CHAPTER I

Financial Management : Introduction

SECTION A
Define Financial management Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operation. What do you mean by Wealth maximization ? Wealth maximization refers to the gradual growth of the value of assets of the firm in terms of benefits it can produce. It is reflected in the market value of shares and maximizes the wealth of shareholders.

SECTION B
What are the important decisions in financial management? Or Explain functions of Financial Management. The functions of financial management involve three important decisions A. Investment Decision B. Finance Decision C. Dividend Decision A. Investment Decision It refers to the activity of deciding the pattern of investment Covers both short term and long term investment Shows the proper allocation of funds in various investment giving better rate of return It is long term financial decision Capital budgeting methods, cost analysis etc are tools for decision B. Financing Decision Proper mix of debt and equity which directly affects profit Maximise rate of return and protect the creditors Additional sources for financing expansion and diversification should also be considered Proper capital structure for reducing financial risk C. Dividend Decision

The ultimate objective of a business concern is to fulfill the desires of equity shareholder such as a. high percentage of dividend b. maximum returns to shareholders in the form of capital gain. This decision is also influenced by the amount of retained earnings and dividend Payout ratio. Section C

Explain Objectives / Goals of Financial Management Financial management deals with procurement and use of funds. Its main purpose is to utilize business funds in such a way that the firms value/earnings are maximized. The objectives of financial management are broadly classified as below : 1. Profit Maximization 2. Wealth Maximization

1. Profit maximization Profit earning is the main aim of every economic activity. No business can survive with earning profit. profit is a measure of efficiency of a business enterprise. Profits also serve as a protection against risks which can not be ensured. The ale accumulation profits enable a business to face risks like fall in prices, competition from other units, adverse government policies etc. Thus profit maximization is considered as the main objective of business. Merits of profit maximization 1. Best criterion of Decision Making The goal of profit maximization is regarded as the best criterion of the decision making as it provides a yard stick to judge the economic performance of the enterprise. 2. Efficient allocation of resources It leads to efficient allocation of scarce resources as they tend to be diverted to those uses which, in terms of profitability, are the most desirable. 3. Optimum utilization Optimum utilization of available resources is possible. 4. Maximum social welfare It ensures maximum social welfare in the form of maximum dividend to shareholders, timely payments to creditors, higher wages, better quality and lower

prices, more employment opportunities to the society and maximization of capital to the owners. Drawbacks of profit maximization. 1. Time factor ignored The term profit does not speak anything about the period of profit whether it is short term profit or long term profit. 2. It is vague The term profit is very vague. It is not clear in what exact sense the term profit is used. Whether it is accounting profit or economic profit or profit after tax or profit before tax. 3. It ignores time value The profit maximization objective fails to provide any idea regarding the timing of expected cash earnings. It ignores the fact that the rupee earned today is more valuable than a rupee earned later. 4. It ignores the risk factor According to economists, profit is a reward for risk and uncertainty bearing. It is also a dynamic surplus or profit is a reward for innovation. But when can the organization maximize profits ? profit maximization objective does not make this clear. 2. Wealth Maximization Wealth maximization is the appropriate objective of an enterprise. Wealth maximization is also called value-maximization. In simple wealth maximization means maximizing the present value of a course of action that is Net Present Value (NPV) which means GPV (Gross Present Value) Investment. Any financial action results in positive NPV, creates and adds to the existing wealth of the organization and the course of action which has a negative NPV reduces the existing wealth and hence be given up. Maximum utility refers to Maximum shareholders wealth which refers to Maximum current stock price per share. Implications of Wealth Maximization 1. It serves the interests of suppliers of loan capital, employees, management and society. Short term lenders are primarily interested in liquidity position so that they get their payments in time. The long term lenders get a fixed rate of interest from the earnings and also have a priority over shareholders in return of their funds. Wealth objective maximization objective not only serves shareholders interests by increasing the value of holdings but ensures security to lenders also.

2. The survival of management for a longer period will be served if the interests of various groups are served properly. Management is the elected body of shareholders. The shareholders may not like to change a management if it is able to increase the value of their holdings. The efficient allocation of productive resources will be essential for raising the wealth of the company. Criticism of Wealth Maximization 1. The objective of wealth maximization is not necessarily socially desirable. 2. The objective of wealth maximization may also face difficulties when ownership and management are separated. When managers act as agents of real owners (equity shareholders) there is a possibility for conflict of interest between shareholders and the managerial interests. 3. There is controversy as to whether the objective is to maximize the stockholders wealth or the wealth of the firm which includes other financial claimholders such as debenture holders, preference shareholders etc.

Explain Scope and Significance of Financial Management Scope of Financial Management The main objective of financial management is to arrange sufficient finances for meeting short term and long term needs. Financial management covers the following areas : 1. Estimating financial requirements The first task of a financial manager is to estimate short term and long term financial requirements of his business. For this purpose he will prepare a financial plan for present as well as for future. The amount needed for purchasing fixed assets and funds for working capital will have to be ascertained. 2. Deciding Capital Structure The capital structure refers to the kind and proportion of different securities for raising funds. After deciding about the quantum of funds required it should be decided which type of securities should be raised. It may be wise to finance fixed assets through long term debts. A decision about various sources for funds should be linked to the cost of raising funds. If the cost of raising funds is very high then such sources may not be useful for long. 3. Selecting a source of finance After deciding capital structure an appropriate source finance is selected. Various sources from which finance may be raised include : Share capital, debentures, financial

institutions, commercial banks, public deposits etc. If funds are required for short period banks, public deposits and financial institutions may be appropriate. On other hand if long term funds are required share capital and debentures may be useful. 4. Selecting a pattern of investment When funds have been procured a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which assets are to be purchased ? Even in various categories of assets a decision the about the type of fixed or other assets will be essential. The decision making techniques such as capital budgeting, opportunity cost etc may be applied in making decisions about capital expenditures. 5. Proper cash management Cash management is also an important task of finance manager. He has to assess various cash needs at different times and then make arrangements for arranging cash. The cash management should be such that neither there is a shortage of it and nor it is idle. Any shortage of cash will damage the creditworthiness of the enterprise. The idle cash with the business will mean that it is not properly used. 6. Implementing financial controls An efficient system of financial management necessitates the use of various control devices. Financial controls include ROI(Return on Investment), Budgetary Control, Break
Even Analysis, Ratio Analysis and Cost and Internal Audit. The use of various control techniques helps to evaluate the performance in various areas.

7. Proper use of surpluses The utilization of profits or surpluses is also an important factor in financial management. A judicious use of surpluses is essential for expansion and diversification plans and also in protecting the interests of shareholders. Significance or importance of Financial Management Financial management is indeed the key to successful business operations. Without proper administration and effective use of funds no business enterprise can utilize its potentials for growth and expansion. 1. Successful promotion Successful promotion of a business concern depends upon efficient financial management. If the plan adopted fails to provide adequate capital to meet the requirements of fixed and working capital the firm can not carry on its business successfully. 2. Smooth running Since funds is required at each stage of the business such as promotion, development, expansion and management of day to day expenses, proper financial administration becomes necessary for smooth running of a business enterprise. 3. Decision making

Financial management provides scientific analysis of all facts and figures through various financial tools such as ration analysis, variance analysis, budgets etc. Such an analysis helps the management to evaluate the profitability of the plan. 4. Solutions to financial problems The efficient financial management helps the top management by providing solutions to the various financial problems faced by it. 5. Measure of performance Financial management is considered as a yard stick to measure the performance of the firm.

CHAPTER II

Cost of Capital
Section A What is Opportunity Cost ? Opportunity Cost or Implicit cost refers to the cost of investment which a company avails due to investment in some other opportunities. The cost of retained earnings is an opportunity cost, for a shareholder is deprived of the opportunity to invest retained earnings elsewhere. What is explicit cost ? Explicit cost the discount rate which equates the present value of cash inflows with the present value of cash outflows. It is the internal rate of return on cash flows. What do you mean by Time value of Money? Time value of money means that the value of a unit of money is different in different time periods. Rational investors prefer current receipt of money to future receipt because the value of a sum of money received today is more than its value received after sometime. This phenomena is also known as investors time preference of money. What is present value of future money? The present value formula is the core formula for the time value of money; each of the other formulae is derived from this formula. PV = 1 (1+r)n Where PV = Present Value r = rate of interest /discount rate n = no of years.

What is Weighted Average Cost of capital? Weighted average cost of capital is the average cost of the costs of various sources of financing. The weightage assigned to each cost is according to book value or market value . It is also known as Composite or Overall or Average cost of capital Define Cost of capital Cost of capital is the minimum required rate of earnings expected by the investors or the cut off rate of capital expenditures. It is also known as Hurdle rate or Discount rate. SECTION B Explain the significance of cost of capital Cost of capital can be used as a basis for evaluating the performance of a firm and helps management in taking other financial decision. a. Acceptance criteria for capital budgeting Capital budgeting decisions are carried by considering the cost of capital. The present value for expected returns is calculated by discounting the expected cash inflows at cutoff rate. b. Determinant of Capital mix in Capital structure decision While designing an optimal capital structure , the management tries to maximize the value of the firm and minimize cost of capital. Thus measurement of cost of capital from various sources is very essential In planning the capital structure of the firm c. Basis for evaluating the financial performance The actual profitability of the project is compared with projected cost of capital of each source If actual profitability is more than actual cost of capital the performance is satisfactory d Basis for taking other financial decisions For other financial decisions such as Dividend policy Capitalization of profits Making Rights issue Working capital

CHAPTER III

Capital Budgeting
Section A Define Capital Budgeting . Capital Budgeting is defined as it is long term planning for making and financing proposed capital outlays. Capital budgeting is the process of making investment decisions in capital expenditures. What is Internal rate of return ? Internal rate of return is that rate at which the sum of discounted cash inflow equals the sum of discounted cash outflows . At IRR, NPV = 0. Section B Explain the factors to be considered while taking capital budgeting decisions. 1. Creative search for profitable opportunities : Profitable investment opportunities should be sought to supplement existing proposals. 2. Long range capital planning : A flexible programme of a companys expected future development over a long period of time should be prepared. 3. Short range capital planning : It indicates its sectoral demand for funds to stimulate alternative proposals before the aggregate demand for funds is finalized. 4. Measurement of project work : Here the project is ranked with other projects. 5. Screening and selection : The project is examined on the basis of selection criteria such as supply and cost of capital, expected returns, alternative investment opportunities etc. 6. Retirement and disposal : The expiry of the cycle in the life of a project is marked at this stage. 7. Forms and procedures : These involve the preparation of reports necessary for any capital expenditure programme.

Section C
Explain the capital budgeting process and its significance. Capital Budgeting process

Capital budgeting involves the following steps. 1. Project Generation 2. Project Evaluation 3. Project Selection 4. Project Execution 1. Project Generation The investment proposals may fall into one of the following categories : a) 1) Proposals to add new product to the product line. 2) Proposal to expand capacity in existing product lines. b) Proposal to reduce the costs of the output of the existing products without altering the scale of operation. 2. Project Evaluation It involves two steps : a) Evaluation of benefits and costs. The benefits and costs must be measured in terms of cash flows. b) Selection of an appropriate criterion to judge the desirability of the project 3.Project Selection Since capital budgeting decisions are of considerable significance the final approval of the project may generally rest on top management. However projects are screened at multiple levels. 4.Project Execution The project execution committee or the top management must ensure that the funds are spent in accordance with appropriations made in the capital budget.

Importance / Significance of Capital Budgeting Capital budgeting is significant for the following reasons 1. Large investments Capital budgeting decisions involve large investment of funds. But the funds available with the firm are always limited. Hence it is very important for a firm to plan and control its capital expenditure. 2. Long term commitment of funds The long term commitment of funds increases the financial risk involved in the investment decision. Greater the risk involved, greater is the need for careful planning of capital expenditure that is capital budgeting. 3. Irreversible nature

Once the decision for acquiring a permanent asset is taken it becomes very difficult to dispose of these assets with incurring heavy losses. 4. Long term effect on profitability The present earnings of the firm not only are affected by the investment in capital assets but also the future growth and profitability of the firm depends upon the investment decision taken today. 5. Difficulties of investment decision The long term investment decision are difficult to be taken because a) decision extends to a series of years beyond the current accounting period b) uncertainties of future and c) higher degree of risk. 6. National Importance : Investment decision though taken by individual concern is of national importance because it determines employment, economic activities and economic growth. What are the various methods of capital budgeting ? Explain its merits and demerits.

1. Payback Period Method

The term payback (or payout or pay-off) is defined as the length of time required for the stream of cash proceeds produced by an investment equal to the original cash outlay required by the investment. In other words the time required to recover the initial investment is known as pay back period. This method is also known as the payout method. If the project generates constant annual cash inflows ,the payback period can be computed by the following formula : Payback period= Initial investment ( cash outlay) --------------------------------------Annual cash inflow Accept or Reject Criterion : The decision rule is accepted if the computed pay-back period is less than the standard; otherwise reject it. Merits: 1. It is an important guide to investment policy. 2 . It lays a great emphasis on liquidity. 3.The rate which capital is recouped has a positive significance. 4.The method enables a firm to choose an investment which yields a quick return on cash funds. 5.It is easy to understand ,calculate and communicate to others.

6.Other than its simplicity, the main advantage claimed for the payback method is that it is built-in safeguard against risk. 7.It enables a firm to determine the period required to recover the original investment with some percentage return and thus arriving at the degree of risk associated with the investment. Demerits: 1.It does not measure the profitability of a project. 2.The time value of money is ignored. 3.It does not value projects of different economic lives. 4.It is only a rule-of-thumb method. It is often difficult to judge objectively whether one proposed project is superior to another and ,if so ,by how much. 5.No allowance is made for taxation nor is any capital allowance made. 2. Accounting Rate of Return Method or Average Rate of Return Method

(ARR)
The accounting rate of return is found out by dividing the average income after taxes by the average investment. This method is based on conventional accounting concepts. The rate of return is expressed as a percentage of the earnings of the invest in a particular project. Following formula can be used to know the ARR. ARR=Average profit after tax ------------------------- ------- x 100 Average Investment Average Investment =Original investment scrap value / 2

Or Average Investment = opening investment + closing investment / 2 Accept or Reject Criterion: This method will accept all those projects whose accounting rate of return is higher than the minimum rate established by management. This will reject those projects which have accounting rate of return less than the minimum rate. Merits: 1.It is very simple to understand and use. 2.It provides a better means of comparison of projects than the payback method. Demerits: 1.It ignores the time value of money.

2.It ignores the fact that the profits earned can be reinvested. 3. Net Present Value Method The NPV method is one of the Discounted Cash Flow [DSF]techniques explicitly Recognizing the time value of money. It is considered to be the best method for evaluating the capital investment projects. The NPV is the difference between the total Present value of future cash flows and cash outflows. NPV = PV of future cash inflow - PV of cash outflow Accept or Reject Criterion If NPV is positive accept the project. If the NPV is negative the project should be rejected. Merits 1. The most significant advantage of the NPV method is that it recognizes the time value of money. 2. It considers all cash flows over the entire life of the project in its calculation. 3. It is consistent with the objective of maximizing the welfare of the shareholders Demerits 1. The NPV method assumes that the discount rate that is firms cost of capital is known. But the cost of capital is difficult to understand and measure in practice. 2. Decisions arrived at may not be satisfactory when the projects being compared involve different amounts of investment.
4.Internal Rate of Return (IRR)

IRR is that rate at which the sum of discounted cash equals the sum of the discounted cash flow. It is the rate at which the net present value of the investment is zero. In other words at IRR , NPV = 0. Accept or Reject Criterion Accept the project if the IRR is higher than or equal to minimum required rate of return. A project shall be rejected if its IRR is lower than the cut off rate. Merits 1. It considers time value of money. 2. It considers cash flows throughout the life of the project. 3. It is not in conflict with the concept of maximizing the welfare of the shareholders. Demerits

1. Calculation of IRR is quite tedious and it is difficult to understand. 2. It may give results inconsistent with NPV method.
5.Profitability Index ( PI )

PI is the ratio of present value of future cash inflow and cash outflow. PI = PV of cash inflows / Initial cash outflow Accept or Reject Criterion Accept if PI is greater than one. Reject if PI is less than one.

CHAPTER IV Corporate Financial Structure Section A

What is Capital Structure? Capital Structure of the company refers to the composition or make-up of its capitalization and includes long term capital resources ie loans, reserves, shares and bonds. What is Optimum capital Structure ? The capital structure which maximizes the value of the firm or the structure that increases wealth of the shareholders is known as optimum capital structure. What is meant by financial risk ? Financial risk is the additional risk a shareholder bears when a company uses debt in addition to equity financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity. Give the meaning of leverage. Leverage has been defined as the employment of an asset or sources of funds of which the firm has to pay a fixed cost or fixed return, . It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity. What is Trading on Equity? Or What is financial leverage ? Trading on Equity or Financial Leverage refers to the use of long-term fixed interest bearing debt and preference capital along with equity share capital.

It refers to the leverage or force applied on debt and the benefit is reflected in the form of higher returns to equity shareholders. Financial Leverage = EBIT / EBT What is Operating leverage ? The fixed cost remaining the same , the percentage change in operating income will be more than the percentage change in sales. This occurrence is called operating leverage. Operating Leverage = contribution / EBIT. What is Combined leverage or Composite leverage? This leverage shows the relationship between change in sales and the corresponding change in taxable income. Combined Leverage = Financial leverage X Operating leverage. Section B What is trading on equity ? Explain the significance and limitations of financial leverage. Trading on Equity or Financial Leverage refers to the use of long-term fixed interest bearing debt and preference capital along with equity share capital. It refers to the leverage or force applied on debt and the benefit is reflected in the form of higher returns to equity shareholders. Financial Leverage = EBIT / EBT

Significance Financial leverage is employed to plan the ratio between debt and equity so that per share is improved a. Planning of Capital structure Capital structure refers to raising the long-term funds both for shareholders and long-term creditors. So decide about the ratio of fixed cost funds ie debt and equity share capital providing less cost of capital and financial risk , financial leverage are considered b. Profit planning The earnings available to each shareholder is affected by the degree of financial leverage . if the profit increases availability to equity shareholder also increases. So leverages are helpful for proper planning by the use of break even analysis. Limitations a. Double edged weapon. Financial leverage can be employed to increase the earnings to shareholders when the earnings of shareholders are more than fixed rate of interest / dividend on shares and debentures

b. Beneficial for companies having stability of earnings Trading on equity is beneficial due to regular burden of interest on debentures which company can pay only when it has regular income. c. Increases risk and rate of interest. Every rupee of debt increases the risk of the firm and also the rate of

SECTION C Explain factors determining the capital structure 1. Financial leverage or Trading on equity The use of long term debt and preference share capital along with equity share capital is called financial leverage or trading on equity. The use of long term debt increases, magnifies the earnings per share if the firm yields a return higher than the cost of debt. The earnings per share also increase with the use of preference share capital. However leverage can operate adversely also if the rate of interest on long term loan is more than the expected rate of earnings of the firm. Therefore it needs caution to plan the capital structure of a firm. 2. Growth and stability of sales If the sales of a firm are expected to remain fairly stable it can raise a higher level of debt. Higher the rate of growth of sales greater can be the use of debt in the financing of firm. On the other hand if firms sales are declining it should not employ debt financing. 3. Nature and size of a firm Public utility concerns may employ more debt because of stability and regularity of their earnings. The firms which do not have stable earnings have to depend mainly upon equity capital. Small companies have to depend upon mainly owned capital. 4. Retaining control The capital structure of a company is also affected by the extent to which the existing management of the company desires to maintain control over the affairs of the company. If the company issues debt capital or preference capital there is no risk of dilution of control. The company can also buy back the shares to increase the control of the promoters over the company. 5. Purpose of financing If funds are required for a productive purpose debt financing is suitable. If funds are required for unproductive use the firm should prefer equity capital. 6. Period of finance

If the fund is required for a very long time equity shares should be issued because it is a permanent source. If the funds are required only for the short period short term debt may be increased. 7. Requirement of investors It is necessary to meet the requirement of both institutional as well as private investors. Investors can be of three types : Bold investors, cautious investors and less cautious investors. Bold investors are willing to take all types of risk and thus prefer equity shares. Over cautious investors prefer safety and stability in returns and hence they prefer debentures. Less cautious investors prefer preference share capital. 8. Market sentiments When there is boom in the capital market it is very easy to issue equity capital. But when in the market bear conditions prevail people will look for the safety. So only debt instruments with good credit ratings can be used for such periods. 9. Floatation costs Floatation costs are incurred when the funds are raised externally. Floatation costs for the issue of shares is more than that of debentures and bonds. Further the floatation costs are lesser when the company issues securities on private placements basis instead of public issue. 10. Corporate tax rate High rate of corporate taxes on profits compel the companies to prefer debt financing because interest is allowed to be deducted while computing taxable profits. On the other hand dividend on shares is not an allowable expense for that purpose. 11. Legal requirements The legal restrictions are very significant as these lay down framework within which capital structure decisions has to be made. The capital structure of the company should satisfy the following legal restrictions : a) The debt equity ratio does not exceed 2:1 b) The ratio of preference capital to equity does not exceed 1:3 c) Promoters hold at least 25% of the equity capital. 12. Assets structure If fixed assets constitute a major proportion of the total assets of the company it may be possible for the company to raise more of long term debts.

CHAPTER V

Dividend Policy
Section A

Define Dividend According to ICAI ( Institute of Chartered Accountants of India ) Dividend is a distribution to shareholders out of profits or reserves available for this purpose. Section B What are the different forms of dividend ? The different forms of dividend are as follows 1. Cash Dividend Cash dividend is the most commonly used term for the payment of dividend. Generally the company which has enough cash balance is likely to pay dividend in cash. Payment of dividend in cash causes outflows of funds. If the company does not have sufficient cash balance it has to take loan from outside. 2. Bond Dividend Sometimes during shortage of cash company may not have any idea about how much time it would take to generate cash. In such cases company may issue the bonds to its shareholders for the longer periods. The issue of bond dividend increases the long term liability of the firm. 3. Scrip Dividend During shortage of cash , for short time, the company may issue promissory note or scrip to shareholders promising to pay them dividend at a certain date in near future. The main reason for scrip dividend is to postpone due payment of cash for short time. Scrip dividend increases the current liability of the company. 4. Property Dividend. Under exceptional circumstances property dividend is paid to its shareholders in some thing rather than cash. In such cases company may give its own asset or product instead of cash dividend. This form of dividend is not prevalent in India. 5. Composite Dividend. It means a part of dividend paid in cash and another part paid in the form of property or any other type dividend. 6. Interim Dividend

Regular dividend s are paid at the end of each financial year but sometimes directors of the company may declare dividend between two annual general meetings . It is called interim dividend. 7. Stock dividend or bonus shares During the financial year company may issue shares to its existing shareholders. These shares are called bonus shares. Issue of bonus shares increases the total number of shares of the existing shareholders. A company issues such shares in a fixed proportion over the existing share holding. 8. Extra dividend. Sometimes in any year if a company earns supernormal profits and decided to give some extra dividend to its shareholders along with regular dividend . This type of dividend is temporary in character and has is directly related with extra earnings of the company. Write a note on Stable Dividend policy. The term stability of dividend means lack of variability in the stream of dividend payments. In other words it means payment of certain minimum amount of dividend regularly . The following are the different forms of stable dividend policy a. Constant Dividend per share Under this form companies follow a policy of paying fixed dividend per share irrespective of the level of earnings year after year. Such firms usually create a dividend equalization fund to enable them to pay fixed dividend even in the year when the earnings are not good or when there are losses. b. Constant Payout ratio Constant payout ratio means payment of a fixed percentage of net earnings as dividend per year. The amount of dividend changes according to the earnings of the company. c. Stable rupee dividend plus extra dividend. Some companies follow a policy of paying constant dividend per share plus an extra dividend in the years of high profit . Advantages of Stable dividend policy. It stabilizes the market value of the shares. It creates confidence among the investors It is a sign of profitable organisations Jt improves the creditworthiness of the company which helps in easy financing It results in continuous flow of the national income and thus stabilizes the economy.

Demerits of Stable dividend policy If the company follows stable dividend policy and withdraws it in between it adversely affects the market price of shares

 When the company pays stable dividend in spite of its incapacity it adversely affects in long run.

Section C Explain factors influencing dividend policy The payment of dividend involves some legal as well as financial considerations. The following are the important factors which determine the dividend policy of a firm 1. Legal restrictions Legal provisions relating to dividends as laid down in sections 93, 205, 205A, 206 and 207 of the Companies Act, 1956 are important because they lay down a framework within which dividend policy is formulated. These provisions require that dividend can be paid only out of current profits or past profits after providing for depreciation. Moreover the Companies Rule 1975 require a company providing more than 10% dividend to transfer certain % of current years profit to reserves. Further it provides that dividends can not be paid out of capital. 2. Magnitude and trend of earnings The amount and trend of earnings is an important aspect of dividend policy. It is rather the starting point of the dividend policy. The past trend of the companys earnings should also be kept in mind while making the dividend decision. 3. Desire and Type of shareholders Desires of shareholders for dividends depend upon their economic status. Investors such as retired persons, widows and other economically weaker persons view dividend as a source of funds to meet their day to day operations. Such investors may prefer regular dividends. On the other hand a wealthy investor in a high income tax bracket may not benefit by high current dividend incomes. Such investor may be interested in lower current dividend and high capital gains. 4. Nature of industry Nature of industry to which the company is engaged also considerably affects the dividend policy. Certain industries have a comparatively steady and stable demand irrespective of the prevailing economic conditions. Such firms expect regular earnings and hence can follow a consistent dividend policy. If earnings are uncertain conservative policy should be followed. 5. Age of the company A newly established concern has to limit payment of dividend and retain substantial part of earnings for financing its future growth and development. Older companies may have sufficient reserves can afford to pay liberal dividends. 6. Future financial requirements

If a company has highly profitable investment opportunities it can convince the shareholders of the need for limitation of dividend to increase the future earnings and stabilize its financial position. When the companies do not have profitable opportunities the company can follow liberal dividend policy. 7. Taxation policy A high or low rate of business taxation affects the net earnings of company and thereby its dividend policy. If the dividend income of shareholders is heavily taxed being in high income bracket the shareholders may forego cash dividend and prefer bonus shares and capital gains. 8. Control objectives When a company pays high dividend out of its earnings it may result in the dilution of both control and earnings for the existing shareholders. Issue of new shares shall cause increase in the number of equity shares and ultimately cause a lower earnings per share and their price in the market. 9. Requirement of institutional investors Dividend policy of a company can be affected by the requirement of institutional investors such as financial institutions, banks, insurance corporations etc. These investors usually favour a policy of regular payment of cash dividends. 10. Stability of dividends Stability of dividend refers to the payment of dividend regularly and shareholders prefer payment of such regular dividends. A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain stable over a number of years. The policy of constant low dividend per share plus some extra dividend in years of high profits is suitable to firms having fluctuating earnings year to year. 11. Liquid resources Although a firm may have sufficient available profits to declare dividends, sometimes, it may not have sufficient liquid resources. In such cases it may not be position to declare dividends. CHAPTER VI

Working Capital Management

Section A

.
What is receivable management ? Receivable management is decision making process which takes into account the creation of debtors, debtors turnover and minimizing cost of burrowing of working capital.

Define Working Capital Working Capital is the amount of funds necessary to cover the cost of operating the enterprise. It is the difference between Current assets and Current liabilities. Working capital = CA CL. Section B Write a note on the significance of Inventory management. Inventory management It refers to stocks, raw materials, components, spares or working progress maintained in the organisation to have continuous production and sales. It is one of the component of working capital management. An efficient system directly contributes to the growth and profitability of the concern by keeping stocks in such a way that there is no overstocking and under stocking and reduction in cost of production. Significance /Objects of inventory management To provide continuous supply of raw materials to carry out uninterrupted production To reduce wastage To exploit the opportunities available and to reduce cost of purchase To introduce scientific inventory management techniques To provide right materials at right time. Tools of Inventory management The various tools of inventory management are as follows 1. Fixation of levels. Inventories are maintained by fixing them at different levels with the help of different factors a. Maximum level It is the level beyond which stocks should not exceed. If it exceeds it is overstocking b. Minimum level.or Safety stock It represents the quantity which must be maintained at all times. If it is less than this level it is understocking c. Reorder level. This level indicates that the material should be procured . it is fixed in between maximum and minimum level. 2. ABC analysis Under this technique the materials are graded as A,B,C on the basis of value the material has in cost, numbers used and part of consumption. The main purpose of adopting this technique is to maintain scientific and proper investment in inventory.

3. Economic Order Quantity Economic order quantity is that quantity of materials to be ordered where it will have least or minimum order placing and carrying cost. It is also called as the size of materials to be purchased most economically. 4. Perpetual Inventory system Under this system the stocks are continuously checked using different types of registers for materials and entries are made on issuing and receiving. It is a costly technique of inventory management. Explain the scope, objectives and importance of cash management Cash management Cash is one of the current assets of a business. It includes money and instruments such as cheques, money orders and bank drafts. Cash is just a medium to acquire other resources. Cash management deals with the following: a. Cash inflows and outflows b. Cash flows within the firm c. Cash balances held by the firm at a point of time. Objectives/Importance of Cash management 1. Adequate Requirement of Cash: Cash is very vital asset to meet every type of expenditure so adequate cash resources are required otherwise it indicates insolvency of the organisation. 2. To make Cash payment Cash is required to make payment for various types of expenditures for smooth business operations. 3. Maintain Minimum Cash reserve Along with liquidity a firm should also maintain minimum reserve for meeting future obligations. The cash inflow and outflow should be properly controlled to conserve cash resources 4. Image of the Organisation Cash management helps to maintain the image of the organisation by making prompt payment to creditors and to avail cash discounts. These are some of the objectives of cash management

What are motives of holding cash?

----- Introduction of Cash management----Cash is held by the firm for the following motives 1. Transaction motive 2. Precautionary motive 3. Speculative motive 4. Compensatory motive 1. Transaction motive A firm needs cash for making transactions in the day to day operations. Cash is needed to make payment for purchases, expenses, taxes and dividend etc. Cash need arises when there is no balance between cash receipts and payments. This can be achieved by investing marketable securities which mature on the day a payment has to be made.
2. Precautionary motive

A firm is required to keep cash for meeting various contingencies such as change in government policies, competitions, accidents and consumer behaviour. To meet these unforeseen situations a firm should always invest in securities with ready liquidity.
3. Speculative motive

To take advantage of unexpected opportunities a firm holds cash for investing in profit making opportunities . Such opportunities do not come in a regular manner.
4. Compensatory motive

This refers to compulsory balance to be maintained in savings and current accounts to get several facilities from the bank Explain the concepts of working capital. Working capital is the amount of funds necessary to cover the cost of operating the enterprises. It is defined as the difference between the inflow and outflow of funds. Ie the excess of current assets and current liabilities. Working capital is also known as revolving or circulating capital. Concepts of Working capital There are two concepts of working capital

A. Balance sheet concept B. Operating Cycle or Circular flow concept. A. Balance sheet concept There are interpretations of working capital a. Gross Working Capital b. Net Working Capital a. Gross Working Capital Gross working capital is the amount of funds invested in various components of current assets. It is most acceptable concept in financial management. Advantages Provides correct amount of working capital at the right time Helps in determining correct rate of return on investments in working capital

b. Net Working Capital Net working capital is the excess of current assets over current liabilities Net working capital = Current assets Current liabilities. Advantages Enables a firm to determine how much amount is left for operational requirements. Indicates financial soundness of firm.

B. Operating Concept Working Capital is required to finance short term requirements such as cash, debtors and stocks. So capital circulates constantly from inflow to outflow and vice versa. This concept is based on working capital cycle of the firm where the cycle starts with the purchase of raw material and other resources and ends with realization of cash from the sale of finished goods Cash Debtors Raw materials

Sales

Work in process

Finished goods.

Differentiate between Temporary and Permanent Working Capital Temporary Working Capital It is the amount of working capital which is required to meet seasonal demand and special conditions Seasonal and Special are two types of variable capital of It is required for a shorter period Permanent Working Capital It is the minimum amount which is required to ensure effective utilization of facilities and circulating current assets Regular and reserve are two types of fixed capital It is permanently employed in business

Meaning

Types Period Usage

Amount Working Capital

of It fluctuates and increases and It is stable or fixed over time decreases according to and increases due to expansion requirement of business

Section C Explain briefly the importance and advantages of Working Capital Advantage of having adequate working capital Working capital is very important for the smooth functioning of the business. The importance of maintaining adequate working capital are as follows. 1. Solvency of business It maintains solvency by providing constant flow of working capital. 2. Goodwill Working capital helps in making prompt payment and creates goodwill of the firm 3. Cash discounts On payment of cash on time firms get cash discounts on the purchase made. 4. Regular supply of raw-materials Ensures regular supply and hence continuous productions 5. Ability to face crisis.

Enables a business to face crisis such as depression in the market which requires more working capital. 6. High morale Adequate working capital ensures security, high morale and overall efficiency of the firm. Need and importance of Working capital The basic objective of financial management is to maximize shareholders wealth. This is possible only when the company earns sufficient profit. The amount of such profits largely depends upon the magnitude of sales. Working capital is needed because of following reasons : 1. Sales do not convert into cash instantly. There is invariably a time lag between the sale of goods and the receipt of cash. Therefore there is a need for working capital in the form of current assets to deal with the problem arising out of the lack of immediate realization of cash against goods sold. 2. Sufficient working capital is necessary to sustain sales activity. 3. Working capital is required to have uninterrupted business operations. 4. The operating cycle can be said to be at the heart of the need for working capital. The operating cycle includes a ) conversion of cash into inventory b) conversion of inventory into receivables c) conversion of receivables into cash 5. Since cash inflows and outflows do not match firms have to necessarily keep cash or invest in short term liquid securities so that they will be in a position to meet obligations when they become due. 6. The working capital is required by the firm to guard against the possibility of not being able to meet demand for their products. Hence adequate inventory provides a cushion against being out of stock. 7. If firms have to be competitive they must sell goods to their customers on credit. it necessitates the holding of accounts receivable. So firms needs working capital.

Explain factors Determining Working capital (WC) requirements

1. Nature of Business The working capital requirements of a firm basically depend upon the nature of its business. Public utility undertakings like Electricity, water supply and Railways need very limited working capital because they offer cash sales only and supply services. On the other hand trading and financial firms require less investment in fixed assets but to have invest large

amount of working capital (WC). The manufacturing concerns also require sizable

working capital along with fixed assets.

2. Size of business

3.

4.

5.

6.

The working capital requirements of a concern are directly influenced by the size of its business which may be measured in terms of scale of operations. Generally greater the size of a business unit, larger will be the requirements of working capital. Production policy The production policy could be kept either steady by accumulating inventories during slack period in order to meet high demand during the peak season OR the production can be reduced during the slack season. If the policy is steady the firm will require larger WC. Credit Policy A firm that buys its goods on credit and sells its products/services on cash requires LESS WC. On the other hand a concern buys its requirements for cash and sells on credit needs LARGER WC. Seasonal Variation Generally during the busy season a firm needs LARGER WC than in the slack season. Because the firm has to purchase raw materials in bulk during the season to ensure an uninterrupted flow of production. WC Cycle The speed with which the WC completes one cycle determines the requirements of WC longer the period of the cycle larger is the requirement of WC.

7. Business Cycle In a period of boom that is when the business is prosperous there is a need for LARGER amount of WC due to increase in sales, rise in prices etc. on the other hand in the times of depression the business declines, sales decline and firms may have a LARGER amount of WC. 8. Rate of Growth of business The WC requirements of a concern increase with the growth and expansion of its business activities. The fast growing concerns require larger amount of WC. 9. Dividend policy A firm that maintains a steady high rate of cash dividend irrespective of its generation of profits needs more WC. Hence the dividend policy of a firm influences the requirements of its working capital.

10. Operating efficiency of firm Operating efficiency of the firm results in optimum use of resources at minimum cost. If firm successfully controls operating costs, it will need LESS WC. 11. Price Level Changes Generally the rising prices will require the firm to maintain larger amount of WC as more funds will be required to maintain the same current assets. 12. Taxation policy In the event of regressive taxation policy of the Govt. as it exists today the firm may have little profits for distribution and retention, consequently, the firm may require MORE WC.

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