Unit I

Strategic Financial Management: Meaning, nature and scope. Financial and nonfinancial objectives, agency theory and conflict of interest in a firm. Strategic decision making framework, interface of financial policy and strategic management, shareholder’s value creation and value drivers.

Corporate Risk Management: Meaning, nature and components of risk. Introduction to financial instruments like Forward, Futures and Options and Swaps as risk management tools.

Risk management in practice. Financial Planning and Forecasting Ratios System: Introduction to long-term and short-term financial planning in a company, types of financial planning models, growth with internal equity, Higging’s sustainable growth model, conditions for the successful use of models, development of Simulations Models and improving financial modelling.

 

 Unit II

Corporate Valuation: Introduction, models and approaches to corporate valuationMarakon Approach, Alcar Approach, Mckinsey Approach and Discounted Cash Flow Approach– FCFE and FCFF model. Shareholder’s Value Creation – MVA Approach; EVA Approach and EVA Analysis of Indian Corporates.

Managerial implications of shareholder’s value creation. Long-term Projects: Valuation of long-term investment decisions, capital intensive

UNIT-1

Introduction

All types of organizations’ require financial management for its successful operations. It contains components for the acquisition, management, allocation and financing of resources for successful growth of an organisation. Every organisation should manage its finances effectively in order to attain its mission and goals. Recently, the fields of strategic management and financial management combined together to evolve a new discipline namely Strategic Financial Management.

Strategic Financial Management refers to the study of finance with a long term perspective which takes into account the strategic goals of the enterprise. Strategic Financial management is a management approach which makes use of various financial tools and techniques in order to come up with a strategic decision plan. It also ensures the implementation of the chosen strategy so as to achieve the desired objectives.

The ultimate objective of strategic financial management is to identify the best possible strategy which may result in maximization of organizations’ market value. Strategic financial management goes a step further in ensuring that the organization remains on track to attain its short-term and long-term goals, while maximizing value for its shareholders.

Strategic financial management is the identification of the possible strategies capable of maximizing an organization’s market value and the allocation of scarce capital resources among competing opportunities. It also involves the implementation and monitoring of the chosen strategy so as to achieve stated objectives.

Strategic financial management is managing an organization’s financial resources so as to achieve its business objectives and maximize its value. Strategic financial management involves a defined sequence of steps that encompasses the full range of a company’s finances, from setting out objectives and identifying resources, analyzing data and making financial decisions, to tracking the variance between actual and budgeted results and identifying the reasons for this variance. The term “strategic” means that this approach to financial management has a long-term horizon.

The Chartered Institute of Management Accountants of UK [CIMA] defines Strategic Financial Management as “the identification of the possible strategies capable of maximizing an organization’s Net Present Value (NPV), the allocation of scarce capital resources between competing opportunities and the implementation and monitoring of the chosen strategy so as to achieve stated objectives.

 

 

 

 

NATURE/SCOPE OF STRATEGIC FINANCIAL MANAGEMENT

The important characteristics of Strategic financial Management are the following:-

1. It is concerned with the long term management of fund with a strategic perspective
2. It aims at maximization of profit and wealth of the concern
3. It is both structured as well as flexible
4. It promotes growth, profitability and existence of the firm in the long run and maximizes shareholder value
5. It is an evolving and continuous process that constantly tries to adopt and revise strategies in order to achieve strategic financial objectives of the firm.
6. It involves innovative, creative and multidimensional approach for finding solutions to the problems.
7. It helps to formulate appropriate strategies and facilitates constant monitoring of action plans to match with the long term objectives.
8. It makes use of analytical financial techniques with qualitative and quantitative judgment on factual information
9. It is result oriented combining of resources, especially of financial and economic resources
10. Strategic financial management offers a number of solutions while analyzing the problems in the organizational context.

 

 

FINANCIAL OBJECTIVE

Financial goal is a tangible focus for business mission and strategy. Financial goals are deeply rooted in the company’s value and political philosophy. Financial goals are so important that it becomes the supreme responsibility of the managers at the higher level of the organisation. There are many objectives which an organisation can pursue. It is generally accepted that there should be one overall objective with all other objectives giving support so that the overall objective can be achieved.

For a business organisation, a financial objective is generally taken as the overall objective. Strategic Financial Management is concerned with procurement and use of funds. It aims to use business funds in such a way that the firm’s value is maximized. Strategic financial Management provides a framework for selecting a proper course of action and deciding a viable commercial strategy. The main objective of a business is to maximize the owner’s economic welfare. This objective can be achieved by

1. Profit maximization
2. Wealth maximization
3. Profit maximization: It is the main aim of every economic activity. No business can survive without earning profit. Profit is the measure of efficiency of the business. Profit also serves as a protection against risks which cannot be insured. The accumulated 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. The arguments in favour of profit maximization are:-
4. When profit earning is the aim of the business then profit maximization should be the obvious objective
5. Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise, thus, profit maximization is justified on the grounds of rationality
6. A business will be able to survive under unfavorable conditions, only if it has some past earnings to rely upon.
7. Profits are the main sources of finance for the growth of a business. So, a business should aim for profits for enabling its growth and development.
8. A firm pursuing profit maximization also maximizes socio-economic welfare.

Profit maximization typically is defined as a more static concept than shareholder wealth maximization. The profit maximization objective from economic theory does not normally consider the time dimension or the risk dimension in the measurement of profits.

In contrast, the shareholder wealth maximization objective provides a convenient framework for evaluating both the timing and the risks associated with various investment and financing strategies. A closely held firm is more likely to be a wealth maximize than a corporation with wide ownership. In the closely held firm, the owners and the managers will share the same objectives because the owners are the managers. In a widely-held corporation, where the ownership and management functions are separate, it is likely that managers may pursue objectives that are more self-serving than owner-serving. Examples of alternative objectives that might be pursued in this situation are extreme risk-averse behavior, size maximization, satisfying, or personal utility function maximization

The arguments against Profit Maximization concept are the following:-

1. The term profit is vague and it cannot be precisely defined. Even if, we take the meaning of profits as earnings per share and maximize the earnings per share, it does not necessarily mean increase in the market value of shares and the owner’s economic welfare.
2. Profit maximization objective ignores the time value of money and does not consider the magnitude and timing of earnings. It treats all earnings as equal though they occur in different periods.
3. It does not take into consideration the risk of the prospective earnings stream. Two firms may have same expected earnings per share, but if the earnings stream of one stream is more risky, then the market value of shares will be comparatively less.
4. The effect of dividend policy on the market price of shares is also not considered in the objective of profit maximization

Non financial objectives

Wealth Maximization

Wealth maximization is the appropriate objective of an enterprise. The goal of shareholder wealth maximization is a long-term goal. Shareholder wealth is a function of all the future returns to the shareholders. Hence, in making decisions that maximize shareholder wealth, management must consider the long-run impact on the firm and not just focus on short-run (i.e., current period) effects.

For example, a firm could increase short-run earnings and dividends by eliminating all research and development expenditures. However, this decision would reduce long-run earnings and dividends, and hence shareholder wealth, because the firm would be unable to develop new products to produce and sell.

A stockholder’s current wealth in the firm is the product of the number of shares owned, multiplied with the current stock price per share.

Stock holders current wealth in a firm = Number of shares owned X Current stock price per share

While pursuing the objective of wealth maximization, all efforts must be put in for maximizing the current present value of any particular course of action. Every financial decision should be based on cost benefit analysis. If the benefit is more than the cost, the decision will help in maximizing the wealth and if vice versa will not be serving the purpose of wealth maximization.

 

 

 

There is a rationale in applying wealth maximizing policy as an operating financial management policy because of the following reasons.

1. It serves the interests of suppliers of loaned capital, employees, management and society.
2. It is consistent with the objective of owners’ economic welfare.
3. The objective of wealth maximization implies long run survival and growth of the firm.
4. It takes into consideration the risk factor and time value of money as the current present value of any particular course of action is measured.
5. The effect of dividend policy on market price of shares is also considered as the decisions are taken to increase the market value of the shares.
6. The goal of wealth maximization leads towards maximizing stockholder’s utility or value maximization of equity shareholders through increase in stock price per share.

The wealth maximization objective has been criticized by certain financial theorists on the following grounds:-

1. It is only a prescriptive idea.
2. It is not socially desirable
3. It is not clear whether this concept include maximizing owners wealth or wealth of the firm which includes claim holders such as debenture holders, preferred stock holders etc.
4. The objective of wealth maximization is a problem when ownership and management are separated. When managers act as agents of the real owners, there is possibility for a conflict of interest between shareholders and managerial interests.

 

AGENCY THEORY AND CONFLICT OF INTEREST IN A FIRM

Agency theory is often described in terms of the relationships between the various interested parties in the firm. The agency theory examines the duties and conflicts that occur between parties who have an agency relationship. Agency relationships occur when one party, the principal, employs another party, called the agent, to perform a task on their behalf. Agency theory is helpful in explaining the actions of the various interest groups in the corporate governance debate. For example, managers can be seen as the agents of shareholders, employees as the agents of managers, managers and shareholders as the agents of long and short-term creditors, etc.

CONFLICT OF INTEREST IN A FIRM

In most of these principal-agent relationships conflicts of interest is seen to exist. It has been widely observed that the conflicts between shareholders and managers and in a similar way the objectives of employees and managers may be in conflict. Although the actions of all the parties are united by one mutual objective of wishing the firm to survive, the various principals involved might make various arrangements to ensure their agents work closer to their own interests. For example, shareholders might insist that part of management remuneration is in the form of a profit related bonus. The agency relationship arising from the separation of ownership from management is sometimes characterized as the agency problem. For example, if managers hold none or very little of the equity shares of the company they work for, what is to stop them from: Working inefficiently? Not bothering to look for profitable new investment opportunities? Giving themselves high salaries and perks?

Agency theory suggests that, in imperfect labor and capital markets, managers will seek to maximize their own utility at the expense of corporate shareholders. Agents have the ability to operate in their own self-interest rather than in the best interests of the firm because of asymmetric information (e.g., managers know better than shareholders whether they are capable of meeting the shareholders’ objectives) and uncertainty (e.g., myriad factors contribute to final outcomes, and it may not be evident whether the agent directly caused a given outcome, positive or negative). Evidence of self-interested managerial behavior includes the consumption of some corporate resources in the form of perquisites and the avoidance of optimal risk positions, whereby risk-averse managers bypass profitable opportunities in which the firm’s shareholders would prefer they invest. Outside investors recognize that the firm will make decisions contrary to their best interests. Accordingly, investors will discount the prices they are willing to pay for the firm’s securities.

Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather than behave in their own self-interests. There are three major types of agency costs:

1. Expenditures to monitor managerial activities, such as audit costs;

 

2. Expenditures to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside members to the board of directors or restructuring the company’s business units and management hierarchy; and

 

3. Opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for shareholder votes on specific issues, limit the ability of managers to take actions that advance shareholder wealth.

One power that shareholders possess is the right to remove the directors from office. But shareholders have to take the initiative to do this, and in many companies, the shareholders lack the energy and organization to take such a step. Even so, directors will want the company’s report and accounts, and the proposed final dividend, to meet with shareholders’ approval at the Annual General Meeting. Another reason why managers might do their best to improve the financial performance of their company is that managers’ pay is often related to the size or profitability of the company. Managers in very big companies, or in very profitable companies, will normally expect to earn higher salaries than managers in smaller or less successful companies. Perhaps the most effective method is one of long-term share option schemes to ensure that shareholder and manager objectives coincide. Management audits can also be employed to monitor the actions of managers.

In addition to the agency conflict between stockholders and managers, there is a second class of agency conflict between creditors and stockholders. Creditors have the primary claim on part of the firm’s earnings in the form of interest and principal payments on the debt as well as a claim on the firm’s assets in the event of bankruptcy. The stockholders, however, maintain control of the operating decisions (through the firm’s managers) that affect the firm’s cash flows and their corresponding risks. Shareholder-creditor agency conflicts can result in situations in which a firm’s total value declines but its stock price rises. This occurs if the value of the firm’s outstanding debt falls by more than the increase in the value of the firm’s common stock.

Creditors commonly write restrictive covenants into loan agreements to protect the safety of their funds. These arrangements involve time and money both in initial set-up, and subsequent monitoring, these being referred to as agency costs.

Strategic Decision Making

Strategic decisions affect the profitability, liquidity and the growth of the organization for years to come and hence build or erode the value of the firm. These are long term decisions rather than the decisions regarding the routine operations Such decisions are cross-functional incorporating the various functional areas of the organization completely, as well as, ensuring that these functional areas harmonize and get together well. The strategic decisions are complex decisions

(a) Involving high degree of uncertainty i.e. the decision-makers are taking the decisions on the basis of their views about the future; they are not sure about the outcomes

(b) Demanding an integrated approach of various departments and

(c) Involving major change in the organization. Such decisions aim to fit the internal environment (strengths and weaknesses) of the firm to the external environment (opportunities and threats) in which it operates.

 

A few examples of such decisions are as follows:

(a) Deciding the goals and objectives of the firm. This decision should be based on Vision of the company. Vision is not a decision. It is a dream of the leader(s) of the organization.

(b) Decisions regarding resource allocations among the competing opportunitiesi.e. Capital expenditure decisions.

(c) Decisions having major resource implications. For example, the decisions regarding computerization / outsourcing some functions of the organization.

(d) Decisions regarding ‘stretching’ an organization’s resources and competences to

(i) Achieving the advantage of the opportunities or

(ii) Face the threats.

(e) Deciding the scope of the activities of the organization. For example, decision regarding receiving or making foreign direct investment, products or services diversifications, opening of foreign branch etc

(f) Decisions regarding the Mergers, Acquisitions, demerger, and corporate restructuring -the most potent corporate restructuring tools. These are the well accepted and established strategies for corporate growth.(These are referred as inorganic growth strategies). Every decision that builds or erodes the value of the firm is a strategic decision framework

 (i) Team of SM people

Strategic decisions is too important to be left to the specialists or heads of concern and departments,. Hence, the SM team includes (a) top level management people like the Executive Chairman, CEO and Executive Directors (b) CFO and (c) the heads of such departments as will be affected by the decision or will be responsible for implementation of the decisions. Sometimes, the team is expanded for some special decisions. For example, the non-executive director having special knowledge / experience regarding the decision to be taken. These people must have a thorough knowledge and analysis of the internal as well as external environment of the organization so as to take right decisions.

 

(ii)Defining and confining the strategic decision making

The strategic decision-making is defined and confined by the vision, values, mission and goals. These are broader guidelines for strategic decision making team. These are explained below:

(a) Vision: The strategic decisions are guided by the vision of the firm. Vision describes the desired long-term future of the organization. Vision provides guidance about protecting and stimulating progress toward a successful future. Vision challenges, inspires and motivates the people to do more and to feel proud, excited and part of the organization. A vision should stretch the organization’s capabilities and image of itself. It gives shape and direction to the organization’s future. Vision is not a decision. It is a dream of the leader(s) of the organization.

(b) Values: Values are the philosophies that guide an organization’s internal conduct as well as its relationship with the external world. The values are self-acknowledged moral standards. Values explain what is and what is not acceptable in the organization. Values shape the actions of the managers and the employees. Examples of the values:

Encourage free and open competition. Do not ruin competitors’ image by fraudulent practices.

Treat everyone (employees, business associates and customers) with respect and integrity.

Meet all the commitments and obligations timely.

The strategic decisions should be within the boundaries of the corporate values.

 

(c) Mission and Goals: Mission describes what the organization intends to do to serve its stakeholders. Mission is a precise description of what the organization doing. It should describe the business the organization is in. It is a definition of “why” the organization exists currently. While vision is a dream for future mission relates to what, why and where we are today and where we want to go in near future. Goal setting is the foundation for success.

 

(iii) Process of strategic decision making:

 

(a) The process of strategic decision making begins with clearly understanding the

(i) Vision, Mission, goals, values and day-to-day business practice of the organization

(ii) The situation regarding which the decision is taken

(iii) Ownstrength (its resources and market standing) and weaknesses and

(iv) Opportunities and threats.

Perform a situation analysis – availability and requirement of resources and competitor analysis. Value addition comes from a detailed understanding of both

(i) The finances and the company’s operating and competitive capabilities and

(ii) Customers requirement and competition.

The strategic management should check the suitability of the proposal under their consideration. Suitability deals with the overall rationale of the proposal. To be suitable, the proposal should

(i) Make economic sense and

(ii) Benefit the society.

The feasibility of the proposal should also be checked. Feasibility is concerned with whether the resources required to implement the strategy are available, can be developed or obtained. Resources include funding, people, time and information.

 

(b) Acknowledge the reality of risk so that it may be faced with thoughtful planning. Keep risk at optimum level. If the business risk is high, the financial risk may be kept at low level. If the business risk is low, the financial risk can be faced.

 

(c) Optimum Alternative: Identify the various alternatives. Select the optimum alternative using the appropriate technique of the strategic decision making, for example NPV, IRR, ROI, Balance Scorecard, EVA, Benefit cost ratio etc.,the decision should be guided by three bases (i) Return (ii) Risk and (iii)Reaction of various stakeholders.

 

The decision should be in the interest of all the stakeholders of the company including the society; hence before final decision, social cost benefit analysis should also be performed. Though the strategic decision making aims at value creation for the shareholders, it tries to balance the interests of other stakeholder as well. If the company does not satisfy the financial claims of its constituents, it will cease to be a viable organization. Employees, customers, and suppliers will simply withdraw their support.

 

(iii) Guidelines for action plans: The strategic decisions should be implemented effectively so that the desired results can be achieved. Hence, the SM people should provide leadership to the other managers who are to convert the decisions into actions. The SM should communicate the decisions to all those who are

(i) Supposed to implement the decision and

(ii) Being affected by the decisions.

The SM lay down the path for moving from present situation to the destination and develops the overall policies. Policies are the intentions and principles which provide a framework for how an organization means to operate. They provide the guidelines for drawing the plans. The plans should be flexible so that they can be changed if the need bathe plans provide (i) the details of how to achieve the mission and (ii) tactics to be applied when the road block is there.

 

(iv) Monitoring and Implementation :

It is a leadership role; The SFM monitors the implementation of the strategic decisions. SFM should provide guidance and motivate the other managers for achieving the results. The managers implementing the decisions should be sure that the top management of the company is with them in their task of implementation.

 

(v) Revising and refining the decisions. Revise and refine the plans according to the new scenario that has emerged after the original plan was instituted. Strategic management is an ongoing process. It assesses and reassesses and re-reassesses a new strategy to meet changed circumstances, new technology, new competitors, a new economic environment, or a new social, financial, or political environment. Revision may also be required if the company finds a road block while the decision is being implemented.

Interface of Financial Policy and Strategic Management.

• The interface of strategic management and financial policy will be understandable if we appreciate the fact that the starting point of an organization is money and the end point of that organization is also money.
• No organization can run an existing business and promote a new expansion project without a suitable internally mobilized financial base or both internally and externally mobilized financial base.
• Sources of finance and capital structure are the most important dimensions of a strategic plan. The generation of funds may arise out of ownership capital and or borrowed capital. A company may issue equity shares and/or preference shares for mobilizing ownership capital.
• At the time of mobilization of funds, policy makers should decide on the capital structure to indicate the desired mix of equity capital and debt capital. There are some norms for debt equity ratio.
• Whereas this ratio in its ideal form varies from industry to industry. It also depends on the planning mode of the organization under study.
• Other important dimension of strategic management and financial policy interface is the investment and fund allocation decisions.
• A planner has to frame policies for regulating investments in fixed assets and for restraining of current assets. Investment proposals mooted by different business units may be addition of a new product, increasing the level of operation of an existing product and cost reduction and efficient utilization of resources through a new approach and or closer monitoring of the different critical activities.
• On the basis of the afore said three types of proposals a planner should evaluate each one of them by making within group comparison in the light of capital budgeting exercise.
• Dividend policy is yet another area for making financial policy decisions affecting the strategic performance of the company. A close interface is needed to frame the policy to be beneficial for all. Dividend policy decision deals with the extent of earnings to be distributed as dividend and the extent of earnings to be retained for future expansion scheme of the firm.
• On the basis of afore said points financial policy of a company cannot be worked out in isolation of other functional policies.
• It has a wider appeal and closer link with the overall organizational performance and direction of growth.
• These policies being related to external awareness about the firm, specially the awareness of the investors about the firm, in respect of its internal performance. • There is always a process of evaluation active in the minds of the current and future stake holders of the company.
• As a result preference and patronage for the company depends significantly on the financial policy framework.
• It should attract, the attention of the corporate planners while framing the financial policies not at a later stage but during the stage of corporate planning itself.

MEASURING SHAREHOLDERS VALUE CREATION: EVA AND MVA

The two new measures used to determine whether an investment positively contributes to the share holder wealth are:-

1. Economic Value Added [EVA]
2. Market Value Added [MVA]
3. Economic Value Added [EVA]

Economic value added (EVA) is a measure of a company’s financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.

EVA can also be referred to as economic profit, and it attempts to capture the true economic profit of a company. This measure was devised by Stern Stewart and Co.

EVA is an internal management performance measure that compares Net Operating Profit to Total Cost of Capital. It is used as an indicator of how profitable company projects are and it therefore serves as a reflection of management performance. Businesses are only truly profitable when they create wealth for their shareholders, and the measure of this goes beyond calculating Net Income.

EVA is the incremental difference in the rate of return over a company’s cost of capital. Essentially, it is used to measure the value a company generates from funds invested into it. If a company’s EVA is negative, it means the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows a company is producing value from the funds invested in it.

Modern investors are demanding shareholder value more strongly than ever. The financial theory suggested that every company’s ultimate aim is to maximize the wealth of its shareholders. This is quite natural since shareholders own the company and as rational investors expect good long term return on their investment. EVA aims to tell what has happened to the wealth of the shareholders. EVA is based on the concept that earning a return greater than the cost of capital increases value of a company, and earning less destroys value.

Calculating EVA

The formula for calculating EVA is: EVA = Net Operating Profit after Taxes (NOPAT)– Invested Capital X Weighted Average Cost of Capital (WACC)

The equation above shows there are three key components to a company’s EVA: NOPAT, the amount of capital invested and the WACC. NOPAT can be calculated manually but is normally listed in a public company’s financials. Capital invested is the amount of money used to fund a specific project. WACC is the average rate of return a company expects to pay its investors; the weights are derived as a fraction of each financial source in a company’s capital structure. WACC can also be calculated but is normally provided as public record. It is calculated as

WACC = [Cost of Equity x proportion of equity from capital + Cost of debt x proportion of debt from capital x [1-tax rate]

Or

 EVA = NOPAT – CAPITAL COST

NOPAT = PBIT [1-T] = PAT + INT [1-T]

OR EVA = [RATE OF RETURN – COST OF CAPITAL] X CAPITAL

The goal of EVA is to quantify the charge, or cost, for investing capital into a certain project, and then assess whether it is generating enough cash to be considered a good investment. The charge represents the minimum return that investors require to make their investment worthwhile. A positive EVA shows a project is generating returns in excess of the required minimum return.

The Benefits of EVA

The purpose of EVA is to assess company and management performance. EVA champions the idea a business is only profitable when it creates wealth and returns for shareholders, and requires performance above a company’s cost of capital.

EVA as a performance indicator is very useful. The calculation shows how and where a company created wealth, through the inclusion of balance sheet items. This forces managers to be aware of assets and expenses when making managerial decisions. However, the EVA calculation relies heavily on the amount of invested capital, and is best used for asset-rich companies that are stable or mature. Companies with intangible assets, such as technology businesses, may not be good candidates for an EVA evaluation.

The idea behind EVA is that shareholders must earn a return that compensates the risk taken. The equity capital has to earn at least same return as similarly risky investments at equity markets. If that is not the case, then there is no real profit and actually the company operates at a loss from the view point of shareholders. On the other hand if EVA is zero, this should be treated as a sufficient achievement because the shareholders have earned a return that compensates the risk.

‘MARKET VALUE ADDED – MVA’

Market value added (MVA) is a calculation that shows the difference between the market value of a company and the capital contributed by investors, both bondholders and shareholders. In other words, it is the sum of all capital claims held against the company plus the market value of debt and equity. It is calculated as:

MVA = company s market value-invested capital

When investors want to see how a company performs for its shareholders, they first look at MVA. A company’s MVA is an indication of its capacity to increase shareholder value over time. A high MVA is evidence of effective management and strong operational capabilities. A low MVA can mean the value of management’s actions and investments is less than the value of the capital contributed by shareholders.

MVA Reflects Commitment to Shareholder Value

Companies with a high MVA are attractive to investors not only because of the greater likelihood they will produce positive returns but also because it is a good indication they have strong leadership and sound governance. MVA can be interpreted as the amount of wealth that management has created for investors over and above their investment in the company.

Companies that are able to sustain or increase MVA over time typically attract more investment, which continues to enhance MVA. The MVA may actually understate the performance of a company because it does not account for cash payouts, such as dividends and stock buybacks, made to shareholders. MVA may not be a reliable indicator of management performance during strong bull markets when stock prices rise in general.

Companies with high MVA can be found across the investment spectrum. Alphabet Inc., the parent of Google, is among the most valuable companies in the world with high growth potential. Its stock returned 1,293% in its first 10 years of operation. While much of its MVA in the early years can be attributed to market exuberance over its shares, the company has managed to nearly triple it over the last five years. Alphabet’s MVA has grown from $128.4 billion in 2011 to $354.25 billion in December 2015.

According to Stewart Market value added tells us how much value company has added to, or subtracted from its shareholders investment. Successful companies add their MVA and thus increase the value of capital invested in the company. Unsuccessful companies decrease the value of the capital originally invested in the company. Whether a company succeeds in creating MVA or not, depends on its rate of return. If a company’s rate of return exceeds its cost of capital, the company will sell on the stock markets with premium compared to the original capital. On the other hand, companies that have rate of return smaller than their cost of capital with discount compared to the original capital invested in company. Whether a company has positive or negative MVA depends on the level of rate of return compared to the cost of capital. All this applies to EVA. Thus positive EVA means also positive MVA and vice versa.

 

Market value added = Present value of all future EVA

MARKET TO BOOK VALUE

MARKET TO BOOK VALUE or MB measures the ratio of market value of a share to its book value. Book value of a share is the net worth divided by number of outstanding shares. It represents the money which the company has received from its shareholders and includes investments made by the company on their behalf by retaining profits (internal accruals).

MB Ratio = [Market price per share/Book Value Per share]

It shows how the company is worth for every one rupee of shareholders money employed as capital in the company. An MB ratio of more than one means the company has added more value to shareholders than the capital contributed by them and vice versa.

The price-to-book ratio is a financial ratio used to compare a company’s current market price to its book value. The calculation can be performed in two ways, but the result should be the same either way.

In the first way, the company’s market capitalization can be divided by the company’s total book value from its balance sheet.

1. Market Capitalization / Total Book Value

The second way, using per-share values, is to divide the company’s current share price by the book value per share (i.e. its book value divided by the number of outstanding shares).

 Share price / Book value per share

As with most ratios, it varies a fair amount by industry. Industries that require more infrastructure capital (for each dollar of profit) will usually trade at P/B ratios much lower than, for example, consulting firms. P/B ratios are commonly used to compare banks, because most assets and liabilities of banks are constantly valued at market values.

A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal (and/or that the market value of the firm’s assets is significantly higher than their accounting value). P/B ratios do not, however, directly provide any information on the ability of the firm to generate profits or cash for shareholders.

This ratio also gives some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately.

It is also known as the market-to-book ratio and the price-to-equity ratio (which should not be confused with the price-to-earnings ratio), and its inverse is called the book-to-market ratio.

Risk

Risk is a term in accounting and finance used to describe the uncertainty that a future event with a favorable outcome will occur. In other words, risk is the probability that an investment will not perform as expected and the investor will lose the money invested in the project. All business decisions and opportunities are based on this concept that future performance and returns are uncertain and rely on many uncontrollable variables.

 

Nature of Risk:

Nature of business risks could be highlighted with reference to its following features:

(i) Opportunities for Gains are hidden in Business Risks:

If the management of the business enterprise is able to successfully handle and manage business risks; these provide many opportunities for gains to the business enterprise.

(ii) Business Risks Depend on Time:

In ancient times, business risks were less and limited. In the present-day-times-characterized by intense competition, advanced technology and globalization of the economy; business risks are quite severe. Further, in times to come, business risks are likely to increase in intensity.

(iii) Business Risks Depend on Size of the Business Enterprise:

Small businesses are less exposed to business risks; because they enjoy flexibility of operations and can easily adapt themselves to changing circumstances. On the other hand, the bigger is the size of business; the lesser is the flexibility possessed by it. Hence bigger businesses are more exposed to business risks.

(iv) Business Risks Depend on the Nature of Business:

In case of business enterprises engaged in the manufacture/purchase of necessary items e.g. salt, sugar, oil, cloth etc. there is lesser risk, because demand for most of the necessary item is inelastic or less elastic. On the other hand, business enterprises engaged in the manufacture/purchase of luxury items are more exposed to business risks; because demand for luxury items is highly elastic.

(v) Business Risk Depends on Terms of Sales:

In those lines of business activities, where there is intense competition; business enterprises are exposed to severe risks caused by the actions and reactions of competitors. As such, business enterprises characterized by monopolistic situations face little risk on account of competition. Actually in a perfectly monopolistic situation, the business enterprise has no risk caused by competition.

(vii) Business Risks Depend on Competence of Management:

The more competent the management of business enterprises is; the lesser is the possibility of losses to be caused as a result of business risks, and vice-versa.

(viii) It is Difficult, if not Impossible, to forecast the Possibility of the Occurrence of Business Risks.

 

(ix) Business Risks, to a Large Extent may depend on the Age of the Business Enterprise:

From this viewpoint, old business enterprises are less exposed to business risks, because of the experience of successfully handling business risks, in the past. New business concerns are more exposed to business risks, because of the lack of experience.

(x) Business risks are, by and large, unavoidable though the possibility of the un-favorable consequences associated with business risks could be minimized.

 

Types of Risk

 

Market risk and specific risk are two different forms of risk that affect assets. All investment assets can be separated by two categories:

systematic risk and unsystematic risk. Market risk, or systematic risk, affects a large number of asset classes, whereas specific risk, or unsystematic risk, only affects an industry or particular company.

Systematic risk is the risk of losing investments due to factors, such as political risk and macroeconomic risk, that affect the performance of the overall market. Market risk is also known as volatility and can be measured using beta. Beta is a measure of an investment’s systematic risk relative to the overall market.

Market risk cannot be mitigated through portfolio diversification. However, an investor can hedge against systematic risk. A hedge is an offsetting investment used to reduce the risk in an asset. For example, suppose an investor fears a global recession affecting the economy over the next six months due to weakness in gross domestic product growth. The investor is long multiple stocks and can mitigate some of the market risk by buying put options in the market.

Specific risk, or diversifiable risk, is the risk of losing an investment due to company or industry-specific hazard. Unlike systematic risk, an investor can only mitigate against unsystematic risk through diversification. An investor uses diversification to manage risk by investing in a variety of assets. He can use the beta of each stock to create a diversified portfolio.

For example, suppose an investor has a portfolio of oil stocks with a beta of 2. Since the market’s beta is always 1, the portfolio is theoretically 100% more volatile than the market. Therefore, if the market has a 1% move up or down, the portfolio will move up or down 2%. There is risk associated with the whole sector due to the increase in supply of oil in the Middle East, which has caused oil to fall in price over the past few months. If the trend continues, the portfolio will experience a significant drop in value. However, the investor can diversify this risk since it is industry-specific.

The investor can use diversification and allocate his fund into different sectors that are negatively correlated with the oil sector to mitigate the risk. For example, the airlines and casino gaming sectors are good assets to invest in for a portfolio that is highly exposed to the oil sector. Generally, as the value of the oil sector falls, the values of the airlines and casino gaming sectors rise, and vice versa. Since airline and casino gaming stocks are negatively correlated and have negative betas in relation to the oil sector, the investor reduces the risks that affect his portfolio of oil stocks.

Business risk refers to the basic viability of a business—the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit. While financial risk is concerned with the costs of financing, business risk is concerned with all the other expenses a business must cover to remain operational and functioning. These expenses include salaries, production costs, facility rent, and office and administrative expenses. The level of a company’s business risk is influenced by factors such as the cost of goods, profit margins, competition, and the overall level of demand for the products or services that it sells.

Credit or Default Risk

Credit risk is the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is particularly concerning to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and, as such, the lowest returns. Corporate bonds, on the other hand, tend to have the highest amount of default risk, but also higher interest rates. Bonds with a lower chance of default are considered investment grade, while bonds with higher chances are considered junk bonds. Investors can use bond rating agencies – such as Standard and Poor’s, Fitch and Moody’s – to determine which bonds are investment-grade and which are junk

Country Risk

Country risk refers to the risk that a country won’t be able to honor its financial commitments. When a country defaults on its obligations, it can harm the performance of all other financial instruments in that country – as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit

Foreign-Exchange Risk

When investing in foreign countries, it’s important to consider the fact that currency exchange rates can change the price of the asset as well. Foreign exchange risk (or exchange rate risk) applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you live in the U.S. and invest in a Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the U.S. dollar.

Interest Rate Risk

Interest rate risk is the risk that an investment’s value will change due to a change in the absolute level of interest rates, the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. This type of risk affects the value of bonds more directly than stocks and is a significant risk to all bondholders. As interest rates rise, bond prices fall – and vice versa

Political Risk

Political risk is the risk an investment’s returns could suffer because of political instability or changes in a country. This type of risk can stem from a change in government, legislative bodies, other foreign policy makers or military control. Also known as geopolitical risk, the risk becomes more of a factor as an investment’s time horizon gets longer

Counterparty Risk

Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions, especially for those occurring in over-the-counter (OTC) markets. Financial investment products such as stocks, options, bonds, and derivatives carry counterparty risk. Bonds are rated by agencies, such as Moody’s and standard and poor’s, from AAA to junk bond status to gauge the level of counterparty risk. Bonds that carry higher counterparty risk pay higher yields.

Financial Instrument

Financial instruments are assets that can be traded, or they can also be seen as packages of capital that may be traded. Most types of financial instruments provide efficient flow and transfer of capital all throughout the world’s investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one’s ownership of an entity.

 

Forwards:

A forward contract is a simple customized contract between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike future contracts, they are not traded on an exchange, rather traded in the over-the-counter market, usually between two financial institutions or between a financial institution and one of its clients. In brief, a forward contract is an agreement between the counter parties to buy or sell a specified quantity of an asset at a specified price, with delivery at a specified time (future) and place. These contracts are not standardized; each one is usually customized to its owner’s specifications.

For example, an Indian car manufacturer buys auto parts from a Japanese car maker with payment of one million yen due in 60 days. The importer in India is short of yen and supposes present price of yen is Rs. 68. Over the next 60 days, yen may rise to Rs. 70. The importer can hedge this exchange risk by negotiating a 60 days forward contract with a bank at a price of Rs. 70. According to forward contract, in 60 days the bank will give the importer one million yen and importer will give the banks 70 million rupees to bank.

 

 

 

 

Features of forward contract

The basic features of a forward contract are given in brief here as under:

1. Bilateral:

Forward contracts are bilateral contracts, and hence, they are exposed to counter-party risk. More risky than futures: There is risk of non-performance of obligation by either of the parties, so these are riskier than futures contracts.

2. Customized contracts: Each contract is custom designed, and hence, is unique in terms of contract size, expiration date, the asset type, quality, etc.
3. Long and short positions: In forward contract, one of the parties takes a long position by agreeing to buy the asset at a certain specified future date. The other party assumes a short position by agreeing to sell the same asset at the same date for the same specified price. A party with no obligation offsetting the forward contract is said to have an open position. A party with a closed position is, sometimes, called a hedger.
4. Delivery price: The specified price in a forward contract is referred to as the delivery price. The forward price for a particular forward contract at a particular time is the delivery price that would apply if the contract were entered into at that time. It is important to differentiate between the forward price and the delivery price. Both are equal at the time the contract is entered into. However, as time passes, the forward price is likely to change whereas the delivery price remains the same.
5. Synthetic assets: In the forward contract, derivative assets can often be contracted from the combination of under­lying assets, such assets are often known as synthetic assets in the forward market. The forward contract has to be settled by delivery of the asset on expiration date. In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which may dominate and command the price it wants as being in a monopoly situation.
6. Pricing of arbitrage based forward prices: In the forward contract, covered parity or cost-of-carry relations are relation between the prices of forward and underlying assets. Such relations further assist in determining the arbitrage-based forward asset prices.
7. Popular in forex market: Forward contracts are very popular in foreign exchange market as well as interest rate bearing instruments. Most of the large and international banks quote the forward rate through their ‘forward desk’ lying within their foreign exchange trading room. Forward foreign exchange quotes by these banks are displayed with the spot rates.
8. Different types of forward: As per the Indian Forward Contract Act1952, different kinds of forward contracts can be done like hedge contracts, transferable specific delivery (TSD) contracts and non-transferable specific delivery (NTSD) contracts. Hedge contracts are freely transferable and do not specify, any particular lot, consignment or variety for delivery. Transferable specific delivery contracts are though freely transferable from one party to another, but are concerned with a specific and predetermined consignment. Delivery is mandatory. Non-transferable specific delivery contracts, as the name indicates, are not transferable at all, and as such, they are highly specific.

Futures:

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. A speculator expects an increase in price of gold from current future prices of Rs. 9000 per 10 gm. The market lot is 1 kg and he buys one lot of future gold (9000 × 100) Rs. 9,00,000. Assuming that there is 10% margin money requirement and 10% increase occur in price of gold. the value of transaction will also increase i.e. Rs. 9900 per 10 gm and total value will be Rs. 9,90,000. In other words, the speculator earns Rs. 90,000.

Suppose a farmer produces rice and he expects to have an excellent yield on rice; but he is worried about the future price fall of that commodity. How can he protect himself from falling price of rice in future? He may enter into a contract on today with some party who wants to buy rice at a specified future date on a price determined today itself. In the whole process the farmer will deliver rice to the party and receive the agreed price and the other party will take delivery of rice and pay to the farmer. In this illustration, 15 there is no exchange of money and the contract is binding on both the parties. Hence future contracts are forward contracts traded only on organized exchanges and are in standardized contract-size. The farmer has protected himself against the risk by selling rice futures and this action is called short hedge while on the other hand, the other party also protects against-risk by buying rice futures is called long hedge.

Features of financial futures contract

Financial futures, like commodity futures are contracts to buy or sell, financial aspects at a future date at a specified price. The following features are there for future contracts:

• Future contracts are traded on organized future exchanges. These are forward contracts traded on organized futures exchanges.
• Future contracts are standardized contracts in terms of quantity, quality and amount.
• Margin money is required to be deposited by the buyer or sellers in form of cash or securities. This practice ensures honor of the deal.
• In case of future contracts, there is a dairy of opening and closing of position, known as marked to market. The price differences every day are settled through the exchange clearing house. The clearing house pays to the buyer if the price of a futures contract increases on a particular day and similarly seller pays the money to the clearing house. The reverse may happen in case of decrease in price.

Types of financial future contracts

Financial futures contracts can be categorized into following types:

1. Interest rate futures: In this type the futures securities traded are interest bearing instruments like T-bills, bonds, debentures, euro dollar deposits and municipal bonds, notional gilt-contracts, short term deposit futures and Treasury note futures.
2. Stock index futures: Here in this type contracts are based on stock market indices. For example in US, Dow Jones Industrial Average, Standard and poor’s 500 New York Stock Exchange Index. Other futures of this type include Japanese Nikkei index, TOPIX etc.
3. Foreign currency futures: These future contracts trade in foreign currency generating used by exporters, importers, bankers, FIs and large companies.
4. Bond index futures: These contracts are based on particular bond indices i.e. indices of bond prices. Municipal Bond Index futures based on Municipal Bonds are traded on CBOT (Chicago Board of Trade).
5. Cost of living index future: These are based on inflation measured by CPI and WPI etc. These can be used to hedge against unanticipated inflationary pressure.

OPTIONS :

The options are important financial derivatives where the instruments have additional features of exercising an option which is a right and not the obligation. Hence, options provide better scope for risk coverage and making profit at any time within the expiration date. The price of the underlying is derived from the underlying asset. Options are of different types. Some are related to stock index, some with currency and interest rates. During the last three decades the option trading gained momentum though the first option in commodity was launched in 1860in USA. Based on the sale and purchase there are two types of options: put and call. The exercise-time of adoption makes it in American or European. The other category of option includes- over the counter (OTC) or exchange traded. Options can be valued either with the help of intrinsic value or with time value. There are two positions in option trading- long and short position.

Option may be defined as a contract between two parties where one gives the other the right (not the obligation) to buy or sell an underlying asset as a specified price within or on a specific time. The underlying may be commodity, index, currency or any other asset. As an example, party has 1000 shares of Satyam Computer whose current price is Rs. 4000per share and other party agrees to buy these 1000 shares on or before a fixed date (i.e. suppose after4month) at a particular price say it is become Rs.4100 per share. In future within that specific time period he will definitely purchase the shares because by exercising the option, he gets Rs. 100 profit from purchase of a single share.

In the reverse case suppose that the price goes below Rs. 4000 and declines to Rs. 3900 per share, he will not exercise at all the option to purchase a share already available at a lower rate. Thus option gives the holder the right to exercise or not to exercise a particular deal. In present time options are of different varieties like- foreign exchange, bank term deposits, treasury securities, stock indices, commodity, metal etc. Similarly the example can be explained in case of selling right of an underlying asset

Features of options

The following features are common in all types of options.

• Contract:

Option is an agreement to buy or sell an asset obligatory on the parties.

• Premium:

In case of option a premium in cash is to be paid by one party (buyer) to the other party (seller).

• Pay off:

From an option in case of buyer is the loss in option price and the maximum profit a seller can have in the options price.

• Holder and writer

Holder of an option is the buyer while the writer is known as seller of the option. The writer grants the holder a right to buy or sell a particular underlying asset in exchange for certain money for the obligation taken by him in the option contract.

• Exercise price

There is call strike price or exercise price at which the option holder buys (call) or sells (put) an underlying asset.

• Variety of underlying asset

the underlying asset traded as option may be variety of instruments such as commodities, metals, stocks, stock indices, currencies etc.

• Tool for risk management

Options are a versatile and flexible risk management tools which can mitigate the risk arising from interest rate, hedging of commodity price risk. Hence options provide custom-tailored strategies to fight against risks.

Types of options

There are various types of options depending upon the time, nature and exchange of trading. The following is a brief description of different types of options:

• Put and call option
• American and European option
• Exchange traded and OTC options.

Put option

It is an option which confers the buyer the right to sell an underlying asset against another underlying at a specified time on or before predetermined date. The writer of a put must take delivery if this option is exercised. In other words put is an option contract where the buyer has the right to sell the underlying to the writer of the option at a specified time on or before the option’s maturity date.

 Call option

It is an option which grants the buyer (holder) the right to buy an underlying asset at a specific date from the writer (seller) a particular quantity of underlying asset on a specified price within a specified expiration/maturity date. The call option holder pays premium to the writer for the right taken in the option.

American option provides the holder or writer to buy or sell an expiry of the option. On the other hand a European option can be exercised only on the date of expiry or maturity is clear that American options are more popular because there is timing flexibility to exercise the same. But in India, European options are prevalent and permitted. Exchange traded options can be traded on recognized exchanges like the futures contracts.

Over the counter options are custom tailored agreement traded directly by the dealer without the CREC, involvement of any organized exchange. Generally large commercial bankers and investment banks trade in OTC options. Exchange traded options have specific expiration date, quantity of underlying asset but in OTC traded option trading there is no such parties. Hence OTC traded options are not bound by strict expiration date, specific limited strike price and uniform underlying asset. Since exchange traded options are guaranteed by the exchanges, hence they have less risk of default because the deals are cleared by clearing houses.

On the other side OTC options have higher risk element of default due to non-involvement of any third party like clearing houses. Offsetting the position by buyer or seller in exchange traded option is quite possible because the buyer sells or the seller buys another option with identical terms and conditions., the rights are transferred to another option holder. But due to unstandardized money is required by the writer of option but there is no such requirement for margin funds in OTC optioning. In exchange traded option contracts, there is low cost of transactions because the creditworthiness of the buyer of options is influencing factor in OTC traded options.

SWAP

Introduction

In the recent past, there has been integration of financial markets world-wide which have led to the emergence of some innovative financial instruments. In a complex world of variety of financial transactions being taken place every now and then, there arises a need to understand the risk factors and the mechanism to avoid the risks involved in these financial transactions. The recent trends in financial markets show increased volume and size of swaps markets.

Financial swaps are an asset liability management technique which permits a borrower to access one market and then exchange the liability for another type of liability. Thus, investors can exchange one asset to another with some return and risk features in a swap market.

Meaning of swaps

The dictionary meaning of ‘swap’ is to exchange something for another. Like other financial derivatives, swap is also agreement between two parties to exchange cash flows. The cash flows may arise due to change in interest Rate or currency or equity etc. In other words, swap denotes an agreement to exchange payments of two different kinds in the future. The parties that agree to exchange cash flows are called ‘counter parties’.

In case of interest rate swap, the exchange may be of cash flows arising from fixed or floating interest rates, equity swaps involve the exchange of cash flows from returns of stocks index portfolio. Currency swaps have basis cash flow exchange of foreign currencies and their fluctuating prices, because of varying rates of interest, pricing of currencies and stock return among different markets of the world.

Features of swaps

The following are features of financial swaps:

 Counter parties: Financial swaps involve the agreement between two or more parties to exchange cash flows or the parties interested in exchanging the liabilities.

Facilitators: The amount of cash flow exchange between parties is huge and also the process is complex. Therefore, to facilitate the transaction, an intermediary comes into picture which brings different parties together for big deal. These may be brokers whose objective is to initiate the counterparties to finalize the swap deal. While swap dealers are themselves counter partied who bear risk and provide portfolio management service.

Cash flows: The present values of future cash flows are estimated by the counterparties before entering into a contract. Both the parties want to get assurance of exchanging same financial liabilities before the swap deal. Less documentation: is required in case of swap deals because the deals are based on the needs of parties, therefore, fewer complexes and less risk consuming

Transaction costs: Generating very less percentage is involved in swap agreement. Benefit to both parties: The swap agreement will be attractive only when parties get benefits of these agreements. Default-risk: is higher in swaps than the option and futures because the parties may default the payment.

Types of financial swaps

The swaps agreement provides a mechanism to hedge the risk of the counter parties. The risk can be- interest rate, currency or equity etc.

 Interest rate swaps

It is a financial agreement to exchange interest payments or receipts for a predetermined period of time traded in the OTC market. The swap may be on the basis of fixed interest rate for floating interest rate. This is the most common swap also called ‘plain vanilla coupon swap’ which is simply in agreement between two parties in which one party payments agrees to the other on a particular date a fixed amount of money in the future till a specified termination date. This is a standard fixed-to-floating interest rate swap in which the party (fixed interest payer) makes fixed payments and the other (floating rate payer) will make payments which depend on the future evolution of a specified interest rate index.

The fixed payments are expressed as percentage of the notional principal according to which fixed or floating rates are calculated supposing the interest payments on a specified amount borrowed or lent. The principal is notional because the parties do not exchange this amount at any time but is used for computing the sequence of periodic payments. The rate used for computing the size of the fixed payment, which the financial institution or bank are willing to pay if they are fixed ratepayers (bid) and interested to receive if they are floating rate payers in a swap (ask) is called fixed rate.

 

 

Currency swaps

In these types of swaps, currencies are exchanged at specific exchange rates and at specified intervals. The two payments streams being exchange dare dominated in two different currencies. There is an exchange of principal amount at the beginning and a re-exchange at termination in a currency swap. Basic purpose of currency swaps is to lock in the rates (exchange rates).As intermediaries large banks agree to take position in currency suppose ‘pounds’ and the other party raises the funds at fixed rate in currency suppose US dollars.

The principal amount is equivalent at the spot market exchange rate. In the beginning of the swap contract, the principal amount is exchanged with the first party handing over British Pound to the second, and subsequently receives US dollars as return. The first party pays periodic dollar payment to the second and the interest is calculated on the dollar principal while it receives from the second party payment in pound again computed as interest on the pound principal. At maturity the British pound and dollar principals are re-exchanged on a fixed-to-floating currency swaps or cross-currency-coupon swaps, the following possibilities may occur:

(a) One payment is calculated at a fixed interest rate while the other in floating rate.

(b) Both payments on floating rates but in different currencies.

(c) There may be contracts without and with exchange and exchange of principals.

Fixed to fixed currency swaps:

In this swap agreement the currencies are exchanged at a fixed rate. A fixed to floating currency swap involves the combinations of a fixed-to-fixed currency swap and floating swap. One party pays to the another at a fixed rate in currency say ‘A’ and the other party makes the payment at a floating rate in currency say ‘B’. In a floating to-floating swap the counter parties will have payment at floating rate indifferent currencies.

 

Valuation of swaps

The value of a swap depends upon so many factors such as the nature of swap, interest rate risks, expiry time, value at expiration, fixed and floating rates of interest, the principal amount and many more. Let’s discuss the valuation aspect of an interest rate swap.

Valuation of interest rate swap

At the initiation stage the worth of an interest swap is zero or nearly zero. With the passage of time, this value may be positive or negative. The fixed rate interest swap is valued by treating the fixed rate payments as cash flows on a traditional bond and the floating rate swap value is quite equivalent to a floating rate note (FRN). If there is no default risk, the value of an interest swap can be computed either as a long position in one bond combined with a short position in another bond or as a portfolio of forward contracts.

Since in a swap agreement the principal is not exchanged. Some financial intermediaries act as market makers and they are ready to quote a bid and an offer for the fixed rate which they will exchange for floating. The is the fixed rate in a contract where the market maker will pay fixed and receive floating while the offer rate in a swap the market maker will receive fixed and pay floating. These rates are quoted for the number of maturities and number of different currencies

Rationale behind swapping

To avoid risk of fluctuation in forex, interest rates, stock indices investors attitude etc. the swap market has merged now to explain that why firms and people want to enter into swap agreement. The rationale can be explained by the following points:

• Market in perfection and inefficiency
• Different risk preferences
• Government regulation
• Funding at low cost
• Demand supply imbalance
• To improve financial records

Imperfect market:

As you know that the swap agreements are meant for transforming financial claims to reduce risk. Since there lie different reasons for the growth in swap market and the most important to the imperfection and inefficiency in the markets. The swap agreements are required in order to investigate market imperfections, difference of attitude of investors, information asymmetry, tax and regulatory structure by the government, various kinds of financial norms and regulations etc. Had there been a uniformity of standards and norms and perfect market conditions, swaps could not have generated much enthusiasm. Hence due to imperfect capital market conditions, swaps give opportunity to the investors for hedging the risk.

Differing risk profiles:

The basis of credit rating of bonds by financial institutions, banks and individual investor is quite different. In other words, the computation of risks are different from point of view of individual, institutional and other types of investor, thereby changing the risk profile. Based on this, the investor has to take decision to hedge, speculate or arbitrage opportunity. In some markets, the company can raise funds at lower cost and can swap for a particular market. A low credit rated firm can raise funds from floating rate credit market and enjoy comparative advantage over highly rated company because it pay a smaller risk premium. The differing interest rates in different markets can be arbitraged and disbursed between the counter parties.

Regulation by govt:

The regulatory practices of government of different nations can make attractive or unattractive the swap markets. Sometimes the government restricts the funding by foreign companies to protect the interest of the domestic investors. It may also happen that to attract foreign companies the government opens the domestic markets. This phenomenon of the government rule and regulations influence the growth of swap agreements.

 

Funding at low cost:

In some businesses suppose export financing, there exists subsidized funding and currency swap agreements can take advantage of this situation. The company can swap the exchange risk by entering into a favorable currency swap.

Demand and supply forces:

Depending on the needs of the country and its development plans, the central bank squeezes the reserve requirements there by increasing the supply of the funds because of resultant lowering of interest rates. Definitely the borrowers will be interested in those markets where there is a sufficient supply of funds. Thus the borrowers can take arbitrage opportunity in his favor due to different economic conditions

Matches Asset-Liability:

The counter parties involved in swap sometimes desire to make the match between asset and liability. For this purpose they take the help of swap and funds can be tapped as per the requirements of the companies. Therefore, differing rates of interests in different markets and over time changes in the same provide arbitrage opportunities which can be tapped by currency swap agreements

Corporate risk management

It refers to all of the methods that a company uses to minimize financial losses. Risk managers, executives, line managers and middle managers, as well as all employees, perform practices to prevent loss exposure through internal controls of people and technologies. Risk management also relates to external threats to a corporation, such as the fluctuations in the financial market that affect its financial assets.

 

 

 

 

Protecting Shareholders

A corporation has at least one shareholder. A large corporation, such as a publicly-traded or employee-owned firm, has thousands, or even millions, of shareholders. Corporate risk management protects the investment of shareholders through specific measures to control risk. For example, a company needs to ensure that its funds for capital projects, such as construction or technology development, are protected until they are ready to use.

 

FINANCIAL PLANNING AND FORCASTING RATIO ANALYSIS:

The First Steps

  Introduction

 

Financial planning is a continuous process of directing and allocating financial resources to meet strategic goals and objectives. The output from financial planning takes the form of budgets. The most widely used form of budgets is Pro Forma or Budgeted Financial Statements. The foundation for Budgeted Financial Statements is Detail Budgets. Detail Budgets include sales forecasts, production forecasts, and other estimates in support of the Financial Plan. Collectively, all of these budgets are referred to as the Master Budget.

 

We can also break financial planning down into planning for operations and planning for financing. Operating people focus on sales and production while financial planners are interested in how to finance the operations. Therefore, we can have an Operating Plan and a Financial Plan. However, to keep things simple and to make sure we integrate the process fully, we will consider financial planning as one single process that encompasses both operations and financing.

 

  Start with Strategic Planning

 

Financial Planning starts at the top of the organization with strategic planning. Since strategic decisions have financial implications, you must start your budgeting process within the strategic planning process. Failure to link and connect budgeting with strategic planning can result in budgets that are “dead on arrival.”

 

Strategic planning is a formal process for establishing goals and objectives over the long run. Strategic planning involves developing a mission statement that captures why the organization exists and plans for how the organization will thrive in the future. Strategic objectives and corresponding goals are developed based on a very thorough assessment of the organization and the external environment. Finally, strategic plans are implemented by developing an Operating or Action Plan. Within this Operating Plan, we will include a complete set of financial plans or budgets.

 

Financial Plans (Budgets)  Operating Plan  Strategic Plan NOTE: Short Course 10 describes how to prepare a Strategic Plan.

 

  The Sales Forecast

 

In order to develop budgets, we will start with a forecast of what drives much of our financial activity; namely sales. Therefore, the first forecast we will prepare is the Sales Forecast. In order to estimate sales, we will look at past sales histories and various factors that influence sales. For example, marketing research may reveal that future sales are expected to  stabilize. Maybe we cannot meet growing sales because of limited production capacities or maybe there will be a general economic slow down resulting in falling sales. Therefore, we need to look at several factors in arriving at our sales forecast.

 

After we have collected and analyzed all of the relevant information, we can estimate sales volumes for the planning period. It is very important that we arrive at a good estimate since this estimate will be used for several other estimates in our budgets. The Sales Forecast has to take into account what we expect to sell at what sales price.

 

  Percent of Sales

 

We now need to estimate account changes because of estimated sales. One way to estimate and forecast certain account balances is with the Percent of Sales Method.  By looking  at past account balances and past changes in sales, we can establish a  percentage relationship. For example, all variable costs and most current assets and current liabilities will vary as sales change.

 

 

 

Chapter

Detail Budgets

We also need to prepare several detail budgets for developing a Budgeted Income Statement. For example, production must be planned for our estimated sales of 16,000 units from Exhibit 1. The Production Department will need to budget for materials, labor, and overhead based on what we expect to sell and what we expect in inventory.

 

Once we have established our level of production (Exhibit 2), we can prepare a Materials Budget. The Materials Budget attempts to forecast the level of purchases required, taking into account materials required for production and inventory levels. We can summarize materials to be purchased as:

 

Materials Purchased = Materials Required + Ending Inventory – Beginning Inventory

 

The second component of production is labor. We need to forecast our labor needs based on expected production. The Labor Budget arrives at expected labor cost by applying an expected labor rate to required labor hours.

 

 

 

As production moves up or down, support services and other costs related to production will also change. These overhead costs represent the third major costs of production. Each item that comprises overhead may warrant independent analysis so that we can determine what drives the specific cost. For example, production rental equipment may be driven by production orders while depreciation is driven by levels of capital investment spending.

 

 

Once production costs (direct materials, direct labor, and overhead) have been budgeted, we can work these numbers into our beginning inventory levels for Direct Materials, Work In Progress, and Finished Inventory. Beginning inventory levels are actual amounts from the last reporting period. We need to apply our costs based on what we want ending inventory to be. The end-result is a Budget for Cost of Goods Sold, which we will use for our Forecasted Income Statement.

 

 

We can now finish our estimate of expenses by looking at all remaining operating expenses. The first major type of operating expense is marketing. Marketing and Sales Manager’s will prepare and submit a Marketing Budget to upper level management for approval.

 

The final area of operating expenses is the administrative costs of running the overall business. These types of expenses will be estimated based on past trends and what we expect to happen in the future. For example, if the company has plans for a new computer system, then we should budget for additional technology related expenses. Several department managers will be involved in preparing the General and Administrative Expense Budget.

 

	EXHIBIT 8 — GENERAL & ADMINISTRATIVE BUDGET   Estimated for each line item per Department Managers: Management Personnel $110,000 Accounting Personnel 55,000 Legal Personnel 40,000 Technology Personnel 45,000 Rent & Utilities 25,000 Supplies 15,000 Miscellaneous 7,500 Total G & A Expenses $ 297,500   Chapter

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Budgeted Financial Statements

Based on the detail budgets we have prepared (Exhibits 1 thru 8), we can finalize our budgets in the form of a Budgeted Income Statement. A few new line items are added to account for non-operating items, such as income received on investments and financing costs. The Finance and Tax Departments will assist in estimating items like financing expenses and income tax expenses. The Budgeted Income Statement will pull together all revenue and expense estimates from our previously prepared detail budgets.

 

 

EXAMPLE 2 — BUDGETED INCOME STATEMENT

 

Halton Company has compiled the following information: Planned sales are 50,000 units at a price of $ 110.00 per unit.

Beginning Inventory consists of 5,000 units at a cost of $ 60.00 per unit. Planned production is 55,000 units with the following production cost:

Direct Materials are $ 18.50 per unit

Direct Labor required is 4 hours per unit @ $ 12.00 per hour Overhead is estimated at 20% of Direct Labor Cost

Desired Ending Inventory is 6,000 units under the LIFO Method. Marketing Expenses are budgeted at $ 350,000

General & Administrative Expenses are budgeted at $ 400,000

 

< – – – – – – – – – – – – – – – Budgeted Income Statement——————– >

 

Sales (50,000 x $ 110) Less Cost of Goods Sold:		$ 5,500,000
Beginning Inventory (5,000 x $ 60.00)	$    300,000
Direct Materials (55,000 x $ 18.50)	1,017,500
Direct Labor (55,000 x 4 hours x $ 12.00)	2,640,000
Overhead ($ 2,640,000 x .20)	528,000
Cost of Available Sales	4,485,500
Less Ending Inventory (1)	( 380,500)
Cost of Goods Sold		(4,105,000)
Gross Profits		1,395,000
Less Operating Expenses:
Marketing Expenses		( 350,000)
General & Administrative		( 400,000)
Net Income		$ 645,000

 

(1) Under LIFO, last costs in are: $ 1,017,500 + $ 2,640,000 + $ 528,000 =

$ 4,185,500 / 55,000 = $ 76.10 x 5,000 = $ 380,500.

 

 

Now that we have a Budgeted Income Statement, we can prepare a Budgeted Balance Sheet. The Budgeted Balance Sheet will provide us with an estimate of how much external financing is required to support our estimated sales.

 

The main link between the Income Statement and the Balance Sheet is Retained Earnings. Therefore, preparation of the Budgeted Balance Sheet starts with an estimate of the ending balance for Retained Earnings. In order to estimate ending Retained Earnings, we need to project future dividends based on current dividend policies and what management expects to pay in the next planning period.

 

Next, we need to account for the acquisition of fixed assets. As a business depletes its asset base, it must re-invest to sustain assets which are the basis for generating revenues. For example, do we need to purchase new machinery or computer equipment? Do we plan to expand our production facilities? Operating personnel and upper-level management will decide on future capital spending. Future capital expenditures are summarized on the Capital Expenditures Budget.

 

Based on the beginning balance in assets and the budget for capital assets (Exhibit 11), we can estimate an ending asset balance for the Budgeted Balance Sheet.

We will assume that liabilities and interest expense will remain the same. However, after we

have determined our level of external financing, we will need to revise these amounts. Additionally, we need to analyze trends and ratios in order to ascertain accounts that do not fluctuate with sales. For example, prepaid expense is a current asset that has little to do with sales.

 

Since the Balance Sheet is a year-end estimate, it assumes that all other estimates have been met. In a world of rapid change, annual forecasts are rarely close. Therefore, we will simplify our preparation of the Budgeted Balance Sheet by relying on relationships. Stable relationships over the last five years are particularly helpful. The Budgeted Balance Sheet will show either a surplus (excess financing over assets) or a deficit (additional financing needed to cover assets). This difference is derived from the Accounting Equation: Assets = Liabilities

+ Equity.

 

 

We also can calculate External Financing Required (EFR) based on the relationships between assets, liabilities, and sales. The following formula can be used:

 

EFR = (A / S x Sales) – (L / S x Sales) – (PM x FS x (1 – d))

A / S: Assets that change given a change in sales, expressed as a percentage of sales.

Sales: Change in sales between the last reporting period and the forecasted sales.

L / S: Liabilities that change given a change in sales, expressed as a percentage of sales. PM: Profit Margin on Sales; i.e. net income / sales.

FS: Forecasted Sales

(1 – d): Percent of earnings retained after paying out dividends; d is the dividend payout ratio.

 

 

EXAMPLE 4 — PREPARE BUDGETED BALANCE SHEET

 

Gilmer Company has compiled the following information:

 

• Sales for the last reporting period were $ 600,000
• Projected sales are $ 800,000
• Profit Ratio is 5% of sales
• Dividend Payout Ratio is 40%
• Current Balance in Retained Earnings is $ 200,000
• Cash as a % of sales is 4%
• Accounts Receivable as a % of sales 10%
• Inventory as a % of sales is 30%
• Net Fixed Assets are budgeted at $ 300,000
• Accounts Payable as a % of sales is 7%
• Accrued Liabilities as a % of sales is 15%
• Common Stock will remain at $ 220,000

 

Budgeted Balance Sheet

 

Cash ($ 800,000 x .04)                                     $     32,000

Accounts Receivable ($ 800,000 x .10)                  80,000

Inventory ($ 800,000 x .30)                                   240,000

Net Fixed Assets                                                  300,000

Total Assets                                              $  652,000

 

Accounts Payable ($ 800,000 x .07)                 $     56,000

Accrued Liabilities ($ 800,000 x .15)                    120,000

Common Stock                                                     220,000

Retained Earnings (1)

Total Liabilities & Equity                               620,000

Total Additional Financing Required              32,000 Total Liabilities & Equity after financing                               $  652,000

 

(1): Beginning Balance                         $ 200,000 Increase for New Income:

$ 800,000 x .05 (profit margin)           40,000 Less Dividends:

.40 x $ 40,000 Net Income                 (16,000)

Ending Balance                               $ 224,000

 

After we have prepared budgeted financial statements, it is very important to carefully review these statements with management. For example, can we truly expect to raise $ 166,303 in capital as indicated in Exhibit 13? Will the budgeted financial statements meet the expectations of shareholders? Several critical questions must be asked before we finalize our budgeted financial statements.

 

Additionally, our budgets were prepared on an annual basis. Many unplanned events can take place during the year, making our annual budgets extremely inaccurate. Therefore, financial planning is often improved by simply forecasting on a monthly or quarterly basis as opposed to an annual basis.

  The Cash Budget

 

A good example of short-term financial planning is the Cash Budget. The Cash Budget is an estimate of future cash inflows and outflows. Cash Budgets are often included with the Budgeted Balance Sheet. However, it should be noted that Cash Budgets are not widely used as a general forecasting tool since they are specific to one account, namely cash. Instead, Cash Budgets are often used by Cash Managers and Treasury personnel for managing cash.

 

We can use our previous forecasts to help us prepare a Cash Budget. For example, we can get an idea of payable disbursements for manufacturing by looking at the Materials Budget (Exhibit 3), Labor Budget (Exhibit 4), and the Overhead Budget (Exhibit 5). We can start preparing a Cash Budget by simply looking at our stable cash flow patterns, such as  accounts receivable, accounts payable, payroll, etc. We also have several predictable transactions, such as insurance payments, loan payments, etc.

 

 

  Summary of the Budgeting Process

 

We started our budgeting process by looking at strategic planning. Strategic Planning should always be the starting point for financial planning. From the Strategic Plan, we develop a Plan of Action so we can implement the Strategic Plan. This is often called an Operating Plan. Within the Operating Plan, we will include a set of budgets for successful implementation of the Strategic Plan. The entire set of budgets can be categorized as follows:

So far, we have emphasized simple approaches to preparing budgets, such as looking at relationships between account balances and  sales. We also should have a clear understanding of past financial performance to help us predict future financial performance. Extending past trends and adjusting for what is expected is a common approach to preparing a forecast. However, we can improve forecasting by using several techniques. The first step  is recognize certain fundamentals about forecasting:

 

1. Forecasting relies on past relationships and existing historical information. If these relationships change, forecasting becomes increasingly
2. Since forecasting can be inaccurate due to uncertainty, we should consider developing several forecast under different scenarios. We can assign probabilities to each scenario and arrive at our expected
3. The longer the planning period, the more inaccurate the If we need to increase reliability in forecasting, we should consider a shorter planning period. The planning period depends upon how often existing plans need to be evaluated. This will depend upon stability in sales, business risk, financial conditions, etc.
4. Forecasting of large inter-related items is more accurate than forecasting a specific itemized When a large group of items are forecast together, errors within the group tend to cancel out. For example, an overall economic forecast will be more accurate than an industry specific forecast.

 

  Quantitative and Qualitative Techniques

 

You should forecast for a specific reason – to help make better decisions. Forecasting is extremely difficult and you must pull from all relevant sources. We previously discussed the Percent of Sales Method and Trend Analysis as a way of forecasting. These forecasting techniques are quantitative. Quantitative techniques of forecasting are best used when changes are infrequent. In today’s world of rapid change, quantitative techniques tend to be  of little use.

We need to add more qualitative techniques into the budgeting process. Qualitative techniques include surveys, interviews with people who are “in the know”, market reports, articles, and other information sources that allow us to make a better judgement. Qualitative or Judgmental Forecasting can help improve the budgeting process, especially if we are operating in a rapidly changing environment.

 

The Delphi Method is an example of a qualitative technique where a group of experts gets together and reaches a consensus on what will happen in the future. A questionnaire is sometimes used to facilitate the process. Two disadvantages of the Delphi Method are low reliability with the consensus and inability to reach a clear consensus.

 

  Smoothing out the Numbers

 

One simple approach to forecasting is to setup a model that relies on averages from past historical data. For example, we can take an average of the last five years. As we move forward to the next planning period, a new moving average is calculated and used as the forecast for the next planning period. Exponential smoothing can be used whereby we place more weight on the most recent set of actual numbers. This can be important where changes have occurred, making older data less reliable.

 

  Regression Analysis

 

A statistical approach can be used for forecasting. We can rely on the average relationships between a dependent variable and an independent variable. Simple regressions look at one independent variable (such as sales pricing or advertising expenses) whereas multiple regressions consider two or more variables (such as sales pricing and advertising expenses together). Regression analysis is very popular for forecasting sales since it helps us find the right fit over a range of observations. For example, if we plot out the following observations, we can prepare a scatter graph and find the right fit:

 

Advertising Expense               Sales Dollars

$ 100	$ 1,500
150	1,560
180	1,610
220	1,655
270	1,685

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  Sensitivity Analysis

 

We can measure how sensitive our forecast is to changes in certain variables. We can develop a range of possibilities under different assumptions and prepare alternative plans. If Plan A fails, we can quickly move to Plan B. Sensitivity analysis also tells us which assumptions have the biggest impact on the forecast. Managers can concentrate most of their resources on the biggest impact areas for improving the forecast. The main benefit of sensitivity analysis is to measure the possibility of errors in the forecast.

 

  Financial Models

 

Budgets can be prepared with the use of formal models which take advantage of techniques like regressions and sensitivity analysis. Models are built around the collection of equations, logic, and data that flows according to the relationships between operating variables and financial outputs. Financial variables (costs, sales, investments, taxes, etc.) can be manipulated by the user so that the user can see the outcome of a decision before it is made. This can help facilitate strategic thinking within the budgeting process. Two types of financial models are simulation and optimization. Simulation attempts to duplicate the effects of a decision and show its impact. Optimization seeks to optimize (maximize or minimize) a forecast objective (revenues, production costs, etc.).

 

Financial models provide decision support services for improvements within budgeting. Some of the benefits of financial models include:

 

• Shows the results of planning under a variety of assumptions, allowing the user to assess the impacts of estimates that have been
• Generates the Budgeted Income Statement and Budgeted Balance Sheet as well as forecasted financials by business unit or

 

In order to build a financial model, we need to establish variables, parameters, and relationships. Additionally, we can divide variables into three types:

1. Control Variables: The inputs that the company can control, such as the level of debt financing or the level of capital
2. External Variables: Inputs that the company cannot control, such as economic conditions, consumer spending, interest rates,
3. Policy Variables: Goals and objectives of the company can impact the expected outcomes. For example, management may set targets for sales, profitability, and

 

Parameters are the baselines or boundaries for the financial model. For example, the level of debt may have a minimum and maximum value. We also will set our beginning account balances within the financial model.

 

Relationships are the logic and specifications required for making things work. For example, the Budgeted Balance Sheet will require that Assets = Liabilities + Equity. Several equations will be used within the financial model. Many of these equations will be relational; i.e. if we change sales prices, total revenues will change. Equations are tested and added to the financial model to make it complete. Equations can be expanded into business and decision rules so that users do not have to worry about calculating things like return on equity. The financial model takes care of critical rules for running the business or making decisions.

 

Chapter

 

 

Making the Budgeting Process Work

Now that we understand what goes into financial planning, it is time to focus on how to make the process into a value-added activity. Many organizations are attempting to re-engineer budgeting practices since budgeting is usually a non-value added activity; i.e. it does not add value to the decision making process. The goal is to make the entire financial planning process into a decision support service within the organization whereby the benefits of the process exceed the costs.

 

In order to fully comprehend the problems associated with budgeting, let’s quickly list the top ten problems with budgeting according to Controller Magazine:

 

1. Takes too long to

 

2. Doesn’t help us run our

 

3. Budgets are out-of-date by the time we get

 

4. Too much playing with the

 

5. Too many iterations / repetitive tasks within the

 

6. Budgets are cast in stone in a constantly changing business

 

7. Too many people are involved in the budgeting

 

8. Unable to control budget

 

9. By the time budgets are complete, I don’t recognize the

 

10. Budgets do not match the strategic goals and objectives of the

 

We will now discuss several ways of making budgeting into a value-added activity within the organization.

 

  Automate the Process

 

In order for budgeting to be value-added, it must accept revisions quickly and easily. A highly automated budgeting process can help streamline the process for quick and easy updating. As a minimum, budgets should be maintained on spreadsheets. A spreadsheet (such as Excel, Lotus 1-2-3, etc.) can have an input panel for entering variables and automatic generation of budgets within a fully integrated set of spreadsheets. For example, we can use a formula to calculate interest expense as:

Interest Rate x (Beginning Long Term Debt + Current Portion of Long Term Debt + External Financing Using Long Term Debt)

 

Spreadsheets also allow us to perform sensitivity analysis. We can simply enter new variables into the input panel and review the impact on our budgets.

 

We can also use more formal software programs for budgeting. The best software programs will give us the option of controlling the level of detail. For example, do we want a cash budget by customer or do we want cash budgets by account or can we simply enter the cash flow data ourselves? It is very important that we have control over the detail since commercial programs sometimes over-analyze transactions and provide way too much detail. This is why many financial planners prefer spreadsheets over commercial programs.

 

  Ten Best Practices in Budgeting

 

Finally, here are some best practices that can transform budgeting into a  value-added activity:

 

1. Budgeting must be linked to strategic planning since strategic decisions usually have financial

 

2. Make budgeting procedures part of strategic For  example, strategic assessments should include historical trends, competitive analysis, and other procedures that might otherwise take place within the budgeting process.

 

3. The Budgeting Process should minimize the time spent collecting and gathering data and spend more time generating information for strategic decision

 

4. Get agreement on summary budgets before you spend time preparing detail

 

5. Automate the collection and consolidation of budgets within the entire Users should have access to budgeting systems for easy updating.

 

6. Budgets need to accept changes quickly and Budgeting should be a continuous process that encourages alternative thinking.

 

7. Line item detail in budgets should be based on material thresholds and not rely on a system of general ledger

 

8. Budgets should give lower level managers some form of fiscal control over what is going

 

9. Leverage your financial systems by establishing a data warehouse that can be used for both financial reporting and

 

10. Multi-National Companies should have a budgeting system that can handle inter- company elimination’s and foreign currency

 

 

Summary

Financial Planning is a continuous process that flows with strategic decision making. The Operating Plan and the Financial Plan will both support the Strategic Plan. The best place to start in preparing a budget is with sales since this is a driving force behind much of our financial activity. However, we have to take into account numerous factors before we can finalize our budgets.

 

Budgeting should be flexible, allowing modification when something changes. For example, the following will impact budgeting:

 

• Life cycle of the business
• Financial conditions of the business
• General economic conditions
• Competitive situation
• Technology trends
• Availability of resources

 

Budgeting should be both top down and bottom up; i.e. upper level management and middle level management will both work to finalize a budget. We can streamline the budgeting process by developing a financial model. Financial models can facilitate “what if” analysis so we can assess decisions before they are made. This can dramatically improve the budgeting process.

 

One of the biggest challenges within financial planning and budgeting is how do we make it value-added. Budgeting requires clear channels of communication, support from upper-level management, participation from various personnel, and predictive characteristics. Budgeting should not strive for accuracy, but should strive to support the decision making process. If we focus too much on accuracy, we will end-up with a budgeting process that incurs time and costs in excess of the benefits derived. The challenge is to make financial planning a value- added activity that helps the organization achieve its strategic goals and objectives.

 

 

Final Exam

Select the best answer for each question. Exams are graded and administered by installing the exe file version of this course. The exe file version of this course can be downloaded over the internet at www.exinfm.com/training.

 

 

1. In order for budgeting to really work, we must link the budgeting process with:

 

1. Financial Statements

 

1. Accounting Transactions

 

1. Strategic Planning

 

1. Operating Reports

 

2. The first forecast we will prepare for budgeting will be the:

 

1. Budgeted Income Statement

 

1. Sales Forecast

 

1. Cash Budget

 

1. Budgeted Balance Sheet

 

3. Taylor Manufacturing has compiled the following production information for manufacturing jugs of beverages:

 

Planned production is 6,000 jugs

Materials required per jug: 10 pounds of powder Desired Ending Inventory for Materials: 4,000 pounds Beginning Inventory for Materials: 3,000 pounds Purchase Cost for Materials: $ 2.00 per pound

 

Based on the above information, what is the total cost for planned materials purchased? a. $ 110,000

1. $ 120,000

 

1. $ 122,000

 

1. $128,000

 

4. Which of the following detail budgets will help us prepare the Budgeted Income Statement?

 

1. Direct Labor Budget

 

1. Cash Budget

 

1. Budgeted Balance Sheet

 

1. Year End Balance Sheet

 

5. If accounts payable have historically been 20% of sales and we have estimated sales of

$ 200,000, than estimated accounts payable must be:

 

1. $ 10,000

 

1. $ 20,000

 

1. $ 30,000

 

1. $ 40,000

 

6. Which budget is prepared for determining how much external financing we will need to support estimated sales?

 

1. Cash Budget

 

1. Budgeted Income Statement

 

1. Budgeted Balance Sheet

 

1. Sales Forecast

 

7. A good place to start in preparing the Budgeted Balance Sheet is with the main link between the Income Statement and the Balance Sheet. This link is:

 

1. Cash

 

1. Retained Earnings

 

1. Current Assets

 

1. Long Term Liabilities

 

8. One way to improve the budgeting process is to include qualitative techniques into Which of the following is an example of a qualitative technique?

 

1. 5 Year Trend Analysis

 

1. Ratio Analysis

 

1. Percent of Sales Method

 

1. Interviewing the President of the Company

 

9. Statistical methods can be used to improve the accuracy of This approach is particularly useful for forecasting sales since we are searching for the right fit based on several observations. One popular approach to finding the right statistical fit is to use:

 

1. Exponential Smoothing

 

1. Regression Analysis

 

1. Executive Polling

 

1. Moving Average

 

10. Which of the following will contribute to making budgeting a non-value added activity; e. the cost of budgeting exceeds the benefit?

 

1. The budgeting process is included within the strategic planning

 

1. Detail and Summary Budgets are prepared at the same time and are distributed to management for

 

1. Budgets throughout the organization are automated for enterprise-wide

 

1. Line item detail in budgets is based on material

 

UNIT-2

CORPORATE  VALUATION:

Corporation valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to perfect the sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners’ ownership interest for buy-sell agreements, and many other business and legal purposes.

Three different approaches are commonly used in business valuation: the income approach, the asset-based approach, and the market approach. Within each of these approaches, there are various techniques for determining the value of a business using the definition of value appropriate for the appraisal assignment. Generally, the income approach determines value by calculating the net present value of the benefit stream generated by the business (discounted cash flow ); the asset-based approach determines value by adding the sum of the parts of the business (net asset value); and the market approach determines value by comparing the subject company to other companies in the same industry, of the same size, and/or within the same region.

1. Income approaches

• Discount or Capitalization Rates

A discount rate or capitalization rate is used to determine the present value of the expected returns of a business. The discount rate and capitalization rate are closely related to each other, but are distinguishable. Generally speaking, the discount rate or capitalization rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment.

• Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is one method of determining the appropriate discount rate in business valuations. The CAPM method originated from the Nobel Prize winning studies of Harry Markowitz, James Tobin, and William Sharpe. The CAPM method derives the discount rate by adding a risk premium to the risk-free rate. In this instance, however, the risk premium is derived by multiplying the equity risk premium times ” beta,” which is a measure of stock price volatility. Beta is published by various sources for particular industries and companies. Beta is associated with the systematic risks of an investment.

• Modified Capital Asset Pricing Model

The Cost of Equity (Ke) is computed by using the Modified Capital Asset Pricing Model

CAPM Model ke = Rf + B ( Rm-Rf) + SCRP + CSRP Where: Rf = Risk free rate of return (Generally taken as 10-year Government Bond Yield) B = Beta Value (Sensitivity of the stock returns to market returns) Ke = Cost of Equity Rm= Market Rate of Return SCRP = Small Company Risk Premium, CSRP= Company specific Risk premium

• Weighted Average Cost of Capital (“WACC”)

The weighted average cost of capital is an approach used to determine a discount rate. The WACC method determines the subject company’s actual cost of capital by calculating the weighted average of the company’s cost of debt and cost of equity. The WACC must be applied to the subject company’s net cash flow to total invested capital.

2. Asset-Based Approaches

The value of asset-based analysis of a business is equal to the sum of its parts. That is the theory underlying the asset-based approaches to business valuation. The asset approach to business valuation is based on the principle of substitution: no rational investor will pay more for the business assets than the cost of procuring assets of similar economic utility. In contrast to the income-based approaches, which require the valuation professional to make subjective judgments about capitalization or discount rates, the adjusted net book value method is relatively objective.

3. Market Approaches

The market approach to business valuation is rooted in the economic principle of competition: that in a free market the supply and demand forces will drive the price of business assets to a certain equilibrium. Buyers would not pay more for the business, and the sellers will not accept less than the price of a comparable business enterprise. It is similar in many respects to the “comparable sales” method that is commonly used in real estate appraisal. The market price of the stocks of publicly traded companies engaged in the same or a similar line of business, whose shares are actively traded in a free and open market, can be a valid indicator of value when the transactions in which stocks are traded are sufficiently similar to permit meaningful comparison.

Discounted Dividend vs. Corporate Valuation

The dividend discount model values a firm at the discounted sum of all of its future dividends, and does not factor in income or assets.

LEARNING OBJECTIVES

Calculate a company’s stock price using the discounted dividend formula

KEY TAKEAWAYS

Key Points

• P = D1 / ( r – g ). P is the current stock price, g is the constant growth rate in perpetuity expected for the dividends, r is the constant cost of equity for that company, and D1 is the value of the next year’s dividends.
• The equation can also be understood to generate the value of a stock such that the sum of its dividend yield (income) plus its growth ( capital gains ) equals the investor ‘s required total return.
• There are also problems with the model, such as the presumption of a steady and perpetual growth rate less than the cost of capital may not be reasonable.

Key Terms

• Miller-Modigliani hypothesis: The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.

The dividend discount model (DDM) is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to value stocks based on the net present value of the future dividends. The equation most always used is called the “Gordon Growth Model. ” It is named after Myron J. Gordon who originally published it in 1959, although the theoretical underpin was provided by John Burr Williams in his 1938 text The Theory of Investment Value.

The variables and equation are:

• P is the current stock price.
• g is the constant growth rate in perpetuity expected for the dividends.
• r is the constant cost of equity for that company.
• D1 is the value of the next year’s dividends.
• There is no reason to use a calculation of next year’s dividend using the current dividend and the growth rate, when management commonly disclose the future year’s dividend, and websites post it.

P=D1r−gP=D1r−g

Income plus capital gains equals total return:

The equation can also be understood to generate the value of a stock such that the sum of its dividend yield (income) plus its growth (capital gains) equals the investor’s required total return. Consider the dividend growth rate as a proxy for the growth of earnings and by extension the stock price and capital gains. Consider the company’s cost of equity capital as a proxy for the investor’s required total return.

Income + Capital Gain = Total Return

Dividend Yield + Growth = Cost of Equity

DP+g=rDP+g=r

DP=r−gDP=r−g

Dr−g=pDr−g=p

Problems with the Model

• a) The presumption of a steady and perpetual growth rate less than the cost of capital may not be reasonable.
• b) If the stock does not currently pay a dividend, like many growth stocks, more general versions of the discounted dividend model must be used to value the stock. One common technique is to assume that the Miller-Modigliani hypothesis of dividend irrelevance is true and, therefore, replace the stocks’s dividend D with E earnings per share. However, this requires the use of earnings growth rather than dividend growth, which might be different.
• c) The stock price resulting from the Gordon model is hypersensitive to the growth rate chosen.

 

LONG TERM PROJECTS:

One of the many positives about children’s services is that many children attend on permanent days each week over a long period of time, making it easy to have long-term projects. The possibilities for these are endless.

 

A few examples of long-term projects are:

• planning and preparing for a community event such as a family evening
• setting up a pen pal arrangement with children overseas or even in another state
• making a scrapbook about the service and adding to it over the year
• planting and maintaining a garden
• writing and performing a play
• creating a mural
• rearranging the space in which the service operates and evaluating the effectiveness of the change
• conducting a simple charity

 

Children need to be enthusiastic about any long-term project they will be motivated to complete it. When children feel empowered and see themselves as collaborators with educators in planning and implementing experiences, they will have ideas and make suggestions, which should be encouraged.

 

At other times educators will get an idea from noticing what children are talking about and showing interest in. Educators will need to make sure that the project is realistic, achievable and appropriate, and that resources needed are available. It is important however, for educators to do this without taking ownership away from children.

 

What is a long-term project?

Typically it is a varied collection of experiences that are related, that have an outcome and that take place over days, weeks or even months. The project may be altered as time passes, but it begins with an idea and a plan.

 

 

 

Some projects in children’s services may be sufficiently complex that over time they involve all the children, while others may be more contained and involve only a few children.

 

Characteristics of successful long-term projects in children’s services

Children of any age gain satisfaction from making a real contribution, doing something that benefits others. This nurtures a sense of belonging and helps the child and others appreciate his or her skills and talents. Many long-term projects offer this opportunity.

 

Successful long-term projects typically have the following characteristics:

• the idea comes initially from the group, or if not, is enthusiastically adopted by the group
• children lead and take responsibility
• the project is sufficiently ‘open’ so that children who do not come to the children’s service every day can still join It is important that children who are leading the project do not see participation as limited to certain people, but allow others to join in as they are interested
• it is accepted that interest and enthusiasm may wax and wane – that is, there are no requirements to participate
• deadlines are realistic, so that there is every chance of success
• the project is open and contains varied tasks, so that children of different ages and with different skills can make a genuine

 

Value of long-term projects

An excellent long-term project shares many qualities with all good experiences in children’s services because it can:

• give more mature children the opportunity to exercise leadership over a period of time
• usually has variety built into it, so that children can choose not only whether or not to be involved but how
• often contribute to or benefit others, which nurtures a sense of community
• help children learn patience, organisational skills, cooperation, negotiation, perseverance
• enable children to exercise leadership in a variety of ways
• give children an opportunity to engage in long-term planning
• require teamwork and collaboration among children of the same, and different, ages

 

 

 

• appeal to all ages and both genders
• require a range of skills and talents to be successful
• help to identify new talents and skills
• involve challenges
• result in strong feelings of satisfaction and achievement on part of those who contributed (if the project has been successful!).

 

‘When children participate collaboratively in everyday routines, events and experiences, and have opportunities to contribute to decisions, they learn to live interdependently. [This can be observed through] children being able to revisit group projects and play over extended periods of time, and [the Educators] participating in children’s group play and projects and supporting children to be responsible for and to share decision-making within the group’

(Department of Education, Employment and Workplace Relations, 2010, p. 92)

 

 

 

Points to consider

There are a number of considerations for educators in relation to a long-term project:

• Is it realistic to expect that we can do this successfully and in the time we have (if there is a completion date)?
• Can we handle having this project and still offering other kinds of opportunities – that is, can we avoid having the project dominate the program over a period of time?
• Do we have enough space for children to work on this project and still offer other experiences so that children have choices?
• If the children’s service does not operate in dedicated space, can this project be packed away and set up again each day?
• Is the session flexible, with big ‘chunks’ of time rather than brief segments, so that children can really get involved? Dividing the session into small segments will interfere with

children’s engagement, as they are likely to have the attitude that they will have to stop before they’re ready – it’s best not to engage too strongly in the first place.

• Do we have the materials and resources?
• Are there ways we can involve people outside the service (for example, family members, school personnel, members of the community) to help make this project successful?

 

 

 

 

It is critical to evaluate the project along the way. This gives children a valuable opportunity to experience revising plans, reassessing goals, being flexible, dealing with success and failure, and thinking creatively. Perhaps build discussion into group meetings about the project or hold special meetings of those most involved to discuss how it is going.

 

UNIT-3

INDEX:

Capital Structure Policy:

Business and financial risk – total risk perspective and market risk perspective –

Determinants of capital structure decision –

Approaches to estimate the target capital structure – variations in capital structures,

EBIT / EPS Analysis and ROI /ROE analysis.

Capital Structure Theories: Net Income Approach – Net Operating

Income Approach – Traditional Approach – Modigliani-Miller Model (MM), Miller

Model – criticism of MM and Miller models – financial distress and agency cost –

asymmetric information theory.

Dividend and Bonus Policy

Capital Structure Policy

The capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings.

KEY TAKEAWAYS

• Capital structure is how a company funds its overall operations and growth.
• Debt consists of borrowed money that is due back to the lender, commonly with interest expense.
• Equity consists of ownership rights in the company, without the need to pay back any investment.
• The Debt-to-Equity (D/E) ratio is useful in determining the riskiness of a company’s borrowing practices.

Understanding Capital Structure

Both debt and equity can be found on the balance sheet. Company assets, also listed on the balance sheet, are purchased with this debt and equity. Capital structure can be a mixture of a company’s long-term debt, short-term debt, common stock, and preferred stock. A company’s proportion of short-term debt versus long-term debt is considered when analyzing its capital structure.

When analysts refer to capital structure, they are most likely referring to a firm’s debt-to-equity (D/E) ratio, which provides insight into how risky a company’s borrowing practices are. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore poses greater risk to investors. This risk, however, may be the primary source of the firm’s growth.

Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to access.

Equity allows outside investors to take partial ownership in the company. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back. This is a benefit to the company in the case of declining earnings. On the other hand, equity represents a claim by the owner on the future earnings of the company.

Measures of Capital Structure

Companies that use more debt than equity to finance their assets and fund operating activities have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates.

Financial Risk vs. Business Risk:

Financial risk and business risk are two different types of warning signs that investors must investigate when considering making an investment. Financial risk refers to a company’s ability to manage its debt and financial leverage, while business risk refers to the company’s ability to generate sufficient revenue to cover its operational expenses.

KEY TAKEAWAYS

• Financial risk relates to how a company uses its financial leverage and manages its debt load.
• Business risk relates to whether a company can make enough in sales and revenue to cover its expenses and turn a profit.
• With financial risk, there is a concern that a company may default on its debt payments.
• With business risk, the concern is that the company will be unable to function as a profitable enterprise.

Financial Risk

A company’s financial risk is related to the company’s use of financial leverage and debt financing, rather than the operational risk of making the company a profitable enterprise.

Financial risk is concerned with a company’s ability to generate sufficient cash flow to be able to make interest payments on financing or meet other debt-related obligations. A company with a relatively higher level of debt financing carries a higher level of financial risk since there is a greater possibility of the company not being able to meet its financial obligations and becoming insolvent.

Some of the factors that may affect a company’s financial risk are interest rate changes and the overall percentage of its debt financing. Companies with greater amounts of equity financing are in a better position to handle their debt burden. One of the primary financial risk ratios that analysts and investors consider to determine a company’s financial soundness is the debt/equity ratio, which measures the relative percentage of debt and equity financing.

Debt/Equity Ratio = Total Liabilities / Shareholders’ Equity

Foreign currency exchange rate risk is a part of the overall financial risk for companies that do a substantial amount of business in foreign countries.

Business Risk

Business risk refers to the basic viability of a business—the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit. While financial risk is concerned with the costs of financing, business risk is concerned with all the other expenses a business must cover to remain operational and functioning. These expenses include salaries, production costs, facility rent, and office and administrative expenses.

DETERMINANTS OF CAPITAL STRUCTURE

The capital structure of a concern depends upon a large number of factors such as leverage or trading on equity, growth of the company, nature and

size of business, the idea of retaining control, flexibility of capital structure, requirements of investors, cost of floatation of new securities, timing of issue, corporate tax rate and the legal requirements. It is not possible to rank hem because all such factors are of different important and the influence of individual factors of a firm changes over a period of time.

1. Financial Leverage or Trading on Equity: The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. Effects of leverage on the shareholders return or earnings per share have already been discussed in this blog. If the assets financed by debt yield a return greater than the cost of the debt, the earnings per share will increase without an increase in the owners’ investment. Similarly, the earnings per share will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because (i) the cost of debt is usually lower than the cost of preference share capital, and (ii) the interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is not. Because of its effect on the earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company. The companies with high level of the Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders’ equity. One common method of examining the impact of leverage is to analyse the relationship between Earnings Per Share (EPS) at various possible levels of EBIT under alternative methods of financing. The EBIT-EPS analysis is one important tool in the hands of the financial manager to get an insight into the firm’s capital structure management. He can consider the possible fluctuations in EBIT and examine their impact on EPS under different financing plans.  The earnings per share also increase with the use of preference share capital but to the act fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is much more.
2. Growth and Stability of Sales: The capital structure of a firm is highly influenced by the growth and stability of its sales. If the sales of a firm are expected to remain fairly stable, it can raise a higher level of debt. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed commitments of interest payment and repayments of debt. Similarly, the rate of growth in sales also affects the capital structure decision.
3. Cost of Capital: Every dollar invested in a firm has a cost. Cost of capitalrefers to the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. A high degree of risk is assumed by shareholders than debt-holders. The capital structure should provide for the minimum cost of capital. Measuring the costs of various sources of funds is a complex subject and needs a separate treatment. Needless to say that it is desirable to minimize the cost of capital. Hence, cheaper sources should be preferred, other things remaining the same. The main sources of finance for a firm are equity share capital, preference share capital and debt capital. The return expected by the supplier of capital depends upon the risk they have to undertake.  For shareholders the rate of dividend is not fixed and the Board of Directors has no legal obligation to pay dividends even if the profits have been made by the company. The loan of debt-holders is returned within a prescribed period, while shareholders can get back their capital only when the company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity. The tax deductibility of interest charges further reduces the cost of debt. The preference share capital is cheaper than equity capital, but is not as cheap as debt is. Thus, in order to minimize the overall cost of capital, a company should employ a large amount of debt.
4. Risk:   There are two types of risk that are to be considered while planning the capital structureof a firm viz (i)  business risk and (ii) financial risk. Business risk refers to the variability to earnings before interest and taxes. Business risk can be internal as well as external. Internal risk is caused due to improper products mix non availability of raw materials, incompetence to face competition, absence of strategic management etc. internal risk is associated with efficiency with which a firm conducts it operations within the broader environment thrust upon it. External business risk arises due to change in operating conditions caused by conditions thrust upon the firm which are beyond its control e.g. business cycle.
5. Cash Flow: One of the features of a sound capital structure is conservation. Conservation does not mean employing no debt or a small amount of debt. Conservatism is related to the assessment of the liability for fixed charges, created by the use of debt or preference capital in the capital structure in the context of the firm’s ability to generate cash to meet these fixed charges. The fixed charges of a company include payment of interest, preference dividend and principal. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital. Whenever a company thinks of raising additional debt, it should analyse its expected future cash flows to meet the fixed charges. It is obligatory to pay interest and return the principal amount of debt. A firm which shall be able to generate larger and stable cash inflows can employ more debt in its capital structure as compared to the one which has unstable and lesser ability to generate cash inflow. Debt financial implies burden of fixed charge due to the fixed payment of interest and the principal. Whenever a firm wants to raise additional funds, it should estimate, project its future cash inflowsto ensure the coverage of fixed charges.
6. Nature and Size of a Firm: Nature and size of a firm also influence its capital structure. All public utility concern has different capital structure as compared to other manufacturing concern. Public utility concerns may employ more of debt because of stability and regularity of their earnings. On the other hand, a concern which cannot provide stable earnings due to the nature of its business will have to rely mainly on equity capital. The size of a company also greatly influences the availability of funds from different sources. A small company may often find it difficult to raise long-term loans. If somehow it manages to obtain a long-term loan, it is available at a high rate of interest and on inconvenient terms. The highly restrictive covenants in loans agreements of small companies make their capital structure quite inflexible. The management thus cannot run business freely. Small companies, therefore, have to depend on owned capital and retained earnings for their long-term funds. A large company has a greater degree of flexibility in designing its capital structure. It can obtain loans at easy terms and can also issue ordinary shares, preference shares and debentures to the public. A company should make the best use of its size in planning the capital structure.
7. Control: Whenever additional funds are required by a firm, the management of the firm wants to raise the funds without any loss of control over the firm. In case the funds are raised though the issue of equity shares, the control of the existing shareholder is diluted. Hence they might raise the additional funds by way of fixed interest bearing debt and preference share capital. Preference shareholders and debenture holders do not have the voting right. Hence, from the point of view of control, debt financing is recommended. But, depending largely upon debt financing may create other problems, such as, too much restrictions imposed upon imposed upon by the lenders or suppliers of finance and a complete loss of control by way of liquidation of the company.
8. Flexibility:Flexibility means the firm’s ability to adapt its capital structure to the needs of the changing conditions. The capital structure of a firm is flexible if it has no difficulty in changing its capitalisation or sources of funds. Whenever needed the company should be able to raise funds without undue delay and cost to finance the profitable investments. The company should also be in a position to redeem its preference capital or debt whenever warranted by future conditions. The financial plan of the company should be flexible enough to change the composition of the capital structure. It should keep itself in a position to substitute one form of financing for another to economise on the use of funds.
9. Requirement of Investors: The requirements of investors is another factor that influence the capital structure of a firm. It is necessary to meet the requirements of both institutional as well as private investors when debt financing is used. Investors are generally classified under three kinds, i.e. bold investors, cautions investors and less cautions investor.
10. Capital Market Conditions (Timing): Capital Market Conditions do no remain the same for ever sometimes there may be depression while at other times there may be boom in the market is depressed and there are pessimistic business conditions, the company should not issue equity shares as investors would prefer safety.
11. Marketability: Marketability here means the ability of the company to sell or market particular type of security in a particular period of time which in turn depends upon -the readiness of the investors to buy that security. Marketability may not influence the initial capital structure very much but it is an important consideration in deciding the appropriate timing of security issues. At one time, the market favors debenture issues and at another time, it may readily accept ordinary share issues. Due to the changing market sentiments, the company has to decide whether to raise funds through common shares or debt. If the share market is depressed, the company should not issue ordinary shares but issue debt and wait to issue ordinary shares till the share market revives. During boom period in the share market, it may not be possible for the company to issue debentures successfully. Therefore, it should keep its debt capacity unutilised and issue ordinary  shares to raise finances.
12. Inflation: Another factor to consider in the financing decision is inflation. By using debt financing during periods of high inflation, we will repay the debt with dollars that are worth less. As expectations of inflation increase, the rate of borrowing will increase since creditors must be compensated for a loss in value. Since inflation is a major driving force behind interest rates, the financing decision should be cognizant of inflationary trends.
13. Floatation Costs:Floatation costs are incurred when the funds are raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage a company to use debt rather than issue ordinary shares. If the owner’s capital is increased by retaining the earnings, no floatation costs are incurred. Floatation cost generally is not a very important factor influencing the capital structure of a company except in the case of small companies.
14. Legal Considerations: At the time of evaluation of different proposed capital structure, the financial manager should also take into account the legal and regulatory framework. For example, in case of the redemption period of debenture is more than 18 months, then credit rating is required as per SEBI guidelines. Moreover, approval from SEBIis required for raising funds from capital market whereas; no such approval is required- if the firm avails loans from financial institutions. All these and other regulatory provisions must be taken into account at the time of deciding and selecting a capital structure for the firm.

EBIT-EPS analysis

EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and shows ways to maximize EPS. Hence EBIT-EPS analysis may be defined as ‘a tool of financial planning that evaluates various alternatives of financing a project under varying levels of EBIT and suggests the best alternative having highest EPS and determines the most profitable level of EBIT’.

Concept of EBIT-EPS Analysis:

The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative methods of financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the effect of financial leverage on the EPS with varying levels of EBIT or under alternative financial plans.

It examines the effect of financial leverage on the behavior of EPS under different financing alternatives and with vary­ing levels of EBIT. EBIT-EPS analysis is used for making the choice of the combination and of the vari­ous sources. It helps select the alternative that yields the highest EPS.

We know that a firm can finance its investment from various sources such as borrowed capital or equity capital. The proportion of various sources may also be different under various financial plans. In every financing plan the firm’s objec­tives lie in maximizing EPS.

Advantages of EBIT-EPS Analysis:

We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior of EPS under various financing plans with varying levels of EBIT. It helps a firm in determining optimum financial planning having highest EPS.

Various advantages derived from EBIT-EPS analysis may be enumerated below:

Financial Planning:

Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial planning the objective of the firm lies in maximizing EPS. EBIT-EPS analysis evalu­ates the alternatives and finds the level of EBIT that maximizes EPS.

Comparative Analysis:

EBIT-EPS analysis is useful in evaluating the relative efficiency of depart­ments, product lines and markets. It identifies the EBIT earned by these different departments, product lines and from various markets, which helps financial planners rank them according to profitability and also assess the risk associated with each.

Performance Evaluation:

This analysis is useful in comparative evaluation of performances of various sources of funds. It evaluates whether a fund obtained from a source is used in a project that produces a rate of return higher than its cost.

Determining Optimum Mix:

EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By emphasizing on the relative value of EPS, this analysis determines the optimum mix of debt and equity in the capital structure. It helps determine the alternative that gives the highest value of EPS as the most profitable financing plan or the most profitable level of EBIT as the case may be.

Limitations of EBIT-EPS Analysis:

Finance managers are very much interested in knowing the sensitivity of the earnings per share with the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis but this technique also suffers from certain limitations, as described below

No Consideration for Risk:

Leverage increases the level of risk, but this technique ignores the risk factor. When a corporation, on its borrowed capital, earns more than the interest it has to pay on debt, any financial planning can be accepted irrespective of risk. But in times of poor business the reverse of this situation arises—which attracts high degree of risk. This aspect is not dealt in EBIT-EPS analysis.

Contradictory Results:

It gives a contradictory result where under different alternative financing plans new equity shares are not taken into consideration. Even the comparison becomes difficult if the number of alternatives increase and sometimes it also gives erroneous result under such situation.

Debarathi Co. Ltd., is planning an expansion programme. It requires Rs 20 lakhs of external financing for which it is considering two alternatives. The first alternative calls for issu­ing 15,000 equity shares of Rs 100 each and 5,000 10% Preference Shares of Rs 100 each; the second alternative requires 10,000 equity shares of Rs 100 each, 2,000 10% Preference Shares of Rs 100 each and Rs 8,00,000 Debentures carrying 9% interest. The company is in the tax bracket of 50%. You are required to calculate the indifference point for the plans and verify your answer by calculating the EPS.

Solution:

Theories of Capital Structure

The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both.

The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm.

If the value of the firm can be affected by capital structure or financing decision a firm would like to have a capital structure which maximizes the market value of the firm. The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both. If average affects the cost of capital and the value of the firm, an optimum capital structure would be obtained at that combination of debt and equity that maximizes the total value of the firm (value of shares plus value of debt) or minimizes the weighted average cost of capital. For a better understanding of the relationship between financial average and the value of the firm, assumptions, features and implications of the capital structure theories are given below.

Assumptions and Definitions:

In order to grasp the capital structure and the cost of capital controversy property, the following assumptions are made:

Firms employ only two types of capital: debt and equity.

The total assets of the firm are given. The degree of average can be changed by selling debt to purchase shares or selling shares to retire debt.

The firm has a policy of paying 100 per cent dividends.

The operating earnings of the firm are not expected to grow.

The business risk is assumed to be constant and independent of capital structure and financial risk. The corporate income taxes do not exist. This assumption is relaxed later on.

The following are the basic definitions:

The above assumptions and definitions described above are valid under any of the capital structure theories. David Durand views, Traditional view and MM Hypothesis are tine important theories on capital structure.

1. David Durand views:

The existence of an optimum capital structure is not accepted by all. There exist two extreme views and a middle position. David Durand identified the two extreme views – the Net income and net operating approaches.

1. a) Net income Approach (Nl):

Under the net income (Nl) approach, the cost of debt and cost of equity are assumed to be independent of the capital structure. The weighted average cost of capital declines and the total value of the firm rise with increased use of average.

1. b) Net Operating income Approach (NOI):

Under the net operating income (NOI) approach, the cost of equity is assumed to increase linearly with average. As a result, the weighted average cost of capital remains constant and the total of the firm also remains constant as average changed.

Thus, if the Nl approach is valid, average is a significant variable and financing decisions have an important effect on the value of the firm, on the other hand, if the NOI approach is correct, then the financing decision should not be of greater concern to the financial manager, as it does not matter in the valuation of the firm.

2. Traditional view:

The traditional view is a compromise between the net income approach and the net operating approach. According to this view, the value of the firm can be increased or the cost, of capital can be reduced by the judicious mix of debt and equity capital.

This approach very clearly implies that the cost of capital decreases within the reasonable limit of debt and then increases with average. Thus an optimum capital structure exists and occurs when the cost of capital is minimum or the value of the firm is maximum.

The cost of capital declines with leverage because debt capital is chipper than equity capital within reasonable, or acceptable, limit of debt. The weighted average cost of capital will decrease with the use of debt. According to the traditional position, the manner in which the overall cost of capital reacts to changes in capital structure can be divided into three stages and this can be seen in the following figure.

Criticism:

1. The traditional view is criticised because it implies that totality of risk incurred by all security-holders of a firm can be altered by changing the way in which this totality of risk is distributed among the various classes of securities.
2. Modigliani and Miller also do not agree with the traditional view. They criticise the assumption that the cost of equity remains unaffected by leverage up to some reasonable limit.
3. MM Hypothesis:

The Modigliani – Miller Hypothesis is identical with the net operating income approach, Modigliani and Miller (M.M) argue that, in the absence of taxes, a firm’s market value and the cost of capital remain invariant to the capital structure changes.

Assumptions:

The M.M. hypothesis can be best explained in terms of two propositions.

It should however, be noticed that their propositions are based on the following assumptions:

1. The securities are traded in the perfect market situation.
2. Firms can be grouped into homogeneous risk classes.
3. The expected NOI is a random variable
4. Firm distribute all net earnings to the shareholders.
5. No corporate income taxes exist.

Proposition I:

Given the above stated assumptions, M-M argue that, for firms in the same risk class, the total market value is independent of the debt equity combination and is given by capitalizing the expected net operating income by the rate appropriate to that risk class.

This is their proposition I and can be expressed as follows:

According to this proposition the average cost of capital is a constant and is not affected by leverage.

Arbitrary-process:

M-M opinion is that if two identical firms, except for the degree of leverage, have different market values or the costs of capital, arbitrary will take place to enable investors to engage in ‘personal leverage’ as against the ‘corporate leverage’ to restore equilibrium in the market.

Proposition II: It defines the cost of equity, follows from their proposition, and derived a formula as follows:

Ke = Ko + (Ko-Kd) D/S

The above equation states that, for any firm in a given risk class, the cost of equity (Ke) is equal to the constant average cost of capital (Ko) plus a premium for the financial, risk, which, is equal to debt-equity ratio times the spread between the constant average of ‘capita’ and the cost of debt, (Ko-Kd) D/S.

The crucial part of the M-M hypothesis is that Ke will not rise even if very excessive raise of leverage is made. This conclusion could be valid if the cost of borrowings, Kd remains constant for any degree of leverage. But in practice Kd increases with leverage beyond a certain acceptable, or reasonable, level of debt.

However, M-M maintain that even if the cost of debt, Kd, is increasing, the weighted average cost of capital, Ko, will remain constant. They argue that when Kd increases, Ke will increase at a decreasing rate and may even turn down eventually. This is illustrated in the following figure.

Criticism:

The shortcoming of the M-M hypothesis lies in the assumption of perfect capital market in which arbitrage is expected to work. Due to the existence of imperfections in the capital market/arbitrage will fail to work and will give rise to discrepancy between the market values of levered and unlevered firms.

Dividend Decisions

 

INTRODUCTION

 

Once a company makes a profit, it must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. The dividend policy decision involves two questions:

 

• What fraction of earnings should be paid out, on average, over time? And,
• What type of dividend policy should the firm follow? I.e. issues such as whether it should maintain steady dividend policy or a policy increasing dividend growth rate

 

DEFINITION: DIVIDEND

 

According to the Institute of Chartered Accountants of India, dividend is “a distribution to shareholders out of profits or reserves available for this purpose.”

“The term dividend refers to that portion of profit (after tax) which is distributed among the owners / shareholders of the firm”.

In other words, dividend is that part of the net earnings of a corporation that is distributed to its stockholders. It is a payment made to the equity shareholders for their investment in the company.

Dividend is a reward to equity shareholders for their investment in the company. It is a basic right of equity shareholders to get dividend from the earnings of a company.

 

DEFINITION: DIVIDEND POLICY

 

“Dividend policy determines the ultimate distribution of the firm’s earnings between retention (that is reinvestment) and cash dividend payments of shareholders.”

“Dividend policy means the practice that management follows in making dividend payout decisions, or in other words, the size and pattern of cash distributions over the time to shareholders.”

In other words, dividend policy is the firm’s plan of action to be followed when dividend decisions are made. It is the decision about how much of earnings to pay out as dividends versus retaining and reinvesting earnings in the firm.

Dividend policy must be evaluated in light of the objective of the firm namely, to choose a policy that will maximize the value of the firm to its shareholders. The dividend policy of a company reflects how prudent its financial management is. The future prospects, expansion, diversification mergers are effected by dividing policies and for a healthy and buoyant capital market, both dividends and retained earnings are important factors.

As we know in corporation, owners are shareholders but management is done through Board of directors. It is the Board of Directors to decide whether to pay dividend or retain earnings for future projects. It is a matter of conflict between shareholders and directors. Shareholders expect a quick return on their capital. On the other hand, directors have to consider a number of factors in determining divided policy.

Most of the company follows some kind of dividend policy. The usual policy of a company is to retain a position of net earnings and distribute the remaining amount to the shareholders. Many factors have to be evaluated before forming a long term dividend policy.

 

TYPES OF DIVIDENDS:

 

Classifications of dividends are based on the form in which they are paid. Following given below are the different types of dividends:

 

1. Cash dividend
2. Bonus Shares referred to as stock dividend

• Property dividend interim dividend, annual

1. Special- dividend, extra dividend
2. Regular Cash dividend
3. Scrip dividend

• Liquidating dividend
• Property dividend

 

Cash dividend:

 

Companies mostly pay dividends in cash. A Company should have enough cash in its bank account when cash dividends are declared. If it does not have enough bank balance, arrangement should be made to borrow funds. When the Company follows a stable dividend policy, it should prepare a cash budget for the coming period to indicate the necessary funds, which would be needed to meet the regular dividend payments of the company. It is relatively difficult to make cash planning in anticipation of dividend needs when an unstable policy is followed.

The cash account and the reserve account of a company will be reduced when the cash dividend is paid. Thus, both the total assets and net worth of the company are reduced when the cash dividend is distributed. The market price of the share drops in most cases by the amount of the cash dividend distributed.

 

Bonus Shares:

 

An issue of bonus share is the distribution of shares free of cost to the existing shareholders, In India, bonus shares are issued in addition to the cash dividend and not in lieu of cash dividend. Hence, Companies in India may supplement cash dividend by bonus issues. Issuing bonus shares increases the number of outstanding shares of the company. The bonus shares are distributed proportionately to the existing shareholder. Hence there is no dilution of ownership. The declaration of the bonus shares will increase the paid-up Share Capital and reduce the reserves and surplus retained earnings) of the company. The total net-worth (paid up capital plus reserves and surplus) is not affected by the bonus issue. Infact, a bonus issue represents a recapitalization of reserves and surplus. It is merely an accounting transfer from reserves and surplus to paid up capital.

 

The following are advantages of the bonus shares to shareholders:

 

• Tax benefit: One of the advantages to shareholders in the receipt of bonus shares is the beneficial treatment of such dividends with regard to income
• Indication of  higher  future  profits:  The  issue  of  bonus  shares  is      normally

 

interpreted by shareholders as an indication of higher profitability.

• Future dividends may increase: if a Company has been following a policy of paying a fixed amount of dividend per share and continues it after the declaration of the bonus issue, the total cash dividend of the shareholders will increase in the
• Psychological Value: The declaration of the bonus issue may have a favorable psychological effect on shareholders. The receipt of bonus shares gives them a chance sell the shares to make capital gains without impairing their principal They also associate it with the prosperity of the company.

 

 

 

Please note from exam point of view only cash dividend and bonus dividend are important.

Special dividend : In special circumstances Company declares Special dividends. Generally company declares special dividend in case of abnormal profits.

 

Extra- dividend: An extra dividend is an additional non-recurring dividend paid over and above the regular dividends by the company. Companies with fluctuating earnings payout additional dividends when their earnings warrant it, rather than fighting to keep a higher quantity of regular dividends.

 

Annual dividend: When annually company declares and pay dividend is defined as annual dividend.

 

Interim dividend: During the year any time company declares a dividend, it is defined as Interim dividend.

 

Regular cash dividends: They may be paid quarterly, monthly, semiannually or annually.

 

Scrip dividends: These are promises to make the payment of dividend at a future date: Instead of paying the dividend now, the firm elects to pay it at some later date. The ‘scrip’ issued to stockholders is merely a special form of promissory note or notes payable.

 

Liquidating dividends: These dividends are those which reduce paid-in capital: It is a pro- rata distribution of cash or property to stockholders as part of the dissolution of a business.

 

Property dividends: These dividends are payable in assets of the corporation other than cash. For example, a firm may distribute samples of its own product or shares in another company it owns to its stockholders.

 

 

THE DIVIDEND DECISION

 

WHO MAKES DIVIDEND DECISION?

 

The tradeoff between paying dividends and retaining profits within the company:

 

The dividend policy decision is a trade-off between retaining earnings v/s paying out cash dividends.

 

Dividend policies must always consider two basic objectives:

1. Maximizing owners’ wealth
2. Providing sufficient financing

 

While determining a firm’s dividend policy, management must find a balance between current income for stockholders (dividends) and future growth of the company (retained earnings).

 

In applying a rational framework for dividend policy, a firm must consider the following two issues:

1. How much cash is available for paying dividends to equity investors, after meeting all needs-debt payments, capital expenditures and working capital (i.e. Free Cash Flow to Equity – FCFE)
2. To what extent are good projects available to the firm (i.e. Return on equity – ROE > Required Return)

 

 

 

Factors FCFE> Dividends FCFE<Dividends ROE> Cost of Equity Good Projects Cash flow surplus No Change Good     Projects     Decrease Dividends Invest in Projects ROE< Cost of Equity Poor Projects Cash flow surplus Increase Dividends                                  Reduce Investment Poor Projects Cash flow Deficit Decrease Dividends                  Reduce Investment

Dividend Decision Matrix

 Where, ROE: Return on Equity and FCFE: Free Cash Flow to Equity. TYPES OF DIVIDEND PO

How do firms view their dividend policies?

 In a classic study, Lintner surveyed a number of managers in the 1950’s and asked how they set their dividend policy. Most of the respondents said that there were a target proportion of earnings that determined their policy. One firm’s policy might be to pay out 40 % of earnings as dividends whereas another company might have a target of 50 %.

 

On the basis of interviews with corporate executives, Lintner concluded that firms select target payout ratios to which they gradually adjust actual dividend payments over time. This would suggest that dividends change with earnings.

 

However, dividend policies may vary between various firms as every firm sets its own policy for dividend distribution.

 

 

Firms may pursue any one of the following dividend policies:

1. Generous or liberal dividend policy: Firms that follow this policy reward shareholders generously by stepping up dividend over the
2. Stable dividend policy: Firms may follow the policy of: Stable dividend payout ratio: According to this policy, the percentage of earnings paid out of dividends remains constant. The dividends will fluctuate with the earnings of the company. Stable rupee (inflation adjusted) dividend policy: As per this policy the rupee level of dividends remains
3. Low regular dividend plus extra dividend policy: As per this policy, a low, regular dividend is maintained and when times are good an extra dividend is paid. Extra dividend is the additional dividend optionally paid by the firm if earnings are higher than normal in a given Although the regular portion will be predictable, the total dividend will be unpredictable.
4. Residual dividend policy: Under this policy, dividends are paid out of earnings not needed to finance new acceptable capital projects. The dividends will fluctuate depending on investment opportunities available to the
5. Multiple dividend increase policy: Some firms follow the policy of very frequent and small dividend The objective is to give shareholders an illusion of movement and growth.
6. Uniform cash dividend plus bonus policy: Under this policy, the minimum rate of dividend per share is paid in cash plus bonus shares are issued out of accumulated reserves. However, bonus shares are not given compulsorily on an annual basis. They may be given over a period of a certain number of years, for example 3-5 years depending on the accumulated reserves of the company that can be utilized for the purpose of issuing

 

 

STABLE DIVIDEND POLICY: A POLICY OF DIVIDEND SMOOTHING

Lintner (1956) had observed that managers tend to value stable dividend policies and corporations tend to smooth dividends relative to earnings. That is, dividends are increased gradually and rarely cut, resulting in a much lower variability of dividends as compared to the variability in earnings.

 

Most Companies adapt a basic policy of maintaining its internal reserves to ensure stable income far into the future, while at the same time seek to distribute a sufficient amount of earnings to shareholders in accordance with business results. with a decrease in EPS, DPS has

 

Firm may adapt any of the following stable dividend policies:

 

• Stable dividend payout ratio
• Stable dividends per share
• A regular plus extra dividend policy

 

Dividend payout Ratio: it is calculated by dividing the total dividend to equity shareholders by the net income available to them for that period as follows:

 

= Total dividend paid/ Net income after tax

 

OR

= Annual dividend paid per share/ EPS

 

OR

= 1- Retention Ratio

 

Where retention ratio = Retained Earnings/ Net income

 

Retention Ratio + Dividend payout Ratio = 1 (which means whatever amount is not paid by dividend is retained by the company to reinvest)

 

1.       Stable dividend payout ratio

 

As per this policy the percentage of dividends paid out of earnings remains constant.

 

 

 

 

 

 

EPS

 

DPS

 

Time (Years)

 

Example: if a company adopts a 30% payout ratio and if EPS is Rs 100, then shareholder having 10 shares will receive Rs.300 as dividend under this policy.

 

2.       Stable dividends per share

 

3.       A regular plus extra dividend policy

 

According to this policy a certain fixed percentage or a minimum amount of dividend is paid every year, which is referred to as regular dividend. The firm pays ‘additional’ or ‘extra’ dividend if earnings are higher than normal in any year.

 

Rationale for stable dividend policy:

Most firms adapt a stable dividend policy. If a firm’s earnings are temporarily depressed or if it needs a substantial amount of funds for investment, then it might well maintain its regular dividend using borrowed funds to meet its needs, until things returned to normal. The logic or rationale for stable dividend policy is:

 

• Stockholders like stable dividends–many of them depend on dividend income, and if dividends were cut, this might cause serious hardship to A stable dividend policy is desirous for many investors such as retired persons, who take dividends as a source to meet their current living expenses.
• A stable dividend policy would reduce investor uncertainty, and reductions in uncertainty are generally associated with lower capital costs and higher stock prices, other things being
• Institutional investors generally prefer to invest in companies having stable dividend records
• Adoption of stable dividends is advantageous for a company interested in raising funds from external sources as shareholders willingly invest in companies having stable dividends as they have more confidence in such

 

The disadvantage is that such a policy might decrease corporate flexibility. Once a company has adapted a stable dividend policy, any change in such a policy may have adverse effects on the company image and may result in creating serious doubts in the minds of investors about financial standing of the company, which might prove to be very dangerous for the company at a later stage.

BONUS POLICY:

Bonus is a reward that is paid to an employee for his good work towards the organisation. The basic objective to give bonus is to share the profit earned by the organisation amongst the employees and staff members. In India there is a principle law relating to this procedure of payment of bonus to the employees and that principle law is named as Payment of Bonus Act, 1965.

The Payment of Bonus Act applies to every factory and establishment employing not less than 20 persons on any day during the accounting year. The establishments covered under the Act shall continue to pay bonus even if the number of employees fall below 20 subsequently.

Eligibility: Every employee not drawing salary/wages beyond Rs. 10,000 per month who has worked for not less than 30 days in an accounting year, shall be eligible for bonus for minimum of 8.33% of the salary/wages even if there is loss in the establishment whereas a maximum of 20% of the employee’s salary/wages is payable as bonus in an accounting year. However, in case of the employees whose salary/wages range between Rs. 3500 to Rs. 10,000 per month for the purpose of payment of bonus, their salaries/wages would be deemed to be Rs. 3500.

There are provisions and benefits for newly formed establishments as well. As per these provisions/benefits, the first five accounting years following the accounting year in which the employer sells goods/renders services, bonus is payable only in respect of the accounting year, in which profits are made but the provisions of set on and set off would not apply.

Applicability: The Act is applicable in whole of India where 10 or more workers are working, or were working on any day of the preceding 12 months with the aid of power. Or whereon 20 or more workers are working or were working on any day of preceding 12 months without the aid of power.

Calculation of bonus: Salary/wages and dearness allowance (DA) are included while calculating bonus. However, other allowances such as over-time, house rent, incentive or commission are not included.

Forfeiture of Bonus: An employee who is dismissed from service on the grounds of fraud, riotous or violent behaviour at the premises of the establishment or for the theft, misappropriation or sabotage of any of the property of the establishment as mentioned in the Act. This shall not only disqualify him from receiving the bonus for the accounting year in which he was dismissed but also for the past years which were remained unpaid to him.

Time limit for payment of bonus: It is mentioned in the Act that all amounts payable to an employee by the way of bonus are to be paid in cash. It is also mentioned that within 8 months from the close of the accounting year the bonus should be paid to the employees. In exception to where there is dispute regarding payment of bonus pending before an authority (Under Industrial Disputes Act) within 1 month from the date on which the award becomes enforceable or settlement comes into operation, in respect of such dispute.

UNIT-4

Working Capital Management:

Meaning, nature, concepts of working capital,

operating cycle, permanent and

Temporary working capital,

Factors determining working services

Securitization in working capital management.

 

Financial distress and corporate restructuring:

Introduction; methods of corporate

restructuring (Both internal as well as external);

Government policies for revival of sick units and turnaround strategies.

Working Capital Management

Working capital management is a business strategy designed to ensure that a company operates efficiently by monitoring and using its current assets and liabilities to the best effect. The primary purpose of working capital management is to enable the company to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations.

A company’s working capital is made up of its current assets minus its current liabilities.

Understanding Working Capital Management

Current assets include anything that can be easily converted into cash within 12 months. These are the company’s highly liquid assets. Some current assets include cash, accounts receivable, inventory, and short-term investments.

KEY TAKEAWAYS

• Working Capital Management requires monitoring a company’s assets and liabilities to maintain sufficient cash flow.
• The strategy involves tracking three ratios: the working capital ratio, the collection ratio, and the inventory ratio.
• Keeping those three ratios at optimal levels ensures efficient working capital management.

• Current liabilities are any obligations due within the following 12 months. These include operating expenses and long-term debt payments.

Ratio Analysis

• Working capital management commonly involves monitoring cash flow, current assets, and current liabilities through ratio analysisof the key elements of operating expenses, including the working capital ratio, collection ratio, and inventory turnover ratio.
• Working capital management helps maintain the smooth operation of the net operating cycle, also known as the cash conversion cycle (CCC)—the minimum amount of time required to convert net current assets and liabilities into cash.

Benefits of Working Capital Management

• Working capital management can improve a company’s earningsand profitability through efficient use of its resources. Management of working capital includes inventory management as well as management of accounts receivables and accounts payables.
• The objectives of working capital management, in addition to ensuring that the company has enough cash to cover its expenses and debt, are minimizing the cost of money spent on working capital, and maximizing the return on asset investments.

Types of Working Capital Management Ratios

• There are three ratios that are important in working capital management: The working capital ratio or current ratio; the collection ratio, and the inventory turnover ratio.
• Working capital management aims at more efficient use of a company’s resources.
• The working capital ratio or current ratio is calculated as current assets divided by current liabilities. It is a key indicator of a company’s financial health as it demonstrates its ability to meet its short-term financial obligations.
• Although numbers vary by industry, a working capitalratio below 1.0 generally indicates that a company is having trouble meeting its short-term obligations. That is, the company’s debts due in the upcoming year would not be covered by its liquid assets. In this case, the company may have to resort to selling off assets, securing long-term debt, or using other financing options to cover its short-term debt obligations.
• Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may suggest that the company is not effectively using its assets to increase revenues. A high ratio may indicate that the company is not securing financing appropriately or managing its working capital efficiently.

The Collection Ratio

• The collection ratio is a measure of how efficiently a company manages its accounts receivables. The collection ratio is calculated as the product of the number of days in an accounting period multiplied by the average amount of outstanding accounts receivables divided by the total amount of net credit sales during the accounting period.
• The collection ratio calculation provides the average number of days it takes a company to receive payment after a sales transaction on credit. If a company’s billing department is effective at collections attempts and customers pay their bills on time, the collection ratio will be lower. The lower a company’s collection ratio, the more efficient its cash flow.

The Inventory Turnover Ratio

• The final element of working capital management is inventory management. To operate with maximum efficiency and maintain a comfortably high level of working capital, a company must keep sufficient inventory on hand to meet customers’ needs while avoiding unnecessary inventory that ties up working capital.
• Companies typically measure how efficiently that balance is maintained by monitoring the inventory turnover ratio. The inventory turnover ratio, calculated as revenues divided by inventory cost, reveals how rapidly a company’s inventory is being sold and replenished. A relatively low ratio compared to industry peers indicates inventory levels are excessively high, while a relatively high ratio may indicate inadequate inventory levels.

OBJECTIVES OF WORKING CAPITAL MANAGEMENT

The primary objectives of working capital management include the following:

• Smooth Operating Cycle:The key objective of working capital management is to ensure a smooth operating cycle. It means the cycle should never stop for the lack of liquidity whether it is for buying raw material, salaries, tax payments etc.
• Lowest Working Capital:For achieving the smooth operating cycle, it is also important to keep the requirement of working capital at the lowest. This may be achieved by favorable credit terms with accounts payable and receivables both, faster production cycle, effective inventory management etc.
• Minimize Rate of Interest or Cost of Capital:It is important to understand that the interest cost of capital is one of the major costs in any firm. The management of the firm should negotiate well with the financial institutions, select the right mode of finance, maintain optimal capital structure
• Optimal Return on Current Asset Investment:In many businesses, you have a liquidity crunch at one point of time and excess liquidity at another. This happens mostly with seasonal industries. At the time of excess liquidity, the management should have good short-term investment avenues to take benefit of the idle funds.

IMPORTANCE OF EFFECTIVE WORKING CAPITAL MANAGEMENT

Although the importance of working capital is unquestionable in any type of business. Working capital management is a day to day activity, unlike capital budgeting decisions. Most importantly, inefficiencies at any levels of management have an impact on the working capital and its management. Following are the main points that signify why it is important to take the management of working capital seriously.

• Ensures Higher Return on Capital
• Improvement in Credit Profile & Solvency
• Increased Profitability
• Better Liquidity
• Business Value Appreciation
• Most Suitable Financing Terms
• Interruption Free Production
• Readiness for Shocks and Peak Demand
• Advantage over Competitors

 

WORKING CAPITAL DECIDING FACTORS – LEVEL AND MODE OF FINANCING

The two main factors that decide the quantum of working capital that a business should maintain, are liquidity and profitability. Let’s understand the impact of both of these factors in details.

Nobody denies the importance of liquidity but most have a question that how much that liquidity should be? What are the right levels of liquidity? We know that a business can’t sit on unlimited or too high liquidity because higher liquidity means higher investment in working capital. And higher investment in working capital means higher cost of capital, interest cost in case financed by bank finance. Therefore, the higher liquidity has a direct impact on the profitability as the capital cost rises. In essence, the relation between liquidity and profitability is inverse. On one hand, higher rather sufficient liquidity is the primary goal of working capital management. Whereas on the other hand, profitability as an objective aligns with the overall objective of an organization i.e. wealth maximization.

With that, it is quite clear that a policy that an organization follows would fall between these pillars. There may be policies that are tilted towards liquidity and others may be towards profitability.  It is then a management decision where do they want to place their organization’s policy.

WORKING CAPITAL MANAGEMENT POLICIES

Working capital management policies deal with the quantum factor i.e. how much of current assets should be maintained? These policies, in essence, are different levels of the tradeoff between liquidity and profitability. Theoretically, following three types of policies are explained whereas they can be n number of policies depending on where the tradeoff is stricken between the liquidity and profitability.

• Relaxed Policy / Conservative policy– This policy has a high level of current assets maintained to honor the current liabilities. Here, the liquidity is very high and the direct impact on profitability is also high.
• Restricted Policy / Aggressive policy– This policy a lower level of current assets. Here, the liquidity levels are very low, therefore, the direct impact on profitability is also low.
• Moderate Policy– It lies between the conservative and aggressive policy.

For a detailed and in-depth understanding, you may refer, Working Capital Policy – Relaxed, Restricted and Moderate.

WORKING CAPITAL MANAGEMENT STRATEGIES

Working capital management strategies deal with the cost of capital factor. The question is – How the costs of capital are optimized? A business has a choice to select between short-term vs. long-term sources of capital. Normally, the short term funds are cheaper to long-term but risky. Short term funds are risky in terms of risk of refinancing and risk of rising interest rates. Once they mature, they may not be refinanced by the same financial institution and there is a possibility of revision in interest rate every time they are renewed.

Let’s divide a firm’s capital investment into two i.e. investment in fixed assets and investment in working capital. Let’s safely assume that long-term funds finance the fixed assets. Now remaining is working capital. Let us further divide working capital into two i.e. permanent and temporary working capital. The nature of permanent working capital is similar to fixed assets i.e. that level of investment in working is always present and remaining part keeps fluctuating. The working capital management strategies define how these two types of working capital are financed.

 

• Hedging(Maturity Matching) Strategy – This strategy follows the principal of finance i.e. long-term funds to finance long-term assets and vice versa. In this strategy, the maturities of currents are matched with the maturity of its financing instrument. It does not have any cushion or flexibility in case of any delay in the realization of current assets. Although it is a very ideal strategy but involves a high risk of bankruptcy.
• Conservative– Its a safer strategy where the apart from financing the whole of the permanent working capital, it finances a part of temporary working capital also.
• Aggressive– It’s a high-risk strategy where the apart from financing the whole of the temporary working capital, it finances a part of permanent working capital also.

For a detailed and in-depth understanding, you may refer, Working Capital Management Strategies / Approaches.

ADVANTAGES OF WORKING CAPITAL MANAGEMENT

• Working capital management ensures sufficient liquidity when required.
• It evades interruptions in operations.
• Profitability maximized.
• Achieves better financial health.
• Develops competitive advantage due to streamlined operations.

DISADVANTAGES OF WORKING CAPITAL MANAGEMENT

• It only considers monetary factors. There are non-monetary factors that it ignores like customer and employee satisfaction, government policy, market trend etc.
• Difficult to accommodate sudden economic changes.
• Too high dependence on data is another downside. A smaller organization may not have such data generation.
• Too many variables to keep in mind say current ratios, quick ratios, collection periods, etc.

What is an operating cycle?

An operating cycle refers to the time it takes a company to buy goods, sell them and receive cash from the sale of said goods. In other words, it’s how long it takes a company to turn its inventories into cash. The length of an operating cycle is dependent upon the industry. Understanding a company’s operating cycle can help determine its financial health by giving them an idea of whether or not they’ll be able to pay off any liabilities.

For example, if a business has a short operating cycle, this means they’ll be receiving payment at a steady rate. The faster the company generates cash, the more it’ll be able to pay off any outstanding debts or expand its business accordingly.

The flow of a cash operating cycle is as follows:

1. Obtaining raw material
2. Producing goods
3. Having finished goods
4. Having receivables from making a sale
5. Obtaining cash (receiving payment from customers)

It’s also important to differentiate an operating cycle from a cash cycle. Whereas they’re both helpful and provide invaluable insight, a cash cycle lets companies see how they’re able to manage cash flow, whereas an operating cycle determines the efficiency of the operation.

Why is the operating cycle important?

The operating cycle is important because it can tell a business owner how quickly the company is able to sell inventory. Simply put, it determines the company’s efficiency. For example, if its operating cycle is short, this means the company was able to make a turnaround relatively quickly. It could also mean it has shorter payment terms and stricter credit policy.

A shorter operating cycle is more favorable as it means the company has enough cash to maintain operations, recover investments and meet various obligations. In contrast, if a business has a longer operating cycle, it means the company requires more cash to maintain operations.

Just as there are many influences on a company’s operating cycle, there are also many ways that an operating cycle can help determine a company’s financial standing. The better a business owner understands the company’s operating cycle, the better that owner will be able to make decisions for the benefit of the business.

How to determine an operating cycle

In order to determine a company’s efficiency, business owners need to calculate their operating cycle. Follow these steps to make this calculation:

1. Determine the inventory period

A business owner first needs its company’s inventory period when calculating its operating cycle. An inventory period refers to how long a company holds its inventory before it’s sold. The inventory period can be calculated as follows:

inventory period = 365 / inventory turnover

To determine a company’s inventory turnover, divide the cost of goods sold by the average inventory. The average inventory refers to the average of a company’s opening and closing inventory. This can be found on the company’s balance sheet, whereas the cost of goods sold can be found on the company’s income statement.

2. Determine the company’s accounts receivable

Business owners also need to know their accounts receivable in their operating cycle calculation. Accounts receivable refers to the amount of money a customer owes a company. Accounts receivable can be calculated as follows:

accounts receivable period = 365 / receivables turnover

To determine a company’s receivables turnover, divide credit sales by the average accounts receivable.

3. Calculate the operating cycle

The following formula can be used for calculating the operating cycle:

operating cycle = inventory period + accounts receivable period

This equation can also be used:

operating cycle = (365 / (cost of goods sold / average inventory)) + (365 / (credit sales / average accounts receivable))

The resulting number is the number of days in the company’s operating cycle.

Tips for shortening a company’s operating cycle

Here are several tips to consider when attempting to shorten a company’s operating cycle:

• Implement a stricter credit policy: Customers are more apt to pay for their purchase on time if companies have a stricter credit policy.
• Reduce the time period on payment terms: The quicker a company is able to collect accounts receivables, the shorter their operating cycle is likely to be.
• Quickly sell a company’s inventory: The quicker a company sells its inventory, the shorter its operating cycle should be.

Examples of operating cycles

In order to understand operating cycles, it’s important to consider various scenarios. Here are some examples of operating cycles:

Example 1

Let’s say Cindy owns a clothing store. Her company’s operating cycle would begin when she started paying for the materials to make various garments. The operating cycle wouldn’t end in this case until all clothing items are produced, sold and the cash has been received from various customers.

Example 2

Let’s say Bob owns a bakery and he’s trying to determine how well operations are running at his shop. To do this, he’ll need to calculate his company’s operating cycle. This means the cycle would start when he began paying for the goods, materials and ingredients used to make various pastries and baked goods. His bakery’s operating cycle wouldn’t end until all of his baked goods have been sold to customers and he’s received cash from his sales.

 

Temporary working capital

Temporary working capital (TWC) is the temporary fluctuation of networking capital over and above the permanent working capital. It is the additional working capital requirement arising out of seasonal demand of the product or any special event which otherwise are not predictable. In other words, it is the difference between net working capital and the permanent working capital.

Business earnings are not like the salary earnings of an employee. An employee earns an equal amount of money every month throughout the year. But, businesses are rarely of such nature. In business, businessmen get an opportunity to earn good money at a particular time and all businessmen try to grab such opportunities. This requires additional working capital for him to take that advantage. Such a requirement of working capital is temporary working capital.

Temporary Working Capital = Net Working Capital – Permanent Working Capital.

Data on the balance net working capital can help us calculate temporary working capital. NWC should be plotted for each day and the lowest amount in it is the permanent working capital. In the example below, 2500 is the permanent working capital and besides it indicates the temporary working capital. It is a fluctuating figure.

TYPES OF TEMPORARY WORKING CAPITAL

Based on the reasons for fluctuation of the net working capital, the TWC is also is further classified into the following two types.

SEASONAL WORKING CAPITAL

It is that fluctuation of NWC which is caused due to the effect of season. For example, the seasons may be of mangoes, school uniform, audit deadlines, crackers, particular festival,

UNIT-4

 

Working Capital Management: 

Meaning, nature, concepts of working capital,

Operating cycle,

Permanent and temporary working capital,

Factors determining working capital.

Approaches to working capital management.

Sources of finance of working capital.

Role of factoring services and securitization in working capital management.

 

Financial distress and corporate restructuring:

 

Introduction; methods of corporate restructuring (Both internal as well as external);

Government policies for revival of sick units and turnaround strategies.

 

Working Capital Management: 

Introduction:

Working capital can be understood as a measure of both a company’s competence and its short term financial healthiness. For a layman, it purely means the distinction among the current assets and current liabilities. It is the firm’s property of current, or short-term, assets. Working capital is normally alienated in two types, viz. gross working capital and net working capital. Gross Working Capital is nothing but the sum of current or circulating resources. Net working capital, means current assets minus current liabilities which provide an exact appraisal of the liquidity situation of firm with the liquidity-profitability dilemma solidly validated in the financial plan of obligations which mature within a twelve-month duration. As we have seen, the two main parts of the working capital are assets and liabilities. First, short-term, or current liabilities comprise the section of funds which have been intended for and raised. Since administrations have to be concerned with correct financial arrangement, these and other funds must be raised sensibly. Short-term or current assets comprise a part of the asset investment conclusion and necessitate meticulous appraisal by the firm’s executives. Further, since there exists a close association between sales fluctuations and invested amounts in current assets, a watchful preservation of the appropriate asset and funds should be ensured.

Concept of Working capital:

Working capital naturally means the firm’s property of current, or short-term, assets such as cash, receivables, stock, and saleable securities. Working capital refers to that fraction of firm’s capital which is requisite for financing short-term or current assets such as cash, saleable securities, debtors, and stocks. In the other words working capital means the sum of funds essential to wrap the cost of operating the venture. Working capital means the resources (i.e.; capital) obtainable and used for day-to-day workings of a venture. It consists generally the segment of assets of a company which are used in or connected to its current operations. It refers to resources which are used during the bookkeeping period to produce a current income of a type which is consistent with main reason of a firm survival. Working Capital is the capital used  make goods and attract sales. The less Working Capital used to attract sales; the superior is likely to be the return on investment. Working Capital management is about the marketable and financial aspects of stock, credit, purchasing, marketing, and royalty and investment strategy. The superior the profit boundary, the lower is probable to be the level of Working Capital tied up in creating and selling titles. The quicker that we create and sell the books the higher is likely to be the return on investment.

There are two probable interpretations of working capital concept:

1. Balance Sheet Concept
2. Operating Cycle Concept

It goes without saying that the outline of management will be very mainly influenced by the approach taken in defining it. Therefore, the two concepts are discussed alone in a nutshell.

1.       Quantitative conception:

The gross working capital refers to the organization’s investment in current assets.

In the words of J.S. Milli, “The sum of current assets is the working capital of the business.” From the management point of sight, this concept is more appropriate as the management formulates all the strategies on the basis of current assets and concentrates his awareness on the quantum of current assets and their prosperity. Thus, this is a quantitative feature of working capital which emphasizes more on number than its character.

2.       Qualitative concept:

The net working capital means the distinction between current assets and current liabilities. If the sum of current assets and current liabilities is equivalent, it means that there is no working capital. The net working capital is a qualitative portion of working capital and it measures the organizations liquidity. It also indicates the extent to which working capital can be financed with long term resources. This concept is helpful only for accountants, investors, creditors and interested persons in the liquidity and financial reliability of the organization.

3.       Operating cycle concept:

The amount of working capital requisite by a firm depends upon the extent of manufacture process and the operating cost needed for this reason. The time mandatory to complete the production procedure right from Purchase of raw material to the grasp of sales in cash is known as the operating cycle or working capital .

This concept is more suitable than the qualitative and quantitative aspect since in this case the fund necessary for carrying on the operational actions is treated as working capital. It is also called circulating capital.

1.          H.G, Guttmann:

“Working Capital is the surplus of current assets over current liabilities.”

2.          Hoglend. J. Bierman, and A. K. Mc Adams:

“Working Capital is descriptive of that capital which is not fixed. But the more common use of the working Capital is to consider it as the distinction between the book value of the current assets and current liabilities.”

3.          Brown and Housard:

“Working Capital represents the overload of current assets over current liabilities”

4.          Weston the Brigham:

“Working Capital to a firm’s investment in short term assets cash short term securities, accounts, receivables and inventories.”

5.          Meal Baker Malott and Field:

“Working Capital represents merely the current capital assets.”

6.          J.S. Mill:

“Working Capital means a sum of current assets”

7.          Prof. C.W. Gerstoberg:

“A Working Capital shortfall exits if current liabilities exceed current assets.”

8.     Lincoln:

“Working Capital equals the aggregate value of current assets minus aggregate value of current liabilities”

9.          Prof. S.C. Kuchhal

“Gross Working Capital may be used to refer to total current assets and net working capital refers to the excess of current assets over current liabilities”

Balance Sheet Concept

There are two interpretation of working capital under the balance sheet concept. It is represented by the surplus of current assets over current liabilities and it is the amount generally obtainable to finance current operations. But, occasionally working capital is also used as a synonym for

total current possessions. In that case, the surplus of current assets over current liabilities is known as the net working capital or net current assets.

The Economists like Mead, Malott, Baket and Field sustain the latter view of working capital. They feel that current assets must be measured as working capital as the whole of it helps to produce profits; and the administration is more concerned with the total current assets as they comprise the total funds obtainable for operational purpose. On the other hand, economists like Lincoln and Salvers support the previous view. They argue that

1. In the long run what matters is the excess of current asserts over current liabilities;
2. It is this concept which helps creditors and investors to judge the monetary soundness of the company;
3. What can always be relied upon to meet the contingencies, is the excess of current assets over the current liabilities since this amount is not to be returned; and
4. This meaning helps to find out the accurate financial situation of companies having the same amount of current

Institute of Chartered Accountants of India, while suggesting a perpendicular form of balance sheet, also endorsed the previous view of working capital when it described net current assets as the distinction between current assets and current liabilities. The conventional description of working capital in terms of the disparity between the current assets and the current liabilities is somewhat puzzling. Working capital is actually what a part of long-term finance is protected in and used for sustaining current actions. Therefore, the larger the amount of working capital so resulting, greater the amount of long-term capital sources siphoned off to short-term actions. It is about stretched working capital position; the logic of the above description would possibly point out distraction to bring in cash, under the conservative method, working capital would obviously remain unaffected. Liquidation of debtors and stock into cash would also keep the stage of working capital unaffected. A comparatively large amount of working capital according to this definition may create a false sense of safety at a time when cash possessions may  be insignificant, or when these may be provided gradually more by long-term fund sources in the absence of sufficient profits. Again, under the conservative method, cash enters into the calculation of working capital. But it may have been more suitable to exclude cash from such calculation because one compares cash necessities with current assets less current liabilities. The inference of this in straight working capital computations is that during the financial period

current assets get transformed into cash which, after paying off the current liabilities, can be used to meet other operational expenses. The contradiction, however, is that such current assets as are relied upon to yield cash must themselves to be supported by long-term funds until are transformed into cash. At least, three points seem to appear from the above.

First, the balance sheet meaning of working capital is maybe not as significant, excluding as an indication of the firm’s current solvency in repaying its creditors. Secondly, when firms talk of shortage of working capital, they in fact probable imply shortage of cash possessions. Thirdly, in fund flow examination and increase in working capital, as conservatively defined, represents employment or appliance of funds.

 

Operating Cycle Concept:

A company’s operating cycle usually consists of three primary actions; purchasing resources, producing the product, and selling the product. These actions create funds flows that are both unsynchronized since cash disbursements typically take place before cash proceeds.

Example: Payments for store purchases takes place before the collection of receivables. They are unsure because prospect sales and costs, which produce the particular receipts and disbursements, cannot be forecasted with total exactness. If the firm is to uphold a cash balance to pay the bills as they come outstanding. In addition, the corporation must invest in inventories to fill customer orders punctually. And, finally, the company invests in accounts receivable to extend credit to its consumers.

Operating cycle = Inventory alteration period + Receivables alteration period

The inventory conversion period is the extent of time required to manufacture and sell the product.

It is defined as under:

Standard inventory

Inventory change period =Cost of sales/365

The payables delay period is the length of time the firm is able to reschedule payment on its various resource purchases. Equation is used to calculate the payables delay period:

Accounts due + Salaries, benefits, and Payroll taxes due

Payables delay period = (Cost of sales + Selling, general and executive expense) /365

 

Finally, the cash exchange cycle represents the net time gap between the collections of cash proceeds from product sales and the cash payments for the company’s different resource purchases.

It is calculated as follows:

Cash conversion cycle = Operating cycle – Payable delay period

 

Significance of Working Capital:

Working capital is the life blood and nerve centre of a company. Just as movement of blood is necessary in the human body for marinating existence, working capital is very necessary to uphold the horizontal running of a company. No business can run productively without an sufficient amount of working capital. The main compensation of maintaining ample amount of working capital is as under:

1.       Solvency of the company:

Sufficient working capital helps in maintaining solvency of the company by providing continuous flow of manufacture.

2.       For Goodwill of business:

Sufficient working capital enables a business concern to make punctual payments and hence helps in creating and maintaining goodwill.

3.       Easy availability of loans:

A business having sufficient working capital, high solvency and good credit standing can assemble loans from banks and other on easy and positive terms.

4.       To avail cash discounts:

Enough working capital also enables a concern to avail cash discounts on the purchases and hence it reduces costs.

5.       Normal supply of raw materials:

Enough working capital ensures usual supply of raw materials and regular production.

6.   Usual payment for day-to-day commitments:

A company which has plenty working capital can make usual payment of salaries, wages and other day-to-day commitments which raises the confidence of its employees, increases their competence, reduces wastages and costs and enhances manufacture and profits.

7.       Utilization of favorable market situation:

 

Only concern with sufficient working capital can exploit positive market conditions such as purchasing its necessities in bulk when the prices are lesser and by holding its inventories for upper prices.

8.       Capability to face crisis:

Sufficient working capital enables a concern to face  company crisis in emergency periods such as gloominess because during such periods, usually, there is much pressure on working capital.

9.       Rapid and regular return on investments:

Every sponsor wants a quick and regular return on his investments. Adequacy of working capital enables a organization to pay quick and usual dividends to its investors as there may not be much force to plough back profits. This gains the assurance of its investors and creates a positive market to raise additional funds in the prospect.

10.   High confidence:

Sufficiency of working capital creates an surroundings of safety, confidence, and high self- esteem and creates overall competence in a business.

 

Factors affecting working capital necessities:

The working capital necessity of a concern depends upon a huge numbers of factors such as nature and size of business, the character of their operations, the length of manufacture cycles, the rate of stock proceeds and the state of economic condition. It is not probable to rank them because all such factors of diverse significance and the influence of individual factors changes for a firm eventually. However the following are significant factors normally influencing the working capital necessity:

1.       Nature of Business:

The working capital necessity of a firm fundamentally depends upon the nature of the business. Public usefulness activities like electricity water supply and railways require very restricted working capital because they offer cash sales only and provide services, not products and as such no funds are coupled up in inventories and receivables. Usually speaking it may be said that public utility activities require small amount of working capital, trading and financial firms necessitate comparatively very large amount, whereas manufacturing activities require considerable working capital between these two limits.

2.       Scale of Operations:

 

The working capital necessity of a concern is directly influenced by the size of its company which may be calculated in terms of scale of operations.

3.       Production strategy:

In certain organizations the require is subject to wide fluctuations due to seasonal variations. The necessities of working capital in such cases depend upon the production strategy.

4.       Manufacturing procedure:

In manufacturing company the necessity of working capital increases in direct proportion of length of manufacturing procedure. Longer the procedure period of produce, larger is the amount of working capital required.

5.       Seasonal disparity:

In certain companies raw material is not obtainable throughout the year. They have to buy raw materials in bulk in the season to make sure and continuous flow and process them during the entire year.

6.       Rate of stock proceeds:

There is a high degree of inverse co-relationship between the quantum of working capital; and the rapidity or speed with which the sales are affected. A firm having a high rate of stock turnover will need lesser amount of working capital as compared to a company, having a low  rate of proceeds.

7.       Credit strategy:

The credit strategy of a company in its dealing with debtors and creditors influence significantly the necessity of working capital. A company that purchases its necessity on credit and sell its products/services on cash require smaller amount of working capital.

8.       Business rotation:

Business cycle refers to alternate development and contraction in common business actions. In a period of bang i.e., when the business is prosperous, there is a need of bigger amount of working capital due to amplify in sales, rise in prices, optimistic expansion of business contracts sales decline, difficulties are faced in collection from debtors and organisations may have a large amount of working capital lying inactive.

9.       Rate of expansion of company:

The working capital requirement of a concern increase with the growth and expansion of its business activities. Though it is difficulties to decide the relationship between the expansion in

 

the volume of a company and the increase in the working capital of a business, yet it may be accomplished that of normal rate of expansion in the volume of business, we may have retained profits to provide for additional working capital but in fast growth in concern, we shall require bigger amount of working capital.

10.   Price stage change:

Changes in the price stage also result on the working capital necessity. Generally the increasing prices will require the firm to maintain bigger amount of working capital as more funds will be essential to maintain the same current assets.

 

Levels of Working Capital Investment:

In a “perfect” world, there would be no requirement for working capital assets and liabilities. In such a world, there would be no ambiguity, no transaction costs, information search costs, development costs, or production and technology constraints. The unit cost of producing goods would not vary with the amount created. Firms would borrow and provide at the same interest rate. Capital, labor, and produces markets would replicate all available information and would be perfectly aggressive. In such a world, it can be shown that there would be no benefit for invest or finance in the temporary period. But the world in which real firm’s purpose is not perfect. It is characterized by the firm’s significant uncertainty regarding the require, market price, excellence, and accessibility of its own products and those of suppliers. There are transaction costs for purchasing or selling goods or securities. Information is faced with restrictions on the production capacity and knowledge that it can employ. There are spreads among the borrowing and lending rates for investments and financing of equivalent risk. Information is not evenly distributed and may not be completely reflected in the prices in product and labor markets, and these markets may not be completely aggressive. These real-world situations introduce troubles with which the organization must deal. While the firm has many strategies obtainable to address these circumstances, strategies that utilize investment or financing with working capital accounts frequently offer a substantial benefit over other techniques.

Example: Assume that the firm is faced with ambiguity regarding the level of its prospect cash flows and will incur substantial costs if it has inadequate cash to meet expenses. Several strategies may be formulated to address this uncertainty and the costs that it may produce.  Among these strategies are some that involve working capital investment or financing such as

 

holding supplementary cash balances beyond expected needs, holding a reserve of short-term borrowing capacity. One of these strategies might well be the least costly approach to the problem. Likewise, the existence of fixed set-up costs in the manufacture of goods may be addressed in several ways, but one possible alternative is hold stock. By these examples, we see that strategies using working capital accounts are some of the probable ways firms can react to many of the troubles engendered by the deficient and constrained world in which they deal. One of the main features of this world is risk, and it is this attribute that gives rise to many of the strategies connecting working capital accounts. Furthermore, a company’s net working capital situation not only is significant from an internal position; it also is widely used as one determine of the organizations’ risk. Risk, as used in this background, deals with the likelihood that a firm will encounter financial difficulties, such as the incapability to pay bills on time. All other things being identical, the more net working capital a firm has the more probable that it will be able to meet current financial obligations. Since net working capital is one debt financing. Many loan agreements with commercial banks and other lending institutions contain stipulation requiring the firm on maintain a minimum net working capital position. Likewise, bond indentures also often hold such necessities. The overall policy considers both the level of working capital investment and its finance. In practice, the firm has to determine the joint impact of these two decisions upon its abundance and risk. The size and nature of a firm’s investment in current assets is a purpose of a number of diverse factors, including the following factors:

1. The kind of products manufactured.
2. The span of the operating
3. The sales stages
4. Inventory strategies
5. Credit strategies
6. How resourcefully the firm manages current assets. (Evidently, the more successfully management economizes on the amount of cash, profitable securities, inventories, and receivables employed, the lesser the working capital necessities).

For the purposes of conversation and analysis, these factors are held steady in the rest of our analysis.

 

Optimal intensity of working capital investment:

 

The optimal intensity of working capital investment is the level predictable to maximize shareholder prosperity. It is a function of several factors, including the variability of sales and cash flows and the degree of operating and financial leverage engaged by the firm. Therefore no single working capital speculation strategy is essentially optimal for all firms. Proportions of Short-term Financing Not only a firm have to be alarmed about the level of current assets; it also has to determine the proportions of short-and long-term debt to use in financing use in these assets. The decision also involves trade-offs between productivity and risk. Sources of debt financing are classified according to their maturities. Specifically, they can be categorized as being either short-term or long-term, with short-term sources having maturities of one year or less and long-term sources having maturities of superior than one year.

Cost of short-term vs. long-term debt:

Traditionally long-term interest rates usually exceeds short-term rate since of the decrease flexibility of long-term borrowing relative to short-term borrowing. In fact, the effectual cost of long-term debt even went short-term interest rates are equivalent to or greater than long-term rates. With long-term debt, a firm incurs the interest expense even throughout times went it has no immediate need for the funds, such as during seasonal or cyclical downturns. With short-term debt, in contrast, the firm can avoid the interest costs on unnecessary funds by playing of the debt. Therefore, the long-term debt usually is superior to the cost of short-term debt.

Risk of long-term vs. short-term debt:

Borrowing companies have diverse attitudes toward the relative risk of long-term vs. short-term debt then lenders. Whereas lenders usually feel that risk increases with maturity, borrowers feel that there is more risk linked with short-term debt. The reasons for this are twofold. Primarily, there is forever the chance that a firm will not be able to repayment its short-term debt. When a firm’s debt matures, it either pays off the debt as part of a debt reduction program or arranges new financing. At the time of maturity, however, the firm could faced with financial problems resulting from such actions as strike, natural disasters, or recessions that cause sales and cash inflows to turn down. Under these circumstances the firm may find it very difficult or even not possible to obtain the needed funds. This could lead to operating and financial difficulties. Second, short-term interest rates tend to change more over time than long-term interest rates. As a result, a firm’s interest expenses and predictable earnings after interest and taxes are subject to more different risk over time with short-term debt than with long-term debt.

 

General working capital strategy:

The goal of a business is to create value for its shareholders. In order to make this value, the business has to create a competitive advantage to exploit inconsistency in the market in which it operates; both its trading and financial environments. As such, Lawrence needs to develop a comprehensive strategic, financial, and implementation plan to facilitate a victorious Working Capital Policy, while fully leveraging existing resources and making their bottom line more profitable while managing risks and events that would threaten the achievement of the endeavor. Working capital administration involves decisions with regard to levels of cash, receivables, and inventory. Too much working capital is costly, reducing profitability and return on capital. However, too little can also be expensive in terms of lost opportunity and the company may suffer increases in cost of capital due to too little cash if it cannot pay bills on time. A company firm can adjust any of the following working capital strategies:

1. Traditional working capital policy
2. Hostile working capital policy
3. Reasonable working capital policy

Let us understand each of them one by one.

 

 

1. Traditional working capital policy:

Under traditional approach, the firm carries high investment in current assets such as cash, saleable securities and carries huge amount of inventories and grants generous conditions of credit to clients resulting in a high level of debtors. The consequences of traditional working capital policy are rapid deliveries to customers and more sales due to generous credit conditions.

2. Hostile working capital policy:

Under hostile working capital policy, investment in current assets is extremely low. The firm keeps less amount of cash and profitable securities, manages with less inventories and tight  credit terms resulting in low level of debtors. The consequences of aggressive working capital policy are frequent production stoppages, delayed deliveries to consumers and loss of sales.

3. Reasonable working capital policy:

Reasonable approach is forever maintaining essential amount of current assets depending upon sales. A tradeoff among two costs namely carrying cost and scarcity cost determines the best possible level of current assets. Costs that rise with current assets i.e. that cost of financing a

 

higher level of current assets form transport costs. Scarcity costs are in the form of disturbance in production schedule, loss of Sales and loss of goodwill.

The optimum level of current assets is denoted by the total costs = (transport costs + scarcity costs) minimize at that level.

Scheduling of working capital:

Cash is the lifeline of a business. If this lifeline deteriorates, so does the company’s capability to fund operations, reinvest and meet capital necessities and payments. Understanding a company’s cash flow healthiness is necessary to making investment decisions. Working capital is of main significance to internal and external analysis since of its close relationship with the current day- to-day operations of a company. Every company desires funds for two purposes.

1.  Long-term funds:

Long-term funds are necessary to create production amenities through purchase of fixed assets such as plants, machineries, lands, buildings, etc.

2.  Short-term funds

Short-term funds are necessary for the purchase of raw resources, payment of wages, and other day-to-day expenses. It is otherwise recognized as rotating or circulating capital. A business firm must maintain an sufficient level of working capital in order to run its business smoothly. It is worthy to note that both extreme and inadequate working capital position are injurious. Working capital is just like the heart of business. If it becomes weak, the business can hardly flourish and survive. No business can run successfully without an sufficient amount of working capital.

 

Types of Working Capital:

The concept of Working Capital involves current assets and current liabilities mutually. There are two concepts of working capital. They are Gross and Net Working Capital.

1.       Gross Working Capital:

Gross Working Capital refers to the firm’s investment in Current Assets. Current assets are the assets, which can be transformed into cash within a financial year or operating cycle. It includes cash, short-term securities, debtors, bills receivables and inventory. The concept of Gross Working Capital focuses notice on two aspects of current assets’ executive. They are:

1. Way of optimizing investment in Current
2. Way of financing current

 

1.  Optimizing Investment in Current Assets:

Investment in Current assets must be just sufficient i.e., neither in surplus nor deficit since excess investment increases liquidity but reduces profitability as idle investment earns nothing and insufficient amount of working capital can threaten the solvency of the firm since of its inability to meet its obligation. It is taken into deliberation that the Working Capital needs of the company may be fluctuating with changing business actions which may cause excess or shortage of Working Capital regularly and punctual management can control the imbalances.

2.  Technique of Financing Current Assets:

This aspect points to the require of arranging funds to finance current assets. It says at any time a need for working Capital arises; financing agreement should be made quickly. The monetary manager should have the knowledge of sources of the working capital funds as wheel as investment avenues where idle funds can be temporarily invested.

 

Net Working Capital:

Net Working Capital means the distinction between Current assets and Current Liabilities are those claims of outsider, which are expected to grown-up for payment within a bookkeeping year. It includes creditors or accounts payables, bills payables and outstanding expenses. Net Working Capital can be positive or negative. A positive net working capital will occur when current assets go beyond current liabilities and vice versa. As compared with the gross working capital, net is a qualitative concept. It indicates the liquidity position of and suggests the extent to which working Capital needs may be financed by enduring sources of funds. Current assets must be optimally additional than Current Liabilities. It also covers the point of exact mixture of long- term and short-term funds for financing current assets. For every firm a particular quantity of net Working Capital is permanent. Therefore it can be financed with long-term funds.

Thus both concepts, Gross and Net Working Capital, are evenly significant for the competent management of Working Capital. There are no definite rules to determine a firm’s Gross and Net Working Capital but it depends on the business activity of the firm. Every business concern should have neither redundant nor cause excess WC nor it should be short of WC. Both conditions are harmful and unprofitable for any business. But out of these two, the shortage of WC is more dangerous for the well being of the firms. Working capital may be of several types,

 

but the most important of them all are equity capital, debt capital, and specialty capital and sweat equity. Each of these is a separate group of financial and has its own benefits and uniqueness.

Equity Capital

Equity capital can be understood as the invested wealth that is not repaid to the investors in the usual course of business. It represents the risk capital staked by the owners through acquire of  the firm’s common stock. Its worth is computed by estimating the current market worth of everything owned by the firm from which the total of all liabilities is subtracted. On the balance sheet of the firm, equity capital is scheduled as stockholders’ equity. Equity Capital is also recognized as equity financing, share capital, net value and book value. There are some companies that are funded completely with equity capital although it is the preferential form for most people because you cannot go bankrupt, it can be extraordinarily costly and require massive amounts of work to grow your venture. For example Microsoft is a model of such an operation because it generates lofty enough returns to justify a pure equity capital arrangement.

Debt Capital:

Debt capital is the capital that a company raises by taking out a loan. It is a loan made to a company that is usually repaid at some future date. Debt capital ranks superior than equity  capital for the repayment of annual returns. This means that legally, the interest on debt capital must be repaid in full before any dividends are paid to any suppliers of equity. Debt  capital is that type of capital which is infused into a business with the understanding that it have to be paid back at a prearranged future date. In the meantime, the owner of the capital (typically a bank, bondholders, or a wealthy individual), agree to recognize interest in exchange for you using their wealth.

 

Operating Cycle:

The degree to which profits can be earned will obviously depend, among other things, upon the extent of the sales. A successful sales program is, in other words, essential for earning profits by any business venture. However, sales do not convert into cash directly: there is invariably a time- lag between the sale of goods and the receipt of cash. There is, consequently, a need for working capital in the form of current assets to deal with the difficulty arising out of the lack of instant realization of cash against goods sold. Therefore, sufficient working capital is necessary to

 

sustain sales activity. Theoretically, this is referred to as the operating or cash cycle.  The simplest meaning of the term operating cycle is, “The standard time between purchasing or acquiring inventory and receiving cash earnings from its sale.” The operating cycle can be said to be at the spirit of the need for working capital. The continuing flow from cash to suppliers, to inventory, to accounts receivable and back into cash is what is called the operating cycle. In  other words, the term cash cycle means the duration of time essential to complete the following cycle of events:

1. Change of cash into inventory
2. Change of inventory into receivables
3. Change of receivables into

 

Computation of working capital:

Working Capital (Current Assets-Current Liabilities) = (Raw Materials Stock + Work-in- progress Stock +Finished Goods Stock+ Debtors + Cash Balance) – (Creditors +Outstanding Wages +Outstanding Overheads).

Where,

Raw Materials = Cost (Average) of Materials in Stock

Work-in-progress Stock = Cost of Materials+ Wages +Overhead of Work-in-progress.

Finished Goods Stock = Cost of Materials + Wages +Overhead of Finished Goods.

Creditors for Material = Cost of Average Outstanding Creditors.

Creditors for Wages = Averages Wages Outstanding. Creditors for Overhead = Average Overheads Outstanding. Thus,

Working Capital =

Cost of Materials in Stores, in Work-in-progress, in Finished Goods and in Debtors.

Less : Creditors for Materials

Plus : Wages in Work-in-progress, in Finished Goods and in Debtors.

Less : Creditors for Wages

Plus : Overheads in Work-in-progress, in Finished Goods and in Debtors.

Less : Creditors for Overheads.

The work sheet for estimation of working capital requirements under the operating cycle method may be presented as follows:

 

Estimation of working capital requirements

 

I Current Assets	Amount	Amount	Amount
Minimum Cash Balance		****
Inventories :
Raw Materials	****
Work-in progress	****
Finished Goods	****	****
Receivables :
Debtors	****
Bills receivables	****	****
Gross Working Capital (CA)		****	****
II Current Liabilities:
Creditors for Purchases		****
Creditors for Wages		****
Creditors for Overheads		****	****
Total Current Liabilities (CL)		****	****
Excess of CA over CL			****
+ Safety Margin			****
Net Working Capital			****

 

The subsequent points are also worth noting while estimating the working capital requisite:

1.       Depreciation:

An significant point worth noting while estimating the working capital necessity is the depreciation on permanent assets. The depreciation on the fixed assets, which are used in the manufacture process or other activities, is not considered in working capital assessment. The depreciation is a non-cash expense and there is no funds locked up in depreciation as such and then, it is unseen. Depreciation is neither incorporated in valuation of work-in-progress nor in finished goods. The working capital considered by ignoring depreciation is known as cash basis working capital. In case, depreciation is incorporated in work ing capital calculations, such estimation is known as total basis working capital.

2.   Margin of Safety:

Occasionally, a firm may also like to have a safety margin of working capital in order to congregate any emergency. The safety margin may be expressed as a % of total current assets or total current liabilities or net working capital. The safety margin, if necessary, is included in the

 

working capital estimates to find out the net working capital required for the firm. There is no hard and fast rule about the quant um of safety margin and depends upon the nature and uniqueness of the firm in addition to the current assets and current liabilities.

Problems

1. Following is the information of Shri Aruna Industries Ltd. Latur for the year 3oth June 2018. Their plan is to sell 30,000 units in the year 2018-2019. The expected cost of goods sold is as under you are required to calculate the working capital

 

Particulars                                                                              Rs. (Per Unit)

 

Raw material	100
Manufacturing expenses	30
Selling, administration and financial expenses	20
Selling price	200
The duration at various stages of the operating cycle is expected to be as follows :
Raw material stage 2 months
Work-in-progress stage 1 month
Finished goods stage 1/2 month
Debtors stage 1 month

Assuming that the monthly sales level of 2,500 units, estimate the gross working capital necessity. Expected cash balance is 5% of the gross working capital necessity, and working- progress in 25% complete with respect to manufacturing expenses.

Solution:

 

In the books of Shri. Aruna Industries Ltd.

Statement showing requirements of Working Capital (For the period of 2018-19)

Particulars	Amt. (Rs.)	Amt. (Rs.)
I Current Assets
Stock of Raw Material (2,500×2×100)		5,00,000
Work-in-progress
Raw Materials                  (2,500×100)	2,50,000
Manufacturing Expenses            25% of (2,500×30)	18,750	2,68,750
Finished Goods:

 

Raw Materials              (2,500×½×100)	1,25,000
Manufacturing Expenses (2,500×½×30)	37,500	1,62,500
Debtors (2,500×150)	3,75,000
Total	13,06,250
Cash Balance (13,06,250×5/95)	68750
Net working capital requirement		13,75,000

Note: Selling, administration and financial expenses have not been incorporated in valuation of closing stock.

 

 

2. Following is the information of Ashok Industries Ltd. Latur for the year 31st 2017. You are required to calculate the working capital requirements from the following information:

Particulars                                    Rs.

Raw materials                                     160

Direct labour                                       60

Overheads                                           120

Total cost                                            340

Profit                                                   60

Selling price                                        400

Raw materials are held in stock on an average for 1 month period. Materials are in process on an average for ½ month period. Finished goods are in stock on an average for 1 month period. Credit allowed by suppliers is 1 month period and credit allowed to debtors is 2 month period. Time lag in payment of wages is 1½ weeks. Time lag in payment of overhead expenses is 1 month. 1/4th of the sales are made on cash basis. Cash in hand and at the bank is anticipated to be Rs. 50,000; and anticipated level of production Cash in hand and at the bank is anticipated to be Rs. 50,000; and anticipated level of production amounts to 1,04,000 units for a year of 52 weeks. You may assume that production is carried on evenly throughout the year and a time period of four weeks is equivalent to a month.

Solution:

Particulars	Rs.	Rs.
I Current Assets:
Cash Balance		50,000

 

Stock of Raw Materials (2,000×160×4)		12,80,000
Work-in-progress :
Raw Materials (2,000×160×2)	6,40,000
Labour and Overheads (2,000×180×2)×50%	3,60,000	10,00,000
Finished Goods (2,000×340×4)		27,20,000
Debtors (2,000×75%×340×8)		40,80,000
Total Current Assets		91,30,000
II Current Liabilities :
Creditors (2,000×Rs. 160×4)		12,80,000
Creditors for Wages (2,000×Rs. 60×1½)		1,80,000
Creditors for Overheads (2,000×Rs. 120×4)		9,60,000
Total Current Liabilities		24,20,000
Net Working Capital (CA– CL)		67,10,000

 

Answer the following questions:

1. Which segment of funds would the current liabilities constitute in a firm?
2. What might occur if the current liabilities of a firm are superior to the current assets it has? What will be its result on the working of the firm?
3. Under insistent working capital policy, investment in current assets is very short, discuss on this point.
4. What will be the consequences of traditional working capital policy?
5. Write your opinion, which would be larger-long-term interest rates or short-term interest rates and why?
6. Why does every corporation vying to generate competitive advantages in the market?
7. A firm’s net working capital situation not only is significant from an interior standpoint; it also is widely used as one measure of the firm’s risk. Validate this
8. What do you think as the cause for the public utility undertakings needing very restricted working capital?

Financial distress and corporate restructuring:

Corporate distress, including the legal processes of corporate insolvency reorganization and liquidation, is a sobering economic reality reflects the corporate demise. Many theorists stated that each firm is unavoidably exposed to ups and downs during its development (Burbank, 2005) and corporate collapse is not an unexpected event (Agarwal and Taffler, 2008). Corporate distress is reversible process through adopting restructuring strategies. Companies undergo a distressed financial situation usually share a series of common patterns which make it problematic to estimate a possible outcome of this situation (Barniv et al., 2002). Among the distressed firms, there are little divergences in the financial weakness indicators in the different failure processes (Ooghe and Prijcker, 2008).

Historically, the business failure phenomenon was visible during the 1970s, more during the recession years of 1980 to 1982, intensified attention during the outburst of defaults and large firm bankruptcies in the 1989–1991 period, and an unparalleled interest in the 2001–2002 corporate catastrophe and troubled years.

Main persistent reason for a firm’s debacle and possible failure is managerial ineptitude. In its earlier annual publication of The Failure Record (no longer published), D&B detailed the numerous causes for failure, and those related to management invariably totalled about 90 percent. It is well established in management reports that most firms fail due to multiple reasons, but management insufficiencies are usually at the major issue. The vital cause of corporate upheaval is usually simply running out of cash, but there are a variety of means-related reasons that contribute to bankruptcies and other distressed conditions in which firms find themselves.

These causes are as under:

1. Chronically sick industries (such as agriculture, textiles, department stores).
2. Deregulation of major industries (i.e., airlines, financial services, health care, and energy).
3. High real interest rates in certain periods.
4. International competition.
5. Congestion within an industry.
6. Increased leveraging of corporate.
7. Comparatively high new business formation rates in certain periods.

Some of these reasons are understandable for corporate distress such as high interest rates, overleveraging, and competition. Deregulation eliminates the protection of a regulated industry and promotes larger numbers of entering and exiting firms. Competition is far greater in a deregulated environment, such as the airline industry. Therefore, airline failures increased in the period of 1980s following deregulation at the end of the 1970s and have continued nearly persistent since. New business creation is usually based on optimism about the future. But new businesses do not succeed with far greater frequency than do more seasoned entities, and the failure rate can be estimated to increase in new business activity.

When any firm undergo financial distress, it cannot typically meet its debt repayment obligations using its liquid assets. Unless there is an unexpected recovery of performance, the distressed firm is likely to default on its debt. This could result in a formal bankruptcy filing, a dismissal of the management, and possibly, liquidation of the firm (Gilson, 1989). To evade this, firms typically respond to financial distress by either reorganisation assets through fire sales, mergers, acquisitions and capital expenditures reductions or liabilities (by restructuring debt-both bank loans and public debt and by injections of new capital from outside sources) or both.

Restructuring strategy:

In case of corporate distress, there is a need of corporate restructuring as a company needs to improve its efficiency and profitability and it requires expert corporate management. When the companies are distressed, the government may intervene and support them to recover and revive. For this, firstly the company has to declare the sick unit, in accordance with the compliances of sick industry company’s act 1985. Company is vested in the hands of board of industrial and financial reconstruction. In the best interest of company, the board may revive it, rehabilitates it or sell off the unit. Company must follow restructuring to generate funds (Rajni Sofat, 2011). In broad sense, corporate restructuring refers to the changes in ownership, business mix, assets mix and alliances with a view to enhance the shareholder value. Hence, corporate restructuring may involve ownership restructuring, business restructuring and assets restructuring.

Purpose of Corporate Restructuring:

1. To enhance the shareholder value, the company should continuously evaluate its Portfolio of businesses, Capital mix, Ownership & Asset arrangements to find opportunities to increase the shareholder’s value.
2. To focus on asset utilization and profitable investment opportunities.
3. To reorganize or divest less profitable or loss making businesses/products.
4. The company can also augment value through capital Restructuring, it can innovate securities that help to reduce cost of capital.

Types of Corporate Restructuring strategies:

1. Mergers / Amalgamation: It is a process by which at least two companies combined to establish single firm. It is a merger with a direct competitor and hence expands as the firm’s operations in the same industry. Horizontal mergers are designed to accomplish economies of scale and result in reduce rivals in the industry. Vertical Merger is a merger which occurs upon the combination of two companies which are operating in the same industry but at different stages of production or distribution system.
2. Acquisition and Takeover: Takeovers and acquisitions are common process in business area. A takeover is a distinct form of acquisition that happens when a company takes control of another company without the acquired firm’s agreement. Takeovers that occur without permission are commonly called hostile takeovers. Acquisitions happen when the acquiring company has the permission of the target company’s board of directors to purchase and take over the company.
3. Divesture: Divesture is a transaction through which a firm sells a portion of its assets or a division to another company. It involves selling some of the assets or division for cash or securities to a third party which is an outsider. Divestiture is a form of contraction for the selling company. It is a means of expansion for the purchasing company. It represents the sale of a segment of a company (assets, a product line, a subsidiary) to a third party for cash and or securities.
4. Demerger (spin off / split up / split off): It is a type of corporate restructuring policy in which the entity’s business operations are segregated into one or more components. A demerger is often done to help each of the segments operate more smoothly, as they can focus on a more specific task after demerger. Spinoffs are a way to offload underperforming or non-core business divisions that can drag down profits. Split-off is a transaction in which some, but not all, parent company shareholders receive shares in a subsidiary, in return for relinquishing their parent company’s share. Split-up is a transaction in which a company spins off all of its subsidiaries to its shareholders and ceases to exist.
5. Joint Ventures: Joint ventures are new enterprises owned by two or more contributors. They are typically formed for special purposes for a certain period. It is a combination of subsets of assets contributed by two (or more) business entities for a specific business purpose and a limited duration. Each of the venture partners continues to exist as a separate firm, and the joint venture represents a new business enterprise. It is a contract to work jointly for a period of time. Each member expects to gain from the activity but also must make a contribution.
6. Buy back of Securities: Buy Back of Securities is significant process for Companies who wants to decrease their Share Capital.
7. Franchising: Franchising is also effective restricting strategy. It is an arrangement where one party (franchiser) grants another party (franchisee) the right to use trade name as well as certain business systems and process, to produce and market goods or services according to certain specifications.
8. A leverage buyout (LBO) is any acquisition of a company which leaves the acquired operating entity with a greater than traditional debt-to-worth ratio.

A corporate restructuring strategy involves the dismantling and renewal of areas within an organization that needs special attention from the management. The procedure of corporate reformation often ensues after buy-outs, corporate attainments, takeovers or bankruptcy. It can involve an important movement of an organization’s accountabilities or properties.

Basically, organizational reorganisation involves making numerous transformation to the organizational setup. These changes have great impact on the flow of authority, responsibility and information across the organization. The causes for restructuring differ from diversification and growth to lessening losses and cutting down costs. Organizational restructuring may be done because of external factors such as amalgamation with some other company, or because of internal factors such as high employee costs. Restructuring strategy is about decreasing the manpower to retain employee costs under control.

Company can also focus on quality enhancement of its product at each step in production process to add a new dimension and enhancement to existing product or services (Rajni Sofat, 2011).

Some restructuring strategies need an organizational change. This might result after a business go into a new market, requiring separate business units to share administrative functions or a corporate headquarters to supervise independent divisions. A reorganization may need to develop a new management team or a small business owner to sell part of the business and bring on a new partner or associates. A company that formerly subcontracted most of its administrative functions might bring them in-house. In other cases, a dealer of products who buys those products from sub-contractors might begin manufacturing the products instead of buying them. When two companies amalgamate, one layer of management and other redundant employees must be terminated, resulting in mass dismissals.

If a company cannot fulfil its capital requirements, it might sell stock or take on investors. This would permit the business to buy another company, open new places or add new products to its business. These changes requires the company to modify its financing strategies based on its new debt load and long-term financing needs. If a company has too much debt to operate lucratively, it might reorganize by taking out new loans at higher interest rates but lower monthly payments. Selling stock or part of the business are two possibilities to help reduce debt. Some restructurings focus on cost-containment, which can result in changing the mix of in-house and outsourced functions the company uses, as well as modifications to its product line, labour use and operations. In this situation, the company might renegotiate its contracts with vendors, suppliers, contractors, leasing companies, creditors and personnel.

Government policies for revival of sick units and turnaround strategies

Sickness is defined under Law-Sick Industrial Companies (Special Provisions Act, 1985 (SICA). According to this act a company is termed as sick, if;

1. it was registered for at least seven years;
2. it incurred cash losses for the current and the preceding year;

• its net worth was

Initially only private companies were covered under this Act. But in 1991, public sector companies were also brought under the purview of the Act.

 

The act was amended in 1994 and the criterion of cash losses for two successive years was eliminated. Firms only need to be registered for five years. A sick industrial unit redefined means a company registered for not less than five years and which has defaulted in payment on due dates of debts (including interest due) to any creditor for atleast four quarters, continuous or not, in a block of two consecutive financial years. It also requires the Board of Directors of any company to inform BIFR, if at the end of any financial year erosion of 50 per cent or more of its peak net worth has resulted during the immediately preceding four years.

 

Basically sickness refers to continued sub-normal standards of performance eroding capital or denying return to the investors. The two questions which need to be addressed are; what is ‘continued’ and what is ‘normal standard’. One option is to define normalcy by an established benchmark. No universally applicable benchmarks are easily accessible or could be fruitfully applied to Indian conditions which were characterised for a long time by a regulated, protected, constrained framework. One could maintain that sub-normal performance, leads to a loss-making state, but one does not necessarily follow from the other. Moreover, loss generation does not capture sub-standard performance, in a specific area. Loss-making state of an enterprise is a cumulative result of several functions.

 

 

Industrial sickness has grown in magnitude over the years. A large number of industrial units in the small-scale sector and non-small scale sector are affected by it. The small-scale sector accounts for 99 per cent of sick/weak units as on March 2001, its share in total bank credit outstanding was only 17-5 per cent.

Table 12.1 : Magnitude of Industrial Sickness

 

No. of Sick  Units
Year	Large and medium	Small	Total
1980	1401	23,149	24,550
1990	2269	2,18,828	2,21,097
1998	2476	2,21,536	2,24,012
1999	2792	3,06,221	3,09,013
2000	3164	3,04,235	3,07,399
2001	3317	2,49,630	2,52,947
Outstanding Bank Credit (Rs. in crore)
1980	1,502	306	1,809
1990	6,926	2,427	9,353
1998	11,825	3,857	15,682
1999	15,150	4,313	19,463
2000	19,047	4,608	23,656
2001	21,270	4,506	25,775

Source: Economic Survey, 2002-03

 

From the data on magnitude of sickness, one can draw the following conclusions (see Table 12.2):

• the total number of sick units increased more than 10 times in a span of 10 years;
• the increase in sickness of small sector units was very large as compared to large and medium enterprises;
• the outstanding bank credit of large and medium enterprises is higher than small units;
• there has been a decrease in number of small-sector sick units after

A large number of sick units project another serious problem. About 90 per cent of small sector sick units are non-viable. The extent of industrial sickness varies by sectors and across regions. In the category of large and medium sick units, textile and engineering industries accounted for about 27 per cent total credit outstanding (1998). Among the states, Maharashtra and West Bengal accounted for about 27.2 .

 

 

Type Time Frame Basic Causes Genetic Historical Varied-technological, economic or management related Structural Launch or Later Decisions on locations, technology, product etc.   Operational   Any time   Management failure, lack of leadership, emergence of competition Policy-linked   Exogenous Any time   Any time, Conditions imposed by policy decisions   Industry location specific, policy specific.

Table 12.2 : Types of Sickness and Their Causes

 

 

 

 

 

 

 

 

 

 

 

 

 

Unpredictable

 

Some enterprises are genetically sick. Among the public enterprises, there is a large number of cases of historic or genetic sickness. Several enterprises were taken over as sick from the private sector to prevent unemployment. Some corporates, outside the public sector are sick structurally. They represent some basic and serious deficiency in their conceptual visualisation. The structural sickness could be due to an uneconomic location, obsolete or inappropriate technology, over-capitalisation, faulty product mix or uneconomic size. Some enterprises become sick after some change in a basic parameter of operation. While it is true that every enterprise has to face change and manage change, some management’s respond to change feebly.

Operational sickness could also occur because of management failures without the occurrence of any change. It could be a case of management fatigue or lack of leadership. Policy-linked sickness and sickness owing to exposure to change is fairly common. Exogenous sickness occurs due to any of the factors affecting the unit from outside.

12.3    REMEDIAL MEASURES AND PREVENTION OF SICKNESS

Consequences of Industrial Sickness: India is a developing country with surplus of labour. Industrial sickness, therefore, has many adverse impacts on the labour economy of our country. India has a limited opportunity for its surplus labour. Closure of sick units adds to the woes of unemployment. Since large units employ large number of labour, closure of such units, leads to unsatisfaction and unrest among the labour class. This may lead to strikes and increase trade unionism. An industrial unit often has close linkages with other related units. Therefore closure of an unit effects the linked units also. This adverse effect may take large proportions and can damage the economy of a country. Sickness is not healthy for the industrial environment of a country. Closure of units discourages other entrepreneurs to set up industrial units. It also causes harm to the investors who had invested large sum of money in that unit. Sickness and closure of industrial units also cause loss of resources which were utilised in setting up that unit. Since resources are scarce, this is a very harmful consequence of sickness. The loss caused to banks and financial institutions due to closure of sick units is quite obvious. The various consequences of sickness can now be summarised as follows:

• increase in unemployment;

 

• loss of resources;
• loss to investors, banks and financial institutions;

Warning Signals of Sickness: To prevent sickness, it is necessary to identify the early symptoms which lead to sickness. These symptoms may be listed as:

• increase in inventories – raw materials and finished goods;
• a firm operates below its break even point – volume of production or salaries not adequate to cover the fixed costs and variable cost;
• shortage of funds to meet short term obligations like salary to labour, purchase of raw materials, interest on loans, payment of tax etc.;
• decrease in net profit;
• unhealthy financial ratio; like debt- equity ratio and ratio of current assets to current liability less than 1:1 (1977) by adding section This section allows for grant of tax benefit to healthy units when they took over the sick units
• provision of margin money to sick units at soft terms
• scheme for grant of excise loan not exceeding 50 per cent of excise duty actually paid for 5 years;

Concessions by Banks and Financial Institutions: Various concessions were announced by banks and FIs for revival of sick enterprises.

• grant of additional working capital;
• recovery of interest at reduced rates;
• freezing of a part of out standing loan;
• setting of a special cell on sick units in the RBI to monitor the performance of sick unit to suggest corrective measure with regard to rehabilitation;
• setting of regional monitoring cells by RBI for better coordination between the banks, state government financial institutions;
• establishment of IRCI – Industrial Reconstruction Corporation of India with functions like – providing financial assistance, managerial and technical assistance, consultancy services ;

Establishment of BIFR –Board for Industrial  and  Financial  Reconstruction: The government established the BIFR, Under the SICA Act of 1985. The Board has various power to tackle industrial sickness. The Board has the authority to enquire and determine the sickness of a company. It can give time to a sick company to make its net worth positive. It can also devise measures like change in management, reconstruction of share capital, sale of part or whole of the unit or merger with a healthy unit. BIFR can also direct banks and financial institutions to-not-to extend any financial assistance for a period of ten years if the Board finds that the sickness is due to a person or partner of a company.

Goswami Committee on Industrial Sickness and Restructuring: The committee submitted its Report in 1993 with the following main elements;

• It recommended a change in the definition of sickness to – default of 180 days or more on repayment to term lending institution and irregularities in cash credits or working capital for 180 days or
• To avoid delays in the BIFR process, the committee recommended that BIFR should use the winding up provision more frequently not only to expedite the sale of economically unviable
• Financial institution could increase monitoring so that they could take corrective 5

 

 

 

 

take over of the management of a sick undertaking with the clear understanding

that the units will not be handed back to the same management;

• merger of the sick unit with a public sector undertaking could be considered;
• Amendment of Income Tax Act

4. Remedial Measures: Public sector has long been considered a social obligation of the government. Thus the sickness of this sector was regarded as a social problem of our country. Cosequently various measures were taken by the government, banks and financial institutions to ruin sick enterprises. The various steps are discussed below.

Government Policy: The government made a policy statement on industrial sickness (1978) and laid down guidelines for various measures to deal with this policy and these measures are as follows:

• arrangements for monitoring and detecting industrial sickness early;
• administrative ministries in the government were given responsibility to coordinate action for revival and rehabilitation;
• setting up of five fast- track winding up tribunals and fine recovery tribunals at Mumbai, Chennai, Kolkata, Delhi and Bangalore;
• giving choice of “voluntary reference” to BIFR instead of mandatory reference so that many cases could be speedily settled outside

However the latest steps of Finance ministry are the repelling of the SICA – 1985. The immediate effect of that would be the winding up of BIFR. In its place a National Company Law tribunal will be set up. The role of this Tribunal will be to serve as a liquidator rather than a rehabilitator.

Turnaround Strategies: Sick enterprises demand changes in their treatment and approach, revival and other strategies for sick enterprises range from simple management intervention like a change in leadership strategies which aim at course – correction are of the following types. Often more than one strategy is required to be used depending on the situation. Strategies of management interventions are:

• Corporate planing
• HRD intervention (for skill development and attitudinal changes)
• TQM/IOS 9000/ 14000 certification
• Change in product mix
• Changes in marketing strategies
• Market and marketing research
• Delayering
• Downsizing
• Capital restructuring
• Cost reduction
• Benchmarking
• Participative management

 

• Recourse to foreign capital
• Customer-orientation

Strategies of basic corporate management are:

• Business process re-engineering

 

 

• Strengthening the Boards through induction of professional Directors
• Reappraisal and change in operating strategies
• Streamlining corporate governance
• Change in corporate leadership Strategies of corporate restructuring are:
• Mergers or amalgamation
• Focus on competency and hence hiving off non-core areas
• Reappraisal and changes in strategic alliances
• Major expansion or diversification
• Forward or backward integration
• Establishing new strategic alliances
• Joint ventures

Strategies of governmental policy formulation are:

• Redefining policies
• Laying down guidelines for performance
• Debottlenecking and streamlining Procedures
• Limiting points of ministerial intervention
• Designing information system and monitoring for governmental intervention
• Establishing sickness signals for governmental intervention
• Formulating policy governing revival and closure
• Setting norms of budgetary support and issue of guarantees
• Setting up norms for access to capital market and foreign markets

Ronald R. Dalesio (1998) has identified some “best practices” which in the public sector environment were overlooked in the past. Moreover they are always missing from sick enterprise. What was considered more important was growth in investment not real growth in output and value addition. Management initiatives were rather discouraged. Complacency and adherence to predetermined procedures was followed. Managers of today cannot ignore the “best practices” listed below though some of these are not directly measurable. These practices have to be followed and operationalised in an effective manner.

• Goal sharing
• Quality upgradation (in product or service)
• Worker satisfaction
• Decision-making quality 7

 

 

Information accessibility (horizontal and vertical)

• Reward system with sharing of value addition
• Dynamic HRD system
• Empowerment
• Communication systems
• Job enrichment
• Quality circles
• Self-managing work teams
• Attitudinal work change
• Technology adaptation and assimilation

The key to sickness prevention is to create competitive advantage. The PSEs did not have to bother much about competitive advantage because of the protected environment in the past. The creation and maintenance of competitive advantage demands focussed strategies. Each product and each market has its own competitive advantage which has to be explored and operationalised. The task before the public sector management in relation to sickness is to:

• Turnaround the reviable sick
• Become proactive in preventing

Survival and revival strategy cannot be done without financial reconstruction. Units must have a financially viable debt – equity ratio. Most PEs in trouble want to convert their government loan capital to equity to avoid interest cost. However, this is not a healthy sign. There should be a mechanism by which restructuring of capital is taken up judiciously.

 

Merger or joint venture option has been approved by the government in the past. The strategy is to revive these companies so that they would be able to support, but would be able to sustain on a long-term basis. Some public enterprises have made large effort in developing plans of revival. But many of them remained unimplemented due to lack of confidence lack of new approach and lack of authority. Such cases need the help of an external agency. This out – sourcing must be designed effectively with a time bound approach, quick evaluation and decision. One of the major causes of sickness is the over staffing in public enterprises. The strategy adopted to turnaround form this ailment is the adoption of VRS packages with high compensation. Public sector enterprises will not be able to survive besides their best effort and initiatives of government. They require a state of robust health with an optimal resource mix of capital, manpower, management, marketing and technology. A correct combination of these strategies is necessary for survival in this world of global competitiveness.

 

Examples of Turnaround Strategies in India :

• Vishakapatnam Steel plant made a comeback from being almost a BIFR case in 1998-99 to a profitable enterprise in 2002-03. The plant which took over 21 years to be commissioned since it was first conceived in 1971, faced many challenges from the world The slowdown in 1998 only made things worse. But a collec- tive approach, a change in focus from result orientation to process orientation, innovative and customer concentric strategies, total employee involvement, technology upgradation and managing external environment helped the company tone up its bottom-line and top-line.

company posting its first loss in six years in competition which led to the com- pany posting its first loss in six years in 1997-98, the problem was accentuated when ECIL. Was named by the us Department of commerce for export embar- goes on all items of US origin, a move followed by several western countries.

 

In the year, ECIL suffered a loss of Rs.60 crore and had to be reported to the BIFR. Since then a careful restructured turnaround strategy, encompassing employee motivation financial discipline, performance monitoring mechanism, business develop- ment through bidding and forging partnership even with competitors and improving technical base through relationship with universities, BARC and DRDO has paid rich dividends.

REFERENCES:

https://www.shahucollegelatur.org.in/Department/Studymaterial/comm/bcom3yr/Working%20Capital%20Management.pdf

 

http://www.egyankosh.ac.in/bitstream/123456789/16482/1/Unit-12.pdf

 

 

Reference:

Department of Education, Employment and Workplace Relations, 2010. Draft Guide to the National Quality Standard Education and Care Services – Centre-based and family day care, Barwon, ACT.

 

PRACTICE QUESTION:

1.Define the term strategic management  with its nature and scope?

2.Define financial and non financial objectives?

3.define the term value creation and value drivers?

4.Define the term corporate risk management? Risk its mgt. in practice?

5.Explain the term financial planning? And forecasting ratio system? Define the models in details?

6. Define the term corporate valuation? Define all the approaches in brief?

7.What do you mean by long term projects?

 

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