UGC NET Commerce Business Finance PDF

UNIT SNAPSHOT UGC NET COMMERCE Unit 4 Business Finance ❖ Financial Management - Financial management is managerial activity which is concerned with the planning and controlling of the firm’s financial resources. a) Howard and Uptron define financial management “as an application of...

UNIT SNAPSHOT UGC NET COMMERCE Unit 4 Business Finance ❖ Financial Management - Financial management is managerial activity which is concerned with the planning and controlling of the firm’s financial resources. a) Howard and Uptron define financial management “as an application of general managerial principles to the area of financial decision-making”. b) Weston and Brighem define financial management “as an area of financial decision making, harmonizing individual motives and enterprise goal”. c) “Financial management is concerned with the efficient use of an important economic resource, namely capital funds” - Solomon Ezra & J. John Pringle. d) “Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient business operations”- J.L. Massie. ❖ Wealth Maximization objective of Financial Management - The earlier objective of profit maximization is now replaced by wealth maximization. The very objective of Financial Management is to maximize the wealth of the shareholders by maximizing the value of the firm. This prime objective of Financial Management is reflected in the EPS (Earning per Share) and the market price of its shares. ❖ Functions of Financial Management - The functions of financial management can be broadly classified into three major decisions, namely Investment decisions, Financing decisions and Dividend decisions. www.everstudy.co.in Query: [email protected] ❖ Investment Decision - The investment decision is concerned with the selection of assets in which funds will be invested by a firm. The assets of a business firm includes long term assets (fixed assets) and short term assets (current assets). The long term investment decision is known as capital budgeting and the short term investment decision is identified as working capital management. ❖ Financing Decision - The financing decision is concerned with capital – mix, financing – mix or capital structure of a firm. The term capital structure refers to the proportion of debt capital and equity share capital. Financing decision of a firm relates to the financing – mix. This must be decided taking into account the cost of capital, risk and return to the shareholders. ❖ Dividend Decision - Dividend policy decisions are concerned with the distribution of profits of a firm to the shareholders. How much of the profits should be paid as dividend? i.e. dividend pay-out ratio. The decision will depend upon the preferences of the shareholder, investment opportunities available within the firm and the opportunities for future expansion of the firm. ❖ Sources of Finance - Sources of finance for business are equity, debt, debentures, retained earnings, term loans, working capital loans, letter of credit, euro issue, venture funding etc. www.everstudy.co.in Query: [email protected] ❖ Bonds - Bonds are issued by organizations generally for a period of more than one year to raise money by borrowing. A bond is generally a form of debt which the investors pay to the issuers for a defined time frame. www.everstudy.co.in Query: [email protected] ❖ Plain Vanilla Bond - A plain vanilla bond is a bond without any unusual features; it is one of the simplest forms of bond with a fixed coupon and a defined maturity and is usually issued and redeemed at the face value. It is also known as a straight bond or a bullet bond. ❖ Zero Coupon Bond - The bonds which do not carry periodic interest payment is called zero coupon bond. The issuance of these bonds are made at a steep discount over its face value and repaid at face value on maturity. ❖ Deep discount Bond - A type of zero interest bonds which are offered for sale at discounted value and is redeemed at face value on its maturity. ❖ Perpetual Bond - These types of bonds pay a coupon rate on the face value till the life of the company. Though Perpetuity means forever, bonds with maturity above 100 years are also considered to be perpetual bonds. ❖ Debentures - In layman’s term, a Debenture is the acknowledgment of the debt the organization has taken from the public at large. Debentures are a debt instrument used by companies and government to issue the loan. The loan is issued to corporates based on their reputation at a fixed rate of interest. www.everstudy.co.in Query: [email protected] ❖ Convertible Debentures - Convertible debenture can be converted into equity shares after the expiry of a specified period. On the other hand, a non-convertible debenture is those which cannot be converted into equity shares. ❖ Redeemable Debentures - Redeemable debentures carry a specific date of redemption on the certificate. The company is legally bound to repay the principal amount to the debenture holders on that date. On the other hand, irredeemable debentures, also known as perpetual debentures, do not carry any date of redemption. ❖ Pari-passu Debentures - Pari-passu means equal in all respects, at the same pace or rate, in the same degree or proportion, or enjoying the same rights without bias or preference. The (secured) debentures, which are discharged ratably, though issued at different dates, are called debentures with pari pasu clause. With a pari passu clause, a debenture holder is assured of getting the repayment in pro rata basis between denture holders, in case of insufficient funds / assets of the company. ❖ Equity Shares - Equity shares are the main source of finance of a firm. It is issued to the general public. Equity share-holders do not enjoy any preferential rights with regard to repayment of capital and dividend. They are entitled to residual income of the company, but they enjoy the right to control the affairs of the business and all the shareholders collectively are the owners of the company. www.everstudy.co.in Query: [email protected] ❖ Preference Shares – Preference shares are shares which are preferred over common or equity shares in payment of surplus or dividend i.e preference shareholders are the first to get dividends in case the company decides to pay out dividends. Owners of preference shares gets fixed dividend. However, in the event of liquidation of the company they are paid after bond holders and creditors, but before equity holders. www.everstudy.co.in Query: [email protected] ❖ Cumulative preference shares: A preference share is said to be cumulative when the arrears of dividend are cumulative and such arrears are paid before paying any dividend to equity shareholders. Suppose a company has 10,000 8% preference shares of Rs. 100 each. The dividends for 2017 and 2018 have not been paid so far. The directors before they can pay the dividend to equity shareholders for the year 2019, must pay the pref. dividends in arrear. ❖ Participating preference shares - Participating preference shares are those shares which are entitled in addition to preference dividend at a fixed rate, to participate in the balance of profits with equity shareholders after they get a fixed rate of dividend on their shares. ❖ Leasing - Lease can be defined as a right to use an equipment or capital goods on payment of periodical amount. There are two principal parties to any lease transaction as under: a) Lessor : Who is actual owner of equipment permitting use to the other party on payment of periodical amount. b) Lessee : Who acquires the right to use the equipment on payment of periodical amount. ❖ Operating Lease - In this type of lease transaction, the primary lease period is short and the lessor would not be able to realize the full cost of the equipment and other incidental charges www.everstudy.co.in Query: [email protected]  thereon during the initial lease period. Computers and other office equipments are the very common assets which form subject matter of many operating lease agreements. ❖ Financial Lease - As against the temporary nature of an operating lease agreement, financial lease agreement is a long-term arrangement, which is is generally the full economic life of the leased asset. Financial lease involves transferring almost all the risks incidental to ownership and benefits arising therefrom except the legal title to the lessee. ❖ Sales and Lease Back Leasing - Under this arrangement an asset which already exists and is used by the lessee is first sold to the lessor for consideration in cash. The same asset is then acquired for use under financial lease agreement from the lessor. This is a method of raising funds immediately required by lessee for working capital or other purposes. The lessee continues to make economic use of assets against payment of lease rentals while ownership vests with the lessor. ❖ Leveraged Lease - A leveraged lease is an agreement where the lessor finances the lease by taking a loan from a lender. The party leasing the asset pays the lessor monthly. The lessor, in turn, remits the payments to the financing company. This allows the lessor to provide a lease and profit from the lease even if the individual leasing the asset does not have the income to obtain the lease outright. ❖ Break Even Lease Rental (BELR) - Break-Even Lease Rental can be from both point of views i.e. from lessee’s view as well as lessor’s point of view. a) Break Even Lease Rental (BELR) from Lessee’s point of view - The rental at which the lessee is indifferent between borrowing and buying option and lease financing option. At this rental the Net Advantage of leasing (NAL) will be zero. b) Break Even Lease Rental (BELR) from Lessor’s point of View - BELR is the minimum (floor) lease rental, which he should accept. In this case also NAL should be zero. ❖ Financial planning - Financial planning involves analyzing the financial flows of a company, forecasting the consequences of various investment, financing and dividend decisions and weighing the effects of various alternatives. www.everstudy.co.in Query: [email protected] ❖ Watered Capital - Watered Capital is the excess of total capitalisation over the real value of the long-term assets of the company. Simply speaking ‘water’ is said to be present in the capital when a part of the capital is not represented by assets. Watered capital arises when a company pays higher price for the assets or when adequate consideration in the form of assets in not received for the issue of securities. ❖ Optimal Capital Structure - The financial manager has to establish an optimum capital structure and ensure the maximum rate of return on investment. The ratio between equity and other liabilities carrying fixed charges has to be defined. In the process, he has to consider the operating and financial leverages of his firm. The operating leverage exists because of operating expenses, while financial leverage exists because of the amount of debt involved in a firm’s capital structure. www.everstudy.co.in Query: [email protected] ❖ Equity Share Capital - It represents the ownership interest in the company. Since equity shares do not mature, it is a permanent source of fund. Equity dividends are paid to the www.everstudy.co.in Query: [email protected]  shareholders out of after-tax profits. Equity share capital does not involve any mandatory payments to shareholders. However, excessive issue of equity share can dilute the ownership of the Company. ❖ Preference Share Capital - The preference share capital is also owners capital but has a maturity period. In India, the preference shares must be redeemed within a maximum period of 20 years from the date of issue. The rate of dividend payable on preference shares is also fixed. As against the equity share capital, the preference shares have two preferences: (i) Preference with respect to payment of dividend, and (ii) Preference with reference to repayment of capital in case of liquidation of company. ❖ Debentures - A bond or a debenture is the basic debt instrument which may be issued by a borrowing company. Debenture carries a promise by the company to make interest payments to the debenture-holders of specified amount, at specified time and also to repay the principal amount at the end of a specified period. ❖ Theories of Capital Structure - Equity and debt capital are the two major sources of long- term funds for a firm. The theories of capital structure suggests the proportion of equity and debt in the capital structure. The theories of capital structure are based on certain assumptions like retention ratio is nil (i.e. total profits are distributed as dividends), no corporate or personal taxes, absence of transaction costs etc. www.everstudy.co.in Query: [email protected] ❖ Net Income Approach - As suggested by David Durand, this theory states that there is a relationship between the Capital Structure and the value of the firm. A firm may increase the total value of the firm by lowering its cost of capital. This theory believes that Cost of Debt (Kd) is less than Cost of Equity (Ke). As the amount of debt in the capital structure increases, weighted average cost of capital decreases which leads to increase the total value of the firm. www.everstudy.co.in Query: [email protected] ❖ Net Operating Income (NOI) Approach - According to David Durand, under NOI approach, the total value of the firm will not be affected by the composition of capital structure. Under this approach, the most significant assumption is that the Ko (overall cost of capital) is constant irrespective of the degree of leverage. The segregation of debt and equity is not important here. An increase in the use of apparently cheaper debt funds is offset exactly by the corresponding increase in the equity- capitalisation rate. ❖ Traditional Approach - It takes a mid-way between the NI approach and the NOI approach. The traditional approach explains that up to a certain point, debt-equity mix will cause the market value of the firm to rise and the cost of capital to decline. But after attaining the optimum level, any additional debt will cause to decrease the market value and to increase the cost of capital. www.everstudy.co.in Query: [email protected] ❖ Modigliani – Miller (MM) Hypothesis - Modigliani – Miller hypothesis is identical with the Net Operating Income approach. Modigliani and Miller argued that, in the absence of taxes the cost of capital and the value of the firm are not affected by the changes in capital structure. M - M Hypothesis can be explained in terms of two propositions as follows: The overall cost of capital (KO) and the value of the firm are independent of the capital structure. The total market value of the firm is given by capitalizing the expected net operating income by the rate appropriate for that risk class. Proposition I can be expressed as follows: Where, ▪ V = the market value of the firm ▪ S = the market value of equity ▪ D = the market value of debt The financial risk increases with more debt content in the capital structure. As a result cost of equity (Ke) increases in a manner to offset exactly. M – M’s proposition II defines cost of equity as: www.everstudy.co.in Query: [email protected]  ▪ Where, ▪ Ke = cost of equity ▪ Kd = Cost of Debt ▪ D/S = debt – equity ratio ❖ Arbitrage Process - According to M –M, two firms identical in all respects except their capital structure, cannot have different market values or different cost of capital. In case, these firms have different market values, the arbitrage will take place and equilibrium in market values is restored in no time. Arbitrage process refers to switching of investment from one firm to another. When market values are different, the investors will try to take advantage of it by selling their securities with high market price and buying the securities with low market price. ❖ M – M Hypothesis Corporate Taxes - Modigliani and Miller later recognised the importance of the existence of corporate taxes. Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. ❖ Leverage - The concept of leverage has its origin in science. It means influence of one force over another. In the context of financial management, the term ‘leverage’ means sensitiveness of one financial variable to change in another. ❖ Operating Leverage - Operating leverage reflects the impact of change in sales on the level of operating profits of the firm. With the use of fixed costs, the firm can magnify the effect of change in sales on change in EBIT. The higher the proportion of fixed operating cost in the cost structure, higher is the degree of operating leverage. Degree of Operating Leverage is computed as follows: www.everstudy.co.in Query: [email protected]  Alternatively, ❖ Financial leverage - Financial leverage is mainly related to the mix of debt and equity in the capital structure of a firm. Financial leverage results from the existence of fixed financial charges in the firm’s income stream. With the use of fixed financial charges, a firm can magnify the effect of change in EBIT on change in EPS. Hence financial leverage may be defined as the firm’s ability to use fixed financial charges to magnify the effects of changes in EBIT on its EPS. The higher the proportion of fixed charge bearing fund in the capital structure of a firm, higher is the Degree of Financial Leverage (DFL) and vice-versa. Degree of Financial Leverage can be computed as follows: ❖ Degree of Combined Leverage – The operating leverage explains the business risk of the firm whereas the financial leverage deals with the financial risk of the firm. But a firm has to look into the overall risk or total risk of the firm, which is business risk plus the financial risk. A combination of the operating and financial leverages is the total or combination leverage. It www.everstudy.co.in Query: [email protected]  can be calculated as follows: ❖ Cost of Capital - The term cost of capital refers to the minimum rate of return a firm must earn on its investments. According to Soloman Ezra, “Cost of Capital is the minimum required rate of earinings or the cut-off rate of capital expenditure”. ❖ Components of Cost of Capital - It comprises three components : ❖ Cost of Debt - Debt may be perpetual or redeemable debt. Moreover, it may be issued at par, at premium or discount. The computation of cost of debt in each is explained below. www.everstudy.co.in Query: [email protected] ❖ Perpetual / irredeemable debt - ❖ Redeemable debt - The debt repayable after a certain period is known as redeemable debt. Its cost computed by using the following formula : ▪ I = Interest ▪ P = proceeds at par; ▪ NP = net proceeds; ▪ n = No. of years in which debt is to be redeemed After tax cost of debt = Before – tax cost of debt × (1-t) ❖ Cost of Preference Capital (kp) - In case of preference share dividend are payable at a fixed rate. However, the dividends are not allowed to be deducted for computation of tax. So no adjustment for tax is required. Just like debentures, preference share may be perpetual or redeemable. Further, they may be issued at par, premium or discount. ❖ Perpetual Preference Capital – Cost of perpetual preference capital is calculated as follows: If issued at par ; Kp = D/P o where; o Kp = Cost of preference capital o D = Annual preference dividend o P = Proceeds at par value www.everstudy.co.in Query: [email protected]  If issued at premium or discount Kp = D/NP ; Where NP = net proceeds ❖ Redeemable preference shares - It is calculated with the following formula : o Where, o Kp = Cost of preference capital o D = Annual preference dividend o MV = Maturity value of preference shares o NP = Net proceeds of preference shares o n = Maturity Period. ❖ Cost of Equity capital - Cost of Equity is the expected rate of return by the equity shareholders. Some argue that, as there is no legal compulsion for payment, equity capital does not involve any cost. But it is not correct. Equity shareholders normally expect some dividend from the company while making investment in shares. Thus, the rate of return expected by them becomes the cost of equity. ❖ Dividend Yield / Dividend Price Approach - According to this approach, the cost of equity will be that rate of expected dividends which will maintain the present market price of equity shares. It is calculated with the following formula: www.everstudy.co.in Query: [email protected]  This method is suitable only when the company has stable earnings and stable dividend policy over a period of time. ❖ Dividend yield plus Growth in dividend methods - According to this method, the cost of equity is determined on the basis of the expected dividend rate plus the rate of growth in dividend. This method is used when dividends are expected to grow at a constant rate. Cost of equity is calculated as: ❖ Earnings Yield Method - According to this approach, the cost of equity is the discount rate that capitalizes a stream of future earnings to evaluate the shareholdings. It is computed by taking earnings per share (EPS) into consideration. It is calculated as : www.everstudy.co.in Query: [email protected] ❖ Cost of Retained Earnings (Kr) - Retained earnings refer to undistributed profits of a firm. Since no dividend is required to paid on retained earnings, it is stated that ‘retained earnings carry no cost’. But this approach is not appropriate. Shareholders expect a return on retained earnings at least equal to that of equity. However, while calculating cost of retained earnings, two adjustments should be made: a) Income-tax adjustment as the shareholders are to pay some income tax out of dividends, and b) adjustment for brokerage cost as the shareholders should incur some brokerage cost while invest dividend income Therefore, after these adjustments, cost of retained earnings is calculated as : ❖ Weighted Average Cost of Capital - It is the average of the costs of various sources of financing. It is also known as composite or overall or average cost of capital. It is calculated by using the following formula: o Where, o Kw = weighted average cost of capital o X = cost of specific sources of finance o W = weights (proportions of specific sources of finance in the total) Weighted average cost of capital is computed by using either of the following two types of weights: www.everstudy.co.in Query: [email protected]  o Market value o Book Value Market value weights are sometimes preferred to the book value weights as the market value represents the true value of the investors. ❖ 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’. ❖ Indifference Point - Indifference points refer to the EBIT level at which the EPS is same for two alternative financial plans. According to J. C. Van Home, ‘Indifference point refers to that EBIT level at which EPS remains the same irrespective of debt equity mix’. The indifference level of EBIT is significant because the financial planner may decide to take the debt advantage if the expected EBIT crosses this level. www.everstudy.co.in Query: [email protected] ❖ Financial Breakeven Point - In general, the term Breakeven Point (BEP) refers to the point where the total cost line and sales line intersect. Similarly financial breakeven point is the level of EBIT at which after paying interest, tax and preference dividend, nothing remains for the equity shareholders. In other words, financial breakeven point refers to that level of EBIT at which the firm can satisfy all fixed financial charges. EBIT less than this level will result in negative EPS. Therefore, EPS is zero at this level of EBIT. ❖ Capital Budgeting - Capital Budgeting is the art of finding assets that are worth more than they cost to achieve a predetermind goal i.e., ‘optimising the wealth of a business enterprise’. A Capital Budgeting decision involves the following process : www.everstudy.co.in Query: [email protected] ❖ Time Value of Money - We know that Rs. 100 in hand today is more valuable than Rs. 100 receivable after a year. We will not part with Rs. 100 now if the same sum is repaid after a year. But we might part with Rs. 100 now if we are assured that Rs. 110 will be paid at the end of the first year. This “additional Compensation” required for parting Rs. 100 today, is called “interest” or “the time value of money”. ❖ Rule of 72 - The "Rule of 72" is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself. For instance, if the rate is 5%, then the doubling period is 72/5 = 14.4 years. www.everstudy.co.in Query: [email protected] ❖ Rule of 69 - Rule of 69 is used to estimate the amount of time it will take for an investment to double, assuming continuously compounded interest. The calculation is to divide 69 by the rate of return for an investment and then add 0.35 to the result. For instance, if the rate is 5%, then the doubling period is: ❖ Rule of 114 - To estimate how long it takes to triple your money, divide 114 by your expected interest rate (or rate of return). ❖ Rule of 144 - To estimate how long it will take to quadruple your money, you can use the number 144. Dividing 114 by your expected interest rate (or rate of return) will give the answer. ❖ Future Value of Annuity - Annuity is a term used to describe a series of periodic flows of equal amounts. These flows can be inflows or outflows. The future value of annuity is expressed as : ❖ Present Value of an Annuity - The present value of an annuity ‘A’ receivable at the end of every year for a period of n years at the rate of interest ‘i’ is equal to: www.everstudy.co.in Query: [email protected] ❖ Investment Appraisal Techniques – They are all those techniques by which projects are appraised for making acceptance-rejection decision. Different techniques can be employed for making such decisions. ❖ Payback Period Method - The basic element of this method is to calculate the recovery time, by yearwise accumulation of cash inflows (inclusive of depreciation) until the cash inflows equal the amount of the original investment. The time taken to recover such original investment is the “payback period” for the project. “The shorter the payback period, the more desirable a project”. Example – Initial investment on a project is Rs. 1,00,000 and expected future cash inflows are Rs. 20,000 , Rs. 40,000 , Rs. 40,000 and Rs. 25,000 for the next 4 years. Thus, the payback period would be 3 years as entire investment is being recovered in 3 years. www.everstudy.co.in Query: [email protected] ❖ Accounting Rate of Return - This method measures the increase in profit expected to result from investment. ❖ Net Present Value (NPV) Method – This method involves computation of Net Present Value or NPV. NPV = Present Value of Cash Inflows – Present Value of Cash Outflows Example - Z ltd. has two projects under consideration A & B, each costing Rs. 60 lacs. total P.V. of net cash flows of project A is Rs. 180 lacs while that of project B is Rs. 160 lacs. As Project “A” has a higher Net Present Value, it has to be taken up. ❖ Internal Rate of Return (IRR) - Internal Rate of Return is a percentage discount rate applied in capital investment decisions which brings the cost of a project and its expected future cash flows into equality, i.e., NPV is zero. The decision rule for the internal rate of return is to invest in a project if its rate of return is greater than its cost of capital. www.everstudy.co.in Query: [email protected] ❖ Profitability Index – It is the ratio of Present Value of Cash Inflows to Present Value of Cash Outflows. PI signifies present value of inflow per rupee of outflow. It helps to compare projects involving different amounts of initial investments. ❖ Discounted Payback Period - In Traditional Payback period, the time value of money is not considered. Under discounted payback period, the expected future cash flows are discounted by applying the appropriate rate, i.e., the cost of capital. Then, discounted cash inflows are used to calculate payback period. ❖ Capital rationing - Capital rationing is a situation where a constraint or budget ceiling is placed on the total size of capital expenditures during a particular period. Under this situation, a decision maker is compelled to reject some of the viable projects having positive net present value because of shortage of funds. It is known as a situation involving capital rationing. Decision making in such situations depends upon whether the projects are divisible www.everstudy.co.in Query: [email protected]  or not. If divisible, then decision should be made based upon Profitability Index and if not, then table of feasible combinations should be prepared. ❖ Working capital - Working capital refers to the circulating capital required to meet the day to day operations of a business firm. Working capital is defined as “the excess of current assets over current liabilities and provisions”. The term “working capital” is often referred to “circulating capital”. ❖ Gross Working Capital - It refers to the firm’s investment in total current or circulating assets. ❖ Net Working Capital - It is the excess of current assets over current liabilities. ❖ Permanent Working Capital - This refers to that minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities. Tandon Committee has referred to this type of working capital as “Core current assets”. ❖ Temporary Working Capital - The amount of such working capital keeps on fluctuating from time to time on the basis of business activities. For example, extra inventory has to be maintained to support sales during peak sales period. www.everstudy.co.in Query: [email protected] ❖ Working Capital Cycle - The Working Capital Cycle for a business is the length of time it takes to convert net working capital (current assets less current liabilities) all into cash. ❖ Maximum Permissible Bank Finance - The Tandon Committee had suggested three methods for determining the maximum permissible bank finance (MPBF). ❖ First Method - According to this method, the borrower will have to contribute a minimum of 25% of the working capital gap from long-term funds, i.e., owned funds and term borrowings. www.everstudy.co.in Query: [email protected] ❖ Second Method - Under this method the borrower has to provide the minimum of 25% of the total current assets. ❖ Third Method - In this method, the borrower’s contribution from long term funds will be to the extent of the entire core current assets and a minimum of 25% of the balance of the current assets. The term core current assets refers to the absolute minimum level of investment in all current assets which is required at all times to carry out minimum level of business activities. ❖ Impact of Overtrading on Working Capital – Overtrading arises when a business expands beyond the level of funds available. Overtrade means an attempt to finance a certain volume of production and sales with inadequate working capital. The overtrading situation will lead to high pressure on liquidity and the firm would feel difficult in paying creditors within the credit period allowed. This in turn would lead to difficulty in procurement of raw materials and services in time. Therefore, the overtrading should be detected in time and remedial action should be taken. ❖ Impact of Under Capitalization on Working Capital - Under capitalization is a situation where the company does not have funds sufficient to run its normal operations smoothly. This may happen due to insufficient working capital or diversion of working capital funds to finance capital items. The Finance manager should take immediate and proper steps to overcome the situation of under capitalization by making arrangement of sufficient working capital. ❖ Impact of Over Capitalization on Working Capital - If there are excessive stocks, debtors and cash, and very few creditors, there will be an over investment in current assets. The inefficiency in managing working capital will cause this excessive working capital resulting in lower return on capital employed and long-term funds will be unnecessarily tied up when they could be invested elsewhere to earn profit. ❖ Working Capital Financing Policy - In working capital financing, the manager has to take a decision of mixing the two components i.e., long term component of debt and short term component of debt. The policies for financing of working capital are divided into three categories. a) Firstly, conservative financing policy in which the manager depends more on long term funds. b) Secondly, aggressive financing policy in which the manager depends more on short term funds, www.everstudy.co.in Query: [email protected]  c) Thirdly, are is a moderate policy which suggests that the manager depends moderately on both long tem and short-term funds while financing. ❖ Matching Approach - The question arising here is how to mix both short term and long term funds while financing required working capital. The guiding approach is known as ‘matching approach’. It suggests that if the need is short term purpose, raise short – term loan or credit and if the need is for a long term, one should raise long term loan or credit. Thus, maturity period of the loan is to be matched with the purpose and for how long. This is called matching approach. www.everstudy.co.in Query: [email protected] ❖ Trade off between Liquidity and Profitability - If a firm maintains huge amount of current assets its profitability will be affected though it protects liquidity. If a firm maintains low current assets, its liquidity is of course weak but the firm’s profitability will be high. The trade off between liquidity and illiquidity are shown as follows: www.everstudy.co.in Query: [email protected] ❖ Inventory management - Inventory management refers to an optimum investment in inventories. It should neither be too low to effect the production adversely nor too high to block the funds unnecessarily. Excess investment in inventories is unprofitable for the business. Both excess and inadequate investment in inventories are not desirable. ❖ Economic Ordering Quantity (EOQ) - Economic Ordering Quantity (EOQ) is the quantity fixed at the point where the total cost of ordering and the cost of carrying the inventory will be the minimum. Cost of carrying includes the cost of storage, insurance, obsolescence, interest on capital invested. Mathematically, it is given as follows: ❖ Maximum Stock Level - The maximum stock level is that quantity above which stocks should not normally be allowed to exceed. Maximum Level = Re-order level—(Minimum consumption) × (Minimum lead times) + Reordering quantity ❖ Minimum Stock Level - The minimum stock level is that quantity below which stocks should not normally be allowed to fall. If stocks go below this level, there will be danger of stoppage of production due to shortage of supplies. Minimum Level = Re-order level – (Average usage × Average lead time) ❖ Re-order Level - This is the point fixed between the maximum and minimum stock levels and at this time, it is essential to initiate purchase action for fresh supplies of the material. Re-order level = Maximum usage X Maximum lead time or Minimum level + Consumption during lead time. www.everstudy.co.in Query: [email protected] ❖ Danger Level - This is the level below the minimum stock level. When the stock reaches this level, immediate action is needed for replenishment of stock. ❖ ABC Analysis for Inventory Control - ABC analysis is a method of material control according to value. The basic principle is that high value items are more closely controlled than the low value items. The materials are grouped according to the value and frequency of replenishment during a Period. a) ‘A’ Class items: Small percentage of the total items but having higher values. b) ‘B’ Class items: More percentage of the total items but having medium values. c) ‘C’ Class items: High percentage of the total items but having low values. ❖ H.M.L. Classification - In ABC analysis, the consumption value of items has been taken into account. But in this case, the unit value of stores items is considered. The materials are classified according to their unit value as high, medium or low valued items. ❖ F S N Analysis - According to this approach, the inventory items are categorized into 3 types. They are fast moving, slow moving and non moving. Inventory decisions are very carefully taken in the case of ‘non moving category’. In the case of item of fast moving items, the manager can take decisions quite easily because any error happened will not trouble the firm so seriously. ❖ V.E.D. classification - V.E.D. classification is applicable mainly to the spare parts. Spares are classified as vital (V), essential (E) and desirable (D). Vital class spares have to be stocked adequately to ensure the operations of the plant but some risk can be taken in the case of ‘E’ class spares. ❖ Just in Time (JIT) - Normally, inventory costs are high and controlling inventory is complex because of uncertainities in supply, dispatching, transportation etc. Lack of coordination between suppliers and ordering firms is causing severe irregularities, ultimately the firm ends-up in inventory problems. Toyota Motors has first time suggested just – in – time approach in 1950s. This means the material will reach the points of production process directly form the suppliers as per the time schedule. ❖ Motives to hold cash - Motives or desires for holding cash refers to various purposes. There are four important motives to hold cash: www.everstudy.co.in Query: [email protected]  a) Transactions motive This motive refers to the holding of cash, to meet routine cash requirements in the ordinary course of business. b) Precautionary motive Cash held to meet the unforeseen situations is known as precautionary cash balance and it provides a caution against them c) Speculative motive Sometimes firms would like to hold cash in order to exploit, the profitable opportunities as and when they arise. This motive is called as speculative motive. d) Compensation motive This motive to hold cash balances is to compensate banks and other financial institutes for providing certain services and loans. Customers are required to maintain a minimum cash balance at the bank. ❖ Baumol model - Baumol model of cash management helps in determining a firm’s optimum cash balance under certainty. It is extensively used and highly useful for the purpose of cash management. As per the model, cash and inventory management problems are one and the same. ❖ Miller and Orr model - Miller and Orr model is the simplest model to determine the optimal behavior in irregular cash flows situation. The model is a control limit model designed to determine the time and size of transfers between an investment account and cash account. www.everstudy.co.in Query: [email protected]  There are two control limits. Upper Limit (U) and lower limit (L). If the cash balance touch the “L’ point, finance manager should immediately liquidate that much portion of the investment portfolio which could return the cash balance to ‘O’ point. (O is optimal point of cash balance or target cash balance). ❖ Dividend - The term dividend refers to that part of profits of a company which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by them in the shares of the company. The investors are interested in earning the maximum return on their investments and to maximize their wealth. www.everstudy.co.in Query: [email protected] ❖ Relevance Concept of Dividends - According to this school of thought, dividends are relevant and the amount of dividend affects the value of the firm. Walter, Gordon and others propounded that dividend decisions are relevant in influencing the value of the firm. ❖ Irrelevance Concept of Dividend - The other school of thought propounded by Modigliani and Miller in 1961. According to MM approach, the dividend policy of a firm is irrelevant and it does not affect the wealth of the shareholders. They argue that the value of the firm depends on the market price of the share; the dividend decision is of no use in determining the value of the firm. ❖ Walter’s model - Walter’s model, one of the earlier theoretical models, clearly indicates that the choice of appropriate dividend policy always affects the value of the enterprise. The formula used by Walter to determine the market price per share is : www.everstudy.co.in Query: [email protected] ❖ Implications: a) Growth Firms (r > k) Such firms must reinvest retained earnings since existing alternative investments offer a lower return. b) Normal Firm (r = k) For such firms dividend policy will have no effect on the market value per share in the Walter’s model. c) Declining Firms (r < k) The management of such firms would like to distribute its earnings to the stockholders so that they may either spend it or invest elsewhere to earn higher return than earned by the declining firms. ❖ Gordon’s Model - Gordon has also developed a model on the lines of Prof. Walter suggesting that dividends are relevant and the dividend decision of the firm affects its value. Gordon’s basic valuation formula can be simplified as under : www.everstudy.co.in Query: [email protected]  Implications:- a) When r > k, the price per share increases as the dividend payout ratio decreases. b) When r = k, the price per share remains unchanged and is not affected by dividend policy. c) When r