns, generally against the first charge by way of legal mortgage on fixed
assets, such as land, buildings, plant and equipment with a margin of about 50% on the net value of the
security. However, the margins differ with the unit and the nature of business.
For the proper co-ordination of their activities, the Industrial Finance Corporation and the State Financial
Corporation observe a convention under which the Industrial Finance Corporation does not normally
entertain applications for loans for amounts less than Rs. 30 lakhs to anyone borrower.
11.16 Foreign Financial Participation:
The Government of India has invited, foreign assistance in cases where sufficient capacity for the
manufacture of a particular item does not exist in the.- country and where it is considered desirable to
secure technical knowledge from leading foreign firms. Several incentives (including tax concessions)
have been offered to foreign investors in order to attract foreign capital which will supplement the
country's capital resources. The participation of foreign capital and management however, is regulated in
the national interest. Normally, it is ensured that the major interest in ownership and control is in Indian
hands and that suitable Indian personnel are trained for eventually replacing foreign experts.
Foreign investment in the equity of Indian industrial projects can be a significant source of long term
finance for these projects which may take the form of patents, licenses, technical know-how, machinery or
cash or a combination of more than one of these forms.
11.17 Foreign Private Loans:
The Major sources of foreign private loans for Indian industries are the suppliers of machinery and
services. Many such firms are prepared to give credit for duration of or more years. 'Often these credits
are financed by their own Government agency to encourage exports, (e.g., The Export Credit ~ Guarantee

11.18 The World Bank.

The International Bank for Reconstruction and Development (IBRD) usually known as the World Bank is
a specialised agency of the United Nations. This Bank is an important source of loans for the industrial
development of member countries. The Bank obtains its funds from:
(a) capital subscription of member countries.
(b) borrowings in the various capital markets of world.
(c) Net earnings.
(d) the sale of portions of loans to investors, and
(e) repayment of loans.
The Banks give loans only after considering the credit-worthiness of the country; its ability to service
additional foreign debt and the soundness of the project to be financed. The appraisal of projects for this
purpose are under- taken for assessing their technical, financial and economic feasibility and their value to
the national economy of the country concerned. Projects are not considered in isolation but reviewed in
the light of the development plans and priority needs of the country. Loans are given in any of the
following forms.
(a) directly to private industrial enterprise (e.&. the two loans granted to Tata Iron & Steel Co. Ltd., India
for an expansion programme of $ 107.5 millions)
(b) through an intermediary Governmental agency to private industrial enterprises ;
(c) to industrial development banks for refinancing to private enterprises ; and
(d) to Government owned Projects; .
Loans of the type referred to in (a) to (c) above have to be guaranteed by the Government. Borrowing
countries can spend the loaned funds in any member country and in Switzerland. Interest costs to
borrowers have ranged between 3 to 6 percent over the years.

11.19 The International Finance Corporation.

The International Finance Corporation is an affiliate of the World Bank. This Corporation caters to the
needs of private enterprises only. Its major objective is to promote economic development in its member
countries by in- vesting in productive private enterprises in association with private capital and
management. No Government guarantee is insisted upon. The Corporation invests only in underdeveloped
countries of the world.
Generally, the corporation does not consider an investment of less than $ 1, 00,000 and does not invest in
enterprises which will have total assets, after their financing, less than $ 5, OO, 0OO. The Corporation
prefers projects with local and foreign collaboration, both as to capital and know-how.
The Corporation can not invest in capital stock or shares. The investment normally takes the form of long-
term loans on a specified rate of interest and with a maturity date. They also provide for right to
participate in capital gains and some profits of the enterprise. The rate of interest charged is slightly
higher than that of the World Bank.
The period of the loans varies between 8 to 12 repayment instalments ~ commencing from 2 to 7 years
after the investment commitment is made The Corporation lends in dollars and requires that repayments
of capital and interest charges be made in dollars.
11.20 Other Foreign Sources.
A number of foreign countries and international agencies have been giv- ing long-term loans, deferred
payment facilities, grants, etc.

11.21 Sale & Leaseback.

It is becoming increasingly popular in the U.S.A. and U.K. for companies having substantial Fixed Assets
at low book values, to sell them at current market price, on condition that the purchaser would lease them
back to the company for long periods, e.g. 99 years lease. The advantages are (I) Assets are realised at
current high valuation (2) Immediate cash is available for increasing working capital (3) the use of the
Assets is assured (4) The rental is a charge in revenue accounts of each period and allowed for Income

Test Questions
Q1 Discuss broadly the structure of financial institutions in India.
Q2 Describe the ways in which financial institutions provide direct financial assistance.
Q3 Explain how the IDBI bill-rediscounting scheme works.
Q4 Explain how the ICICI suppliers credit scheme works.
Q5 “Financial Institutions in India have come up of age.” Comment.
Chapter 12 Lease financing

12.1 Introduction
A lease is a contractual arrangement whereby one party (i.e., the owner of an asset) grants the other party
the right to use the asset in return for a periodic payment. A lease is essentially the renting of an asset for
some specified period. The owner of the assets is called the lessor while the other party that uses the
assets is known as the lessee. A lessee can be an individual. a firm or a company interested in the use of
the assets without owning it, while the lessor may be the seller, supplier, a finance company or the
manufacturer who can finance the purchase of the assets. Under the lease contract, the ownership of the
assets remains with the lessor whereas the use of the assets is available to the lessee. In return, the lessee
has to pay a fixed periodic amount to the lessor. This periodic payment is known as the lease rental.
Generally, the lease rental is fixed and the amount and timing of its payments are a matter of agreement
between the lessor and the lessee.
The terms and conditions regulating the lease arrangement are given in the lease contract. At the end of
the lease period, the assets generally revert to the lessor, who is the real owner of the assets. As a legal
owner, the lessor is also entitled to claim depreciation on the assets. Acquiring an asset by a business firm
under a lease arrangement is a recent phenomenon, particularly in India. Gradually, it is gaining
popularity and has emerged as a significant source of long term financing over recent years.
The concept of leasing can be understood by comparing the lease to the purchase of a specific asset. If a
firm wishes to obtain the service of a specific asset, it has two alternatives: Purchase or Lease. To
purchase the asset, the firm must payout a lump sum or agrees to some type of installment plan that
involves incurring a long term liability. Leasing the assets, on the other hand, provides the firm with
asset's services without necessarily incurring any capital liability. Leasing is a source of financing as it
enables the firm to obtain the use of assets in exchange for agreeing to pay lease rentals. The present
chapter discusses various aspects of lease financing from the point of view of both the lessor and the
12.2 Lease, Hire-purchase and Installment Sale:
In case of leasing, as already stated, the asset is handed over by the lessor to the lessee in return for a
lease rental. The ownership and the title to the assets remain with the lessor. The lessor, however, recovers
the cost of the assets as well as a reasonable return in form of rental income. The lessor also gets the
deduction in taxable income for the depreciation of the assets (though not using the assets). The lessee
gets the opportunity of using the assets in its entirety without owning it. Further, the rental, paid by the
lessee gets fully deducted from the taxable income of the lessee.
In case of hire purchase, the seller hands over the assets to the buyer but the title to goods are not
transferred. The buyer becomes the owner of the goods and acquires the title to the goods only when he
makes the payments of all the installments. In case of default in payment by the buyer, the seller can
repossess the goods. The buyer treats the installments already paid by the buyer up to the date of
repossession, in such a case, as ‘hire’ towards using the assets. The hire-purchaser shows the assets in his
balance sheet and can claim depreciation from taxable income, although he may not be the owner at that
time. The interest part of the installment can also be claimed as deduction from the taxable income.
In case of installment sale, the title to goods is immediately transferred to the buyer though the payment
of price is to be discharged in future. This is just like a credit sale. In case of default, the seller has no
option but to claim the money in the court of law. The seller cannot repossess the goods, a facility which
is available in leasing as well as in hire” purchase.
12.3 Types Of Lease Arrangements
From the point of view of the lessee, leasing involves obtaining the use of specific assets without
acquiring the title to the assets. In exchange for the use of the assets the lessee pays the lessor a ed
periodic payment which is normally agreed in advance and is made in the beginning of each the lease
period. As the lease is, basically, a contract between the lessor and the lessee and they can agree for any
set of terms and conditions, there can be different types of lease arrangements. Broadly speaking, the
lease may be classified as a finance lease or an operating lease.
FINANCE LEASE: A finance lease, also called a capital lease, is one which usually covers the full useful
economic life of the assets or a period that is close to the economic life. The lessor receives: lease rentals
during the lease period so as to recover fully not only the cost of the assets but also a reasonable return on
the funds used to buy the assets. The finance lease is usually a non-cancelable and the lessee provides for
the maintenance of the assets. The lease payment under financial lease is a payment for the use of the
assets only and the responsibility for the repair d maintenance of the assets generally lies with the lessee.
Since the term of a finance lease is normally closely aligned with the economic life of the assets, the
lessee's position is quite similar that of an owner; and the cost of maintaining is in its hands. At the end of
the lease period, the assets may be returned to the lessor or handled as per the lease contract.
From the point of the view of the lessee, the finance lease ensures him an uninterrupted use the assets. For
him a finance lease is essentially a form of borrowing for the purpose of acquiring an asset. The lessor
may not be involved in dealing with the assets. The lessee may select the assets according to his
requirement, may even negotiate the price, the delivery schedule etc., with supplier and get the delivery
also. The payment however, is made by the lessor to the supplier. This arrangement is concurrent to the
signing of the lease contract. There may be different types finance lease depending upon how the lessee
acquires the asset. Some of these are as follows:
Direct Lease: This is the most straight forward type of finance lease. The lessor itself purchases the asset
and hands it over to the lessee. A manufacturer can also act as a lessor and can deliver the assets to the
lessee under the lease agreement (instead of delivering under the sale agreement). In other words, the
lessee will normally specifies the manufacturer, the model number and other relevant characteristics of
the asset it wishes to lease and the lessor will procure for the lessee.
Leveraged Lease: A leveraged lease is an arrangement where the lessor borrows a portion of the
purchase price from some lender/financial institutions. This loan is secured by the assets and the lease
rentals. The loan is repaid out of the lease rentals either directly by the lessee or the lessor. The surplus
(i.e., the difference between the lease rental and the repayment portion of it) then goes to the lessor. So,
under the leveraged lease, the lessor acts as an equity participants supplying only a part of the cost of the
assets and the lender supplies the balance. The lease rentals are distributed first to the lender to satisfy the
scheduled debt service payments; any surplus then going to the lessor. If lease payments are less than the
debt service, the lessor or the lessee (as the contract may provide for) will have to make up the difference.
The lease payment must be large enough to meet the debt repayment, interest payment to the lender as
well as provide a return to the lessor. The leveraged lease may generally be adopted in case of costly

Sale and Lease Back: Under both the direct lease and the leveraged lease, the lessee ac- quire the assets
after the lease arrangement. However, in case of sale and lease back, the situation is different. The lessee
is already the owner of the assets. He, under the lease agreement, sells the assets to the lessor who, in
turn, leases the assets back to the owner (now the lessee). Under the sale and lease back, the lessee not
only retains the use of the assets but also gets funds from the 'sale' of the assets to the lessor. The sale and
lease back is usually preferred by firms having fixed assets but shortage of funds. The Following Figure
depicts the mechanism of sale and lease back.

Sales of Assets


Lease back Resale Funds

Lessor Lease Rental

Figure: Sale and Lease Back System.

The sale and lease back agreement is essentially to help the lessee to mobilize the funds to tied over the
liquidity position. In practice, it is a common type of lease arrangement. The tax pro- vision relating to
sale and lease back are
a) The asset is to be sold initially by the lessee to the lessor at the book value of the asset and not at the
revalued figure.
b) The lease rental payable by the lessee is allowed as deductible expense.
c) Depreciation on the asset is available to the lessor on the basis of the book value of the asset, and
d) The rental income will be taxable in the hands of the lessor.
OPERATING LEASE: An operating lease is an agreement in which the lessee acquires the use of an
asset on a period to period basis. It is a lease arrangement for a period considerably shorter than the life of
the asset. The lessor may lease the asset to different lessees one after another. The lease rental payable by
one lessee during his lease period is not sufficient to cover fully the cost of the asset plus a reasonable
return on that.
An operating lease is usually assigned for a period much shorter than the economic life of the asset and
the present value of lease payment is generally much lower than the actual price of the asset. At the end of
the life of the lease, the asset reverts back to the lessor, who can either offer it to sell to the lessee or
somebody else or lease it to some other lessee. The operating lease normally includes a maintenance
clause requiring the lessor to maintain the asset. The maintenance may include not only the repairs but
also the insurance and tax payments. The lessor of course, will include in the lease rentals, a sufficient
compensation for the expected maintenance cost of the leased asset.
The operating lease is generally cancelable by either party and is more expensive than a finance lease
because the lessee has to compensate the lessor (owner), as the latter assumes the ownership risk and the
lessee bearing no risk of asset becoming obsolete. Vehicles, amusement equipments, display fixtures,
furniture etc., are some of the assets which may be acquired on operating lease basis.
The finance lease and operating lease may be differentiated as follows:
Basis Finance Lease Operating Lease
Life of contract Approximates the economic life Shorter than the economic
of the asset. life of the assets.
Maintenance Provided by the lessee or cov- Provided by the lessor and
ered by a separately agreement. included in lease rentals.
Lease payments Return the cost of the assets Not sufficient to cover the
and allow a profit to the lessor. cost of the asset.
Cancellation May be cancelled only if both May be cancelled before
the lessor and the lessee agree. expiring date.
It is important to note that the finance lease and operating lease differ not only on the basis of the length
of the contract but also with respect to the period of lease vis-à-vis the economic life of the assets.
Although, the differences between the finance and the operating lease are obvious, some lease
arrangement may not fit neatly into one or another of these extremes. They may have features of both
types of leases and may be called a combination lease.
Effect of leasing on expenses, income and taxes: The finance lease and the operating lease have
different effects on the income and expenses as follows:
Effect of Finance Lease. The Guidance Note on Leasing issued in 1988 by the Institute of Chartered
Accountants of India deals with the treatment of lease rentals in the books of the lessee as well as the
lessor. It says that the entire lease rental is not to be treated as the revenue income of the lessor. Against
the receipt of lease rental, an amount equivalent to statutory minimum depreciation on the asset leased is
shown as a deductible expense and only the balance is considered as the income of the lessor. The
accounting adjustment is made through the Lease Terminal Adjustment Account. From the point of view
of the lessee the entire lease payment is an operating expense and hence tax deductible.
Effect of Operating Lease.. In case of operating lease, the lease payment by the lessee to the lessor is an
expense item for the lessee and an income item for the lessor. So, the lease rental payable by the lessee is
tax deductible for him. On the other hand, for the lessor the entire lease rental received by him is of
revenue nature and hence taxable. However. he can claim depreciation, interest on borrowings (made for
purchase for the asset) etc., from his taxable income.
The lease payment provides a tax benefit to the lessee and the after tax impact may be ascertained as
After tax effect of lease payment = LR (l --t)
Where LR = Annual lease rent, and t = Tax rate
Since, operating lease is basically, a type of renting an asset for a short period, does not involve much of a
decision. But, the finance lease, on the other hand, is an important financial decision, a finance manager
usually concerned with. In the following discussion, therefore, only the finance lease is being discussed.

12.4 Lease Versus Buy: The Basic Decision

As already noted, leasing is a source of financing provided by the lessor to the lessee. The lessee receives
the services of the asset for a specific period of time in exchange for the payment of fixed lease rental.
The only other way, the lessee could obtain the services of the given asset would be to purchase it
outright, and the outright purchase of the asset would require sufficient funds. The lessee might have
these sufficient funds to purchase the assets outright without borrowing, but the funds would not be free
as there is always an opportunity cost of the funds. Every time, there- fore, a firm has to acquire an asset,
it may have to decide between two mutually exclusive situations: First, should the assets be purchased
and become the owner of the asset and second, should the asset be acquired on a lease basis.
Even if the firm has liquid resources with which it can purchase the asset, the use of these resources may
be viewed as a form of borrowing because the opportunity cost of the funds is at least equal to the
prevailing interest rate on borrowings. A firm contemplating the acquisition of an asset, the ownership of
which is only incidental to obtaining the services of the assets, has also to decide whether it should lease
the asset or borrow the funds and buy the assets This is known as lease-buy decision and is essentially a
financing decision. In case of lease financing the lease rentals are payable, which are analogous to
payment of interest on borrowings, which may be needed for raising the funds for buying the asset. A
lease-buy decision therefore, is financing decision and involves a choice between debt financing and lease
Another point worth noting about a lease-buy decision is that the firm should compare leasing to
borrowing the amount of purchase price and then buying the asset (rather than using equity to buy the
asset). This is because leasing creates such obligations for the firm, which is very similar to those, created
by borrowing. Buying the assets entirely, or even substantially, with equity capital would expose the firm
to far less risk than leasing the asset in as much as lease payments represent a contractual commitments,
whereas the equity do not. In case of lease, there is contractual payment in the form of the lease rental and
it maybe taken as similar to the payment of interest and repayment of principal amount of the borrowing.
Therefore, the lease decision may rightly be evaluated as an alternative to financing the asset purchase by
100% debt financing. In general, leasing should be compared to borrowing all the funds required for the
asset and buying it. Thus, the lease-buy decision involves evaluating the relative advantages and
disadvantages of leasing and of debt financing particularly in the form of effect on lessee's cash flows.
In the lease-buy decision, the choice depends upon the present value of the two series of after tax cash
flows to the lessee; and to evaluate the lease-buy decision, the financial manager has to consider only the
relevant cash flows i.e., he has to consider only those cash flows that differ under the two alternatives. For
example, the lessee, irrespective of the fact, may pay the maintenance cost of the asset whether the asset
is purchased or is acquired on lease. This cost can be ignored by the financial manager as it is irrelevant
as the maintenance cost is payable in both the options.
What is needed is an after tax present value comparisons of the two options. As in the capital budgeting
decisions, all costs (of leasing as well as buying option) should be measured on an after tax basis and the
lease obligations or the additional borrowing is assumed to be small relative to the total capital structure,
thereby causing the firm's capital structure and the risk to remain basically unchanged. The evaluation
procedure may be explained as follows:

12.5 Evaluation of Lease-buy Decision:

The decision may be taken on the basis of evaluation of both the options, for which the following steps
may be required.
Identification of Relevant Cash flows: First of all, the cash flows emanating from the lease option as
well as the buying option is to be identified. In case of lease, the firm receives benefits from using the
assets but has no claim on its residual salvage value, which is re-, served for the lessor in most of the
cases. The lessee firm has to make lease payments and also to meet all or some of the maintenance
expenses. The lease payments and all such expense payment associated with the leased assets are tax
deductible for the lessee. The lessee cannot claim depreciation, as he is not the owner.
In case of buying the assets, on the other hand, the firm assumes all the risk and benefit associated with
the ownership including the salvage value, if any. It may also incur the costs of maintaining the asset. The
firm also has to pay the interest on the funds borrowed to finance the asset, together with the repayment
as per schedule. It may be noted that in case of buying the assets, depreciation, maintenance expense, and
interest are all deductible.
The after tax cash flows emanating from the lease option are relatively easier to be identified. The lease
option requires only cash outflows in the form of the lease rental payment which is to be considered on an
after tax basis. The after tax cash flow of lease rental may be taken as equal to the difference between the
lease rental and the tax benefit. However, the cash flows associated with borrowings are more difficult to
obtain due to the need to identify both the interest and the depreciation associated with the asset. The
calculation of cash outflow associated with borrowing has two steps. The first is to determine the annual
interest components and the depreciation; and the second is to determine the cash outflow, which is equal
to interest payment less tax shield on account of interest and depreciation plus principal repayment. The
cash flows associated with the buying option may be enumerated as follows:
* Interest payment on the debt, which are tax deductible.
* Principal repayment of the debt, which is not tax deductible.
* Tax savings accruing from the depreciation of the asset.
* Any other operating expenses arising as a consequence of buying the assets.
* Any salvage value at the end of assets life.
II. Analysis of Incremental Cash flows: After identification, the cash flows are to be analyzed for each
year for tax shield etc., under both the options. For this purpose, the present value of the stream of after
tax cash outflows associated with each option must be calculated. This is because the cash flows occur at
different point of time. However, there is a difference of opinion about the rate of discount being used to
find out the present values. These are:
i) The discount rate used to evaluate the cash flows should be the after tax cost of debt. It may be noted
that the lease payment and interest payment create similar commitment for the firm. Consequently, they
should be treated similarly, in terms of risk, for purposes of estimating discount rates. Because the
discount rate for debt is the after tax cost of borrowings for the firm, the discount rate for the lease
payment should also be after tax cost of debt.
ii) However, it is also argued that the after tax weighted average cost of capital i.e., kg and not the after tax
cost of debt i.e., kd , should be used to discount the net cash flows under the buying option because
funding for the purchase option in fact comes from mingled funds raised from different sources and
cannot be associated with the anyone particular type of security. The same overall weighted average cost
of capital should be used to discount the cash flows of the leasing option.
Example 12.1 and 12.2 explain the evaluation procedure for a lease-buy decision
Example 12.1
A firm can purchase for Rs. 2,500 an asset having life of 5 years after which its salvage value is Rs. 500.
The firm provides depreciation on straight line method. Purchasing and using the asset will increase the
firm's expected revenues by Rs. 1,500 per year and will raise its expected operating expenses (not
including depreciation) and interest by Rs. 700 per year. The corporate tax is 50% and the cost of capital
of the firm is 10%.
The firm can also lease the asset for a yearly rental of Rs. 650. The incremental revenue will be same at
Rs. 1,500 per year and the increase in firm's expected non-depreciation expense is Rs. 600 per year only.
Evaluate the proposals.
In this case, the firm has two options as follows: (i) To lease, and (ii) To buy the asset. The incremental
revenue are same at Rs. 1,500 per year in both the options. However, in case of lease option, a lease rent
of Rs. 650 and expenses of Rs. 600 are payable per year and both are taxes deductible? In case of buying
option, the operating expense are Rs. 700 per year and the depreciation will be Rs. 700 per year i.e., (Rs.
2,500 - 500)/5. This depreciation is tax deductible. The two proposals may now be evaluated as follows:

Computation of Net Present Value of Buying Option

Year Profit Expenses Dep. PAT Cash flows PVF@10% PV
1 Rs.l,500 Rs.700 Rs.400 Rs.200 Rs.600 .909 Rs.545
2 1,500 700 400 200 600 .826 496
3 1,500 700 400 200 600 .751 451
4 1,500 700 400 200 600 .683 410
Year Profit Expenses Dep. PAT Cash flows PVF@10% PV
5 1,500 700 400 200 600 .621 373
5 Salvage value 500 .621 310
Initial cash outflow (cost of asset)
Net Present Value 85
Computation of Net Present Value of Leasing Option
Year Profit Expenses Rentals PAT or Cash flows PVF@10% PV
1 Rs.l, 500 Rs.600 Rs.650 Rs.125 .909 Rs.114
2 1,500 600 650 125 .826 103
3 1,500 600 650 125 .751 94
4 1,500 600 650 125 .683 85
5 1,500 600 650 125 .621 77
Net Present Value 473
As the NPV of the leasing option is higher at Rs. 473, than the NPV of the buying option, the firm should
lease the asset.
Example 12.2
ABC Ltd. needs an asset for which the manufacturer has placed the following two options.
1. The asset can be acquired on lease basis on a payment of annual lease rent of Rs. 15,000 per
annum for 4 years.
2. The assets is available of Rs. 50,000 for which funds can be raised by the issue of 12% loan,
which is to be repaid together with interest in 4 equal annual installments.
The firm provides depreciation on straight line basis and the tax rate applicable is 30%. Which;
option should the firm choose?
The decision in this situation can be taken by considering the after tax cash flows. If the company
acquires the asset on lease basis on an annual rental of Rs. 15,000 per annum for 4 years, then this lease
rental is tax deductible. Therefore, the firm will pay Rs. 15,000 to the lessor but will get a tax saving of
Rs. 4,500 (i.e., 30% of Rs. 15,000) and hence the net cash outflow for each of the 4 year would be Rs.
10,500 only.
However, if the firm buys the asset, it will have to borrow Rs. 50,000 which together with Interest at the
rate of 12% will be repaid as an annuity in next 4 years. The annuity table shows lat in order to pay Rs.
3.037 together with interest @ 12% in 4 years, an annuity of Re. 1 is payable. Therefore, in order to repay
Rs. 50,000, annuity of Rs. 16,464 (i.e., Rs. 50,000+3.037) should e paid. The cash outflow will be Rs.
16,464 on account of principle repayment, however, the net ash inflows/outflow may be ascertained a
Bifurcation of Annuity Payment into Interest and Principal
Year Payment Interest Repayment Balance
0 --- ------- --------- Rs. 50,000
1 Rs. 16,464 Rs.6,000 Rs. 10,464 39,536
2 16,464 4,744 11,720 27,816
3 16,464 3,338 13,128 14,688
4 16,464 1,776 14,688 --------
The tax shield @ of 30% will be available on the interest payment of Rs. 6,000, Rs. 4,744, Rs. 3,338 and
Rs. 1,776 respectively. The company will also provide depreciation of Rs. 12,500 (i.e., Rs.50,000/4) and
will get a tax benefit at the rate of 30% i.e., Rs. 3,750 per year. The net cash flow in the buying option
may now be ascertained as follows:
Year Repayment Tax Saving Tax Saving Net CF
on interest on depreciation
1 Rs. -16,464 Rs.l,800 Rs.3,750 Rs. -10,914
2 -16,464 1,423 3,750 -11,291
3 -16,464 1,001 3,750 -11,713
4 -16,464 533 3,750 -12,181
The choice between the leasing and the buying option is, in fact, the choice between the two series of cash
outflows. The firm should choose that option which gives lower present value of cash outflows when the
payment streams are discounted at the firms after tax cost of debt i.e., 12% (1-0.3) = 8.4%. The after tax
cash flow under both the option and their present values may be presented as follows:
Leasing Option Buying Option
Year Outflows PV@ 8.4% Outflows PV@ 8.4%
1 Rs. -10,500 Rs. -9,686 Rs. -10,914 Rs. -10,068
2 -10,500 -8,936 -11,291 -9,609
3 -10,500 -8,243 -11,713 -9,196
4 -10,500 -7,605 -12,181 -8822
Present Value -34.470 -37.695
The above calculations show that the present value of cash outflows under the lease option and the buying
option are Rs. 34,470 and Rs. 37,695 respectively. The cash outflows in present value terns are lower in
case of lease option; therefore, the firm should lease the asset instead of buying it from the borrowed
Comparison of the solution and presentation given in Examples 10.1 and 10.2 raises a few doubts about
the difference in approach. In Example 10.1, the revenue earnings from the asset have been considered
but in the Example 10.2, these revenue incomes are neither given nor considered. Further, the decision in
the former is based on the NPV, while in the latter; it is based on the present value of outflows. The reason
for this is obvious. As the cash inflows on account of revenues being generated by the assets are same in
both options of lease and buy, therefore, these are irrelevant cash flows and may be ignored. The revenue
has been treated differently in the two examples only to explain the different presentations. The decision
will not be affected if the revenue (i) are ignored in Example 10.1, and (ii) are incorporated in analysis of
cash flows of Example' 10.2.
The evaluation procedure for a lease-buy decision can be summarized as follows:
1. Compute the net present value of the asset's cash flows if the asset is purchased.
2. Compute the net present value of the cash flows generated for the firm by the asset if it is leased.
3. Compare the NPV (buying option) with the NPV (leasing option). The option with the higher NPV is
superior and the other should be rejected.
The above analysis is based on the assumption that the firm had decided that it needed the asset, based on
project analysis. In some cases, the option to lease an asset may change a project from 'unacceptable' to
'acceptable'. For this to happen, the following sequence of events has to unfold. First, the project analysis,
done on the assumption that the asset would be bought, should have yielded a negative NPV. Second, the
lease option should be specific to this project and should not reflect a company wide advantage to leasing
versus buying. Finally, the lease decision should yield savings in present value relative to buy decision,
which exceed the negative NPV from the first step.
In analyzing the lease-buy decision it has been implicitly assumed that the lease lasts for the length of the
life of the asset. If the life of the lease is different from the life of the assets, however, the analysis
changes. The issue may be avoided by assuming that the lessee will buy the assets at the end of the lease
life or that the assets will be sold at the end of the lease life, under the buy option. In particular, one of the
following two may be adopted:
a) Assume that the lease will be renewed to cover the life of the assets. For example, for an asset having
life of 15 years, where the lease in only 5 years, this will require renewing the lease twice i.e., at the end
of 5 years and 10 years. Once this assumption is made, the NPV of the lease (with two renewals) option
and the buying option may be evaluated.
b) Estimate the annuity of equivalent annual cost of leasing and buying on the basis of an appropriate rate
of discount. The annuities of both options may be compared to select one.
The excess of present value of lease cash outflows over buying cash outflows is also known as Net
Benefit-of Leasing (NBL). In the Example 10.2, the NBL is Rs. 3,225 i.e., 34,470-(-37,695). If NBL is
positive, it implies that the lease financing is better than the buying option, which itself may be positive or
negative. Thus, a positive NBL does not itself imply that assets should be acquired. The NPV of the asset
should be assessed separately as an investment. If it is found worth buying, then positive NBL suggest
that lease is better option. If NBL is negative, then buying option with borrowed funds will be better for
the firm. It may be noted that the NBL is not a criteria of selecting the investment; rather it only helps in
choosing the method of financing the asset. The position of NBL and the investment decision has been
depicted in the following Figure

Positive Negative

Positive Negative Positive Negative


Lease Buy-out Lease Rejection

Financing Financing if

Net Benefit of Leasing and Investment Decision.

12.6 Lease Financing-Leassor’s View Point: So far the lease decision has been evaluated from the point
of the lessee in terms of the lease –buy decision. However, the lessor also has to evaluate the leasse
decisions from the point of view of his return. The lessor is financing the assets out of the funds procured
from different sources, and obviously there is a cost of all these funds to the lessor. So, the lessor will like
to provide lease financing only if the return from the lease is at least equal to the overall cost of capital of
the lessor.
The lease decision for a lessor is in fact a capital budgeting decision, where the lessor invests the funds in
expectation of the returns in the form of lease rentals. The lessor will accept the proposal for the lease
financing only if the NPV of the decision is positive at the required rate of return i.e., overall cost of
capital, k . In terms of the IRR methodology, the lease financing may be accepted only when the IRR of
the lease financing is more than the cut-off rate. As a capital budgeting decision, therefore, the lease
decision may be evaluated as follows:
Cash Outflows: In case of lease situation, the lessor has to 'buy' the asset. Therefore, the initial cash
outflow is the amount paid by the lessor at the time of purchasing the assets. If there is any other
incidental expense or outflow then it should also be included in the initial outflows.
Cash Inflows: In case of lease financing, the cash inflows are in terms of periodic lease rentals. In order to
find out the after tax cash inflows, these periodic lease rentals are to be adjusted for (i) tax liability on
account of income from lease rentals, and (ii) tax shield on account of depreciation on the asset. The
annual net cash flows may be ascertained as follows:
Net Cash flows = (LR-Dep.) x (l-t)+Dep.
Where LR = Periodic lease rental, and t = tax rate
These cash inflows are then discounted at the required rate of return to find out the present value of
inflows. This present value of inflows may be compared with the initial cash outflows to find out the NPV
of the lease decision. If the present value of the inflows is more than the present value of outflows, the
lessor may accept the lease financing. In case, the lessor is using the IRR technique, the IRR of the cash
inflows and outflows may be computed. If this IRR is higher than the cut-off rate, the lessor may accept
the lease financing. Example 25.3 illustrates the lease evaluation from the point of view of the lessor.

IIl"stration 12.3
A person wishing to take on lease an office premises, has been given two options by the landlord. The
options are:
Option I: Lease period 18 years,
Initial non-refundable deposit of Rs. 2, 00, 000.
A yearly rent of Rs. 60,000 to be increased by 10% every 5th year of tenancy
Option II: A yearly rent of Rs. 1,00,800 to be increased by 10% every 5th year of tenancy. Lease
period - 18 years
You are required to give your views on the alternatives from the point of view of the tenant. The rate of
discount is to be taken at 18%. The present value of Re. I payable at the end of the each year at 18%
starting from year I to year 18 are as follows: 1.0, 0847458,0.718184,0.608631',
0.515789,0.437109,0.370432,0.313925, 0.266038, 0.225456, 0.191064, 0.161919, 0.137220, 0.116288,

0.098549,0.083516,0.070776, and 0.059980

Sohltion : Comparison of the Options
Year Option I Option II Excess of PVFCI8%.n) Present Value
Outflows Outflows II over I
I Rs.2,60,000 Rs.I,00,800 -Rs.l,59,200 Rs.1.000000. Rs.-1,59,200
2 60,000 1,00,800 +40,800 .847458 +34,576
3 60,000 1,00,800 +40,800 .718184 +29,302
4 60,000 1,00,800 +40,800 .608631 +24,832
5 66,000 1,10,880 +44,880 .515789 +23,149
6 66,000 1,10,880 +44,880 .437109 +19,617
7 66,000 1,10,880 +44,880 .370432 +16,625
8 66,000 1,10,880 +44,880 .313925 +14,089
9 66,000 1,10,880 +44,880 .266038 +11,940
10 72,600 1,21,968 +49,368 .225456 +11,130
11 72,600 1,21,968 +49,368 .191064 +9,432
12 72,600 1,21,968 +49,368 .161919 +7,993
13 72,600 1,21,968 +49,368 .137220 +6,774
14 72,600 1,21,968 +49,368 .116288 +5,741
15 79,860 1,34,165 +54,305 .098549 +5,352
16 79,860 1,34,165 +54,305 .083516 +5,535
17 79,860 1,34,165 +54,305 .070776 +3,843
18 79,860 1,34,165 +54,305 .059980 +3.257
Net present value of excess cost of II over I +72.987
The net present value of excess cost of Option II over Option I is Rs. 72,987. Therefore, option I should
be accepted by the tenant. Under this option he will be able to save an amount of Rs.72, 987 in terms of

Test Questions
1. Right short notes on:
a) Finance Lease.
b) Sale and Lease back.
2. What is Lease? How is it different from installment sale?
3. Explain the concept of leasing. What are its advantages and limitations?
4. Explain the difference between leasing and hire-purchase.
5. What do you understand by the finance lease? Explain the difference between finance lease
and operating lease. '
6. Differentiate between leveraged lease and sale and lease-back.
7. What is lease-buy decision? What is the difference in lease ~buy decision from the point of'
view of the lessor and the lessee.
8. How are lease payments timed? What effect might advance payment have on the cash out- flows and
the tax benefits associated with the lease?
9. Leasing is often called hedge against obsolescence. Under what conditions is it true?
10. What are the similarities and differences between lease financing and debt financing? In what cases,
lease may be preferred?
P12.1 A company is considering to lease an equipment which has a purchase price of Rs. 3,50,000. The
equipment has an estimated economic life of 5 years. As per the Income Tax Rules a written down
depreciation at 25% is allowed. The lease rentals per year are Rs. 1,20,000. The company's marginal tax
rate is 50%. If the before-tax borrowing rate for the company is 16%, should the company lease the
![Answer: The purchase option is better.]

P12.2 ABC Company Ltd., has two financial options in respect of procuring an Equipment for j
ulitising the same for 5 years costing Rs. 10,00,000. The two options are:-
Option I: Borrow Rs. 10,00,000 at an interest rate of 15%. The loan is repayable at 5 year-end
instalments. The equipment could be sold at the end of its 5 year economic life at a realisable value
Option 11: Lease-in the asset for a period of 5 years at yearly rental of Rs. 3,30,000 I payable at year-end.
The rate of depreciation allowable on the equipment is 15%. The company has to pay Income Tax @ 50%
and has a discounting rate of 16%. Capital gain or loss is to be ignored. Evaluate the two options and give
your opinion.
[Answer: PV of outflow of buying option is Rs. 5,78,164 and of leasing option is Rs. 5,40,210. So,
leasing is better.]
P12.3 ABC Machine Tool Company is considering the acquisition of a large equipment to set
up its factory in a backward region for Rs. 12,00,000. The equipment is expected to have an economic
useful life of 8 years. The equipment can be financed either with an eight: year term loan at 14% interest,
repayable in equal instalments of Rs. 2,58,676 per year, or by an equivalent amount of lease rental per
year. In both cases, payments are due at the end of the year. The equipment is subject to the straight line
method of depreciation. Assuming no salvage value, and 50% corporate tax rate. Which of the financing
alternatives should it select?
[Answer: The PV of outflows in buying option is Rs. 7,52,088 and in leasing option i.

Chapter.13 Mergers and Acquisitions

13.1 Concept of Mergers and Acquisitions
Today mergers, acquisitions and other types of strategic alliances are on the agenda of most industrial
groups intending to have an edge over competitors. Stress is now being made on the larger and bigger
conglomerates to avail the economies of scale and diversification. Different companies in India are
expanding by merger etc. In fact, there has emerged a phenomenon called merger wave.
"'The terms merger, amalgamation, take-over, and acquisition are often used interchangeably to refer to a
situation where two or more firms come together and combine into one to avail the benefits of such
combination. Business combinations and re-structuring in the form of merger etc., have been attempted to
face the challenge of increasing competition and to achieve synergy in business operations. This chapter
attempts to analyze various aspects of the business combination and re-structuring of firms, besides
having an over view of the tax provisions and guidelines relating to mergers and acquisitions in India.

13.2 Mergers And Acquisitions: Types

Various terms such as merger, amalgamation, take-over, consolidation etc., are used interchange- ably to
denote the process of corporate re-structuring. There is no common definition and these terms may be
used to describe a re-structuring of one type of the other. Generally, these terms are used to denote a
particular type of re-structuring as follows:
Merger: The term merger includes consolidation, amalgamation and absorption. It refers to a situation
when two or more existing firms combine together and form a new entity. Either a new company may be
incorporated for this purpose or one existing company (generally a bigger one) survives and another
existing company (which is smaller) is merged into it. If a new company is incorporated, it is known as a
case of consolidation/amalgamation. However, if an existing company is merged into another existing
company, it is known as absorption. The merger of first, Tata Oil Mills Ltd. and then Brook Bond Lipton
(India) Ltd. into Hindustan Lever Ltd. were cases of absorption. On the other hand, merger of 4
companies into HCL Ltd. was a case of consolidation. In year 2000, Times Bank has been merged with
HDFC Bank in India, in line with the wave of consolidation that is sweeping across the global banking
Thus, merger is an arrangement for bringing the assets of two firms under control of one which mayor
may not be one of the two original firms. It signifies the transfer of all assets and liabilities of one or more
existing companies to another existing or new company. A basic feature of merger is the one company
takes the ownership of another company and combines its operations with that of its own operations. The
term merger is used to denote the fusion of two or more companies to achieve expansion and
Acquisition: It includes take-over also. In general, acquisition refers to the acquiring of owner- ship right
in the property and assets. It denotes a situation when one company acquires (i) owner- ship in the assets,
and to control of monies of another company. The other company, of which the control is so acquired,
remains a separate company and is not liquidated, but there is a change in control. Acquisition results
when one company purchases the controlling interest in the share capital of another existing company in
any of the following ways:
a) By entering into an agreement with a person or persons holding controlling interest in the other
b) By subscribing new shares being issued by the other company.
c) By purchasing shares of the other company at a stock exchange, and
d) By making an offer to buy the shares of other company, to the existing shareholders of that company.

The term take-over is used to denote the acquisition, which is hostile in nature and the company, which is
being taken-over, may put resistance and oppose the take-over bid. Two companies i.e., DCM Ltd. and
Escorts Ltd. successfully resisted the take-over bid on their companies by the Caparo Group of the U.K.
Recently, ICI Ltd. has acquired 9% (approx.) equity share capital of Asian Paints Ltd. (from one of its
major shareholder in order to acquire controlling interest in the latter).
Another form of acquisition may take place in the form of holding-subsidiary relationship between two
companies. A company is called a holding company if it controls the composition of the Board of
Directors of the other company, or holds more than half in nominal value of the equity share capital of the
other company. The other company in such a case is known as the subsidiary company. Both holding and
the subsidiary company, maintain their individual identity in the eyes of law as well as in practice.
Generally, the relationship between holding and subsidiary companies takes place at the time of
incorporation of the latter. Reliance Petro Chemical Ltd. was incorporated as a subsidiary of Reliance
Industries Ltd. and later it was merged into the holding company. Hindustan Lever Chemical Ltd.
(erstwhile Stepan Chemical Ltd.) is a subsidiary of Hindustan Lever Ltd. In most of the cases, subsidiary
companies are small in size and operate as an investment or financing arm of the holding company.
The Accounting Standard, AS-14, issued by the Institute of Chartered Accountants of India has defined
the term amalgamation by classifying (i) Amalgamation in the nature of merger, and. (ii) Amalgamation
in the nature of purchase.
Amalgamation in the nature of Merger: As per AS-14, an amalgamation is called in the nature of merger if
it satisfies all the following conditions:
i) All the assets and liabilities of the transferor company should become, after amalgamation, the assets
and liabilities of the other company.
ii) Shareholders holding not less than 90% of the face value of the equity shares of the transferor
company (other than the equity shares already held therein, immediately before the amalgamation, by the
transferee company or its subsidiaries or their nominees) become equity shareholders of the transferee
company by virtue of the amalgamation.
iii) The consideration for the amalgamation receivable by those equity shareholders of the transferor
company who agree to become equity shareholders of the transferee company is discharged by the
transferee company wholly by the issue of equity share in the transferee company, except that cash may
be paid in respect of any fractional shares.
iv) The business of the transferor company is intended to be carried on, after the amalgamation, by the
transferee company.
v) No adjustment is intended to be made in the book values of the assets and liabilities of the transferor
company when they are incorporated in the financial statements of the transferee company except to
ensure uniformity of accounting policies.
An amalgamation which does not fulfill any of the conditions mentioned above, is known as
amalgamation in the nature of purchase. It may be noted that the difference between amalgamation in the
nature of merger and amalgamation in the nature of purchase (as envisaged by the AS- 14) is relevant
particularly from the point of view of the accounting treatment of the merger trans- action in the books of
the transferee company.

Reverse Merger: It is a merger of a prosperous and profit making company into a loss making company,
which is generally a sick company and having eroded a substantial portion of its net worth. In the context
of the Companies Act, 1956, there is no difference between the regular merger and the reverse merger. It
is like any other merger. However, if one of the merging companies is a sick company under the Sick
Industries Companies Act, then such merger should take place through the Board\ of Industrial and
Financial Re-construction (BIFR). The reverse merger automatically makes the transferee company
entitled for the concessions and rebates under the Income Tax Act, 1961.
Difference types of merger and acquisitions can also be classified on the basis of the functional
relationship between two companies and the economic impact of the merger on their operations. The
merger may take place in any of the following situations:
1. Horizontal Merger: It is a case of merger of two or more companies that compete in the same
industry. It is a merger with a direct competitor and hence expands the firm's operations in the same
industry. Horizontal mergers are designed to produce, primarily, substantial economies of scale and result
in decrease in the number of competitors in the industry. The merger of Tata Oil Mills Ltd. with the
Hindustan Lever Ltd. was a horizontal merger.
In case of horizontal merger, the top management of the company being merged is generally, replaced by
the management of the transferee company. One potential repercussion of the horizontal merger is that it
may result in monopolies and restrict the trade.
2. Vertical Merger: It is a merger, which takes place upon the combination of two companies, which are
operating, in the same industry but at different stages of production or distribution system. If a company
takes over its supplier/producers of raw material, then it may result in backward integration of its
activities. On the other hand, forward integration may result if a company decides to take 'over the retailer
or customer company. Vertical merger may result in many operating and financial economies. The
transferee firm will get a stronger position in the market, as its production/distribution chain will be more
integrated than that of the competitors. Vertical merger provides a way for total integration to those firms,
which are striving for owning of all phases of the production schedule together with the marketing
network (i.e., from the acquisition of, raw materials to the retailing of final products).
3. Conglomerate Merger: It is a merger of two or more firms operating in different and unrelated
industries. It is an expansion of a company into areas unrelated to existing lines of business. In this case,
the company may not get the operating economies such as those, which may arise in case of horizontal or
vertical merger. In fact, the conglomerate merger results in portfolio of lines of business. There may
neither be increased concentration in anyone particular industry (as in horizontal merger), nor new control
of raw material etc., (as in case of vertical merger). But there is an increase in total economic activities of
the firm.
The conglomerate merger may be called pure when the activities of two firms being merged are totally
unrelated e.g., merger of an automobile company with textile company. It may be called congeneric
merger if the companies being merged are engaged in activities which are complementary but not direct
competitive e.g., merger of a car manufacturer with a scooter manufacturer. The conglomerate mergers do
not reduce the number of competitors in an industry but may result in some operating and financial
economies to the company.

Irrespective of the type of merger, there are at least two firms involved. One, the buying company that
acquires the other company, and survives after merger. This firm is known as an acquiring firm or
transferee company. The other is the company, which is merged and loses its identity in the process. This
is called the acquired company, or Transferor Company or the target firm. There are various modes in
which the acquiring firm can attempt a merge~' move and therefore, merger can also be classified on the
basis of initiative style or the procedure adopted by the acquiring firm. These are as follows:
a) Negotiated Merger: It is also called friendly merger. In this case, the management/owners of both the
firms sit together and negotiate for merger. The acquiring firm negotiates directly with the management of
the target firm. So, the willingness of the management of the target firm is implied here. If the two firms
reach an agreement, the proposal for merger may be placed before the shareholders of the two companies.
However, if the parties do not reach at an agreement, the merger proposal stands terminated and dropped
out. The merger of ITC Classic Ltd. with ICICI Ltd., and merger of Tata Oil Mills Ltd. with Hindustan
Lever Ltd. were negotiated mergers. However, if the management of the target firm is not agreeable to the
merger proposal, then the acquiring firm may go for other procedures i.e., tender offer or hostile take-
b) Tender Offer: A tender offer is a bid to acquire controlling interest in a target firm by the acquiring
firm by purchasing shares of the target firm at a fixed price. The acquiring firm approaches the
shareholders of the target firm directly to sell their shareholding to the acquiring firm at a fixed price. This
offered price is generally, kept at a level higher than the current market price in order to induce the
shareholders to disinvest their holding in favor of the acquiring firm. The Acquiring firm may also
stipulate in the tender offer as to how many shares it is willing to buy or may purchase all the shares that
are offered for sale.
In case of tender offer, the acquiring firm does not need the prior approval of the management of the
target firm. The offer is kept open for a specific period within which the shares must be tendered for sale
by the shareholders of the target firm. Consolidated Coffee Ltd. was taken- over by Tata Tea Ltd. by
making a tender offer to the shareholders of the former at a price, which was higher than the prevailing
market price. In India, in recent times, particularly after the announcement of new take-over code by
SEBI, several companies have made tender offers to acquire the target firm. A popular case is the tender
offer made by Sterlite Ltd. and then counter offer by Alcan to acquire the control of Indian Aluminium
c) Hostile Take-over Bid: The acquiring firm, without the knowledge and consent of the management of
the target firm, may unilaterally pursue the efforts to gain a controlling interest in the target firm, by
purchasing shares of the later firm at the stock exchanges. Such case of merger/acquisition is popularity
known as 'raid'. The Caparo Group of the U.K. made a hostile take-over bid in 1988 to take-over DCM
Ltd. and Escorts Ltd. Similarly, some other NRl's have also made hostile bid to take-over some other
Indian companies. The new take- over code, as announced by SEBI deals with the hostile bids.
d) Arranged Mergers: In India, the Board for Industrial and Financial Reconstruction has also been
active for arranging mergers of financially sick companies with other companies under the package of
rehabilitation. These merger schemes are framed in consultation with the lead bank, the target firm and
the acquiring firm. These mergers are motivated and the Lead bank takes the initiative and decides terms
and conditions of merger. The recent take- over of Modi Cements Ltd. by Gujarat Ambuja Cement Ltd.
was an arranged take-over after the financial reconstruction of Modi Cement Ltd.
13.3 Defence against Tender Offer and Hostile Take-over Bids: A firm having all or any of the
following features may provide a temptation to an acquiring firm to take-over the former:
a) The target firm has under performed other shares and the overall market in terms of retutn the
shareholders in the preceding years.
b) The target firm has been less profitable than other firms, and
c) The promoter/owner group has lower shareholding in the target firm and the public has a, higher
If an acquiring firm makes an offer for negotiated merger to the management of the target firm, it is up to
the latter to accept or not to accept the offer. The target firm may not find the offer to be attractive and
hence it may reject the offer. However, the acquiring firm may still persists with the idea either by making
a tender offer or attempting a hostile take-over bid. In such a case, it is the responsibility of the
management of the target firm to take defensive measures to thwart away any bid for take-over. The
management has a fiduciary position in the company and should take decisions in the best interest of the
shareholders. Moreover, the existence of the management of the target firm is also uncertain, as there is
an all likely chance of change of management of the target firm, if the take-over bid is successful.
What the present management can do in such circumstances? One obvious but impractical solution is that
promoter should increase their shareholding so as to have 51 % plus holding. This may require a public
offer, which is not only expensive but will also expose the company to a counter bid. Such a situation is
not consistent with the concept of a listed company where substantial public funds are used. Alternatively,
the promoter and the existing management have three options before it as measures against the hostile
take-over bid. These are first, those which can ~e taken prior to the bid, second, those which are taken up
when the bid is in progress, and third, which can be taken up after the completion of the bid. The
management of the target firm should adopt tactics and fight away the take-over bid. The following are
some of the strategies that may be adopted to avoid/fight away the take-over bid.
i) Legal Strategy: The target firm cat} take a legal action by moving a court of law for grant-
Ing injunction against the offer. Relevant provision of Securities Contracts (Regulations) Act, 1956 and
the Companies Act, 1956 may be referred to. Lawsuits may be initiated to block or at least delay the
tender offer. Refusal to transfer registration of shares is the vintage and one of the most successful of
measures. Undoubtedly, the application of this measure is made at the time when the shares are lodged for
the transfer by the bidder. However, adequate preparation in advance also needs to be made to ensure that
such refusal is successful and is finally upheld in the court of law.

ii) Tactica1 Strategy: The management of target firm can adopt different types of tactical moves to
thwart away the take-over bid. The firm can mount a media campaign against the tender offer. However,
the campaign must be based on facts and figures. The firm can also send letters etc., to the shareholders
explaining them about the defects of the tender offer. The directors may explain that the consideration
being offered by the acquiring firm is not ad- equate; and that the merger/takeover does not make any
economic sense and the performance of the firm may be adversely affected by the take-over.
The management of the target firm may also persuade their business associates, directors, and employees
etc., to purchase the shares of the target firm from the market. This may result in reduction of floating
stock of the target firm and thus making it difficult for the bidder firm to acquire the controlling interest.
Another way to thwart away the take-over bid is to find out a 'White Knight' who offers a higher bid for
the share of the target firm. With the higher bid offered by the White Knight, the take-over may not
remain a viable and profitable proposition to the original bidder. However in this case, the target firm still
loses its independence to the White Knight, but may get a better deal.
Further that the present management can increase the stake in the target firm by the issue of warrants or
convertible preference shares or convertible bonds etc., at a relatively low price. This is a good strategy to
fight away the expected take-over bid, however, the provisions of the new take-over code regarding
pricing of preferential issues must be taken-care of.
iii) Defensive Strategy: The target firm may take some action to destroy the attractiveness of the firm. It
may sell, mortgage, lease or otherwise dispose off some of its precious assets. The target firm, if having
large liquidity, may dispose of its liquidity by acquiring some as- set or other firm. This strategy is also
known as "Poison Pill". For example, if a hostile bid is made, the target firm takes on exorbitant and
expensive debts, which make it unattractive. While such a measure is not easily available in India in view
of the legal restrictions, this may be considered only as a theoretical strategy.
iv) Offensive Strategy: It is also known as 'Pac man' Strategy. The target firm in turn, may launch a
counter take-over bid on the acquiring firm. For example, firm A makes a tender offer before the
shareholders of firm B. As a strategy, the firm B may also make a tender offer to acquire the shares of
firm A. However, this strategy can be adopted only in case when the target firm is quite big and
financially sound. As a variant, the target firm may also buy-off the acquirer by placing a lucrative offer
before the management of the acquiring firm. The management of the target firm may also offer to pay a
higher price for the shares in the target firm already purchased by the acquiring firm. It is quite possible
that in view of such a move from the target firm, the acquiring firm may not pursue the take-over bid.
13.4 Motives and Reasons Behind Mergers: A number of motives have been often cited as the reason
for mergers. The simplest rationale is the under valuation of the target firm. An under valued firm (by the
financial market) will be a target for acquisition by other firms. However, the fundamental motive for the
acquiring firm to take-over a target firm may be the desire to increase the wealth of the shareholders of
the acquiring firm. This is possible only if the value of the new firm is expected to be more than the sum
of individual value of the target firm and the acquiring firm. For example, if A Ltd. and B Ltd. decide to
merge into AB Ltd. then the merger is beneficial if
Value of AB Ltd. > Value of A Ltd. + Value of B Ltd.
A merger, which results in meeting the test of in9reasing the wealth of the shareholders, is said to contain
synergistic properties. Synergy is the increase in value of the firm combining two firms into one entity
i.e., it is the difference value between the combined firm and the sum of the value of the individual firms.
There may be various sources for this extra value arise i.e., the in- crease in wealth of the shareholders as
a result of merger. Some of these are:
1. Operating Economies: The key to the existence of synergy is that the target firm controls a specialized
resource that becomes more valuable when combined with the bidding firm's re- sources. The sources of
synergy of specialized resources will vary depending upon the merger.

In case of horizontal merger, the synergy comes from some form of economies of scale, which reduce
costs, or from increased market power, which increases profit margins and sales. There are several ways
in which the merger may generate operating economies. The firm might be able to reduce the cost of
production by eliminating some fixed costs. Eliminating similar research efforts and repetition of work
already done by the target firm will also substantially reduce the research and development expenditures
in the new set up. The management expenses may also come down substantially as a result of corporate

The selling, marketing and advertisement department can be streamlined. The marketing economies may
be produced through savings in advertising (by reducing the need to attract each other's customers), and
also from the advantage of offering a more complete product line (if the merged firms produce different
but complementary goods), since a wider product line may provide larger sales per unit of sales efforts
and per sales person. When a firm having strength in one functional area acquires another firm with
strength in a different functional area, synergy may be gained by exploiting the strength in these areas. A
firm with a good distribution network may acquire a firm with a promising product line, and thereby can
gain by combining these two strength. The argument is that both firms will be better off after the merger.
A major saving may arise from the consolidation of departments involved with financial activities e.g.,
accounting, credit monitoring, billing, purchasing etc.

Thus, when two firms combine their resources and efforts, they will be able to produce bet- ter results
than they were producing as separate entities because of savings in various types of operating costs. These
resultant economies arc known as synergistic operating economies. There is no denying the fact that there
is a potential for operating synergy, in one form or the other, in most of take-over. Some disagreement
exists however, over whether synergy can be valued, and if so, how much that value should be. Some
argue that the synergy is too nebulous to be valued and that any attempt to do so requires so many
assumptions that it is point less. Although valuing synergy requires assumptions about future cash flows
and growth, the lack of precision in the process does not mean that an unbiased estimate of value cannot
be made. The synergy can be valued by answering fundamental questions: What form is the synergy
expected to take? Will it reduce costs as a percentage of sales and increase profit margins? Will it increase
future growth?

2. Diversification: Diversification into new areas and new products can also be a motive for a
firm to merge an other with it. A firm operating in North India, if merges with another firm
operating primarily in South India, can definitely cover broader economic areas. Individually
these firms could serve only a limited area. Moreover, products diversification resulting from
merger can also help the new firm fighting the cyclical/seasonal fluctuations. For example, firm
A has a product line with a particular cyclical variations and firm B deals in product line with
counter cyclical variations. Individually, the earnings of these two firms may fluctuate in line
with the cyclical variations. However, if they merge, the cyclically prone earnings of firm A
would be set off by the counter cyclically prone earnings of firm B. Smoothing out the earnings
of a firm over the different phases of a cycle tends to reduce the risk associ ated with the firm. The
figure 30.1 depicts the effect of counter-cyclical diversification.
The above figure shows that through the diversification effects, merger can produce benefits to all firms
by reducing the variability of firm’s earnings. If firm A's income generally rises when B's income
generally falls, and vice-a-versa, the fluctuation of one will tend to set off the fluctuations of the other,
thus producing a relatively level pattern of combined earnings. Indeed, there will be some diversification
effect as long as the two firm's earnings are not perfectly correlated (both rising and falling together). This
reduction in overall risk is particularly likely if the merged firms are in different lines of business.
The diversification motive is based on the proposition that if two risky projects are combined, then the
risk of combination will be less than the weighted average of the risk of these two projects. The greatest
benefit from diversification can be obtained by continuin5 firms from different industries i.e.,
conglomerate mergers, where two firms with poorly correlated cash flows merged to create a portfolio of
a firms (a conglomerate can be viewed as a portfolio of firms.
Sometimes, doubts are raised for considering diversification as a motive for merger. The real question is
whether the firm should create a portfolio of firms or the shareholders themselves can do the same by
diversifying their portfolios. In both the cases, the total risk of the shareholders is reduced. But portfolio
of firms in a conglomerate merger is costly as the acquisition of firms is a costly exercise. On the other
hand, a shareholder can easily create a diversified portfolio of firms merely by holding the shares of
diversified companies. This is much easier and cheaper than creating a portfolio of firms in conglomerate
3. Earnings Per Share (EPS): Increasing the EPS of the firm can also be a motive for the merger. A firm
can increase its EPS by acquiring another firm, which is profitable and has a low Price Earning (PE)
Ratio. Suppose, firm A and firm B have the following particulars.
Firm A Firm B
Earnings Rs.10,00,000 Rs.3,00,000
Number of shares 10,00,000 2,00,000
EPS Re.l.00 Rs.l.50
Market price Rs.20 Rs.12
PE Ratio 20 8

Now the firm A decides to acquire firm B and for this purpose evaluates three options of price offer: (i)
Rs. 12 per share of firm B (i.e., the market price); (ii) Rs. 30 per share of firm B (i.e., the EPSxExlsting
PE Ratio of firm A); and (iii) Rs. 35 per share of firm B (i.e., a price higher than EPS of B x Existing PE
Ratio of firm A). The effects of these three price options have been presented in the following table:

Situation 1 Situation 2 Situation 3

Price payable per share Rs.12 Rs.30 Rs.35
Total amount (Price x No. of shares) Rs.24,00,000 Rs.60,OO,OOO Rs.70,00,000
Issue price of firm A's shares Rs.20 Rs.20 Rs.20
No. of share issued 1,20,000 3,00,000 3,50,000
Total number of shares of firm A 11,20,000 13,00,000 13,50,000
Total earnings (after merger) Rs.13,00,000 Rs.13,00,000 Rs.13,00,OOO
EPS Rs.l.16 Rs.l.OO Re.0.96
PE Ratio of price paid (price/existing EPS) 8 20 23.3
It may be found that in situation I, when the PE Ratio of price offered is 8 (less than the PE Ratio of firm
A), the EPS of the new firm increase. When the PE Ratio of price offered is 20 (equal to the PE Ratio of
firm A), the EPS of the new firm is same as that of the old firm, and when the PE Ratio of offered price is
23.3 (i.e., more than the PE Ratio of firm A), the EPS of the new firm is reduced. Thus, it may be noted
that, subject to the PE Ratio, the increase in EPS may be a motive A for merger. So, a firm can increase in
EPS by merging another firm at a lower PE Ratio.
However, increase in EPS need not necessarily increase the market price of the share. The firm with a
lower PE Ratio might be a lower growth firm and therefore, after merger, the investor may not be willing
to pay a higher price for the new firm. The investor may reduce the PE multiple, and keep the market
price of the new firm unchanged despite the increase in EPS. Moreover, in- creasing in EPS as a motive
for merger is not a good motive at all. The primary concern of the financial manager should be to
maximize the market price of the share and not the EPS. An undue concentration on the EPS does not
benefit the shareholders.
4. Financial Synergy: Financial synergy refers to increase in the value of the firm that accrues to the
combined firm from financial factors such as better use of cash slack or tax benefit etc.
a) Cash Slack: It is a situation in which the firm has excess cash than what is needed to finance firm's
existing viable projects. It makes a sense for a company with excess cash and no investment opportunities
(known as cash slack) to take-over a cash poor firm with good investment opportunities, or vice-a-versa.
The additional value of the combined firm lies in the present value of the projects that would not have
been taken had they stayed away but can now be taken because of availability of cash.
b) Tax Benefits: Several tax benefits may accrue from take-over. First, if one of the firm has tax
deductions that it cannot use because it is incurring losses, whereas the other firm has profits on which it
pays taxes; combining the two firms can result in tax benefits that can be shared by the two firms. The
value of this synergy is the present value of the tax savings that accrue because of the merger.
Theoretically, if possible, the assets of the firm being taken-over may be written up to reflect new market
values and thus leading to higher tax savings from depreciations in coming years.
5. Corporate Control: Many hostile take-over bids are justified on the basis of existence of a value for
corporate control i.e., the investors and firms are willing to pay large premiums over the market price to
control the management of other firms. The value of getting control of a firm is inversely proportional to
the perceived quality of the existing management and its capacity to maximize the value. In general, the
value of control will be much greater for a poorly managed firm that operates at below optimum capacity
than for: well managed firm. The value of controlling a firm comes from changes that can be made to
existing policies. These changes cover several areas such as assets can be acquired or disposed off; the fi-
nancing mix can be changed; the dividend policy can be re-evaluated; and the firm can be re-constructed
to maximize the value. The value of the control can than be written as :
Value of control = Value of the firm (after re-construction)- Value of the firm (without re-construction).
The value of control is negligible for firms that are operating at or close to their optimum value, because
the re-structuring will yield little additional value. However, the value of control can be substantial for
firms that are operating at well below optimal, because re-structuring can lead to significant additional
Test Questions
Q1. Write short notes on
a) Reverse Merger
b) Hostile Take-over
c) Horizontal Merger
Q2. Certain production and operating economics can result from mergers. Explain.
Q3. What can be the motives of mergers?
Q4. What are the different ways of financing the mergers?
Q5. What tactics can be employed by a target firm to defend itself from the take-over bid?