CURRENT ASSET TO FIXED ASSET RATIO

 Current Assets to Fixed Assets Ratio

• The finance manager is required to determine the optimum level of current assets so that the shareholders’ value is maximized. 
• A firm needs fixed and current assets to support a particular level of output. 
• As the firm’s output and sales increases, the need for current assets also increases. Generally, current assets do not increase in direct proportion to output; current assets may increase at a decreasing rate with output. As the output increases, the firm starts using its current asset more efficiently. 
• The level of the current assets can be measured by creating a relationship between current assets and fixed assets. Dividing current assets by fixed assets gives current assets/fixed assets ratio. 
• Assuming a constant level of fixed assets, a higher current assets/fixed assets ratio indicates a conservative current assets policy and a lower current assets/fixed assets ratio means an aggressive current assets policy assuming all factors to be constant.
• A conservative policy implies greater liquidity and lower risk whereas an aggressive policy indicates higher risk and poor liquidity. Moderate current assets policy will fall in the middle of conservative and aggressive policies. The current assets policy of most of the firms may fall between these two extreme policies. 
• The following illustration explains the risk-return trade off of various working capital management policies, viz., conservative, aggressive and moderate.

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APPROACHES OF WORKING CAPITAL

 Approaches of working capital investment
Based on the organisational policy and risk-return trade off, working capital investment decisions are categorised into three approaches i.e. aggressive, conservative and moderate.

(a) Aggressive: Here investment in working capital is kept at minimal investment in current assets which means the entity does hold lower level of inventory, follow strict credit policy, keeps less cash balance etc. The advantage of this approach is that lower level of fund is tied in the working capital which results in lower financial costs but the flip side could be that the organisation could not grow which leads to lower utilisation of fixed assets and long term debts. In the long run firm stay behind the competitors.

(b) Conservative: In this approach of organisation use to invest high capital in current assets. Organisations use to keep inventory level higher, follows liberal credit policies, and cash balance as high as to meet any current liabilities immediately. The advantage of this approach are higher sales volume, increased demand due to liberal credit policy and increase goodwill among the suppliers due to payment in short time. The disadvantages are increase cost of capital, higher risk of bad debts, shortage of liquidity in long run to longer operating cycles.

(c)Moderate: This approach is in between the above two approaches. Under this approach a balance between the risk and return is maintained to gain more by using the funds in very efficient manner.

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INVESTMENT OF WORKING CAPITAL

Investment of working capital:

How much to be invested in current assets as working capital is a matter of policy decision by an entity. It has to be decided in the light of organisational objectives, trade policies and financial (cost-benefit) considerations. There is not set rules for deciding the level of investment in working capital. Some organisations due to its peculiarity require more investment than others. For example, an infrastructure development company requires more investment in its working capital as there may be huge inventory in the form of work in process on the other hand a company which is engaged in fast food business, comparatively requires less investment. Hence, level of investment depends on the various factors listed below:

(a) Nature of Industry: Construction companies, breweries etc. requires large investment in working capital due long gestation period.

(b) Types of products: Consumer durable has large inventory as compared to perishable products.

(c) Manufacturing Vs Trading Vs Service: A manufacturing entity has to maintain three levels of inventory i.e. raw material, work-in-process and finished goods whereas a trading and a service entity has to maintain inventory only in the form of trading stock and consumables respectively.

(d) Volume of sales: Where the sales are high, there is a possibility of high receivables as well.

(e) Credit policy: An entity whose credit policy is liberal has not only high level of receivables but requires more capital to fund raw material purchases. 

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DETERMINANTS OF WORKING CAPITAL

DETERMINANTS OF WORKING CAPITAL
Working capital management is concerned with:-

a) Maintaining adequate working capital (management of the level of individual current assets and the current liabilities) and

b) Financing of the working capital.

For the point a) above, a Finance Manager needs to plan and compute the working capital requirement for its business. And once the requirement has been computed he needs to ensure that it is financed properly. This whole exercise is nothing but Working Capital Management.
Sound financial and statistical techniques, supported by judgment should be used to predict the quantum of working capital required at different times.

Some of the factors which need to be considered while planning for working capital requirement are:-

1. Cash – Identify the cash balance which allows for the business to meet day-to- day expenses, but reduces cash holding costs.

2. Inventory – Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and hence increases cash flow; the techniques like Just in Time (JIT) and Economic order quantity (EOQ) are used for this.

3. Receivables – Identify the appropriate credit policy, i.e., credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa). The tools like Discounts and allowances are used for this.

4. Short-term Financing Options – Inventory is ideally financed by credit granted by the supplier; dependent on the cash conversion cycle, it may however, be necessary to utilize a bank loan (or overdraft), or to “convert debtors to cash” through “factoring” in order to finance working capital requirements.

5. Nature of Business - For e.g. in a business of restaurant, most of the sales are in Cash. Therefore need for working capital is very less.

6. Market and Demand Conditions - For e.g. if an item’s demand far exceeds its production, the working capital requirement would be less as investment in finished goods inventory would be very less.

7. Technology and Manufacturing Policies - For e.g. in some businesses the demand for goods is seasonal, in that case a business may follow a policy for steady production through out over the whole year or instead may choose policy of production only during the demand season.

8. Operating Efficiency – A company can reduce the working capital requirement by eliminating waste, improving coordination etc.

9. Price Level Changes – For e.g. rising prices necessitate the use of more funds for maintaining an existing level of activity. For the same level of current assets, higher cash outlays are required. Therefore the effect of rising prices is that a higher amount of working capital is required.

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OPTIMUM WORKING CAPITAL

 Optimum Working Capital

• If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that want their money quickly.
• Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it) has traditionally been considered the best indicator of the working capital situation. 
• It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm has an optimum amount of working capital. This is supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one). Thus it is considered that there is a comfortable liquidity position if liquid current assets are equal to current liabilities. 
• Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have, for years, considered the current ratio at ‘two’ and the acid test ratio at ‘one’ as indicators of a good working capital situation. As a thumb rule, this may be quite adequate. 
• However, it should be remembered that optimum working capital can be determined only with reference to the particular circumstances of a specific situation. Thus, in a company where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound. 
• In nutshell, a firm should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous.

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IMPORTANCE OF ADEQUATE WORKING CAPITAL

 Importance of Adequate Working Capital

Management of working capital is an essential task of the finance manager. He has to ensure that the amount of working capital available with his concern is neither too large nor too small for its requirements.

A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to pay huge amount as interest on such funds.

If the firm has inadequate working capital, such firm runs the risk of insolvency. Paucity of working capital may lead to a situation where the firm may not be able to meet its liabilities.

The various studies conducted by the Bureau of Public Enterprises have shown that one of the reasons for the poor performance of public sector undertakings in our country has been the large amount of funds locked up in working capital. This results in over capitalization. Over capitalization implies that a company has too large funds for its requirements, resulting in a low rate of return, a situation which implies a less than optimal use of resources. A firm, therefore, has to be very careful in estimating its working capital requirements.

Maintaining adequate working capital is not just important in the short-term. Sufficient liquidity must be maintained in order to ensure the survival of the business in the long- term as well. When businesses make investment decisions they must not only consider the financial outlay involved with acquiring the new machine or the new building, etc., but must also take account of the additional current assets that are usually required with any expansion of activity. For e.g.:-

•  Increased production leads to holding of additional stocks of raw materials and work-in-progress. 
• An increased sale usually means that the level of debtors will increase. 
• A general increase in the firm’s scale of operations tends to imply a need for greater levels of working capital. 

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MEANING AND CONCEPT OF WORKING CAPITAL

MEANING AND CONCEPT OF WORKING CAPITAL

In accounting term working capital is the difference between the current assets and current liabilities. If we break down the components of working capital we will found working capital as follows:

               Working Capital = Current Assets – Current Liabilities

Current Assets: An asset is classified as current when:

(i) It is expected to be realised or intends to be sold or consumed in normal operating cycle of the entity;

(ii) The asset is held primarily for the purpose of trading;

(iii) It is expected to be realised within twelve months after the reporting period;

(iv) It is non- restricted cash or cash equivalent.

Generally current assets of an entity, for the purpose of working capital management can be grouped into the following main heads:

(a) Inventory (raw material, work in process and finished goods)

(b) Receivables (trade receivables and bills receivables)

(c) Cash or cash equivalents (short-term marketable securities)

(d) Prepaid expenses

Current Liabilities: A liability is classified as current when:

(i) It is expected to be settled in normal operating cycle of the entity.

(ii) The liability is held primarily for the purpose of trading

(iii) It is expected to be settled within twelve months after the reporting period

 Generally current liabilities of an entity, for the purpose of working capital management can be grouped into the following main heads:

(a) Payable (trade payables and bills receivables)

(b) Outstanding payments (wages & salary etc.)

In general Working capital management is essentially managing Current Assets management of working capital arises as a part of the process of such management.

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REASONS FOR LEASING

REASONS FOR LEASING/ADVANTAGES OF LEASING

(1) Lease may be low cost alternative: Leasing is alternative to purchasing. As the lessee is to make a series of payments for using an asset, a lease arrangement is similar to a debt contract. The benefit of lease is based on a comparison between leasing and buying an asset. Many lessees find lease more attractive because of low cost. For example – you are transferred to another city for 6 months. For daily travel you need a car. If you buy car in your own name then as per Motor Vehicles Act you have to pay one time road tax and incur other expenses besides cost of car. You can always sell the car after 6 months before leaving. It may be economical to take a car on lease for 6 months as lease rental may be less than net cash outflow arising from difference between total cost of the car and sale value you realise.

(2) Tax benefit: In certain cases tax benefit of depreciation available for owning an asset may be less than that available for lease payment. In other words, differential tax treatment between owning an asset and taking it on lease may result in a decision in favour of lease. For example – if a firm owns an asset, it gets tax saving for depreciation on book value as per the I-T law ( in case of MAT, depreciation on the book value is as per the depreciation schedule of the Companies Act, 2013, based on useful life), but in case of lease rent entire lease rental is tax deductible. In some cases this differential tax treatment means a higher tax savings for lease, implying lease is a smarter decision subject to other factors.

(3) Working capital conservation: When a firm buy an equipment by borrowing from a bank (or financial institution), they never provide 100% financing. Depending upon the firm’s credit rating bank may finance 75% or 60% (say) of total cost of equipment. The rest 25% or 40% (as the case may be), the firm has to bring in – the amount that the firm provides as down payment from its own source is called margin money. Margin money requirement naturally reduces firm’s working capital (and liquidity). In case of high value asset the amount may be substantial having an adverse impact on operation. But in case of lease one gets normally 100% financing in the sense that one needn’t bring in margin money generally for taking an asset on lease. This enables conservation of working capital.

(4) Preservation of Debt Capacity: As per the accounting standard operating lease is not capitalised in the books of the lessee. Operating lease payment is treated as expenditure in the profit and loss account. Neither the asset taken on lease appears as asset nor does the liability representing present value of future lease payment (cost of leased asset) appear as liability in the balance sheet. That is, operating lease doesn’t have any balance sheet impact. So, operating lease does not matter in computing debt equity ratio. This enables the lessee to go for debt financing more easily. The access to and ability of a firm to get debt financing is called debt capacity (also, reserve debt capacity). Operating lease, if it is properly structured, can work efficiently as a substitute of debt though there may hardly be any difference between the two in respect of regular cash out flow; but at the same time it keeps the debt capacity in fact.

However, it is to be noted the above preservation of debt capacity is not generally applicable for finance lease as the present value of future lease payment (cost of leased asset) appears as liability in the balance sheet of the lessee and to be duly considered in calculating debt equity ratio.

(5) Obsolescence and Disposal: After purchase of leased asset there may take place technological obsolescence of the asset. That means a technologically upgraded asset with better capacity may come into existence after purchase. To retain competitive advantage the lessee as user may have to go for the upgraded asset. The obsolete old asset may fetch a small portion of the book value upon disposal resulting in capital loss. In case of cancellable operating lease the lessee can terminate the contract in such circumstances. However, it is to be kept in mind that where there is a possibility of technological obsolescence the lessor will cover the risk by fixing a higher lease rental.

(6) Restrictive Conditions for Debt Financing: When a company takes loan to purchase equipment (say), in the loan agreement lender may impose several restrictions on the borrower company to protect his interest. Apart from creating charge on the equipment purchased ( primary security), lender may ask for collateral securities on other assets, like -mortgage of landed property, pledging fixed deposit receipts with the bank, asking for guarantor etc. The lender can impose other conditions too - like restriction on payment of dividend, putting lender’s representative on the board to ensure proper utilization of fund etc. In case of lease such tight conditions are not imposed as lessor remains the owner of the asset legally and he can recover the asset if the lessee fails to abide by the lease terms and conditions.

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CLASSIFICATION OF FINANCIAL LEASE

 Classification of Financial Lease
(i) Tax-oriented Lease: In financial lease, we have pointed out that risk and reward of ownership are substantially transferred to lessee in economic sense. Nevertheless in a financial lease if the lessor is considered as the owner of the asset for claiming tax benefit of depreciation, then the financial lease is considered as ‘tax -oriented lease’. Deduction of depreciation from lease rental reduces profit of lessor which is then subjected to tax. In other words, depreciation reduces the tax burden. Depreciation is a non-cash expenditure that results in ‘tax saving’. Putting differently we can say there is a cash inflow arising out of tax saving due to depreciation. This is a genuine benefit that arises from depreciation being a tax deductible non-cash expenditure. The lesser can pass on a part of depreciation benefit to the lessee making the arrangement attractive for the lessee. This enhances the competitive advantage of the lessor. If in place of lessor, lessee is entitled to claim depreciation for tax purpose then it is not a ‘tax oriented lease’. In that case, the tax treatment will be same as that of owning an asset through borrowing.

Depreciation benefit of tax is of paramount importance in lease versus buy decision in determining cash flow implication to the lessor and lessee and the subsequent value of the lease to the respective parties.

(ii) Leveraged Lease: A leveraged lease is tax oriented lease where the lessor borrows substantial amount from the lender to purchase the asset he leases. But an arrangement is made in such a way through tripartite agreement between the lender ( financier of the leased asset), lessor and the lessee , so that, in case of default of payment of lease rental by the lessee , the lessor is not liable to make loan repayment to the lender. Instead of lessor, the lender has to take appropriate steps to recover the loan instalments due on loan to purchase the leased asset from the lessee. Leveraged lease is a complicated arrangement and normally entered in case of very high value transactions.

(iii) Sale and Lease Back: It is arrangement under which an entity sells the asset to another party and simultaneously takes it back from the other party under a lease arrangement.

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SIGNIFICANT FEATURES OF FINANCE LEASE

 The significant features of finance lease are :

•  Lease rental over the lease period covers the cost of leased asset plus a return on investment made by the lessor for the leased asset.
•  Though the lesser may continue to remain the legal owner of the asset, but for all practical purposes (i.e. in substance), risk and reward associated with ownership is substantially transferred to the lessee since the inception of the lease. 
• The lessee bears the maintenance cost, insurance and taxes of the asset. 
•  Under the lease agreement, the lessee is not entitled to cancel or terminate the lease except at a very high penalty. This means lessee must pay the lease instalment otherwise lessor will sue him for nonpayment of unpaid instalments with cost and damage in the capacity of a creditor.

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FINANCE LEASE

Finance Lease (Capital Lease)
Under finance lease the lease rental is fixed in such a manner that the lessor recovers the entire price of the leased equipment plus a return on investment ( made for purchasing the equipment leased) within the lease period through lease rent. In such a situation the lessee normally retains the possession of the equipment even after the lease period is over as he pays the price of the equipment. In this case, in substance there is no difference between – ‘borrow to buy’ and lease. Example 3 will clarify the matter.

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EXAMPLE OF OPERATING LEASE

EXAMPLE OF OPERATING LEASE

Example 2 : Suppose in example 1 above, the cost of the car given on lease by X rental is ` 20 lacs. The economic life of the car is 8 years - implying that the car will create cash flow for next 8 years. Now, from the lease rental for 2 years total recovery will be ` 600,000 (` 25000 X 12X 2). In 2 years’ lease cost of car remains unrecovered. The economic life of the asset is far more so that the cost can be recovered by further leasing or selling the car. Hence, this is an example of operating lease.

The significant features of operating lease are :

•  Payments by way of lease rental over the period of lease are not enough to cover the cost of leased asset. 
•  The lesser generally takes back the possession of the asset on the expiry of the lease period. 
•  The lesser bears the cost of insurance, maintenance, tax etc. of the leased asset 
•  The lessee has the right to cancel the lease before the expiry of the lease term. 
• The lessor remains the owner of the asset in the legal and economic sense (in substance). 
•  Operating lease is always a tax oriented lease.

OPERATING LEASE

Operating Lease

• If under the lease agreement the lessor is entitled to take back the possession of the asset leased from the lessee – the arrangement is considered as operating lease. Operating lease is a genuine lease where ownership for tax and accounting purpose remains with the owner.
•  When ownership remains with the owner for tax purpose then the lease is called tax oriented lease. Tax orientation has a significant importance in determining and measuring cash flow impact of lease transactions and their valuation.
•  Operating lease is always a tax oriented lease. Under lease agreement lessor is required to maintain and service the leased asset. A common example is licensing agreement of flats in big cities. Under the agreement the landlord leases his (her) flat for eleven months for monthly rental renewable at the option of the landlord after the expiry of eleven months. 
• The landlord bears the cost of maintenance and service (security, lift etc). An important feature of operating lease is - lease period is sufficiently less than the economic life of the asset. This means total lease rental recovered based on the lease period is substantially less than the cost of the asset.

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LEASE VS. HIRE PURCHASE

 Lease Vs Hire Purchase

Hire-purchase transaction is also almost similar to a lease transaction with the basic difference that the person using the asset on hire-purchase basis is the owner of the asset and full title is transferred to him after he has paid the agreed installments. The asset will be shown in his balance sheet and he can claim depreciation and other allowances on the asset for computation of tax during the currency of hire-purchase agreement and thereafter.

In a lease transaction, however, the ownership of the equipment always vests with the lessor and lessee only gets the right to use the asset. Depreciation and other allowances on the asset will be claimed by the lessor and the asset will also be shown in the balance sheet of the lessor. The lease money paid by the lessee can be charged to his Profit and Loss Account. However, the asset as such will not appear in the balance sheet of the lessee. Such asset for the lessee is, therefore, called off the balance sheet asset.

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PARTIES TO A LEASE AGREEMENT

 Parties to a Lease Agreement

There are two principal parties to any lease transaction as under:

• Lessor : Who is actual owner of equipment permitting use to the other party on payment of periodical amount.

• Lessee : Who acquires the right to use the equipment on payment of periodical amount.

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WHAT IS LEASE?

 What is lease

Lease can be defined as a right to use equipment or capital goods on payment of periodical amount. This may broadly be equated to an instalment credit being extended to the person using the asset by the owner of capital goods with small variation.

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CONCEPT OF LEASING

 Concept of Leasing

• From the standpoint of finance, assets are acquired to generate cashflow. Finance executives or managers understand that the cash flows are generated by use of assets and not by owning them (the assets). Almost any asset that can be bought (sold) can also be taken (given) on lease. For example, a firm having a factory 20 km away from Nagpur city requires a couple of buses for transportation of staff from city to the factory site. The firm can either purchase the buses by using its own fund (equity financing) or by taking loan from bank (debt financing) or partly by own fund and partly by loan (equity and loan financing). Alternatively, the firm can take the buses on lease.
•  Therefore, lease is nothing but an alternative financing arrangement. More specifically, lease is a financing decision. First, a firm has to make an investment decision in an asset that will generate cash flow. After that the finance manager has to decide whether the asset is to be bought by using internal fund or borrowing or by both or by taking the asset on lease. 

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STEPS OF CAPITAL BUDGETING PROCEDURE

 Steps of Capital Budgeting Procedure
1. Estimation of Cash flows over the entire life for each of the projects under consideration.

2. Evaluate each of the alternative using different decision criteria.

3. Determining the minimum required rate of return (i.e. WACC) to be used as Discount rate.

Accordingly, this chapter is divided into two section

1. Estimation of Cash Flows

2. Capital Budgeting Techniques

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TYPES OF CAPITAL INVESTMENT DECISIONS

TYPES OF CAPITAL INVESTMENT DECISIONS

On the basis of decision situation

The capital budgeting decisions on the basis of decision situation are classified as follows:

(i) Mutually exclusive decisions : The decisions are said to be mutually exclusive if two or more alternative proposals are such that the acceptance of one proposal will exclude the acceptance of the other alternative proposals. For instance, a firm may be considering proposal to install a semi-automatic or highly automatic machine. If the firm installs a semi-automatic machine it excludes the acceptance of proposal to install highly automatic machine.

(ii) Accept-reject decisions : The accept-reject decisions occur when proposals are independent and do not compete with each other. The firm may accept or reject a proposal on the basis of a minimum return on the required investment. All those proposals which give a higher return than certain desired rate of return are accepted and the rest are rejected.

(iii) Contingent decisions : The contingent decisions are dependable proposals. The investment in one proposal requires investment in one or more other proposals. For example, if a company accepts a proposal to set up a factory in remote area it may have to invest in infrastructure also e.g. building of roads, houses for employees etc.

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TYPES OF CAPITAL INVESTMENT DECISIONS(ON THE BASIS OF FIRM'S EXISTENCE)

TYPES OF CAPITAL INVESTMENT DECISIONS

 On the basis of firm’s existence
The capital budgeting decisions are taken by both newly incorporated firms as well as by existing firms. The new firms may be required to take decision in respect of selection of a plant to be installed. The existing firm may be required to take decisions to meet the requirement of new environment or to face the challenges of competition. These decisions may be classified as follows:

(i) Replacement and Modernisation decisions : The replacement and modernisation decisions aim at to improve operating efficiency and to reduce cost. Generally, all types of plant and machinery require replacement either because of the economic life of the plant or machinery is over or because it has become technologically outdated. The former decision is known as replacement decisions and latter is known as modernisation decisions. Both replacement and modernisation decisions are called cost reduction decisions.

(ii) Expansion decisions : Existing successful firms may experience growth in demand of their product line. If such firms experience shortage or delay in the delivery of their products due to inadequate production facilities, they may consider proposal to add capacity to existing product line.

(iii) Diversification decisions : These decisions require evaluation of proposals to diversify into new product lines, new markets etc. for reducing the risk of failure by dealing in different products or by operating in several markets.

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CAPITAL BUDGETING PROCESS

CAPITAL BUDGETING PROCESS
The extent to which the capital budgeting process needs to be formalised and systematic procedures established depends on the size of the organisation; number of projects to be considered; direct financial benefit of each project considered by itself; the composition of the firm’s existing assets and management’s desire to change that composition; timing of expenditures associated with the projects that are finally accepted.

(i) Planning : The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firm’s fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. Opportunities having little merit are rejected and promising opportunities are advanced in the form of a proposal to enter the evaluation phase.

(ii) Evaluation : This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple payback method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique selected should be the one that enables the manager to make the best decision in the light of prevailing circumstances.

(iii) Selection : Considering the returns and risks associated with the individual projects as well as the cost of capital to the organisation, the organisation will choose among projects so as to maximise shareholders’ wealth.

(iv) Implementation : When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project.

(v) Control : The progress of the project is monitored with the aid of feedback reports. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits.

(vi) Review : When a project terminates, or even before, the organisation should review the entire project to explain its success or failure. This phase may have implication for firms planning and evaluation procedures. Further, the review may produce ideas for new proposals to be undertaken in the future.

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CAPITAL BUDGETING

PURPOSE OF CAPITAL BUDGETING
The capital budgeting decisions are important, crucial and critical business decisions due to following reasons:

(i) Substantial expenditure : Investment decisions are related with fulfilment of long term objectives and existence of an organization. To invest in a project or projects, a substantial capital investment is required. Based on size of capital and timing of cash flows, sources of finance are selected. Due to huge capital investments and associated costs, it is therefore necessary for an entity to make such decisions after a thorough study and planning.

(ii) Long time period : The capital budgeting decision has its effect over a long period of time. These decisions not only affect the future benefits and costs of the firm but also influence the rate and direction of growth of the firm.

(iii) Irreversibility : Most of the investment decisions are irreversible. Once the decision implemented it is very difficult and reasonably and economically not possible to reverse the decision. The reason may be upfront payment of amount, contractual obligations, technological impossibilities etc.

(iv) Complex decision : The capital investment decision involves an assessment of future events, which in fact is difficult to predict. Further it is quite difficult to estimate in quantitative terms all the benefits or the costs relating to a particular investment decision.

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INVESTMENT DECISIONS

 INTRODUCTION (INVESTMENT DECISIONS)
In the first chapter we have discussed the three important functions of financial management which were Investment Decisions, Financing Decisions and Dividend Decisions. So far we have studied Financing decisions in previous chapters. In this chapter we will discuss the second important decision area of financial management which is Investment Decision. Investment decision is concerned with optimum utilization of fund to maximize the wealth of the organization and in turn the wealth of its shareholders. Investment decision is very crucial for an organization to fulfil its objectives; in fact, it generates revenue and ensures long term existence of the organization. Even the entities which exists not for profit are also required to make investment decision though not to earn profit but to fulfil its mission.

As we have seen in the financing decision chapters that each rupee of capital raised by an entity bears some cost, commonly known as cost of capital. It is necessary that each rupee raised is to be invested in a very prudent manner. It requires a proper planning for capital, and it is done through a proper budgeting. A proper budgeting requires all the characteristics of budget. Due to this feature, investment decisions are very popularly known as Capital Budgeting, that means applying the principles of budgeting for capital investment.

In simple terms, Capital Budgeting involves: -

•  Identification of investment projects that are strategic to business overall objectives;
•  Estimating and evaluating post-tax incremental cash flows for each of the investment proposals; and
•  Selection an investment proposal that maximizes the return to the investors.

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FEATURES OF DEBENTURES OR BONDS

 Features of debentures or bonds:

(i) Face Value: Debentures or Bonds are denominated with some value; this denominated value is called face value of the debenture. Interest is calculated on the face value of the debentures. E.g. If a company issue 9% Non- convertible debentures of ` 100 each, this means the face value is ` 100 and the interest @ 9% will be calculated on this face value.

(ii) Interest (Coupon) Rate: Each debenture bears a fixed interest (coupon) rate (except Zero coupon bond and Deep discount bond). Interest (coupon) rate is applied to face value of debenture to calculate interest, which is payable to the holders of debentures periodically.

(iii) Maturity period: Debentures or Bonds has a fixed maturity period for redemption. However, in case of irredeemable debentures maturity period is not defined and it is taken as infinite.

(iv) Redemption Value: Redeemable debentures or bonds are redeemed on its specified maturity date. Based on the debt covenants the redemption value is determined. Redemption value may vary from the face value of the debenture.

(v) Benefit of tax shield: The payment of interest to the debenture holders are allowed as expenses for the purpose of corporate tax determination. Hence, interest paid to the debenture holders save the tax liability of the company. 

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COST OF LONG TERM DEBT

COST OF LONG TERM DEBT

External borrowings or debt instruments do not confers ownership to the providers of finance. The providers of the debt fund do not participate in the affairs of the company but enjoys the charge on the profit before taxes. Long term debt includes long term loans from the financial institutions, capital from issuing debentures or bonds etc. (In the next chapter we will discuss in detail about the sources of long term debt.).

As discussed above the external borrowing or debt includes long term loan from financial institutions, issuance of debt instruments like debentures or bonds etc. The calculation of cost of loan from a financial institution is similar to that of redeemable debentures. Here we confine our discussion of cost debt to Debentures or Bonds only.

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DETERMINATION OF THE COST OF CAPITAL

DETERMINATION OF THE COST OF CAPITAL
The cost of capital can either be explicit or implicit. The cash outflow of an entity towards the utilization of capital which is clear and obvious is termed as explicit cost of capital. These outflows may be interest payment to debenture holders, repayment of principal amount to financial institution or payment of dividend to shareholders etc. On the other hand Implicit cost is the cost which is actually not a cash outflow but it is an opportunity loss of foregoing a better investment opportunity by choosing an alternative option. An entrepreneur for example, uses its bank deposits which earns interest @ of 9% p.a. for the business purpose. Using its bank deposits for business purpose means forgoing interest earnings from the bank on this deposit. The cost of capital in this case will be 9% interest that could have been earned by not investing the deposit for the business purpose. This opportunity loss of 9% is called implicit cost capital or opportunity cost.

The two factors which are considered to determine the cost of capital are:

(i) Source of Finance

(ii) Reciprocal payment of the using finance.

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SIGNIFICANCE OF THE COST OF CAPITAL

SIGNIFICANCE OF THE COST OF CAPITAL

The cost of capital is important to arrive at correct amount and helps the management or an investor to take an appropriate decision. The correct cost of capital helps in the following decision making:

(i) Evaluation of investment options: The estimated benefits (future cashflows) from available investment opportunities (business or project) are converted into the present value of benefits by discounting them with the relevant cost of capital. Here it is pertinent to mention that every investment option may have different cost of capital hence it is very important to use the cost of capital which is relevant to the options available. Here Internal Rate of Return (IRR) is treated as cost of capital for evaluation of two options (projects).

(ii) Performance Appraisal: Cost of capital is used to appraise the performance of a particulars project or business. The performance of a project or business in compared against the cost of capital which is known here as cut-off rate or hurdle rate.

(iii) Designing of optimum credit policy: While appraising the credit period to be allowed to the customers, the cost of allowing credit period is compared against the benefit/ profit earned by providing credit to customer of segment of customers. Here cost of capital is used to arrive at the present value of cost and benefits received.

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MEANING OF COST CAPITAL

 MEANING OF COST OF CAPITAL
Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and the debt-holders) to the business as a compensation for their contribution to the total capital. When an entity (corporate or others) procured finances from either sources as listed above, it has to pay some additional amount of money besides the principal amount. The additional money paid to these financiers may be either one off payment or regular payment at specified intervals. This additional money paid is said to be the cost of using the capital and it is called the cost of capital. This cost of capital expressed in rate is used to discount/ compound the cashflow or stream of cashflows. Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc. It is used as a benchmark for:

•  Framing debt policy of a firm.
•  Educating Capital budgeting decisions.

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INTRODUCTION (COST OF CAPITAL)

INTRODUCTION (COST OF CAPITAL)
The cost of capital i.e. cost of having capital for long period from different sources of finance. Generally the sources of finance for non corporate entity could be either internal (savings, investments in current and non-current assets etc.) or external borrowings (loan from financial institutions, local borrowings etc.).

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DIFFERENCE BETWEEN EQUITY SHARE AND PREFERENCE SHARE

Difference between Equity share and Preference are as follows:

Sl. No.	Basis of Distinction	Equity Share	Preference Share
1	Preference dividend	Equity Dividend is paid after preference dividend.	Payment of preference dividend is preferred over equity dividend
2	Rate of dividend	Fluctuating	Fixed
3	Convertibility	Not convertible	Convertible
4	Voting rights	Equity      shareholders enjoy voting rights	They do not have vot- ing rights

ADVANTAGES/DISADVANTAGES OF RAISING FUNDS BY ISSUE OF PREFERENCE SHARES

Advantages and disadvantages of raising funds by issue of preference shares are:

(i) No dilution in EPS on enlarged capital base - If equity is issued it reduces EPS, thus affecting the market perception about the company.

(ii) There is leveraging advantage as it bears a fixed charge. Non-payment of preference dividends does not force company into liquidity.

(iii) There is no risk of takeover as the preference shareholders do not have voting rights except in case where dividend arrears exist.

(iv) The preference dividends are fixed and pre-decided. Hence preference shareholders do not participate in surplus profits as the ordinary shareholders.

(v) Preference capital can be redeemed after a specified period.

VARIOUS TYPES OF PREFERENCE SHARES

Various types of Preference shares can be as below:

Sl. No.	Type of Preference Shares	Salient Features
1	Cumulative	Arrear Dividend will accumulative
2	Non-cumulative	No right to arrear dividend
3	Redeemable	Redemption should be done
4	Participating	Participate also in the surplus of firm
5	Non- Participating	Over fixed rate of Dividend
6	Convertible	Option of Convert into equity Shares

PREFERENCE SHARE CAPITAL

 Preference Share Capital

 These area special kind of shares; the holders of such shares enjoy priority, both as regards to the payment of a fixed amount of dividend and also towards repayment of capital on winding up of the company. Some of the characteristics of Preference Share Capital are:-

•  Long-term funds from preference shares can be raised through a public issue of shares.
•  Such shares are normally cumulative, i.e., the dividend payable in a year of loss gets carried over to the next year till there are adequate profits to pay the cumulative dividends. 
• The rate of dividend on preference shares is normally higher than the rate of interest on debentures, loans etc. 
•  Most of preference shares these days carry a stipulation of period and the funds have to be repaid at the end of a stipulated period. 
•  Preference share capital is a hybrid form of financing which imbibes within itself some characteristics of equity capital and some attributes of debt capital. It is similar to equity because preference dividend, like equity dividend is not a tax deductible payment. It resembles debt capital because the rate of preference dividend is fixed. 
•  Cumulative Convertible Preference Shares (CCPs) may also be offered, under which the shares would carry a cumulative dividend of specified limit for a period of say three years after which the shares are converted into equity shares. These shares are attractive for projects with a long gestation period. 
•  Preference share capital may be redeemed at a pre decided future date or at an earlier stage inter  out of the profits of the company. This enables the promoters to withdraw their capital from the company which is now self- sufficient, and the withdrawn capital may be reinvested in other profitable ventures.

DISADVANTAGES OF RAISING FUNDS BY ISSUE OF EQUITY SHARES

Disadvantages of raising funds by issue of equity shares are:
Apart from the above mentioned advantages, equity capital has some disadvantages to the company when compared with other sources of finance. These are as follows:

(i) The cost of ordinary shares is higher because dividends are not tax deductible and also the floatation costs of such issues are higher.

(ii) Investors find ordinary shares riskier because of uncertain dividend payments and capital gains.

(iii) The issue of new equity shares reduces the earning per share of the existing shareholders until and unless the profits are proportionately increased.

(iv) The issue of new equity shares can also reduce the ownership and control of the existing shareholders.

ADVANTAGES OF RAISING FUNDS BY ISSUE OF EQUITY SHARES

Advantages of raising funds by issue of equity shares are:

(i) It is a permanent source of finance. Since such shares are not redeemable, the company has no liability for cash outflows associated with its redemption.

(ii) Equity capital increases the company’s financial base and thus helps further the borrowing powers of the company.

(iii) The company is not obliged legally to pay dividends. Hence in times of uncertainties or when the company is not performing well, dividend payments can be reduced or even suspended.

(iv) The company can make further issue of share capital by making a right issue.

OWNERS CAPITAL OR EQUITY CAPITAL

 Owners Capital or Equity Capital
A public limited company may raise funds from promoters or from the investing public by way of owner’s capital or equity capital by issuing ordinary equity shares. Some of the characteristics of Owners/Equity Share Capital are:-

•  It is a source of permanent capital. The holders of such share capital in the company are called equity shareholders or ordinary shareholders. 
•  Equity shareholders are practically owners of the company as they undertake the highest risk.
•  Equity shareholders are entitled to dividends after the income claims of other stakeholders are satisfied. The dividend payable to them is an appropriation of profits and not a charge against profits. 
•  In the event of winding up, ordinary shareholders can exercise their claim on assets after the claims of the other suppliers of capital have been met. 
•  The cost of ordinary shares is usually the highest. This is due to the fact that such shareholders expect a higher rate of return (as their risk is the highest) on their investment as compared to other suppliers of long-term funds. 
•  Ordinary share capital also provides a security to other suppliers of funds. Any institution giving loan to a company would make sure the debt-equity ratio is comfortable to cover the debt. There can be various types of equity shares like New issue, Rights issue, Bonus Shares, Sweat Equity.

LONG TERM SOURCES OF FINANCE

LONG-TERM SOURCES OF FINANCE

There are different sources of funds available to meet long term financial needs of the business. These sources may be broadly classified into:

•  Share capital (both equity and preference) & 
•  Debt (including debentures, long term borrowings or other debt instruments).

FINANCIAL NEEDS OF A BUSINESS

FINANCIAL NEEDS AND SOURCES OF FINANCE OF A BUSINESS 

Financial Needs of a Business

Business enterprises need funds to meet their different types of requirements. All the financial needs of a business may be grouped into the following three categories:

(i) Long-term financial needs: Such needs generally refer to those requirements of funds which are for a period exceeding 5-10 years. All investments in plant, machinery, land, buildings, etc., are considered as long term financial needs. Funds required to finance permanent or hard core working capital should also be procured from long term sources.

(ii) Medium-term financial needs: Such requirements refer to those funds which are required for a period exceeding one year but not exceeding 5 years. For example, if a company resorts to extensive publicity and advertisement campaign then such type of expenses may be written off over a period of 3 to 5 years. These are called deferred revenue expenses and funds required for these are classified in the category of medium term financial needs.

(iii) Short- term financial needs: Such type of financial needs arises to finance current assets such as stock, debtors, cash, etc. Investment in these assets is known as meeting of working capital requirements of the concern. The main characteristic of short term financial needs is that they arise for a short period of time not exceeding the accounting period. i.e., one year.

FINANCIAL DISTRESS AND INSOLVENCY

FINANCIAL DISTRESS AND INSOLVENCY

• There are various factors like price of the product/ service, demand, price of inputs e.g. raw material, labour etc., which is to be managed by an organisation on a continuous basis. Proportion of debt also need to be managed by an organisation very delicately. 
• Higher debt requires higher interest and if the cash inflow is not sufficient then it will put lot of pressure to the organisation. Both short term and long term creditors will put stress to the firm. If all the above factors are not well managed by the firm, it can create situation known as distress, so financial distress is a position where Cash inflows of a firm are inadequate to meet all its current obligations.
•  Now if distress continues for a long period of time, firm may have to sell its asset, even many times at a lower price. Further when revenue is inadequate to revive the situation, firm will not be able to meet its obligations and become insolvent. 
• So, insolvency basically means inability of a firm to repay various debts and is a result of continuous financial distress.

ROLE OF FINANCE EXECUTIVE

ROLE OF FINANCE EXECUTIVE

Modern financial management has come a long way from the traditional corporate finance. As the economy is opening up and global resources are being tapped, the opportunities available to finance managers virtually have no limits.

A new era has ushered during the recent years for chief financial officers in different organisation to finance executive is known in different name, however their role and functions are similar. His role assumes significance in the present day context of liberalization, deregulation and globalisation.

To sum it up, the finance executive of an organisation plays an important role in the company’s goals, policies, and financial success. His responsibilities include:

(a) Financial analysis and planning: Determining the proper amount of funds to employ in the firm, i.e. designating the size of the firm and its rate of growth.

(b) Investment decisions: The efficient allocation of funds to specific assets.

(c) Financing and capital structure decisions: Raising funds on favourable terms as possible i.e. determining the composition of liabilities.

(d) Management of financial resources (such as working capital).

(e) Risk management: Protecting assets.

WEALTH / VALUE MAXIMISATION

 Wealth / Value Maximisation

We will first like to define what is Wealth / Value Maximization Model. Shareholders wealth are the result of cost benefit analysis adjusted with their timing and risk i.e. time value of money.

So,

       Wealth = Present value of benefits – Present Value of Costs
It is important that benefits measured by the finance manager are in terms of cash flow. Finance manager should emphasis on Cash flow for investment or financing decisions not on Accounting profit. The shareholder value maximization model holds that the primary goal of the firm is to maximize its market value and implies that business decisions should seek to increase the net present value of the economic profits of the firm. So for measuring and maximising shareholders wealth finance manager should follow:

•  Cash Flow approach not Accounting Profit
•  Cost benefit analysis
•  Application of time value of money.

How do we measure the value/wealth of a firm? According to Van Horne, “Value ofa firm is representedby the marketpriceof the company’s common stock. The market price of a firm’s stock represents the focal judgment of all market participants as to what the value of the particular firm is. It takes into account present and prospective future earnings per share, the timing and risk of these earnings, the dividend policy of the firm and many other factors that bear upon the market price of the stock. The market price serves as a performance index or report card of the firm’s progress. It indicates how well management is doing on behalf of stockholders