ALAGAPPA UNIVERSITY · 2020-04-20 · 4.4. Objectives of Cost Accounting a ture a nd Scope of Cost Accou ing 4.6. Management Accounting 4.7. Objectives of Management Accounting 4.8

ALAGAPPA UNIVERSITY [Accredited with ’A+’ Grade by NAAC (CGPA:3.64) in the Third Cycle

and Graded as Category–I University by MHRD-UGC]

(A State University Established by the Government of Tamilnadu)

KARAIKUDI – 630 003

DIRECTORATE OF DISTANCE EDUCATION

MASTER OF COMPUTER

APPLICATION

IV-SEMESTER

31541/34041

ACCOUNTING AND FINANCIAL

MANAGEMENT

Copy Right Reserved For Private use only

Author: Dr. S. NAZEER KHAN

Assistant Professor

PG & Research Department of Commerce

Dr. Zakir Husain College, Illayankudi

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All rights reserved. No part of this publication which is material protected by this copyright notice

may be reproduced or transmitted or utilized or stored in any form or by any means now known or

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or by any information storage or retrieval system, without prior written permission from the

Alagappa University, Karaikudi, Tamil Nadu.

SYLLABI-BOOK MAPPING TABLE ACCOUNTING AND FINANCIAL MANAGEMENT

Syllabi Mapping in Book

BLOCK -I: INTRODUCTION – FINANCIAL ACCOUNTING

UNIT-I Financial Accounting: Meaning and Scope – Principles –

Concepts – Conventions

Pages - 1 - 13

UNIT-II Accounting Process: Journal – Ledger – Trial Balance-

Trading Account – Profit and Loss Account – Balance Sheet

Pages - 14 - 25

UNIT- III Accounting Ratio Analysis – Funds Flow Analysis – Cash

Flow Analysis – Computerized Account

Pages - 26 - 40

BLOCK -II: COST AND MANAGEMENT ACCOUNTING

UNIT-IV Introduction: Meaning Scope and Uses of Cost and

Management Accounting – Elements of Cost

Pages 41 - 47

UNIT-V Cost Sheet – Marginal Costing and Cost Volume Profit

Analysis

Pages 48 - 66

UNIT-VI Break Even Analysis: Concepts, Applications and

Limitations

Pages 67- 70

BLOCK- III: STANDARD COSTING AND BUDGETING

UNIT -VII Introduction: Concept and Importance Standard Costing -

Variance Analysis – Material – Labor – Overhead – Sales – Profit

Variances

Pages 71 - 79

UNIT- VIII Budgets and Budgetary Control – Meaning and Types of

Budgets – Sales Budget – Production Budget

Pages 80 - 86

UNIT-IX Budgets: Cash Budget – Master Budget – Flexible

Budgeting – Zero Base Budgeting

Pages 87 - 94

BLOCK -IV: FINANCIAL MANAGEMENT

UNIT X Introduction: Objectives and Functions of Financial

Management –Risk – Return Relationship – Time Value of Money

Pages 95 - 111

UNIT-XI Capital Budgeting: Basic Methods of Appraisal

Investments

Pages 112 - 136

UNIT XII Working Capital: Concepts of Working Capital, Factors

affecting Working CFapital – Estimation of Working Capital

Requirements

Pages 137 - 161

BLOCK V: COST OF CAPITAL

UNIT XIII Cost of Capital Structure and Dividend: Meaning and

types of Cost of Capital – Computation of Cost for Debt and Equity

- Sources of Capital and Weighted Average Cost of Capital

Pages 162 - 173

UNIT XIV Capital Structure Meaning and types of Capital Structure

– Determinants of Capital Structure – Types of Dividend Policy –

Types of Dividend Decision.

Pages 174 - 209

Contents Page

BLOCK 1: INTRODUCTION – FINANCIAL ACCOUNTING

UNIT - I Financial Accounting: 1 - 13

1.1. Introduction

1.2. Definition of Accounting

1.3 Accounting

1.4. Objectives of Accounting

1.5. Classifications of Accounting

1.6. Methods of Accounting

1.7. Accounting Terminology

1.8. Single Entry System of Book-Keeping

1.9. Difference Between Double Entry And Single-Entry System

1.10. Rules of The Double Entry System

1.11. Terms Used In Accounting

1.12. Functions of Financial Accounting

1.13. Accounting Concepts

1.14. Golden Rules of Book –Keeping or Accounting

1.15. Accounting Conventions

1.16. Accounting Equation

UNIT - II Accounting Process 14 - 25

2.1. Journal

2.2. Difference Between Trade Discount and Cash Discount

2.3. Ledger

2.4. Trial Balance

2.5. Trading Account

2.6. Profit and Loss Account

UNIT - III Accounting ratio analysis 26 - 40

3.1. Fund Flow Analysis

3.2. Cash Flow Analysis

3.3 Format of Cash Flow From Investing And Financing Activities

3.4. Treatment of Some Peculiar Items

3.5. Computerized Account

3.6. Objective of Computerized Accounting

3.7. Role of Computerized Accounting

3.8. Features of A Computerised Accounting Program

3.14 Manual Accounting Vs Computerized Accounting

UNIT - IV Cost and Management Accounting 41 - 47

4.1. Introduction

4.2. Meaning and Definitions of Cost Accounting

4.3. Cost Accounting

4.4. Objectives of Cost Accounting

4.5. Nature and Scope of Cost Accounting

4.6. Management Accounting

4.7. Objectives of Management Accounting

4.8. Nature and Scope of Management Accounting

UNIT – V Cost Sheet 48 - 66

5.1. Evolution

5.2. Cost

5.3. Different Types of Cost

5.4. Costing



5.7. Advantages of Cost Accounting

5.8. Limitation of Cost Accounting

5.9. Characteristics of A Good (or) An Ideal Costing System

5.10. Difference Between Cost Accounting And Management Accounting

5.11. Cost Classification

5.12. Elements of Cost

5.13. Components of Total Cost

5.14. Format of a Cost Sheet

5.15. Problems and Solutions

UNIT -IV Break Even Analysis 67 - 70

6.1. Concept

6.2. Application of Break-Even Analysis

6.3. Limitations of Be Analysis

6.4 Advantages of Break-Even Chart

UNIT - VII Standard Costing and Budgeting 71 - 79

7.1 Definition

7.2 Concept and Importance Standard Costing

UNIT - VIII Budgets and Budgetary Control 80 - 86

8.1 Introduction

8.2 Definition of Budget

8.3 Types of Budgeting

UNIT - IX BUDGETS 87 - 94

9.1 Cash Budget

9.2 Procedure For Preparation of Cash Budget

9.3 Master Budget

9.4 Flexible Budget

9.5 Zero Base Budgeting (ZBB)

UNIT – X FINANCIAL MANAGEMENT 95 – 111

10.1 Introduction

10.2 Definition of Financial Management:

10.3 Scope of Financial Management

10.4 Objectives of Financial Management:

10.5 Differences between Profit maximization &Wealth maximization

10.6 Other Objectives

10.7 Position of Finance Manager:

10.8 Role of Finance Manager

10.9 Financial Management and other Functional Areas

10.10 Significance of Financial Management

10.11 The changing scenario of Financial Management in India

UNIT – XI CAPITAL BUDGETING 112 - 136

11.1 Introduction

11.2 Meaning of Capital Budgeting

11.3 Definition of Capital Budgeting

11.4 Features of Capital Budgeting

11.5 Objectives of Capital Budgeting

11.6 Capital budgeting process

11.7 Types of Capital Budgeting Decisions

11.8 Procedure for computation of ARR

11.9 Procedure for computation of NPV

11.10 Procedure for computation of IRR

UNIT - XII WORKING CAPITAL MANAGEMENT 137 - 161

12.1 Introduction

12.2 Meaning of working capital

12.3 Definition of working capital

12.4 Concepts of working capital

12.5 Types of working capital

12.6 Features of Working Capital

12.7 Significance of working capital

12.8 Adequacy of working capital

12.9 Advantages of adequate working capital

12.10 Dangers of Redundant or Excessive Working Capital

12.11 Determinants of working capital requirements

12.12 Working capital management

12.13 Significance of operating cycle

12.14 Sources of working capital

12.15 Advantages of raising funds by issue of equity shares

12.16Advantages of Raising Finance by Issue of Debentures

12.17 Regulation of Bank Credit- Tandon Committee

UNIT - XIII COST OF CAPITAL 162 - 173

13.1 Introduction

13.2 Meaning of Cost of Capital

13.3 Definition of Cost of Capital

13.4 Components of Cost Of Capital

13.5 Factors determining the Cost of Capital

13.6 Types of Cost of Capital

13.7 Computation of cost of capital

13.8 Benefits of market value approach:

13.9 Benefits of book value approach

UNIT - XIV CAPITAL STRUCTURE 174 - 209

14.1 Introduction

14.2 Meaning of Capital Structure

14.3 Definition of Capital Structure

14.4 Type of securities to be used or issued

14.5 Patterns of Capital Structure

14.6 Difference between Capital Structure and Financial Structure

14.7 Difference between Capital structure and Capitalization

14.8 Optimum Capital Structure

14.9 Features of an Appropriate Capital Structure

14.10 Factors determining Capital Structure

14.11 Technique of Planning the Capital Structure

14.12 Point of Indifference

14.13 Theories of Capital Structure

14.14 Dividend Policy

SEMESTER IV

COURSE CODE TITLE OF THE COURSE

31541/34041 ACCOUNTING AND FINANCIAL MANAGEMENT

Unit

No.

CONTENTS

BLOCK 1: INTRODUCTION – FINANCIAL ACCOUNTING

1 Financial Accounting: Meaning and Scope – Principles – Concepts – Conventions

2 Accounting Process: Journal – Ledger – Trial Balance- Trading Account – Profit

and Loss Account – Balance Sheet

3 Accounting Ratio Analysis – Funds Flow Analysis – Cash Flow Analysis –

Computerized Account

BLOCK 2: COST AND MANAGEMENT ACCOUNTING

4 Introduction: Meaning Scope and Uses of Cost and Management Accounting –

Elements of Cost

5 Cost Sheet – Marginal Costing and Cost Volume Profit Analysis

6 Break Even Analysis: Concepts, Applications and Limitations

BLOCK 3: STANDARD COSTING AND BUDGETING

7 Introduction: Concept and Importance Standard Costing -Variance Analysis –

Material – Labor – Overhead – Sales – Profit Variances

8 Budgets and Budgetary Control – Meaning and Types of Budgets – Sales Budget –

Production Budget

9 Budgets: Cash Budget – Master Budget – Flexible Budgeting – Zero Base

Budgeting.

BLOCK 4: FINANCIAL MANAGEMENT

10 Introduction: Objectives and Functions of Financial Management – Risk – Return

Relationship – Time Value of Money

11 Capital Budgeting: Basic Methods of Appraisal Investments

12 Working Capital: Concepts of Working Capital, Factors affecting Working Capital

– Estimation of Working Capital Requirements

BLOCK 5: COST OF CAPITAL

13 Cost of Capital Structure and Dividend: Meaning and types of Cost of Capital –

Computation of cost for debt and equity - Sources of Capital and Weighted Average

Cost of Capital

14 Capital Structure Meaning and types of Capital Structure – Determinants of Capital

Structure – Types of Dividend Policy – Types of Dividend Decision.

1

Financial Accounting

NOTES

Self-Instructional Material

BLOCK- I UNIT -I INTRODUCTION

FINANCIAL ACCOUNTING Structure

1.1. Introduction

1.2. Definition of Accounting

1.3 Accounting

1.4. Objectives of Accounting

1.5. Classifications of Accounting

1.6. Methods of Accounting

1.7. Accounting Terminology

1.8. Single Entry System of Book-Keeping

1.9. Difference Between Double Entry and Single-Entry System

1.10. Rules of The Double Entry System

1.11. Terms Used in Accounting

1.12. Functions of Financial Accounting

1.13. Accounting Concepts

1.14. Golden Rules of Book –Keeping or Accounting

1.15. Accounting Conventions

1.16. Accounting Equation

1.1. INTRODUCTION A businessman invests capital with the objective of making profit and

thereby increasing his resources. He incurs various expenses like salaries,

rent and Stationery to operate his business. He receives income from

different sources like commission, interest and discount. He deals with

several persons in the course of buying and selling of goods, purchasing

and selling of assets and borrowing money for financing the business. He

acquires various properties and assets like building, machinery, furniture to

generate revenue.

Effective management of business requires control over expenses to reduce

the cost of operation and to make the business profitable. Assets must be

properly maintained to increase their productivity. Liabilities of a business

have to be prepaid in due time. Dealings with customers and suppliers must

be managed properly to keep them satisfied. In order to maintain property

in good condition, to repay debts in time, to reduce the expenses and to

increase sales, the businessman requires complete information about all his

business transactions.

In practice, it is impossible for any businessman to memorise and recollect

all his business dealings. Moreover, he will be interested in knowing at the

end of each year (i) what he owns? (ii) what he owes? (iii) how much profit

he has earned? (iv) what his financial position is? To relieve businessmen

from the burden of memorising all the business dealings and for providing

necessary information, Accounting was developed.

Businessmen also require accounting records to submit in courts to prove

their claims or to defend in courts against claims made by outsiders. They

are required to produce business records to tax authorities whenever

demanded. Similarly, financiers require accounting records of businessmen

to decide about sanctioning of loans. Thus, transactions relating to business

have become so important that their recording has become a necessity.

2


NOTES


1.2. DEFINITION OF ACCOUNTING According to the American Institute of Certified Public Accountants

(AlCPA) "Accounting is the art of recording, classifying and summarizing

in a significant manner and in terms of money transactions and events

which are of a financing character and interpreting the results thereof"

This comprehensive definition highlights in a logical sequence the

difference steps in the accounting process and some important attributes of

accounting. The following detailed explanation makes each of them clear.

1.3 ACCOUNTING Accounting is a systematic record of the daily events of a business leads to

presentation of a complete financial picture. Accounting in its elementary

stages is called book-keeping. The modern system of accounting was

formulated by Lucas Pacioli an Italian, in the 15th century (1494). The

Institute of Certified Public Accountants defines accounting as the art of

recording, classifying and summarising in a significant manner and in

terms of money transactions and events which are in part at least, of a

financial character and interpreting the results thereof"

1.4. OBJECTIVES OF ACCOUNTING

i) To provide information about the whole activities of the business

enterprise both to the owners and the external groups.

ii) To provide useful information to investors and creditors, so that they

can take decisions on investment and lending.

iii) To effectively direct and control the organisation's human and material

resources.

iv) To facilitate social functions and control.

v) To provide information regarding accounting policies.

1.5. CLASSIFICATIONS OF ACCOUNTING The following are the categories of accounting

i) Financial Accounting

ii) Cost Accounting and

iii) Management Accounting

i) Financial Accounting: Generally accounting denotes the financial

accounting. The main purpose of financial accounting is to record the

business transactions in the books of accounts which enables the

businessman to know the results.

ii) Cost Accounting: I.C.M.A. London, defines Cost Accounting as an

application of accounting and costing principles, methods and techniques

in the ascertainment of cost and the analysis of savings and / or excesses as

compared with past or with standards".

iii) Management Accounting: It is the method of accounting which useful

for managerial decisions. The data necessary for management accounting

are collected both from 'financial accounting and Cost accounting

1.6. METHODS OF ACCOUNTING Basically, all methods of accounting are classified under two headings: -

1. Single entry system

2. Double entry system.

1.6.1. Single entry system The term single entry is vaguely used to define the method of

maintainingaccounts which do not conform to strict principles of double

entry. It is wrong todefine it as system. The term 'single entry' does not

3


NOTES


mean that there is only oneentry for each transaction. It simply signifies

that principles of double entry book-keeping have not been observed in all

cases. Under this system, only the personal accounts of the debtors and

creditors and cash book of the trader are maintained. Impersonal accounts

such as sales accounts, purchase accounts ignored. The absence of the two-

fold etc., as well as the assets accounts are effect of each transaction makes

it impossible to prepare a trial balance and to check the arithmetical

accuracy of the books of accounts, engendering a spirit of laxity and

inviting fraud and misappropriations. Owing to the absence of purchases

and sales accounts, the preparation of trading account is not possible.

Again Profit &Loss account and Balance Sheet cannot be prepared due to

the absence of nominal accounts and real accounts. Hence, single entry is

not only incomplete, but the final results are also not reliable.

Practically this system is followed by those firms whose transactions are

limited and at the same time, who maintain only the essential records.

There is no hard and fast rule for maintaining records under this system.

i.e., it depends the circumstances and the needs of the firm.

1.6.2. Double entry system This system was invented by an Italian named LucoPacioli in 1494 A.D.

and it has spread all over the world, becoming as popular as Arabic

numerals. According to this system, every transaction has two aspects. One

is receiving aspect or incoming aspect and the other one is benefit giving or

outgoing aspect. The benefit receiving aspect is said to be a 'debit and

benefit giving aspect is said to be a 'credit'. For every transaction, one

accounts is to be debited and another account is to be credited in order to

have a come record of the transaction. Therefore, every transaction affects

two account Opposite direction.

For example, 'if furniture is purchased for cash', it is a monetary

transaction. Furniture is benefit receiving aspect, it is debited. Cash is

benefit giving as it is credited.

Therefore, the basic principle, under this system is that for every debit must

be a corresponding and equal credit and for every credit there must

corresponding and equal debit.

1.6.3. Meaning of debit and credit The word Debit is derived from the Latin word Debit un which means

Debit that. In short, the benefit receiving aspect of a transaction is known

as de

The word Credit is derived from the Latin word Creditor which means Due

for that. The benefit giving aspect of a transaction is known as credit.

The abbreviations 'Dr' for debit and 'Cr' for credit are usually used.

By convention, the left-hand side of an account is termed as debit side right

hand side of an account is termed as credit side.

1.6.4. Advantages of Double Entry System (i) Complete record: Double entry system enables businessmen to keep

complete, systematic and accurate record of all business transactions.

Detail any transactions or events can be verified at any time.

(ii) Ascertainment of Profit or loss: The systematic record maintained

under double entry system enables a business to ascertain the result of

business operations for any given period. The owners can know the

profitability of but operations periodically.

4


NOTES


(iii) Knowledge of financial position: With the help of Real and Personal

accounts, the financial position of the business can be ascertained with

accuracy. This is done by preparing balance sheet.

(iv) A check on the accuracy of accounts: Under the double entry. Every

debit has a corresponding credit'. The arithmetical accuracy of the can be

tested by preparing a statement called 'Trial Balance'.

(v) NO scope for fraud: The firm is saved from frauds and

misappropriations since full information about all assets and liabilities will

be available.

(vi) Tax authorities: The businessmen can satisfy the tax authorities if he

maintains his accounts books properly under the double entry system.

(vii) Amount due from customers: The account books will reveal the

amount due by customers, reminders can be sent to the customers who do

not settle their accounts promptly.

(viii) Amount due to suppliers: The trader can ascertain from the books of

accounts the sums he owes his creditors and make proper arrangements to

pay them promptly.

(ix) Comparative study: Results of one year may be compared with those

of previous years and reasons for the change may be ascertained.

1.7. ACCOUNTING TERMINOLOGY It is necessary to understand some basic accounting terms which are

routinely used in business world. The following are some of the important

terms which enable a student to comprehend accounting in a better way:

1. Capital: It represents owners' funds invested in a business. It may be the

original amount invested by the owner or original contribution adjusted for

profits and drawings. It is also known as owners’ equity or net worth.

Capital represents owners' claim against the assets of the business. It is

equal to the total assets minus outside liabilities.

2. Liability: It represents temporary interest of outside creditors in the

assets of a business. In the words of Finny and Miller, "Liabilities are

debts; they are amounts owed to creditors; thus, the claims of those who

are not owners are called liabilities"

In simple terms, debts repayable to outsiders by the business are called

liabilities.

4. Revenue: It is defined as the inflow of assets which results in an

increases in the owners' equity. It includes all incomes like sales receipts,

interest, commission, brokerage etc. However, receipts of capital nature

like addition capital, sale of assets etc., are not a part of revenue.

5. Expense: It is any amount spent in order to produce and sell the goods

and services which bring in the revenue. Expense may be defined as the

cost of the use of things or services for the purpose of generating revenue.

Expense can be capital expense and revenue expense. Capital expense

generates revenue over several accounting years. Revenue expense

generates revenue in the current accounting year.

Capital expense includes acquisition of long-term assets like machinery

whereas revenue expense includes current expenses like salary, rent,

lighting etc.,

6. Debtors: A person who receives a benefit without giving money or

money or money’s worth immediately but, liable to pay in future is a

debtor. Debtor can be a 'trade debtor' if he buys goods on credit. Others are

non-trade debtors.

5


NOTES


7. Creditors: A person who gives a benefit without receiving money or

money's worth immediately but, liable to claim in future is a creditor.

Creditor can be a ‘trade creditor' if he supplies good son credit. Others are

non-trade creditors.

8. Tangible Assets: Assets which have physical existence. i.e., they can be

seen on felt or touched, are termed as tangible assets. Examples: cash,

machinery, buildings.

9. Intangible Assets: Assets which have no physical existence. i.e., they

cannot be seen or felt or touched, are termed as intangible assets.

Examples: goodwill, patent rights, copyrights.

10. Fictitious Assets: Items shown along with other assets on the assets

side of a balance sheet, but representing unadjusted losses are termed as

fictitious assets. Examples: preliminary expenses, profit and loss account

debit balance etc.

11. Wasting Assets: Those assets which certainly lose value with usage are

earned as wasting assets. Mines, forests etc., become waste once the

mineral usefully extracted or the timber is fully cut.

12. Fixed Assets: Assets acquired for income generation, but not for resale

are called fixed assets. The benefit from them is derived for a longer period

than one year. (e.g.,) machinery.

13. Current or Floating Assets: Those assets which are converted into

cash on normal course of business in less than one year are termed as

current or floating assets. (e.g.,) stock, debtors.

14. Purchases: Buying of goods with the intention of resale is called

purchases. If cash is paid immediately for the purchase, it is cash

purchases. If the payment is postponed, it is credit purchases.

15. Sales: Selling of goods in the normal course of business is termed

assets. If the sale is for immediate cash payment, it is cash sales. If

payment for sales is postponed, it is credit sales.

16. Stock: The term 'stock' refers to goods lying unsold on a specified date.

The stock of goods at the end of the accounting period is called 'closing

stock and the stock of goods at the beginning of an accounting period is

called 'opening stock'.

17. Losses: 'Loss' really indicates something against which a firm receives

no benefit. It represents money given up without any return. It may be

noted that expense leads to revenue, but losses do not. (e.g.,) loss due to

fire, theft and damages payable to others.

18. Drawings: Any amount of money or money's worth withdrawn by the

owners of the business is termed as drawings. It is usually subtracted from

capital.

19. Invoice: It is a statement prepared by a seller of goods to be sent to the

buyer. It shows details of quantity, price, value etc., of the goods and any

discount given, finally showing the net amount payable by the buyer.

20. Voucher: It is the written record and evidence of a transaction. So,

documentary evidence of any transaction is called a voucher. Vouchers are

essential for audit of accounts. Example: cheque book counterfoils, cash

receipts, invoices.

21. Goods: The term 'goods' includes all merchandise, commodities etc., in

which a trader deals in the normal course of business. Thus, commodities

bought for resale are treated as goods. For a furniture dealer, furniture is

goods but for other firms’ furniture is an asset.

6


NOTES


22. Current liability: Those liabilities which are payable within one year

in the normal course of a business are termed as current liabilities.

Example: creditors, bills payable.

23. Long term Liabilities: Liabilities repayable beyond a period of one

year are treated as long term liabilities. Example: bank loans, mortgage

loans.

24. Solvent: A person who has assets with realisable values which exceed

his liabilities is solvent.

25. Insolvent: A person whose liabilities are more than the realisable

values of his assets is called an insolvent.

1.8. SINGLE ENTRY SYSTEM OF BOOK-KEEPING It is the method of maintaining accounts which does not exactly follow the

principles of double entry system. Under this system, only the cash book

and personal ledgers are maintained, i.e., the real and nominal accounts are

not maintained under this system. No fixed assets, purchases, sales,

expenses income accounts etc., can be found under this system.

As Trial Balance can't be prepared, the accuracy of accounts can't be

ascertained. Also, it is not possible to prepare the final account and Balance

Sheet under this system. Therefore, this system is an unscientific system

1.9. DIFFERENCE BETWEEN DOUBLE ENTRY AND

SINGLE-ENTRY SYSTEM S.No Double entry system Single entry system

1 Both debit and credit aspects of a transaction are recorded.

Only one aspect of a transaction is recorded.

2 All the three accounts namely

Personal, Real and Nominal – are

maintained.

Only personal accounts and cash

accounts are maintained.

3 For every debit there is a

corresponding and equal credit.

There may be a debit without a

corresponding and equal credit.

4 Trial Balance can be prepared. Trial Balance can't be prepared.

5 Trading, Profit & loss a/c and balance-sheet can be prepared

Trading, Profit & loss a/c and balance sheet can't be prepared directly.

6 Accurate net profit can be

calculated.

Only approximate profit can be

calculated.

7 It is a perfect and scientific system.

It is an imperfect and unscientific system.

8 It involves more clerical work. It involves less clerical work.

9 Tax authorities accept this

method.

Tax authorities do not accept as such.

10 Arithmetic accuracy can be

checked.

No arithmetic accuracy can be checked.

1.10. RULES OF THE DOUBLE ENTRY SYSTEM

Types of Accounts: -

A business may have dealings

i) with persons, firms, institutions, companies etc.,

ii) with assets and liabilities

iii) expenses and income

Based on these dealings the accounts are classified into three

category, namely,

a) Personal Account b) Real Accounts c) Nominal

Accounts

7


NOTES


a) Personal Accounts: It deals with accounts relating to persons, firms,

companies and man-made institutions. It is further classified into three as

shown below:

b)Real Account: It deals with accounts relating to the properties and assets

of the business. (e.g., Cash a/c, furniture a/c, land and buildings a/c,

machinery a/c, shares a/c, goods (purchases and sales) a/c.

C) Nominal Account: It deals with those items which exist in names only.

i.e., it deals with items of income and expenditures. (e.g. rent, salary,

commission, discount, dividend received, depreciation, etc.,).

1.11. TERMS USED IN ACCOUNTING

i) Business Transactions:

Any exchange of money or money's worth as goods and services between

two parties is called a business transactions.

ii) Capital:

This is the owner's financial holding in the business.

iii) Assets:

Any physical thing or right owned that has a money value is an asset.

iv) Liabilities:

The equities of creditors represent debts of the business are called

liabilities.

v) Debtors:

A person who owes money to the business is called debtors.

vi) Debt:

The amount due from a debtor is called debt.

vii) Book debt:

The amount due from a person as per the books of account is called a book

debt.

viii) Creditor:

A person to whom money is payable is called a creditor.

ix) Goods:

This includes all articles, commodities or merchandise a business deals.

x) Income:

Personal Accounts

Natural Person’s

personal Account

(e.g. customers,

Bala, Mohan etc.,)

Artificial Persons’

Personal Account

(e.g. Banks, firms,

companies Clubs

etc.,)

Representatives’

personal Accounts. It

represents the

persons. ( e.g. Capital

Drawings,

outstanding Liabilities

ets.,)

Real Account

Intangible Tangible

8


NOTES


Income is the favourable change in owner's equity results from business

operations.

xi) Expense:

It is an expenditure whose benefit is enjoyed immediately.

xii) Drawings:

Any amount or goods withdrawn by the owner of a business for personal

use is called drawings.

xii) Turnover:

Total trading income from cash sales and credit sales is called turnover

1.12. FUNCTIONS OF FINANCIAL ACCOUNTING

The following are the functions of financial accounting.

a) Record Keeping Function:

The primary function of financial accounting relates to recording,

classification and summary of financial transaction and preparation of

financial statements.

b) Protection of Properties Function:

Another important function of financial accounting is to protect

'he properties of the business. This is done for proper utilisation of the asset

and its proper valuation in the books of the accounts.

c) Communication of Results Function:

It is the duty of accountant to communicate the results obtained by

arranging and classifying data to interested parties like proprietors,

investors, creditors, employees and government.

d) Legal Requirement Function:

Auditing is compulsory in case of registered firms. Auditing is not

possible without accounting. Thus, accounting becomes compulsory to

comply with legal requirements. Accounting is a base and with its help

various returns, documents, statements and the like are prepared.

1.13. ACCOUNTING CONCEPTS

Accounting is the language of business. The basic assumptions of

conditions upon which the science of accounting is based on the concepts

of accounting. The different concepts of accounting are given below:

i) Business Entity concept: This concept denotes that a business unit is

separate and distinct from the owners. Therefore, it is necessary to record

the business transactions separately to distinguish from the owner's

personal transactions. This concept has now been extended to accounting

for various divisions of a firm in order to ascertain the results of each

division.

ii) Going concern concept: It is assumed that the business will exist for a

long time and transactions are recorded from this point of view. That

people may come and go, but business remains, is the principle of this

concept Hence, proper classification of expenses (capital and revenue) is to

be made.

iii) Money measurement concept: Accounting records only those

transactions which are expressed in terms of money. The use of building

and the use of clerical services can be added up only through money values

and not otherwise

iv) Cost concept: The transactions are entered in the books of accounts at

the amounts involved. For example: if a firm purchases a land for Rs.

2,00,000 but considers it as worthy Rs. 4,00,000 the purchase will be

9


NOTES


recorded at Rs. 2,00,000 and not at anymore. This is one of the most

important concepts.

v) Dual - Aspect Concept: Each transaction has two aspects. If a business

has acquired an asset, the asset which comes in this is one aspect. To

acquire the asset the business has to pay money (cash or bank) which goes

out – this is another aspect. If it is acquired for credit, a liability arises to

that extent. Thus, if there is an increase in assets, there will be an increase

in liability also.

Assets = Liabilities + Capital (or) Capital = Assets - Liabilities.

vi)Realisation concept: Accounting is a historical record of transactions. It

records what has happened. Unless money has been realised - cither cash

has been received or legal obligation to receive from the customer - no sale

can be said to have taken place and no profit or income can be said to have

arisen

1.14. GOLDEN RULES OF BOOK –KEEPING OR ACCOUNTING

As a every transaction has two aspects (i.e., debt aspect, credit

aspect) to record, which aspect is to be debited and which is to be credited

is to be analysed. They are to be recorded based on the following rules:

Personal Accounts DEBIT THE RECEVIER

CREDIT THE GIVER

Real Accounts DEBIT WHAT COMES IN

CREDIT WAS GOES OUT

Nominal Accounts DEBIT ALL EXPENSES AND LOSSES

CREDIT ALL INCOME AND GAINS

1.15. ACCOUNTING CONVENTIONS

1.15.1. Convention of Full Disclosure

According to this convention, all accounting statements should be prepared

honestly. This should be evident through the transparency of the

statements. The statement should disclose fully all the significant

information. Facts, figures and the details which are of material interest to

the owners, investors, creditors etc., must be clearly presented in the

financial statements. This type of disclosure needs proper classification,

summarisation, aggregation and explanation of the numerous business

transactions.

The convention of disclosure is gaining importance due to the shift in the

growth of business organisations. Modern business world is dominated by

joint stock companies where ownership is completely separated from the

management The Companies Act 1956, has made several provisions for the

disclosure of essential information by companies. Detailed form and

schedules are prescribed by the Act. The basis for valuation of investments

and inventories has to be specifically stated. Contingent liabilities have to

be listed out. The scope for concealment of information by joint stock

companies is very limited.

The footnotes, comments, descriptive captions, supplementary

schedulesDal etc., in the accounting reports are an invaluable aid for full

disclosure. For example, market value of investments may be given as a

foot note. Revaluation reserves included in the reserves and surpluses may

be indicated through a separate caption. The full disclosure does not imply

providing any information required by anybody or revealing trade secrets

and strategies. But the legitimate demands for information of the interested

parties like shareholders and creditors should usefully satisfied.

10


NOTES


1.15.2. Convention of Consistency

The basic aim of the doctrine of consistency is to preserve the

comparability and reliability of financial statements. According to this

convention, the rules, practices and concepts used in accounting should be

continuously observed and applied year after year. Comparisons of results

among different accounting periods can be significant and meaningful only

when consistent practices were followed in ascertaining them. Valuation of

stock can be done in different acceptable ways like average price method

or cost price method. It can also be based on cost or market price

whichever is lesser. Similarly, depreciation can be provided under different

methods; investments can be valued in several ways. Whichever method or

practice is followed, it should be followed regularly. If any change is

implemented it must be clearly indicated with reasons for the change.

According to E.L. Kohler, consistency can be at three levels - vertical,

horizontal and dimensional.

Vertical consistency refers to consistency in the various aspects of financial

statements in the same year in a firm.

Horizontal consistency refers to consistency of practices between different

years in a firm

Dimensional consistency refers to consistent accounting practices in the

financial statements of different firms in the same industry.

Consistency serves the purpose of eliminating personal bias, whims and

fancies of the accountants. They will have to follow consistent rules,

practices and methods. The convention of consistency makes the financial

statements more reliable and comparable for the needs of the end users.

1.15.3. Convention of Materiality

Materiality means 'relative importance'. All-important items and facts

should be disclosed in accounting statements. Unimportant and immaterial

details need not be separately given. Otherwise, the accountant becomes

overburdened with unnecessary details. For example, a plastic container for

drinking water can be clubbed with general expenses instead of separately

being disclosed as an asset.

According to the American Accounting Association (AAA) "An item

Should be regarded as material if there is reason to believe that knowledge

of it Would influence the decision of informed investor". The test of

materiality can be applied to three aspects. (i) information,(ii) amounts and

(iii) procedures.

(i) Loans to directors and employees can be material information and

should be separately disclosed, as per Banking Companies Regulation Act.

(ii) Adjusting amounts to the nearest Rupee is based on materiality of

amounts.

(iii) Disclosing procedural changes in valuation of inventories is based on

materiality of procedures.

The term 'Material' is subjective, amenable for interpretation of individual

accountants. Similarly, what is material in one firm may be immaterial for

another firm. What is material in one accounting year may not be so in the

subsequent years. Despite these limitations, maximum possible material

details should be provided in the financial statements.

1.15.4. Convention of Conservatism

Conservatism is a policy of caution or ‘playing safe’. It demands taking a

'gloomy' view of a situation. Conservatism is the defensive accounting

mechanism against 'uncertainty'. According to Kohler, "Conservatism is a

11


NOTES


guideline which chooses between acceptable accounting alternatives for

recording events and transactions so that the least favourable immediate

effect on assets, income and owner's equity is reported".

Uncertainty is unavoidable in the estimation of useful life of assets,

contingent liabilities, realisation of receivables etc. The convention of

conservatism demands that the least favourable situation to the firm will

materialise and precaution should be taken on that basis.

When stocks are valued, the usual principle followed is 'cost or market

price whichever is lower'. If market price is more than cost, stock is shown

at cost only All provisions like provision for doubtful debts, provision for

discount on debtors, provision for contingencies are based on the

convention of conservatism. Conservatism may result in understatement of

assets and income and overstatement of provisions and liabilities. This may

result in secret reserves. Over emphasis on conservatism may bring about a

conflict with the convention of full disclosure. Conservatism, within limits,

serves a useful purpose. It should not be taken to extremes where it can

distort the operating results and financial position of a business unit.

1.16. ACCOUNTING EQUATION

Accounting equation is a statement of equality between debits and the

credits. It explains that the assets of a business are always equal to the total

of liabilities and capital. It is also called balance sheet equation.

Assets = liabilities +capital (or) A = L + C

Assets are the total value of the properties owned by the business.

Liabilities are the rights of third parties to the properties of the

business or the among due by the business to the third parties.

Capital is the initial amount or assets contributed by the proprietor

to start the business.

Dual aspect concept is the basis for rules of debit and credit used in the

Double entry system of book - keeping. According to this concept, every

business transaction recorded in accounts has two aspects-giving of benefit

and receiving of benefit. The former is the credit aspect and the latter the

debit aspect. Both the aspects have to be recorded in accounts

appropriately. American accountants have derived the rules of debit and

credit through a 'novel' medium i.e., accounting equation. The equation is

as follows: Assets= Equities.

The basis for the equation is the principle of 'Rights'. Accounting deals

with property and rights to property. The total of the properties owned by a

business’s equal to the total of the Rights' to the properties. The properties

owned by a business are called assets. The rights to properties are called

equities.

Equities can be sub-divided into equity of the owners which is known as

capital and equity of creditors who represent the debts of the business

known as liabilities. These equities may also be called internal equity and

external equity. Internal equity represents the owners' equity in the assets

and external equity represents the outsiders' interest in the assets. Based on

the bifurcation of equity, the accounting equation can be restated as

follows:

Assets Liabilities+ Capital (or) Capital Assets - Liabilities.

When a business is started, entire resources needed may be supplied by the

owner or owners. Later on, additional funds may be mobilised through

credit purchases and loans. For example, Gokul starts a business with a

capital of Rs. 10,000, the accounting equation will be

12


NOTES


Gokul's Capital Rs. 10,000 Cash Rs. 10,000

The Balance Sheet on that date appears as follows:

Balance Sheet of Gokul as on………. Capital & Liabilities. Amount (Rs.) Property & Assets Amount (Rs.)

Gokul's capital 10,000 Cash 10,000

The balance sheet of a business is an expression of the accounting

equation.

It is also called balance sheet equation. It shows the relationship between

assets of the business and capital and liabilities.

1.16.1. Rules for Accounting Equation

The following 'rules' help in understanding the accounting equation clearly.

(1) Capital: When capital is increased, it is credited, when capital is

withdrawn, it is debited.

(2) Outsiders' liabilities: When liabilities increase, outsiders' accounts are

credited. When liabilities decrease, their accounts are debited.

(3) Revenue Income: Owner's equity is increased by the amount of revenue

income.

(4) Revenue Expense: Owner's equity is decreased by the amount of

revenue expenses.

(5) Assets: If there is increase in assets, the assets, accounts are debited. If

there is decrease in assets, the assets' accounts are credited.

1.16.2. Interaction between assets and liabilities and their effect on

Accounting Equation:

(a) Sometimes, one asset decreases, and another asset increases due to

transaction. For example, when debtors are collected, debtors decrease and

cash increases. This does not change the accounting equation.

(b) One liability decrease, and another liability increases due to a

transaction for example, creditors are paid through bank overdraft.

Creditors decrease and bank overdraft increases. This transaction also does

not alter the total figures in the accounting equation.

(c) Assets may increase and correspondingly liabilities may increase due to

some transactions. For example, loan taken from bank increases cash on

the assets side and bank loan on the liabilities side. This transaction alters

the total figures in the accounting equation.

(d)Assets decrease and liabilities also decrease correspondingly due some

transactions. For example, creditors paid in cash decreases creditors on

liabilities side and cash on the assets side.

1.16.3. Check Your Progress

1. What is accounting? What are its objectives?

2. Explain the golden rules of bookkeeping.

1.16.4. Answers to Check Your Progress Questions

1. Accounting is a systematic record of the daily events of a business leads

to presentation of a complete financial picture.

Objectives:

i) To provide information about the whole activities of the business

enterprise both to the owners and the external groups.

ii) To provide useful information to investors and creditors, so that they

can take decisions on investment and lending.

iii) To effectively direct and control the organisation's human and material

resources.

iv) To facilitate social functions and control.

v) To provide information regarding accounting policies.

13


NOTES


2.

Personal Accounts DEBIT THE RECEVIER

CREDIT THE GIVER

Real Accounts DEBIT WHAT COMES IN

CREDIT WAS GOES OUT

Nominal Accounts DEBIT ALL EXPENSES AND LOSSES

CREDIT ALL INCOME AND GAINS

Self-Assessment Questions and Exercise:

1) What is Double entry system of book-keeping? Explain its advantages?

2) What is accounting equation?

3) What are accounting concepts and conventions? How are they evolved?

4) What are accounting conventions? Explain them.

5) What are the functions of financial accounting?

6) How does double entry system of accounting differ from single entry

system of accounting?

Further Reading:

1. Financial Accounting, Paul, S.K. 4th ed, New Central Book Agency

Pvt. Ltd.

2. Financial Accounting, Jain S.P., Narang K.L., Kalyani Publishers,

Delhi

3. Advanced Accountancy, Hrishikesh Chakraborty, Oxfort

University Press

4. Fundamentals of Advanced Accounting, R.S.N. Pillai Bagavathi,

Sultan Chand Publications

Accounting Process

NOTES


UNIT II– ACCOUNTING PROCESS Structure

2.1. Journal

2.2. Difference Between Trade Discount and Cash Discount

2.3. Ledger

2.4. Trial Balance

2.5. Trading Account

2.6. Profit and Loss Account

2.1. JOURNAL

Journal is derived from the French word ‘Jour’ which means a day. Journal

means a daily record. It is a book original record to record every

transaction in the first instance before it is posted to the ledger. The form in

which it is recorded is called journal entry and recording or entering a

transaction in the journal is known as journalising.

Below each journal entry, a brief explanation of the transaction is given

within brackets. This is called ‘Narration’.

2.1.1 Rules for journalising

The journal has five columns as given below:

Date Particulars l.F DebitRs. CreditRs.

(1)

Year Month

Date

(2)

Name of the a/c to be debited Name of the a/c

credited (narration)

(3) (4)

Rs. P. Amount

(5)

Rs. P. Amount

Column: 1 The date of transaction is written in the first column with the

year on the top.

Column: 2 In this column the accounts to be debited and credited are

written.

Column: 3 L.F means Ledger Folio. This column cannot be filled, when

rerecord the transaction; but only when the entries are posted to certain

pages of the ledger, we can fill in ‘Ledger Folio’ column. The debit aspect

goes to a specified a/c found on a certain page of the ledger. On the other

hand, the credit aspect is taken to a different a/c found on a different page.

These page numbers are written in L.F column so that we can have a cross

reference.

2.1.2. Compound Journal

Suppose there are two or more transactions of a similar nature

occurring on the same day and either Debit or Credit account is common.

Such transactions can be conveniently recorded in the form of one journal

entry instead of making a separate entry for each transaction. Such entries

are called compound Journal entries.

Example: Stationery a/c Dr.

Rent a/c Dr.

Salaries a/c Dr.

To cash a/c

(Being payment of stationery, Rent and salaries made)

2.1.3. Advantages of Journal

i. It provides a chronological record of all transactions and hence acts

as a permanent record.

ii. It provides the information of debit and credit in an entry and an

explanation for a proper understanding.

iii. It reduces the possibility of error as both aspects of a business

transaction are written side by side.

15

Accounting Process

NOTES


iv. It provides information relating to various aspects like, transfer

entries and closing entries.

2.1.4. Limitations of Journal

i. All transactions in the journal, make it too long and unwieldy.

ii. It is not possible to ascertain daily cash balance, from the journal.

iii. It becomes difficult in practice to post each and every transaction

from the journal to the ledger. Hence, in order to make the

accounting easier and systematic, transactions are recorded in total

in different books.

2.2. DIFFERENCE BETWEEN TRADE DISCOUNT AND CASH

DISCOUNT

Trade Discount Cash Discount

It is allowed at the time of sales (or) purchase

It is allowed at the time of payment.

It is given to promote sale It is allowed to encourage early cash

payment

It is shown as a deduction in the invoice.

It has nothing to do with the invoice

Entry is not made in the account book. Entry is made in the account book.

Separate ledger accounts are opened for ‘Discount received’ and for ‘Discount

allowed”.

The object is to enable the buyer to sell

at the catalogue price.

The object is to induce the debtors to

pay their dues promptly.

It is allowed or not allowed according

to sales policy followed by a business

concern.

It is allowed only one a condition. The

dues should be paid within the

stipulated time. If not, the debtors are

not eligible for cash discount.

It is usually given in percentage. It is

given on the list price or catalogue

price or retail price.

It may be given in percentage or in

absolute figure.

Illustration 1

Journalise the following transactions: 2008 Jan.

11 Purchased goods for Rs. 1,500.

12 Purchased goods from GK stores Rs. 900

13 Sold goods for Rs. 1,100

14 Sold goods to Raju Rs. 250

15 Bought furniture for cash Rs. 2,000

16 Bought furniture from JFA furniture mart Rs. 800

17 Goods returned to GK stores Rs. 200

18 Raju returned goods worth Rs. 100

19 Drew for private use Rs. 500

20 Electric charges amounted to Rs. 120

Solution: Journal Entries

Date Particulars l.F Debit Rs. Credit Rs.

2008

Jan. 11

Purchases a/c Dr.

To cash (Being cash purchase made)

1,500

1,500

12

Purchases a/c Dr.

To GK stores (Being credit purchase made)

900

900

13

Cash a/c Dr.

To sales

(Being cash sales made)

1,100

1,100

Accounting Process

NOTES


14

Raju a/c Dr.

To sales (Being credit sales made)

250

250

15

Furniture a/c Dr.

To cash (Being the furniture purchased for

cash)

2,000

2,000

16

Furniture a/c Dr.

To JFA furniture mart (Being the furniture purchased on

credit)

800

800

17

Gk Stores a/c Dr.

To Purchase return (Being the goods returned to GK

stores)

200

200

18

Sales return a/c Dr. To Raju

(Being the goods returned from

Raju)

100 100

19

Drawings a/c Dr. To cash

(Being the cash drew for private

use)

500 500

20

Electric charges a/c Dr. To cash

(Being electric charges paid)

120 120

Illustration 2

Give journal entries for the following transactions.

1. Start business with cash Rs. 60,000.

2. Opened a business bank account with a deposit of Rs. 20,000.

3. Purchased machinery for Rs. 22,000 pay cash of Rs. 15,000 and the

balance on account.

4. Earned commission in cash Rs. 900.

5. Withdrew cash Rs. 2,700 from bank.

6. Paid office rent Rs. 1,100.

Solution: Journal Entries

Date Particulars l.F Debit Rs. Credit Rs.

1. Cash a/c Dr. To Capital

(Being cash brought in to start

business)

60,000 60,000

2. Bank a/c Dr.

To Cash

(Being bank a/c opened)

20,000

20,000

3. Machinery a/c Dr. To Cash

To Supplier account

(Being the machinery purchased by paying a cash of Rs. 15,000 and

the balance on credit)

22,000 15,000

7,000

4. Cash a/c Dr.

To Commission earned (Being the commission earned in

cash)

900

900

5. Cash a/c Dr.

To Bank (Being the cash withdrew from

2,700

2,700

17

Accounting Process

NOTES


bank)

6. Rent a/c Dr. To cash

(Being the office rent paid)

1,100 1,100

2.3. LEDGER

Ledger is a register with of pages numbered consecutively. Each account is

allotted one or more pages in the ledger. If one page is complete, the

account will be continued in the next or some other page. An index of

various accounts opened in the ledger is given at the beginning of the

ledger for the purpose of easy reference.

2.3.1. Advantages of keeping a ledger

1. Ledger gives information regarding all transactions of a particular

account whether it is a personal a/c, Real a/c or Nominal a/c

2. The final effect, of a series of transactions of a certain customer (or)

a certain property (or) a certain expenses is known at a glance.

3. Leger provides immediately the totality of certain dealings. For

(e.g) Total purchases, Total sales, Total expenditure on a specified

head etc.

4. It is useful in preparation of trial balance.

5. It facilitates the preparation of the final statement such as trading

a/c, profit & loss a/c and balance sheet.

2.3.2. Ledger account A ledger account is nothing but a summary statement of all

transactions relating to a person, asset, expense or income, which have

taken place during a given period of time showing their net effect.

Proforma of a Ledger account Dr. Name of the account Cr.

Date Particular J.

F

Amount Date Particular J.

F

Amount

year

Month

date

To (Name if

credit element)

Rs. p year

Month

date

To (Name if

debit element)

Rs. p

2.3.3. Methods of Balancing a Ledger Account

a) The bigger total is taken first and it is written on both sides of the

account. One the smaller side the balance is written above the total

next to the last entry on that side. This method is more commonly

used.

b) In the next method the totals are written on both sides, one sides

showing smaller and the other side showing bigger amount. The

difference is written in the smaller side below the smaller total.

After doing so, grand totalling is made on both sides. Obviously,

they will be equal. This method is used only in certain concerns like

the electricity companies.

2.3.4. Differentiate Journal from Ledger

Journal Ledger

It is the book of original entry It is the main book of accounts

Entries are made as and when

transactions occur.

Entries are posted at eh convenience

of the trader.

Transactions are entered in the chronological order (ie) according to

the dates of transaction.

Transaction are recorded on the basis of the account to which they belong.

Transactions pertaining to a person (or) property (or) expenses are spread

over a number pages.

Transactions relating to a particular account are found together on a

particular page or pages even if they

Accounting Process

NOTES


have occurred on different dates.

The final position of a customer (Debtor or Creditor) Cannot be found

out unless one wades through the

entire book

The final position can be ascertained just at a glance as the transaction are

written together on a page or pages in

the appropriate sides (Debit and Credit side) of the account

It is so ruled as to show the total

number of transactions that occur day

after day.

It is so rules as to show the dates on

which a particular a/c is debited or

credited

Journal losses its importance after the

transactions are posted to the ledger.

It will never lose its importance

because it is the main book of

accounts which is relied upon.

Tax authorities do not rely upon this book.

Tax authorities rely on the ledger for assessment purpose.

Illustration 1

Prepare ledger accounts for the following transactions: 2009 May

1 Mr. Ajith started business with cash Rs. 75,000

1 Purchased machinery for Rs. 12,000

3 He opened an account with Indian Bank Rs. 20,000

5 Goods purchase form kamala Rs. 15,000

10 Paid to kamala in full settlement Rs. 14,500

14 Goods sold to Mr. Balaji Rs. 20,000

16 Cash received from Mr. Balaji Rs. 5000

18 Goods purchased for Rs. 10,000

25 Goods sold for Rs. 25,000

31 Interest on capital @ 10% for the month.

31 Depreciate machinery @ 10% for the month.

Solution Dr. Cash account Cr.

Date Particular J.

F

Amount Date Particular J.

F

Amount

2009

May

1 16

25

To Capital a/c

To Balaji To Sales

75,000

5,000 25,000

2009

May 1

3 5

18

31

By Machinery

By Indian Bank

By kamala

By Purchases

By Balance c/d

12,000

20,000 14,500

10,000

48,500

1,05,000 1,05,000

June

1

To Balance b/d 48,500

Dr. Capital account Cr.

Date Particular J.F Amount Date Particular J.F Amount

2009

May 31

To Balance c/d

75,625

2009

May 1

By cash By Int. on. cap

75,000 625

75,625 75,625

Dr. Machinery account Cr.


2009

May

1

To Cash

12,000

2009

May

1

By

Depreciation

By Balance c/d

100

11,900

19

Accounting Process

NOTES


12,000 75,625

Dr. Indian Bank account Cr.


2009

May 3

To Cash

20,000

2009

May 31

By Balance c/d

20,000

20,000 20,000

June 1


Dr. Purchase account Cr.


2009

May

5

To Kamala

To Cash

15,000

10,000

2009

May

31

By Balance

c/d

25,000

25,000 25,000

June

1


Dr. Kamala account Cr.


2009 May

10

To Cash

To Discount

14,500

500

2009 May

5

By Purchase

15,000

15,000 15,000

Dr. Discount account Cr.


2009

May

31

To Balance

c/d

500

2009

May

10

By Kamala

500

500 500

June

1

By Balance

b/d

500

Dr. Sales account Cr.


2009

May 31

To Balance c/d

45,000

2009

May 14

May

25

By Balaji By Cash

20,000 25,000

45,000 45,000

June 1 By Balance

b/d

45,000

Dr. Balaji account Cr.


2009

May 14

To sales

20,000

2009

May 16

31

By cash By Balance

c/d

5,000 15,000

20,000 20,000

June 1


Accounting Process

NOTES


Dr. Interest on capital account Cr.


2009

May

31

To Capital

625

2009

May

31

By Balance

c/d

625

625 625

June

1

To Balance b/d 625

Dr. Interest on capital account Cr.


2009

May 31

To Machinery

100

2009

May 31

By Balance c/d

100

100 100

June

1

To Balance b/d 100

2.4. TRIAL BALANCE

A trial balance is the list of balances extracted from the ledger account

prepared to check the arithmetic of accounts.

2.4.1. Objectives of Trial balance

i. The trail balance is prepared to check the arithmetic accuracy of

accounts.

ii. Errors in the accounts are disclosed. But there are some errors that

are not disclosed by trial balance.

iii. It is useful in the preparation of the final account.

iv. It helps to prepare the trading, profit and loss account.

v. It also helps to prepare the balance sheet.

vi. It is the lucid form of the accounts prepared.

2.4.2. Definition

Trial balance can be defined as “A list of all balances standing on

the ledger accounts and cash books of a concern at any given time”.

2.4.3. Specimen form of a Trial balance

Trial Balance as on .....

S. No. Name of accounts L.F Debit Credit

1.

Total

2.4.4. Preparing Trial Balance

As the balances are to be extracted from the ledger accounts, first

go to the ledger accounts of each and every head of accounts, see the

amount appearing in the ‘balance c/d’ and the side it appears.

Post it to the Trail Balance by writing the name of account to the

respective side.

Now total the debit column and credit column in the Trial balance.

Both the totals should tally with each other if not verify the posting,

totalling, carry forward and transferring to the Trial Balance.

For this purpose, the following rules are worth remembering

Debit balances Credit balances

Assets

Expenses

Losses

Drawings

Opening stock

Liabilities

Incomes

Gains

Capital

Reserves & Provisions

21

Accounting Process

NOTES


2.4.5. Methods of Trial Balance

1. Balance Method

2. Total Method

1. Balance Method

This method is used in preparing the trial balance from the ledger

account. Under this method the ledger accounts are balanced, and the

balance is carried forward to trial balance. The excess of debit over credit

is called debit balance and written in the debit is called credit balance and

written on the credit side of the trial balance. Both the debit side and the

credit side of the trial balance total should tally.

2. Total Method

Under this method, the total of the debit side and the credit side of

every ledger account is separately written in the debit and credit column of

the trial balance.

Suspense account

When the trial balance does not agree with each side, the different

is placed to a temporary account called suspense account. This suspense

account will be closed after locating the errors and the same have been

rectified.

Illustration 1

From the under mentioned balances, prepare a trial balance as on 31.3.2007 Particulars Rs. Particulars Rs.

Cash in hand

Purchases Opening stock

Sundry creditors

Machinery

Wages Sales

4,800

4,80,000 1,40,000

96,000

2,40,000

64,000 8,04,000

Furniture

Bills receivable Salaries

Capital

Bills payable

Sundry debtors Rent

60,000

80,000 80,000

4,00,000

88,000

2,00,000 40,000

Solution:

Trial Balance as on 31.3.2007 Name of Accounts Rs. Name of Accounts Rs.

Cash in hand

Purchases Opening stock

Machinery

Wages Furniture

Bills receivable

Salaries

Sundry debtors Rent

4,800

4,80,000 1,40,000

2,40,000

64,000 60,000

80,000

80,000

2,00,000 40,000

Sundry creditors

Sales Capital

Bills payable

96,000

8,04,000 4,00,000

88,000

13,88,800 13,88,800

2.5. TRADING ACCOUNT Trading means buying and selling. The trading account shows the

results of buying and selling of goods. It is the first part in the final

accounts, and it gives the trading result. Trading account considers the cost

of goods sold during a period on the one hand and on the other, the value

of goods sold.

Specimen form Trading account for the year ended .... Particulars Debit Rs. particulars Credit Rs

To Opening stock

To purchases

xxx

xxx

xxx

By sales xxx

Less: Returns xxx

By closing stock

xxx

Accounting Process

NOTES


Less: Returns

xxx To Factory expenses

To Direct expenses

To Gross profit

xxx

xxx xxx

By Gross loss xxx

xxx xxx

2.6. PROFIT AND LOSS ACCOUNT

The profit & Loss account is credited with gross profit transferred

from the trading account (or with gross loss which is debited to the profit &

loss a/c). After this all, expenses and losses (which have not been dealt

with while preparing the trading a/c) are transferred to the debit side of the

profit & loss a/c. If there are any incomes or gains, like rent received,

interest received on investment, discount received from suppliers, these

will bne credited to the profit and loss a/c.

Specimen form Profit and loss account of ...... for the year ended

Particular Debit Rs. Particular Credit Rs.

To Gross loss b/d

Office &

Administrative Exp.

To salaries

To office lighting To Rent, Rates & taxes

To printing & stationery

To Postage, fax & telegram

To Insurance premium

To General expenses

To Loss by fire or theft To legal expenses

To trade expense

Selling & Distribution

Exp.

To salesman’s salary

To Commission paid To advertising expenses

To Carriage outwards

To Travelling expenses

To Bad debts To packing expenses

Financial Expenses:

To interest on capital To Interest in loan

To Discount allowed

Maintenance Exp. To Repairs &

maintenance

(of van, car, & other

assets) To Depreciation on

assets

To Loss on sale of assets

Other Expenses:

To provision for bad

debts To Net profit c/d

By gross profit b/d By discount received

By commission

earned

By Interest received By interest from

investment

By apprentice premium

By Rent from tenants

By Interest on

Drawings By profit on sale of

assets

By net loss a/c

23

Accounting Process

NOTES


Specimen form of a Balance sheet Balance of sheet of ....... As on ...

Liabilities Rs. Rs. Assets Rs. Rs.

Outstanding

expenses

Income received Bank overdraft

Bills payable

sundry creditors Loans

Mortgage

Reserve fund Capital

Add: Net profit

Interest on cap

Less: Drawings

xxx

Interest on drawing

xxx

Income tax xxx

xxx

xxx

xxx

xxx

xxx

xxx

xxx xxx

xxx

xxx xxx

xxx

xxx

xxx

Cash in hand

Cash at bank

Prepaid expenses Bills receivable

Sundry debtors

Closing stock Investment

Furniture & Fitting

Less: Depreciation

Loose tools

Less: Depreciation

Plant & Machinery Land & Building

Less: Depreciation

Business premises

Less: Depreciation

Patents &trademark Good will

xxx

xxx

xxx

xxx

xxx

xxx

xxx

xxx

xxx

xxx

xxx xxx

xxx

xxx xxx

xxx

xxx

xxx

xxx

xxx

xxx xxx

xxx xxx

Illustration 1

From the following Trial Balance prepare a Trading and profit and loss a/c

for the year ending 31st March 2009.

Stock 1stApril, 2008 wages

Discount allowed

Bad debts Repairs

Depreciation

5,000 3,000

200

500 300

1,000

Rent, Rates and Taxes Salaries

Purchases

Office expenses Interest received

Sales

800 2,000

10,000

2,500 600

17,000

Solution: Trading account for the year ended 31-3-2009

Particulars Rs. Particulars Rs.

To Opening stock

To purchases

To Wages To Gross profit c/d

5,000

10,000

3,000 9,000

By sales

By Closing stock

17,000

10,000

27,000 27,000

Profit and loss account for the year ended 31-3-2009

Particulars Debit

Rs.

Assets Credit

Rs.

To salaries

To Rent, Rates and Taxes To Office expenses

To Repairs

To Depreciation

To Bad Debts To Discount allowed

To Net profit transferred to

capital a/c

2,000

800 2,500

300

1,000

500 200

2,300

By Gross profit b/d

By interest received

9,000

600

9,600 9,600

Accounting Process

NOTES


2.7. Check Your Progress

1. What are the differences between trade discount and cash discount?

2. What is meant by trading account?

2.8. Answers to Check Your Progress Questions

1.

Trade Discount Cash Discount

It is allowed at the time of sales (or)

purchase

It is allowed at the time of payment.

It is given to promote sale It is allowed to encourage early cash payment

It is shown as a deduction in the

invoice.

It has nothing to do with the invoice

Entry is not made in the account book. Entry is made in the account book.

The object is to enable the buyer to sell

at the catalogue price.

The object is to induce the debtors to

pay their dues promptly.

It is usually given in percentage. It is

given on the list price or catalogue price or retail price.

It may be given in percentage or in

absolute figure.

2.

Trading means buying and selling. The trading account shows the results of

buying and selling of goods. It is the first part in the final accounts, and it

gives the trading result. Trading account considers the cost of goods sold

during a period on the one hand and on the other, the value of goods sold.


A. Short answer

1. What is profit and loss account?

2. What is trading account?

3. Explain ledger account?

4. Define journal.

B. Long answer

1. Prepare ledger accounts and Trail balance for the following

transactions:

2011 May

1 Mr. Z started business with cash Rs. 85,000

1 Machinery purchased for cash Rs. 13,000

3 He opened a bank account with SBI Rs. 10,000

5 Bought Goods form kamalesh Rs. 15,000

10 Paid to kamalesh in full settlement Rs. 14,500

14 Sold Goods to Mr. B Rs. 22,000

16 Cash received from Mr. B Rs. 7000

18 Goods purchased for Rs. 10,000

25 Goods sold for Rs. 25,000

31 Interest on capital @ 8% for the month.

31 Depreciation on machinery @ 10% for the month

2. The following are the account balance of ABC agency after preparing

trading and profit and loss a/c for the year ending 31st December 2004.

Land & Building

Closing stock

Cash in hand

Cash in bank

Sundry debtors

B/R

Insurance prepaid

Machines

20,000

13,000

7,500

2,200

12,000

5,300

200

14,000

Furniture& Fittings

B/P

Bank loan

Sundry creditors

Salaries outstanding

Drawings

Capital

Net profit of the year

6,000

14,000

15,000

16,000

1,200

3,000

30,000

7,000

Prepare Balance sheet of ABC Agency.

25

Accounting Process

NOTES


Further Reading:

1. Financial Accounting Dr. V.K. Goyal, Published by Excel Books

2. Financial Accounting, Grewal, Shukla, Sultan Chand Publications,

Delhi

3. Financial Accounting, Paul, S.K. 4th ed, New Central Book Agency

Pvt. Ltd.


Delhi

5. Advanced Accountancy, Hrishikesh Chakraborty, Oxfort

University Press

6. Principles and Application of financial Accounting, Amitabh Basu



26

Accounting Ratio Analysis

NOTES


UNIT - III ACCOUNTING RATIO

ANALYSIS Structure

3.1. Fund Flow Analysis

3.2. Cash Flow Analysis

3.3 Format of Cash Flow from Investing and Financing Activities

3.4. Treatment of Some Peculiar Items

3.5. Computerized Account

3.6. Objective of Computerized Accounting

3.7. Role of Computerized Accounting

3.8. Features of A Computerised Accounting Program

3.14 Manual Accounting Vs Computerized Accounting

3.1. FUND FLOW ANALYSIS

Prof. Foulke defines, “A statement of sources and applications of fund is

technical devices designed to analyse the change in the financial condition

of a business enterprise between two dates.”

Fund Flow statement is a financial statement. It is a report on movement of

funds or working capital during a period. It explains the way in which the

working capital raised and used during the period.

This statement consists of sources (receipts) and application (payment) of

funds. It is supplement to the financial statements. The business

transactions which cause an increase in the working capital are considered

as sources of funds and which causing a decrease in the working capital are

application on funds.

3.1.1. Merits of fund flow statement

1. It shows how the funds were raised collected and disbursed (used)

during a period.

2. It helps to formulated financial policies like dividends declaration,

creating reserve etc.

3. It points out the reasons for changes in working capital.

4. It shows the financial strength and weakness of the firm.

5. It helps to assess the credit worthiness and repaying capacity of the

firm.

6. It lays down the plan for efficient use of scare resources in future.

3.1.2. Demerits of fund flow statement

1. It is not an original statement. It is only a re-arrangement of

financial data.

2. It shows only the past position and not future.

3. When both the aspects of a transaction are current or non-current,

they are not included in this statement.

4. It is not an ideal tool for financial analysis.

Schedule of Changes in Working Capital

A statement shows the changes in current assets and current liabilities of

two periods is known as “Schedule of Changes in Working Capital”. This

statement is prepared with current assets and current liabilities as appeared

in the balance sheet. The net increase or decrease of working capital is

arrived at the end. The format is given below.

27


NOTES


Particulars Previous

year value

Current

year value

Effect of Working

capital

Increase Decrease

Current Assets:

Cash

Bank Debtors

Bills Receivable

XXX

XXX XXX

XXX

XXX

XXX XXX

XXX

XXX

XXX

XXX

XXX

C.A XXX XXX

Current liabilities:

Creditors

Bills payable

Bank overdraft

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

C.L XXX XXX

Net working capital XXX XXX XXX XXX

Net Increasing or Decrease Increase Decrease Increase Decrease

Total XXX XXX XXX XXX

3.1.4. Funds from operation

Funds from operation is the only internal sources of funds. The net profit

earned by the business in known as internal sources. However, to find out

the real funds from operation the non-operating incomes and expenditures

are adjusted with the net profit because non-operating items, do not affect

the working capital. There are two methods to find out funds from

operations.

I. Statement FUNDS FROM OPERATIONS

Rs. Rs.

Net profit (Current year – Last year)

Add: Non-operating expenses:

a) Depreciation on fixed assets b) Preliminary expenses written off

c) Goodwill written off

d) Discount on issue of shares

e) Patents written off f) Loss on sale of fixed assets

g) Transfer to reserves

h) Interim dividend i) Proposed dividends

j) Provision for taxation

XXX

XXX XXX

XXX

XXX

XXX XXX

XXX

XXX XXX

XXX

(If taken as non-current item)

Less: Non-operating Income: a) Profit on sale of fixed assets

b) Refund of income tax

c) Dividend received d) Rent received

e) Interest on investment

XXX

XXX

XXX XXX

XXX

XXX

XXX

Fund from operation XXX

II. Account form

Adjusted profit & loss account is the alternative account format for

the calculation of funds operation. The format is: Dr. Adjusted profit and loss account Cr.

Rs. Rs.

To Depreciating

To Good will, pattern, preliminary exp

To Transfer to reserve, dividend

equalisation fund, sinking fund

XXX

XXX

XXX

XXX

By Net profit or last year

By Transfer form excess provision

By Appreciation in the

value of fixed asset

XXX

XXX

XXX

28


NOTES


etc.

To Interim dividend paid To Dividend paid

To Proposed dividend (If taken as

non-current item) To Provision for taxation (If taken

as non-current item)

To Loss on sale of any assets

XXX

XXX

XXX XXX

By Dividend received

By Profit on sale of fixed asset

By Funds from operations

(Bal.fig)

XXX

XXX

XXX

3.1.5. Sources and applications of funds

While preparing fund flow statement, it is necessary to find out the

sources and applications of funds. The sources of funds can be both

internal and external sources. Internal sources of funds from operations.

The external sources are:

a) Issue of shares and debentures.

b) Long term borrowing.

c) Sale of fixed assets.

d) Income from investment.

e) Decrease in working capital (as per schedule of changes in

working capital).

The application of funds means disbursement or payment of funds.

They are:

a) Purchase of fixed assets.

b) Redemption of preference shares and debentures.

c) Repayment of loans.

d) Payment of dividends.

e) Increase in working capital (as per schedule of changes)

3.1.6. Formats of Fund Flow Statement

There are three approaches are available for preparation of funds

flow statement.

i) Accounts form or T-form

ii) Vertical form, and

iii) Vertical form reconciliation type

i) Accounts form or T-form Fund Flow Statement

Sources of Funds Rs. Application of Funds Rs.

Funds from operations Sale of fixed assets/

Investments etc.

Issue of shares

Raising long-term loan Non-trading income, (eg.)

dividend

Decrease in working capital

XXX XXX

XXX

XXX

XXX

XXX

Funds lost in operations Purchase of fixed assets/

investments

Redemption of preference

shares/ debentures Repayment of long-term

loans

Payment of tax Payment of Dividend

Increase in working capital

XXX

XXX

XXX XXX

XXX

XXX XXX

XXX XXX

ii) Vertical Form: Fund Flow Statement

Particulars Rs.

Sources of Funds Funds from operations Sale of fixed assets/ Investments etc.

Issue of shares / Debentures

Proceeds from long term loans

Non-trading income Decrease in working capital

XXX XXX

XXX

XXX

XXX XXX

XXX

29


NOTES


Application of Funds

Funds lost in operations Purchase of fixed assets

Redemption of preference shares/ debentures

Repayment of long-term loans Payment of tax

Payment of Dividend

Non-trading losses Increase in working capital

XXX XXX

XXX

XXX XXX

XXX

XXX XXX

Fund From operations XXX

ii) Vertical Form – Reconciliation Type Fund Flow Statement

Particulars Rs. Rs.

Working Capital at the beginning of the year

Add: Sources of Funds:

Funds from operations

Sale of fixed assets/ Investments etc. Issue of shares / Preference share/Debentures

Long term liabilities

XXX

XXX XXX

XXX

XXX

XXX

Less: Application of Funds

Funds lost in operations

Purchase of fixed assets

Redemption of shares/ preference shares/ debentures Repayment of long-term loans

XXX

XXX

XXX XXX

XXX

XXX

Working capital at the end of the year XXX

Illustration 1 From the following prepare a schedule of changes in

working capital. Liabilities Rs. Rs. Assets Rs. Rs.

Share capital 2,00,000 2,10,000 Land 1,00,000 1,20,000 P & L a/c 28,000 49,000 Investment 28,000 48,000

Bank Loan - 10,000 Stock 58,000 54,000

creditors 39,000 30,000 Debtors 53,000 59,000 Cash 28,000 18,000

2,67,000 2,99,000 2,67,000 2,99,000

SOLUTION:STATEMENT OF CHANGES IN WORKING CAPITAL

Particulars 2006 Rs.

2007 Rs.

Effect of Working capital

Increase Decrease

Current Assets:

Stock

Debtors Cash at Bank

58,000

53,000 28,000

54,000

59,000 18,000

-

6,000 -

4,000

- 10,000

C.A 1,39,000 1,31,000

Current Liabilities

Creditors 39,000 30,000 9,000

C.L 39,000 30,000

Net working capital (CA-CL) 1,00,000 1,01,000 15,000 14,000

Net Increase in working cap. 1,000 - - 1,000

1,01,000 1,01,000 15,000 15,000

Illustration 2From the following Profit and Loss, a/c compute the funds

from operations. Dr. Profit and Loss A/c Cr.

Rs. Rs.

To salaries

To Rent To Provision for

depreciation

13,000

3,000 14,000

20,000

By Gross profit

By Profit on sale of machinery

To Refund of tax

2,00,000

5,000 5,000

30


NOTES


To Transfer to Reserve

To Provision for tax To Loss on sale of

investments

To Preliminary expenses To Selling expenses

To Net profit

10,000

5,000 5,000

20,000

1,20,000

2,10,000 2,10,000

Solution Calculation of funds from operations

Rs. Rs.

Net profit

Add: Provision for depreciation Transfer to Reserve

Provision for tax

Loss on sale of investment

Preliminary expenses

14,000 20,000

10,000

5,000

5,000

1,20,000

54,000

Less: Profit on sale of machine

Refund of tax

5,000

5,000

1,74,000

Fund from Operations 1,64,000

Illustration 3

Prepare Fund flow statement from the following Balance sheet and other

details. Liabilities Rs. Rs Assets Rs. Rs.

Equity share

capital

3,00,000 4,00,000 Good will 1,15,000 90,000

Redeemable pref. 1,50,000 1,00,000 Land &

Buildings

2,00,000 1,70,000

General Reserve 40,000 70,000 Plant 80,000 2,00,000

Profit & Loss A/c 30,000 48,000 Debtors 1,60,000 2,00,000

Proposed Divid. 42,000 50,000 Stock 77,000 1,09,000

Creditors 55,000 83,000 B/R 20,000 30,000

Bills payable 20,000 16,000 Cash in hand 15,000 10,000

Prov. for Taxation 40,000 50,000 Cash at Bank 10,000 8,000

6,77,000 8,17,000 6,77,000 8,17,000

Additional Information:

a) Depreciation of Rs. 10,000 and Rs. 20,000 have been charged.

b) A dividend of Rs. 20,000 has been paid.

c) Income-tax of Rs. 35,000 has been paid.

Solution Statement of changes in working capital Particulars 2006

Rs.

2007

Rs.

Effect of Working capital

Increase Decrease

Current Assets:

Debtors Stock

Bills Receivable

Cash in hand Cash in Bank

1,60,000 77,000

20,000

15,000 10,000

2,00,000 1,09,000

30,000

10,000 8,000

40,000 32,000

10,000

- -

-

-

5,000 2,000

C.A 2,82,000 3,57,000

Current Liabilities:

Creditors Bills payable

55,000 20,000

83,000 16,000

- 4,000

28,000

C.L 75,000 99,000

Networking cap (CA-CL) 2,07,000 2,58,000 86,000 35,000

Net Increase in working cap. 51,000 - - 51,000

2,58,000 2,58,000 86,000 86,000

31


NOTES


Dr. Plant Account Cr.

Rs. Rs.

To Opening

Balance To Cash purchase

80,000

1,30,000

By Depreciation

By Closing Balance

10,000

2,00,000

2,10,000 2,10,000

Dr. Plant Account Cr.

Rs. Rs.

To Opening

Balance

2,00,000 By Depreciation

By Cash sales By Closing Balance

20,000

10,000 1,70,000

2,00,000 2,00,000

Dr. Land and Building Account Cr.

Rs. Rs.

To Opening

Balance

To Cash purchase

80,000

1,30,000

By Depreciation

By Closing

Balance

10,000

2,00,000

2,10,000 2,10,000

Dr. Proposed Dividend Account Cr.

Rs. Rs.

To Bank (Dividend

paid)

To Closing Balance

20,000

50,000

By Opening Balance

By Adj. Profit &

Loss A/c (Bal. fig)

42,000

28,000

70,000 70,000

Dr. Provision for taxation Account Cr.

Rs. Rs.

To Bank (Tax paid)

To Closing Balance

35,000

50,000

By Opening Balance

By Adj. Profit & Loss A/c (Bal. fig)

40,000

45,000

85,000 85,000

Funds from Operations Net profit (48,000 – 30,000)

Add: Non- operating expenses:

Depreciation – plant 10,000

Depreciation – Land 20,000 Tax provided during the year

Dividend provided during the year

General Reserve transfer during the year Good will written off

18,000

30,000 45,000

28,000

30,000 25,000

Fund from operation 1,76,000

Fund Flow Statement

Sources Rs. Applications Rs.

Fund from operations

Issue of Equity shares

Sale of Land and Buildings

1,76,000

1,00,000

10,000

Purchase of Plant

Redemption of preference

shares Payment of Dividend

Payment of Income Tax

Increase in Working capital

1,30,000

50,000

20,000 35,000

51,000

2,86,000 2,86,000

32


NOTES


3.2. CASH FLOW ANALYSIS

Cash flow means incoming and outgoing of cash in an organisation during

a period.

“It is a statement which discloses the changes in cash position between two

periods”.

Yes, the revised AS-3 (Accounting Standard – 3) has made it mandatory

for all listed companies to prepare and present a cash flow statement along

with other financial statements on annual basis.

A cash flow statement is one which provides information about the

historical changes in cash and cash equivalents of an enterprise by

classifying cash flow into operating, investing and financing activities.

3.2.1. Various terms used in cash flow statement

a) Cash – “It comprises cash on hand and demand deposits with banks”.

b) Cash equivalents – “They are short term highly liquid investments that

are readily convertible into known amounts of cash and which are subject

to an insignificant risk of changes in value”.

c) Cash flows – “Inflow and outflows of cash and cash equivalents”.

d) Operating activities – “They are the principal revenue producing

activities of the enterprise.

e) Investing activities – “They are the acquisition and disposes of long-

term assets and other investments not included in cash equivalents”.

f) Financing activities – “Activates that result in changes in the size and

composition of the owners’ capital and borrowings of the enterprise”.

3.2.2. Objectives of Cash flow statement

1. To provide useful information about cash flows and outflows of an

enterprise.

2. To help for short-term planning.

3. To provide the users of financial statements with a basis to assess

the ability of the enterprise to generate cash and cash equivalents.

4. The heads of the enterprise to utilize those cash flows.

3.2.3. Advantages of cash flow statement

i) Helps in efficient cash management:

It helps to provide information about the liquidity and solvency

information of an organisation and to determine how much cash will be

available at a particular point of time to meet obligation.

ii) Helps in internal financial management:

It enables the management to make available enough cash

whenever needed and invest surplus cash in productive and profitable

opportunities.

iii) Discloses the movement of cash:

It discloses the sources and application of the cash of an

organisation and cash flows in the different segment of the business.

iv) Comparison between two organisation:

It is useful to compare the projected cash flow with the actual cash

flow for controlling and for taking remedial actions.

v) Comparison between two organisation:

It increases the comparability of the reporting of operating

performance by different organisation.

vi) Cash planning:

It helps to evaluate the current cash position and plan the financial

policies for future.

33


NOTES


vii) Analysis of profitability and net cash flow:

It explains the reasons for low cash balance in spite of huge profits

and vice-versa.

3.2.4. Limitations of Cash Flow statement

i) It ignores non-cash items; hence it cannot be equated with the

income statement.

ii) The cash balance as disclosed by the cash flow statement may

not represent the true liquid position of the organisation.

iii) Working capital concept gives complete picture than cash flow

concept.

3.2.5. Difference between Cash flow statement and Fund flow

statement

Cash Flow Statement Fund Flow Statement

It starts with opening balance and

ends with closing balance.

No such balance.

It deals with cash receipts and

payments.

It deals with increase or decrease in

working capital.

It shows the changes in cash. It shows the changes in working

capital.

It is useful for short-term financial

analysis.

It is useful for long-term financial

analysis.

Flow of cash means definitely be

flow of funds.

Flow of funds does not mean flow

of cash.

Cash is a part of working capital. Working capital may not necessarily

mean cash.

3.2.6. Difference between Cash Flow Statement and Cash Book

Cash Flow Statement Cash Book

It is present the amount of cash flow

from operation with careful study

and interpretation.

It prevents only the actual cash

receipts and cash payments.

Good will written off, preliminary

expenses, depreciation etc, are to be

recorded in cash flow statement.

These items will not appear in cash

book.

Items for which on payment is

made, but which incur losses are to

be shown in cash flow statement.

Items for which no payment is made

do not appear in cash book.

It reveals the analysis and re-

investigation of the items appearing

in the financial statement.

It reveals only the continuous day-

to-day monetary transactions.

3.2.7. Presentation of cash flow statement

As per AS-3 the cash flow statement is presented in three categories.

i) Operating activity

ii) Investing activity

iii) Financing activity

Classification by activities provides information which may be used

to evaluate the relationship among these activities and the impact of those

activities on the financial position of the organisation.

A single transaction may include mix of cash flows that are

classified differently. Example:

a) Instalment paid on fixed asset: This includes both interest and

principal, interest is classified under financing activities and the principal

under investing activities.

34


NOTES


1. Operating activities

Cash flow from operating activities are primarily derived from the

principal revenue producing activities of the enterprise that enter into the

determination of net profit or net loss. Example for cash flows from

operating activities:

Cash inflows from operating activities

i. Cash receipts from the sale of goods or services.

ii. Cash receipts from royalties, fees, commission and other revenue.

iii. Cash received from the insurance enterprise towards claims,

annuities and other policy benefits.

iv. Refund of income tax.

Cash outflow from operating activities

i. Cash payments to suppliers for goods and services.

ii. Cash payments to and on behalf of employees.

iii. Cash payments relating to future contract, forward contracts, for

dealing of trading purpose.

iv. Cash payment towards insurance premium.

v. Cash payment of income tax.

2. Investing activities

The activities of acquisition and disposal of long-term assets and

other investments intended to generate future income and cash flows.

Cash inflows from investing activities

i. Cash receipts from disposal of shares, debenture, interests in joint

venture etc. of other companies held as investment.

ii. Cash receipts from the repayment of advance and loans made to

third parties (other than financial enterprise).

Cash outflow arising from investing activities

i. Cash payments to acquire fixed assets including intangible assets.

ii. Cash payments relating to capitalized research and development

cost and self-constructed fixed assets.

iii. Cash payments to acquire shares, debentures, interests in joint

venture etc. of other companies for investment purpose.

iv. Cash advance and loans made to third parties (other than financial

enterprise)

Financing Activities

Financing activities are those activities which result in change in

the equity capital and the borrowed funds of the organisation.

Cash inflow from financing activities

i. Cash proceeds from issuing equity/preference shares.

ii. Cash proceeds from issuing debentures, loans, bonds and other

short/long-term borrowing.

Cash outflow from financing activities

i. Cash repayments of amounts borrowed.

ii. Interest paid on debenture and long-term loans and advances.

iii. Dividends paid on equity and preference capital.

3.3. Methods of converting net profit There are two methods of converting net profit into net cash flows

from operating activities. 1) Direct method and 2) Indirect method.

1. Direct Method:

Under direct method actual cash receipts from operating revenues

and actual cash payments for operating expenses are arranged and

35


NOTES


presented in the cash flow statement. The difference between cash receipts

and cash payments is the net cash flow from operating activities.

Under direct method items lie depreciation, amortisation of

intangible assets, preliminary expenses, debenture discount are ignored

from cash flow statement, since the direct method includes only cash

transactions and non-cash items are omitted.

likewise, no adjustment is made for loss or gain on the sale of fixed

assets and investments.

FORMAT OF CASH FLOW FROM OPERATING ACTIVITIES

DIRECT METHOD (Option: 1)

Particulars Rs. Rs.

Cash flow from operating activities Cash receipts from customers

Less: Cash paid to suppliers and employees

XXX

XXX

Cash generated from operations Less: Income tax paid

XXX XXX

Cash flow before extraordinary items

Less: Extraordinary items (earthquake direct settlement

etc.)

XXX

XXX

XXX

Net cash from operating activities (A) XXX XXX

ii) Indirect Method:

In this method the net profit is used as the base then adjusted for

items that affected net profit but did not affect cash.

Non-cash and non-operating charges in debit side of the profit and

loss account are added back to the net profit while non-cash and non-

operating credit are deducted to calculate operating profit before working

capital changes. It is a partial conversion of accrual basis profit to cash

basis profit.

Further necessary adjustments are made for increase or decrease in

current assets and current liabilities to obtain net cash from operating

activities. Format of cash flow from operating activities Indirect Method (Option: 2)

Particulars Rs. Rs.

CASH FLOW FROM OPERATING ACTIVITIES:

Net profit before tax and Extraordinary item(or)

Closing balance of profit & loss Less: Opening balance of profit & Loss

xxx xxx

xxx

(or) xxx

Add: Transfer red. to Reserve

Provision for Taxation made during the current year

Proposed dividend made during the current year Interim dividend paid during the year

Any extraordinary expenses debited to P&L

Less: Refund Tax’ Any extra ordinary income credited to P&L

xxx xxx

xxx

xxx

xxx xxx

xxx

xxx

Add: Non-operating expenses / items

Depreciation of Fixed assets

Loss on sale of fixed assets Preliminary expenses, Discount on issue of shares and

debentures (written off)

Goodwill, Patent, Trademark Amortised (Written off)

xxx

xxx xxx

xxx

xxx

Less: Non-operating Income/Items

Interest and dividend received

Profit on sale of fixed assets

Rental Income

xxx

xxx

xxx

xxx

xxx

Operating profit before adjustment for working capital xxx

36


NOTES


changes

Add: Decrease in current assets Increase in current liabilities

xxx

xxx

Less: Increase in current assets

Decrease in current liabilities

xxx

xxx

xxx

xxx

Opening profit after charging working capital changes Less: Income tax paid (Net of capital tax refund received

xxx xxx

Operating profit before charging extra ordinary items

Add/ Less: Extraordinary items

xxx

xxx

Net cash flow from operating activities (A) xxx

3.3 FORMAT OF CASH FLOW FROM INVESTING AND

FINANCING ACTIVITIES

Particulars Rs. Rs.

CASH FLOW FROM INVESTING ACTIVITIES

Add: Proceeds from sale of fixed assets (Including

intangible assets/ goodwill) Dividend and interest received (non-financial companies)

xxx

xxx

Less: Purchase of Fixed assets (including intangible

assets)

Purchase of investment Loan to subsidiaries

xxx

xxx

xxx

xxx

xxx

Net cash from investing Activities (B) xxx

Cash Flow from Financing activities

Add: Proceeds from issue of shares and debentures Proceeds from other long-term Borrowings

xxx

xxx

Less: Final Dividend paid

Interim dividend paid

Interest on debenture and long-term loan paid Redemption of shares and debentures

Repayment of other long-term loan

xxx

xxx

xxx xxx

xxx

xxx

xxx

Net cash from Financing activities (c) xxx

Net Increase / Decrease in cash and cash equivalent (A+ B + C)

Add: Opening cash and cash equivalents

Cash in hand Cash at bank

Short-term deposit

Marketable securities

xxx

xxx

xxx xxx

xxx

Less: Bank O/D xxx xxx

Closing cash and cash equivalent xxx

3.4. TREATMENT OF SOME PECULIAR ITEMS

i) Extraordinary items

Extraordinary items are not regular phenomenon and they are non-

recurring in nature. As far as possible classify them into operating,

investing and financing activities.

Example: Bad debts recovered, claims from insurance companies, winning

of a lawsuit, winning of lottery etc.

ii) Interest and Dividends

a) In case of a non-financial enterprise:

Interest paid and dividend paid-Financing activities (cash out flow)

Interest received and dividend received – Investing activities (cash

inflow)

b) In case of financial enterprise:

Interest paid – Operating activities (cash out flow)

37


NOTES


Interest and dividend received – Operating activities (Cash inflow)

Dividend paid – Financing activities (cash out flow)

c) Interest paid on working capital loans – Operating activities (cash

outflow)

iii) Taxes on Income:

It should be classified as cash flows from operating activities unless

they can be specifically identified with financing and investing activities.

Tax on net profit – Operating activities (cash out flows)

Tax paid on dividend – Financing activity along with dividend paid

iv) Non - cash transactions

Investing and financing transactions that do not require the use of

cash or cash equivalent should be excluded from a cash flow statement.

Example: Acquisition of assets by issue of shares (or) debentures,

conversion of debts into equity etc.

Procedure in Preparation of cash flow statement

The following procedure are used to prepare the cash flow statement

i. Calculation of net increase or decrease increase or decrease in cash

and cash equivalents:

The difference between cash and cash equivalents for the period

may be computed by comparing these accounts given in the

comparative balance sheets.

ii. Calculation of the net cash provided (or) used by operating

activities:

It is calculated by the analysis of profit and loss a/c, comparative

balance sheet and selected additional information.

iii. Final preparation of a cash flow statement:

The net cash flow provided or used in operating activities (a)

investing activities (b) and financing activities (c) are highlighted

and the aggregate of net cash flow is equal to net increase or

decrease in cash and cash equivalents.

Illustration 1 Calculate cash flow from operating activities: Total sales for the year

Total purchase for the year

Commission received during the year Office expenses for the year

Administrative expenses for the year

Income Tax paid during the year

10,00,000

6,50,000

10,000 15,000

20,000

12,000

Solution: Cash flow from operating activities

Particulars Rs. Rs.

Total sales for the year

Add: Commission received

10,00,000

10,000

Less: Total purchase for the year

Office expenses for the year

Administrative expenses

6,50,000

15,000

20,000

10,10,000

6,85,000

Cash generated from operations

Less: Income tax paid

3,25,000

12,000

Net cash from operating activities (A) 3,13,000

3.5. COMPUTERIZED ACCOUNT Computerized Accounting involves making use of computers

and accounting software to record, store and analyse financial data.

A computerized accounting system brings with it many advantages that are

unavailable to analogue accounting systems.

38


NOTES


Computerized accounting systems are software programs that are stored on

a company's computer, network server, or remotely accessed via the

Internet. Computerized accounting systems allow you to set up income and

expense accounts, such as rental or sales income, salaries, advertising

expenses, and material costs.

3.6. OBJECTIVE OF COMPUTERIZED ACCOUNTING 3.6.1. Labour Saving:

Labour saving is the main aim of introduction of computers in accounting.

It refers to annual savings in labour cost or increase in the volume of work

handled by the existing staff.

3.6.2. Time Saving:

Savings in time is another object of computerization. Computers should be

used whenever it is important to save time. It is important that jobs should

be completed in a specified time such as the preparation of pay rolls and

statement of accounts. Time so saved

by using computers may be used for other jobs.

3.6.3. Minimization of Frauds:

Computer is mainly installed to minimize the chances of frauds committed

by the employees, especially in maintaining the books of accounts and

handling cash.

3.6.4. Effect on Personnel:

Computer relieves the manual drudgery, reduces the hardness of work and

fatigue, and to that extent improves the morale of the employees.

3.6.5. Accuracy:

Accuracy in accounting statements and books of accounts is the most

important in business. This can be done without any errors or mistakes

with the help

of computers. It also helps to locate the errors and frauds very easily.

3.7. ROLE OF COMPUTERIZED ACCOUNTING 1. The manual system of recording accounting transactions requires

maintaining books of accounts such as journal, cash book, special purpose

books, and ledger and so on. From these books, summary of transactions

and financial statements are prepared manually.

2. The advanced technology involves various machines, which can perform

different accounting functions, for example a billing machine. This

machine is capable of

computing discount, adding net total and posting the requisite data to the

relevant accounts.

3.8. FEATURES OF A COMPUTERISED ACCOUNTING

PROGRAM

1. Inputting invoices, credit notes, receipts and payments

2. By entering one transaction all the double entry is completed for you.

(Because a computerised accounting system is fully integrated)

3. There may be a separate payroll program

4. Generating Management reports

3.8.1. Advantages

1.All banking activities are done by using computer system

2. Transaction can be done anywhere and anytime

3. It takes shorten time for any banking process

3.8.2. Dis-advantages

1. Cost of computerized system is very high

39


NOTES


2. High cost for maintenance

3. The system can be infected by viruses

4. Member of workers have to be reduced as they are no longer needed

3.9 MANUAL ACCOUNTING vs COMPUTERIZED

ACCOUNTING Manual Accounting Computerized Accounting

Manual accounting is the system in

which we keep physical register of

journal and ledger for keeping the

records of each transaction.

In this system of accounting, we use

computer and different accounting

software for digital record of each

transaction.

In manual accounting, all calculation

of adding and subtracting are done

manually.

In computerized accounting, our duty is

to record the transactions manually in

the database. All the calculations are

done by computer system.

In manual accounting, we check the

journal and then we transfer figures to

related accounts debit or credit side through manual posting.

Computerized accounting system will

automatically process the system and

will make all the accounts ledgers because we have passed the voucher

entries under its respected ledger

account.

Both adjustment journal entries and its posting in the ledger accounts will be

done manually one by one.

Only adjustment entries will pass in the computerized accounting system,

posting in the ledger accounts will be

done automatically.

We have to make the financial statements manually by careful

transferring trial balance’s figures in

income statement and balance sheet.

We need not prepare financial statement manually; financial statements will

become automatically.


1. What do you mean by computerized accounting

2. What is fund from operation?

3. Calculate cash flow from operating activities: Total sales for the year


Commission received during the year

Office expenses for the year Administrative expenses for the year


10,00,000

6,50,000

10,000

15,000 20,000

12,000


1.Computerized Accounting involves making use of computers

and accounting software to record, store and analyse financial data.

A computerized accounting system brings with it many advantages that are

unavailable to analogue accounting systems.

2. Funds from operation is the only internal sources of funds. The net profit

earned by the business in known as internal sources.

3. Solution: Cash flow from operating activities

Particulars Rs. Rs.

Total sales for the year Add: Commission received

10,00,000 10,000

Less: Total purchase for the year

Office expenses for the year Administrative expenses

6,50,000

15,000 20,000

10,10,000

6,85,000

Cash generated from operations

Less: Income tax paid

3,25,000

12,000

Net cash from operating activities (A) 3,13,000

40


NOTES



A. Short answer

1. What is computerized accounting?

2. Define Fund flow analysis.

3. Explain the cash flow analysis.

4. Explain the merits and demerits of fund flow analysis.

5. What are the objectives of cash flow statement?

B. Long Answer

1. Calculate cash flow from operating activities: Total sales for the year


Commission received during the year Office expenses for the year

Administrative expenses for the year


20,00,000

7,50,000

20,000 25,000

30,000

22,000

2. What are the difference between manual accounting and computerized

accounting?

3. what are the differences between fund flow statement and cash flow

statement?

4. From the following information, calculate cash flow from operating

activities using indirect method.

Statement of Profit and Loss A/c

for the year ended on March 31, 2016

Particular Rs. Rs.

Revenue from operations

Expenses:

Cost of materials consumed

Employees benefits expenses Depreciation

Other expenses:

Insurance premium

2,40,000

60,000 40,000

16,000

4,40,000

Total expenses 3,56,000

Profit before tax

Less: Income tax

84,000

20,000

Profit after tax 64,000


Particular 31.3.2015 31.3.2015

Trade Receivables

Trade Payables Inventory

Outstanding employees’ benefits

Prepaid insurance Income tax payable

66,000

34,000 44,000

4,000

10,000 6,000

72,000

30,000 54,000

6,000

11,000 4,000

Further Reading:

1. Financial Accounting Dr. V.K. Goyal, Published by Excel Books

2. Financial Accounting, Grewal, Shukla, Sultan Chand Publications,

Delhi


Delhi



5. Financial Management, Khan & Jain – Tata McGraw Hill

6. Cost and Management Accounting, Jain S.P. & Narang, K.L.

Kalyani Publishers, Delhi

41

Cost and Management Accounting

NOTES


BLOCK II

UNIT IV - COST AND MANAGEMENT

ACCOUNTING Structure

4.1. Introduction

4.2. Meaning and Definitions of Cost Accounting



4.5. Nature and Scope of Cost Accounting

4.6. Management Accounting

4.7. Objectives of Management Accounting

4.8. Nature and Scope of Management Accounting

4.1. INTRODUCTION

A business enterprise must keep a systematic record of what

happens from day- tot-day events so that it can know its position clearly.

Most of the business enterprises are run by the corporate sector. These

business houses are required by law to prepare periodical statements in

proper form showing the state of financial affairs. The systematic record

of the daily events of a business leading to presentation of a complete

financial picture is known as accounting. Thus, Accounting is the

language of business. A business enterprises peaks through accounting.

It reveals the position, especially the financial position through the

language called accounting.

Accounting is the process of recording, classifying, summarizing,

analysing and interpreting the financial transactions of the business for

the benefit of management and those parties who are interested in

business such as shareholders, creditors, bankers, customers, employees

and government. Thus, it is concerned with financial reporting and

decision-making aspects of the business.

The American Institute of Certified Public Accountants Committee

on Terminology proposed in 1941 that accounting may be defined as,

“The art of recording, classifying and summarizing in a significant

manner and in terms of money, transactions and events which are, in

part at least, of a financial character and interpreting the results

thereof”.

4.2. MEANING AND DEFINITIONS OF COST

ACCOUNTING “Cost accounting is a quantitative method that accumulates,

classifies, summarizes and interprets information for three major

purposes: (i) Operational planning and control; (ii) Special decision; and

(iii) product decision.” – Charles T. Horngren.

“Cost accounting is the process of accounting for costs from the

point at which the expenditure is incurred of committed to the

establishment of its ultimate relationship with cost units. In its widest

sense, it embraces the preparation of statistical data, the application of

cost control methods and the ascertainment of the profitability of the

activates carried out or planned is defined as the application of

accounting and costing principles, methods and techniques in the

ascertainment of costs and the analysis of saving and or excess of

42


NOTES


compared with previous experience or with standards.” – Institute of

Cost and Management Accountants of London.

“Cost accounting is defined as the application of costing and cost

accounting principles, methods and techniques to the science, art and practice

of cost control and the ascertainment of profitability. It includes the

presentation of information derived therefore for the purposes of managerial

decision making. – Wheklon.

4.3. COST ACCOUNTING

An accounting system is to make available necessary and

accurate information for all those who are interested in the welfare of

the organization. The requirements of major it the mare satisfied by

means of financial accounting. However, the management requires far

more detailed information than what the conventional financial

accounting can offer. The focus of the management lies not in the past

but on the future.

For a businessman who Manu factures goods or renders services,

cost accounting is a useful tool. It was developed on account of

limitations of financial accounting and is the extension of financial

accounting. The advent of factory system gave an impetus to the

development of cost accounting. It is a method of accounting for cost.

The process so recording and accounting for all the elements of cost is

called cost accounting.

The Institute of Cost and Works Accountants, London defines

costing as, “the process of accounting for cost from the point at which

expenditure is in corridor committed to the establishment of its ultimate

relationship with cost centres and cost units. In its wider usage it

embraces the preparation of statistical data, the application of cost

control methods and the ascertainment of the profitability of activities

carried out or planned”.

The Institute of Cost and Works Accountants, India defines cost

accounting as, “the technique and process of ascertainment of costs.

Cost accounting is the process of accounting for costs, which begin with

recording of expenses or the bases on which they are calculated and

ends with preparation of statistical data”.

To put it simply, when the accounting process is applied or the

elements of costs (i.e., Materials, Labour and Other expenses), it

becomes Cost Accounting.

4.4. OBJECTIVES OF COST ACCOUNTING Cost accounting was born to fulfil the needs of manufacturing

companies. It is a mechanise accounting through which costs of good,

so eservices are ascertained and controlled for different purposes. It

helps to ascertain the true cost of every operation, through watch, say,

cost analysis and allocation. The main objectives of cost accounting are

as follows: -

4.4.1. Cost Ascertainment

The main objective of cost accounting is to find out the cost of product,

process, job, contract, service or any unit of production. It is done through

various methods and techniques.

4.4.2. Cost Control

The very basic function of cost accounting is to control costs. Comparison

of actual cost with standards reveals the discrepancies (Variances). The

43


NOTES


variances reveal whether cost is within control or not. Remedial actions are

suggested to control the costs which are not within control.

4.4.3. Cost Reduction

Cost reduction refers to the real and permanent reduction in the unit cost of

goods manufactured or services rendered without affecting the use

intended. It can be done with the help of techniques called budgetary

control, standard costing, material control, labour control and overheads

control.

4.4.4. Fixation of Selling Price

The price of any product consists of total cost and the margin required.

Cost data are useful in the determination of selling price or quotations. It

provides detailed information regarding various components of cost. It also

provides information in terms of fixed cost and variable costs, so that the

extent of price reduction can be decided.

4.4.5. Framing business policy

Cost accounting helps management in formulating business policy and

decision making. Break even analysis, cost volume profit relationships,

differential costing, etc are helpful in taking decisions regarding key areas

of the business like-

a. Continuation or discontinuation of production b. Utilization of

capacity

c. The most profitable sales mix D Key factor

e. Export decision

f. Make or buy

g. Activity planning, etc.

4.5. NATURE ANDSCOPE OF COST ACCOUNTING Cost accounting is concerned with ascertainment and control of

costs. The information provided by cost accounting to the management

is helpful forecast control and cost reduction through function so

planning, decision making and control. Initially, cost accounting

confined itself to cost ascertainment and presentation of the same mainly

to find out product cost. With the introduction of large-scale production,

the scope of cost accounting was widened and providing information for

cost control and cost reduction has assumed equal significance along

with finding out cost of production. To start with cost accounting was

applied in manufacturing activities but now it is applied in service

organizations, government organizations, local authorities, agricultural

farms, extractive industries and soon.

Cost accounting guides for ascertainment of cost of production.

Cost accounting discloses profit able and unprofitable activities. It helps

management to eliminate the unprofitable activities. It provides

information for estimate and tenders. It discloses the losses occurring in

the form of idle times pillage or scrap etc. It also provides a per petal

inventory system. It helps to make effective control over inventory and

for preparation of inter in financial statements. It helps in controlling the

cost of production with the help of budgetary control and

standardcosting.Costaccountingprovidesdataforfutureproductionpolicies.

It discloses there relative efficiencies of different workers and for

fixation of wages to workers.

4.6. MANAGEMENT ACCOUNTING Management accounting is not a specific system of accounting. It

could be any form of accounting which enables a business to be

44


NOTES


conducted more effectively and efficiently. It is largely concerned with

providing economic information to mangers for achieving organizational

goals. It is a next tension of the horizon of cost accounting towards

newer areas of management. Much management accounting information

is financial in nature but has been organized in a manner relating direct ly

to the decision non hand.

Management accounting is comprised of t w o words

“Management and Accounting”. It means the study of managerial aspect

of accounting. The emphasis of management accounting is to re design

accounting in such a way that it is helpful to the management

information of policy, control of execution and appreciation of

effectiveness.

Management accounting is of recent origin. This was first used

in1950bya team of accountants visiting U.S. A under the us paces of

Anglo-American Council on Productivity.

Anglo-American Council on Productivity defines Management

Accounting as, “the presentation of accounting information in such a

way as to assist management to the creation of policy and the day today

operation of an undertaking”.

The American Accounting Association defines Management

Accounting as “the methods and concepts necessary for effective

planning for choosing among alternative business actions and for control

through the evaluation and inter pre station of performances”.

The Institute of Chartered Accountants of India defines

Management Accounting as follows: “Such of its techniques and

procedures by which accounting mainly seeks to aid the management

collectively has come to be known as management accounting”

From these definitions, it is very clear that financial data is

recorded, analysed and presented to the management in such a way that

it becomes useful and helpful in planning and running business

operations more systematically.

4.7. OBJECTIVES OF MANAGEMENT

ACCOUNTING

The fundamental objective of management accounting is to enable

the management to maximize profits or minimize losses. The evolution

of management accounting has given a new approach to the function of

accounting. The main objectives of management accounting are as

follows:

4.7.1. Planning and policy formulation

Planning involves fore casting on the basis of available information,

setting goals; framing polices determining he alternative courses of

action and deciding on the programme of activities. Management

accounting can help greatly in this direction. It facilitates the preparation

of statements in the light of past results and gives estimation for the

future.

4.7. 2. Interpretation process

Management accounting is to present financial information to the

management. Financial information is technical in nature. Therefore, it

must be presented in such a way that it is easily understood. It presents

accounting information with the help of statistical devices like charts,

diagrams, graphs, etc.

4.7.3. Assists in Decision-making process

45


NOTES


With the help of various modern techniques management

accounting makes decision-making process more scientific. Data relating

to cost, price, profit and savings for each of the available alternatives are

collected and analysed and provides a base for taking sound decisions.

4.7.4. Controlling

Management accounting is a useful for managerial control.

Management accounting tools like standard costing and budgetary

control are helpful in controlling performance. Cost control is affected

through the use of standard costing and departmental control is made

possible through the use of budgets. Performance of each and every

individual is controlled with the help of management accounting.

4.7.5. Reporting

Management accounting keeps the management fully informed

about the latest position of the concern through reporting. It helps

management to take proper and quick decisions. The performance of

various departments is regularly reported to the top management.

4.7.6. Facilitates Organizing

“Return on Capital Employed” is one of the tools of management

accounting.

SincemanagementaccountingstressesmoreonResponsibilityCentreswitha

view to control costs and responsibilities, it also facilitated centralization

to a greater extent. Thus, it is helpful in setting up effective and

efficiently organization framework.

4.7.7. Facilitates Coordination of Operations:

Management accounting provides tools for overall control and

coordination of business operations. Budgets are important means of

coordination.

4.8. NATURE AND SCOPE OF MANAGEMENT

ACCOUNTING Management accounting involves furnishing of accounting data to

the management for basing its decisions. It helps in improving efficiency

and achieving the organizational goals. The following paragraphs

discuss about the nature of management accounting.

4.8.1. Provides accounting information

Management accounting is based on accounting information.

Management accounting is a service function and it provides necessary

information to different levels of management. Management accounting

involves the presentation of information in a way it so its managerial

needs. The accounting data collected by accounting department is used

for reviewing various policy decisions.

4.8.2. Cause and effect analysis

The role of financial accounting is limited to find out the ultimate

result, i.e., profit and loss; management accounting goes a step further.

Management accounting discusses the cause and effect relationship.

There as on for the loss are probed and the factors directly influencing

the profitability are also studied. Profits are compared to sales, different

expenditures, current assets, interest payables, share capital, etc.

4.8.3. Use of special techniques and concepts

Management accounting uses special techniques and concepts

according to necessity to make accounting data more useful. The

techniques usually used include financial planning and analyses,

46


NOTES


standard costing, budgetary control, marginal costing, project appraisal,

control accounting, etc.

4.8.4. Taking important decisions

It supplies necessary information to the management which may be

useful for its decisions. The historical data issued to see its possible

impact on future decisions. The implications of various decisions are

also taken into account.

4.8.5. Achieving of objectives

Management accounting uses the accounting information in such a

way that it helps in formatting plans and setting up objectives.

Comparing actual performance with targeted figures will give an idea to

the management about the performance of various departments. When

there are deviations, corrective measures can be taking not once with the

help of budgetary control and standard costing.

4.8.6. No fixed norms

No specific rules are followed in management accounting as that of

financial accounting. Though the tools are the same, their use differs

from concern to concern. The deriving of conclusions also depends upon

the intelligence of the management accountant. The presentation will be

in the way which suits the concern most.

4.8.7. Increase in efficiency

The purpose of using accounting information is to increase

efficiency of the concern. The performance appraisal will enable the

management top in-point efficient and inefficient pots. Effort is made to

take corrective measures so that efficiency is improved. The constant

review will make the staff cost conscious.

4.8.8. Supplies information and not decision

Management accountant is only to guide and not to supply

decisions. The data is to be used by the management for taking various

decisions. ‘How is the data to be utilized’ will depend upon the calibre

and efficiency of the management.

4.8.9. Concerned with forecasting

The management accounting is concerned with the future. It

helps the management in planning and forecasting. The historical

information is used to plan future course of action. The information is

supplied with the objector guide management for taking future decisions.


1. Define Cost Accounting.

2. Write short note on nature and scope of management accounting


1. “Cost accounting is defined as the application of costing and cost accounting

principles, methods and techniques to the science, art and practice of cost

control and the ascertainment of profitability. It includes the presentation of

information derived therefore for the purposes of managerial decision making. –

Wheklon.

2. Provides accounting information, increase in efficiency, Achieving of

objectives, Cause and effect analysis, Use of special techniques


Short answer

1. Define Cost Account?

47


NOTES


2. What is Management Accounting?

3. List down nature and scope of Management accounting.

Essay Type Questions:

1. What are the objectives of cost accounting?

2. What are the differences between cost accounting and Management

accounting?

3. What are the characteristics of Management accounting?

Further Reading:






48

Cost Sheet

NOTES


UNIT – V COST SHEET Structure

5.1. Evolution

5.2. Cost

5.3. Different Types of Cost

5.4. Costing


5.6. Objectives of Cost Accounting 5.7. Advantages of Cost Accounting

5.8. Limitation of Cost Accounting

5.9. Characteristics of A Good (or) An Ideal Costing System

5.10. Difference Between Cost Accounting and Management Accounting

5.11. Cost Classification

5.12. Elements of Cost

5.13. Components of Total Cost

5.14. Format of a Cost Sheet

5.15. Problems and Solutions

5.1. EVOLUTION Today business is a dynamic organism. Every businessman must

face tough competitions, uncertainty and risk prevailing in the trade. A

business may be altered because of technological development, economic

situations, political changes, social considerations etc. Increase in

population may be turned into more demand, and thus new enterprises take

birth to meet the demands. When may enterprises come up, there arises

widespread competition, and this will cause the business more and more

complex? Thus, the sellers must be ready to face survival situations and

stiff competitions. In the ordinary situations of business, in the past, the

businessman or the entrepreneur was in close touch with his customers and

suppliers. He was able to have a close observation and measure the

efficiency of his business. But, when the business grows and begins to

function through stiff competition, uncertainty and risk, the businessman

looks into the accounting information. The accounting information profit

and loss account and balance sheet is aimed to serve the interests of

owners, shareholders, bankers, agencies, government etc. The proprietors,

who invest money can be satisfied when they know the income accruing to

them; the law of a country also needs such financial statements. Thus,

financial accounting is mainly concerned with external reporting.

It is rightly admitted that the financial statements profit, and loss

account and balance sheet are also used as medium of control. They

provide historical information. The main purpose of financial accounting

is to record the transactions in books in order to reveal the results of a

concern for a period. An assessment of the financial statements helps us to

understand the overall progress of a concern strength or weakness. But the

management of a concern needs more and more information as the

financial information fails to give all the needed information.

Every businessman tries to reduce the cost of manufacture to the

minimum in the stage of complexity and competition more particularly in

the large-scale production. Therefore, the businessman looks for

information to study the cost of a manufacture in the past, and on this basis,

he assesses what it will cost in the future. Therefore, more importance is

given to profit and loss account, which is prepared on the cost principle.

49

Cost Sheet

NOTES


5.2. COST The word ‘cost’ is used very often in our day-to-day affairs. The

committee on Terminology, American Institute of Certified Public

Accountants defined cost as:

“Cost is the amount, measured in money, of cash expended or other

property transferred, capital stock issued, services performed, or liability

incurred, in consideration of goods or services received or to be received”.

Cost represents the resources that have been or must be sacrificed

to attain objective. “Cost may be defined as a total of all expenses

incurred, whether paid or outstanding, in the manufacture and sale of a

product. We say that the cost of a sofa set is Rs. 800, which means we

have spent an amount or Rs. 800 in making the sofa set. In other words,

we can say that we spent Rs. 800 towards the cost of materials, labour and

other expenses. Thus, cost means an amount of expenditure on a given

thing, here the sofa set costs Rs. 800.

5.3. DIFFERENT TYPES OF COST Cost varies with purpose the same cost data cannot serve all

purpose equally well. The word cost is used in such a wide variety of ways

that it is advisable to use it with an adjective or phrase, which will convey

the meaning intended. Certain types of cost are briefly discussed below:

1. Historical costs are ‘post-mortem’ costs which are collected after they

have been incurred. These costs report past events and the time-lag

between event and its reporting makes the information out-of-date and

irrelevant for decision-making.

2. Future costs are costs expected to be incurred later.

3. Replacement cost is the cost of replacement in the current market.

4. Standard cost is a scientifically pre-determined cost which is arrived at

assuming a level of efficiency in utilisation of material, labour and indirect

services.

5. Estimated cost is an approximate assessment of what the cost will be. It

is based on past averages adjusted to anticipated future changes.

6. Product cost is the cost of a finished product built up from its cost

element.

7. Production cost it represents prime cost-plus absorbed production

overhead.

8. Direct cost is a cost which can be economically identified with a

specific saleable cost unit.

9. Prime cost is the aggregate of direct material cost and direct labour cost.

10. Indirect cost is the cost which cannot be directly identified t the unit of

output or to the segment of a business operation.

11. Fixed cost/Fixed overhead/Period cost. It is cost which is incurred for

a period, and which, within certain output and turnover limits, tends to be

unaffected by fluctuations in the levels of activity (output or turnover).

Examples are rent, rates, insurance and executive salaries.

12. Variable cost is the cost which tends to vary with the level of activity.

13. Opportunity cost is the value of a benefit sacrificed in favour of an

alternative course of action.

14. Controllable cost is the cost which can be influenced by budget main

product.

15. Non-controllable cost is the cost which is not subject to control at any

level of managerial supervision.

50

Cost Sheet

NOTES


16. Joint cost is the cost of process which results in more than one main

product.

17. Sunk cost CIMA defines it as the past cost not considered in decision

making.

18. Postponable cost is that cost which can be shifted to the future with

little or no effect on the efficiency of current operations.

19. Out-of-pocket cost is that cost which involves the cash outflow due to

a management decision. Depreciation on assets is an item of cost which

will not form part of out-of-pocket cost, because it does not entail cash

outflow.

20. Differential cost is the difference in total cost between alternatives

calculated to assist decision making.

21. Conversion cost is the cost incurred for converting the raw material

into finished product i.e., direct labour, direct expenses and factory

overhead. It is also referred to as the production cost excluding the cost of

direct materials.

22. Avoidable cost is the specific costs of an activity or sector of a

business which would be avoided if that activity or sector did not exist.

23. Marginal cost is the cost of one unit of product or service which would

be avoided if that unit were not produced or provided.

24. Relevant costs: CIMA defines relevant costs as “costs appropriate to a

specific management decision.”

5.4. COSTING Costing is different from cost accounting. It is referred to “as classifying,

recording and appropriate allocation of expenditure for the determination

of the costs of products or services”. Costing is the technique and process

of ascertaining cost. The technique means and consists of principles and

rules which govern the procedure of ascertaining costs of a product or

service. The process of costing ‘is the day-to-day routine of ascertaining

costs, whatever the costs ascertained may be and whatever be the means by

which the costs are determined”.

Staubus observes, “costing is the process of determining the cost of

doing something i.e., the cost of manufacturing and article, rendering a

service or performing a function.”

The techniques of costing used in industries for ascertaining the

cost of products and services:

Historical costing, i.e., ascertainment of costs after they have been

incurred. This costing is based on recorded data and the costs arrived at

are verifiable by past events.

Standard costing, CIMA defines it as “a control technique which

compares standard costs and revenues with actual results to obtain

variances which are used to stimulate improved performance.”

Marginal costing, Marginal costing is the accounting system in which

variable costs are charged to cost units and fixed costs of the period are

written-off in full against the aggregate contribution. Its special value is in

decision-making.

Direct costing, under direct costing, a unit cost is assigned only the direct

cost. All indirect costs are charged to profit and loss account of the period

in which they arise. Indirect costs are disregarded for inventory valuation

as well. Basically, the terms direct costing and marginal costing are two

different terms. While direct costing is based on traceability of cost to cost

objective, marginal costing is based on variability of cost. Unlike marginal

51

Cost Sheet

NOTES


cost, direct cost may include a part of fixed cost which is directly

identifiable.

Absorption costing is a technique that assigns all costs, i.e., both fixed

cost and variable cost, to product cost or cost of service rendered.

Uniform costing CIMA defines it as “the use by several undertakings of

the same costing system, i.e., the same basic costing methods, principles

and techniques.”

5.5. COST ACCOUNTING The institute of Cost and Works Accountants, India defines “Cost

Accounting is the technique and process of ascertainment of costs. “Cost

Accounting is the technique and process of ascertainment of costs. Cost

accounting is the process of accounting for costs, which begins with

recording of expenses or the bases on which they are calculated and ends

with preparation of statistical data.”

5.5.1. Definition

The Official Terminology of the Chartered Institute of Management

Accountants (CIMA), London, defines Cost Accounting as “the

establishment of budgets, standard costs and actual cost of operations,

processes, activities or products; and the analysis of variances, profitability

or the social use of funds”.

5.5.2. Various methods of Cost Accounting

No. Methods Examples (Applied in)

1. Job Costing Printing press, Engineering,

industries, etc.

2. Contract Costing Construction of bridges,

buildings, dams, roads, etc.

3. Batch Costing Manufacturers of biscuits,

Readymade garments; etc.

4. Unit/Single Costing Industries like mines, oil

drilling, etc.

5. Process Costing Industries like sugar, Chemicals,

Textiles, etc.

6. Operating Costing Transport Company, Power

Houses, etc.

7. Operation Costing Toy making industries, etc.

5.6. OBJECTIVES OF COST ACCOUNTING Cost accounting was born to fulfil the needs of management of

manufacturing companies for a detailed information about the cost. Cost

accounting is a mechanism of accounting by means of which costs of

services or products are ascertained and controlled in a manufacturing firm

for different purposes. The main objectives or purposes are as follows:

1. Ascertainment of cost. It enables the management to ascertain

the cost of product, job, contract, service or unit of production so as to

develop cost standard. Costs may be ascertained, under different

circumstances, using one or more types of costing principles—standard

costing, marginal costing, uniform costing etc.

2. Fixation of Selling Price. Cost data are useful in the

determination of selling price or quotations. Apart from cost

ascertainment, the cost accountant analyses the total cost into fixed and

variable costs. This will help the management to fix the selling price;

52

Cost Sheet

NOTES


sometimes, below the total cost but above the variable cost. This will

increase the volume of sales—more sales than previously, thus leading to

maximum profit. The scientific way of reducing the prices is possible in an

industry only where a sound costing system exists. In other words, cost

reduction, in the absence sound costing system, may cause to shut down

the industries.

3. Cost Control. The object is to minimise the cost of

manufacturing. Comparison of actual cost with standards reveals the

discrepancies—variances. If the variances are adverse, the management

enters into investigation so as to adopt corrective action immediately.

4. Matching Cost with Revenue. The determination of

profitability of each product, process, department etc. Is the important

object of costing.

5. Special Cost Studies and Investigations. It undertakes special

cost studies and investigations, and these are the basis for the management

in decision-making or policies. This will also include pricing of new

products, contraction or expansion programmes, closing or continuing a

department, product mix, price reduction in depression etc.

6. Preparation of Financial Statements, Profit and Loss

Account, Balance Sheet. To prepare these statements, the value of stock,

work-in-progress, finished goods etc., are essential; in the absence of the

costing department, when we have to close the accounts it rather tales too

much time. But a good system of costing facilitates the preparation of the

statements, as the figures are easily available; they can be prepared

monthly or even weekly.

5.7. ADVANTAGES OF COST ACCOUNTING It offers a few advantages, and the following are the main

advantages:

5.7.1. To the Management

1. Action Against Unprofitable Activities. It reveals unprofitable

activities, inefficiencies such as wastage of materials—spoilage, leakage,

pilferage, scrap etc, and wastage of resources—inadequate utilisation etc.

The management can concentrate on profitable jobs and consider change or

closure of unprofitable jobs.

2. Facilitates Decision-Making. It provides necessary data along

with information to the management to take decision on any matter,

relating to the business.

3. Assistant is Fixing Prices. The various types of cost accounting

are much helpful in fixing the cost and selling price of product. Thus the

desired volume of production is secured at the minimum possible cost.

4. Improves Efficiency. Through the standard cost and budgetary

control, remedial action can be chosen in order to improve the efficiency

and implement new principles.

5. Facilitates Cost Control. It facilitates cost control possible by

comparisons, product-wise or firm-wise.

6. Establishes Standard Cost. It enables the mangers to find out

the cost of each job and to know what it should have cost; it indicates

where the losses and wastes occur before the work is finished. Standard

cost is a pre-determined cost and offers several advantages to the

management.

53

Cost Sheet

NOTES


7. Inventory Control. An effective system and check are provided

on all materials and stores. Interim profit and loss account, and balance

sheet can be prepared without checking the physical inventory.

8. Prevents Fraud. An effective costing system prevents frauds

and manipulation and supplies reliable cost data to the management.

9. Future Prospects. The cost accountant not only provides the

present trend, the future prospects also. On this basis, bankers, debenture

holders, financial agencies etc., form an idea of the soundness of the firm

before granting credits.

10. Budgeting. As cost accounting reveals actual cost, estimate

cost and standard cost of products, preparation of budget is easy. Effective

budget control is also possible. Thus “Cost accounting is a system of

5.7.2. To the Employees

1. Sound wages policy: Cost accounting introduces incentive wage

scheme, bonus plans etc. Which bring better reward to sincere and

efficient workers. Cost data aid the management in devising a suitable

wage policy for the workers. Time wage system and piece rate system can

be blended to provide higher wages and at the same time increasing

productivity rate.

2. Higher Bonus Plans: Cost accounting leads to an increase in

productivity, lowering of costs and increase in profitability. Workers get

their share in profits in the form of bonus. Higher profits naturally allow

higher bonus distribution.

3. Distinction Between Efficient and Inefficient Workers: Cost

accounting provides standards for the measurement of efficiency of

workers. Efficient workers can be distinguished, and their efficiency

recognised and rewarded. Employees have been initiated and

recommended for higher promotions.

4. Security of Job: Employees get better remuneration, security of

job etc., due to the increasing prosperity of the industries. Monetary

appreciation of the efficiency of a worker is good tonic which leads to

higher rate of productivity.

5.7.3. To the Creditors

Bankers, creditors, investors etc., can have a better understanding

of firm, as regards the progress and prosperity, before they offer financial

lending’s.

5.7.4. To the Government

1. The proper systems of cost accounting are of great use in the

preparation of national plans, economic developments etc.

2. By studying the trend of cost, the government can make policies

like taxation, import, export, price selling, granting subsidy etc.

3. Costing system has stability and cost reduction in industries.

Cost audit is important, and industries have to keep books of accounts to

show the utilisation of materials, labour and other costs.

5.7.5. To the Public

1. Cost accounting removes all types of wastages and inefficiencies.

These will enable the consumers to get goods at better quality the cheaper

rates.

2. The public feels that the costing system facilitates the customers

to pay fair price.

3. Development and prosperity of industries will create

employment opportunities.

54

Cost Sheet

NOTES


5.8. LIMITATION OF COST ACCOUNTING 1. It is expensive.

2. It is a failure and criticised as defective.

3. It involves too much paper works.

4. It is unnecessary.

5. Its applicability is restricted.

5.9. CHARACTERISTICS OF A GOOD (OR) AN IDEAL COSTING

SYSTEM

1. It should be simple and easy to operate.

2. It must be economical.

3. It should be flexible to adopt new requirements.

4. It should be suitable to the nature of business.

5. It provides suitable methods for effective control of material and

wages.

6. Proper allocation, apportionment and absorption of overheads.

7. Facilitate periodic reconciliation of cost accounts and financial

accounts.

5.10. DIFFERENCE BETWEEN COST ACCOUNTING AND

MANAGEMENT ACCOUNTING

Cost Accounting Management Accounting

1. Objectives To ascertain and

control of cost of

products

To help the management in

decision-making, planning,

control, etc.

2. Scope Deals with cost data Deals with both cost and

revenue. It includes financial

accounting, cost accounting,

budgeting, etc. Its scope is

wider than cost accounting.

3. Nature Uses both past and

present figures.

Concerned with the

projection of figures for

future.

4. Purpose Both internal and

external purposes

Internal purposes only.

5. Recording of

information

Only quantitative

aspect is recorded.

Both quantitative and

qualitative aspects are

recorded.

Mention the steps that should be taken to install cost accounting

1. Study the nature of the organisation of the business.

2. Technical aspects of the business should be taken into

consideration.

3. Should be simple and easy to operate.

4. Should be capable of reconciliation.

5. Should be designed after careful analysis of the nature of

operations involved.

Mention the difficulties involved in installation of a costing system

1. Lack of support from top management.

2. Refusal from the existing accounting staff.

3. Non-cooperation at other levels or organisation.

4. Shortage of trained staff in costing department.

5. Requires additional cost for installation.

55

Cost Sheet

NOTES


5.11. COST CLASSIFICATION Cost classification is the process of grouping cost according to their

common characteristics. Costs are to be classified suitably to identify with

cost centre or cost unit. In a manufacturing concern, the total operating

cost is divided into two:

(a) Manufacturing cost or production cost or factory cost, is the

summary of the costs of direct material, direct labour and factory overhead.

(b) Commercial expenses are of selling and general expenses. The

important classifications are:

5.12. ELEMENTS OF COST 5.12.1. Classification According to Nature or Element. The terminology

defines as “the primary classification of costs according to the factors upon

which expenditure is incurred material cost, labour cost and expenses”.

According to this classification, the costs are divided into three categories;

i.e., materials, labour and expenses. Material cost means the cost of

commodities supplied to an undertaking. Labour cost or wages mean the

cost of remuneration, such as wages, salaries, bonuses etc. of the

employees of the undertaking. Expense means cost of services provided to

and undertaking and notional cost of the use of owned asset i.e.,

depreciation etc. Further subdivision of the three elements is possible and

is as follows.

5.12.2. Classification According to the Function of Companies. Under

this, costs are classified according to the purpose for which they are

incurred. On the basis of activity, the classification leads to different

groups. They are production cost, administrative cost, selling cost and

distribution cost.

5.12.3. Classification According to Variability. Costs are also classified

into fixed, variable and semi-variable on the basis of variability of cost in

the volume of production.

(a) Fixed Cost. Fixed cosy means that the cost tends to be

unaffected with the volume of output. Fixed cost depends upon the

passage of time and does not vary directly with the volume of output. It is

also known as period cost, e.g., rent and rates of factory buildings,

insurance of buildings, depreciation of buildings, etc.

(b) Variable Cost. Variable cost tends to vary directly with the

volume of output. It varies almost in direct proportion to the volume of

production. The examples of such expenses are the cost of direct materials,

direct labour, direct chargeable expenses such as power, repairs etc. If

production increases, the costs will also increase and vice versa. Fixed cost

remains constant per unit of time and variable cost remains constant per

unit of output.

56

Cost Sheet

NOTES


(c) Semi-Variable Costs are those which are partly fixed and partly

variable. In other words, both fixed and variable elements are present in

these costs; they are also known as semi-fixed costs.

Examples are depreciation of plant and machinery which is not

doubled on account of production doubling; telephone rent, repairs etc.

5.12.4. Classification According to Capital and Revenue. Capital costs

are those costs incurred in the acquisition of assets, either to earn income or

increase the earning capacity of the business. For example, cost of plant,

machinery etc. Revenue costs are those costs incurred to maintain the

earning capacity of the firm. In costing only revenue expenditure is taken

into account while capital cost is ignored.

5.12.5. Classification According to Normality Costs. Normal cost is a

cost which is normally incurred at a given level of output in the conditions

in which that level of output is normally attained. Abnormal costs are not

normally incurred at a given level of output in the conditions in which that

level of output in normal. Normal cost is taken as an item of cost of

production; but it excludes abnormal cost from cost of production.

5.13. COMPONENTS OF TOTAL COST Prime Cost Direct Material + Direct Labour + Direct

Expenses

Works/ Factory Cost Prime Cost + Works Overheads + Opening work-

in-progress – Closing Work-in-progress.

Cost of Production Works Cost + Office & Administration

Overheads

Cost of Goods Sold Cost of Production + Opening Finished Goods –

Closing Finished Goods

Cost of Sales Cost of Goods Sold + Selling and Distribution

Overheads

In order to exercise proper control of costs for sound managerial

decisions, the management may be provided with necessary data. For this

reason, the total cost of the product is analysed by the elements of cost—

nature of expenses. Traditionally, the product cost is divided into three—

material, labour and other overhead expenses and these can further be

analysed into different elements, as shown in Table.

The total expenditure consisting of material, labour and expenses

can further be analysed as under.

Prime Cost = Direct materials + Direct Labour + Direct expenses

Work Cost (Factory) = Prime Cost + Factory overhead

Cost of Production = Factory Cost + Administration overhead

Total Cost (Cost of sales) = Cost of production + Selling and

distribution overhead

Each element of cost is explained in detail, as below:

1. Direct Material Cost. Direct material is material that can be

directly identified with each unit of the finished product. Direct material is

that material which becomes a part of the product. Raw materials, semi-

finished materials, components etc. Which become part and parcel of the

product are known as direct materials. For example, cloth in garments,

leather in shoemaking, spare parts in assembling of radio, cycle, scooter,

etc.

Direct material includes the following: 1. Materials including component parts, specially purchased for the

job.

57

Cost Sheet

NOTES


2. Material transferred from one cost centre to another, one process

to another process.

3. Primary packing materials like cartons, wrappings, card-board

boxes etc.

2. Direct Wages. All labour expenses in altering, composition,

construction, conformation etc., of the product are included in direct

wages, they include the payment made to the following group of labour;

1. Labour engaged on the actual production of the product; i.e.,

carrying out the operation or process.

2. Labour engaged in aiding the operation; i.e., supervision,

foreman, wafers of internal transport personnel, shop clerks etc.

3. Inspectors, analysts etc., especially needed for the production.

Direct wages are also known as direct labour, productive labour,

process labour or prime cost labour.

3. Direct or Chargeable Expenses. Expenses other than direct

material, direct labour, which can be identified with and allocated to cost

units or cost centres as they are specially incurred for a particular product

or process, form a part of prime cost. Direct expenses are also known as

chargeable expenses, prime cost expenses, process expenses or productive

expenses. The following groups of expenses fall under direct expenses:

1. Cost of special drawing, designs or layout

2. Hire charge, repair and maintenance of special equipment hired

3. Experimental expenses of a job

4. Excise duty, Royalty

5. Architect or surveyor’s fee

6. Travelling expense connected to the job

7. Cost of rectifying defective work.

4. Indirect Materials. Indirect materials are those materials which

cannot be traced as part of the product.

Examples are:

(a) Stores items used in maintenance of machinery like lubricant,

cotton waste, grease, oil, stationery etc.

(b) Small tools for general use.

(c) Some minor items or materials, treated as indirect materials, due

to their small costs, such as cost of thread in dressmaking, cost of nails in

shoemaking etc.

5. Indirect labour. Labour whose wage cannot be allocated, but

which can be apportioned to or absorbed by the cost centre or cost units is

known as indirect labour. In other words, wages which cannot be directly

identified with a job; are generally treated as indirect wages. Examples

are: Salaries and wages of foremen, supervisors, inspectors, maintenance

labour, storekeepers, clerical staff, watch and ward, internal transport etc.

6. Indirect Expenses. These are expenses which cannot be

allocated but can be apportioned to or absorbed by the cost centres or cost

units. In other words, expenses other than indirect material and labour are

indirect expenses. The following are examples of indirect factory

expenses:

(a) Rent, rates and insurance in relation to factory

(b) Depreciation, repairs, maintenance on factory building, plant

etc.

7. Overheads. All expenses other than the direct material cost,

direct wages and direct expenses are known ad indirect expenses or

58

Cost Sheet

NOTES


overheads. According to Weldon, overhead means “the cost of indirect

materials, indirect labour and such other expenses, including services as

cannot conveniently be charged direct to specific cost units”. In other

words, overhead means the aggregate of indirect material cost, indirect

labour and indirect expenses. In general, overheads may be sub-divided

into the following groups:

(a) Production overhead or works overheads or factory overhead or

manufacturing overhead

(b) Administrative overhead

(c) Selling overhead

(d) Distribution overhead.

All expenses relating to product are extracted from financial

accounts and analysed under expense heads in the form of statement. This

tabulated statement is called cost sheet. Cost sheet is a document which

provides for the assembly of the detailed cost of a cost centre or cost unit.

Cost sheet is a statement showing the details of the total cost of a job,

operation or order. It brings out the composition of total cost in a logical

order, under proper classifications and sub-divisions. The period covered

by the cost sheet may be a week, a month, or so. It should present cost

information in total as well as per unit. It would be better, for comparison,

if the information for the previous year also is given.

Advantages

1. It exhibits total cost and cost per unit of the product.

2. Break up cost details can be collected.

3. Helpful for preparation of estimates/ tenders.

4. Helps in fixing the selling price.

5. Comparison of data with previous period is possible.

5.14. FORMAT OF A COST SHEET

Cost Sheet of ...... Limited for the period ending .......

Particulars Rs. Rs.

Raw materials Consumed/ Direct Material:

(Opening Stock of materials Add Purchases

Less Closing Stock of Materials)

Direct Labour

Direct Expenses

XXX

XXX

XXX

XXX

Prime Cost XXX

Factory (or) Works Overheads;

Indirect Materials like oil, Consumable Stores;

Indirect Labour like Foreman salary; and

Indirect Expenses like power, Factory rent,

Depreciation, Repairs, etc.

XXX

XXX

Add: Opening Work-in-Progress (W.I.P.) XXX

XXX

Less: Closing W.I.P and sale of Scrap if any XXX XXX

Factory (or) Works cost XXX

Office & Administration Overheads:

Office lighting, Rent, Depreciation on premises,

Manager’s Salary, telephone Charges, etc.

XXX

XXX

Cost of production XXX

Selling & Distribution Overheads:

Travelling Expenses, Advertisement, Carriage

59

Cost Sheet

NOTES


outwards, warehouse charges, salesman salary and

commission, etc.

XXX

XXX

Cost of sales XXX

Profit XXX

Sales XXX

5.15. PROBLEMS AND SOLUTIONS

PROBLEM – 1:

From the following calculate the value of raw material consumed:

Raw material purchases Rs. 88,000

Opening stock of Raw Materials Rs. 1,00,000.

Closing stock of Raw Materials Rs. 1,23,500.

Solution: Value of Raw Material Consumed:

Opening Stock

Add: Purchases

Less: Closing Stock

Raw Material Consumed

Rs.

100000

88000

188000

123500

64500

PROBLEM – 2:

From the particulars given below, calculate works cost:

Raw materials Rs. 60,000.

Wages Rs. 40,000

Direct expenses Rs. 10,000

Factory overhead Rs. 50,000

Solution:

Calculation of Work Cost Rs.

Raw materials

Wages

Direct Expenses

Prime cost

Factory Overheads

Works Cost

60000

40000

10000

110000

50000

160000

PROBLEM – 3:

From the following prepare statement of cost account.

Materials consumed Rs. 45,500; Direct wages Rs. 23,000; Factory

overheads Rs. 9,200; Administration overheads Rs. 3,000. Selling

distribution overheads Rs. 2000 and sales Rs. 90,000.

Solution:

Statement of Cost Account

Materials

Direct Wages

Prime Cost

Factory Overheads

Factory Cost

Administration Overheads

Cost of Production

Selling & Distribution Overheads

Cost of Sales

Profit (B/F)

Sales

Rs.

45500

23000

68500

9200

77700

3000

80700

2000

82700

7300

90000

60

Cost Sheet

NOTES


PROBLEM – 4:

Prepare a Cost Sheet:

Raw material consumed – Rs. 80,000

Wages – Rs. 20,000

Factory expenses is charged at 100% of wages

Office overheads charged at 20% on Factory cost

Solution:

Cost Sheet

Raw Materials consumed

Wages

Prime Cost

Factory Expenses: 100% of Wages

Factory Cost (FC)

Office Overheads: 20% on FC (1,20,000×20%)

Cost of Production

Rs.

80,000

20,000

1,00,000

20,000

1,20,000

24,000

1,44,000

PROBLEM – 5:

From the following particulars, prepare a cost sheet:

Rs.

Opening stock of raw materials 60,000

Raw materials purchased 9,00,000

Wages paid 4,60,000

Factory overheads 1,84,000

Work-in-Progress (Opening) 24,000

Work-in-progress (Closing) 30,000

Raw materials (Closing stock) 50,000

Finished goods (Opening) 1,20,000

Finished goods (Closing) 1,10,000

Selling and distribution expenses 40,000

Sales 18,00,000

Administration expenses 60,000

Solution:

Cost Sheet

Rs. Rs.

Raw Materials:

Opening

Add: Purchase

60,000

900000

960000

Less: Closing 50000 910000

Wages 460000

Prime Cost 1370000

Factory overheads 184000

1554000

Add: Opening Work in progress 24000

1578000

Less: Closing Work-in-progress 30000

Work Cost 1548000

Administration Expenses 60000

Cost of production 1608000

Add: Opening Finished goods 120000

61

Cost Sheet

NOTES


1728000

Less: Closing Finished goods 110000

Cost of Goods Sold 1618000

Selling & Distribution Expenses 40000

Cost of Sales 1658000

Profit (B/F) 142000

Sales 1800000

PROBLEM – 6:

From the following particulars, prepare a statement showing (a)

Prime Cost (b) Factory cost (c) Cost of production (d) Cost of goods sold

and (e) Profit.

Rs.

Direct labour 3,00,000

Direct materials (31.12.90) 40,000

Finished goods (31.12.91) 1,50,000

Finished goods (31.12.90) 1,00,000

Work-in-progress (31.12.90) 10,000

Work-in-progress (31.12.91) 14,000

Materials purchased 4,00,000

Direct materials (31.12.91) 50,000

Manufacturing overheads 2,14,000

Selling and distribution overheads 3,30,000

Sales 12,00,000

Solution: Statement of Cost Sheet

Rs. Rs.

Direct Materials:

Opening (31.12.90) 40000

Add: Purchases 4,00,000

440000

Less: Closing (31.12.91) 50000 390000

Direct Labour 300000

(a) Prime cost 690000

Manufacturing Overheads 214000

904000

Add: Opening Work-in-Progress (31.12.90) 10000

914000

Less: Closing work-in-progress (31.12.91) 14000

(b) Factory Cost 900000

Office Overheads Nil

(c) Cost of Production 900000

Add: Opening Finished Goods (31.12.90) 100000

1000000

Less: Closing Finished Goods (31.12.91) 150000

(d) Cost of goods sold 850000

Selling & Distribution overheads 330000

Cost of Sales 1180000

(e) Profit (B/F) 20000

Sales 1200000

62

Cost Sheet

NOTES


PROBLEM – 7:

Meenambigai Engineering company has received and enquiry for

the supply of 10,000 units. The costs are estimated as follows:

Raw materials 1,00,000 kgs at Re. 1 per kg.

Direct wages 10,000 hours at Rs. 4 per hour

Variable overheads:

Factory overheads at Rs. 2.40 per labour hour

Selling and distribution Rs. 16,000

Fixed overheads:

Factory Rs.8,000

Selling and distribution Rs. 20,000

Prepare a statement showing the price to be fixed which will give a

profit of 20% on selling price.

Solution:

Quotation Price

(for 10000 units)

Rs. Rs.

Raw materials (100000 kgs @ Re. 1 per kg) 100000

Direct Wages (10000 hours @ Rs. 4 Per hr) 40000

Prime Cost 140000

Factory Overheads:

Variable (10000 hours @ Rs. 2.40 per Labour

hour

24000

Fixed 8000 32000

Work cost & Cost of Production 172000

Selling & Distribution Overheads:

Variable 16000

Fixed 20000 36000

Cost of sales 208000

Profit (20% on selling Price (or) 25% on cost of

Sales (208000×25/100)

52000

Sales 260000

Selling Price per unit

=260000/10000 = Rs. 26 per Unit.

PROBLEM – 8:

In a factory two types of ceiling fans viz. Usha and Crompton are

produced. Ascertain the cost and profit per unit sold from the particulars

given below:

Usha (Rs.) Crompton (Rs.)

Materials 16,400 18,900

Wages 8,900 9,800

Works overhead is 60% of wages and office overhead 20% on work

cost. The selling expenses per fan sold is Rs. 2. The selling price of Usha

and Crompton are Rs. 550 and Rs. 800 respectively. 80 fans of Usha and

100 fans of Crompton are sold. There is no opening or closing stock.

Solution: Cost Sheet

Usha Fans Crompton Fans

Total 80

No. Rs.

Per unit

Rs.

Total

100 No.

Rs.

Per unit

Rs.

63

Cost Sheet

NOTES


Materials 16400 205.00 18900 189.00

Wages 8900 111.25 9800 98.00

Prime cost 25300

5340

316.25

66.75

28700

5880

287.00

58.80 Works Overheads –

(60% of wages) Works

cost

Work Cost 30640

6128

383.00

76.60

34580

69196

345.80

69.16 Office overheads – (20%

of Works cost)

Cost of Production 36768

160

459.60

2.00

41496

200

414.96

2.00 Selling Expenses (Rs. 2

per Fan sold)

Cost of sales 36928 461.60 41696 416.96

Profit 7072 88.40 38304 383.04

Sales 44000 550.00 80000 800.00

PROBLEM – 9:

From the following details of ALPHA Company Ltd., prepare Cost Sheet.

Particulars Rs.

Purchase of Raw materials 2,40,000

Rent, insurance premium, factory expenses 80,000

Direct wages 2,00,000

Carriage inwards 2,880

Stock on 1.1.1996:

Raw materials 40,000

Work-in-progress 9,600

Finished goods ( 2,000 T) 32,000

Stock on 31.12.1996:

Raw materials 44,480

Work-in-progress 32,000

Finished goods (4,000 T) 64,000

Sales 6,00,000

Factory – Supervision 16,000

Total production 32,000 Tonnes

Selling & Distribution expenses Rs. 2/ Tonnes

Find out (a) Net profit (b) Net profit per tonne (c) Total production cost.

Solution:

Cost Sheet – Alpha Company Ltd.

(for 32000 tonnes)

Rs. Rs.

Raw Materials:

Opening Materials 40000

Add: Purchases 240000

Add: Carriage Inwards 2880

282880

Less: Closing Materials 44480 238400

Direct wages 200000

Prime Cost 438400

64

Cost Sheet

NOTES


Factory Overheads – Rent, Insurance,

Premium, Factory Expenses

80000

Factory Supervision 16000 96000

534400

Add: Opening works-in-progress 9600

544000

Less: Closing Work-in-progress 32000

Works Cost & Cost of Production 512000

Statement of Sales and Profit Total Per Ton

Cost of Production (512000 / 32000 =16) 512000 16.00

Add: Opening Finished goods 32000

544000

Less: Closing finished goods 64,000

Cost of Goods sold for 30000 Tonnes

(ie 32000 + 2000 – 4000 Tonnes)

480000

16.00

Selling & Distribution Expenses @ Rs. 2 per

ton for 30000 tons) [Refers Notes]

60000

2.00

Cost of sales 540000 18.00

Profit (B/F) 60000 2.00

Sales 600000 20.00

Notes:

No. Of Units Sold = Opening Finished Goods + Units Produced – Closing

Finished Goods

= 2000 + 32000 + 4000 Tonnes = 30000 Tonnes

Selling & Distribution Expenses @ Rs. 2 per to for 30000 tons = Rs.

60000.

PROBLEM – 10:

The Oriental Electrical Suppliers give you the following figures for

the three months ending 31st December 2003. These figures relate to the

manufacture of Ceiling Fans,

Rs.

Completed Stock on 1st October 2003 Nil

Completed Stock on 31st December 2003 20,250

Stock of Raw Materials, 1st October 2003 5,000

Stock of Raw Materials, 31st December 2003 3,500

Factory wages 75,000

Indirect charges 12,500

Materials purchased 32,500

Sales 1,12,500

The number of fans manufactured during the three months was 3,000.

Prepare a statement showing the cost per fan.

Solution:

Oriental Electrical suppliers statement showing the cost per fan for 3

month ending 31st Dec.2003

(For 3000 Fans)

Rs. Rs.

Raw Materials:

Opening stock (1st Oct 2003) 5000

Add: Purchase 32500

37500

65

Cost Sheet

NOTES


Less: Closing Stock (31st Dec 2003) 3500 34000

Direct wages: Factory wages 75000

Prime Cost 109000

Factory Overheads: Indirect Charges 12500

Works Cost & Cost of production 121500

Total cost 121500

Cost per fan= ---------------------------- = ------------------ = Rs. 40.50

No. of fan manufactured 3000

Statement of sales and profit

Rs.

Cost of production 121500

Add: Opening finished stock (1st Oct 2003) Nil

121500

Less: Closing finished stock (31st Dec 2003) 20250

Cost of goods sold 101250

Profit 11250

Sales 112500


1. What are the components of total cost?

2. What are the different types of cost? Explain in brief.

3. Prepare a Cost Sheet from the following information


Wages – Rs. 20,000




1.

Prime Cost Direct Material + Direct Labour + Direct

Expenses

Works/ Factory Cost Prime Cost + Works Overheads + Opening work-

in-progress – Closing Work-in-progress.

Cost of Production Works Cost + Office & Administration

Overheads

Cost of Goods Sold Cost of Production + Opening Finished Goods –

Closing Finished Goods

Cost of Sales Cost of Goods Sold + Selling and Distribution

Overheads

2. Historical cost, Future costs, Replacement cost, Standard cost, Estimated

cost, Product cost, Production cost, Direct cost, Prime cost. Indirect cost,

Fixed cost/Fixed overhead/Period cost, Variable cost, Marginal Cost etc.,

3.

Cost Sheet

Raw Materials consumed

Wages

Prime Cost

Factory Expenses: 100% of Wages

Factory Cost (FC)

Office Overheads: 20% on FC (1,20,000×20%)

Cost of Production

Rs.

90,000

20,000

1,10,000

20,000

1,30,000

24,000

1,54,000

66

Cost Sheet

NOTES



Short Questions:

1. What is cost sheet?

2. What is prime cost?

3. What is works cost?

4. What do you mean by costing

5. What is meant by replacement cost?

Long Answer Questions:

1. What are the various methods of costing?

2. Briefly explain the elements of cost

3. What are the different types of cost?

4. In a factory two types of fans namely Orient and Luminas are produced.:

Orient (Rs.) Luminas (Rs.)

Materials 32,800 37,800

Wages 17,800 19,600

Works overhead is 60% of wages and office overhead 20% on work

cost. The selling expenses per fan sold is Rs. 2. The selling price of Usha

and Crompton are Rs. 550 and Rs. 800 respectively. 80 fans of Usha and

100 fans of Crompton are sold. There is no opening or closing stock.

Find the cost and profit per unit sold from the above particulars.

Further Reading:






4. Financial Management: Pandey, I. M. Viksas 5. Theory & Problems in Financial Management: Khan, M.Y. Jain,

P.K. TMH

67

Break Even Analysis

NOTES


UNIT -VI BREAK EVEN ANALYSIS Structure

6.1. Concept

6.2. Application of Break-Even Analysis

6.3. Limitations of Be Analysis

6.4 Advantages of Break-Even Chart

6.1. CONCEPT Break- Even point is a very significant concept in Economics and

business, especially in Cost Accounting. Break- Even point is

a point where the cost of production and the revenue from sales are exactly

equal to each other; which means that the firm has neither made profits nor

has incurred any losses. A break-even analysis is a useful tool for

determining at what point your company, or a new product or

service, will be profitable. Put another way, it's a financial calculation used

to determine the number of products or services you need to sell to at least

cover your costs.

6.2. APPLICATION OF BREAK-EVEN ANALYSIS Break even analysis not only highlights the areas of economic strength and

weakness in the firm but also helps in finding out the ways which can

enhance its profitability. With the help of this analysis management of

production firm can take decisions related to the following:

(i) Safety margin. It decides the extent to which the firm can afford to

decline in sales, before it starts incurring losses.

(ii) Volume needed to attain target profit.

(iii) Change in price, and its affect.

(iv) Whether to expand production capacity or not.

(v) Whether to add a new product or drop production of any product.

(vi) Whether to make or buy.

(vii) Selection of production machinery to get maximum profit for a

particular volume of the product out of the available machineries.

(viii) Improving profit performance by:

a. Increasing the volume of sales, and or

b. Increasing the selling prices, and or

c. Reducing the variable expenses per unit, and or

d. Reducing the fixed costs.

6.3. LIMITATIONS OFBE ANALYSIS 1. The basic assumptions are at times baseless. For example, we can say

that the fixed costs cannot remain unchanged all the time. And the

constant selling price and unit variable cost concept are also not

acceptable. 2. It is difficult to segregate the cost components as fixed and

variable costs. 3. It is difficult to apply formulate in a company.

4. It is a short-run concept and has a limited use in long range planning. 5. It is a static tool since it gives the relationship between cost, volume

and profit at a given point of time and 6. It fails to pre duct future revenues and costs.

68

Break Even Analysis

NOTES


The following illustration will help to understand the whole principle:

Method of Preparation:

(a) Draw fixed cost of Rs. 40,000 line parallel to ‘X’ axis. Then plot the

variable cost line over fixed cost level at various level of activity and join

the variable cost line with fixed cost line at zero level of activity which will

indicate total cost line—variable cost being over fixed cost line.

At the same time, ascertain sales value at various activity level and plot

them on the graph paper and then join to zero which line indicates the

volume of sales. It is interesting to note that where the sales line intersects

the total cost line, that is known as Break-Even Point.

Needless to mention here that RES will be ascertained by dropping a

perpendicular to ‘X’ axis from the point of intersection which measures the

horizontal distance from the zero point from where the perpendicular is

drawn. Similarly, in order to find out BES value, another perpendicular to

the ‘Y’ axis from the point of intersection is drawn.

Comments:

From the above BEC, it becomes clear that profit/loss at different levels of

activity can be understood from this chart. For example, if we find the sales

line is about the total cost lines, there will be profit, and vice versa.

Similarly, if total cost is equal to total sales, there is no profit or no loss,

i.e., break-even point. In the above diagram, 50% level of activity brings

break-even level.

6.4 Advantages of Break-Even Chart:

The following advantages may be offered by a BEC: (i) Easy to Construct and Easy to Understand:

A Break-Even Chart gives us a very clear-cut information which helps the

management to take correct decisions as it depicts a detailed picture of the

entire undertaking.

http://cdn.yourarticlelibrary.com/wp-content/uploads/2015/10/clip_image00264.jpg

69

Break Even Analysis

NOTES


(ii) Useful Tool to Help Management:

We know that a BEC gives us the relationship between Cost, Volume and

Profit. Thus, the same may present the effect of changes in cost and selling

price due to the change in variable cost and fixed cost.

(iii) Helps to Select the Most Profitable Product Mix:

No doubt a BEC helps us to select the most profitable product mix or sales

mix for earning more profits.

Problem 1

Pepsi Company produces a single article. Following cost data is given

about its product: ‐ Selling price per unit Rs.40 Marginal cost per

unit Rs.24 Fixed cost per annum Rs. 16000 Calculate:(a) P/V ratio (b)

break even sales (c) sales to earn a profit of Rs. 2,000 (d) Profit at sales of

Rs. 60,000 (e) New break-even sales, if price is reduced by 10%.

Solution: We know that (S‐v) /S= F + P OR s x P/V Ratio =

Contribution

So,

(A) P/V Ratio = Contribution/sales x 100

= (40‐24)/40 x 100 = 16/40 x 100 OR 40%

(B) Break even sales S x P/V Ratio = Fixed Cost

(At breakeven sales, contribution is equal to fixed cost)

Putting this values: s x 40/100 = 16,000

S = 16,000 x 100 / 40 = 40,000 OR 1000 units

(C) The sales to earn a profit of Rs. 2,000

S x P/V Ratio = F + P

Putting this values: s x 40/100 = 16000 + 2000

S = 18,000 x 100/40 S = Rs. 45,000OR 1125 units

(D)Profit at sales of 60,000 S x P/V Ratio = F + P

Putting this values: Rs. 60,000 x 40/100 = 16000 + P

24,000 = 16000 + P

24,000 – 16,000 = P

8,000

(E) New break-even sales, if sale price is reduced by10%

New sales price = 40‐10% = 40‐4 = 36

Marginal cost = Rs. 24 Contribution = Rs. 12 P/V Ratio =

Contribution/Sales = 12/36 x100 OR 33.33%

Now, s x P/V Ratio = F (at B.E.P. contribution is equal to fixed cost) S

x 100/300 = Rs.16000

S = 16000 x 300/100

S= Rs.48,000.

A company has a machine No. 9 which can produce either product A or B.

The cost data relating to machine A and B are as follows:

Problem 2

Particulars Product A Product B

Selling price Rs. 20.00 Rs. 30.00

Variable expenses Rs. 14.00 Rs. 18.00

Contribution Rs. 6.00 Rs. 12.00


a. Capacity of machine No. 9 is 1, 000 hrs.

b. In one hrs machine No. 9 can produce 3 units of A and 1 unit of B.

Which product should machine No. 9 produced?

70

Break Even Analysis

NOTES


Solution:

Statement showing contribution per hour for machine No. 9

Particulars Product A Product B

Sales 20.00 30.00

Variable expenses 14.00 18.00

Contribution per unit 6 12

Contribution per hour 18.00 12.00

Contribution per 1, 000 units 18, 000 12, 000

From the above table we can see that company should produce product A

with the help of machine No. 9.


1. Write short on BEP analysis.

2. What are the disadvantages of BEP?


1. Break- Even point is a point where the cost of production and the

revenue from sales are exactly equal to each other, which means that the

firm has neither made profits nor has incurred any losses.

2. It is difficult to apply formulate in a company. It is a short-run

concept and has a limited use in long range planning. It is a static

tool since it gives the relationship between cost, volume and profit at

a given point of time and It fails to pre duct future revenues and

costs.


Short Questions:

1. What is break even analysis

2. What is breakeven point of sale

3. what are the advantages of BEP

4. What are the limitations of BEP

5. Draw a BEP Chart.

Long answer questions.

6. A manufacturer produces 1500 units of products annually. The marginal

cost of each product is Rs. 960 and the product is sold for Rs. 1200. Fixed

cost incurred by the company is Rs. 48, 000 annually. Calculate P/V Ratio

and what would be the break ‐ even point in terms of output and in terms

of sales value?

7. From the information given below, calculate P/V Ratio, Fixed expenses,

expected profit if sales are budgeted at Rs. 90, 000.

Year sales Profit

2004 1, 80, 000 30, 000

2005 2, 60, 000 50, 000

Further Reading:

1. Principles of financial management: Inamdar, S.M. Everest




71

Break Even Analysis

NOTES




71

Standard Costing and Budgeting

NOTES


UNIT - VII STANDARD COSTING AND

BUDGETING Structure

7.1 Definition

7.2 Concept and Importance Standard Costing

7.1 Definition

STANDARD: According to Prof. Erie L.Kolder, “Standard is a desired

attainable objective, a performance, a foal, a model”.

STANDARD COST: Standard cost is a predetermined estimate of cost to

manufacture a single unit or a number of units during a future period. The

Chartered Institute of Management Accountants, London, defines Standard

Cost as, “a pre-determined cost which is calculated from managements

standards of efficient operation and the relevant necessary expenditure. It

may be used as a basis for price fixing and for cost control through

variance analysis”.

STANDARD COSTING: It is defined by I.C.M.A. Terminology as,

“The preparation and use of standard costs, their comparison with actual

costs and the analysis of variances to their causes and points of incidence”.

According to the Chartered Institute of Management Accountants, London

Standard Costing is “the preparation and use of Standard Cost, their

comparison with actual costs, and the analysis of variances to their causes

and points of incidence”.

The study of standard cost comprises of:

1. Ascertainment and use of standard costs.

2. Comparison of actual costs with standard costs and measuring the

variances.

3. Controlling costs by the variance analysis.

4.Reporting to management for taking proper action to maximize the

efficiency.

7.2 Concept and Importance Standard Costing: 7.2.1 Variance Analysis:

Computation of variances

The causes of variance are necessary to find remedial measures;

and therefore, a detailed study of variance analysis is essential. Variances

can be found out with respect to all the elements of cost, i.e., direct

material, direct labour and overheads. The following are the common

variances, which are calculated by the management. Sub-divisions of

variances really give detailed information to the management in order to

control the cost.

1. Material variances

2. Labour variances

3. Overhead variances (a) variable (b) fixed

7.2.2 Material Variance

The following are the variances in the case of materials

72


NOTES


a) Material Cost Variance (MCV). It is the difference between the

standard cost of direct materials specified for the output achieved and the

actual cost of direct materials used. The standard cost of materials is

computed by multiplying the standard price with the standard quantity for

actual output; and the actual cost is computed by multiplying the actual

price with the actual quantity. The formula is:

Material Cost Variance (or) MCV:

(Standard cost of materials - Actual cost of materials used) (or)

(Standard Quantity for actual output x Standard Price) - (Actual Quantity x

Actual Rate) (or) (SO x SP) - (AQ x AP)

b) Material Price Variance (MPV). Material price variance is that portion

of the direct materials cost variance which is the difference between the

standard price specified and the actual price paid for the direct materials

used. The formula is:

Material Price Variance:

(Actual Quantity consumed x Standard Price) – (Actual Quantity

consumed x Actual Price) (or) Actual Quantity consumed (Standard Price -

Actual Price) (or) MPV= AQ (SP-AP)

c) Material Usage (Quantity) Variance (MUV). It is the deviation caused

by the standards due to the difference in quantity used. It is calculated by

multiplying the difference between the standard quantity specified and the

actual quantity used by the standard price. Thus, material usage variance is

“that portion of the direct materials cost variance which is the difference

between the standard quantity specified for the production achieved,

whether completed or not, and the actual quantity used, both valued at

standard prices”.

Material Usage or Quantity Variance:

Standard Rate (Standard Quantity Actual Quantity) (or) MUV = SR (SQ-

AQ)

d) Material Mix Variance (MMV). When two or more materials are used

in the manufacture of a product, the difference between the standard

composition and the actual composition of material mix is the material mix

variance. The variance arises due to the change in the ratio of material and

the standard ratio. The formula is:

Material Mix Variance = Standard Rate (Standard Mix – Actual Mix)

Standard is revised due to the shortage of a particular type of material. The

formula is:

MMV = Standard Rate (Revised Standard Quantity - Actual Quantity)

Revised Standard Quantity (RSQ) =

Total weight of actual mix

------------------------------------- x Standard Quantity

Total weight of standard mix

After finding out this revised standard mix it is multiplied by the revised

standard cost of standard mix and then the standard cost of actual mix is

subtracted form the result.

73


NOTES


Example:1

The standard cost of material for manufacturing a unit a particular product

is estimated as 16kg of raw materials @ Re. 1 per kg. On completion of the

unit, it was found that 20kg. of raw material costing Rs. 1.50 per kg. has

been consumed. Compute Material Variances.

Answer:

MCV = (SQ x SP) - (AQ x AP) = (16 x Rs.1) - (20 x Rs.1.50)

#NAME?

= Rs. 14 (Adverse) MPV = (SP – AP) x AQ = (1 – 1.50) x 20

= Rs. 10 (Adverse) MUV = (SQ – AQ) x SP = (16 – 20) x 1=

Rs. 4 (Adverse)

Example:2

Calculate the materials mix variance from the following:

Material Standard Actual

A 90 units at rs12 each 100 units at rs. 12 each

B 60 units at rs.15 each 50 units at rs. 16 each

Answer:


Qty Rate Amount Qty Rate Amount

A 90 12 1080 100 12 1200

B 60 15 900 50 16 800

150 1980 150 2000

MMV = SR (SQ-AQ)

Material A: MMV = Rs.12 (90-100)

= Rs 12 x10

= Rs. 120(A)

Material „B‟: MMV = Rs. 15 (60-50)

= Rs. 15 x 10

= Rs 150 (F) Total MMV = Rs. 120(A) + Rs. 150 (F)= Rs. 30 (F)

(e) Material Yield Variance: It is that portion of the direct material usage

variance which is due to the difference between the standard yield

specified and the actual yield obtained. The variance arises due to

abnormal contingencies like spoilage, chemical reaction etc. Since the

variance is a measure of the waste or loss in the production, it known as

material loss or waste variance.

ICMA, LONDON, it is defined as “The difference between the

standard yield of the actual material input and the actual yield, both

valued at the standard material cost of the produce”. in case actual yield

is more than the standard yield, the material yield variance is favourable

and, if the actual yield is less than the standard yield, the variance is

unfavourable or adverse.

(i) When actual mix and standard mix are the same, the formula is: MYV =

Standard Yield Rate (Standard Yield - Actual Yield)

(or) = Standard Revised Rate (Actual Loss - Standard Loss)

Here Standard Yield Rate =

74


NOTES


Standard cost of standard mix

---------------------------------------

Net standard output

Net standard output = Gross output – Standard loss

(ii) When the actual mix and the standard mix differ from each other, the

formula is:

Standard Rate = Standard cost of revised standard mix

----------------------------------------------------

Net Standard Output

Material Yield Variance=

Standard Rate (Actual Standard Yield – Revised Standard Yield)

7.2.3 Labour Variances

Labour Variances arise because of (I) Difference in Actual Rates and

Standard Rates of Labour and (Ii) The variation in Actual Time taken y

workers and the Standard Time allotted to them for performing a job.

These are computed on the same pattern as that of Material Variances.

For Labour Variances by simply putting the word “Time” in place of

“Quantity” in the formula meant for Material Variances. The various

Labour Variances can be analysed as follows:

(A) Labour Cost Variance

(B) Labour Rate Variance

(C) Labour Time or Efficiency Variance

(D) Labour Idle Time Variance

(E) Labour Mix Variance or Gang Composition Variance

a) Labour Cost Variance (LCV)

This variance represents the difference between the Standard Labour Costs

and the Actual Labour Costs for the production achieved. If the Standard

Cost is higher, the variation is favourable and vice versa. It is calculated as

follows:

Labour Cost Variance: = (Standard Cost of Labour - Actual Cost of

Labour)

#NAME?

#NAME?

b) Labour Rate Variance (LRV)

It is the difference between the Standard Rate of pay specified and the

Actual Rate Paid. According to ICMA, London, the variance is “the

difference between the standard and the actual direct Labour Rate per hour

for the total hours worked. If the standard rate is higher, the variance is

Favourable and vice versa.

Labour Rate Variance = Actual Time (Standard Wage Rate X Actual Wage

Rate)

=AT (SR-AR)

75


NOTES


C) Labour Time or Labour Efficiency Variance (LEV)

It is the difference between the Standard Hours for the actual production

achieved and the hours actually worked, valued at the Standard Labour

Rate. When the workers finish the specific job in less than the Standard

Time, the variance is Favourable. If the workers take more time than the

allotted time, the variance is Adverse.

Labour Efficiency Variance (LEV):

=Standard Rate (Standard Time - Actual Time)

=SR (ST-AT)

d) Idle Time Variance: It arises because of the time during which the

Labour remains idle due to abnormal reasons, i.e. power failure, strikes,

machine breakdown, shortage of materials, etc. It is always an Adverse

variance

Labour Idle Time Variance = Actual Idle Time x Standard Hourly Rate

e) Labour Mix Variance or Gang Composition Variance (LMV):

It is the difference between the standard composition of workers and the

actual gang of workers. It is a part of labour efficiency variance. It

corresponds to material mix variance. It enables the management to study

the labour cost variance occurred because of the changes in the

composition of labour force.

The rates of pay of the different categories of workers-skilled, semi-skilled

and unskilled are different. Hence, any change made in composition of the

workers will naturally cause variance. How much is variance due to the

change, is indicated by Labour Mix Variance.

(i) When the total hours i.e. time of the standard composition and actual

composition of workers does not differ, the formula is:

Labour Mix variance= (Standard Cost of Standard Mix) - (Standard cost of

Actual Mix)

(ii) When the total hours i.e. time of the standard composition and actual

composition of workers differs, the formula is:

Labour Mix variance

Total Time of Actual mix ------------x Std cost of Std. mix) - (Std. cost of

Actual Mix) Total Time of Standard mix

If, on account of short availability of some category of workers, the

standard composition is itself revised, then Labour Mix Variance will be

calculated by taking revised standard mix in place of standard mix.

Labour Yield Variance (LYV)

It is just like Material Yield Variance. It is the difference between the

standard labour output and actual output of yield. It is calculated as below:

Labour Yield Variance

= Standard cost per unit {Standard production of Actual mix - Actual

Production}

7.2.4OVERHEAD VARIANCE

It is the difference between standard overheads for actual output i.e.

Recovered Overheads and Actual Overheads. It is the total of both fixed

and variable overhead variances. The variable overheads are those costs

76


NOTES


which tend to vary directly in proportion to changes in the volume of

production. Fixed overheads consist of costs which are not subject to

change with the change in the volume of production. The variances under

overheads are analysed in two heads, viz Variable Overheads and Fixed

Overheads:

Overheads Cost Variance= Standard Total Overheads-Actual Total

Overheads

The term overhead includes indirect material, indirect labour and indirect

expenses and the variances relate to factory, office or selling and

distribution overheads. Overhead variances are divided into two broad

categories: (i) Variable overhead variances and (ii) Fixed overhead

variances. To compute overhead variances, the following terms must be

understood:

a) Standard overhead rate per unit

Budgeted overheads

#NAME?

Budgeted output

b) Standard overheads rate per hour

Budgeted overheads

#NAME?

Budgeted hours

c) Standard hours for actual output

Budgeted hours

……………………. x Actual output

Budgeted output

d) Standard output for actual time

Budgeted output

……………………. x Actual hours

Budgeted hours

e) Recovered or Absorbed overheads = Standard rate per unit x Actual

output f) Budgeted overheads = Standard rate per unit x budgeted output

g) Standard overheads = Standard rate per unit x Standard output for

actual time

h) Actual overheads = Actual rate per unit x Actual output

7.2.5 VARIABLE OVERHEAD VARIANCE

Variable cost varies in proportion to the level of output, while the cost is

fixed per unit. As such the standard cost per unit of these overheads

remains the same irrespective of the level of output attained. As the volume

does not affect the variable cost per unit or per hour, the only factors

leading to difference is price. It results due to the change in the expenditure

incurred.

(i) Variable Overhead Expenditure Variance: It is the difference

between actual variable overhead expenditure incurred and the standard

variable overheads set in for a particular period. The formula is: -

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NOTES


{Actual Hours Worked X Standard Variable Overhead Rate per hour}-

Actual

(ii) Variable Overhead Efficiency Variance:

It shows the effect of change in labour efficiency on variable overheads

recovery. The formula is: - Standard Rate (Standard Quantity-

Actual Quantity)

Standard Overhead Rate= (Standard Time for Actual output- Actual Time)

(iii) Variable Overhead Variance

It is divided into two: Overhead Expenditure Variance and Overhead

Efficiency variance.

The formula is: -

Variable overhead Expenditure Variance + Variable overhead Efficiency

variance

7.2.6 FIXED OVERHEAD VARIANCE (FOV):

Fixed overhead variance depends on (a) fixed expenses incurred and (b)

the volume of production obtained. The volume of production depends

upon (i) efficiency (ii) the days for which the factory runs in a week

(calendar variance) (iii) capacity of plant for production.

FOV = Actual Output (Fixed Overhead Rate - Actual Fixed Overheads)

(a) Fixed Overhead Expenditure Variance. (Budgeted or cost Variance).

It is that portion of the fixed overhead which is incurred during a particular

period due to the difference between the budgeted fixed overheads and the

actual fixed overheads.

Fixed Overhead expenditure variance=Budgeted fixed overhead-Actual

fixed overhead

(b) Fixed Overhead Volume Variance. This variance is the difference

between the standard cost of overhead absorbed in actual output and the

standard allowance for that output. This variance measures the cover of

under recovery of fixed overheads due to deviation of actual output form

the budgeted output level.

(i) On the basis of units of output:

Fixed Overhead Volume Variance = Standard Rate (Budgeted Output-

Actual Output) OR

= (Budgeted Cost –Standard Cost) OR

= (Actual Output x Standard Rate)- Budgeted Fixed Overhead

(ii)On the basis of standard hours: Fixed Overhead Volume Variance =

Standard Rate per hour (Budgeted Hours-Standard Hours) Standard Hour =

Actual Output + Standard Output per hour

Example: 1

A manufacturing concern furnished the following information:

Standard: Material for 70kg, finished products:100kg; Price of materials:

Re.1 per kg

Actual: Output: 2,10,000 kg; Material used: 2,80,000; cost of material:

Rs.5,52,000.

Calculate: -

78


NOTES


(a) Material Usage Variance (b) Material Price Variance (c) Material Cost

Variance

Solution:

Standard quantity:

For 70kg standard output

Standard quantity of material = 100 kg

210000 kg of finished products

= 210000 x 100

70 = 300000 kg

Actual Price per kg

= 252000

280000 = 0.90

A) Material usage or quantity variance

= SP (SQ – AQ)

1 (300000 – 280000)

1 X 20000

Rs. 20000 (Favourable)

B) Material price variance

= AQ (SP – AP)

280000 (1 – 0.90)

280000 X 0.10

Rs. 28000 (Favourable)

C) Material cost variance

= (SQ x SP) – (AQ x AP)

(300000 x 1) – (280000 x 0.90)

(300000) – (252000)

Rs 48000 (Favourable)

Exercise: 1

With the help of following information calculate:

a) Labour Cost variance

b) Labour rate variance

c) Labour Efficiency variance

Standard hours: 40 at Rs. 3 per hour.

Actual hours 50 at Rs. 4 per hour.

Exercise: 2

Vivek Ltd has furnished you the following for the month of Aug. 1994

Particulars Budget Actual

Output

Units (hour)

Fixed hours

Variable OH

Working days

30000

30000

Rs. 45000

Rs. 60000

25

32500

33000

Rs. 50000

Rs. 68000

26

Calculate the variances

79


NOTES



1. Define Standard cost.

2. What is labour rate variance?


1. “a pre-determined cost which is calculated from managements standards

of efficient operation and the relevant necessary expenditure. It may be

used as a basis for price fixing and for cost control through variance

analysis”.

2. “the difference between the standard and the actual direct Labour Rate

per hour for the total hours worked. If the standard rate is higher, the

variance is Favourable and vice versa.

Labour Rate Variance = Actual Time (Standard Wage Rate x Actual Wage

Rate)

=AT (SR-AR)


Short Questions:

1. What is standard costing

2. What is material cost variance?

3. What is fixed cost variance?


4. From the following information calculate:

a) Labour Cost variance

b) Labour rate variance

c) Labour Efficiency variance

Standard hours: 40 at Rs. 3 per hour.

Actual hours 50 at Rs. 4 per hour.

Further Reading:

1. Financial management: Panday, I.M. 9th ed Vikas




4. Financial Management: Text & Problems, Khan, M. Y Jain, P.K.

3rd ed, TMH




80

Budgets and Budgetary Control

NOTES


UNIT - VIII BUDGETS AND

BUDGETARY CONTROL Structure

8.1 Introduction 8.2 Definition of Budget

8.3 Types of Budgeting

8.1 Introduction

To achieve the organizational objectives, an enterprise should be managed

effectively and efficiently. It is facilitated by chalking out the course of

action in advance. Planning, the primary function of management helps to

chalk out the course of actions in advance. But planning is to be followed

by continuous comparison of the actual performance with the planned

performance, i.e., controlling. One systematic approach in effective

follow up process is budgeting. Different budgets are prepared by the

enterprise for different purposes. Thus, budgeting is an integral part of

management.

8.2 Definition of Budget: “A budget is a comprehensive and coordinated plan, expressed in financial

terms, for the operations and resources of an enterprise for some specific

period in the future”. (Fremgen, James M – Accounting for Managerial

Analysis)

“A budget is a predetermined detailed plan of action developed and

distributed as a guide to current operations and as a partial basis for the

subsequent evaluation of performance”. (Gordon and Shillinglaw)

“A budget is a financial and/or quantitative statement, prepared prior to a

defined period of time, of the policy to be pursued during the period for the

purpose of attaining a given objective”. (The Chartered Institute of

Management Accountants, London)

Definition of Budgetary Control:

CIMA, London defines budgetary control as, “the establishment of the

budgets relating to the responsibility of executives to the requirements of a

policy and the continuous comparison of actual with budgeted result either

to secure by individual action the objectives of that policy or to provide a

firm basis for its revision”

“Budgetary Control is a planning in advance of the various functions of a

business so that the business as a whole is controlled”. (Wheldon)

“Budgetary Control is a system of controlling costs which includes the

preparation of budgets, coordinating the department and establishing

responsibilities, comprising actual performance with the budgeted and

acting upon results to achieve maximum profitability”. (Brown and

Howard)

Budget, Budgeting and Budgetary Control:

A budget is a blueprint of a plan expressed in quantitative terms. Budgeting

is a technique for formulating budgets. Budgetary Control refers to the

81


NOTES


principles, procedures and practices of achieving given objectives through

budgets.

According to Rowland and William, “Budgets are the individual objectives

of a department, whereas Budgeting may be the act of building budgets.

Budgetary control embraces all and in addition includes the science of

planning the budgets to effect an overall management tool for the business

planning and control”.

8.3 Types of Budgeting: Budget can be classified into three categories from different points of view.

They are:

1. According to Function

2. According to Flexibility

3. According to Time

I. According to Function:

(a) Sales Budget:

The budget which estimates total sales in terms of items, quantity, value,

periods, areas, etc is called Sales Budget.

(b) Production Budget:

It estimates quantity of production in terms of items, periods, areas, etc. It

is prepared based on Sales Budget.

(c) Cost of Production Budget:

This budget forecasts the cost of production. Separate budgets may also be

prepared for each element of costs such as direct materials budgets, direct

labour budget, factory materials budgets, office overheads budget, selling

and distribution overheads budget, etc.

(d) Purchase Budget:

This budget forecasts the quantity and value of purchase required for

production. It gives quantity wise, money wise and period wise about the

materials to be purchased.

(e) Personnel Budget:

The budget that anticipates the quantity of personnel required during a

period for production activity is known as Personnel Budget.

(f) Research Budget:

The budget relates to the research work to be done for improvement in

quality of the products or research for new products.

(g) Capital Expenditure Budget:

The budget provides a guidance regarding the amount of capital that may

be required for procurement of capital assets during the budget period.

(h) Cash Budget:

This budget is a forecast of the cash position by time period for a specific

duration of time. It states the estimated amount of cash receipts and

estimation of cash payments and the likely balance of cash in hand at the

end of different periods.

(i) Master Budget:

82


NOTES


It is a summary budget incorporating all functional budgets in a capsule

form. It interprets different functional budgets and covers within

its range the preparation of projected income statement and projected

balance sheet.

II. According to Flexibility:

On the basis of flexibility, budgets can be divided into two categories.

They are:

1. Fixed Budget

2. Flexible Budget

1. Fixed Budget:

Fixed Budget is one which is prepared on the basis of a standard or a fixed

level of activity. It does not change with the change in the level of activity.

2. Flexible Budget:

A budget prepared to give the budgeted cost of any level of activity is

termed as a flexible budget. According to CIMA, London, a Flexible

Budget is, “a budget designed to change in accordance with level of

activity attained”. It is prepared by taking into account the fixed and

variable elements of cost.

III. According to Time:

On the basis of time, the budget can be classified as follows:

1. Long term budget

2. Short term budget

3. Current budget

4. Rolling budget

1. Long-term Budget:

A budget prepared for considerably long period of time, viz., 5 to 10 years

is called Long-term Budget. It is concerned with the planning of operations

of the firm. It is generally prepared in terms of physical quantities.

2. Short-term Budget:

A budget prepared generally for a period not exceeding 5 years is called

Short - term Budget. It is generally prepared in terms of physical quantities

and in monetary units.

3. Current Budget:

It is a budget for a very short period, say, a month or a quarter. It is

adjusted to current conditions. Therefore, it is called current budget.

4. Rolling Budget:

It is also known as Progressive Budget. Under this method, a budget for a

year in advance is prepared. A new budget is prepared after the end of each

month/quarter for a full year ahead. The figures for the month/quarter

which has rolled down are dropped and the figures for the next

month/quarter are added. This practice continues whenever a

month/quarter ends and a new month/quarter begins.

I. SALES BUDGET:

Sales budget is the basis for the preparation of other budgets. It is the

forecast of sales to be achieved in a budget period. The sales manager is

83


NOTES


directly responsible for the preparation of this budget. The following

factors taken into consideration:

a. Past sales figures and trend b. Salesmen’s estimates

c. Plant capacity

d. General trade position e. Orders in hand

f. Proposed expansion g. Seasonal fluctuations h. Market demand

i. Availability of raw materials and other supplies j. Financial position

k. Nature of competition l. Cost of distribution

m. Government controls and regulations n. Political situation.

Example

1. The Royal Industries has prepared its annual sales forecast,

expecting to achieve sales of Rs.30,00,000 next year. The

Controller is uncertain about the pattern of sales to be expected by

month and asks you to prepare a monthly budget of sales. The

following sales data pertained to the year, which is considered

to be representative of a normal year:

Month Sales (Rs.) Month Sales (Rs.)

January 1,10,000 July 2,60,000

February 1,15,000 August 3,30,000

March 1,00,000 September 3,40,000

April 1,40,000 October 3,50,000

May 1,80,000 November 2,00,000

June 2,25,000 December 1,50,000

Prepare a monthly sales budget for the coming year based on the above

data.

Answer: Sales Budget

Month Sales

(given)

Sales estimation based on cash sales ratio

given

January 1,10,000 (1,10,000/25,00,000) x 30,00,000 = 1,32,000

February 1,15,000 (1,15,000/25,00,000) x 30,00,000 = 1,38,000

March 1,00,000 (1,00,000/25,00,000) x 30,00,000 = 1,20,000

April 1,40,000 (1,40,000/25,00,000) x 30,00,000 = 1,68,000

May 1,80,000 (1,80,000/25,00,000) x 30,00,000 = 2,16,000

June 2,25,000 (2,25,000/25,00,000) x 30,00,000 = 2,70,000

July 2,60,000 (2,60,000/25,00,000) x 30,00,000 = 3,12,000

August 3,30,000 (3,30,000/25,00,000) x 30,00,000 = 3,96,000

September 3,40,000 (3,40,000/25,00,000) x 30,00,000 = 4,08,000

84


NOTES


October 3,50,000 (3,50,000/25,00,000) x 30,00,000 = 4,20,000

November 2,00,000 (2,00,000/25,00,000) x 30,00,000 = 2,40,000

December 1,50,000 (1,50,000/25,00,000) x 30,00,000 = 1,80,000

Total 25,00,000 30,00,000

Example:

2. M/s. Alpha Manufacturing Company produces two types of products,

viz., Raja and Rani and sells them in Chennai and Mumbai markets. The

following information is made available for the current year:

Market Product Budgeted Sales Actual Sales

Chennai Raja 400 units @ Rs.9 each 500 units @ Rs.9 each

,, Rani 300 units @ Rs.21 each 200 units @ Rs.21 each

Mumbai Raja 600 units @ Rs.9 each 700 units @ Rs.9 each

Rani 500 units @ Rs.21 each 400 units @ Rs.21 each

Market studies reveal that Raja is popular as it is under-priced. It is

observed that if its price is increased by Re.1 it will find a readymade

market. On the other hand, Rani is overpriced, and market could absorb

more sales if its price is reduced to Rs.20. The management has agreed to

give effect to the above price changes.

On the above basis, the following estimates have been prepared by Sales

Manager:

% increase in sales over current budget

Product

Chennai Mumbai

Raja 10% 5%

Rani 20% 10%

With the help of an intensive advertisement campaign, the following

additional sales above the estimated sales of sales manager are possible:

Product Chennai Mumbai

Raja 60 units 70 units

Rani 40 units 50 units

You are required to prepare a budget for sales incorporating the above

estimates.

Answer:

Sales Budget

85


NOTES


Workings:

1. Budgeted sales for Chennai:

Raja Rani

Units Units

Budgeted Sales 400 300

Add: Increase (10%) 40 (20%) 60

440 360

Increase due to advertisement 60 40

Total 500 400

2. Budgeted sales for Mumbai:

Raja Rani

Units Units

Budgeted Sales 600 500

Add: Increase (5%) 30 (10%) 50

630 550

Increase due to advertisement 70 50

Total 700 600

II. PRODUCTION BUDGET:

Production = Sales + Closing Stock – Opening Stock

Example:

3. The sales of a concern for the next year is estimated at 50,000 units.

Each unit of the product requires 2 units of Material „A‟ and 3 units of

Material „B‟. The estimated opening balances at the commencement of the

next year are:

Finished Product : 10,000 units

Raw Material “A” : 12,000 units

Raw Material “B” : 15,000 units

The desirable closing balances at the end of the next year are:

Finished Product : 14,000 units

Raw Material “A” : 13,000 units

Raw Material “B” : 16,000 units

Prepare the materials purchase budget for the next year.

Answer:

86


NOTES


Production Budget

Estimated Sales 50,000 units

14,000 ,, Add: Estimated Closing Finished Goods

64,000 ,,

10,000 ,,

Less: Estimated Opening Finished Goods

Production 54,000 ,,

Materials Purchase Budget

Material A Material B

Material Consumption 1,08,000 units 1,62,000 units

Add: Closing stock of materials 13,000 16,000

1,21,000 1,78,000

Less: Opening stock of materials 12,000 15,000

Materials to be purchased 1,09,000 1,63,000

Workings:

Materials consumption: Material A Material B

Material required per unit of production 2 units 3 units

For production of 54,000 units 1,08,000 1,62,000


1. Define budget.

2. What is sales budget?


1“A budget is a predetermined detailed plan of action developed and

distributed as a guide to current operations and as a partial basis for the

subsequent evaluation of performance”.

2. Sales budget is the basis for the preparation of other budgets. It is the

forecast of sales to be achieved in a budget period. The sales manager is

directly responsible for the preparation of this budget.


Short Questions:

1. What is cash budget?

2. What is zero budget?

3. What is flexible budget?

4. What is fixed budget?

5. What is master budget?

Long Questions:

1. What are the points to be considered while preparing material

purchase budget?

2. How do you prepare production budget?

Further Reading:





3rd ed, TMH




87

Budgets

NOTES


UNIT - IX BUDGETS Structure

9.1 Cash Budget

9.2. Procedure for Preparation of Cash Budget

9.3 Master Budget

9.4 Flexible Budget

9.5 Zero Base Budgeting (ZBB)

9.1 CASH BUDGET It is an estimate of cash receipts and disbursements during a future period.

“The Cash Budget is an analysis of flow of cash in a business over a future,

short or long period of time. It is a forecast of expected cash intake and

outlay” (Soleman, Ezra – Handbook of Business administration).

9.2. PROCEDURE FOR PREPARATION OF CASH

BUDGET

1. First take into account the opening cash balance, if any, for the

beginning of the period for which the cash budget is to be prepared.

2. Then Cash receipts from various sources are estimated. It may be from

cash sales, cash collections from debtors/bills receivables, dividends,

interest on investments, sale of assets, etc.

3. The Cash payments for various disbursements are also estimated. It

may be for cash purchases, payment to creditors/bills payables, payment to

revenue and capital expenditure, creditors for expenses, etc.

4. The estimated cash receipts are added to the opening cash balance, if

any.

5. The estimated cash payments are deducted from the above proceeds.

6. The balance, if any, is the closing cash balance of the month concerned.

7. The closing cash balance is taken as the opening cash balance of the

following month.

8. Then the process is repeatedly performed.

9. If the closing balance of any month is negative i.e the estimated cash

payments exceed estimated cash receipts, then overdraft facility may also

be arranged suitably.

Example:

1. From the following budgeted figures prepare a Cash Budget in respect of

three months to June 30, 2006.

Month Sales

Rs.

Materials

Rs.

Wages

Rs.

Overheads

Rs.

January 60,000 40,000 11,000 6,200

February 56,000 48,000 11,600 6,600

March 64,000 50,000 12,000 6,800

April 80,000 56,000 12,400 7,200

May 84,000 62,000 13,000 8,600

June 76,000 50,000 14,000 8,000

Additional information:

1. Expected Cash balance on 1st April 2006 – Rs. 20,000

2. Materials and overheads are to be paid during the month following the

month of supply.

3. Wages are to be paid during the month in which they are incurred.

88

Budgets

NOTES


4. All sales are on credit basis.

5. The terms of credits are payment by the end of the month following the

month of sales: Half of credit sales are paid when due the other half to be

paid within the month following actual sales.

6. 5% sales commission is to be paid within in the month following sales

7. Preference Dividends for Rs. 30,000 is to be paid on 1st May.

8. Share call money of Rs. 25,000 is due on 1st April and 1st June.

9. Plant and machinery worth Rs. 10,000 is to be installed in the month of

January and the payment are to be made in the month of June.

Answer:

Cash Budget for three months from April to June 2006

Particulars April May June

Rs. Rs. Rs.

Opening Cash Balance 20,000 32,000 (-) 5,600

Add: Estimated Cash Receipts:

Sales Collection form debtors 60,000 72,000 82,000

Share call money 25,000 25,000

1,05,000 1,04,600 1,01,400

Less: Estimated Cash Payments:

Materials 50,000 56,000 62,000

Wages 12,400 13,000 14,000

Overheads 6,800 7,200 8,600

Sales Commission 3,200 4,000 42,000

Preference Dividend Nil 30,000 Nil

Plant and Machinery Nil Nil 10,000

72,400 1,10,200 98,800

Closing Cash Balance 32,600 (-)5,600 2,600

Workings:

1. Sales Collection:

Payment is due at the month following the sales. Half is paid on due and

another half is paid during the next month. Therefore, February sales Rs.

50,000 is due at the end of March. Half is given at the end of March and

another half is given in the next month i.e., in the month of April. Hence,

the sales collection for the month of April will be as follows:

For April – Half of February Sales (56,000 x ½) = 28,000

- Half of March Sales (64,000 x ½) = 32,000

Total Collection for April = 60,000

Similarly, the sales collection for the months of May and June may be

calculated.

2. Materials and overheads:

These are paid in the following month. That is March is paid in April, April

is paid in May and May is paid in June.

3. Sales Commission:

It is paid in the following month. Therefore,

For April – 5% of March Sales (64,000 x 5 /100) = 3,200

89

Budgets

NOTES


For May – 5% of March Sales (80,000 x 5 /100) = 4,000

For April – 5% of March Sales (84,000 x 5 /100) = 4,200

9.3 MASTER BUDGET

Master budget is a comprehensive plan which is prepared from and

summarizes the functional budgets. The master budget embraces both

operating decisions and financial decisions. When all budgets are ready,

they can finally produce budgeted profit and loss account or income

statement and budgeted balance sheet. Such results can be projected

monthly, quarterly, half-yearly and at year end. When the budgeted profit

falls short of target it may be reviewed and all budgets may be reworked to

reach the target or to achieve a revised target approved by the budget

committee.

9.4 FLEXIBLE BUDGET

A flexible budget consists of a series of budgets for different level of

activity. Therefore, it varies with the level of activity attained. According

to CIMA, London, A Flexible Budget is, „a budget designed to change in

accordance with level of activity attained‟. It is prepared by taking into

account the fixed and variable elements of cost. This budget is more

suitable when the forecasting of demand is uncertain.

Points to be remembered while preparing a flexible budget:

1. Cost can be classified into fixed and variable cost.

2. Total fixed cost remains constant at any level of activity.

3. Total Variable cost varies in the same proportion at which the level of

activity varies.

4. Fixed and variable portion of Semi-variable cost is to be segregated.

5. The following information at 50% capacity is given. Prepare a flexible

budget and forecast the profit or loss at 60%, 70% and 90% capacity.

Example

Fixed expenses: Expenses at 50% capacity (Rs.)

Salaries 5,000

Rent and taxes 4,000

Depreciation 6,000

Administrative expenses 7,000

Variable expenses:

Materials 20,000

Labour 25,000

Others 4,000

Semi-variable expenses:

Repairs 10,000

Indirect Labour 15,000

Others 9,000

It is estimated that fixed expenses will remain constant at all capacities.

Semi- variable expenses will not change between 45% and 60% capacity,

will rise by10% between 60% and 75% capacity, a further increase of 5%

when capacity crosses 75%.

90

Budgets

NOTES


Estimated sales at various levels of capacity are:

Capacity Sales (Rs.)

60% 1,10,000

70% 1,30,000

90% 1,50,000

Answer: FLEXIBLE BUDGET (Showing Profit & Loss at various

capacities)

Capacities

Particulars 50% 60% 70% 90%

Rs. Rs. Rs. Rs.

Fixed Expenses:

Salaries 5,000 5,000 5,000 5,000

Rent and taxes 4,000 4,000 4,000 4,000

Depreciation 6,000 6,000 6,000 6,000

Administrative expenses 7,000 7,000 7,000 7,000

Variable expenses:

Materials 20,000 24,000 28,000 36,000

Labour 25,000 30,000 35,000 45,000

Others 4,000 4,800 5,600 7,200

Semi – Variable expenses:

Repairs 10,000 10,000 11,000 11,500

Indirect labour 15,000 15,000 16,500 17,250

Other 9,000 9,000 9,900 10,350

Total cost 1,05,000 1,14,800 1,28,000 1,49,300

Profit (+) or loss (-) (-) 4,800 (+)2,000 (+)700

Estimated sales 1,10,000 1,30,000 1,50,000

Example 2:

The following information relates to a flexible budget at 60% capacity.

Find out the overhead costs at 50% and 70% capacity and also determine

the overhead rates:

Particulars Expenses at 60% capacity

Variable overheads: Rs.


Indirect Materials 8,400

Semi-variable overheads:

Repair and Maintenance 7,000

(70% fixed; 30% variable)

Electricity 25,200


Fixed overheads:

91

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Office expenses including salaries 70,000

Insurance 4,000

Depreciation 20,000

Estimated direct labour hours 1,20,000 hours

Answer: FLEXIBLE BUDGET

50 %

Capacity

60%

Capacity

70%

Capacity

Rs. Rs. Rs.

Variable overheads:

Indirect Labour 8,750 10,500 12,250

Indirect Materials 7,000 8,400


Repair and Maintenance

(1)

6,650 7,000

Electricity

(2)

23,100 25,200

Fixed overheads:

Office expenses including

salaries

70,000 70,000 70,000

Insurance 4,000 4,000 4,000

Depreciation 20,000 20,000 20,000

Total overheads 1,39,500 1,45,100 1,50,700

Estimated direct labour hours 1,00,000 1,20,000 1,50,000

Overhead rate per hour (Rs.) 1.395 1.21 1.077

Workings:

1. The number of Repairs and maintenance at 60% Capacity is Rs.

7,000. Out of this, 70% (i.e Rs. 4,900) is fixed and remaining 30% (i.e Rs.

2,100) is variable. The fixed portion remains constant at all levels of

capacities. Only the variable portion will change according to change in the

level of activity. Therefore, the total amount of repairs and maintenance for

50% and 70% capacities are calculated as follows:

Repairs and maintenance 50% 60% 70%

Fixed (70%) 4,900 4,900 4,900

Variable (30%) 1,750 2,100 2,450

Total 6,650 7,000 7,350

9.5 ZERO BASE BUDGETING (ZBB)

It is a management technique aimed at cost reduction. It was introduced by

the U. S. Department of Agriculture in 1961. Peter A. Phyrr popularized it.

In 1979, president Jimmy Carter issued a mandate asking for the use of

ZBB by the Government.

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9.5.1 ZBB - Definition:

“It is a planning and budgeting process which requires each manager to

justify his entire budget request in detail from scratch (Zero Base) and

shifts the burden of proof to each manager to justify why he should spend

money at all. The approach requires that all activities be analysed in

decision packages, which are evaluated by systematic analysis and ranked

in the order of importance”. – Peter A. Phyrr.

It implies that-

Every budget starts with a zero base

No previous figure is to be taken as a base for adjustments

Every activity is to be carefully examined afresh

Each budget allocation is to be justified on the basis of anticipated

circumstances

Alternatives are to be given due consideration

9.5.2 Advantages of ZBB:

1. Effective cost control can be achieved

2. Facilitates careful planning

3. Management by Objectives becomes a reality

4. Identifies uneconomical activities

5. Controls inefficiencies

6. Scarce resources are used beneficially

7. Examines each activity thoroughly

8. Controls wasteful expenditure

9. Integrates the management functions of planning and control

10. Reviews activities before allowing funds for them.


1. What is zero base budgeting?

2. Define flexible budget.

3. Prepare a Cost Sheet from the following information


Wages – Rs. 20,000




1. It is a management technique aimed at cost reduction. It was

introduced by the U. S. Department of Agriculture in 1961

2. A Flexible Budget is, „a budget designed to change in accordance

with level of activity attained‟.


Short Questions:

1. What cash budget?

2. What are the importance of preparing cash budget?

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3. What is master budget?

4. What is flexible budget?

Long Answer Questions:

1. What are the points to be considered while preparing cash budget?

2. What are the advantages and disadvantages of cash budget?

3. Why do you prepare flexible budget?

4. State the merits and demerits of zero-base budgeting.

5. From the following budgeted figures prepare a Cash Budget in

respect of three months to June 30, 2006.

Month Sales

Rs.

Materials

Rs.

Wages

Rs.

Overheads

Rs.

January 70,000 50,000 11,000 6,200

February 66,000 58,000 11,600 6,600

March 74,000 60,000 12,000 6,800

April 90,000 66,000 12,400 7,200

May 94,000 72,000 13,000 8,600

June 86,000 60,000 14,000 8,000



2. Materials and overheads are to be paid during the month

following the month of supply.

3. Wages are to be paid during the month in which they are

incurred.


5. The terms of credits are payment by the end of the month

following the month of sales: Half of credit sales are paid when due

the other half to be paid within the month following actual sales.

6. 5% sales commission is to be paid within in the month following

sales



9. Plant and machinery worth Rs. 10,000 is to be installed in the

month of January and the payment are to be made in the month of

June.

6. The following information relates to a flexible budget at 50% capacity.

Find out the overhead costs at 60% and 70% capacity and determine the

overhead rates:

Particulars Expenses at 50% capacity

Variable overheads: Rs.


Indirect Materials 8,400


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NOTES


Repair and Maintenance 7,000


Electricity 25,200


Fixed overheads:

Office expenses including salaries 70,000

Insurance 4,000

Depreciation 20,000

Estimated direct labour hours 1,20,000 hours

Further Reading:

1. Financial management: Theory. Concepts and Problems, Rustagi,

R.P. 3rd revised ed, Galgotia



Kalyani Publishers, Delhi 4. Financial Management: Pandey, I. M. Viksas

5. Theory & Problems in Financial Management: Khan, M.Y. Jain,

P.K. TMH

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NOTES


BLOCK - IV

UNIT – X FINANCIAL MANAGEMENT Structure

10.1 Introduction

10.2 Definition of Financial Management:

10.3 Scope of Financial Management

10.4Objectives of Financial Management:

10.5 Differences between Profit maximization &Wealth maximization

10.6 Other Objectives

10.7 Position of Finance Manager:

10.8 Role of Finance Manager

10.9Financial Management and other Functional Areas

10.10 Significance of Financial Management

10.11 The changing scenario of Financial Management in India

10.1 Introduction Finance is the life blood and nerve Centre of a business, just as

circulation of blood is essential in the human body for maintaining life;

finance is very essential for smooth running of the business. It has been

rightly termed as universal lubricant that keeps the firm dynamic. No

business, whether big, medium or small, can be started without an adequate

amount of finance. Right from the very beginning i.e . , conceiving an idea

to business, finance is needed to promote or establish the business, acquire

fixed assets, make investigations such as market surveys etc., develop

product, keep men and machines at work, encourage management to make

progress and create values. Even an existing firm may require further

finance for making improvement or expanding the business. Finance has

thus become an integral part of the firm. Unless the finance is managed in a

profitable manner, the firm cannot reach its full potentials for growth and

success. In order to manage finance, a new management discipline was

conceived. Such discipline is known as financial management. Financial

management was a branch of Economics till 1890. Later on its was

developed into a separate subject. The subject of financial management has

become utmost important both to the academicians and practicing

managers. The academicians find interested in the subject because the

subject is still in its developing stage and there are still certain areas where

controversies exist for which no unanimous solutions have been reached

yet. Practicing managers are interested in the subject because among the

most the most crucial decisions of the theory of financial management

provides them with conceptual and analytical insights to make those

decisions skilfully. This chapter is designed to give an overall view on the

concept of financial management.

Meaning of financial Management:

Financial management refers to the management of flow of funds

in the firm. It deals with the financial decision making of the firm. It is

mainly concerned with the timely procurement of adequate finance from

various sources and its utmost effective utilization for the attainment of

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organizational objectives. Since raising of funds and their best utilization is

the key to the success of any firm, the financial management as a

functional area has got a place of prime relevance. It is mainly focusing on

overall managerial decision making in general and with the management of

economic resources in particular. All business decisions have financial

implications and therefore financial management is inevitably related to

almost every aspect of business operation. Broadly speaking, the financial

management includes any decision made by a firm that affects its finances.

10.2 Definition of Financial Management: The term financial management has been defined differently by

various authors. Some of the authoritative definitions are as follows:

(i) Solomon: Financial management is concerned with the efficient

use of an important economic resource, namely capital funds.

(ii) Phillioppatus: Financial management is concerned with the

managerial decisions that result in the acquisition and financing of short

term and long-term credits for the firm.

(iii) S.C. Kuchhal: Financial management deals with procurement

of funds and their effective utilization in the business.

(iv) J.F. Bradley: Financial management is the area of business

management devoted to a judicious use of capital and a careful selection of

sources of capital in order to enable a business firm to move in the

direction of reaching its goals.

(v) J.L. Massie: Financial management is the operational activity of

a business that is responsible for obtaining and effectively utilizing the

funds necessary for efficient operations.

(vi) Weston and Brigham: Financial management is an area of

financial decision making. Harmonizing individual motives and enterprise

goals.

(vii) Howard and Upton: Financial management is the area or set of

administrative functions in an organization which relate with arrangement

of cash and credit so that the organization may have the means to carry out

its objectives as satisfactorily as possible.

(viii) Archer and Ambrosio: Financial management is the

application of the planning and control function to the finance function.

10.3 Scope of Financial Management: Financial management has undergone significant changes over the

years, in its scope and coverage. In order to have a better exposition of

these change, it will be appropriate to study both the traditional approach

and the modern approach to the function.

(i) Traditional Approach: The traditional approach to the scope of

financial management refers to its subject matter in the academic literature

in the initial stages of its evolution as a separate branch of study.

According to this approach, the scope of financial management is confined

to the raising of funds. Hence, the scope of finance was treated by the

traditional approach in the narrow sense of procurement of funds by

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corporate enterprises to meet their financial needs. Since the main

emphasis of finance function at that period was on the procurement of

funds, the subject was called corporation finance till the mid-1950’s and

covered discussion on the financial instruments, institutions and practices

through which funds are obtained. Further, as the problem of raising funds

is more intensely felt at certain episodic events such as merger, liquidation,

consolidation, reorganization and so on. These are the broad features of the

subject matter of corporation finance which has no concern with the

decisions of allocating firm’s funds. But the scope of finance function in

the traditional approach has now been discarded due to the following

limitations:

(a) The emphasis in the traditional approach is on the procurement

of funds by the corporate enterprises which was woven around the

viewpoint of the suppliers of funds such as investors, financial institutions,

investment bankers, etc. i.e. outsiders. It implies that the traditional

approach was the “outsider-looking in” approach.

(b) Internal financial decision making was completely ignored.

(c) The scope of financial management was confined only to the

episodic events such as merger, acquisition, reorganization etc. The scope

of finance function in this approach was confined to a description of these

infrequent happenings in the life of a firm. Thus, it places over emphasis

on the topics of securities and its markets, without paying any attention on

the day to day financial aspects.

(d) The focus was on the long-term financial problem, thus

ignoring the importance of the working capital management. Thus, this

approach has failed to consider the routine managerial problems relating to

finance of the firm.

During the initial stages of development, financial management was

dominated by the traditional approach as is evident from the finance books

of early days. The traditional approach was found in the first manifestation

by Green’s book written in 1897, Medias on Corporation Finance, in 1910;

Dewing’s on Corporate Promotion and Reorganisation, in 1914 etc.

As mentioned earlier, in this approach all these writings

emphasized the financial problems from the outsiders’ point of view

instead of looking into the problems from management point of view. It

overemphasized long term financing, lacked in analytical content and

placed heavy emphasis on descriptive material. Thus, this approach has

completely ignored the important aspects like cost of capital, optimum

capital structure, valuation of firm etc. In the absence of these crucial

aspects in the finance function, this approach implied a very narrow scope

of financial management. The modern approach provides a solution to all

these aspects of financial management.

(ii) Modern Approach: After the 1950’s, the approach and utility

of financial management has started changing in a revolutionary manner.

The emphasis of financial management has been shifted from raising of

funds to the effective and judicious utilization of funds. The modern

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approach of the finance function focuses on ‘wise use of funds’. Since

financial decisions have a great impact on all other business activities, the

finance manager should be concerned about determining the size and

nature of technology, setting the direction and growth of the business,

shaping the profitability, amount of risk taking, selecting the mix of assets,

determination of optimum capital structure etc. The modern approach is

thus an analytical way of viewing the financial problems of a firm.

According to this approach, the financial management is concerned with

the solution for the major areas relating to the financial operations of a firm

viz., investment, financing and dividend decision. The modern finance

manager has to take financial decision in the most rational way. These

decisions have to be made in such a way that the funds of the firm are used

optimally. These decisions are referred to as managerial finance functions

since they require special care with extraordinary administrative ability,

management skills and decision-making techniques etc.

10.4 Objectives of Financial Management: Efficient financial management requires the existence of some

objectives or goals because judgment as to whether or not a financial

decision is efficient must be made in the light of some objectives. The

objectives of financial management are broadly divided into two. i.e. (i)

Basic objectives and (ii) Other objectives.

(i) Basic objectives

The basic objectives of the financial management are:

(A) Profit Maximization

(B) Wealth Maximization

(A) Profit Maximization

Profit maximization is one of the basic objectives of

financial management. According to this concept, a firm should undertake

all those activities which add to its profits and eliminate all others which

reduce its profits. This objective highlights the fact that all decisions—

financing, dividend and investment, should result in profit maximization.

Following arguments are given in favour of profit maximization concept:

(a) Profit is a yardstick of efficiency on the basis of which

economic efficiency of a business can be evaluated.

(b) It helps in efficient allocation and utilization of scarce means

because only such resources are applied which maximize the profits.

(c) The rate of return on capital employed is considered as the best

measurement of the profits

(d) Profits act as motivator which helps the business organization to

be more efficient through hard work.

(e) By maximizing profits, social and economic welfare is also

maximized.

However, this objective has been criticized on various counts:

(a) Ambiguity: The term ‘profit maximization’ as a criterion for

financial decision is vague and ambiguous concept. It lacks precise

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connotation. The term ‘profit’ is amenable to different interpretations by

different people. For example, profit may be long term or short term. It

may be total profit or rate of profit. It may be not profit before tax or net

profit after tax. It may be return on total capital employed or total assets or

shareholders equity and so on.

(b) Time value of money: This concept ignores time value of

money. i.e. under this concept, income different years get equal weight.

But, in fact, the value of rupee today will be greater as compared to the

value of rupee receivable after one year. In this same manner, the value of

income received in the first year will be greater from that which will be

received in later years e.g. the profits of two different projects are as

follows:

Year Project X Project Y

Rs. Rs.

1 10,000 -

2 20,000 20,000

3 10,000 20,000

Both the projects have a total earnings of Rs. 40,000 in three years and

according to this concept, both will be considered equally profitable. But

project X has greater profits in the initial years of the project and therefore,

is more profitable in terms of value of income. The profits earned in initial

years can be reinvested and more profits can be earned.

(c) Risk factor: This concept ignores risk factor. The certainty or

uncertainty of income receivable in future can be high or less. High

uncertainty increases risk and less uncertainty reduces risk. Less income

with more certainty is considered better as compared to high income with

greater uncertainty.

Thus, the profit maximization concept was more significant for sale

trader and partnership firms because at that time when personal capital was

invested in business, they wanted to increase their assets by maximizing

profits. Companies are now managed by professional managers and capital

is provided by shareholders, debenture holders, financial institutions etc.

One of the major responsibilities of business management is to co-ordinate

the conflicting interest of all these parties. In such a situation, profit

maximization concept does not appear proper and practicable for financial

decisions.

(B) Wealth Maximization

Another basic objective of financial management is maximization

of shareholders’ wealth. This objective is also known as value

maximization or net present-worth maximization. According to this

concept, finance manager should take such decisions which increase net

present value of the firm and should not undertake any activity which

decrease net present value. This concept eliminates all the three basic

criticisms of the profit maximization concept.

As the value of an asset is considered from viewpoint of profits

accruing from it, in the same manner the evaluation of an activity depends

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on the profit arising from it. Therefore, all three main decisions of finance

manager – financing decision, investment decision, affect net present value

of the firm. The greater the amount of net present value, the greater will be

value of the greater the amount of net present value, the greater will be

value of firm and more it will be in the interest of shareholders. When the

value of firm increases, the market price of equity shares also increase.

Thus, to maximize net present worth means to maximize the market price

of shares.

The concept of wealth maximization is considered good for the

companies in present situation. This concept gives due consideration to the

time value of expected income receivable over different periods of time.

Under this concept, risk and uncertainty are analysed with the help of

interest rate. If uncertainty and time period are greater, higher rate of

interest will be used to calculate present value of expected future cash

benefits, whereas the interest rate will be lower for the projects with low

risk and uncertainty. Besides, this concept uses cash flows instead of

accounting profits which removes ambiguity associated with the term

‘profit’.

10.5 Differences between Profit maximization &Wealth

maximization: The profit maximization concept measures the performance of a

firm by looking at its total profit. It does not take into account the risk

which the firm may undertake in maximization of profit. The profit

maximization concept does not consider the effect of earnings per share,

dividends paid or any other return to shareholders on the wealth of

shareholders. On the contrary, the objective of wealth maximization

considers all future cash flows, dividends, earnings per share, risk of a

decision etc. So, the wealth maximization concept is operational and

objective in its approach.

A firm, interested in maximizing its profits may not like to pay

dividend to its shareholders, whereas a firm interested in maximizing

wealth of shareholders, may pay regular dividends. The shareholders

would certainly prefer an increase in wealth against the generation of

increasing flow of profits to the firm. Moreover, the market price of a share

explicitly reflects the shareholders expected return, considers risk and

recognizes the importance of distribution of returns. Therefore, the

maximization of shareholders wealth as reflected in the market price of a

share is considered as a proper objective of financial management. The

profit maximization can be considered as a part of the wealth maximization

strategy but should never be permitted to overshadow the latter.

10.6 Other Objectives: Besides basic objectives, the following are the other objectives of

financial management:

(i) Return maximization: The financial management is to safeguard the

economic interest of the persons who are directly or indirectly connected

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with the firm i.e. shareholders, creditors and employees. All these

interested parties must get the maximum return for their contributions. But

this is possible only when the firm earns higher profits or sufficient profits

to discharge its obligation to them.

(ii) Provide support for decision making: Financial management is to

provide managers with the information and knowledge they need to

support operational decisions and to understand the financial implications

of decisions before they are made. It also enables managers to monitor

their decisions for any potential financial implications and for lessons to be

learnt from experience and to adapt or react as needed.

(iii) Mange risks: Financial management is to assist a firm in identifying

and assessing the financial consequence of events that could compromise

its ability to achieve its goals and objectives and/or result in significant loss

of resources. Financial management is an important component of risk

management needs to be considered with the full range of business risks

such as operational and strategic risk as well as social, legal, political and

environmental risks.

(iv) Use resources efficiently, effectively and economically: Financial

management is to ensure that a firm has enough resources to carry out its

operations and that it uses these resources with due regard to economy,

efficiency and effectiveness.

(iv) provide a supportive control environment: Financial management

is to contribute for promoting an organizational climate that fosters the

achievement of financial management objectives- a climate that includes

commitment from senior management, shared values and ethics,

communication and organizational learning.

(v) Comply with authorities and safeguard assets: Financial

management is to ensure that a firm carries out its transactions in

accordance with applicable legislation, regulations and executive orders;

that spending limits are observed; and that transactions are authorized. It

should also provide a firm with a system of controls for assets, liabilities,

revenues and expenditures. These controls help to protect against fraud,

financial negligence, violation of financial rules or principles and losses of

assets or public money.

10.7 Position of Finance Manager: In present organizations, financial management is treated as a

specialized activity and a separate department is created for finance

function.

The department is generally headed by an executive, popularly

known as “financial manager” has the responsibility of carrying out all the

functions expected of financial management. The finance manager has the

responsibility of carrying out all the functional management. The position

of finance department and finance manager in a firm can be illustrated as

follows:

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From the above, we can observe that the position of finance

manager is of the head of finance department of a firm. The position can be

explained as follows:

(a) Finance manager is generally head of finance department.

(b) The position of finance manager is of a line manager.

(c) The functions of finance manager are multiple.

(d) Finance manager is accountable to top level management.

10.8 Role of Finance Manager:

The finance manager is required to discharge all the

functions/activities envisaged by financial management. The important

functions of finance manager are as follows:

(i) Forecasting Financial Requirements:

The first function of finance manager is to forecast the required

funds in the firm. Certain funds are required for long term purposes i.e.

investment in fixed assets etc. A careful estimate of such funds, and of the

exact timing, when such funds are required must be made. Also, an

assessment has to be made regarding requirements of working capital

which involves estimating the amount of funds blocked in various current

assets and the amount of funds likely to be generated for short periods

through current liabilities. Forecasting the requirements of funds involves

the use of techniques of budgetary control and long-range planning.

Estimates of requirement of funds can be made only if all the physical

activities of a firm have been forecasted. They can then be translated into

monetary terms.

(ii) Financing Decision:

Once the requirements of funds have been estimated, the finance

manager has to take decision regarding various sources from where these

funds would be raised. A proper mix of various sources has to be worked

out. Each source of manager has to carefully look into the existing capital

structure and see how the various proposals of raising funds will affect it.

He has to maintain a proper balances between long term funds and short-

term funds. He has to ensure that he raises sufficient long-term funds in

order to finance fixed assets and other long-term investments and to

provide for the permanent needs of working capital. Within the total

volume of long-term loan funds, he must maintain a proper balance

between the loan funds and own funds. Long term funds raised from

outsiders have to be in a certain proportion with the funds procured from

the owners. There are various options available for procuring outside long

term funds also. The finance manager has to decide the ratio between

outside long-term funds and own funds. He has also to see that the overall

capitalization of the firm is such that the firm is able to procure funds at

minimum cost and is able to tolerate shocks of lean periods. All such kinds

of decisions are termed as ‘Financing Decisions’.

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(iii) Investment Decision:

After having procured the funds from different sources, the finance

manager has to take investment decisions. Investment decisions relate to

selection of assets in which funds are to be invested by the firm.

Investment alternatives are numerous. Resources are scarce and limited.

They have to be rationed and discretely used. Investment decisions allocate

and ration the resources among the competing investment alternatives or

opportunities. The effort is to find out the projects, which are acceptable.

Investment decisions relate to the total amount of assets to be held

and their composition in the form of fixed and current assets. Both the

factors influence the risk the firm is exposed to take. The more important

aspect is how the investors perceive the risk.

The investment decision result in purchase of assets. Assets can be

classified under two broad categories:

(a) Long term investment decisions – Long term assets.

(b) Short term investment decisions – short term assets.

(a) Long term investment Decisions:

The long-term investment decisions are referred to as capital

budgeting decisions, which relate to fixed assets. The fixed assets are long

term in nature. Basically, fixed assets create earnings to the firm. They give

benefits in future. It is difficult to measure the benefits as future is

uncertain.

The investment decision is important not only for setting up new

units but also for expansions of existing units. Decisions related to them

are, generally, irreversible. Often reversal of decision result in substantial

loss. When a brand-new car is sold, even a day after its purchase, buyer

treats the vehicle as a second-hand car. The transaction, invariably, results

in heavy loss for a short period of owning. So, the finance manager has to

evaluate profitability of every investment proposal carefully before funds

are committed to them.

(b) Short term Investment Decisions:

The short-term investment decisions are, generally referred as

working capital management. The finance manager has to allocate among

cash and cash equivalent, receivables and inventories. Though these

current assets do not, directly, contribute to the earnings, their existence is

necessary for proper, efficient and optimum utilization of fixed assets.

(iv) Dividend Decision:

The finance manager is also concerned with the decision to pay or

declare a dividend. He has to assist the top management in deciding as to

what amount of dividend should be paid to the shareholders and what

amount should be retained in the business itself. Generally, firms distribute

certain amount of profit in the form of dividend, in a stable manner, to

meet the expectations of shareholders and balance is retained within the

firm for expansion. If dividend is not distributed, there would be great

dissatisfaction to the shareholders. Non- declaration of dividend affects the

market price of equity share severely. One significant element in the

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dividend decision is, therefore, the dividend pay-out ratio i.e. What

proportion of dividend is to be paid to the shareholders? The dividend

decision depends on the preference of the equity shareholders and

investment opportunities available within the firm. A higher rate of

dividend, beyond the market expectations, increases the market price of

shares. However, it leaves a small amount in the form of retained earnings

for expansion. The business that reinvests less will tend to grow slower.

The other alternative is to raise funds in the market for expansion. It is not

a desirable decision to retain all the profit for expansion, without

distributing any amount in the form of dividend.

There is no ready-made answer, how much is to be distributed and

what portion is to be retained. Retention of profit is related to:

(a) Re investment opportunities available to the firm.

(b) Alternative rate of return available to equity shareholders, if

they invest themselves.

The principal function of a finance manager relates to decisions

regarding procurement, investment and dividends. However, the finance

manager also undertakes the following subsidiary functions:

(v) Deciding over all objectives:

The finance manager needs to be guided by some objectives. As a

head of finance department, the finance manager, therefore, he has to

determine the overall goals of finance department. The goals help in

effective financial planning and decision making.

(vi) Supply of funds to all parts of the organization:

The finance manager has also to ensure that all sections i.e.

branches, factories, departments and units of the organization are supplied

with adequate funds. Sections which have an excess of funds have to

contribute to the central pool for use in other sections which need funds.

An adequate supply of cash at all points of time is absolutely essential for

the smooth flow of business operations. Even if one of the 200 retail

branches do not have sufficient funds, the whole business may be in

danger. Hence the need for laying down cash management and cash

disbursement policies with a view to supplying adequate funds at all times

and at all points in an organization is an important function of finance

manager. Cash management should also ensure that there is no excessive

cash.

(vii) Evaluating financial performance:

Management control system are often based upon financial

analysis. One prominent example is the ROI (Return on Investment)

system of divisional control. The finance manager has to constantly review

the financial performance of the various units of the organization. The ROI

chart is extremely useful in this regard. Analysis of the financial

performance helps the management for assessing how the funds have been

utilized in various divisions and what can be done to improve it.

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(viii) Financial negotiation:

A major portion of the time of finance manager is utilized in

carrying out negotiations with the financial institutions, banks and public

depositors. He has to furnish a lot of information to these institutions and

persons and have to ensure that raising of funds is within the statutes the

Companies Act etc. Negotiations for outside financing often required

specialized skills.

(ix) Keeping touch with stock exchange quotations and behaviour of

share prices:

This involves analysis of major trends in the stock market and

judging their impact on the prices of the shares of the firm.

Liquidity Vs Profitability (Risk – Return Trade off)

As a principal function, the finance manager takes various types of

financial decisions- finance decision, investment decision and dividend

decision- as discussed above, from time to time. In every area of financial

management, the finance manager is always faced with the dilemma of

liquidity Vs profitability. He has to strike a balance between the two.

Liquidity means that the firm has (a) adequate cash to pay bills as

and when they fall due, and (b) sufficient cash reserves to meet

emergencies and unforeseen demands, at all time.

Profitability goal, on the other hand, requires that the funds of the

firm be so utilized as to yield the highest return.

Liquidity and profitability are conflicting decisions. When one

increases, the other decreases. More liquidity results in less profitability

and vice versa. This conflict, finance manager has to face as all the

financial decisions involve both liquidity and profitability.

Example: Firm may borrow more, beyond the risk-free limit, to

take advantage of cheap interest rate. This decision increases the liquidity

to meet the requirements of firm. Firm has to pay committed fixed rate of

interest at fixed time irrespective of the return the liquidity (funds) gives.

Profitability suffers, in this process of decision, if the expected return does

not materialize. This is the risk the firm faces by this financial decision.

Risk: Risk is defined as the variability of the expected return from

the investment.

Return: Return is measured as a gain or profit expected to be made,

over a period, at the time of making the investment.

Example: If an investor makes a deposit in a nationalized bank,

carrying an interest of 8% p.a., virtually, the investment is risk free for

repayment, both principal and interest. However, if a similar amount is

invested in the equity shares, there is no certainty for the amount of

dividend or even for getting back initial investment as market price may

fall, subsequently, at the time of sale. The expected dividend may or may

not materialize. In other words, the dividend amount may vary, or the firm

may not declare dividend at all. A bank deposit is a safe investment, while

equity share is not so, risk is associated with the quality of investment.

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The relationship between risk and return can be expressed as

follows:

Return: Risk free rate+ Risk premium

Risk free rate is a compensation or reward for time and risk

premium for risk. Risk and return go hand in hand. Higher the risk, higher

the required return expected. It is only an expectation at the time of

investment. There is no guarantee that the return would be, definitely,

higher. If one wants to make an investment, without risk, the return is

always lower. For this reason, only, deposit in a bank or post office carry

lower returns, compared to equity shares.

So, every financial decision involves liquidity and profitability

implications, which carries risk as well as return. However, the quantum of

risk differs from one decision to another. Equally, the return from all the

decision is not uniform and also varies, even from time to time.

Relationship between liquidity & Profitability and Risk Return:

Example: If higher inventories are built, in anticipation of an

increase in price, more funds are locked in inventories. So, firm can

experience problems in making other payments in time. If the expected

price increase materials, firm enjoys a boost in profit due to the windfall

return the decision yields. The expected increase in price is a contingent

event. In other words, the increase in price may or may not happen. But

firm suffers liquidity problems immediately. This is the price firm has to

pay, which otherwise is the risk the firm carries.

It may be emphasized that risk and return always go together, hand

in hand. More risk, chances of higher return exist. One thing must be

remembered, there is no guarantee of higher return, with higher risk. The

classical example is lottery. There is a great risk, if one invests amount in a

lottery. There is no guarantee that you would win the lottery. However,

liquidity and profitability are conflicting decisions. There is a direct

relationship between higher risk and higher return. In the above example,

building higher inventories, more than required, is a higher risk decision.

This higher risk has created liquidity problem. But the benefit of higher

return is also available. Higher risk, on one hand, endangers liquidity and

higher returns, on the other hand, increases profitability. Liquidity and

profitability are conflicting, while risk and return go together. The pictorial

presentation is as under:

Conflicting Go together Role of finance Manager – Relationship between

liquidity and profitability and risk and return

The finance manager cannot avoid the risk altogether in this

decision making. At the same time, he should not take decision,

considering the return aspect only. At the time of taking any financial

decision, the finance manager has to weigh both the risk and return in the

proposed decision and optimize the risk and return at the same time. A

proper balance between risk and return has to be maintained by the finance

manager to maximize the market value of shares. A particular combination

where both risk and return are optimized is termed as Risk-Return Trade

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off. In other words, Risk and Return Trade to the level of operations at

which shareholders’ wealth can be maximized. Every finance manager

should take efforts to achieve that trade off in every finance decision. At

this level, the market value of the firm’s shares would be maximum. To

achieve maximum return, funds flowing in and out of the firm are to be

constantly monitored to ensure their safety and proper utilization.

10.9 Financial Management and other Functional Areas: Financial management is one of the important parts of overall

management, which is directly related with other functional areas such as

production, material, personnel, marketing, accounting etc. The

relationship between financial management and other functional areas has

been explained briefly in the pages to come.

(i) Financial Management and Production Management:

Production management is the operational part of the business concern,

which helps to multiply the money into profit. Profit of the firm depends

upon the production performance. Production performance needs finance,

because production department requires raw materials, machinery, etc.

These expenditures are decided and estimated by the finance department

and the finance manager allocates the appropriate finance to production

department. The finance manager must be aware of the operational process

and finance required for each process of production activities.

(ii) Financial Management and Material Management: The

financial management and the material department are also interrelated.

Material department covers the areas such as storage, maintenance and

supply of material and stores, procurement etc. The finance manager and

material manager in a firm may come together while determining economic

order quantity, safety level, storing place requirement, stores personnel

requirement, etc. The costs of all these aspects are to be evaluated so that

the finance manager may come forward to help the material manager.

(iii) Financial Management and Personnel Management: The

personnel department is entrusted with the responsibility of recruitment,

training and placement of the staff. This department is also concerned with

the welfare of the employees and their families. This department works

with finance manager to evaluate employee’s welfare, revision of their pay

scale, incentive schemes, etc.

(iv) Financial Management and Marketing Management: The

marketing department is concerned with the selling of goods and services

to the customers. It is entrusted with framing marketing, selling,

advertising and other related policies to achieve the sales target. It is also

required to frame policies to maintain and increase the market share, to

create a brand name etc. For all this, finance is required. So, the finance

manager has to play an active role for interacting with the marketing

department.

(v) Financial Management and Accounting: Accounting records

include the financial information of the firm. Hence, we can easily

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understand the relationship between the financial management and

accounting. In the olden periods, both financial management and

accounting are treated as a same discipline and then it has been merged as

management accounting, because this part is very much helpful to finance

manager to take decision. But now a day’s financial management and

accounting discipline are separate and interrelated.

(vi) Financial Management and Mathematics: Modern

approaches of the financial management apply large number of

mathematical and statistical tools and techniques. They are also called

Econometrics. Economic order quantity, discount factor, time value of

money, present value of money, cost of capital, ratio analysis and working

capital analysis are used as mathematical and statistical tools and

techniques in the field of financial management.

(vii) Financial Management and Economics: Economics

concepts like Micro and Macroeconomics are directly applied with the

financial management approaches. Investment decisions, micro and macro

environmental factors are closely associated with the functions of finance

manager. Financial management also uses the economic equations like

money value discount factor, economic order quantity etc. Financial

economics is one of the emerging areas, which provides immense

opportunities to finance and economical areas.

Methods and Tools of Financial Management:

The finance manager has to employ various methods and

techniques at the time of taking various financial decision such as finance

decision, investment decision and dividend decision. In the area of

financing, there are various methods to procure funds. Funds may be

obtained from long term sources as well as from short term sources. Long

term funds may be made available by owners i.e. shareholders, lenders by

issuing debentures, from financial institutions, banks and public at large.

Short term funds may be procured from commercial banks. Suppliers of

goods, public deposits, etc. The finance manager has to decide an optimum

capital structure to maximise shareholders’ wealth. For this, judicious use

of financial leverage or trading on equity is important to increase the return

to shareholders. In planning the capital structure, the aim is to have proper

mix of debt and equity. EBIT-EPS analysis, PE Ratios and mathematical

models are used to determine the proper debt-equity mix to derive

advantage to the owners and firm.

In the area of investment decisions, Payback period, Average rate

of return, Net present value, Profitability Index and Internal Rate of Return

are some of the methods applied in evaluating capital expenditure

proposals.

In the area of working capital management, certain techniques are

adopted such as ABC analysis, Economics order Quantity, Cash

management models etc. to improve liquidity and to maintain adequate

circulating capital. For evaluation of firm’s performance, Ratio analysis is

pressed into service. With the help of ratios, an investor can decide whether

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to invest in a firm or not. Funds flow statement, cash flow statement and

projected financial statements help a lot to the finance manager in

ascertaining required funds at the right time.

10.10 Significance of Financial Management: The significance of financial management is summarized as given

below:

(i) Financial management is essential wherever funds are involved

– in a centrally planned economy and also in a capitalist set up. It attempts

to use funds in the most productive manner i.e. optimizing the output from

the given inputs of funds. It focuses on effective utilization of the most

important resource in any activity i.e. money.

(ii) Financial management helps in ascertaining how the firm would

perform in future. It helps in including whether the firm will generate

enough funds to meet its various obligations like repayment of the various

instalments due on loans, redemption of other liabilities etc.

(iii) Financial management provides complete coordination

between various functional areas marketing, production, etc. to achieve the

organizational goals. If financial management is defective, the efficiency of

all other departments can, in no way, be maintained. For example, it is very

necessary for the finance department to provide finance for the purchase of

raw materials and meeting the other day- to- day expenses for the smooth

running of the production unit. If finance department fails in its

obligations, the production and the sales will suffer and consequently the

income of the firm and rate of profit on investment will also suffer. Thus,

financial management occupies a central place in the business organization

which controls and co-ordinates all the other activities in the firm.

(iv) Almost, every decision in the business is taken in the light of its

profitability. Financial management provides scientific analysis of all facts

and figures through various financial tools, such as different financial

statements, budgets etc, which help in evaluating the profitability of the

given circumstances, so that a proper decision can be taken to minimize the

risk involved in the plan.

(v) Saving are possible only when the firm makes substantial profits

and maximizes its wealth. Effective financial management helps in

promoting and mobilizing individual and corporate savings.

(vi) Financial management also helps in profit planning, capital

spending, measuring costs, controlling inventories, accounts receivables

etc.

10.11 The changing scenario of Financial Management in

India:

Modern financial management has come a long way from the

traditional corporate finance. As the economy is opening up and global

resources are being tapped, the opportunities available to finance managers

virtually have no limits. The finance manager is now responsible for

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shaping the fortunes of the firm and is involved in the most vital decisions

of the allocation of capital.

Due to the changes in the global environment, the finance manager

needs to have a broader and far- sighted outlook, and must realize that his

actions would have far- reaching consequences for the firm because they

influence the size, profitability, growth, risk and survival of the firm, and

as a consequence, affect the overall value of the firm.

Some of the important changes in the environment are:

(a) Interesting rates have been freed from regulation. Treasury

operations therefore have to be more sophisticated as the interest rates are

fluctuating. Minimum cost of capital necessitates anticipating interest rate

movements.

(b) The rupee has become fully convertible on current account.

(c) Optimum debt-equity mix is possible. The firms have to take

advantage of the financial leverage to increase the shareholders’ wealth.

However, using financial leverage necessarily makes a business vulnerable

to financial risk. Finding a correct trade-off between the risk and the

improved return to shareholders is a challenging task for the finance

manager.

(d) With free pricing of issues, optimum price determination of new

issues is a daunting task as overpricing results in under subscription and

loss of investor confidence while under-pricing leads to unwanted increase

in number of shares there by reducing the earnings per share (EPS).

(e) Ensuring management control is vital especially in the light of

foreign participation in equity which is backed by huge resources making

the firm an easy takeover target. Existing management may lose control in

the eventuality of being unable to take up the share entitlements. Financial

strategies to prevent this are vital to the present management.


1. Define financial management.

2. Write short note on profit maximization.


1 Financial management is concerned with the efficient use of an important

economic resource, namely capital funds.

2. Profit maximization is one of the basic objectives of financial

management. According to this concept, a firm should undertake all those

activities which add to its profits and eliminate all others which reduce its

profits.


Short Questions:

1. What is wealth maximization?

2. Write short on dividend decision.

3. Explain the current scenario of financial management in India


4. What are the significances of financial management?

5. What are the roles of financial manager?

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Further Reading:



Kalyani Publishers, Delhi 3. Financial management: Panday, I.M. 9th ed Vikas


3rd ed, TMH




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UNIT – XI CAPITAL BUDGETING Structure

11.1 Introduction

11.2 Meaning of Capital Budgeting

11.3 Definition of Capital Budgeting

11.4 Features of Capital Budgeting

11.5 Objectives of Capital Budgeting

11.6 Capital budgeting process

11.7 Types of Capital Budgeting Decisions

11. 8 Procedure for computation of ARR

11.9 Procedure for computation of NPV

11.10 Procedure for computation of IRR

11.1 Introduction As mentioned in chapter 1, the finance manager of a firm is

responsible to procure the required quantum of funds from different

sources and invest the raised funds in various assets in the most profitable

way. The investment of funds requires a number of decisions to be taken in

a situation in which funds are invested and benefits are expected over a

long period. The finance manager is to determine the compositions of

assets of the firm. The assets of the firm are of two types i.e., fixed assets

and current assets. The aspect of taking the financial decision with regard

to fixed assets of taking the financial decision with regard to fixed assets is

called capital budgeting.

11.2 Meaning of Capital Budgeting Capital budgeting means planning the capital expenditure in

acquisition of fixed (capital) assets such as land, building, plant or new

projects as a whole. It includes replacing and modernising a process.

Introduction a new product and expansion of the business. It involves the

preparation of Detailed Project Report (DPR) and cost and revenue

statements indication the profitability. The project which gives the highest

return on investment is to be selected and then investment is to be made in

such a project as to maximize the profitability of the firm.

11.3 Definition of Capital Budgeting The term capital budgeting is formally defined as follows:

I. Charles T. Horngren: capital budgeting is the long term planning

for making and financing proposed capital outlays.

II. GC.Philoppatos: capital budgeting is concerned with the allocation

of the firm’s scarce financial resources among the available market

opportunities. The consideration of investment opportunities

involves the comparison of the expected future streams of earnings

from a project, with the immediate and subsequent streams of

expenditure for it.

III. Milton H.Spencer: capital budgeting involves the planning for

assets. The returns from which will be realised in future time

periods.

IV. Keller and Ferrara: The capital expenditure budget represents the

plans for the appropriations and expenditures for fixed assets during

the budget period.

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V. R.M. Lynch: Capital budgeting consists in planning for

development of available capital for the purpose of Maximising the

long term profitability (return on investment) of the firm.

Capital budgeting is thus, broader term and includes not only

investment decisions but also the exploration of profitable

investment opportunities, marketing and engineering investigation

of these opportunities and financial analysis as to their future

profitability. However, the terms “Investment Decisions”, “Capital

expenditure decisions”, “Capital Expenditure Management”, “Long

term Investment Decision” and “Management of Fixed Assets” are

generally used interchangeably.

11.4 Features of Capital Budgeting The following basic features of capital budgeting may be deduced

from the preceding discussion:

I. Investments: Capital expenditure plans involve a huge investment

in fixed assets.

II. Long-term: Capital expenditure, once approved, represents long

term investment that cannot be reversed or withdrawn without

sustaining a loss.

III. Forecasting: preparation of capital budget plans involves

forecasting of several years profits in advance in order to judge the

profitability of projects.

IV. Serious consequences: In view of the investment of large amount

for a fairly long period of time, any error in the evaluation of

investment projects may lead to serious consequences, financially

and otherwise and may adversely affect the other future plans of the

organization.

11.5 Objectives of Capital Budgeting The objectives of capital budgeting are summarized as given below:

I. Capital budget aims at deciding the most profitable among the

numerous investment proposals available.

II. It decides the most suitable among different sources of finance on

the basis of capital market constraints.

III. The growth and expansion of the firm and modernization can be

taken care of.

Need and significance of Capital Budgeting

Capital buffeting decision is of paramount importance in financial

decision making. Special care should be taken in making these decisions on

account of the following reasons:

I. Substantial expenditure: Capital budgeting decisions involve the

investment of substantial amount of funds. It is therefore necessary

for a firm to make such decisions after a thoughtful consideration

so as to result in the profitable use of its scarce resources. The hasty

and incorrect decision would not only result in huge losses but may

also account for the failure of the firm.

II. Long term implications: The capital budgeting decisions has its

effect over a long period of time. These decisions not only affect

the future benefits and cost of the firm but also influence the rate

and direction of growth of the firm.

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III. Irreversible decisions: The capital budgeting decisions are

irreversible and the heavy amount invested cannot be taken back

without causing a substantial loss because it is very difficult to find

a market for the second hand capital goods and their conversion

into other uses may not be financially feasible.

IV. Complexity: The capital budgeting decisions are based on

forecasting of future events and inflows. Quantification of future

events involves applications of statistical and probabilistic

techniques, careful judgment and application of mind is necessary.

V. Risk: The longer the time period of returns, greater is the

risk/uncertainty associated with cash flows. Hence capital

budgeting decisions should be taken after a careful review of all

available information.

VI. Surplus: Funds are raised by the firm at a certain cost (i.e.,WACC).

Even internally generated funds have an implicit cost. Hence, there

is a need to obtain a surplus over and above the cost of funds. Only

then, the investment is justified.

Advantages of Capital Budgeting

The main advantages of capital budgeting are as under:

I. At any given time, numerous in investment proposals may be

available. Capital budgeting evaluates them and ranks them as

per merit. This enables management to decide on implementing

appropriate proposals.

II. The limited funds available can be most effectively utilised.

III. The timing and actual execution of each project can be adjusted to

changes in capital market.

IV. Different sources of finance can be considered, and judicious

selection of sources can reduce overall cost of capital.

V. Capital budgeting can take care of the proportion of debt and equity

in the capital structure and the resulting capital gearing.

VI. In tight money situations, capital rationing van be followed not to

waste scarce funds available.

11.6 Capital budgeting process Capital investment decisions are the part of the capital budgeting

process, which is concerned with determining (a) which specific project

a firm should accept, (b)the total amount of capital expenditure which

the fir should undertake, and(c) how the total amount of capital

expenditure should be financed generally.

The following stages are involved in the capital budgeting process:

I. Identification of investment proposals: The capital budgeting

process begins with the identification of investment proposals.

The proposals may come from a rank and file worker of any

department or from any line officer. The department head

collects all the investment proposals and reviews them in the

light of financial and risk policies of the organization in order

to send them in the capital expenditure planning committee for

consideration.

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II. Screening the proposals: after getting the proposals, the

expenditure planning committee analyses all the proposals

from various angles to ensure that these are in accordance with

the corporate strategies or selection criterion of the firm and

also do not lead to departmental imbalance.

III. Evaluation of proposals: Evaluation of different proposals in

terms of cost of capital, expected returns from alternative

investment opportunities and life of the assets is the next step

in the capital budgeting process. Various methods such as

payback period, average rate of return method, NPV method,

IRR method etc., which are discussed later in the chapter, are

employed to evaluate the proposals.

IV. Fixing priorities: Once the evaluation process is over, only

economic and profitable proposals are given green signal to go

ahead. But it is not possible to take up all the proposals

simultaneously due to fund constraints. In view of this, all the

accepted proposals are ranked and priorities are given in the

following order:

(a) Current and incomplete projects are given first priority.

(b) Safety projects and projects necessary to carry on the

legislative requirements.

(c) Projects for maintaining present efficiency of the firm.

(d) Projects for supplementing the income, and

(e) Projects for the expansion of product line.

V. Final approval: projects finally recommended by the committee

are sent to the top management along with the detailed report,

both of the capital expenditure and of sources of funds to meet

them. The management affirms its final seal to proposals taking

in view urgency, profitability of the projects and the available

financial resources.

VI. Implementing proposals: When the proposals are finally

selected, funds are allocated for them. Such formal plan for the

allocation of funds is called capital budget. It is the duty on the

part of the top management to ensure that funds are spent in

accordance with the allocation made in the capital budget. A

control over such capital expenditure is very much essential

and for that purpose, a monthly report showing the amount

allocated, amount spent, amount approved but not spent should

be prepared and submitted to the controller.

VII. Follow up: Finally, a system of following up the results of

completed projects should be established. Such follow up

comparison of actual performance with budgeted data will

ensure better forecasting and will also help in sharpening the

technique of forecasting.

11.7 Types of Capital Budgeting Decisions There are many ways to classify the capital budgeting decision.

Generally capital investment decisions are classified in two ways. One way

is to classify them on the basis of firm’s existence. Another way is to

classify them on the basis of decision situation.

I. On the basis of firm’s existence: The capital budgeting

decisions are taken by both newly incorporated firms as well as

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by existing firms. The new firms may be required to take

decision in respect of selection of a plant to be installed. The

existing firm may be required to take decisions to meet the

requirement of new environment or to face the challenges of

competition. These decisions may be classified into:

(i) Replacement and modernization decisions: All types of

plant and machinery eventually requires

replacement. If the existing plant is to be replaced

because the economic life of the plant is over, then

the decision may be known as a replacement

decision. However, if an existing plant is to be

replaced because it has become technologically

outdated (though the economic life is not over), the

decision may be known as a modernization

decision. These two decisions are also known as

cost reduction decisions.

(ii) Expansion decisions: Existing successful firms may

experience growth in demand of their product line.

If such firms experience shortage or delay in the

delivery of their products due to inadequate

production facilities, they may consider proposal to

add capacity to existing product line.

(iii) Diversification decisions: Sometimes, the firms may

be interested to diversify into new product lines,

new markets, production of spare parts etc. In such

a case, the finance manager is required to evaluate

not only the marginal cost and benefits, but also the

effect of diversification on the existing market share

and profitability. Both the expansion and

diversification decision may also be known as

revenue increasing decisions.

II. On the basis of decision situation: The capital budgeting

decisions on the basis of decision situation are classified as

follows:

(i) Mutual exclusive decisions: Decisions are said to be

mutually exclusive if two or more alternative

proposals are such that the acceptance of one

proposal will exclude acceptance of the other

alternative proposals. For example, a firm may be

considering proposal to buy either a low cost

economy model asset or a high cost super model

asset. If the economy model is purchased, it means

that the super model need not be purchased and vice

versa.

(ii) Accept – Reject decisions: The accept – reject

decisions occur when proposals are independent

and do not compete with each other. The firm may

accept or reject a proposal on the basis of a

minimum return on the required investment. All

those proposals which give a higher return than

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certain desired rate of return is accepted and the rest

are rejected.

(iii) Contingent decisions: These are independent

proposals. The investment in one proposal requires

investment in one or more other proposals. For

example, if a company accepts a proposal to set up

a factory in a remote area, it may have to invest in

infrastructure also e.g. building of roads, houses for

employees etc.

11.7.1 Factors influencing Capital Budgeting Decisions

The following factors are generally taken into account while

making capital budgeting decisions:

I. Initial investment: This equals the cash outflow at the initial

stage, net of salvage value of old assets if any. Initial

investment = Cost of new assets purchased+ Investment

in working capital – Salvage value of old assets, if any

II. Cash flows after taxes (CFAT): It indicates income

generated by the projects at various points of time.

Generally, CFAT= Profit before depreciation, after tax.

III. Terminal cash inflows: There may be some terminal cash

inflows at the end of the project like recovery of working

capital investment in the project, salvage value of fixed

assets etc.

IV. Time value of money: The value of money differs at

different points of time. So, the present value of future

cash inflow will have to be ascertained by discounting the

same at the appropriate discount rate.

V. Discount rate: It is a cut off rate for capital investment

evaluation A project which does not earn at least the cut

off rate should be rejected. Generally, the rate used for

discounting is the Weighted Average Cost of Capital

(WACC).

VI. PV factor and Annuity factor tables: These two tables are

used for calculation of present value of future cash

inflows. In case of uniform cash inflows during the

project life, PV annuity factor table can be used. If the

cash inflows are not uniform, the PV factor table can be

used.

11.7.2 Evaluation of Capital Budgeting Proposals

As discussed earlier in the chapter, the capital budgeting decision

requires a current investment, the benefits of which are received in

future/after one year i.e., it involves a long term commitment. This

decision actually is a very significant one since the future development and

the competitive power of the firm depends on it which, in other words, has

a direct impact on the future earning and growth of the firm. For this

purpose, a sound appraisal method should be adopted in order to measure

the economic worth of each investment proposal. In practice, several

methods are used to evaluate and select an investment proposal. These

methods can be grouped into two categories as given below:

1. Traditional (or) Non-discounting Method

2. Improvement in traditional approach to payback period

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I. Traditional (or) Non-discounting Method

As the name itself suggests, these methods do not discount cash

flows to find out their present worth. There are two such methods

available i.e., (i) payback period method, and (ii) the accounting or

average rate of return method. These are essentially rules of thumb

that intuitively grapple with the trade-off between net investment

and operating cash inflows. Both these traditional evaluation

criteria are discussed below:

1. Payback Period Method: This method, sometimes called the

payout or pay off or replacement period method, determines the

length of time required to recover the initial outlay of a project.

In other words, it is the period within which the total cash

inflows from the project equals the cost of investment in the

project. The lower the payback period, the better it is since

initial investment is recouped faster.

Example: Suppose a project with an initial investment of Rs. 5 lakh,

yields profit of Rs.1 lakh, after writing off depreciation of Rs. 25,000 per

annum. In this case, the payback period is computed as given below:

= 1,00,000 + 25,000 = Rs. 1,25,000

Procedure for computation of payback period

(i) Ascertain the initial investment (cash outflow) of the project.

(ii) Ascertain the cash inflows (CFAT)from the project for various

years.

(iii)Calculate the payback period as under:

(a) In case of uniform CFAT p.a.

(b) In case of differential CFAT for various years.

(i) Compute cumulative CFAT at the end of each year.

(ii) Find out the year in which cumulative CFAT exceeds

initial investment (calculated on time proportion basis).

(iii)Accept if the payback period is less than maximum or

benchmark period, else reject the project.

11.7.3 Merits of Payback Period Method

(i) It is very easy to apply, calculate and interpret.

(ii) It is most useful when cost is not high, and the capital project is

completed in a short period.

(iii)It focuses on early return heavily and ignores distant returns. It,

thus, contains a built-in edge against economic depreciation or

obsolescence.

(iv) It is useful in evaluating those projects which involve high

uncertainty.

(v) It gives an indication to a company facing shortage of funds to

invest in projects with small payback period. This is particularly

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useful when funds are difficult to obtain, and a quick return is

essential for rapid repayment.

11.7.4 Limitations of Payback Period Method

(i) This method fails to take into account the time value of

money. All cash flow is treated and weighed equally regardless

of the time period of their occurrence.

(ii) It does not measure the profitability of a project. It ignores

the cash inflows beyond the payback period. Thus, it is a biased

indicator of economic value.

(iii) It does not differentiate between projects requiring different

cash investments and thus it does not provide a meaningful and

comparable criterion.

(iv) It does not indicate any cut-off period for the purpose of

investment decision.

(v) A slight change in operation cost will affect the cash inflows

and as such payback period shall also be affected.

(vi) Neither allowance is made for taxation nor is nay capital

allowance made.

11.7.5 Improvement in traditional approach to payback period

(a) Discounted Payback Period Method: The payback period method

discussed above can be reworked, taking into consideration the time

value of money and the firms required rate of return, thereby

overcoming one of the limitations of the undiscounted payback

period method. When payback period is calculated by taking into

account the discount or interest factor, it is known as discounted

payback period.

Procedure for calculation of discounted payback period

(i) Ascertain the initial investment (cash outflow)

(ii) Ascertain CFAT (profit before depreciation and after tax) for

each year.

(iii) Ascertain the PV factor for each year and compute discounted

CFAT (CFAT ×PV factor) for each year.

(iv) Ascertain cumulative discounted CFAT at the end of each year.

(v) Calculate discounted payback period at the tie at which

cumulative discounted CFAT exceeds initial investment.

(vi) Accept if discounted payback period is less than

maximum/benchmark period, else reject the project.

(b) Post pay-back Profitability: One of the major limitations of

payback period method is that it neglects the profitability of

investment during the excess of economic life period over the

payback of that investment. Hence, an improvement over this

method can be made by taking into account the returns receivables

beyond the payback period. These returns are called post pay-back

profits. If other things remain equal, the project which has highest

post pay-back profits is to be preferred. The formula for calculating

post pay-back profitability index is as follows:

120

Capital Budgeting

NOTES


(c) Payback reciprocal: as the name indicates, it is the reciprocal of

payback period. A major limitation of payback period method is

that it does not indicate any cut off period for the purpose of

investment decision. It is, however, argued that the reciprocal of the

payback period and the project generated equal amount of the

annual cash inflow. In practice, the payback reciprocal is a helpful

tool for quickly estimating the rate of return of the project provided

its life is at least twice the payback period. The payback reciprocal

can be ascertained by using the formula given below:

(Or)

2. Accounting or Average Rate of Return (ARR) Method

ARR is the annualised net income earned on the average funds

invested in a project. It is a measure based on the accounting

profit (profit after depreciation and tax) rather than the cash

flows and is very similar to the measure of rate of return on

capital employed, which is generally used to measure the

overall profitability of the firm. The alternative formula for

calculating the ARR is as follows:

a) Annual return on original investment method

Where, Annual average net earnings = Average of the

earning (savings) after depreciation and tax over the whole of the

economic life of the project.

Investment = Capital cost of the equipment minus

salvage value of the old equipment

b) Annual return on average investment method

The amount of ‘Average investment’ can be

computed in any of the following methods:

(i) Average investment

(ii) Average investment

121

Capital Budgeting

NOTES


(iii) Average investment

11. 8 Procedure for computation of ARR (i) Determine the average investment as given above.

(ii) Determine the profit after tax for each year: PAT = CFAT less

depreciation.

(iii) Calculate the total PAT for N years, where N = project life.

(iv) Calculate average PAT per annum (Total PAT of all years / N

years)

(v)

Merits of ARR Method

(i) It is very simple and easy to understand and to use.

(ii) It takes into consideration the total earnings from the project

during its lifetime.

(iii) It places emphasis on the profitability of the project, rather

than on liquidity as in the case of payback period

method.

(iv) It can be calculated by using the accounting data without

another set of workings like cash flow etc.

Demerits of ARR Method

(i) It ignores the time value of money and considers the profit

earned in the 1st year as equal to the profits earned in

later years. It does not discount the future profits.

(ii) It does not consider the length of project life

(iii) It ignores salvage value of the proposal. In real sense, the

salvage value is also a return from the proposal and

should be considered.

(iv) It also fails to recognize the size of investment required for

the project particularly, in case of mutually exclusive

proposals, the two projects having significantly different

initial costs, may have same ARR.

II. Discounted Cash Flow (DCF) Methods (or)

Time Adjusted Methods (or)

Present Value Methods

The payback period and ARR methods discussed above did not

recognise the time value money i.e., a rupee today is considered more

valuable than the one receivable after a year or two. Discounted cash flow

methods take into account the time value of money. The basic feature of

discounted cash inflows and cash outflows are discounted at a

predetermined discounting rate to ascertain their present values. Usually,

the discounting rate is the cost of capital rate of the firm. But it can be any

other rate also. Discounting factors can be obtained from present value

tables. They can also be ascertained by using the following formula:

Where, r = Discount rate

n = No. of years

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Capital Budgeting

NOTES


The second commendable feature of DCF methods is that they take into

account all benefits and costs during the entire life of the project.

Moreover, they use cash flows (i.e, CFAT) and not the accounting concept

of profit (i.e., PAT).

The DCF methods are becoming increasingly popular day

by day. Following are the discounted cash flow methods:

1. Net Present Value (NPV) Method

2. Internal Rate of Return (IRR) Method

3. Profitability Index (PI)

1. Net Present Value (NPV) Method: It is one of DCF methods in which

both future cash inflows and outflows from a project are discounted at a

cost of capital rate. This gives present value of cash inflows and

outflows. The difference between present value of cash inflows and

outflows is called Net Present Value (NPV)

11.9 Procedure for computation of NPV (i) Ascertain the total cash inflows of the project and the time

periods in which they arise.

(ii) Calculate the present value of cash inflows i.e., CFAT × PV

factor

(iii) Ascertain the total cash outflows of the project and the time

periods in which they occur.

(iv) Calculate the present value of cash outflows i.e., cash

outflows × PV factor.

(v) Calculate NPV = Present value of cash inflows – Present

value of cash outflows

(vi) Accept project if NPV is positive, else reject. If two projects

are mutually exclusive, the project with higher NPV

should be preferred.

Merits of NPV Method

(i) It recognizes the time value of money.

(i) It uses the discount rate which is the firm’s cost of capital.

(ii) It considers all cash flows over the entire life of the project.

(iii) NPV constitutes addition to the wealth of shareholders and

thus focuses on the basic objective of financial

management.

(iv) Since all cash flows are converted into present value

(current rupees), different projects can be compared on

NPV basis, thus, each project can be evaluated

independent of others on its own merit.

Limitations of NPV Method

(i) This method assumes that the discount rate i.e., firm’s cost

of capital is known. But the cost of capital is difficult to

understand and measure in practice.

(ii) It may not give reliable answers while dealing with

alternative projects under the conditions of unequal lives

of projects.

(iii) Decisions arrived at may not be satisfactory when projects

being compared involve different amounts of

investment.

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Capital Budgeting

NOTES


2. Internal Rate of Return (IRR) Method

IRR is the rate of return at which the sum of discounted cash

inflows equals the sum of discounted cash outflows. It is the

rate at which the NPV of the investment is zero. It is called

internal rate because it depends mainly on the outlay and

proceeds associated with the project and not on any rate

determined outside the investment. This method is also

known as marginal rate of return method or time adjusted

rate of return method. This method is generally employed

when cost of investment and annual cash inflows are

known, while the unknown rate of return (i.e., rate of cost of

capital) is to be ascertained.

11.10 Procedure for computation of IRR IRR is calculated according to two methods on the basis tabular

values.

(a) When cash inflows are uniform for all the years: In this

case, the IRR is determined with the help of annuity table

showing the present value of Re. 1 received annually over

‘n’ years by adopting the following two steps:

Step (i): The factors to be located in the relevant annuity table is

calculated by using the following simple equation:

Where, F = Factors to be located

I = Initial investment

C = Cash inflow per year

Step (ii): The factor, thus, calculated is located in annuity table on

the line representing number of year corresponding to the estimated

useful life of the assets and the relevant percentage of the discount

which represents IRR.

(b) When cash inflows are not uniform: In this case, IRR is to

be ascertained by trial and error process. In this process,

cash inflows are to be discounted by a number of trial rates.

Just to start, the average cash inflows of different years are

to be found. Original investment is to be divided by this

average cash inflow. This may be taken as present value

factor. The rate can be ascertained from PV table for this

factor and at this rate, the PV of case inflows of several

years are to be calculated, then total PV of cash inflows are

compared with the original investment. If the calculated PV

of cash inflows is less than the original investment, the

further interpolation be carried on at lower rate. On the

other hand, a higher rate should be tried if the PV of cash

inflows is higher than the original investment. This process

continues till the PV of cash inflows and the original

investment are equal or nearly equal. However, the exact

rate of return can be ascertained with the help of the

following formula:

124

Capital Budgeting

NOTES


Accept or reject criterion

Accept the project if the IRR is higher than or equal to minimum

required rate of return. The minimum required rate of return is also known

as cut off rate or firm’s cost of capital. While evaluating two or more

projects, project giving a higher IRR should be preferred.

Merits of IRR Method

(i) All cash inflows of the project arising at a different point of

time are considered.

(ii) Time value of money I taken into account.

(iii) Decision are immediately taken by comparing IRR with the

cost of capital.

(iv) It helps in achieving the basic objective of maximization of

shareholders wealth. All projects having IRR above the

cost of capital will be automatically accepted.

Limitations of IRR Method

(i) Computation of IRR is quite tedious, and it is difficult to

understand.

(ii) Both NPV and IRR assume that the cash inflows can be

reinvested the discounting rate in the new projects.

However, reinvestment of funds at the cut-off rate is

more appropriate than at the IRR. Hence, NPV method

is more reliable than IRR for ranking two or more

projects.

(iii) It may give results inconsistent with NPV method, this is

especially true in case of mutually exclusive projects

i.e., projects where acceptance of one would result in the

rejection of the other. Such conflict of results arises due

to the following:

(a) Differences in cash outlays

(b) Unequal lives of projects

(c) Different pattern of cash flows

3. Profitability Index (PI) Method

This method is a variant of the NPV method. It is also known as

benefit cost ratio or present value index. It is also based on the basic

concept of discounting the future cash flows and is ascertained by

comparing the present value of cash inflows with the present value

of cash outflows. It is calculated dividing the former by the latter.

Significance of PI

The PI represents the amount obtained at the end of the

project life, for every rupee invested in the project life, for every rupee

invested in the project at the initial stage. The higher the PI, the better it is,

since the greater is the return for every rupee of investment in the project.

Accept or Reject Criterion

Accept the project if its PI is more than 1 and reject the

project if the PI is less than 1. However, if the PI is equal to 1, then the

firm may be indifferent because the present value of inflows is expected to

be just equal to the present value of the outflows. In case of mutual

125

Capital Budgeting

NOTES


exclusive projects, project with highest PI should be given top priority,

while the project with the lowest PI should be assigned lowest priority. The

projects having PI of less than 1 are likely to be out rightly rejected.

Merits of PI Method

(i) It considers the time value of money.

(ii) It is a better project evaluation technique than NPV and

helps in ranking projects where NPV is positive.

(iii) It focuses on maximum return per rupee of investment and

hence is useful in case of investment in divisible

projects, when funds are not fully available.

Limitations of PI Method

(i) The PI as a guide in resolving capital rationing fails where

projects are indivisible. Once a single large project with

high NPV is selected, possibility of accepting several

small projects which together may have higher NPV

than the single project is excluded.

(ii) Situations may arise where a project with a lower PI

selected may generate cash flows in such case being

more than the one with a project with highest PI.

The PI approach thus cannot be used indiscriminately but all types of

combinations of projects will have to be worked out.

Profitability Index Vs NPV Method Vs IRR Method of Ranking of

Projects

In case, a firm has two or more projects competing for the same funds at its

disposal, the question of raking the projects arises. For a given project, PI

and NPV methods give the same accept and reject signals. However, if we

have to select one project out of two mutually exclusive projects, the NPV

method should be preferred. It is because of the fact that the NPV indicated

the economic contribution of the project in absolute terms. As such a

project which gives higher economic contribution should be preferred.

As regard NPV method versus IRR method, one has to consider the

basic presumption behind the two. In the case of IRR method, the

resumption is that intermediate cash inflows will be reinvested at the same

rate i.e., IRR, whereas the case of NPV method, intermediate cash inflows

are presumed to be reinvested at the cut off rate. It is obvious that re-

investment of funds at the cut off rate is more possible than at the IRR

which at times may be very high. Hence, the NPVs being obtained from

discounting at a fixed cut off rate more reliable in ranking two or more

projects than the IRR.

Capital Rationing

Generally, firm fix up maximum amount that can be invested in

capital projects, during a given period of time, say a year. The firm then

attempts to select a combination of investment proposals, that will be

within the specific limits providing maximum profitability and put them in

descending order according to their rate of return, such a situation is then

considered to be capital rationing.

A firm should accept all investment projects with positive NPV,

with an objective to maximise the wealth of shareholders. However, there

may be resource constraints due to which a firm may have to select from

126

Capital Budgeting

NOTES


among various projects with positive NPVs. Thus, there may arise a

situation of capital rationing where there may be internal or external

constraints on procurement of necessary funds to invest in all investment

proposals with positive NPVs.

The capital rationing can be experienced due to external factors,

mainly imperfections in capital markets which can be attributed to non-

availability market information, investors attitude etc. internal capital

rationing is due to the self-imposed restrictions imposed by management

like not to raise additional debt or laying down a specified minimum rate of

return on each project.

There are various ways of resorting to capital rationing. For

instance, a firm may affect capital rationing through budgets. It may also

put up a ceiling when it has been financing investment proposals only by

way of retained earnings (ploughing back of profits).

Since the amount of capital expenditure in that situation cannot exceed the

amount of retained earnings, it is said to be an example of capital rationing.

Capital rationing may also be introduced by following the concept

of “Responsibility Accounting”, whereby management may introduce

capital rationing by Authorising a particular department to make

investment only up to a specified limit, beyond which the investment

decisions are to be taken by higher ups.

Selection of projects under Capital Rationing

The selection of projects under capital rationing involves two steps:

(i) Identify the projects which can be accepted by using

methods of evaluation discussed above.

(ii) To select the combination of projects.

In capital rationing, it may also be more desirable to accept several

small investment proposals than few large investment proposals so

that there may be full utilisation of budgeted amount. This may

result in accepting relatively less profitable investment proposals if

full utilisation of budget I a prime consideration. Similarly, capital

rationing may also mean that the firm forgoes that next most

profitable investment following after the budget ceiling even

though it is estimated to yield a rate of return much higher than the

required rate of return. Thus, capital rationing does not always lead

to optimum results.

Inflation in capital Budgeting

Inflation has become almost a way of life. It causes erosion in the

purchasing power of money. It should be incorporated in capital budgeting

analysis. It can be incorporated in the capital budgeting evaluation

procedure by adjusting the cash flows or the discount rate. But care must

be taken that the treatment of inflation must be consistent. If inflation is

included in the cash flows (i.e., money cash flow), then it should be

included in discount rate also or in other words, both the cash flows as well

as the discount rate may be stated in real terms as if there has been no

inflation. The consequences of a mismatch can be dire. If money cash

flows are discounted at real discount rate, the resultant NPV will be

overestimated. Further, if real cash flows are discounted at money

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Capital Budgeting

NOTES


(nominal) discount rate, the resultant NPV will be understated. If

adjustment for inflation is done consistently, however, the NPV will be

identical (i.e., either money cash flows are discounted at money discount

rate or the real cash flows are discounted at real discount rate). An example

will make this concept more clear.

Example: A firm usually forecast cash flows in nominal terms and

discounts at a 10.25% nominal rate. The firm is considering a project at

present involving an immediate cash flow of Rs. 20,000 and has forecasted

cash flows in real terms i.e., in terms of current purchasing power of rupees

as follows:

Year 1 2 3

Cash inflow (Rs.) 10000 16000 12000

The firm expects inflation to be at the rate of 5% p.a Calculate NPA

Solution:

I. Computation of NPV by discounting money cash flows at money

discount rate:

(i)Calculation of Money Cash flows

Since the future cash inflows are given in current price and the

inflation rate is 5%, the future cash inflows in money term would be as

follows:

Year CFAT

Rs.

Inflation factor Money cash

inflow

Rs.

1 10,000 (1.05)1 10,500

2 16,000 (1.05)2 17,640

3 12,000 (1.05)3 13,892

(ii) Calculation of PV factor @ 10.25%

Where, r = 10.25 %, n = 5 years

= 0.907

= 0.823

= 0.746

(iii) Calculation of NPV

Year Money cash

inflow (Rs.)

PVF 10.25%

(Inflation

adjusted)

Present value

Rs.

1 10,500 0.907 9,524

2 17,640 0.823 14,518

3 13,892 0.746 10,363

P.V. of money cash inflows

Less: P.V. of cash outflow (20,000 x1)

34,405

20,000

NPV 14,405

128

Capital Budgeting

NOTES


II. Computation of NPV by discounting real cash flows at real

discount rate

(i) Calculation of real discount rate

(ii) Calculation of NPV

Year CFAT

(Real cash inflows) Rs.

PVF 5% Present value

Rs.

1 10,000 0.9524 9,524

2 16,000 0.9070 14,512

3 12,000 0.8638 10,366

P.V. of real cash inflows

Less: P.V. of cash outflow (20,000 x1)

34,402

20,000

NPV 14,402

From the above example, it is to be noted that the real discount rate is

approximately equal to the difference between the nominal discount rate of

10.25% and the inflation rate of 5% discounted at 5.25% (difference

between the two factors i.e., nominal rate inflation = 4.9875(i.e., 5.25 ×

95%) as compared with 5% as calculated earlier – not exactly right, but

close. The message of all this is quite simple. Discount nominal cash flows

at a nominal discount rate. Discount real cash flows at real discount rate.

Risk Analysis in Capital Budgeting

So far, our analysis of investment decisions has been based on

condition of certainty regarding the future and the proposed investment do

not carry any risk. The assumptions of certainty and no risk were made

simply to facilitate the understanding of capital investment decisions. But

in practice, all investment decisions are undertaken under conditions of risk

and uncertainty. Since investment decisions involve projecting the future

cash inflows and outflows, uncertainty inevitably creeps in. neither rupee

amounts not the dates of cash flows can be known with precision. The

amount and timing of the long-term future cash flows could vary

significantly from those predicted. It is, therefore, essential to consider risk

factor at the time of determining cash flows from a project for the purpose

of capital budgeting decisions. However, incorporation of risk factor in

capital budgeting decisions is a difficult task. Some of the popular methods

used for this purpose are as follows:

1. Risk adjusted discount rate method

2. Certainty – equivalent method

3. Sensitivity analysis

4. Probability assignment

129

Capital Budgeting

NOTES


5. Standard deviation and coefficient of variation.

6. Decision tree analysis.

These methods are discussed one by one in detail in the pages to come.

1. Risk adjusted Discount Rate Method: This method is also known

as varying discount rate method. It is based on the presumption that

investors expect a higher rate of return on risky projects as

compared to less risky projects. The rate requires determination of

(a) risk free rate and (b) risk premium rate. Risk free rate is the rate

at which the future cash inflows should be discounted has there

been no risk. Risk premium rate is the extra return expected by the

investors over the normal rate (i.e., the risk-free rate), on account of

the project being risky. Thus, Risk adjusted discount rate is a

composite discount rate that takes into account both the time and

risk factors. A higher discount rate will be applied for projects

which are considered more risky, conversely, lower discount rate is

applied for less risky projects.

2. Certainty-Equivalent method: Under this method, risk element is

compensated by adjusting cash inflows rather than adjusting the

discount rate. Expected cash flows are converted into certain cash

flows by applying certainty-equivalent co-efficient, depending upon

the degree of risk inherent in cash flows. To the cash flows having

higher degree of certainty, higher certainty – equivalent co-efficient

is applied and foe cash flows having low degree of certainty, lower

certainty equivalent co-efficient is used. For evaluation of various

projects, cash flows so adjusted are discounted by a risk-free rate.

3. Sensitivity Analysis: In the methods discussed above, only one

figure of cash flow for each year is considered. However, there are

chances of making estimation errors. The sensitivity analysis

approach takes care of this aspect by giving more than one estimate

of the future cash flow of a project. It is thus superior to one figure

forecast as it provides a more clear idea about the variability of the

return. Generally, sensitivity analysis gives information about cash

inflows under three assumptions i.e., ‘Optimistic’, ‘Most likely’ and

“Pessimistic” outcomes associated with the project; it explains how

sensitive the cash flows are under these three situations. Further

cash inflows under these three situations are discounted to

determine net present values. The larger the difference between the

pessimistic and optimistic cash flows, the more risky is the project

and vice versa.

4. Probability assignment: Although sensitivity analysis approach

provides different cash flow estimated under three assumption, it

does not provide chances of occurrence of each of these estimates.

The chances of occurrence can be ascertained by assigning

appropriate probabilities to each of these estimates. In most of the

capital budgeting situations, the probabilities are usually assigned

by the decision maker on the basis of some relevant facts and

figures and his subjective considerations. If the decision maker

foresees a risk in the proposal, then he has to prepare a separate

130

Capital Budgeting

NOTES


probability distribution to summaries the possible cash flow for

each year through the economic life of the proposal. Thereafter he

has to find out the expected value of probability distribution for

each year.

To determine the expected value, each cash flow of the probability

distribution is multiplied by the respective probability of the cash

flow and then adding the resulting products. This procedure is to be

adopted for the probability distribution for all the years and the

expected value of cash inflows are discounted at an appropriate

discount rate to determine the NPV of the proposal.

5. Standard Deviation and Co-efficient of variation:

The probability assignment discussed above does not give a

precise value indicating about the variability of cash flows and

therefore the risk. This limitation can be overcome by following

standard deviation approach. Standard deviation (SD) is a measure

of dispersion. It is defined as the square root of squared deviation

calculated from the mean. In case of capital budgeting, SD is

applied to compare the variability of possible cash flows of

different projects from their respective mean or expected value. A

project having a larger SD will be more risky as compared to a

project having smaller SD. The SD is calculated by using following

formula:

Co-efficient of variation is a relative measure of dispersion and can be

applied in capital budgeting decision process to measure the risk of a

project particularly in case when the alternative projects are of different

size. It is defined as the standard deviation of the probability distribution

divided by its expected value. The formula for calculation of CV is as

follows:

6. Decision Tree Analysis: This is a useful alternative for evaluating risky

investment proposals. It takes into account the impact of all probabilistic

estimates of potential outcomes. Every possible outcome is weighed in

probabilistic terms and then evaluated. A decision tree is a pictorial

representation in tree form which indicates the magnitude probability and

inter-relationship of all possible outcomes. The format of the problem of

the investment decision has an appearance of a tree with branches and

therefore this analysis is termed as decision tree analysis. The decision tree

shows the sequential cash flows and NPV of the proposed project under

different circumstances.

ILLUSTRATIONS

i. Payback Period Method

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Capital Budgeting

NOTES


1. A project has initial investment of Rs. 200000. It will produce cash

flows after tax of Rs. 50,000 per annum for six years. Compute the

payback period for the project.

Solution:

Computation of Payback period (Uniform CFAT)

2. Project Y has an initial investment of Rs 500000.its cash flows for 5

years are Rs.150000, Rs.180000, Rs.150000, Rs.132000 and Rs.120000.

Determine the payback period.

Solution:

Computation of payback period (differential CFAT)

Since the cash inflows are not uniform, accumulation cash inflows have to

be ascertained to calculate payback period.

Statement showing cumulative cash inflow

Year CFAT Rs. Cumulative CFAT

Rs.

1 150000 150000

2 180000 330000

3 150000 480000

4 132000 612000

5 120000 732000

Initial investment is Rs. 500000.Rs.480000 can be recovered in three years.

The remaining amount of Rs.20000 is to be recovered in the fourth year.

Time required for earning Rs.132000 in the fourth year =12 months.

Time required to earn Rs. 20,000 in the fourth year =

(or) 2

months

Payback period = 3 years, 2 months.

3. A company has to choose one of the following two mutually exclusive

projects. Investment required for each project is Rs 150000. Both the

projects have to be depreciated on straight line basis. The tax rate is 50%.

Calculate payback period.

Year Profit before depreciation

Profit X (Rs.) Profit Y (Rs.)

132

Capital Budgeting

NOTES


1 42,000 42,000

2 48,000 45,000

3 70,000 40,000

4 70,000 50,000

5 20,000 1,00,000

Solution:

In this problem, profit before depreciation is given. For calculation of

payback period, CFAT (profit before depreciation, after tax) is needed.

Project x

Statement showing CFAT & Cumulative CFAT

Year Profit

before

dep. &

tax

Dep.

(1,50,000/5)

PBT PAT CFAT Cum.

CFAT

(1) (2)

Rs.

(3)

Rs.

(4)

Rs.

(5)

Rs.

(6)

Rs.

(7)

Rs.

1 42,000 30,000 12,000 6,000 36,000 36,000

2 48,000 30,000 18,000 9,000 39,000 75,000

3 70,000 30,000 40,000 20,000 50,000 1,25,000

4 70,000 30,000 40,000 20,000 50,000 1,75,000

5 20,000 30,000 (-)

10,000

(-)

10,000

20,000 1,95,000

The above table shows that is 3 years, Rs. 1,25,000 has been

recovered, Rs. 25,000 is left out of initial investment. In the 4th Year, the

CFAT is Rs. 50,000. It means the payback period is between third and

fourth years.

= 3 years, 6 months

Project x

Statement showing CFAT & Cumulative CFAT

Year Profit

before

dep. &

tax

Dep.

(1,50,000/5)

PBT PAT CFAT Cum.

CFAT

(1) (2)

Rs.

(3)

Rs.

(4)

Rs.

(5)

Rs.

(6)

Rs.

(7)

Rs.

1 42,000 30,000 12,000 6,000 36,000 36,000

2 45,000 30,000 15,000 7,500 37,500 73,500

3 40,000 30,000 10,000 5,000 35,000 1,08,500

4 50,000 30,000 20,000 10,000 40,000 1,48,500

5 1,00,000 30,000 70,000 35,000 65,000 2,13,500

The above statement reveals that Rs. 1,48,500 has been recovered

in 4 years’ time. Rs. 1,500 is left out of initial investment. In the 5th year,

the CFAT is Rs. 65,000. It means the payback period is between 4th and 5th

year.

= 4 years, 9 days

II. Discounted Payback Period Method

1. Project M has an initial investment of RS.3 lakh. Its cash flows for five

years are RS. 90000 RS. 108000 RS.90000 RS 79200 and RS 72000.

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Capital Budgeting

NOTES


Determine the discounted payback period assuming a discount rate of 10%

p.a.

Solution:

Statement showing Discounted CFAT & Cumulative Discount CFAT

Year CFAT

Rs.

P.V factor

AT 10%

DCFAT

Rs.

Cum.

DCFAT

Rs.

1

2

3

4

5

90,000

1,08,000

90,000

79,200

72,000

0.909

0.826

0.751

0.683

0.621

81,810

89,208

67,590

54,094

44,712

81,810

1,71,018

2,38,608

2,92,702

3,37,414

The above table reveals that in 4-year, RS. 292702 has been recovered,

Rs.7298 is left out of initial investment. In the 5th year, the CAFT is

44712.It means the payback period is between fourth and fifty years.

= 4 years, 2 months

Note: In case of different CFAT, use P.V. factors.

III. Accounting (or) Average Rate of Return (ARR) Method

1. Project k required an investment of RS 20 lakh and yields profits after

tax and depreciation as follows:

Year 1 2 3 4 5

Profits after

tax &

depreciation

(Rs.)

1,00,000 1,50,000 2,50,000 2,60,000 1,60,000

At the end of 5th year, the plant can be sold for Rs. 1,60,000. You are

required to calculated ARR.

Solution:

Average profit =

=

= 20%

2. X Ltd. is considering the purchase of a new machine to replace a

machine which has been in operating in the factory for the lest 5 year.

Ignoring interest but considering tax at 50% of net earnings, suggest which

of the two alternatives should be preferred. The following are the details:

134

Capital Budgeting

NOTES


Old machine New machine

Purchase price Re. 40,000 Re. 60,000

Estimated life on

machine

10 years 10 Years

Machine running hours

p.a

2,000 2,000

Units per hour 24 36

Wages per running 3 5.25

Power per annum 2,000 4,500

Consumable stores p.a 6,000 7,500

All other charges p.a 8,000 9,000

Material cost per unit 0.50 0,50

Selling price per unit 1.25 1.25

You may assume that the above information regarding sales and cost of

sales will hold good throughout the economic life of each of the machines.

Depreciation has to be charged according to straight line method. Calculate

accounting rate of return.

Solution:

Profitability statement

Particulars Old Machine New machine

Rs. Rs.

Sales

Less: Cost of

sales:

Direct materials

Wages

Power

Consumable

stores

Other charges

Depreciation

(48,000 x 1.25)

(48,000 x 0.50)

(2,000 x 3)

40,000/10

60,000

24,000

6,000

2,000

6,000

8,000

4,000

(72,000 x 1.25) 90,000

36,000

10,500

4,500

7,500

9,000

6,000

Profit before tax

Less: Tax @

50%

10,000

5,000

16,500

8,250

Profit after tax 5,000 8,250

Working note: Calculate of No. of units produced

Output = Units per hour x Running hours

Old machine = 24 x 2,000 = 48,000 units

New machine = 36 x 2,000 = 72,000 units

Calculation of Accounting Rate of Return (ARR)

ARR =

Old machine =

New machine =

Analysis: As the accounting rate of return of new machine (13.75%) is

higher than that of old machine (12.5%), the old machine can be replaced

by the new machine.

135

Capital Budgeting

NOTES


IV. Net present value (NPV)

1. An investment of Rs. 10,000 (having scrap value of Rs. 500) yields the

following returns:

Year 1 2 3 4 5

CFAT 4,000 4,000 3,000 3,000 2,500

The cost of capital is 10%. Is the investment desirable? Discuss it

according to NPV method assuming the P.V. factors for 1st , 2nd , 3rd, 4th

and 5th year. 0.909, 0.826, 0.751, 0.683 and 0.620 respectively.

Solution:

Statement showing Net Present Value

Year CFAT

Rs.

P.V factor @

10%

Present value

Rs.

(1) (2) (3) (4) = (2) x(3)

1

2

3

4

5

4,000

4,000

3,000

3,000

2,500

500 (scrap)

0.909

0.826

0.751

0.683

0.620

0.620

3,636

3,304

2,253

2,049

1,550

310

Total present value of cash inflows

Less: Present value of cash outflow(10,000x 1)

13,102

10,000

Net present value (NPV) 3,102

Note: (i) The scrap value is taken as an additional inflow at the end of fifth

year.

(ii) In case of differential CFAT, use P.V factors.

Analysis: Since NPV is positive, the investment is desirable.

V. Internal Rate of Return (IRR) Method

1. (Uniform CFAT)

Initial outlay RS 100000

Life of the assets 6 year

Estimated cash inflow RS 20000

You are required to calculate internal rate of return.

Solution:

Computation of internal Rate of Return (IRR)

Present value factor = initial investment/CFAT = 100000/20000= 5

The present value factor is to be found out in the present value

annuity table in the column of 6 year (life of the assets). The figure 4.917

(nearer to 5) is found in the row of 6%. Therefore, the IRR is 6%.

11.11 Check Your Progress

1. What is capital budging?

2. What are the features of capital budgeting?


136

Capital Budgeting

NOTES


1. Capital budgeting means planning the capital expenditure in acquisition

of fixed (capital) assets such as land, building, plant or new projects as a

whole. It includes replacing and modernising a process.

2. Investments: Capital expenditure plans involve a huge investment in

fixed assets. Long-term: Capital expenditure, once approved, represents

long term investment that cannot be reversed or withdrawn without

sustaining a loss. Forecasting: preparation of capital budget plans involves

forecasting of several years’ profits in advance in order to judge the

profitability of projects.


1. What are the advantages of capital budgeting?

2. What are the capital budgeting decisions?

3. Calculate the pay-back period for a project which requires a cash outlay

of Rs.100000 and generates cash inflows Rs.25000 Rs.35000, Rs.30000,

and Rs.25000 in the first, second, third and fourth years respectively.

5. Calculate discount payback period from the details given below:

Cost of project: Rs. 6,00,000; Life of the project: 5 years; Annual cash

inflow; Rs. 2,00,000; Cut off rate: 10%

Year 1 2 3 4 5

Discount

factor 0.909 0.826 0.751 0.683 0.621

6. A project requires an investment of RS.500000 and has a scrap value of

Rs.20000 after 5 year. It is expected to yield profile after taxes and

depreciation during the five years amounting to RS.40000, Rs.60000,

Rs.70000, Rs.50000 and Rs.20000. calculate the Average rate of return on

investment.

7. An investment of Rs. 10,000 (having scrap value of Rs. 500) yields the

following returns:

Year 1 2 3 4 5

CFAT 4,000 4,000 3,000 3,000 2,500

The cost of capital is 10%. Is the investment desirable? Discuss it

according to NPV method assuming the P.V. factors for 1st , 2nd , 3rd, 4th

and 5th year. 0.909, 0.826, 0.751, 0.683 and 0.620 respectively.

Further Reading:

• Financial management: Panday, I.M. 9th ed Vikas

• Principles of financial management: Inamdar, S.M. Everest

• Fundamentals of Advanced Accounting, R.S.N. Pillai Bagavathi,


• Financial Management: Text & Problems, Khan, M. Y Jain, P.K.

3rd ed, TMH

• Financial Management, Khan & Jain – Tata McGraw Hill

• Cost and Management Accounting, Jain S.P. & Narang, K.L.


137

Working Capital Management

NOTES


UNIT - XII WORKING CAPITAL

MANAGEMENT Structure

12.1 Introduction

12.2 Meaning of working capital

12.3 Definition of working capital

12.4 Concepts of working capital


12.6 Features of Working Capital

12.7 Significance of working capital

12.8 Adequacy of working capital

12.9 Advantages of adequate working capital


12.11 Determinants of working capital requirements

12.12 Working capital management


12.14 Sources of working capital

12.15 Advantages of raising funds by issue of equity shares


12.17 Regulation of Bank Credit- Tandon Committee

12.1 Introduction

It is common knowledge that a firm’s value cannot be Maximised

in the long run unless it survives the short run. Firms fail most often

because they are unable to meet their working capital needs. Consequently,

sound working capital management is a requisite for firm’s survival.

Working capital management is requisite for firm’s survival. Working

capital management is the functional area of finance that covers all the

current assets of the firm. It is concerned with management of the level of

individual current assets as well as the management of total working

capital. In chapter 1, it is mentioned that financial management means

procurement of funds and effective utilization of these procured funds.

Procurement of funds is firstly concerned for financing working capital

requirement of the firm and secondly for financing fixed assets. In this

chapter, we are going to deal with various issue relating to financing and

management of working capital.

12.2 Meaning of working capital Working capital is the amount of funds required for meeting day-to-

day expenses of the business. The firm starts with cash. It buys raw

materials, employs workers and spends on expenditures like advertising

etc. Even then it may not receive cash immediately if sold on credit. The

firm will have to use its own cash before it gets back sales revenue and

then the cycle can go on. So, the money or funds required to meet the

expenditure until it gets back through sales revenue is called working

capital and this much funds it has to keep. In simple words, working capital

refers to that part of the firm’s capital which is required for financing short

term or current assets such as cash, marketable securities, debtors and

138


NOTES


inventories. Funds, thus, invested in current assets keep revolving fast and

are being constantly converted into cash and this cash flows out again in

exchange for other current assets. Hence, it is also known as revolving or

circulating or short-term capital.

12.3 Definition of working capital (i) ICAI: Working capital means the funds available for day-to –day

operation of an enterprise.

(ii) Shubin: Working capital is a part of capital which is required for

purchase of raw materials and for meeting day-to-day

expenditure on salaries, wages, rent and advertising etc.

(iii)J.M. Mill: The sum of the current assets is the working capital of

the business.

(iv) C.W. Gerstenberg: Working capital is the excess of current assets

over current liabilities.

(v) Annual survey of Industries (1961) : Working capital is defined to

include “stocks of materials, fuels, semi-finished goods

including work-in-progress and finished goods and by-

products; cash in hand and at bank and the algebraic sum of

sundry creditors as represented by (a) outstanding factory

payments i.e., rent, wages, interest and dividend; (b)

purchase of goods and services; (c) short term loans and

advances and sundry debtors comprising amounts due to the

factory on account of sale of goods and services and

advances due to the factory on account of sale of goods and

services and advances towards tax payments.

12.4 Concepts of working capital From the above definitions, it is observed that there are two concepts of

working capital. They are: (i) Gross concept and (ii) Net concept.

i) Gross concept: According to this concept, the term working capital

refers to the amount of funds invested in current assets that are employed

in the firm. The amount of current liabilities is not subtracted from the total

current assets. This concept views working capital and aggregate of current

assets as two interchangeable terms. To understand this concept, it is

essential to know the meaning of current. Current assets are such assets as

in the orderly and natural course of business move onward through the

various process of production, distribution and payment of goods, until

they become cash or its equivalent by which debts may be readily and

immediately paid. In other words, correct assets refer to those assets which

can be converted into cash in hand and with banks, stock-finished, in-

process and raw materials, receivables for sale of merchandise, marketable

securities held as temporary investment, prepaid expensed and accrued

income.

Those gross concept is also known as “current capital” or “circulating

capital”. This concept is sometime preferred due to the following reasons:

a) Earnings in each firm are the outcome of both fixed as well as

current assets. Individually these assets have no significance. The points of

139


NOTES


similarity in these assets are that both are borrowed, and they yield profit

much more than the interest cost. But the distinction in the two lies in the

fact that fixed assets constitute the fixed capital of a firm, whereas current

assets are of a circulating nature. Hence, logic demands that current assets

should be considered as the working capital of the firm.

(b) This concept takes into consideration the fact that there would

be an automatic increase in the working capital with every increase in the

funds of the firm; but it is not so according to the net concept of working

capital.(c) Every management is interested in the total current assets out of

which the operation of a firm is made possible, rather than in the sources

from where the capital is procured; (d) This concept is also useful in

determining the rate of return on investment in working capital.

Net concept: According to this concept, working capital is the excess of

current assets over currents liabilities, or say, Net working capital =

Current Assets-Current liabilities. The term “Current liabilities” refers to

those claims of outsiders which are expected to mature for payment within

an accounting year and includes sundry creditors, bill payable, bank

overdraft, outstanding expensed, short term loans, advances and deposits,

provision for tax if it does not amount to appropriation of profit. The net

working capital can be positive or negative. When current assets exceed

current assets, the net working capital becomes negative. The Net concept

lays emphasis upon the qualitative aspect of the working capital. It is an

accounting concept. It deals with the management of “Net working capital

flows” in the long run. It is concerned with the management of each current

asset as well as each current liability. It is more widely accepted and is

used in the analysis of fund flow, ratio analysis and also in the structured

decisions and management of working capital. Accounting Standard Board

has used the term ‘working capital’ and not ‘net working capital’ and says

it refers to excess of current assets over current liabilities, thus, implicitly

accepted the “net concept”.

The net working capital concept is useful in the following ways:

a) It is a qualitative concept, which indicates the firm’s ability to meet its

operating expenses and short-term liabilities.

b) It indicates the margin of protection available to the short-term creditors.

(a) It is an indicator of the financial soundness of the firm.

(b) It suggests the need of financing a part of working capital

requirement out of the permanent sources of funds.


Generally speaking, the amount of funds required for operating

needs varies from time to time in every business. A certain amount of

assets in the form of working capital is always required, if a business has to

carry out its functions efficiently and without a break. But a certain amount

is needed for meeting day-to-day expenditures of business which varies

from time to time. These two types of requirements – permanent and

variable are the basis for a convenient classification of working capital.

(i) Permanent working capital: It is the amount of funds which is required to

produce good and service necessary to satisfy demand at its lowest point.

140


NOTES


Such capital is constantly changing from one assets to another without

leaving the business process until the business ceases to exist. Tandon

committee has named it as “Core current assets”. This capital can again be

subdivided into (1) Regular working capital and (2) Reserve margin or

cushion Working capital.

Regular working capital is the minimum amount of liquid capital needed to

keep up the circulation of the capital from cash to inventories to receivables

and back again to cash .This would include a sufficient cash balance in the

bank to pay all bills, maintain an adequate supply of raw materials for

processing, carry a sufficient stock of finished goods to give prompt delivery

and effect the lowest manufacturing costs and enough cash to carry the

necessary accounts receivables for the type of business engaged in.

Reserve margin or cushion working capital is the excess over the need for

regular working capital that should be provided for contingencies that arise

at unstated period. The contingencies include (a) rising prices, which may

make it necessary to have more money to carry inventories and receivables

or may make it advisable to increase inventories;

(b)business depressions ,which may raise the amount of cash required to

ride out usually stagnant periods;(c)strikes ,fires and unexpectedly severe

competition ,which use up extra supplies of cash ,and (d)Special operations

such as experiments with new products or with new method of distribution

,war contracts, contracts to supply new businesses and the like, which can

be undertaken only if sufficient funds are available and which in many

cases mean the survival of a business.

12.6 Features of Working Capital The permanent working capital has the following characteristics:

a) It is classified on the basis of time factor;

b) It constantly changes from one asset to another and continues to

remain in the business process;

c) Its size increases with the growth of business operation;

d) It should be financed out of long-term funds

(ii) Temporary working capital:

It represents working capital requirements over and above permanent

working capital and is dependent on factors like peak season, trade

cycle, boom etc. It is also called fluctuating or variable working capital.

It can further be classified as seasonal working capital and special

working capital.

Seasonal working capital is the additional amount of current assets-

particularly cash, receivable and inventory which is required during the

more active business seasons of the year.

Special working capital is the part of temporary working capital which

is required for financing special operations such as extensive marketing

campaigns, experiments with product or methods of production,

carrying of special jobs etc.

Features: The temporary working capital possesses the following

characteristics:

a) It is not always gainfully employed, though it may change from

one assets to another, as permanent working capital does.

b) It is particularly suited to businesses of a seasonal or cyclical

nature.

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NOTES


The distinction between permanent and temporary working capital

is of great significance particularly in arranging the finance for a

firm. The Permanent working capital should be raised in the same

way as fixed capital is procured, through a permanent investment of

the owner or through long term borrowing. As business expands,

this regular capital will necessarily expand. if the cash realized

from sales includes a large enough profit to take care of expanding

operations and growing inventories, the necessary additional

working capital may be provided by the earning surplus of the

business. Temporary working capital needs can, however, be

financed out of short-term borrowings from the bank or from public

in the form of deposits.

The position with regard to the “permanent working capital” and

“Temporary working capital” can be shown with the help of

following figure:

Form the above figure, it is crystal clear that the amount of

permanent working capital remains the same over all periods of

time.e.g.,Rs.5 lakh at all times, irrespective of the amount of sales,

activity etc .But it cannot be presumed that the permanent working

capital will always remain fixed throughout the life of the firm. As

the size of the business grows, permanent working capital too is

bound to grow. This position can be depicted with the help of the

following figure:

The above figure made it clear that the permanent working capital

increases in amount (rupee value) based on the activity level of the firm.

For example, working capital of Rs.5 lakh may be sufficient for a turnover

level of 25 lakh. But when the turnover increased to Rs.50 crore, after a

certain time period, the amount of working capital should rise and hence,

should be an amount higher than Rs.5 lakh.

12.7 Significance of working capital Every business firm requires some amount of working capital .Even a fully

equipped manufacturing firm is sure to collapse without(a)an adequate

supply of raw materials to process;(b)cash to meet the wage bill;(c)The

capacity to wait for the market for its finished product(d)the ability to grant

credit to its customers. similarly, a commercial enterprise is virtually good

for nothing without customers. Similarly, a commercial enterprise is

virtually good for nothing without merchandise to sell. Working capital,

thus ,is the backbone of a business. As a matter of fact, any organization,

whether profit oriented or otherwise will not be able to carry on production

and distribution activities smoothly without adequate working capital.

12.8 Adequacy of working capital As indicated above, every firm is supposed to have adequate working

capital i.e., as much as needed by the firm. It should neither be excessive

nor inadequate .Both inadequate and redundant working capital situations

are dangerous. Excess working capital means idle funds lying with the firm

and not earning any profit for it. Whereas inadequate working capital

means that the firm does not have sufficient funds for financing its daily

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NOTES


business activities, which ultimately result in stoppage of production and

reduced productivity .It is rightly said, “Inadequate working capital is

dangerous; whereas redundant working capital is a criminal waste”.

12.9 Advantages of adequate working capital (i) Cash discount: The business can avail the advantage of cash discount

by paying cash for the purchase of raw materials and merchandise. If

proper cash balance is maintained, this will reduce the cost of

production.

(ii) Sense of security and confidence: Adequate working capital creates a

sense of security and confidence not only among the business

executives but also among the customers, creditors and business

associates.

(iii)Credit worthiness: prompt payment of dues results in establishing

credit worthiness of the business. This facilitates commanding

Favourable terms for further borrowings.

(iv) Continuous supply of raw materials: A firm with adequate working

capital is assured of regular supply of required raw materials on the

basis of prompt payment.

(v) Exploitation of good opportunities: Good opportunities can be

exploited in case of adequacy of capital in a concern. For Example, a

firm may make off-season purchases resulting in substantial savings or

it can fetch big supply orders resulting in good profits.


(i) Inefficient management: Excessive working capital indicates

inefficient management of the firm. It show that the management is not

interested in expanding the business, otherwise the excessive working

capital might have been utilized for this purpose.

(ii) Increased capital expenditure: As enough fund is available, there may

be boost up in acquiring plant and machinery to enhance production. In

case there is not enough sales potentiality with adequate margin of

profit, such fixed investment may not be worthwhile for fund

employment.

(iii)Over capitalization: Excessive working capital gives birth to over

capitalization with all its evils. Over capitalization is not only

disastrous to the smooth survival of the firm but also affects the

interests of those associated with the firm.

(iv) Lower return on capital employed: A firm with excessive working

capital cannot earn a proper rate of return on its total investments, as

profit are distributed on the whole of its capital. This brings down the

rate of return to the shareholders. In turn, lower dividend reduces the

market value of share and causes capital loss to the shareholders

12.11 Determinants of working capital requirements The following factors are considered for a proper assessment of the

quantum of working capital requirements:

(a) Nature of business: working capital is very limited in public sector

undertakings such as electricity, water supply and railways

because they offer cash sales only and supply services, not

products and no funds are tied up in inventories and receivables.

143


NOTES


On the other hand, the trading and financial firms require less

investment in fixed assets but have to invest large amount of

working capital along with fixed investment.

(b) Length of production cycle: The longer the manufacturing time, the

raw materials and other supplies have a be carried for a longer

time in the process with progressive increment of labour and

service costs before the final product is obtained. so working

capital is directly proportional to the length of the

manufacturing process.

(c) Rate of stock turnover: There is an inverse co-relationship between

the question of working capital and the velocity or speed with

which the sale is affected. A firm having a high rate of stock

turnover will need lower amount of working capital as

compared to a firm having a low rate of turnover.

(d) Business cycle: In period of boom, when the business is prosperous,

there is need for larger amount of working capital due to rise in

sales, rise in prices, optimistic expansion of business etc. On the

contrary, in times of depression, the business contracts, sales

decline, difficulties are faced in collection from debtors and the

firm may have a large amount of working capital.

(e) Earning capacity and dividend policy: some firms have more

earning capacity then others due to quality of their products,

monopoly condition, etc. such firm may generate cash profits

from operations and contribute to their working capital. The

dividend policy also affects the requirement of working capital.

A firm maintaining a steady high rate of cash dividend

irrespective of its profits, need working capital than the firm

that retains larger part of its profits and does not pay so high

rate of cash dividend.

(f) Operating cycle: The speed with which the operating cycle

completes its round

(i.e., cash raw materials finished product accounts

receivables cash) plays a decisive role in influencing the

working capital needs.

(g) Operating efficiency: operating efficiency means optimum

utilization of resources. The firm can minimize its need for

working capital by efficiently controlling its operation costs.

With increased operating efficiency, the use of working capital

is improved, and pace of cash cycle is accelerated. Better

utilization of resources improves profitability and helps in

relieving the pressure on working capital.

(h) Price level changes: Generally, rising price level requires a higher

investment in working capital. With increasing prices, the same

levels of current assets need enhanced investment. However,

firms which can immediately revise prices of their products

upwards may not face a severe working capital problem in

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NOTES


periods of rising levels. The effects of increasing price level

may, however, be felt differently by different firms due to

variations in individual prices. It is possible that some

companies may not be affected by rising prices, whereas others

may be badly hit by it.

(i) Degree of mechanization: In a highly mechanized concern having a

low degree of dependence on labour, working capital

requirement gets reduced. Conversely, in labour intensive

industries, greater sums shall be required to pay for wages and

related facilities.

(j) Growth and expansion of business: In the business, the working

capital requirements of a firm are low. However, with the

gradual growth and expansion, its working capital needs also

increase. Discernibly, larger amount of working capital in a

growing concern is required for its expansion programmes.

(k) Seasonal variations: some industries manufacture and sell goods

only during certain seasons. For example, sugar, oil, timber, and

textile industries have either seasonal supplies of raw materials

or make their sales in a particular season. Hence, the working

capital requirements of such industries will be higher during a

certain season as compared to any other period.

(l) Capital structure of the firm: If shareholders have provided some

funds towards the working capital needs (at least to satisfy the

permanent working capital needs), the management will find it

relatively easy to manage working capital. If the firm has to

depend entirely upon outside sources for both permanent and

temporary working capital needs, it faces an uphill task under

dear money conditions.

(m) Credit policy: A firm making purchases on credit and sales on cash

will always require lower amount of working capital. On the

contrary, a firm which is compelled to sell on credit and at the

same time having no credit facilities may find itself in a tight

corner. Prevailing trade practices and changing economic

conditions do generally exert greater influence on the credit

policy of the concern.

(n) Size of the business: The size of business has also an important

impact on its working capital needs. Size may be measured in

terms of scale of operation. A firm with larger scale of

operation will need more working capital than a small firm.

(o) Production policy: The production policies pursued by the

management have a significant effect on the requirement of

working capital of the business. The production schedule has a

great influence on the level of inventories. The decisions of the

management regarding automation, etc. Will also have effect on

working capital requirements. In case of labour-intensive

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NOTES


industries, the working capital requirements will be more.

While in case of a highly automatic plant, the requirement of

long-term funds will be more.

(p) Profit margin: Firm differ in their capacity to generate profit from

business operation. Some firm enjoy a dominant position, due

to quality product or good marketing management or monopoly

power in the market and earn a high profit margin. Some other

firms may have to operate in an environment of intense

competition and may earn a low margin of profit. A high net

profit margin contributes to wards the working capital pool. In

fact, the net profit is a source of working capital to the extent it

has been earned in cash.

(q) Liquidity and profitability: In case, a firm desires to take a greater

risk for bigger gains, it reduces the size of its working capital in

relation to its sales. If it is interested in improving its liquidity,

it increases the level of its working capital. However, this policy

is likely to result in a reduction of the sales volume, and

therefore, of profitability. A firm, therefore, should choose

between liquidity and profitability and decide about its working

capital requirements accordingly.

(r) Capacity to repay: A firm’s ability to repay determines level of its

working capital. The usual practice of a firm is to prepare cash

flow projections according to its plans of repayment and fix the

working capital levels accordingly.

(s) Value of current assets: A decrease in the real value of current

assets as compared to their book value reduces the size of the

working capital. If the real value of current assets increases,

there is an increase in working capital.

(t) Means of transport and communication: Working capital needs also

depend upon the means of transport and communication. If they

are not well developed, the industries will have to keep huge

stocks of raw materials, spares, finished goods, etc., at places of

production as well as distribution outlets.

12.12 Working capital management Working capital management is best described as the administration of all

aspects of current assets and current liabilities. It is concerned with the

problems that arise in the management of current assets, current liabilities

and the interrelationships that exist between them.

The primary objective of working capital management is to manage

the firm’s current assets and current liabilities in such a way that the

satisfactory amount of working capital is maintained i.e., it is neither

inadequate nor excessive. Both inadequate and excessive working capital

are dangerous. Inadequate working capital may lead to stoppage of

production. Excessive working capital may lead to carelessness about costs

and therefore, to inefficiency of operations. If a firm invests more in

current assets, it increases liquidity, reduces the risk and profitability. The

146


NOTES


reason is the opportunity cost of earning from excess investment in current

assets is lost. On the other hand, less investment in current assets reduces

liquidity, but increases the risk and profitability. Thus, the amount of

investment made in current assets has a bearing on liquidity and

profitability. In fact, liquidity and profitability are inversely related. When

one increases, the other decreases. Therefore, the finance manager has to

frame a suitable working capital management policies to strike a balance

between the liquidity and profitability.

Working capital management policies also have a great impact on

the structural health of the organization. If different components of

working capital are not balanced, then in spite of the fact that current ratio

and liquid ratio may indicate satisfactory financial position in respect of the

liquidity of the firm, it may not in fact be as liquid as indication by the

current and liquid ratios. For example, if the proportion of inventory is very

high in the total current assets or greater proportion is appropriated by slow

moving or obsolete inventory, then this cannot provide the cushion of

liquidity. Similarly, high investment in accounts receivable and failure to

collect them on time will also adversely affect the real liquidity of the firm,

thereby adversely affecting the structural health of the organization. In

case, a firm maintains more cash and bank balances, it means that the firm

is not making profitable use of its resources.

It is, therefore, important that the finance manager has to frame

proper working capital management policies for the various constituents of

working capital i.e., cash account receivables, inventories etc., so as to

ensure higher profitability, proper liquidity and sound structural health of

the organization.

In order to achieve the objective of maintaining satisfactory level of

working capital in a firm, the finance manager has to perform the following

two functions:

1. Forecasting the working capital requirements

2. Finding the sources of working capital

I. Forecasting the working capital requirements

As stated earlier, an adequate amount of working capital is essential

for the smooth running of a firm. The finance manager should

forecast working capital requirements carefully to determine the

optimum level of investment in working capital. While forecasting

working capital requirements, it should be borne in mind that

working capital requirements are to be determined on an average

basis and not at any specific point of time. The following two

methods are generally adopted to forecast the working capital

requirements:

1. operating cycle method

2. Estimation of components of working capital method

1. operating cycle method: one of the methods for forecasting

working capital requirements is based on the concept of

operating cycle. As discussed at the beginning of this chapter,

when goods are sold on credit as is the normal practice of

business firms today to cope with increased competition, the

sale of goods cannot be converted into cash instantly because of

time lag between sales and realization of cash.

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NOTES


As there is a time lag between sales and realization of

receivables, there is a need for sufficient working capital to deal

with the problem which arises due to lack of immediate

realization of cash against goods sold. The operating cycle is

the length of time required for conversion of non-cash assets

into cash. This operating cycle refers to the time taken for the

conversion of cash into raw materials, raw materials into work-

in-progress, work-in-progress into finished goods, finished

goods into receivables, receivables into cash and this cycle

repeats. This cycle is also known as working capital cycle or

cash cycle.

The operating cycle length differs from firm to firm. If a firm

has lengthy production process or a firm has liberal credit

policy, the length of operating cycle will be more. On the other

hand, if a firm is a trading concern, then the length of operating

cycle will be reduced to a greater extent. The following

diagrams will make this concept more clear:

Operating cycle of manufacturing firm operating

cycle of Trading firm


(a) Surplus generation: It represents the activity cycle of business i.e.,

purchases, manufacture, sales and collection thereof. Hence, the

operating cycle stands for the process that creates surplus or profit

for the business.

(b) Funds rotation: It indication the total time required for rotation of

funds. The faster the funds rotate, the better it is for the firm.

(c) Going concern: It lends meaning to the going concern concept. If

the cycle stops in between, the going concern assumption may be

violated. Hence, operating cycle should be on par with the industry

148


NOTES


average. A long cycle indicates overstocking of inventories or

delayed collection of receivables and is considered unsatisfactory.

Computation of operating cycle

The operating cycle can be determined as given below:

Days

Raw material storage period

Add: Work-in-progress holding

period

Finished goods storage period

Debtors collected period

xxx

xxx

xxx

xxx

Less: Creditors payment period

xxx

xxx

Operating cycle period xxx

The various components of operating cycle can be calculated by using

following formula given below:

(i) Raw material storage period:

(ii) Work-in-progress holding period:

(iii) Finished goods storage period:

(iv) Debtors collection period:

(v) Creditors payment period:

Computation of working capital required

After ascertaining the various constituents of working capital as

discussed above, the difference between total current assets and total

current liabilities is to be taken as required working capital. It may be

prudent to add a certain percentage to cover contingencies. The following

is the proforma for estimation of working capital requirements:

Statement showing working capital requirements

Particular Rs. Rs.

Current assets:

(i) Stock:

Raw material

Work-in-progress:

xxx

149


NOTES


Raw materials (100%)

Labour (50%)

Overheads (50%)

Finished goods

xxx

xxx

xxx

xxx

xxx

xxx

(i) Trade debtors

(ii) Cash balance

xxx

xxx

xxx

Less: Current liabilities:

Trade creditors

Outstanding wages

Outstanding overheads

xxx

xxx

xxx

xxx

Net working capital (CA- CL)

Add: Provision for contingencies xxx

xxx

working capital required xxx

12.14 Sources of working capital After determining the working capital requirements of the firm, the next

function of finance manager is to find an assortment of appropriate source

of working capital to finance for its current assets. A firm has various

sources to meet its financial requirements. The sources of working capital

are of two types i.e., long term and short-term sources. The financing of

current assets through long term sources is generally costlier than that of

short-term sources. However, financing of current assets from long term

sources provides stability, reduces risk of repayments and increases

liquidity of the firm. The following is a snapshot of various sources of

working capital available to a firm.

(i) Long term sources

(ii) Short term sources

(i) long term sources

(a) Issue of equity shares

(b) Issue of preference shares

(c) Issue of debentures or shares

(d) Retained earnings

(e) Loans from financial institutions

(ii) Short term sources

Internal

(a) Depreciation fund

(b) Provision for taxation

(c) Outstanding expenses

External

(a) Trade credit

(b) Commercial paper

(c) Advances from customers

(d) Bank credit

I. Long term sources

a) issue of equity shares:

A firm may raise funds from promoters or from the investing

public by way of owners’ capital or equity capital by issue of

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NOTES


ordinary shares. Ordinary shareholders are owners of the firm. Since

equity shares can be paid off only in the event of liquidation, this

source has the least risk involved. Further, the dividend payable on

shares is an appropriation of profits and not a charge against profits.

This means that it has to be paid only out of profits after tax.

12.15 Advantages of raising funds by issue of equity shares 1. It is a permanent source of finance.

2. The issue of new equity shares increases flexibility of the firm.

3. The firm can raise further share capital by making a rights issue.

4. There is no mandatory payments to shareholders of equity shares.

b) Issue of preference shares:

These are a special kind of shares, the holders of such shares

enjoy priority, both as regards the payment of a fixed amount of

dividend and repayment of capital on winding up of the firm.

Preference share capital is a hybrid from of financing which

partakes some characteristics of equity capital and some attributes

of debt capital. It is similar to equity because preference dividend,

like equity dividend is not a tax-deductible payment. It resembles

debt capital because the rate of preference dividend is fixed.

Typically, when preference dividend is skipped, it is payable in

future because of the cumulative feature associated with most of

preference shares.

Cumulative convertible preference share may also be

offered, under which the shares would carry a cumulative

dividend of specified limit for a period of say there years after

which the shares are converted into equity shares. These shares

are attractive for projects with a long gestation period. For normal

preference shares, the maximum permissible rate of dividend is

14%. preference share capital can be redeemed at a Pre decided

future date or at an earlier stage inter alia out of profits of firm.

This enables the promoters to withdraw their capital from the firm

which in now self-sufficient and the withdrawn capital may be

reinvested in other profitable ventures. It may be mentioned that

irredeemable preference shares cannot be issued by any firm.

The advantages of taking the preference share capital route

are:

(i) No dilution in EPS on enlarged capital base-if equity

is issued, it reduces EPS, thus affecting the

market perception about the firm.

(ii) There is leveraging advantage as it bears a fixed

charge.

(iii)There is no risk of takeover.

(iv) There is no dilution of managerial control.

(v) Preference share capital can be redeemed after a

specified period.

c) Issue of debentures or bonds:

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NOTES


Loans can be raised from public by issuing debentures or

bonds by the firm. Debentures are normally issued in different

denominations ranging from Rs.100 to Rs. 1000 and carry

different rates of interest. By issuing debentures, a firm can

raise long term loans from public. Normally, debentures are

issued on the basis of a debenture trust deed which list the

terms and conditions on which the debentures are floated.

Debentures are normally secured against the assets of the firm.

As compared with preference shares, debentures provide

a more convenient mode of long-term funds. The cost of

capital raised through debentures is quite low since the interest

payable on debentures can be charged as an expense before

tax. From the investors’ point of view, debentures offer a more

attractive prospect then the preference shares since interest on

debentures is payable whether or not the firm makes profits.


1) The cost of debentures is much lower than the cost of preference

or equity capital as the interest is tax deductible. Also, investors

consider debenture investment safer than equity or preference

investment and, hence may require a lower return on debentures

investment.

2) Debenture financing does not result in dilution of control.

3) In a period of rising prices, debenture issue is advantageous. The

fixed monetary outgo decrease in real terms as the price level

increases.

The disadvantages of debentures financing are:

1) Debentures interest and capital repayment are obligatory payment

2) The protection covenants associated with a debenture issue may be

restrictive

3) Debentures financing enhances the financial risk associated with

the firm.

d) Retained earnings:

It represents undistributed profits of the firm commonly used by

the established firm for financing their permanent working capital

requirements known as “ploughing back of profit”. It is a regular

and cheapest source of working capital. It makes the firm

financially strong and increases credit worthiness. It can be used

not only for the development, expansion and modernization of the

firm but also for redeeming debt and stabilizing the rate of

dividend.

e) Loans from financial institutions:

In India, specialized institutions provide long term finance to

firms. Thus, IFCI, SFC, LIC of India. ICICI, IDBI etc. provide

term loans to firm. Such loans are available at different rates of

interest under different schemes of financial institutions and are to

be repaid according to a stipulated repayment schedule. The loans

152


NOTES


in many cases stipulate a number of conditions regarding the

management and certain other financial policies of the firm.

II. Short term sources

The temporary working capital requirements can be met through

two major short-term sources i.e., Internal sources and external

sources.

(A) Internal sources

(1) Depreciation fund: The depreciation funds created out of firm’s

profits provide a reliable source of working capital so long as they are not

invested in assets or distributed as dividends.

(2) Provision for taxation: There remains a time lag between creating

provision for taxes and their actual payment. Thus, the funds appropriated

for taxation can be used for the short-term working capital requirements of

the firm during the intermittent period.

(3) Outstanding expenses: Sometimes, the firm postpones the payment

of certain expenses due on the date of finalization of accounts.

Outstanding expenses like unpaid wages, salaries, rent, etc. also constitute

an important source of short-term working capital.

(B) External sources

(a) Trade credit: It represents credit extended by the suppliers of

goods in the normal course of business. The usual duration of credit is 15

to 90 days. It is granted to the firm on open “account”, without any

security except that of the goodwill and financial standing of purchaser.

No interest is expressly charged for this, only the price is a little higher

than the cash price. This source of working capital has the following

advantages:

(1) Ready availability: There is no need to arrange financing formally.

(2) Flexible means of financing: Trade credit is a more flexible means

of financing. The firm does not have to sign a promissory note, pledge

collateral or adhere to a strict payment schedule on the note.

(3) Economic means of financing: Generally during periods of tight

money, large firms obtain credit more easily then small firms do.

However, trade credit as a source of financing is still more accessible by

small firms even during the periods of tight money.

(b) Commercial paper (CP): CP is a “since promissory note” issued

by a firm, approved by RBI, negotiable by endorsement and delivery,

issued at such discount on the face value as may be determined by the

issuing firm. Each CP will bear a certificate from the banker verifying

signature of the executors. These are issued by a firm to raise funds for a

short period, generally verging from a few days to few months. The CP

may be issued in multiples of Rs.5 lakh.

Eligibility: The following conditions are to be fulfilled by the firm for

issuing CP:

(a) The issuing firm should have a tangible net worth of not less than

Rs. 4 core as per the latest balance sheet.

(b) The firm should have working capital limit of not less than Rs. 4

core.

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NOTES


(c) The current ratio should be minimum 1.33 as per the latest balance

sheet.

(d) The firm should have minimum P2/A2 rating from

CRISIL/ICRA/CARE or any other credit Rating Agency for the purpose.

The rating should not be more than two months old from the date of issue

of the CP.

(e) The borrowing account of the firm is classified as standard assets

by financing banking company/companies.

No CP can be issued for period less than 15 days from the date of its

issue. There is no grace period for payment of CPs. The RBI has increased

the maturity period of the CPs from a maximum of 6 months to a

maximum of less than 1-year period from the date of its issue.

There is, however, reluctance on the part of investors, especially banks

to invest in less than 1-year CP because of the absence of a secondary

market.

CP may be issued to any person including individuals, banks and other

corporate bodies registered/incorporated in India and unincorporated

bodies. It cannot, however, be issued to NRI’s

A firm issuing CP may request the banker to provide standby facility for

an amount not exceeding the amount of issue for meeting the liability of

CP on maturity. The financing banker shall correspondingly reduce the

working capital limits of every firm issuing the CP.

Issuing Norms: As per the guidelines issued by RBI, a firm will issue

CP’s through same bank/consortium of banks from whom it has a line of

credit. In other words, instead of making loans and advances, the bank will

deal in the issue.

Another underlying issue is the time dimension. The firms applying for

issue of CP to RBI have to obtain credit rating, which should not be more

than two months old. This implies that firm intending to issue CP has to

obtain a fresh rating if time lapses.

Besides, once the RBI approves a firm’s application, it has to make

arrangement within 15 days for placing the CP privately.

Advantage: The advantages of commercial paper lie in its simplicity

involving hardly any documentation between the issuer and the investor

and its flexibility with regard to short-term maturity. A well rated firm can

diversify its sources of finance from banks to the short-term money

markets at a somewhat cheaper cost, especially in a situation of easy

money market. The CP provides investors with higher returns than they

could obtain from the banking system. They have to pay off their debts

semi-annually I.e., for instance eight instalments over a period of year.

(c)Advances from customers: Firms engaged in producing or

constructing costly goods involving considerable length of manufacturing

or construction time usually demand advance money from their customers

at the time of accepting their orders for executing their contracts or

supplying the goods. This is a cost-free source of working capital and

really useful.

(d) Bank credit: Commercial banks provide working capital to the

firm in the form of cash credit, overdraft, bills discounting, bills

acceptance, line of credit, letter of credit and bank guarantee. Banks do not

sanction loans on a long-term basis beyond a small proportion of their

demand and time liabilities. Loans are granted against tangible securities

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NOTES


such as goods, shares, promissory notes, bills, etc. All forms of loans given

by the banks are explained briefly as given below:

(i) Cash credit: This facility will be given by the banker to the

customers by giving certain amount of credit facility against security of

inventory on continuous basis. The borrower will not be allowed to

exceed the limits sanctioned by the bank.

(ii) Bank overdraft: It is a short-term borrowing facility made available

to the firms in case of urgent need of funds. The banks will impose limits

on the amount they can lend. When the borrowed funds are no longer

required, they can quickly and easily be repaid. The banks provide

overdrafts with a right to call them in at short notice.

(iii) Bills discounting: The firm which sells goods on credit, will

normally draw a bill on the buyer who will accept it and sent it to the seller

of goods.

The seller, in turn discounts the bill with his banker. The banker will

generally earmark the discounting bill limit.

(iv) Bills acceptance: To obtain finance under this type of arrangement,

a firm draws a bill of exchange on bank. The bank accepts the bill

thereby promising to pay out the amount of the bill at some specified

future date.

(v) Line of credit: It is a commitment by bank to lend a certain amount

of funds on demand specifying the maximum amount.

(vi) Letter of credit: It is an arrangement by which the issuing bank on

the instruction of a customer or on its own behalf undertakes to pay or

accept or negotiate or authorize another bank to do so against stipulated

documents subject to compliance with specified terms and conditions.

(vii) Bank guarantees: Bank guarantee is one of the facilities that the

commercial banks extend on behalf of their clients in favorer of third

parties who will be the beneficiaries of the guarantees.

12.17 Regulation of Bank Credit- Tandon Committee A study group was appointed by the RBI in July 1974, under the

chairmanship of shri Prakash Tandon to suggest guidelines for the rational

allocation and optimum use of bank credit in view of the number of

weaknesses in the bank lending at that time.

Recommendation

(a)Inventory and receivable norms: The study group recommended

norms for inventory/receivable for 15 major industries. The banker should

finance only the genuine production needs of the borrower. The borrower

should maintain the reasonable levels of inventory and receivable. He

should hold just enough inventory to carry on target production. Efficient

management of resources should be ensured to eliminate slow moving and

flabby inventories. Flabby, profit-making or excessive inventory should not

be permitted under any circumstances. Similarly, the banker should finance

only those receivable which are in tune with the practices of the borrower’s

firm and industry. Initially, the norms for inventory and receivables were

intended to be applied to all borrowers with aggregate credit limit of Rs. 10

155


NOTES


lakh or more from the banking system but were to be gradually extended to

all borrowers.

(b) Lending norms: The Tandon committee has introduced the concept of

maximum permissible bank finance (MPBF) and suggested that bank

should attempt to supplement the borrower’s resources in financing the

current assets. It has recommended that the banker should finance only a

part of working capital gap, the other part to be financed by the borrower

from the long-term resources. The working capital gap is defined as current

assets minus current liabilities excluding bank borrowings.

In this connection, the committee suggested three methods of determining

MPBF:

(i) First method: The borrower will contribute 25% of the

working capital gap, the remaining 75% can be financed from

bank borrowings. This method will give a minimum current

ratio of 1:1 and maximum current ratio of 1.17:1

(ii) Second method: The borrower will contribute 25% of the total

current assets. The remaining working capital gap can be bridged from

the bank borrowings. This method will give a current ratio of 1.33:1

(iii) Third method: The borrower will contribute 100% of core current

assets representing the irreducible technological minimum of assets and

25% of the balance of current assets. The remaining working capital gap

can be met from the borrowings. This method will further strengthen the

current ratio.

The methods discussed above for determining the MPBF may be

described as given below:

First method: MPBF = 75% of (Current assets – Current liabilities)

Second method: MPBF = 75% of (Current assets – Current liabilities)

Third method: MPBF = 75% of (Current assets – Core Current assets) –

Current liabilities.

Working capital ratios

As indicated earlier, the finance manager has to maintain an adequate

working capital at every time so as to carry on the operations successfully

and maximize the return on investment. He has to be vigilant about the

trends in the items that make up the working capital. This requires a

careful inquiry into the current assets and current liabilities in order to

control the working capital and to conserve it properly. Ratio analysis is

the most common tool of financial analysis of working capital. It is used

by financial executives to check upon the efficiency with which working

capital is being used in the firm. The following are the most useful ratios

in diagnosing the working capital position of a firm:

(i) Current ratio: It is also known as ‘working capital ratio’. It shows

whether the short-term obligations are sufficiently covered by the current

assets. The formula is as follows:

Current ratio

Here,

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NOTES


Current Assets = Stock + Debtors + Cash in hand + Cash at bank + Bills

Receivable + Prepaid expenses + Accrued income

Current Liabilities: Creditors + Bills payable + Bank overdraft +

Outstanding expenses + Income received in advance etc.

(i) Quick ratio: It is the ratio between quick assets of the firm

and current liabilities, also known as acid- test ratio, or

liquid ratio. It deposits the immediate liquid position of the

firm. It is calculated as follows:

Quick ratio = Current liabilities

Here,

Liquid Assets = Current assets – Stock - Prepaid expenses

Cash ratio: Cash ratio is the preferred measure of liquidity. It is also known

as absolute liquidity ratio. It is the ratio of cash and equivalent assets to

current liabilities. As per formula:

Cash ratio =

(iv) Debtors turnover ratio: It expresses the relationship between net credit

sales and average accounts receivable. It measures the number of times the

receivable is rotated in a year in terms of sales. It also indicates the

efficiency of credit collection and efficiency of credit policy. It is

calculated by applying the following formula:

Debtors turnover ratio =

Here,

Accounts receivable = Debtors +B/R

(v) Stock turnover ratio: It establishes relationship between average stock

at cost and cost of goods sold. It is employed to measure how quickly stock

is converted into sales. It is calculated by using the following formula:

Stock turnover ratio =

Here,

Average stock =

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NOTES


Cost of goods sold = Sales – Gross profit (or) Operating stock +

Purchases + Direct expenses – Closing stock

(vi) Creditors turnover ratio: It expresses relationship between credit

purchases and average accounts payable. It is calculated to find out

whether the firm is making payments to creditors on time. It is calculated

as under:

Creditors turnover ratio =

Here,

Accounts payable = Creditors + Bills payable

(vii) Working capital turnover ratio: It indicates the number of times the

working capital is converted into sales. It is calculated as given below:

Working capital turnover ratio =

(viii) Current assets turnover ratio: It is a ratio of sales revenue to total

current assets. It measures how effective; management is in controlling the

current assets. It shows the over or under trading position in relation to the

quantum of working capital. As per formula:

Current assets turnover ratio =

Illustration

1. From the following information extracted from the books of a

manufacturing company, compute the operating cycle in days:

Period covered: 365 days

Average period of credit allowed by suppliers: 16 days

Rs.

Average total of debtors outstanding

Raw materials consumption

Total production cost

Total cost of sales

Sales for the year

Value of Average stock maintained:

Raw materials

Work-in-progress

Finished goods

4,80,000

44,00,000

1,00,00,000

1,05,00,000

1,60,00,000

3,20,000

3,50,000

2,60,000

Solution:

Statement showing operating cycle

Particulars Rs

(a) Raw material held in stock:

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NOTES


27

(b) Work – in – progress:

13

(c) Finished goods held in stock:

9

(d) Credit period allowed to debtors:

11

Less: Average credit period allowed by creditors

60

16

Net operating cycle period 44

2. Determine the working capital requirements of a company from the

information given below:

Operating cycle components:

Raw materials =60 days

W.I.P =45 days

Finished goods =15 days

Debtors = 30 days

Creditors = 60 days

Annual turnover =73 lakh; Cost structure (as % of sale price) is Materials

50%, Labour 30%, Overheads 10 % and Profit 10%. Of the overheads,

30% constitute depreciation.

Desired cash balance to be held at all times: Rs. 3 lakh.

Solution:

Working notes:

(i) Calculation of % of WIP cost under Total Approach

WIP cost %. =Materials+50% of Labour and OH

=50%+50% of (30% +10 %) = 70%

(ii) Calculation of % of WIP cost under Cash cost Approach

WIP cost % =Materials +50% of Labour and OH minus

depreciation

=50%+50% of (30% +7%)- 68.5%

Statement showing calculation of Effective days of operating cycle

Particulars Gross

days

Total Approach Cash cost

Approach

Cost % Effective

days

Cost % Effective

days

Current Assets:

Raw material

WIP

Finished goods

Debtors

60

45

15

30

50%

70%

90%

100%

30.00

31.50

13.50

30.00

50%

68.5%

87%

87%

30.00

30.825

13.05

26.10

Total

Less: Current liability:

150

105

99.975

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NOTES


Creditors 60 50% 30 50% 30.000

Operating cycle 90 75 69.975

Statement showing working capital Requirements

Particulars Total Approach Cash cost Approach

working capital

(Based on sales)

Add: Minimum cash

balance required

73,00,000 = 75/365

= 15,00,000

= 3,00,000

73,00,000x69.975/365

= 13,99,500

= 3,00,000

Required working

capital

18,00,000 16,99,500

NOTE: In order to determine working capital requirements, two

conceptual approaches are followed i.e. Total approach and cash cost

approach. Under total approach, all expenses and profit margin are

considered. Under cash cost approach, only cash expenses (excluding

depreciation) are considered.


1. Define working capital.

2. What are the types of working capital

3. What are the sources of working capital


1. Working capital is the excess of current assets over current liabilities.

C.W. Gerstenberg:

2. Permanent working capital and Temporary working capital

3. Long term sources, Short term sources


Short Questions:

1. What is working capital?

2. What are the significances of working capital?

3. Explain the term working capital ratio.


4. Briefly explain the term concepts of working capital.

5. What are the disadvantages of maintaining insufficient working

capital?

6. State the disadvantages of maintaining excessive working capital in a

company.

7. Calculate the operating cycle of a company which gives the

following details relating to its operating:

Raw materials consumption per annum

Annual cost of production

Annul cost of sales

Annual sales

Average value of current assets held:

Raw materials

Work-in-progress

Finished goods

Debtors

The company gets 30 days credit from its suppliers. All sales made

by the firm are on credit only. You may take one year as equal to

365 days.

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NOTES


[Ans: operating cycle: 120 days]

8. From the following estimates, calculate the average amount of

working capital required:

(a)Average amount locked-up in stock: P.A. (Rs.)

Stock of finished goods &W.I.P 10000

Stock of stores, materials, etc. 8000

(b)Average credit given:

Local sales:2 weeks credit 104000

Sales outside the state: 6 weeks credit 312000

(c)Time available for payment:

For purchases:4 weeks 78000

For Wages:2 weeks 260000

Add10% to allow for contingencies

[Ans: Net working capital Rs.46200]

9. From the following estimates of RLG Ltd., You are required to

prepare a forecast of working capital requirements:

Expected level of production for the year: 15600 units.

Cost per unit: Raw materials Rs.90, Direct labour Rs.40, overheads

Rs.75.

Selling price per unit Rs.265

Raw materials in stock on an average for one month.

Materials are in process on an average for 2 week.

Finished goods in stock on an average for one months.

Credit allowed by suppliers is one months.

Time lag in payment from debtors is 2 months.

Lag in payments of Wages 1 ½ weeks.

Lag in payment of overheads is one month. All sales are on credit.

Cash in hand and at bank is expected to be Rs.60000

It is assumed that production is carried on evenly throughout the

year. Wages and over heads accrued evenly and a period of 4 week

is equivalent to a month.

[Ans: Net working capital required Rs.778500]

10. You are required to prepare a statement of working capital

needed to finance a level of activity of 5200 units of output. You are

given the following information:

Elements of cost Amount per unit

Rs.

Raw materials 8

Direct labour 2

Overheads 6

Total cost 16

Profit 4

Selling price 20

Raw materials are in stock on an average – one months. Materials

are in process on an average – half-a-month. Finished goods are in

stock on an average -6 weeks. Credit allowed by creditors is one

month. Lag in payment of Wages is 1.5 weeks. Cash in hand and at

161


NOTES


bank is expected to be Rs.7300. Credit allowed to debtors is two

months.

You are information that production is carried on evenly during the

year and wages and overheads accrue similarly.

[Ans: Net working capital required Rs.31800]

Further Reading:



Kalyani Publishers, Delhi 3. Financial Management: Pandey, I. M. Viksas


P.K. TMH


3rd ed, TMH






162

Cost of Capital

NOTES


UNIT - XIII COST OF CAPITAL Structure

13.1 Introduction

13.2 Meaning of Cost of Capital

13.3 Definition of Cost of Capital

13.4 Components of Cost of Capital

13.5 Factors determining the Cost of Capital

13.6 Types of Cost of Capital

13.7 Computation of cost of capital

13.8 Benefits of market value approach:

13.9 Benefits of book value approach

13.1 Introduction In order to evaluate investment proposals, different methods have been used in

chapter 3 on capital budgeting. All those methods, their application, evaluation

criteria etc. depend upon two basis inputs i.e., cash flows emanating from

projects and the discount rate. The discount rate is actually the ‘cost of capital’.

The cost of capital is also known as cut-off rate, minimum required rate of

return, rate of interest, hurdle rate, target rate etc. The concept of cost of capital

has two applications. First in capital budgeting, it is used to find the present

value of future cash flows and it is also used in optimization of the financial

plan or capital stricter of a firm. The second aspect of concept of cost of capital

will be taken up in chapter 5. In this chapter, an attempt has been made to

measure the cost of capital of each source of finance so as to find the total cost

of capital of a firm.

13.2 Meaning of Cost of Capital: For financing its operations, a firm can raise long term funds

through a combination of (i) Debt, (ii) Preference share capital, and (iii) Equity

share capital. The firm has to service these funds by paying interest, preference

dividend and equity dividend respectively. The payment made by the firm

constitutes the cost of obtaining/utilising that source of finance.

13.3 Definition of Cost of Capital: (i) Milton H. Spencer: Cost of capital is the minimum rate of return

which a firm requires as a condition for undertaking an investment.

(ii) G.C. Phillioppatus: The cost of capital is the minimum required

rate of return, the hurdle or handle or target rate, the cut-off rate or the financial

standard of performance of a project.

(iii) James C. VanHorne: The cost of capital represents a cut-off

rate for the allocation of capital to investment of projects. It is the rate of return

on a project that will leave unchanged the market price of the stock.

(iv) Hamplon John J: Cost of capital is the rate of return the firm

requires from investment in order to increase the value of the firm in the market

rate.

(v) Haley and Schall: In general sense, the cost of capital is any

discount rate used to value cash streams.

(vi) Solomon Ezra: The cost of capital is the minimum rate of

return or cut-off rate for capital expenditures.

(vii) Hunt William and Donaldson: Cost of capital is the rate that

must be earned on the net proceeds to provide the cost elements of the burden at

the time they are due.

163

Cost of Capital

NOTES


We can, thus, define cost of capital as a minimum rate of return which a

firm is expected to earn from a proposed project so as to make no reduction in

the earnings per share to equity shareholders and its market price.

13.4 Components of Cost of Capital: The cost of capital of a firm consists of the following three

components:

(i) Return at Zero risk: This includes the projected rate of return on

investment when the project does not involve any business of financial risk.

(ii) Premium for business risk: The cost of capital includes

premium for business risk. Business risk refers to the changes in operating

profit on account of charges in sales. The projects involving higher risk than the

average risk can be financed at a higher rate of return than the normal rate. The

suppliers of funds for such project will expect a premium for increased business

risk. The business risk is generally determined while taking capital budgeting

decisions.

(iii) Premium for financial risk: The cost of capital includes

premium for financial risk arising on account of higher debt content in capital

structure, requiring higher operating profit to cover periodic payment of interest

and repayment of principal amount on maturity. As the chances of cash

insolvency of a firm with higher debt content in its capital structure are greater,

the suppliers of funds would expect a higher rate of return as a premium for

higher risk.

13.4.1 Importance of Cost of Capital:

Prior to the development of the concept of cost of capital, the

problem was ignored or by-passed. The progressive management always takes

notice of the cost of capital while taking a financial decision. This concept is

quite relevant in the following managerial decision:

(i) Capital Budgeting decision: Cost of Capital is used as a

‘measuring rod’ for evaluating investment proposals. The firm, naturally, will

choose the project which gives a satisfactory return on investment which would

be in no case less than the cost of capital incurred for its financing. In various

methods of capital budgeting, cost of capital is the key factor in deciding the

project out of various proposals pending before the management. It measures

the financial performance and determines the acceptability of all investment

opportunities.

(ii) Designing the capital structure: The cost of capital is

significant in designing the firm’s capital structure. The cost of capital is

influenced by the changes in capital structure. A capable financial executive

always keeps an eye on capital market fluctuations and tries to achieve the

sound and economical structure for the firm. He may try to substitute the

various sources of finance in an attempt to minimize the cost of capital so as to

increase the market price and the earning per share.

(iii) Deciding about the method of financing: A capable financial

executive must have knowledge of the fluctuations in the capital market and

should analyse the rate of interest on loans and normal dividend rates in the

market from time to time. Whenever firm requires additional finance, he may

have a better choice of the sources of finance which bears the minimum cost of

capital. Although cost of capital is an important factor in such decision, equally

important are the considerations of relating control and of avoiding risk.

(iv) Performance of top management: The cost of capital can be

used to evaluate the financial performance of the top executives. Evaluation of

the financial performance will involve a comparison of actual profitability of

164

Cost of Capital

NOTES


the projects undertaken with the projected overall cost of capital and an

appraisal of the actual costs incurred in raising the required funds.

(v) Other areas of decisions making: The concept of cost of

capital is also used in many other areas of decision making, such as leasing,

bond refunding, dividend policy decision, working capital management

policies, etc. In social accounting, this concept is used in selecting the best

investment opportunities which would maximise the social and minimize the

social costs.

13.5 Factors determining the Cost of Capital: Following are some of the factors which are relevant for the determination

of cost of capital of the firm:

(i) General economic conditions: General economic conditions

determine the demand and supply of capital within the economy as well as the

level of expected inflation. This economic variable is reflected in the risk less

rate of return. This economic variable is reflected in the risk less rate of return.

This rate represents the rate of return on risk-free investment such as the interest

rate on short term government securities, in principle, as the demand for money

in the economy changes relative to the supply, investors alter their required rate

of return. For example, if the demand for money increases without an

equivalent increase in the supply, lenders will raise their required interest rate.

At the same time, if inflation is expected to deteriorate the purchasing power of

the rupee, investors require a higher rate of return to compensate for this

anticipated loss.

(ii) Market Conditions: When an investor purchases a security

with significant risk, an opportunity for additional return is necessary to make

the investment attractive. Essentially, as risk increases, the investor requires a

higher rate of return. This increase is called premium. When investors increase

their required rate of return, the cost of capital rises simultaneously. If the

security is not readily marketable, when the investor wants to sell or even if a

continuous demand for the security exists, but the price varies significantly, an

investor will require a relatively high rate of return. Conversely, if a security is

readily marketable and its price is reasonable stable, the investor will require a

lower rate of return and the firm’s cost of capital will be lower.

(iii) Operating and financing decision: Risk or the variability of

returns, also results from decisions made with in the firm. Risk resulting from

these decisions is generally divided into two type: business risk and financial

risk. Business risk is the variability in returns on assets and is affected by the

firm’s investment decisions. Financial risk is the increased variability in returns

to equity shareholders as a result of financing with debt or preferred stock. As

business risk and financial risk increase or decrease, the investor’s required rate

of return (and the cost of capital) will move in the same direction.

(iv) Amount of financing: The last factor determining the firm’s

cost of funds is the level of financing that the firm requires. As the financing

requirements of the firm become larger, the overall cost of capital increases for

several reasons. For instance, as more securities are issued, additional floatation

cost or the cost incurred by the firm for issuing securities, will affect the

percentage cost of the funds to the firm. Also, as management approaches the

market for large amounts of capital relative to the firm’s size, the investors’

required rate of return of return may rise, supplier of capital become hesitant to

grant relatively large sums without evidence of management’s capability to

absorb this capital into the business, This is typically “too much too soon”.

Also, as the size of the issue increases, there is greater difficulty in placing it in

165

Cost of Capital

NOTES


the market without replacing the price of the security, which also increases the

firm’s cost of capital.

13.6 Types of Cost of Capital: Cost of Capital can broadly be classified as under:

(i) Historical cost and Future cost: Historical cost refers to the cost

refers to the cost which has already been incurred in order to finance a

particular project. It is useful for projecting future cost. Future cost is the

expected cost of funds for financing a particular project. It is applied for taking

financial decision. For example, at the time of taking a capital budgeting

decision, a comparison is to be made between the expected IRR and the

expected cost of funds for financing the same i.e., the relevant cost here is the

future cost.

(ii) Explicit cost and Implicit Cost: The explicit cost is the discount

rate that equates the present value of cash flows that are incremental to the

taking of the financing opportunity with the present value of its incremental

cash flows. It is the internal rate of the cash flows of financing opportunity.

Implicit cost is also known as opportunity cost. It is a rate of

return associated with the best investment opportunity for the firm and its

shareholders that will be foregone if the project is accepted. The cost of

retained earnings is an opportunity cost of because a shareholder is deprived of

the opportunity to invest the retained earnings elsewhere.

(iii) Specific cost and composite cost: It refer to the cost of each

component of capital viz., equity share capital, preference share capital, debt

etc. It is particularly useful where the profitability of the project is evaluated on

the basis of specific source of funds taken for financing the said project. For

example, if the estimated cost of equity capital becomes 10% that project which

is financed by equity shareholders’ funds, will be accepted provided the same

will yield at least a return of 10%.

The composite cost refers to the combined cost of equity capital,

preference capital, debt etc. It is also known as weighted average cost of capital

or overall cost of capital. This cost is used for evaluating capital structure

decisions.

(iv) Average cost and Marginal cost: Average cost is the weighted

average cost of each component of funds invested by the firm for a particular

project i.e., percentage or proportionate cost of each element in total

investment.

Marginal cost is the cost of obtaining another rupee of new capital.

Generally, a firm raises a certain amount of fund for fixed capital investment.

But marginal cost reveals the cost of additional amount of capital which is

raised by a firm for current or fixed capital investment. When a firm raises

additional capital from one particular source only i.e., equity shares, the

marginal cost in that case is known as specific or explicit cost of capital.

13.7 Computation of cost of capital: 1. Cost of Debt:

Cost of debt may be defined as the returns expected by the potential

investors of debt securities of a firm. It measures the current cost to the firm of

borrowing funds to finance the projects. It is generally determined by the

following variables:

(i) The current level of interest rates: As the level of interest rates

increases, the cost of debt will also increase;

166

Cost of Capital

NOTES


(ii) The default risk of the firm: As the default risk of the firm

increase, the cost of debt will also increase. One way of measuring the default

risk is to use the bond rating for the firm; higher interest rates.

(iii) The tax advantages associated with the debt: Since the interest

is tax deductible, the after-tax cost of debt is a function of tax-rate. The tax

benefit that accrues from paying interest makes the after-tax cost of debt lower

than the pre-tax cost.

The cost of debt is of two types i.e., cost of irredeemable debt and

cost of redeemable debt.

1. Cost of Irredeemable Debt: Irredeemable debt also known as perpetual debt

refers to the debt which is not redeemable during the lifetime of the firm.

Interest payable on such debt is called cost of irredeemable debt. It is calculated

by using the following formula:

A. Cost of debt before tax (Kdb)

Kdb =

(a) Interest on debt should be calculated only on the face value of debt

irrespective of issue price.

(b) Net proceeds (NP) is to be ascertained as gives below:

(i) Debt issued at par:

NP= Face value - Issue expenses

(ii) Debt issued at premium:

NP= Face value + Securities premium – Issue expenses

(iii) Debt issued at discount:

NP = Face value – Discount - Issue expenses.

B. Cost of debt after tax (Kda)

As the interest on debt is tax deductible, the firm gets a saving in its tax

liability. The interest works as a tax liability of the firm is reduced. Thus, the

effective cost of debt is lower than the interest paid to debt investors. The cost

of debt is determined as given below:

Cost of debt after tax (Kda)=

The after-tax cost of debt may also be determined by applying the formula

given below:

Kda= Kdb(1- Tax rate)

2. Cost of Redeemable Debt:

Redeemable debt refers to the debt which is repayable after a stipulated

period, say 5 or 7 or 10 years. The cost of this debt is determined as given

below:

(A) Cost of debt before tax (Kdb)

Kdb= (a) Computation of Annual cost before tax

Rs.

Interest on debt p.a. xxx

Add: Issue expenses, amortised p.a. xxx

Add: Discount on issue, amortised p.a. xxx

Add: Premium on redemption of debt,

amortised p.a.

(In case of redemption at premium) xxx

——

xxx

167

Cost of Capital

NOTES


Less: Premium on issue of debt, amortised p.a.

(In case of issue at premium) xxx

——

Annual cost before tax xxx

——

Note: (i) While calculating annual cost, the issue expenses, discount on issue,

premium on redemption and premium on issue are amortised over the tenure of

debt.

(ii) Issue expenses (floatation costs) are to be calculated at face the issue

price whichever is higher.

(b) Computation of average value of debt (AV):

The average value of debt is the average of net proceeds (NP) and

redemption value (RV) of debt.

AV=

(B) Cost of debt after tax (Kda):

The cost of redeemable debt after tax is calculated as given bellow:

Kda=

The cost of redeemable debt after tax can be ascertained by using the following

formula:

Kda= Kdb(1-Tax rate)

II Cost f Preference share capital

Dividend paid to the preference shareholders is the cost of preference

share capital. The cost of preference share capital is based on the rate of return

required by the firm’s preference shareholders, which is determined by the

market price of the preference shares. Since preference dividend is not tax

deductible, there is no need for tax adjustment in calculating the effective cost

of preference share capital. Like debt capital, preference shares are divided into

two categories i.e., irredeemable and redeemable. In India, Companies

Amendment Act, 1988 prohibits issue of irredeemable preference shares.

A. Cost of Irredeemable Preference Share capital:

In case of irredeemable preference shares, the dividend at the fixed rate will

be payable to the preference shareholders perpetually. The cost of irredeemable

preference share capital can be calculated with the help of the following

formula:

Cost of Preference share capital (Kp ) =

The net proceeds indicate the net amount realized from the issue of

preference shares which can be determined as follows:

(a) Issued at par:

NP=Face value - Issue expenses

(b) Issued at premium:

NP = Face value + Security premium – Issues expenses

(c) Issued at discount:

NP= Face value – Discount – issue expenses

(B) Cost of Redeemable Preferences Share capital (RPS)

If the preferences shares are redeemable at the end of a specified period, then

the cost of preference share capital can be calculated by applying the formula

given under:

168

Cost of Capital

NOTES


Cost of Redeemable preferences share capital =

(a) Computation of Annual Cost:

Rs.

Annual preference dividend

Add: Issue expenses, amortised p.a.

Discount on issue, amortised p.a. (In

case of issue at discount)

Premium on redemption amortised

p.a.

(In case of redemption at premium)

xxx

xxx

xxx

xxx

Less: Premium on issue amortised

p.a.

(In case of issue at premium)

xxx

xxx

Annual cost xxx

Note: The issue expenses, discount on issue, premium on redemption and

premium on issue are to be amortised over the tenure of the preference shares to

determine the annual cost.

(b) Computation of average value of RPS:

The average value of redeemable preference shares is the average of net

proceeds (NP) of the issue and the redemption value (RV)

Average value of RPS =

The Net Proceeds (NP) is to be ascertained as given below:

(i) Issued at par:

NP=Face value - Issue expenses

(ii) Issued at premium:

NP = Face value + Security premium – Issues expenses

(iii) Issued at discount:

NP= Face value – Discount – issue expenses

III. Cost of Equity Capital:

Computation of cost of equity is quite complex. Some people argue that

the equity capital is cost free as the firm is not legally bound to pay dividend to

equity shareholders. But this is not true. Shareholders invest their funds with the

expectation of dividends. The market value of equity share depends on the

dividends expected by shareholders, the book value of firm and the growth in

the value of firm. Thus, the required rate of return which equates the present

value of the expected dividends with the market value of equity share is the cost

of equity capital. The cost of equity capital may be expressed as the minimum

rate of return that must be earned on new equity share capital financed

investment in order to keep the earnings available to the existing equity

shareholders of the firm unchanged. The following are the different methods on

the basis of which the cost of equity capital may be computed:

(i) Dividend yield (or) Dividend price method

According to this method, the cost of equity is calculated on the basis of a

required rate of return in terms of future dividend to be paid on equity shares for

maintaining their present market price. The cost of new equity share can be

determined according to the following formula:

169

Cost of Capital

NOTES


Cost of equity (Ke)=

Where: = Expected dividend per share

NP = Net proceeds per share

Note: In case of new issue, the firm will have to incur some floatation costs

such as fees to investment bankers, brokerage, underwriting commission and

commission to agents etc. So, the net proceeds per share (Face value –

Floatation Costs) is considered for calculating cost of equity.

In case of existing equity shares, the cost of equity should be calculated on

the basis of market price of firm’s equity share according to the following

formula:

Cost of equity (Ke) =

Where = Expected dividend per share

MP = Market Price per share

This method is simple and rightly emphasises the importance of dividend,

but it suffers from two serious limitations: (i) It ignores the earning on retained

earning which increases the rate of dividend on equity shares and (ii) It ignores

growth in dividends, capital gains and future earnings. This method is suitable

only when the firm has stable dividend policy over a reasonable length of time.

(ii) Dividend price plus growth (D/p+g) method

Under this method, the cost of equity is determined on the basis of the

expected dividend rate plus the rate of growth in dividend. The growth rate in

dividend is assumed to be equal to the growth rate in earnings per share and

market prices per share. The cost of equity, under this method, is determined by

using the following formula: as the variability of returns inherent, in the type of

security, while the return is defined as the total economic return obtained from

it including interest, dividends and market appreciations.

The CAPM divides the total risk associated with a security/assets into

two classes i.e., (i) The diversifiable/unsystematic risk and (ii) non –

diversifiable systematic risk. The risk refers to that risk which can be eliminated

by more and more diversification. On the other hand, non – diversifiable risk is

that risk which affects all the firms at a particular point of time and hence

cannot be eliminated e.g., risk of political uncertainties, risk of government

policies etc.

The CAPM further states that the investor can eliminate the diversifiable

risk by diversifying into more and more securities, however, the non-

diversifiable risk is the point where the investor’s attention is required. This

non-diversifiable risk of a security is measured in relation to the market

portfolio and is denote by the beta coefficient ᵝ. In order to estimate the

required rate of return of the equity investors, the risk associated with the shares

(as represented by beta factor) and risk – return relationship in the securities

market need to be estimated. The CAPM as applied to find out the cost of

equity can be presented as follows:

Ke =Rf + ᵦ (Rm - Rf)

Where, Ke= Cost of equity capital

Rf = Risk free return (Risk free interest rate)

ᵦ = The beta factor i.e., the measure of non-diversifiable risk

Rm= The expected cost of capital of market portfolio or average rate of

return on all assets or market return.

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Cost of Capital

NOTES


For example, a firm having beta coefficient of 1.6 finds that the risk-free

rate to be 9% and the market cost of capital at 12%. The cost of equity of the

firm will be:

Ke =Rf + ᵦ (Rm - Rf)

= 0.09 + 1.6 (0.12 – 0.09)

= 0.138 or 13.8%

IV. Cost of Retained Earnings:

Retained earnings are the accumulated amount of undistributed profits

belonging to the equity shareholders. They provide a major source of financing,

expansion and diversification of projects. Their cost is the opportunity cost of

the funds. If these were distributed to the shareholders, they would have

reinvested them in the same firm by purchasing its equity and earned on the

additional shares the same rate of return as they are earning on their existing

shares. Thus, the cost of retained earnings is the same as the cost of equity

capital. However, unlike issue of equity shares, retained earnings do not involve

the payment of personal income tax as well as any floatation cost. This makes

their cost slightly lower than the cost of equity capital. The cost of retained

earnings may be calculated as follows:

(i) Cost of equity (Ke) xxx

(ii) Less: Tax on cost of equity xxx

(iii) Less: Brokerage (% on (i) –(ii))

xxx

xxx

Cost of retained earning xxx

Alternatively, the cost of retained earnings can be ascertained by using the

following formula:

Cost of retained earnings (Kᵧ) = Ke (1 – t) (1 – b)

Where, Ke= Cost of equity capital

t = tax rate

b = brokerage

v. Weighted Average Cost of Capital (WACC):

After having ascertained the cost of each component of capital as

explained above, the average or composite cost of all the sources of

capital is to be determined. The cost of each component of the capital

weighted by the relative proportion of that type of funds in the capital

structure. Them it is called Weighted Average Cost of Capital (WACC).

WACC is defined as the average of the costs of each source of funds

employed by the firm, properly weighted by the proportion they hold in the

capital structure of the firm. It is denoted by ko. The proportion or

percentage or weight of each component may be determined based on

either book value or market value of capital.

13.8 Benefits of market value approach: As the cost of capital is used as a cut-off rate for investment projects,

the market value approach is considered better due to the following

reasons:

(a) It evaluates profitability as well as the long-term financial position

of the firm.

(b) Investors always consider the committing of his funds to a firm and

an adequate return on his investment. In such cases, book values are of

little significance.

(c) It considers price level changes.

13.9 Benefits of book value approach:

171

Cost of Capital

NOTES


However, as the market value fluctuates widely and frequently, the use of

book value weights is preferred in practice due to following reasons:

(a) The firms set their targets in terms of book value.

(b) It can easily be calculated from published accounts.

(c) The investors generally use the debt-equity ratio on the basis of

published figures to analyse the riskiness of the firm.

Computation of weighted average cost of capital:

The following steps are to be taken to calculate WACC:

Step 1: Calculate the cost of specific sources of funds, for example, cost of

debt, cost of equity etc.

Step 2: Multiple the cost of each source by its proportion in capital

structure.

Step 3: Add the weighted component costs to get the firm’s WACC.

The following format may be adopted for computation of WACC:

Sources of funds Amt. Proportion

to total

After tax

cost

Weighted

cost

Debt

Preference share

capital

Retained earnings

Equity share capital

xx

xx

xx

xx

w1

w2

w3

w4

k da

k p k r k e

k da x w1

k p x w2

k r x w3

k e x w4

Total xx WACC xxx

13.10 Significance of weighted average cost of capital:

(i) In capital budgeting, WACC is used as a cut off rate (or Hurdle

rate) against which projects can be evaluated. A project can be considered

viable only if the returns from the project are higher than the cost there of

i.e., WACC.

(ii) WACC represents the minimum rate of return at which a firm

can produce value for its investors (Debt and equity). If a firm’s return on

capital employed is less than its WACC, it means the firm is losing its

value/wealth. Such a situation is most disadvantageous to equity

shareholders.

(iii) WACC is useful in making economic value added

(EVA)calculations.

VI. Marginal Cost of Capital (MCC)

The MCC is defined as the cost of raising an additional rupee of capital.

Since the capital is raised in substantial amount in practice, marginal cost is

referred to as the cost incurred in raising new funds. MCC is derived when

we calculate the average cost of capital using the marginal weights. The

marginal weights represent the proportion of funds the firm intends to

employ. Thus, the problem of choosing between the book value weights

and the market value weights does not arise in the case of MCC

computation. To calculate MCC, the intended financing proportion should

be applied as weights to marginal component costs. The MCC should,

therefore, be calculated in the composite sense. When a firm raises funds in

proportional manner and the component’s cost remain unchanged, there

will be no difference between average cost of capital (of the total funds)

and the marginal cost of capital. The component costs may remain constant

up to certain level of funds raised and then start increasing with amount of

funds raised. For example, the cost of debt may remain 8% (after tax) till

Rs. 20 lakh of debt is raised, between Rs. 20 lakh and Rs. 30 lakh, the cost

172

Cost of Capital

NOTES


may be 10% and so on. Similarly, if the firm has to use the external equity

when the retained profits are not sufficient, the cost of equity will be higher

because of the floatation costs. When the components cost start rising, the

average cost of capital will rise and the MCC will, however rise at a faster

rate.

ILLUSTRATIONS

Illustration: 1(Cost of irredeemable debt)

Sakthi Ltd. Issued 20,000 8% debentures of Rs. 100 each on 1st

April 2009. The cost of issue was Rs. 50,000. The company’s tax rate is

35%. Determine the cost of debentures (before as well as after tax) if they

were issued, (a) at par; (b) at a premium of 10% and (c) at a discount of

10%.

Solution:

a) Debentures issued at par:

Rs.

(i) Interest: (20,00,000 x 8%)

Less: Tax (1,60,000 x 35%)

1,60,000

56,000

Interest after tax 1,04,000

Rs.

(ii) Gross proceeds: (20,000 x 100)

Less: Cost of issue

20,00,000

50,000

Net proceeds 19,50,000

Cost of debentures before tax (kdb) =

= X100 = 8.21%

Cost of debentures after tax (kda) =

= X100 = 5.33%

(b) Debentures issued at a premium of 10%

Gross proceeds (20,000 x 110)

Less: Cost of issue

22,00,000

50,000


Cost of debentures before tax (kdb) = = 7.44%

Cost of debentures after tax (kda) = = 4.84%

(c) Debentures issued at a discount of 10%

Gross proceeds (20,000 x 90)

Less: Cost of issue

18,00,000

50,000


Cost of debentures before tax (kdb) = = 9.14%

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Cost of Capital

NOTES


Cost of debentures after tax (kda) = = 5.94%

Note: Whether the debentures are issued at par (or) at par at premium (or)

at discount, interest on debentures should be calculated only on the face

value of debentures.


1. What do you mean by cost of capital

2. What are the importance of cost of capital?

3. What is meant by cost of retained earning?


1. The cost of capital is the minimum required rate of return, the hurdle or

handle or target rate, the cut-off rate or the financial standard of

performance of a project.

2. Capital Budgeting decision, Designing the capital structure, deciding

about the method of financing, Performance of top management: Other

areas of decisions making.

3. Retained earnings are the accumulated amount of undistributed profits

belonging to the equity shareholders. They provide a major source of

financing, expansion and diversification of projects.


Short Questions:

1. What are the significances of weighted average of cost of capital?

2. What is cost of equity capital?

3. Define cost of capital.


1. What are the factors determining cost of capital?

2. What are the components of cost of capital?

3. What are the types of cost of capital?

4. How do you calculate cost of capital?

Further Reading:




3. Financial Management: Pandey, I. M. Viksas 4. Theory & Problems in Financial Management: Khan, M.Y. Jain,

P.K. TMH 5. Financial Management: Text & Problems, Khan, M. Y Jain, P.K.

3rd ed, TMH






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NOTES


UNIT - XIV CAPITAL STRUCTURE Structure

14.1 Introduction


14.3 Definition of Capital Structure

14.4 Type of securities to be used or issued

14.5 Patterns of Capital Structure

14.6 Difference between Capital Structure and Financial Structure

14.7 Difference between Capital structure and Capitalization

14.8 Optimum Capital Structure

14.9 Features of an Appropriate Capital Structure

14.10 Factors determining Capital Structure

14.11 Technique of Planning the Capital Structure

14.12 Point of Indifference

14.13 Theories of Capital Structure

14.14 Dividend Policy

14.1 Introduction As mentioned in chapter 1, one of the objectives of financial

management wealth maximization. Since the finance manager is

responsible to procure the required funds for a firm from different sources,

he has to select a finance mix or capital structure which maximizes

shareholders wealth. For designing the capital structure, he is required to

select such a mix of sources of finance overall cost of capital is minimum.

In this chapter, let us pay our attention designing capital structure taking

into account the cost of capital to the firm.


Capital structure refers to the mix of sources from where the long

term funds required in a firm may be raised i.e. what should be the

proportions of equity share capital, preference share capital, internal

sources, debentures and other sources of funds in the total amount of

capital which a firm may raise for establishing its business.

14.3 Definition of Capital Structure The term capital structure has been defined by several authors

differently. Some of the definitions are as follows

(i) I.M. Pandey: Capital structure refers to the composition of long-term

sources of funds such as debentures, long term debt, preference share

capital and ordinary share capital including reserves and surpluses

(retained earnings).

(ii) Weston and Brigham: Capital structure is the permanent financing of

the firm, represented primarily by long term debt, preferred stock, and

common equity, but excluding all short-term credit. Common equity

includes common stock, capital surplus and accumulated earnings,

(iii) John J. Hampton: Capital structure is the combination of debt equity

securities that comprise a firm's financing of its assets.

(iv) R.H. Wessel: The term capital structure is frequently used to the long-

term sources of funds employed in a business enterprise.

(v)W. Gerstenberg: Capital structure refers to the kind of securities that

make up the capitalization.

(vi) Guthman and Dougali: From a strictly financial point of view, the

optimum capital structure is achieved by balancing the financing so as to

achieve the lowest average cost of long-term funds. This, in turn. produces

175

Capital Structure

NOTES


the maximum market value of the total securities issued against a given

amount of corporate finance.

We can thus, define capital structure as the overall mix of components of

capitalisation. It is a composite function and includes the following

decisions:

14.4 Type of securities to be used or issued (a) Shares: Equity shares, Preference shares.

(b) Debt: Debentures, bonds, public deposits, loans from banks and

financial institutions.

(ii)Ratio or proportion of securities: The ratio or proportion of securities

in any capital structure is an important decision. The decision of capital

mix is called capital gearing.

The capital gearing may be high, low or even. When the proportion of

equity share capital is high in comparison with other securities in the total

capitalization, it is low geared and in the opposite case, it is high geared

and at the same time, if equity share capital is equal to the other securities,

it is called evenly geared.

14.5 Patterns of Capital Structure There may be four fundamental patterns of capital structure as follows:

(i) Equity share capital only (including Reserves & surplus)

(ii) Equity share capital and preference share capital.

(ii) Equity, preference share capital and long-term debt. i.e. Debentures,

bonds and loans from financial institutions etc.

(iv) Equity share capital and long-term debt.

14.6 Difference between Capital Structure and Financial

Structure

The term capital structure differs from financial structure. Financial

structure Refers to the composition or make up of the entire liabilities side

of the balance sheet of a firm. It shows the way in which the firm's assets

are financed. It includes long term as well as short term sources of finance.

Capital structure is the permanent financing of the firm represented

primarily by long term debt and shareholders’ funds but excluding all

short-term credit. Thus, a firm's capital structure is only a part of its

financial structure.

14.7 Difference between Capital structure and

Capitalization Following are the major differences between Capital Structure

Capitalization:

Basis Capital Structure Capitalization

1.Coverage

2.Scope

3.Nature

It refers to mix of various

sources of capital e.g.

Capital, debt, etc.

It is an overall policy

decision about the

proportion of various

sources of long-term

finance.

It is a qualitative decision

It refers to all long-term

securities e.g. equity, debt

and free reserves not

meant for distribution.

It is implementation of

policy decision about

capital structure.

It is a quantitative

decision.

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Capital Structure

NOTES


14.8 Optimum Capital Structure The capital structure is said to be optimum capital structure when

the firm has selected such a combination of equity and debt so that the

wealth of firm is maximum. At this capital structure, the cost of capital is

minimum and market price per share is maximum.

It is, however, difficult to find out optimum debt and equity mix

where the capital structure would be optimum because it is difficult to

measure a fall in the market value of an equity share on account of increase

in risk due to high debt content in the capital structure.

In theory one can speak of an optimum capital structure but in

practice appropriate capital structure is more realistic term than the former.

14.9 Features of an Appropriate Capital Structure (i) Minimum cost: An appropriate capital structure should attempt to

establish the mix of securities in such a way as to raise the requisite funds

at the lowest possible cost. As the cost of various sources of capital is not

equal in all circumstances, it should be ascertained on the basis of weighted

average cost of capital. The management should aim at keeping the issue

expenses and fixed annual payments at a minimum in order to maximize

the return to equity shareholders.

(ii)Maximum return: An appropriate capital structure should be devised

in such a way so as to maximize the profit of the firm. In order to

maximize profit, the firm should follow a proper policy of trading on

equity so as to minimize the cost of capital.

(iii) Minimum risk: An appropriate capital structure should possess the

quality of minimum risk. Risk, such as increase in taxes, rates of interest,

Costs etc. and decrease in prices and value of shares as well as natural

calamities adversely affects the firm's earnings. Therefore, the capital

structure should be devised in such a way as to enable it to afford the

burden of these risks easily.

(iv) Maximum control: An appropriate capital structure has also the

quality of retaining control of the existing equity shareholders on the

affairs of the firm. Generally, the ultimate control of the firm rests with the

equity shareholders who have the right to elect directors. Thus, while

determining the issue of securities, the question of control in management

should be given due consideration. In case the firm issues a large number

of equity shares, the existing shareholders may not be able to retain control.

The firm should, therefore, issue preference shares or debentures to the

public instead of equity shares because preference shares carry limited

voting rights and debentures do not have any voting rights. Thus, the

capital structure of a firm should not be changed in such a way which

would adversely affect the voting structure of the existing shareholders,

dilute their control on the firm's affairs.

(v) Flexibility: An appropriate capital structure should have the quality of

flexibility in it. A flexible capital structure enables the firm to make the

necessary changes in it according to the changing conditions. In other

words, under flexible capital structure, a firm can procure more capital

whenever required or redeem the surplus capital.

(vi) Proper liquidity: An appropriate capital structure has to maintain

proper liquidity which is essential for the solvency of the firm. In order to

achieve proper liquidity, all debts which threaten the solvency of the firm

should be avoided and a proper balance between fixed assets and current

assets should be maintained according to the nature and size of business.

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Capital Structure

NOTES


(vii) Conservatism: A firm has to follow the policy of conservatism in

devising the capital structure. This would help in maintaining the debt

capacity of the firm even in unfavourable circumstances.

(viii) Full utilisation: An appropriate capital structure is needed for

optimum utilization of financial resources of a firm. Both under

capitalization and over capitalization are injurious to the financial interest

of a firm. Thus, there should be a proper co-ordination between the

optimum of capital and the financial needs of a firm. A fair capitalization

enables a firm to make full utilization of the available capital at minimum

cost.

(ix) Balanced leverage: An appropriate capital structure should attempt to

secure a balanced leverage by issuing both types of securities i.e.

ownership securities and creditorship securities. Generally, shares are

issued when the rate of capitalization is high, and debentures are issued

when rate of interest is low.

(x) Simplicity: An appropriate capital structure should be easy to

understand and easy to operate. For this purpose, the number and type of

securities issued should be limited.

14.10 Factors determining Capital Structure The following factors must be considered while determining the capital

structure of a firm:

(i) Trading on equity: The concept of trading on equity is based on the

concept of taking advantage of equity i.e. owner funds to earn additional

profits. In case, where the rate of return of firm is higher than the cost of

borrowed funds i.e. preference shares or debentures or public deposits or

debts, the firm shall prefer to arrange more funds from these sources, so

that it earns additional profits after paying fixed rate on these sources. So,

trading on equity is an arrangement under which the finance manager

raises funds by issuing securities which carry fixed rate of interest or

dividend which is less than average earnings of the firm to increase the

return on equity shares. This can be explained by the following example.

Capital Structure A Ltd., B Ltd.,

(i)Equity

(ii) 15% Debentures

Gross income

Less: Interest on

debentures

Net earnings

Earnings on shares:

Net earnings/Equity

capital x 100

40 lakh

8 lakh

9.2 lakh

1.2 lakh

8 lakh

8/40 x 100 =

20%

8 lakh

40 lakh

9.2 lakh

6.0 lakh

3.20 lakh

3.20/8 x 100 =

40%

So, the rate of return of B Ltd is higher than A Ltd. This additional earning

due to borrowing more of fixed interest funds is called trading on equity.

Merits of trading on equity:

(a) Trading on equity maximises returns for the shareholders

(b) It helps declare higher dividend.

(c) It helps to retain more profit.

(d) The control in management is in the hands of limited number of

persons.

Limitation: It is not suitable if earnings of firm are lower than the fixed rate

carried by debt funds.

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Capital Structure

NOTES


(ii)Stability on sales: An established firm which has a growing market and

high sales does not have any difficulty in meeting its fixed commitments.

Interest on debentures has to be paid regardless of profits. If sales are on

the rise, interest payments can be met and therefore, a firm is able to

employ more debt in its capital structure. If sales are fluctuating and

unstable, then the firm will not be able to pay interest charges as and when

they become due. Therefore, it is better not to employ too much debt in its

capital structure.

(iii) Exercise control: The control of a firm is entrusted to the board of

directors elected by the equity shareholders. If the board of directors and

shareholders of a firm wish to retain control over the firm in their hands,

they should not allow further issue of equity shares to the public. In such a

case, more funds can be raised by issuing preference share and debentures.

(iv)Cost of capital: Cost of capital, as stated earlier, is the payment made

by firm to obtain capital. Thus, interest is the cost of debentures or loans

and the dividend paid by the firm is the cost of preference and equity

capitals. It is to be noted that rate of dividend on preference Capital is fixed

which is generally lower than that of equity capital. The cost of debentures

is generally lower and tax deductible. Therefore, a firm may prefer as much

debt as it possibly can subject to its earring Capacity so as to enable the

firm to keep on paying its interest obligation.

(v)Statutory requirements: The structure of capital of a firm is also

Influenced by the requirements of the statutes applicable to it. For

Example, banking companies have been prohibited by the Banking

Regulation Act from issuing any type of securities except equity shares.

(vi) Capital market conditions: The conditions prevailing in the capital

market also influences the determination of the securities to be issued. For

instance, during depression, people do not like to take risk and so are not

interested in equity shares. But during boom, investors are ready to take

risk and invest in equity shares. Therefore, debentures and preference

shares which carry fixed rates of return may be marketed

(vii) Corporate taxation: Under e Income tax laws, dividend on shares is

not deductible while interest paid on borrowed capital is allowed as

deduction. Cost of raising finance through borrowing is deductible in the

year in which it is incurred. if it is incurred during the pre-commencement

period, it is to be capitalized. Cost of issue of shares is allowed as

deduction. Owing to these provisions, corporate taxation plays an

important role in determining the choice between sources of financing.

(viii) Government policies: Government policies are a major factor in

determining capital structure. For example, a change in the lending policies

of financial institutions may mean a complete change in the financial

pattern to be followed in the firms. Similarly, the Rules and Regulations

frame by SEBI considerably affect the capital issue policy of various firms.

Monetary and fiscal policies of the Government also affect the capital

structure decision.

(ix) Flexibility: It denotes the capacity of the business and its management

to adjust to expected and unexpected changes in the business environment.

The capital structure should provide maximum freedom to changes at all

times.

(x) Timing: Closely related to flexibility is the timing for issue of

securities. Proper timing of a security issue often brings substantial savings

because of the dynamic nature of the capital market. Intelligent

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Capital Structure

NOTES


management tries to anticipate the climate in capital market with view to

minimize the cost of raising funds and also to minimize the dilution

resulting from an issue of new equity shares.

(xi) Size of the firm: Small firms rely heavily on owner's funds, while

large and widely held firms are generally considered to be less risky by the

investors. Such large firm can issue different types of debt instruments or

securities.

(xii) Purpose of financing: In case funds are required for productive

Purposes like manufacturing etc., the firm may raise funds through long

terms sources On the other hand, if the funds are required for non -

productive purposes like welfare facilities to employees such as schools,

hospitals, etc., the firm may rely only on internal resources.

(xiii) Period of finance: Funds required for medium- and long-term

periods, say 8 to 10 years, may be raised by way of borrowings, but if the

funds are for permanent requirement, it will be appropriate to raise them by

issue of equity shares.

(xiv) Requirement of investors: Different of types of securities are issued

to different classes of investors according to their requirements. Sometimes

the investor may be motivated by the options and advantages available

with a security e.g. double options, convertibility, security of Principal and

interest, etc.

(xv) Provision for future growth: Future growth consideration and future

requirements of capital should also be considered while planning the

capital structure.

14.11 Technique of Planning the Capital Structure A widely used financial technique of EBIT-EPS Analysis is

generally applied to de e an appropriate capital structure of a firm. This

technique involves of the EBIT comparison the choice of alternative

methods of financing under various ass options of combination of sources

with the capital structure would be one which, for a given level of EBIT,

would ensure the largest earnings per share (EPS). Alternatively, the choice

of combination should ensure the market price per share (Market

price=EPS x PE ratio).

14.12 Point of Indifference Indifference point refers to the EBIT level at which EPS remains

unchanged irrespective of debt-equity mix. Given the total amount of

capitalization and the on bonds, a firm reaches indifference point when it

earns exactly the me interest amount rate of income what it has promised to

pay on debt. In other words, rate of return on capital employed is equal to

rate of interest on t at Indifference point. Indifference point of EBT

changes with variation in the total funds to be raised or the interest rate to

be paid on borrowed capital.

The indifference point can be determined with the help of following

formula:

x = EBIT

I1=Interest under financial Plan 1

I2=Interest under financial Plan 2

T=Tax rate

P. D= Preference Dividend

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Capital Structure

NOTES


N1=-No. of equity shares (or) Equity share capital under Plan 1

N2=No of equity shares (or) Equity share capital under Plan 2

14.13 Theories of Capital Structure The objective of a firm should be directed towards the

maximization of the value of the firm. The capital structure decision should

be examined from the point of view fits 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.

There are broadly four approaches in this regard. These are:

(i)Net Income (NI) Approach

(ii) Net operating Income (NOI) Approach

(iii) Traditional Approach

(iv)Modigliani and Miller Approach

These approaches analyse relationship between the leverage, cost of capital

and the value of the firm in different ways. However, the following

assumptions are made to understand the relationship:

(b) There are only two sources of funds Viz. Debt and Equity (No

preference share capital).

(c) The total assets of the firm and its capital employed are constant. (No

change in capital employed). However, Debt-Equity mix can be changed.

This can be done by

(i) either by borrowing debt to repurchase (redeem) equity shares or

(ii) by raising equity capital to retire (repay) debt.

(d) All residual earnings are distributed to equity shareholders (No retained

earnings)

(e)The firm earns operating profit and it is expected to grow. No losses).

(f) The business risk is assumed to be constant and is not affected by the

Financing mix decision (No change in fixed cost or operating risks).

(g) There are no corporate or personal taxes (No taxation)

(h) The investors have the same subjective probability distribution of

expected earnings (No difference in investor expectations).

(i)Cost of debt (Kd) is less than cost of equity (Ke). (Low cost of deb).

(i) Net Income (NI) Approach: This approach has been suggested by

Durand. According to this approach, a firm can increase it’s or lower the

Overall cost of capital by increasing the proportion of debt in the capital

structure. In other words, if the degree of financial leverage in increases,

the weighted average cost of capital will decline with every increase in the

debt content in total capital employed, while the value firm will increase.

Reverse will happen in a converse situation.

The NI Approach is based on the following three assumptions:

(a)There are no corporate taxes.

(b) The cost of debt (Kd) is less than cost of equity (Ke).

(c) The use of debt content does not change the risk perception of

investors.

As a result, both the Kd and Ke remain constant.

The total market value of the firm (V)under the N1 approach is

determined with the help of the following formula:

V= S+D

Where, V=Total market value of the firm

S=Market value of equity shares

D = Market value of Debt.

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Capital Structure

NOTES


Market value of equity shares (S) = Net income /Equity capitalisation

rate

(or)

= Earnings available to shareholders/Cost of equity (ke)

The overall cost of capital (ko) or weighted average cost of capital is

Ascertained as follows: ko=EBIT/ Value of firm (V)

(ii) Net Operating Income (NOI) Approach: This approach has been

suggested by Durand. According to this approach, the market value of the

firm is not affected by the capital structure changes the market value of the

firm is ascertained by capitalizing the net operating income at the overall

cost of capital which is constant. The market value of the firm is

determined as follows:

Market value of firm(V) = EBIT (Net operating Income) / Overall cost of

capital (Ko)

The value of equity can be ascertained by applying the following equation:

Value of equity (S) - Market value of firm (V)-Market value of debt (D)

Cost of equity (Ke) = EBT (Earnings after interest, before tax) / Value of

equity (S)

The NOI approach is based on the following assumptions:

(a)The overall cost of capital remains constant for all degree of debt-equity

mix

(b) The market capitalizes the value of firm as a whole. Thus, the split

between debt and equity is not important.

(c) The use of less costly debt funds increases the risk of shareholders. This

causes the equity capitalization rate to increase. Thus, the advantage of

debt is set off exactly by increase in equity capitalization rate.

(d) There are no corporate taxes.

(e) The cost of debt is constant.

(iii) Traditional Approach: This approach is also known as intermediate

approach as it takes a midway between NI approach (hat the value of the

firm can be increased by increasing financial leverage) and NO1 approach

(that the value of firm is constant irrespective of the degree of financial

leverage). According to this approach, the use of debt up to a point is

advantageous. It can help to reduce the overall cost of capital and increase

the value of the firm. Beyond this point, the debt increases the financial

risk of shareholders. As a result, cost of equity also increases. The benefit

of debt is neutralized by the increased cost of equity. Thus, up to a point,

the content of debt in capital structure will be favourable. Beyond that

point, the use of debt will adversely affect the value of the firm. At that

point, the capital structure is optimal, and the overall cost of capital will be

the least.

iv) Modigliani and Miller Approach: Modigliani and Miller have

explained the relationship between cost of capital, capital structure and

total value of the firm under two conditions:

(a) When there are no corporate taxes

(b) When there are corporate taxes

I. When there are no Corporate Taxes

The MM approach is identical to NO1 approach, when there are no

corporate taxes. Modigliani and Miller argued that in the absence of taxes,

the cost of capital and value of the firm are not affected by capital structure

or debt-equity mix. They gave a simple argument in support of their

approach. They argued that according to traditional approach, cost of

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Capital Structure

NOTES


capital is the weighted average of cost of debt and cost of equity etc. The

cost of equity, they argued, is determined from the level of shareholders'

expectations. Now if shareholders expect 15% from a particular firm, they

do take into account the debt-equity ratio and they expect 15% merely

because they find that 15% covers the particular risk which this firm

entails. Suppose further that the debt content in the capital structure of this

firm increases; this means that in the eyes of shareholders, the risk of the

firm increases, since debt is a riskier mode of finance. Hence, shareholders

will now start expecting a higher rate of return from the shares of the firm.

Hence, each change in the debt-equity mix is automatically offset by a

change in the expectations of the shareholders from the equity share

capital. This is because a change in debt equity ratio changes the risk

element of the firm, which in turn changes the expectations of the

shareholders from the particular shares of the firm. Modigliani and Miller,

therefore, argued that financial leverage has nothing to do with the overall

cost of capital and the overall cost of capital is equal to the capitalization

rate of pure equity stream of its class of risk. Hence financial leverage has

no impact on share market prices nor on the cost of capital.

Modigliani and Miller make the following propositions:

(a) The total market value of a firm and its cost of capital are independent

of its capital structure. The total market value of the firm s given by

capitalizing the expected stream of operating earnings at a discount rate

considered appropriate for its risk class.

b) The cost of equity (Ke) is equal to capitalization rate of purely equity

stream plus a premium for financial risk. The financial risk increases with

more debt content in the capital structure. As a result, Ke increases in a

manner to offset exactly the use of less expensive source of funds.

c) The cut off rate for investment purposes is completely independent of

the way in which the investment is financed.

Assumptions

MM approach is based on the following assumptions:

(a) The capital markets are perfect. This means that investors are free to

buy and sell securities. They are well informed about the risk-return on all

types of securities. There are no transaction costs. The investors behave

rationally. They can borrow without registrations on the same terms as the

firms do.

(b) The firms classified into homogenous risk classes. All firms within the

same class will have the same degree of business risk.

(c) All investors have the same expectations from a firm's net operating

income (EBIT) which are necessary to evaluate the value of a firm.

(d) 100% pay-out ratio i.e., all earnings are distributed to shareholders as

dividends.

(e) There are no corporate taxes.

Arbitrage process:

Modigliani and Miller hypothesis reveals that the total value of a

firm is determined by its operating income or EBIT. It is independent of

the debt equity mix. Two firms which are identical in all respects except

their capital structure, cannot have different market values or different cost

of capital. If market value of the firms differ, arbitrage process will take

place and make them equal.

For example, suppose there are two firms X and Y in the same risk class.

Firm x is financed by equity and firm Y has a capital structure which

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Capital Structure

NOTES


includes deb. Their market values do not differ for a long time. If the

market value of firm Y is higher than firm X, the shareholders/ investors of

firm Y will dispose of the shares of the overvalued firm Y and will

purchase the shares of undervalued firm X In addition, firm X has no debt.

Therefore, shareholders /investors of firm Y borrow on their personal

account (Substitution of personal leverage for corporate leverage) and use

the additional funds for buying shares of firm X. As a result, the market

price of firm Y share will decline due to selling pressure and that of firm

share will increase. This process will continue till both of them attain the

Same market value. As such, as soon as the firms reach the identical

position, the average cost of capital and the value of the firm will be equal.

So, the total value of the firm and average cost of capital are independent.

II. When there are Corporate Taxes

Modigliani and Miller agreed that the capital structure will affect

the value of the firm and the cost of capital when taxes are applicable to

corporate income .if a firm uses debt in its capital structure, the cost of

capital will decline and market value of the firm will increase. This is

because interest is deductible expense for tax purposes and therefore, the

effective cost of debt is less than the contractual rate of interest. A levered

firm (firm which uses debt) can therefore have more earnings to its equity

shareholders than an unlevered firm (firm which does not use deb). This

makes debt financing advantageous and value of the levered firm will be

higher than that of an unlevered firm. A firm can achieve optimum capital

structure by maximizing debt financing. According to MM approach, the

value of unlevered firm can be determined with the help of the following

formula:

Where,

EBIT = Earnings before interest and taxes

Ke= Cost of equity

T = lax rate.

(or)

Vu= EAT/Ke= Earnings available to shareholders / Cost of equity

Value of levered firm can be ascertained as given below.

Value of levered firm m (VL) -Value of unlevered firm + (Tax

rate x Debt).

Criticism of MM Approach

The propositions of MM approach have been criticized by

numerous authorities. Mostly criticism is about perfect market assumption

and the arbitrage assumption. MM hypothesis argue that through arbitrage,

investors would quickly eliminate any inequalities between the value of

levered firms and value of unlevered firms in the same risk class. The basic

argument here is that individual arbitragers, through the use of personal

leverage, can alter corporate leverage. This argument is not valid in the

practical world, for it is extremely doubtful that individual investors would

substitute personal leverage for corporate leverage, since they do not have

the same risk characteristics. The MM approach assumes availability of

free and Up to date information This is also not normally valid.

To conclude, one may say that the controversy between the

traditionalists and supporters of MM approach cannot be resolved due to

lack of empirical research. Traditionalists argue that the cost of capital of a

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Capital Structure

NOTES


firm can be lowered and the market value of the shares can be increased by

a careful use of financial leverage. However, after certain stage as the firm

becomes highly geared, it becomes too risky for investors and lenders.

Hence, beyond a point, overall Cost of capital begins to rise. This point

indicates the optimal or appropriate capital structure. AMM argue that in

the absence of corporate income taxes, Overall cost of capital is

independent of the capital structure of the firm.

ILLUSTRATION

I.EBIT-EPS Analysis

1. Dubin Ltd has equity share capital of Rs. 1200000 divided into

shares of Rs. 100 each. It wishes to raise further Rs. 600000 for

expansion-cum-modernisation scheme. The company plans the

following financing alternatives:

Plan A – By issuing equity share only.

Plan B – Rs. 200000 by issuing equity shares and Rs.400000

through debentures @10% p.a.

Plan C – Rs. 200000 by issuing equity shares and Rs. 400000 by

issuing 9% preference shares.

Plan D – By Raising tern loan only at 10% p.a.

You are required to suggest the best alternative giving your

comment assuming that the estimated EBIT after expansion is

Rs.2,25,000 and corporate rate of tax is 40%.

Particulars Plan A Plan B Plan C plan D

Earnings before

interest and taxes

(EBIT)

(-) Interest on debt

2,25,000

-

2,25,000

40,000

2,25,000

-

2,25,000

60,000

Earnings before tax

(EBT)

(-) Tax @ 40%

2,25,000

90,000

1,85,000

74,000

2,25,000

90,000

1,65,000

66,000

Earnings after tax

(-) Pref. dividend

1,35,000

-

1,11,000

-

1,35,000

36,000

99,000

-

Profit for equity

shareholders

1,35,000 1,11,000 99,000 99,000

Workings:

Interest on debt

plan B = 4,00,000 x10 % = 40,000

Plan D = 6,00,000 x 10% = 60,000

EPS:

Plan A = 1,35,000 / 18,000 = 7.50

Plan B = 1,11,000 / 14,000 = 7.93

Plan C = 99,000 / 14,000 = 7.07

Plan D = 99,000 / 12,000 = 8.25

Analysis: EPS of Rs.8.25 is highest in case of plan D. Hence, it is

suggested that plan D may be implemented i.e., raising the required funds

of Rs.600000 by way of borrowing term loan at 10% per annum.

II. Indifference point

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Capital Structure

NOTES


1. A new project requires an investment of Rs. 1200000.Two

alternative methods of financing are under consideration:

(i) Issue of Equity shares of Rs.10 each for Rs.1200000

(ii) Issue of equity shares of Rs.10 each for Rs.800000 and issue

of 15% Debentures for Rs.400000

Find out the indifference level of EBIT assuming a

tax rate of 35% verify your answer.

Solution:

Indifference level of EBIT is calculated as under:

EPS under plan I = EPS under plan 2

(Equity financing) (Equity and Debt financing)

x = EBIT =?

I1=Interest under plan 1 = 0

I2 = Interest under plan 2 = 400000 x 15% = Rs.60000

T = Tax rate = 35%

N1 = No. of equity shares under plan 1 = 120000

N2 = No. of equity shares under plan 2 = 80000

By cross multiplication

0.65x(8) = 0.65x(12) – 3.9(12)

5.2x = 7.8x – 46.8

5.2x – 7.8x = -46.8

-2.6x = -46.8

X=46.8/2.6 = 18 or 18 x 10000 = Rs.180000

Indifference level of EBIT is Rs.118000 and at that level, EPS of plan

1 and plan 2 should be equal. This can be verified as given below:

Verification:

Particulars Plan 1

Rs.

Plan 2

Rs.

EBIT

Less: Interest

1,80,000

-

1,80,000

60,000

EBT

Less: Tax @ 35%

1,80,000

63,000

1,20,000

42,000

EAT 1,17,000 78,000

EPS 0.975 0.975

WORKING NOTE:

EPS =

Plan 1 = 1,17,000 / 1,20,000 = 0.975

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Capital Structure

NOTES


plan 2 = 78,000 / 80,000 = 0.975

III. Net Income Approach

1.Jennifer Ltd. is expecting an annual EBIT of Rs. 200000.The company

has Rs. 200000 in 10% Debentures. The equity capitalization rate (ke) is

12%. You are required to ascertain the total value of the firm and overall

cost of capital. What happens if the company borrows Rs. 200000 at 10%

to repay equity capital?

Solution:

Value of firm

Under NI approach = Market value of equity + Market value of debt

(i) Calculation of market value of equity

Rs.

Earnings before interest & taxes

(EBIT)

(-) Interest (2,00,000 x 10%)

2,00,000

20,000

Earnings available to equity

shareholders

1,80,000

Market value of equity =

= 1,80,000 / 12 % = Rs. 15,00,000

(ii) Calculation of value of firm

Value of firm = Market value of equity + Market value of

debt

= 1500000 + 200000

= Rs. 1700000

(iii)Calculation of overall cost of capital (k0)

K0 = EBIT/value of firm x 100

= 200000/1700000 x 100 = 11.76%

Calculation of value of firm when the company borrows Rs. 2 lakh to

pay off equity capital

(i) Calculate of market value of equity

Rs.

Earnings before interest & taxes

(EBIT)

2,00,000

40,000

Earnings available to equity

shareholders

1,80,000

Market value of equity = 1,60,000 / 12% = Rs. 13,33,333.

(ii) Calculate of value of firm

Value of firm = Market value of equity + Market value of debt

= 13,33,333 + 4,00,000

= Rs. 17,33,333.

(iii) Calculation of overall cost of capital K0

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Capital Structure

NOTES


K0 = EBIT/value of firm x 100

= 2,00,000 / 17,33,333 x 100

= 11.54%

Analysis: Under net Income approach, increase in debt content leads to

increase in value of firm and decrease in overall cost of capital.

IV. Net operating Income Approach

1. Dewey Ltd. has an EBIT of Rs. 450000. The cost of debt is

10% and the outstanding debt is Rs. 1200000. The overall

capitalization rate (k0) is 15%. Calculation the total value of the

firm and equity capitalization rate under NOI approach.

Solution:

(i) Calculation of Market value of firm

Market value of firm = EBIT/ overall cost of capital

(k0) x 100

= 450000/15%

= Rs. 3000000

(ii) Calculation of Market value of equity

Market value of firm = Market value of equity +

Market value of debt

/Market value of equity = Market value of firm –

Market value of debt

= 3000000 – 1200000

= Rs. 1800000

(iii)Calculation of earnings available to equity shareholders

Rs.

EBIT

(-) Interest (12,00,000 x 10%)

4,50,000

1,20,000

Earnings available of equity

shareholders

3,30,000

(iv) Calculation of equity capitalization rate (ke)

= 3,30,000 / 18,00,000 x 100

= 18.33%

14.14 DIVIDEND POLICY 14.14.1 Introduction:

Since the primary objective of financial management is to

maximise the market value of equity shares, we may ask here, what is the

relationship between dividend policy and market price of equity shares?

Does a high dividend payment decrease, increase or does not affect at all

the market price of equity shares? These are controversial and unresolved

questions in corporate finance. An attempt has been made in this chapter to

find answers for these questions. Before we deal with different aspects of

dividend policy, let us first understand the concept of dividend.

14.14.2 Meaning of Dividend

The term dividend refers to that part of the profit (after tax) which

is distributed among the owners/shareholders of the firm. In other words, it

is a taxable payment declared by a firm’s board of directors and given to its

shareholders out of the firm’s current or retained earnings usually

188

Capital Structure

NOTES


quarterly. Dividends are usually given as cash (cash dividend), but they can

also take the form of stock (stock dividend) or other property. Dividend

provide an incentive to own stock in stable firms even if they are not

experiencing much growth. Firms are not required to pay dividends. The

firms that offers dividends are most often firms that have progressed

beyond the growth phase and no longer benefit sufficiently by reinvesting

their profits. So, they usually choose to pay them out to their shareholders,

also called pay out.

14.14.3 Types of Dividends Following are the different types of dividends offered to the

shareholders of the firm:

(i) Regular Dividend: It is paid annually, proposed by the board of

directors and approved by the shareholders in general meeting. It is also

known as final dividend because it is usually paid after the finalization of

accounts. It is generally paid in cash as a percentage of paid up capital, say

10% or 15% of the capital. Sometimes it is paid per share. No dividend is

paid on calls-in-advance or calls-in-arrear.

(ii) Interim Dividend: If Articles so permit, the directors may

decide to pay dividend at any time between the two Annual General

Meetings before finalizing the accounts. It is generally declared and paid

when firm has earned heavy profits or abnormal profits during the year and

directors wish to pay the profits to shareholders. Such payment of dividend

in between the two Annual General Meetings before finalization of

accounts is called Interim Dividend. No interim dividend can be declared

or paid unless depreciation for the full year (not proportionately) has been

provided for. It is thus an extra dividend paid during the year requiring no

need of approval of the Annual General Meeting. It is paid in cash.

(iii) Stock Dividend: Stock dividend is in the form of issue of

bonus shares to the equity shareholders in lieu or addition to the case

dividend. It is a permanent capitalization of earnings. It will increase the

capital and reduce reserve and surpluses. It has no impact on the wealth of

shareholders. Shareholders who receive stock dividend receive more

shared of the firm’s stock, but because the firm’s assets and liabilities

remain the same, the price of the stock must decline to account for the

dilution. For shareholders, this situation resembles a slice of cake. You can

divide the slice into two, three or four pieces and no matter how many

ways you slice it, its overall size remains the same. After a stock dividend,

shareholders receive more shares, but their proportionate ownership

interest in the firm remains the same and the market price declines

proportionately.

Stock dividends usually are expressed as a percentage of the

number of shares outstanding. For example, if a firm announces a 10%

stock dividend and has 1 million shares outstanding, the total shares

outstanding are increased to 1.1 million shares after the stock dividend is

issued.

(iv) Bond Dividend: In rare instances, dividends are paid in the

form of bonds for a long-term period. The firm generally pays interest on

these bonds and repay the bonds on maturity. Bond dividend enables the

firm to postpone payment of cash.

(v) Property Dividend: Sometimes, dividend is paid in the form of

asset instead of payment of dividend in cash. The distribution of dividend

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Capital Structure

NOTES


is made whenever the asset is no longer required in the business such as

investment or stock of finished goods.

But it is however important to note that in India, distribution of

dividend is permissible in the form of cash or bonus shares only.

Distribution of dividend in any other form is not allowed.

14.14. 4 Meaning of Dividend Policy:

Dividend policy refers to the policy chalked out by firms regarding

the amount they would pay to their shareholders as dividend. Once firms

make profits, they have to decide on what to do with these profits. The

firms have two options with them:

They can retain these profits within the firm.

They can pay these profits in the form of dividends to their

shareholders.

The dividend policy to be adopted by the firm is based on these two

options. If the firm pays dividends, it affects the cash flow position of the

firm but earns goodwill among the investors who, therefore, may be

willing to provide additional funds for the financing of investment plans of

the firm. On the other hand, the profit which are not distributed as

dividends become an easily available source of funds at no explicit costs.

However, in the case of ploughing back of profits, the firm may lose the

goodwill and confidence of the investors and may also defy the standards

set by other firms. Therefore, in taking the dividend policy, the finance

manager has to strike a balance between distribution and retention. He

should allocate the earnings between dividends and retained earnings in

such a way that the value of the firm (i.e., wealth of shareholders) is

maximized.

14.14.5 Definition of Dividend Policy:

The term dividend policy has been defined by some authors as

given below:

(i) Weston and Brigham: Dividend policy determines the division

of earnings between payments to shareholders and retained earnings.

(ii) Gitman: The firm’s dividend policy represents a plan of action

to be followed whenever the dividend decision must be made.

14.14.6 Nature of Dividend Policy:

The above discussion has brought to light the nature of dividend

policy as given bellow:

(i) Tied up with retained earnings: A dividend policy is tied up

with the retained earnings policy. It has the effect of dividing net earnings

of the firm into two parts: retained earnings and dividend.

(ii) Influence on financing decision: Dividend policy has an

influence on the financing decision of the business. Distribution of

dividends reduces the cash funds of the business and to that extent it has to

depend upon external sources of finance. The cost of funds raised from

external sources is relatively higher than the cost of retained earnings. The

management will decide to pay dividend when the firm does not have

profitable investment opportunities.

(iii) Impact on shares: Dividend policy of the firm has far

reaching consequences on the share prices, growth rate of the business and

the wealth of shareholders. Due to market imperfections and uncertainty,

shareholders give a higher weightage to the current dividends rather than

future dividends and capital gains.

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Capital Structure

NOTES


Thus, the payment of dividends influences the market price of shares.

Higher the rate of dividends, greater the price of shares and vice versa.

Higher market price of shares and bigger current dividends enhance the

wealth of shareholders.

(iv) Optimal dividend policy: As dividend is an active decision

variable, it has to be intelligently managed by the finance manager who

should endeavour to formulate an optimal dividend policy i.e., a policy

with few or no dividends payment fluctuations, over a long period of time

, having a favourable impact on the wealth of shareholders.

14.14.7 Objectives of Dividend Policy:

Following are the major objectives of dividend policy of a firm.

(i) Providing sufficient financing: As dividend policy has a direct bearing

on retained earnings of a firm, the first objective of its dividend policy

should be to ensure that retain earnings are sufficient enough to finance the

investment requirements of the firm.

(ii) Return to shareholders: The second objective of a dividend policy

should be to ensure a reasonable rate of return to shareholders in the form

of dividend in order to satisfy their desire for current income and develop

their confidence in the firm’s successful operations.

(i) Wealth maximization: The third objective of a firm’s dividend

policy should be to maximise the shareholder’s wealth in

the long run through retention of earnings and their

investment in profitable projects.

14.14.8 Factors determining Dividend Policy:

Following are the factors which influence the dividend policy of a

firm:

(i) Stability of earnings: The nature of business has an important bearing

on the dividend policy. Industrial units having stability of earnings may

formulate a more consistent dividend policy than those having an uneven

flow of incomes because they can predict easily their savings and earnings.

Usually firms dealing in necessities suffer less from oscillating earnings

than those dealing in luxuries or fancy goods.

(ii) Age of firm: Age of the firm counts much in deciding the dividend

policy. A newly established firm may require much of its earnings for

expansion and plant improvement and may adopt a rigid dividend policy.

While, on the other hand, an older company can formulate a clear cut and

more consistent policy regarding dividend.

(iii) Regularity and stability in dividend payment: Dividend should be

paid regularly because each investor is interested in the regular payment of

dividend. The management should, in spite of regular payment of dividend,

consider that the rate of dividend should be all the more constant. For the

purpose, sometimes firms maintain dividend equalization fund.

(iv) Time for payment of dividend: When should the dividend be paid is

another consideration. Payment of dividend means outflow of cash. It is,

therefore, desirable to distribute dividend at a time when cash is least

needed by the firm because there are peak times as well as lean periods of

expenditure. Wise management should plan the payment of dividend in

such a manner that there is no cash outflow at a time when the firm is

already in need of funds.

(v) Liquidity of funds: Availability of cash and sound financial position is

also an important factor in dividend decision. A dividend represents a cash

flow and the greater the fund and the liquidity of the firm, the better the

191

Capital Structure

NOTES


ability to pay dividend. The liquidity of a firm depends very much on the

investment and finance decisions of the firm which in turn determine the

rate of expansion and the manner of financing. If cash position is weak,

stock dividend can be distributed and if cash position is good, the firm can

distribute the cash dividend.

(xi)Policy of control: If the directors want to have control on firm,

they would not like to add new shareholders and therefore, declare

dividend at low rate. Because by adding new shareholders, they fear

dilution of control and diversion of policies and programmes of the

existing management. So, they prefer to meet the need for funds through

retained earnings. If the directors do not bother about the control of affairs,

they will follow a liberal dividend policy. Thus, control is an influencing

factor in framing the dividend policy.

(vii) Repayment of loan: Firms having loan indebtedness are

vowed to a high rate of retention earnings, unless some other arrangements

are made for the redemption of debt on maturity. It will naturally lower

down the rate of dividend. Sometimes, the lenders (mostly institutional

lenders) put restrictions on the dividend distribution till such time their

loan is outstanding. Formal loan contracts generally provide a certain

standard of liquidity and solvency to be maintained. Management is bound

to consider such restrictions and to limit the rate of dividend payout .

(viii)Government policies: The earning capacity of the firm is

widely affected by the change in fiscal, industrial, labour, control and other

government policies. Sometimes government restricts the distribution of

dividend beyond a certain percentage in a particular industry or in all

spheres of business activity as was done in emergency. The dividend policy

has to be modified or formulated by firms according to such restrictions.

(ix)Legal requirements: In deciding on the dividend, the directors

take the legal requirements too into consideration. In order to protect the

interests of creditors, and outsiders, the Companies Act 1956 prescribes

certain guidelines in respect of the distribution and payment of dividend.

Moreover, a firm is required to provide for depreciation on its fixed and

tangible assets before declaring dividend on shares. It proposes that

dividend should not be distributed out of capital in any case. Likewise,

contractual obligations should also be fulfilled, for example, payment of

dividend on preference shares in priority over ordinary dividend.

(x)Trade cycles: Business cycles also exercise influence upon

dividend policy. Dividend period is adjusted according to the business

oscillations. During the boom, prudent management creates reserves for

contingencies which follow the inflationary period. High rates of dividend

can be used as a tool for marketing the securities in an otherwise depressed

market. The financial solvency can be proved and maintained by the firms

in dull years if adequate reserves have been built up.

(xi) Need for additional capital: Firms retain a part of their profits

for strengthening their financial position. The income may be conserved

for meeting the increased requirement of working capital or of future

expansion. Small companies usually find difficulties in raising finance for

their needs of increased working capital for expansion programmes. They,

having no other alternative, use their ploughed back profits. Thus, such

firms distribute dividend at low rates and retain a large part of profits.

(xii) Ability to borrow: Well established and large firms have

better access to the capital market than the new firms and may borrow

192

Capital Structure

NOTES


funds from the external sources if there arises any need. Such firms may

have a better dividend pay-out ratio. Whereas smaller firms have to depend

on their internal sources and therefore they will have to build up good

reserves by reducing the dividend pay-out ratio for meeting any obligation

requiring heavy funds.

(xiii) Extent of share distribution: Nature of ownership also

affects the dividend decision. A closely held firm is likely to get the assent

of the shareholders for the suspension of dividend or for following a

conservative dividend policy. On the other hand, a firm having a good

number of shareholders widely distributed and forming low- or middle-

income group, would face great difficulty in securing such assent because

they will emphasise to distribute higher dividend.

(xiv) Past dividend rates: While formulating the dividend policy,

the directors must keep in mind the dividends paid in past years. The

current rate should be around the average past rate. If it is abnormally

increased the shares will be subjected to speculation. In a new concern, the

firm should consider the dividend policy of the rival organisations.

(xv) Taxation: The tax status of the major shareholders also affects

the dividend decision sometimes. For example, if a firm is owned by a few

shareholders in the high-income tax bracket, it would be in their interest

not to receive too high an amount of dividend. Such shareholders may be

interested in taking their return from the investment in the form of capital

gains rather than in the form of dividends.

14.14.9 Types of Dividend Policy

Following are the different types of dividend policy that are

generally pursued in firms:

(i) Generous Dividend Policy: Firms which adopt this dividend

policy, reward shareholders generously by stepping up total dividend

payment over time Typically, these firms maintain the dividend rate at a

certain level (15% to 25%) and issue bonus shares when reserves position

and earnings potential permit. Such firms normally have a strong

shareholders orientation.

(ii) Erratic Dividend Policy: Firms which follow this dividend

policy, do not bother about the welfare of equity shareholders. Dividends

are paid erratically whenever the management believes that it will not

strain its resources.

(iii) Stable Dividend Policy: Firms which adopt this dividend

policy pay a fixed number of dividends regularly irrespective of

fluctuations in earnings year after year. This policy attaches equal

importance to the financial requirements of the firm and interest of the

shareholders. The stable dividend may be in any of the following three

forms.

(a) Constant dividend per share: Firm follows a policy of paying certain

fixed amount per share as dividend.

(b) Constant pay-out ratio: Firm pays fixed percentage of earnings every

year. With this policy, the amount of dividend will fluctuate in direct

proportion to earnings.

(c) Constant dividend per share plus extra dividend: Firm usually pays

a fixed dividend to the shareholders and additional dividend in a year of

good earnings.

14.14.10 Advantages of Stable Dividend Policy

(i)This policy provides regular income to investors of the firm.

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Capital Structure

NOTES


(ii) It helps to maintain stability in market values of the firm's shares.

(iii) Firms which follow this policy enjoy a high degree of investor

confidence.

(iv) Firms with stable dividend policy have always high credit standing in

the market. They can raise as much funds as they like from the market

because of widespread demand of their shares.

14.14.11 Limitation of Stable Dividend Policy

The greatest danger associated with a stable dividend policy is that

once it is adopted by the firm, it cannot be changed without seriously

affecting the confidence of shareholders in management and the credit

worthiness of the firm Therefore it is prudent that the dividend rate is fixed

at a lower level so that it can be maintained even in years with reduced

profits.

14.14.12 Dividend Theories

There are conflicting opinions regarding impact of dividend

decision on the value of firm. The dividend theories are broadly classified

into two groups i.e. 1. Theories of relevance, and 2. Theories of

irrelevance.

1. Theories of Relevance (Relevance concept of Dividend)

These theories associated with Walter and Gordon models hold that

the dividend policy of a firm has a direct effect on the position of the firm

in the stock exchange. Because higher dividend increases the value of

shares, whereas low dividend decreases its value in the market due to the

fact that dividend actually presents information relating to the profit

earning capacity or profitability of a firm to the investors. Two models

representing this argument may be discussed below:

(a)Walter's Model

Professor James. E. Walter argues that dividend policy is an active

variable that influences share price and also value of the firm. Both

dividend policy and investment policy are inseparable business decisions.

In determining the significance of dividend policy, Walter holds that the

relationship between the firm's internal rate of return (r) and Cost of

Capital (k) is crucial. If the r> k, the firm should retain the earnings. It

should distribute its earnings if r < k so that the shareholders can make

higher earnings by investing elsewhere. Thus, Walter has related dividend

policy with investment opportunities of the firm. Where firm has ample

investment opportunities promising higher return than cost of capital, it

should retain earnings. Such a firm is called growth firm. Optimum

dividend policy for such a firm would be no dividend distribution.

On the contrary, if a firm lacks in such investment opportunities as

could assure rate of return higher than cost of capital, it should distribute its

earnings. Cent-per cent distribution of earnings constitutes the optimum

dividend policy of such firm called declining firm.

There is another category of firm whose internal rate of return is

equal to cost of capital. Such firm is known as normal firm. In such firm,

shareholders are indifferent between retention and distribution of earnings.

14.14.13 Assumptions

Walter's proposition is based on the following assumptions:

(i)Retained earnings represent the only source of financing for the firm.

(ii) The return on the firm's investment remains constant.

(iii) The cost of capital for the firm remains constant.

194

Capital Structure

NOTES


(iv) The firm has an infinite life.

(v) All the earnings are distributed or reinvested in the firm.

(vi) Earnings per share and dividend remain constant in determining a

given value.

Walter's Formula

The following formula can be applied to determine the market price

per share under Walter's model:

D+ x (E-D)

K

Market price per share (P) =

K

where

D=Dividend per share

r=Rate of return on investment by firm

k=Cost of Capital

E=Earnings per share.

Inference / implications

As pointed earlier, the following inferences are to be made in

Walter's modal:

(a) The optimal payment ratio for a growth firm is Nil.

(b) Pay-out ratio f for a normal firm is irrelevant.

(c) Optimal pay-out ratio for a declining firm is 100%

(d) Higher the retention ratio, higher is the value of the firm and vice versa

Criticisms

(i) No external financing: This assumption may lead to sub-optimal

investment opportunities since it is not always possible to go in for equity

financing, particularly when the equity funding is costlier than the external

financing.

(ii) Constant rate of return: When the amount of investments increases

the return made for every incremental rupee of investment falls.

(iii) Constant opportunity cost: Firm's cost of capital does not remain

constant. It changes with changes in the firm's risk. Firm's risk undergoes a

change over time. By assuming a constant discount rate (i.e., cost of

capital), this model ignores the effect of risk on the value of the firm.

(b) Gordon's Model

Myron J. Gorden has also put forth a model arguing for relevance

of dividend decision to valuation of firm. The model is founded on the

following

(i) The firm is an equity firm. No external financing is used, and

investment programmes are financed exclusively by retained earnings.

(ii) The internal rate of return (r) and appropriate discount rate (k) for the

firm are constant.

(iii)The firm has perpetual life and its stream of earnings are perpetual.

(iv) The corporate taxes do not exist.

(v) The retention ratio (b) once decided upon is s constant. Thus, the

growth rate (g) (g= br) is also constant.

(vi) Cost of capital (k) is greater than the growth rate (g).

Like Walter, relevance of dividend policy to valuation of firm has

been held by Gordon. He is of the view that investors always prefer

dividend as current income to dividend to be obtained in future because

they are rational and would be non chalant to take risk. The payment of

current dividends completely removes any possibility of risk. They would

195

Capital Structure

NOTES


lay less emphasis on future dividends as compared to the current dividend.

This is why when a firm retains is earnings, its share value receives set

back. Investors preference for current dividend exists even in situation

where r= k. This sharply contrasts with Walter's model which holds that

investors are indifferent between dividends and retention when r=k.

Gordon's Formula

Gordon has provided the following formula to determine the market

value of a share.

Market value per share (P) = where,

D=Dividend per share k=Cost of capital

g=Growth rate = b x r E=Earnings per share

b=Retention ratio r=Rate of return.

Implications

(a) The optimal pay-out ratio for a growth firm is Nil

(b) The pay-out ratio for a normal firm is irrelevant

(c) The optimal pay-out ratio for a declining firm is 100%.

Criticisms

(i)Assumption of 100% equity funding defeats the objective of

maximization of wealth, by leveraging against a lower cost of debt capital.

(ii) Constant rate of return and current opportunity cost is not in tune with

realities.

2.Theories of Irrelevance (Irrelevance concept of dividend)

These theories associated with Modigliani and Miller hold that

dividend policy has no effect on the share prices of a firm and is therefore

of no consequence. Investors are basically indifferent between current cash

dividends and future capital gains. They are basically interested in getting

higher return on their investments. If the firm has adequate investment

opportunities giving a higher rate of return than the cost of retained

earnings, the investors will be satisfied with the firm for retaining the

earnings. However, in case, the expected return on projects is less than

what it would cost, the investors would prefer to receive dividends. So, it is

needless to mention that a dividend decision is nothing but a financing

decision. In short, if the firm has profitable investment opportunities, it will

retain the earnings for investment purposes or if not, the said earnings

should be distributed by way of divided among the investors/shareholders.

Modigliani-Miller Hypothesis (M.M. Model)

Modigliani-Miller argue that value of a firm is determined by its

earnings potentiality and investment pattern and not by dividend

distribution. According to them, the dividend decision is irrelevant, and it

does not affect the market value of equity shares, because the increase in

wealth of shareholders resulting from dividend payments will be offset

subsequently when additional share capital is raised. If the additional

capital is raised in order to meet the funds requirement, it will dilute the

existing share capital which will reduce the share value to the original

position.

Assumptions

The above theory is based on the following assumptions:

196

Capital Structure

NOTES


1. Capital markets are prefect. Investors are free to buy and sell securities.

There are no transaction costs. The investors behave rationally. They can

borrow without restrictions on the same terms as the firms do.

2. There are no corporate and personal taxes. If taxes exist, the tax rates are

the same for dividend and capital gains.

3. The firm has a fixed investment policy under which at each year end, it

invests a specific amount as capital expenditure.

4. Investors are able to predict future dividends and l future market prices

and there is only one discount rate for the entire period.

5. All investments are funded either by equity or by retained earnings.

Determination of Market price of share

Under M.M. Model, the market price of a share at the beginning of

the period (Po) is equal to the present value of dividends received at the

end of the period plus the market price of the share at the end of the period.

Po = Present value of Dividends received + Market price of the

share at the end of the period.

This can be expressed as follows:

Po = The market price of the share at the end of the period (P1) can be

ascertained as follows:

P1=po(1+ke)-D1

where,

P1= Market price per share at the end of the period.

Po=Market price per share at the beginning of the period i.e.,

current market price.

Ke= Cost of equity capital

D1= Dividend per share at the end of the period.

Determination of No. of New shares

The investment requirements of a firm can be financed by retained

earnings or issue of new shares or both. The number of new shares to be

issued can be determined as follows:

Investment Proposed. xxx

less: Retained earnings available for investment:

Net income xx

(-) Dividends distributed. xx

xxx

Amount to be raised by issue of new shares. xxx

No. of New shares =

Implications

1. Higher the retention ratio, higher is the capital appreciation enjoyed by

the shareholders. The capital appreciation is equal to the amount of

earnings retained.

2. If the firm distributes earnings by way of dividends, the shareholders

enjoy dividends equal to the amount of capital appreciation if the firm had

retained the number of dividends.

Criticisms

The MM model may be criticized as follows:

197

Capital Structure

NOTES


(i) The assumption of perfect capital market is theoretical in nature as the

perfect capital market is never found in practice

(ii) Following propositions on dividend are impracticable and unrealistic:

(a) Investors can switch between capital gains and dividends

(b) Dividends are irrelevant, and

(c) Dividends do not determine the firm value.

(iii) The Situation of zero taxes is not possible

(iv) The assumption of no stock floatation or time lag and no transaction

costs are impossible.

ILLUSTRATIONS

Illustrations:1 (Growth firm)-Walter Model

The cost of capital and the rate of return on investment of Rafael

Ltd. are 10% and 18% respectively. The company has 5 lakh equity shares

of Rs. 10 each and earnings per share are Rs. 20. Compute the market price

per share and value of firm in the following sit ns. Use Walter Model and

comment on the results.

(i)No retention, (ii) 40% retention, (iii) 80% retention.

Solution:

(i) 0% retention: 100 % pay-out

r

D+ (E-D)

K

Market price per share under Walter Model =

K

D=Dividend per share = EPS x Pay-out

=20x 100% = Rs. 20

r=Rate of return =18%

k=Cost of capital =10%

E=Earnings per share =Rs. 20

0.18

20 + (20-20)

0.10

Market price per share =

0.10

= 20 / 0.10 = Rs. 200.

Value of firm: No. of equity shares x Market price per share

=5,00,000x 200

=Rs. 10,00,00,000

(ii) 40% retention; 60% pay-out

D = per share :20 x 60% = Rs.12

0.18

12 + (20-12)

0.10


0.10

26.4

= = Rs.264

0.10

Value of firm: 5,00,000 shares x Rs. 264 =Rs. 13,20,00,000

(iii) 80% retention: 20% pay-out

198

Capital Structure

NOTES


D= Dividend per share 20x 20%=Rs.4

0.18

4 + (20-4)

0.10


0.10

32.8

= = Rs.328

0.10

Value of Firm: 5,00,000 shares× 328 = Rs. 16.40,00,000

Analysis: Rafeal Ltd is a growth firm (r>k). As pay-out increases,

the value of firm decreases. Ideal pay-out is 0%.

Illustration: 2 (Normal firm)-Walter Model

The earnings per share of Nadal Ltd. are Rs. 15 and the rate of

capitalization applicable to the company is 12%. The productivity of

earnings (r) is 12%.

Compute the market value of the company's share if the pay-out is

(i) 20%; (ii) 50% (iii) 70%. Which is the optimum pay-out?

Solution:

Computation of market value per share

(i) Pay-out 20%

r

D + (E -D)

K


K

D = Dividend per share = EPS x Pay-out ratio

=15x 20% = Rs.3

r= Rate of return =12%

k= Cost of capital = 12%

E=Earnings per share = Rs. 15

0.12

3 + (15-3)

0.12


0.12

15

= = Rs.125

0.12

(ii) Payout = 50%

D=Dividend per share =15 x 50%=Rs. 7.50

0.12

7.50+ (15-7.50)

0.12


0.12

199

Capital Structure

NOTES


15

= = Rs.328

0.10

(iii) Pay-out is 70%

D=Dividend per share=15x 70%=Rs, 10.5

0.12

10.5+ (15-10.5)

0.12


0.12

15

= = Rs.125

0.12

Analysis: Nadal Ltd. is a normal firm (r-k). Market value per share

remains the same for all pay outs. Hence there is no optimum pay-out.

Illustration: 3 (Declining firm)-Walter Model

The earnings per share of Wick Mayer Ltd. are Rs. 12. The rate of

capitalization is 15% and the rate of return on investment is 9%.

Compute the market price per share using Walter's formula if the

dividend pay-out is (a) 25% (b) 50% and (c) 100%. Which is the

ideal pay-out?

Solution:

(i) Computation of market price per share when pay-out is 25%

r

D + (E-D)

k


k

D=Dividend per share=EPS x Pay-out ratio

=12 x 25%Rs. 3

r=Rate of return=9%

k=Cost of capital=15%

E=Earnings per share-Rs. 12

0.09

3 + (12-3)

0.15


0.15

8.4

= = Rs.56

0.15

(ii) Computation of market price per share when payout is 50%

D=Dividend per share = 12x 50%=Rs.6

0.09

6 + (12-6)

200

Capital Structure

NOTES


0.15


0.15

9.6

= = Rs.64

0.15

(iii) Computation of market price per share when pay-out is 100°%

D=Dividend per share = 12x 100% = Rs. 12

0.09

12+ (12-12)

0.15

Market price per share

0.15

12

= = Rs.80

0.15

Analysis: Wickmayer Ltd. Is a declining firm (r <k). Market price

per share is the highest when pay-out ratio is 100% Hence, the ideal pay-

out ratio for the company is 100%.

Illustration: 5

The following information is available in respect of Gill Ltd:

Earnings per share: RS. 15 Cost of capital: 10%

Find out the market price of the share applying Walter Model under

different rates of return of 8%, 10% and 15% for different pay-out ratios of

0%, 40% and 100%.

Solution:

(i) Computation of market price of share if pay-out ratio is 0%

(a) Rate of return (r) = 8%

r

D + (E-D)

k


k

D = Dividend per share = 15 x 0% = 0

K = Cost of capital = 10%

E = Earnings per share = RS. 15

0.08

0 + (15-0)

0.10


0.10

= 12/0.10 = RS. 120

(b) Rate of return (r) = 10%

0.10

0 + (15-0)

0.10


201

Capital Structure

NOTES


0.10

= 15/0.10 = RS. 150

(c) Rate of return (r) = 15%

0.15

0 + (15-0)

0.10


0.10

= 22.5/0.10 = RS. 225

(ii) Computation of market price of share if pay-out ratio is 40%


r

D + (E-D)

k


k

D = Dividend per share = 15 x 40% =RS.6



0.08

6 + (15-6)

0.10


0.10

= 13.2/0.10 = RS. 132


0.10

6 + (15-6)

0.10


0.10

= 15/0.10 = RS. 150


Market price of share = 6+ [0.15/0.10] (15-6)/0.10

= 19.5/0.10 = RS. 195

(iii) Computation of market price of share if pay-out ratio is 100%


r

D + (E-D)

k


k

D = Dividend per share = 15 x 410% =RS.15



0.08

202

Capital Structure

NOTES


15 + (15-15)

0.10


0.10

= 15/0.10 = RS. 150


= 15/0.10 = RS. 150


0.15

15 + (15-15)

0.10


0.10

= 15/0.10 = RS. 150

Illustrations: 6 (Growth firm) – Gordon Model

The following data relates to Yanina Ltd.

Earnings per share = RS.14

Capitalisation rate = 15%

Rate of return = 20%

Determine the market price per share under Gordon’s Model if

retention is (a) 40%, (b) 60%, (c) 20%.

Solution:

Computation of market price per share under Gordon’s Model

(a) Retention ratio = 40%

D

Market value per share (p) =

k-g

D = Dividend per share = Eps x pay-out ratio

= 14x60% = RS. 8.40


g = Growth rate = Retention ratio (b) x Rate of return (r)

= 40% x 20%

= 0.4 x 0.2

= 0.08 x 100 = 8%

8.40


15%-8%

= 8.40/7% = RS. 120

(b) If Retention ratio = 60%

D


k-g


= 14x40% = RS. 5.6


= 60% x 20%

= 0.6 x 0.2

= 0.12 x 100% = 12%

5.6


15%-12%

203

Capital Structure

NOTES


= 5.6/3% = RS. 186.67

(c) If Retention ratio = 20%

Market price per share = D/K-g


= 14x80% = RS. 11.20


= 20% x 20%

= 0.2 x 0.2

= 0.04 x 100% = 4%

11.20


15%-4%

= 11.20/11% = RS. 101.182

Analysis: Yanina Ltd is a growth firm (r>k)

Illustration: 7 (Normal firm) – Gordon Model

Du preez Ltd. gives you the following information:

Earnings per share: RS. 45

Cost of capital: 18%

Return on investment: 18%

Ascertain the market value per share using Gordon’s Model, if the pay-

out is (a) 30%, (b) 60%, (c) 90%.

Solution:


(a) pay-out ratio = 30%: Retention ratio = 40%

D


k-g


= 45x30% = RS. 13.50



= 70% x 18%

= 0.7 x 0.18

= 0.126 x 100 = 12.6%

13.50


18%-12.6%

= 13.50/5.40% = RS. 250

(b) pay-out ratio = 60%; Retention ratio = 40%


= 45x60% = RS. 27


= 40% x 18%

= 0.4 x 0.18

= 0.072 x 100% = 7.2%

27


18%-7.2%

= 27/10.8% = RS. 250

204

Capital Structure

NOTES


(c) pay-out ratio = 90%; Retention ratio = 10%


= 45x90% = RS. 40.50


= 10% x 18%

= 0.1 x 0.18

= 0.018 x 100% = 1.8%

40.50


18%-1.8%

= 40.50/16.2% = RS. 250

Analysis: Du Preez Ltd is a normal firm (r=k). the share price remains the

same for different pay-out ratios.

Illustration: 8(Declining firm)- Gordon Model

Perkins Ltd. earns a profit of Rs. 35 per share. The rate of

capitalization is 15% and the productivity of retained earnings is 10%.

Using Gordon’s model, determine the market price per share if the pay-

out is (a) 20%, (b) 40% and (c) 70%

Solution:


(a) Pay-out ratio: 20%: Retention ratio :80%

Market price per share = D/k-g

D= Dividend per share = EPS x pay-out ratio

= 35 x 20% = Rs.7


G = Growth rate = Retention ratio (b) x Rate of

return (r)

= 80% x 10%

= 0.8 x 0.10 = 0.08 x 100 = 8%

/Market price per share = 7/15%-8%

= 7/7% = Rs.100

(b) Pay-out ratio = 40% : Retention ratio = 60%

D = Dividend per share = 35 x 40% = Rs.14

G = Growth rate = b x r = 60% x 10%

= 0.6 x 0.10 = 0.06 x 100

= 6%

Market price per share = 14/15%- 6% = 14/9%

= Rs. 155.56

(c) Pay-out ratio = 70%: Retention ratio = 30%

D= Dividend per share = 35 x 70% = Rs.24.5

G = Growth rate = b x r = 30% x 10%

= 0.3 x 0.10 = 0.03 x 100

= 3 %

Market price per share = 24.5/15%-3%

= 24.5/12% =Rs. 204.17

Analysis: Perkins Ltd. is a declining firm (r<k)

14.15. Check Your Progress 1.What are the differences between capital structure and capitalization?

2. Define capital structure.

3. The earnings per share of N Ltd. are Rs. 15 and the rate of capitalization

applicable to the company is 12%. The productivity of earnings (r) is 12%.

205

Capital Structure

NOTES


Calculate the market value of the company's share if the pay-out is

(i) 20%; (ii) 50% (iii) 70%. Which is the optimum pay-out?

14.16. Answers to Check Your Progress Questions 1.

Basis Capital Structure Capitalization

1.Coverage

2.Scope

3.Nature

It refers to mix of various

sources of capital e.g.

Capital, debt, etc.

It is an overall policy

decision about the

proportion of various

sources of long-term

finance.

It is a qualitative decision

It refers to all long-term

securities e.g. equity, debt

and free reserves not

meant for distribution.

It is implementation of

policy decision about

capital structure.

It is a quantitative

decision.

2. Capital structure refers to the composition of long-term sources of funds

such as debentures, long term debt, preference share capital and ordinary

share capital including reserves and surpluses (retained earnings).

3. calculation of market value per share

(i) Pay-out 20%

r

D + (E -D)

K


K

D = Dividend per share = EPS x Pay-out ratio

=15x 20% = Rs.3

r= Rate of return =12%

k= Cost of capital = 12%

E=Earnings per share = Rs. 15

0.12

3 + (15-3)

0.12


0.12

15

= = Rs.125

0.12

(ii) Pay-out = 50%

D=Dividend per share =15 x 50%=Rs. 7.50

0.12

7.50+ (15-7.50)

0.12


0.12

15

206

Capital Structure

NOTES


= = Rs.328

0.10

(iii) Pay-out is 70%

D=Dividend per share=15x 70%=Rs, 10.5

0.12

10.5+ (15-10.5)

0.12


0.12

15

= = Rs.125

0.12

Analysis: N Ltd. is a normal firm (r-k). Market value per share

remains the same for all pay outs. Hence there is no optimum pay-out.


1. What are the features of an appropriate capital structure?

2.What are the points to be taken into consideration while determining

capital structure?

3. ABC Ltd has an EBIT of Rs. 1,60,000. Its capital structure consists of

the following securities:

10% Debentures

Rs.5,00,000

12% Preference shares Rs.1,00,000

Equity shares of Rs. I00 Rs.4,00,000

The company is in the 55% tax bracket. You are required to determine:

(a) The company's EPS

(b) The percentage change in EPS associated with 30% increase and 30%

decrease in EBIT

4. Good shape Company has currently an ordinary share capital of Rs, 25

lakh, consisting of 25,000 shares of s. 100 each. The management is

planning to raise another 20 lakh to finance a major programme of

expansion through one of four possible financing plans. The options are as

under:

(a) Entirely through ordinary shares.

(b) RS.10 lakh through ordinary shares and Rs. Lakh through long term

borrowing at 15% interest per annum.

(c) Rs. 5 lakh through ordinary shares and Rs.15 lakh through long term

borrowings at 16% interest per annum.

(d) Rs. 10 lakh through ordinary shares and Rs.10 lakh through preference

shares with 14% dividend.

The company's expected EBIT will be Rs. 8 lakh. Assuming a corporate

tax rate of 50% determine the EPS in each alternative and suggest the best

alternative.

5. Universal Ltd. wants to implement a project for which Rs.60 lakh is to

be raised.

The following financial plans are under evaluation:

Plan A: issue off 6 lakhs equity shares of Rs. 10 each,

Plan B: Issue of 30,000 10% non-convertible debentures of Rs. 100 each

and issue of 3 lakhs equity shares of Rs. 10 each.

207

Capital Structure

NOTES


Assuming a corporate tax of 55%, calculate the indifference point.

6. The following information is available in respect of Khan Ltd.:

Number of shares issued 10,000

Market price per share Rs.20

Interest rate 12%

Tax rate 46%

Expected EBIT Rs.15,000

The firm needs Rs.50,000 for investment next year. Should the firm issue

debt or equity to produce higher EPS? Also find out the difference level of

EBIT for the two alternatives. What is the EPS for that EBIT?

7. Krishna Ltd is expecting an annual EBIT of Rs.2,00,000. The company

has Rs.7,00,000 in 10% debentures. The cost of equity capital or

capitalization rate is 12.5%. You are required to calculate the total value of

the firm. Also ascertain the overall cost of capital.

8. Skylekha Ltd. has an EBIT The of Rs.2,50,000. The cost of debt is 8%

and the outstanding debt is Rs.10,00,000. The overall capitalization rate

(Ke)is 12.5%. Calculate the total value of the firm and equity capitalization

rate under NOI Approach.

9. From the following data relating to Vasanth Ltd., calculate the market

value of the company and overall cost of capital:

Net operating income 1,20,000

Total investment 6,00,000

Equity capitalization rate:

(a) If the company uses no debt = 10%

(b) If the company uses a debt of Rs.2,40,000 = 11%.

(c) If the company uses a debt of Rs.3,60,000 =12%

The debt of Rs.2,40,000 can be raised at 5% rate of interest, while the debt

of Rs.3,60,000 can be raised at 7%.

10. (With tax) Merry Lid. has earnings before interest and taxes (EBIT) of

Rs.30,00,000 and a 40% tax rate. Its required rate of return on equity in the

absence of borrowing world is 18%. In the absence of personal taxes, what

is the of the company in MM world (i) with no leverage; (ii) with

Rs.40,00,000 in debt; and (iii) with Rs.70,00,000 in debt?

11. The following information relates to Siddle Ltd:

EPS Rs.10 IRR 18%

Cost of capital 20% Pay-out ratio 40%

Compute the market price under the Walter's model.

12. The cost of capital and the rate of return on investment of WM Ltd. is

10% and 15% respectively. The company has one million equity shares of

Rs. 10 each outstanding and its earnings per share are Rs. 5. Calculate

value of the firm in the following situations using Walter's model: (i) 100%

retention, (ii). 50% retention, and (iii). No retention. Comment on the

results.

13. Details regarding three companies are given below:

A Ltd. B Ltd. CLtd

r= 15%

ke = 10%

E= Rs. 10

r= 10%

ke = 10%

E= Rs. 10

r= 8%

ke = 10%

E= Rs. 10

By using Walter's model, you are required to:

208

Capital Structure

NOTES


(i) Calculate the value of an equity share of each these companies when

dividend pay-out ratio is (a) 20%, (b) 50%, of each (c). 0 and (d). 100%.

(ii) Comment on the results drawn.

14. Following are the details regarding three companies AI Ltd. and C Ltd.

Details A Ltd B Ltd C Ltd

Internal rate of return.

Cost of equity capital

Earnings per share

15%

10%

Rs. 8

5%

10%

Rs. 8

10%

10%

Rs. 8

Calculate the value of an equity share of each of these company applying

Walter’s formula when dividend pay-out ratio (D/P ratio) is (i). 50

applying Walter's Y% and (iii). 25%.

15. Victory Ltd. earns Rs.5 per share. The capitalisation rate is 10% and

the return on investment is 12%. Under Walter's model, determine

(a) the optimum pay-out

(b) the market price of the share at this pay-out.

(c) the market price of the share if the pay-out is 20%

(d) the market price of the share if the pay-out is 40%.

16. The earnings per share of a company are Rs. 8 and the rate of

capitalization applicable to the company is 10% The company has before it

an option of adopting a pay-out ratio of 25% or 50% and 75%. Using

Walter’s formula of dividend pay-out, compute the market value of the

company’s share if the productivity of retained earnings (i)15% (ii) 10%

and (iii) 5%

17. From the data given below relating to Jayant Ltd. determine the market

price per share under Gordon's model:

EPS Rs. 8 Retention ratio (b) = 25%

Capitalisation rate (k) = 10% Rate of return (r) = 15%

18. Calculate the market price of a share of ABC Ltd. under (i) Walter’s

formula, and (ii). Dividend growth modal from the following date:

Earnings per share Rs.5 Dividend per share Rs.3

Cost of capital 16%Internal rate of return on investment 20%

Retention ratio 40%

19. Anand Corporation Ltd. Belongs to a risk class of which the

appropriate capitalisation rate is 10%. It currently has 1,00,000 shares

quoting Rs. 100 each. The company proposes to declare a dividend of Rs. 6

per share at the end of the current fiscal year which has just begun.

Answer the following questions based on Modigliani and miller model and

assumption of no taxes.

(i) What will be the price of the share at the end of the year if dividend is

not declared?

(ii) What will be the price if dividend is declared?

(iii) Assuming that the company pays dividends, has a net income of Rs. 10

lakh and plans new investment of Rs. 20 lakh during the period, how many

new shares must be issued?

(iv) Is the MM Model realistic? What factors might mar is validity?

Further Reading:




3. Financial Management: Pandey, I. M. Viksas

209

Capital Structure

NOTES



P.K. TMH 5. Financial Management: Text & Problems, Khan, M. Y Jain, P.K.

3rd ed, TMH





Sultan Chand Publications.

DISTANCE EDUCATION – CBCS – (2018 – 2019 Academic Year Onwards)

Question Paper Pattern – Accounting & Financial Management

(PG Programs)

Time: 3 Hours Maximum: 75 Marks

Part – A (10 x 2 = 20 Marks)

Answer all questions

1. What do you mean by double entry system of accounting?

2. Explain the term journal.

3. Write at least four objectives of cash flow statement.

4. Define costing.

5. What is meant by management accounting?

6. Write short on BEP

7. What is idle time variance?

8. What is profit maximization?

9. What is working capital?

10. Explain the term master budget.

Part – B (5 x 5 = 25 Marks)

Answer all questions choosing either (A) or (B)

11. (A) How does double entry system of accounting differ from single entry system of accounting?

(or)

(B) What is trail balance? State its objectives.

12. A) From the following particulars, prepare a cost sheet:

Rs.

Opening stock of raw materials 60,000

Raw materials purchased 9,00,000

Wages paid 4,60,000

Factory overheads 1,84,000

Work-in-Progress (Opening) 24,000

Work-in-progress (Closing) 30,000

Raw materials (Closing stock) 50,000

Finished goods (Opening) 1,20,000

Finished goods (Closing) 1,10,000

Selling and distribution expenses 40,000

Sales 18,00,000

Administration expenses 60,000

(or)

(B) From the following information, calculate cash flow from operating activities using

indirect method.

Statement of Profit and Loss A/c

for the year ended on March 31, 2016

Particular

Rs.

Rs.

Revenue from operations

Expenses:

Cost of materials consumed Employees benefits expenses

Depreciation

Other expenses:

Insurance premium

2,40,000 60,000

40,000

16,000

4,40,000

Total expenses 3,56,000

Profit before tax

Less: Income tax

84,000

20,000

Profit after tax 64,000


Particular

31.3.2015

31.3.2015

Trade Receivables

Trade Payables Inventory

Outstanding employees’ benefits

Prepaid insurance Income tax payable

66,000

34,000 44,000

4,000

10,000 6,000

72,000

30,000 54,000

6,000

11,000 4,000

13. (A) From the following information extracted from the books of a manufacturing company,

compute the operating cycle in days:

Period covered: 365 days

Average period of credit allowed by suppliers: 16 days

Rs.

Average total of debtors outstanding

Raw materials consumption

Total production cost

Total cost of sales

Sales for the year

Value of Average stock maintained:

Raw materials

Work-in-progress

Finished goods

4,80,000

44,00,000

1,00,00,000

1,05,00,000

1,60,00,000

3,20,000

3,50,000

2,60,000

(or)

(B). Determine the working capital requirements of a company from the information given

below:

Operating cycle components:

Raw materials =60 days

W.I.P =45 days

Finished goods =15 days

Debtors = 30 days

Creditors = 60 days

Annual turnover =73 lakh; Cost structure (as % of sale price) is Materials 50%, Labour

30%, Overheads 10 % and Profit 10%. Of the overheads, 30% constitute depreciation.

Desired cash balance to be held at all times: Rs. 3 lakh.

14. (A) Calculate the material mix variance from the following


A 90 units at rs12 each 100 units at rs. 12 each

B 60 units at rs.15 each 50 units at rs. 16 each

(or)

(B) From the following budgeted figures prepare a Cash Budget in respect of three

months to June 30, 2006.

Month Sales

Rs.

Materials

Rs.

Wages

Rs.

Overheads

Rs.

January 70,000 50,000 11,000 6,200

February 66,000 58,000 11,600 6,600

March 74,000 60,000 12,000 6,800

April 90,000 66,000 12,400 7,200

May 94,000 72,000 13,000 8,600

June 86,000 60,000 14,000 8,000



2. Materials and overheads are to be paid during the month following the month of

supply.

3. Wages are to be paid during the month in which they are incurred.


5. The terms of credits are payment by the end of the month following the month of

sales: Half of credit sales are paid when due the other half to be paid within the month

following actual sales.

6. 5% sales commission is to be paid within in the month following sales



9. Plant and machinery worth Rs. 10,000 is to be installed in the month of January and

the payment are to be made in the month of June.

15. (A) What are the factors determining cost of capital?

(or)

(B) What are the differences between capitalization and capital structure?

Part – C (3 x 10 = 30 Marks)

Answer any three out of five questions

16. Elements of Cost – Explain in detail.

17. Pepsi Company produces a single article. Following cost data is given about its product: ‐

Selling price per unit Rs.40 Marginal cost per unit Rs.24 Fixed cost per annum Rs. 16000

Calculate:

(a)P/V ratio

(b) Break even sales

(c) Sales to earn a profit of Rs. 2,000

(d) Profit at sales of Rs. 60,000

(e) New break-even sales, if price is reduced by 10%.

18. M/s. Alpha Manufacturing Company produces two types of products, viz., Raja and Rani and

sells them in Chennai and Mumbai markets. The following information is made available for

the current year:

Market

Product

Budgeted Sales

Actual Sales

Chennai Raja 400 units @ Rs.9 each 500 units @ Rs.9 each

,, Rani 300 units @ Rs.21 each 200 units @ Rs.21 each

Mumbai Raja 600 units @ Rs.9 each 700 units @ Rs.9 each

Rani 500 units @ Rs.21 each 400 units @ Rs.21 each

Market studies reveal that Raja is popular as it is under priced. It is observed that if its price is

increased by Re.1 it will find a readymade market. On the other hand, Rani is over priced and

market could absorb more sales if its price is reduced to Rs.20. The management has agreed to

give effect to the above price changes.

On the above basis, the following estimates have been prepared by Sales Manager:

% increase in sales over current budget

Product

Chennai Mumbai

Raja 10% 5%

Rani 20% 10%

With the help of an intensive advertisement campaign, the following additional sales above the

estimated sales of sales manager are possible:

Product

Chennai

Mumbai

Raja 60 units 70 units

Rani 40 units 50 units

You are required to prepare a sales budget.

19. A firm usually forecast cash flows in nominal terms and discounts at a 10.25% nominal rate.

The firm is considering a project at present involving an immediate cash flow of Rs. 20,000 and

has forecasted cash flows in real terms i.e., in terms of current purchasing power of rupees as

follows:

Year

1

2

3

Cash inflow (Rs.) 10000 16000 12000

The firm expects inflation to be at the rate of 5% p.a

Calculate NPA

20. Current scenario of financial management in India – explain

Documents

ALAGAPPA UNIVERSITY · 2020-04-20 · 4.4. Objectives of Cost Accounting a ture a nd Scope of Cost Accou ing 4.6. Management Accounting 4.7. Objectives of Management Accounting 4.8