The MM model argues that if two firms are alike in all respect except
that they differ in respect of their financing pattern and their market
value, then the investors will develop a tendency to sell the shares
of the over valued firm (creating selling pressure) and buy the
shares of the under-valued firm (creating the demand pressure).
This buying & selling will continue till the two firms have the same
market values.
CAPITAL BUDGETTING DECISIONS
Capital budgeting decisions are often the most
important decisions of corporate financial
management as they affect the profitability of the
firm.
Any decision that requires the use of resources
is a capital budgetting decision. The relevance &
significance of capital budgetting may be stated
as follows.
A) Long term effects
B) Substantial Commitments
C) Irreversible decisions
D) Affect the capacity & strength to compete.
IRR vs NPV METHOD
• IRR approach gives a rate which is unique to each
project. NPV approach gives a trade-off between the
cash-inflows & cash-outflows using a general required
rate of return.
• IRR gives % return while NPV gives absolute return.
• For IRR, the availability of required rate of return is not a
pre-requisite while for NPV it is necessary.
• NPV can be used as an indicator of expected increase
in the wealth of the shareholders, while IRR can’t be
used so.
• NPV can be more conclusive in accept-reject decisions.
IRR may give multiple results.
• NPV gives better ranking as compared to the IRR.
• NPV calculations are relatively easier compared to IRR
calculations which are based on Trial & Error method.
RISK & UNCERTAINTY IN CAPITAL BUDGETTING
• CONSEQUENCES
• Profits showing declining trend resulting a lower ROI.
• Decline in market value of shares.
• Loss of reputation
• REMEDIES
• Dynamic & result oriented approach
• Diversification and attempt to improve utilisation factor of
the firm’s resources.s
RBI Guidelines on W.C. finance
• Tandon Committee Recommendations
The recommendations are based on following points.
• Determination of working capital requirements of industry,
which the banks should finance.
• Supervision of credit for ensuring proper end-use of
funds.
• Methodology of sending periodical forecasts by borrowers
relating to: business of the company, production plans
and credit requirements
• Norms for build-up of current assets and for debt to equity
ratio to ensure minimal dependence on bank finance.
• Suggestions for improvement of manner & style of
lending.
The committee submitted it’s report in Aug 1975.This report
has been a major breakthrough in the improvement of bank
credit system. The recommendations relate to:
• Norms for holding inventory and receivables.
• Quantum of permissible bank loans.
• Style of credit.
• Follow-up & supervision of credit.
Norms For Inventory & Receivables :- These norms have been suggested
for 15 major industries. The committee has suggested the level of
current assets which each industrial unit is supposed to hold. Norms
are maximum level of current assets that a unit is to hold. The norms
are expressed as follows -
Raw Materials – so many months of cost of materials consumed
W-I-P – so many months of cost of production
Finished Goods – so many months of cost of sales
Receivables – so many months of cost of sales
Quantum of Permissible Bank Finance :- Three methods have been
suggested for determining the maximum permissible amount of bank
finance. The extent of bank finance will gradually reduce stepwise.
Method 1:- MPBF = 0.75(CA-CL)
Method 2:- MPBF = 0.75(CA)-CL
Method 3:- MPBF = 0.75(CA-CCA)-CL CCA=Core Current Assets
Tandon Committee suggested that borrowings in excess of what is permissible
under the first method should be converted into a working capital term loan
and repaid over a period of time.
• Chore Committee Recommendations
One recommendation of Tandon Committee Report was to bifurcate cash credit
limits into a demand loan and a fluctuating cash credit component. Chore
committee(1979) made a deep study on this issue. The committee was to:
A) Review the operation of the cash credit system in recent years particularly
with reference to the gap between sanctioned credit limits and the extent of
their utilisation.
B) Suggest –
i) modifications to ensure rational management of funds by commercial
banks.
ii) Alternate type of credit facilities, which would ensure greater discipline and
enable banks to relate credit limits to increase in output or other productive
activities.
Implementation of Recommendations
• A) Working Capital Advances of Rs.10 lakhs and over per
borrower:- For this category, banks should review the accounts of the
borrower to verify the continued viability and also the need based
character of the advance.
• B) Working Capital Advances of Rs.50 lakhs and over per
borrower:- It was proposed that banks should sanction separate
limits for peak level requirements and non-peak level requirements.
The important criteria would be borrowers’ utilisation of bank credit in
the past.
• Withdrawals from accounts are to be regulated through quantity
statements. If the borrower does not submit the statement in time,
bank may charge 1% premium on the total outstanding till the
statement is submitted. In the event of default being persistent in
nature the account of the borrower may be frozen.
• Ad-hoc or temporary advances may be sanctioned for
predetermined period to meet unforeseen contingencies. For all these
advances banks are to charge 1% more than the normal rate except
in cases of natural calamity.
• Discounting bills should be encouraged in place of cash credit against
book debt for financing sales.
• Recent RBI Guidelines :-
Following recent changes have been made by RBI in the guidelines for
bank lending for working capital purposes and by way of term loans.
I) Lending Norms for Working Capital :-
a) Banks would henceforth decide the levels of holding of individual
items of inventory as also of receivables, which should be supported
by bank finance, after taking into account the production/processing
cycle of an industry. RBI would only advise about the overall levels of
inventory and receivables for various industries to serve as a broad
indicators for guidance of banks.
b) Banks would be free to sanction ad hoc credit limits to borrowers,
where considered necessary and charging of additional interest for
this purpose is no longer mandatory.
c) Other aspects like maintenance of minimum current ratio,
submission of quarterly data would continue with simplification of
presentation of information.