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Table of Contents

Describe the various sources of owned finance for business unit.

Equity shares: (Write short note on Equity as a source of finance)

A share is a share in the capital of the company.  Equity Capital also referred to as risk capital, considers no fixed rate of dividend.  It represents the contribution of equity shareholders who are the owners of the company.  Equity share holders own the company, enjoy the rewards as well as bear the risk of ownership.

Benefits of Equity Capital as a source of finance:

·        Equity capital is a permanent source of capital, as there is no obligation of re-payment.

·        The payment of dividend is not compulsory so the company has sufficient freedom in utilization of profits and funds.

·        Large equity base of a company means greater is its ability to obtain credit.

·        There is no charge on the assets of the company due to issue of equity shares.

Disadvantages:

·        The cost of equity capital is high since dividend on equity capital is not a tax deductible expense.

·        The cost of issuing equity capital is higher because it involves underwriting commission, remuneration to lead managers, brokerage costs, publicity expenses etc.

·        Issue of more equity shares may dilute the existing shareholders ownership and thereby control over management.

Preference Shares:

Preference shares are those shares which enjoy priorities in the payment of dividend as well as in repayment of capital.  Preference shareholders have no other rights except on matters affecting their interest. Preference shareholders are entitled to receive a fixed rate of dividend before the dividend is paid to the equity shareholders.  Similarly, preference shareholder is paid back the capital before any payment is made to equity shareholders.

Types of Preference shares: Participating and Non-Participating Preference shares, Redeemable and Non redeemable Preference shares, Convertible and Non Convertible Preference shares, Cumulative and Non cumulative preference shares.

Retained Earnings:

The funds generated by the business but kept as reserve is called as retained earnings. Every company reserves a part of its profits for future investments.  It is called internal financing or plough back of profits. Raising finance through retained earnings is the best source since it is easily available and cost of finance is also less than equity.

Briefly discuss the meaning and types of lease contracts.

Leasing is a general contract between the owner and user of the asset over a specified period of time. The asset is purchased initially by the lessor (leasing company) and thereafter leased to the user (lessee company) which pays a specified rent at periodical intervals. Thus, leasing is an alternative to the purchase of an asset out of own or borrowed funds. Moreover, lease finance can be arranged much faster as compared to term loans from financial institutions.

Types of Leased Contracts: Broadly lease contracts can be divided into following two categories:

a)     Operating Lease: A lease is classified as an operating lease if it does not secure for the lessor the recovery of capital outlay plus a return on the funds invested during the lease term. Normally, these are callable lease and are cancelable with proper notice.

The term of this type of lease is shorter than the asset’s economic life. The lease is obliged to make payment until the lease expiration, which approaches useful life of the asset.

An operating lease is particularly attractive to companies that continually update or replace equipment and want to use equipment without ownership, but also want to return equipment at lease end and avoid technological obsolescence.

b)     Finance Lease: Financial lease is longer term in nature and non cancellable. It can be regarded as any leasing arrangement that is to finance the use of equipment for major part of its useful life. The lessee has the right to use the equipment while the lessor retains legal title. It is also called capital lease, as it is nothing but a loan in disguise.

Thus it can be said, a contract involving payments over an obligatory period of specified sums sufficient in total to amortize the capital outlay of the lessor and give some profit.

Briefly write about the different types of debentures.

Debentures are classified into different types based on their tenure, redemption, mode of redemption, convertibility, security, transferability, type of interest rate, coupon rate, etc. Following are the various types of debentures vis-a-vis their basis of classification.

Redemption / Tenure

Redeemable and Irredeemable (Perpetual) Debentures: Redeemable debentures carry a specific date of redemption on the certificate. The company is legally bound to repay the principal amount to the debenture holders on that date. On the other hand, irredeemable debentures, also known as perpetual debentures, do not carry any date of redemption. This means that there is no specific time of redemption of these debentures. They are redeemed either on the liquidation of the company or when the company chooses to pay them off to reduce their liability by issues a due notice to the debenture holders beforehand.

Convertibility

Convertible and Non Convertible Debentures: Convertible debenture holders have an option of converting their holdings into equity shares. The rate of conversion and the period after which the conversion will take effect are declared in the terms and conditions of the agreement of debentures at the time of issue. On the contrary, non convertible debentures are simple debentures with no such option of getting converted into equity. Their state will always remain of a debt and will not become equity at any point of time.

Security

Secured (Mortgage) and Unsecured (Naked) Debentures: Debentures are secured in two ways. One when the debenture is secured by charge on some asset or set of assets which is known as secured or mortgage debenture and another when it is issued solely on the credibility of the issuer is known as naked or unsecured debenture. A trustee is appointed for holding the secured asset which is quite obvious as the title cannot be assigned to each and every debenture holder.

Transferability / Registration

Registered Unregistered Debentures (Bearer) Debenture: In the case of registered debentures, the name, address, and other holding details are registered with the issuing company and whenever such debenture is transferred by the holder; it has to be informed to the issuing company for updating in its records. Otherwise the interest and principal will go the previous holder because company will pay to the one who is registered. Whereas, the unregistered commonly known as bearer debenture. can be transferred by mere delivery to the new holder. They are considered as good as currency notes due to their easy transferability. The interest and principal is paid to the person who produces the coupons, which are attached to the debenture certificate. and the certificate respectively.

Type of Interest Rates

Fixed and Floating Rate Debentures: Fixed rate debentures have fixed interest rate over the life of the debentures. Contrarily, the floating rate debentures have floating rate of interest which is dependent on some benchmark rate say LIBOR etc.

No Coupon Rate

Zero Coupon and Specific Rate Debentures: Zero coupon debentures do not carry any coupon rate or we can say that there is zero coupon rate. The debenture holder will not get any interest on these types of debentures. Need not to get surprised, for compensating against no interest, companies issue them at a discounted price which is very less compared to the face value of it. The implicit interest or benefit is the difference between the issue price and the face value of that debenture. These are also known as ‘Deep Discount Bonds’ .All other debentures with specified rate of interest are specific rate debentures which are just like a normal debenture.

Secured Premium Notes / Debentures: These are secured debentures which are redeemed at a premium over the face value of the debentures. They are similar to zero coupon bonds. The only difference is that the discount and premium. Zero coupon bonds are issued at discount and redeemed at par whereas the secured premium notes are issued at par and redeemed at premium.

State the sources of short term funds (Short term sources of finance)

Trade credit:  It is credit given by suppliers of goods.  Period of credit may range from 15 days to 90 days.  It is normally in the form of Bills Payable, Open Account (Rotating)

Advance from customers against orders. The customers may be asked to pay an advance against the order of goods to be supplied at a later date. The period of advance may be 1 or 2 months and that is a short term source of financing the operations.

Cash Credit Facility:

A major part of working capital requirement of any unit would consist of maintenance of inventory of raw materials, semi finished goods, finished goods, stores and spares etc. In trading concern the requirement of funds will be to maintain adequate stocks in trade. Finance against such inventories by banks is generally granted in the shape of cash credit facility where drawings will be permitted against stocks of goods. It is a running account facility where deposits and withdrawals are permitted.

Overdraft Facility:

Overdrawing permitted by the bank in current account is termed as an overdraft facility. Overdraft may be permitted without any security as ‘clean overdraft’ for temporary periods to enable the borrower to tide over some emergent financial difficulty. ‘Secured overdraft’ facility is against fixed deposits, NSC, and other securities.

How does overdraft differ from a Cash Credit Account?

The difference relates to the operation of the account. In the case of Cash Credit, a proper limit is sanctioned which normally is a certain percentage of the value of the goods/stock pledged by the account holder with the Bank. Overdraft, on the other hand, is allowed against a host of other securities including financial instruments like shares, units of mutual funds, surrender value of LIC policy and debentures etc. Some overdrafts are even granted against the perceived “Net worth” of a company.

Bills Finance:

Under this type of lending, Bank takes the bill drawn by borrower on his(borrower’s) customer and pay him immediately deducting some amount as discount/commission. The Bank then presents the Bill to the borrower’s customer on the due date of the Bill and collects the total amount. If the bill is delayed, the borrower or his customer’s pay the Bank a pre-determined interest depending upon the terms of transaction.

Export Finance:

Banks grant export credit on very liberal terms to meet all the financial requirements of exporters. The bank credit for exports can broadly be divided in two groups as under:

1. Pre Shipment advances/packing credit advances: Financial assistance sanctioned to exporters to enable them to manufacture/procure goods meant for exports and arrange for their eventual shipment to foreign countries is termed as pre shipment credit.

2. Post shipment credit the bills purchase/discount facility granted to exporters is grouped as post shipment advance.

Commercial Papers

Commercial Papers are short-term, unsecured, negotiable promissory notes with fixed maturity issued by rated corporate.  CPs can be issued in denomination of Rs.5 lakhs and in multiples thereof. The essential features of CPs are:

a.     CPs are issued by Corporates and Financial Institutions

b.     CPs are short term instruments.  Their maturity varies between 7 days to one year. Typically CPs are issued for periods of 7/15/30/45/60/90/120/270/360 days

c.      CPs are unsecured forms of borrowing

d.     CPs are negotiable

e.     CPs are issued as a discounted instrument

f.       Unlike CD, the issuer can buy back its own CP

Certificate of Deposits

CDs are issued by banks and financial institutions to collect funds by attracting deposits from corporate, wealthy individuals, trusts etc.  Banks can issue CDs from 7 days to one year maturity. FIs can issue CDs with an initial maturity of one year to three years. The minimum issue size of a CD issued to a single investor is Rs.1 lakh and in multiples of Rs.1 lakh, thereafter. There is no cap on the amount that can be raised through a CD issue. The features of CD are:

a.     CDs are unsecured negotiable instruments

b.     CDs are issued at a discount to face value and the discount is market determined

c.      Bank CDs are always discounted bills, whereas CDs issued by FIs are coupon bearing

d.     CDs are freely transferable

e.     Banks are not allowed to grant loans against CDs or to buy-back their own CDs

Explain Preference share capital. What are its types?

Preference shares are those shares which fulfill both the following two conditions: (i) They carry preferential share right in respect of dividend at a fixed rate, (ii) They also carry preferential right in regard to payment of capital on winding up of the company.

Preference shares are those shares which enjoy priorities in the payment of dividend as well as in repayment of capital.  Preference shareholders have no other rights except on matters affecting their interest. Preference shareholders are entitled to receive a fixed rate of dividend before the dividend is paid to the equity shareholders.  Similarly, preference shareholder is paid back the capital before any payment is made to equity shareholders.

Types of Preference shares: Participating and Non-Participating Preference shares, Redeemable and Non redeemable Preference shares, Convertible and Non Convertible Preference shares, Cumulative and Non cumulative preference shares.

Preference shares can be further classified as follows:

(1) Cumulative and Non – Cumulative :If in any year the profits are insufficient to pay the preference dividend then in case of cumulative preference shares this dividend can be paid in the subsequent year before any other dividend is paid. In other words the right to receive the dividend goes on accumulating till it is paid. In case of Non – cumulative preference shares the dividend can be paid only in that year. If there are insufficient profits then such preference shareholders do not get any dividend for that year.

(2) Participating & Non-Participating Preference Shares: Participating preference shares are entitled to participate in the surplus profits remaining after the payment of (a) Fixed dividend to Preference shareholders and (b) Dividend to the equity shareholders. They are also entitled to participate in the surplus funds remaining at the time of winding of the company after payment of (a) Preference share capital & (b) Equity Share Capital. Non – participating preference share are not entitled to participate in the surplus profits or surplus funds left over at the time of winding off.

Short note on Term loans

Term Loans’ are a source of long-term debt with a maturity of more than one year and which could be as long as 25 years, carrying fixed interest rates, monthly or quarterly or half-yearly repayment schedules and secured by loan agreements between the borrower and the lending bank / financial institution.

Bankers tend to classify term loans into 3 categories based on the period of repayment.

  1. Short term loans ®     Loans, which are generally repayable within a period of 36 months.
  2. Medium term loans ®Loans, which are repayable in more than 36 months and less than 72 months are called as medium term loans.
  3. Long-term loans ®Loans, which are repayable in more than 72 months, are called long-term loans.

Features of term loans:

Some of the basic features of term loans are as follows:-

  1. Maturity :

Term loans are always granted for a fixed period. But sometimes grace period may also be granted.  The period for which the term loan is granted depends upon the life of the assets that is acquired with that term loan.  The term also depends upon the repaying capacity of the borrower.

  1. Direct negotiation :

Term loans are directly negotiated by borrower and lender bank. It avoids underwriting commission and other flotation costs.

  1. Formal agreement :

There is a formal agreement between borrower and lender bank where in the terms and condition on which the loan is provided is specified.

  1. Appraisal of project :

Term loans are granted only after detailed appraisal of the project, for which the loan is sought, is completed.

Project appraisal is to examine whether the resources are properly utilized to produce the best results, i.e., whether the project is viable. Any venture, which sustains itself without external support can be considered to be viable. Viability study can be made on the following aspects.

  1. Technical feasibility ® focuses mainly on product-mix, process of manufacture, engineering know-how, technical collaboration, site and location, man-power requirement, requirement of R.M and consumables, break-even, etc.
  2. Financial Appraisal ® Reasonable estimate of capital cost, reasonable estimate of working results, adequate rate of return IRR, ROI, etc.
  3. Commercial and economic viability ® Adequacy of marketing tools like market survey for demand forecasts, promotional efforts for generating the demand, distribution network for sustaining demand etc.
  4. Managerial competence ®    The essence of managerial appraisal is to ensure that the project is in the hand of people competent to implement it and carry on the business efficiently. The ability of the people behind the project is the most important factor determining its future.
  5. Security:

Term loans are always secured. They are secured specifically by the assets acquired using the term loans funds, which is called primary security. If the term loans are secured by all assets, present and future, then it is called secondary/collateral security. Also the lender may create either fixed/floating charge against the assets of the company. Fixed charge means mortgage of specific assets. Floating charge is general mortgage covering all assets. (Charge may be defined as transfer of an interest or right in the assets of a person in favour of a lender for the purpose of securing the repayment of loan)

  1. Restrictive covenants:

Certain conditions, which restrict the freedom of management of business of the borrower company is called restrictive covenants. Some examples of such restrictive covenants are maintain minimum asset base, maintain minimum current ratio, not to sell fixed assets without lender’s approval, restrain further loan, restrict payment of cash dividend, appoint nominee directors, etc.

  1. Repayment schedule:

The repayment has two components Interest and repayment of principal.

Repayment is in equal installments, which may be quarterly, half yearly or annual and interest is paid on the outstanding amount of loan.  There are two popular loan amortization pattern.

  1. Interest:

Financial institutions charge an interest rate that is related to the risk of the project subject to a certain minimum Bank prime lending rate (BPLR).  The general rate of interest on term loans in India is 12 to 15%. Previously RBI was rigidly monitoring interest rates on term lending. However, now RBI has granted freedom to the banks to determine their own rates of interest on advances.  So Banks decides the interest rate based on the credit rating of the borrower. Interest rates are decided by adding Minimum Lending Rate (MLR) and risk involved.

What are the functions of finance manager?

There are 3 major decisions which are termed as functions of financial management.  They are

·       Financing decisions:  (Procurement of funds)

o   To identify the sources from which funds can be raised, the amount that can be raised from each source and the cost and consequences involved are important financing decision.

·       Investment decisions: (Effective utilization)

o   It refers to the selection of assets in which the funds will be invested.  The assets which can be acquired fall into two groups – Long term or capital assets and Short term or current assets.  Accordingly the asset selection decision of a firm is of 2 types.

o   Capital Budgeting – for long term / capital assets

o   Working capital – for short term / current assets

·       Dividend policy decisions:  These decisions relate to determine how much and how frequently dividend should be paid to the shareholders.  There are 2 alternatives available to deal with profits – distribute it as dividend or retain for future growth and expansion.  Company needs to balance both – dividend and retain.

o   Apart from these major functions following subsidiary functions are also performed by finance managers:

·       To ensure supply of adequate funds to all parts of organization (Cash Management) All the different sections and departments of a company require finance for day to day operations.  The finance manager has to ensure that these requirements are met by ensuring regular cash flows.

·       To evaluate financial performance and financial position (Financial Statement Analysis) The Profit and loss account of the company shows the profit earned or loss incurred during the financial year. Balance Sheet shows the statement of assets and liabilities as at the end of the year.  The finance manager should use various tools of financial analysis like common size analysis, comparative analysis, ratio analysis, trend analysis and so on to study the financial statements for the purpose of decision making and control.

·       To negotiate with bankers, financial institutions and suppliers of credit The finance manager is also responsible for interacting and communicating, review and control of various external financial stakeholders like banks, financial institutions, financial advisories, corporate clients and suppliers, financial regulators and so on.

·       To analyze and keep track of stock market prices, etc The finance manager has to monitor the stock market price of the company’s shares in particular and general stock market movements. He should be well aware of the stock market trends and regulations.

Write a short note on Capital Budgeting.

Capital budgeting decisions pertain to fixed / long term assets which by definition refer to assets which are in operation, and yield a return, over a period of time, usually, exceeding one year. Capital budgeting is the process of evaluating and selecting long-term investments that generate maximum returns.  Capital Budgeting decisions can be of two types (1) those which expand revenues and (2) those which reduce costs.

Capital budgeting process refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives.  Basically, the company may be confronted with three types of capital budgeting decisions:

(1)   Accept – reject decisions – This is a fundamental decision in capital budgeting.  If the project is accepted, the company would invest in it; if the project is rejected, the company does not invest in it.  Under accept reject decision, all independent projects that satisfy the minimum investment criterion should be implemented.

(2)   Mutually exclusive project decisions – Mutually exclusive projects are those which compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects.  The alternatives are mutually exclusive and only one may be chosen. Mutually exclusive investment decisions are significant when more than one proposal is acceptable. Then, some technique has to be used to determine the “best” one.  The acceptance of this “best” alternative automatically eliminates the other alternatives.

(3)   Capital Rationing decision – It refers to a situation in which a company has more acceptable investments than it can finance.  It is concerned with the selection of a group of investment proposals out of many investment proposals that are acceptable.

What are the qualities of finance manager?

Qualities of finance manager:

1.     Intelligence, Initiative and Innovative The finance manager should possess the requisite qualifications and relevant experience to perform the role.  He should be intelligent, should take initiative and be innovative in his approach in order to perform his role effectively as the finance manager.  He should apply his skills and creativity for problem solving approach to adapt to the ever changing financial environment in which the company operates.

2.     Self confidence and communication skills As the finance manager has to interact with all stake holders from time to time, he has to build rapport with them. He should have the self confidence and communication skills to understand the problems of the subordinates and address the same effectively.

3.     Decision making The role of finance manager involves various short term and long term decisions.  He should have the necessary skills required to take the right decision at the right time.

4.     Administration skills The finance manager heads a team of finance personnel and he should have the skills required to allocate and fix responsibility to his team members based on their skills and expertise.

5.     Patience and discipline The finance manager should patiently handle the finance functions and avoid hasty decisions. He has to be disciplined in order to enforce discipline among the organization staff.

6.     Honesty and sincerity The finance manager should be honest and sincere in his approach to work.

What is the relation between finance function and marketing function?

Finance is said to be the life blood of any organization.  It is closely linked with all other aspects like Purchase, Sales and Marketing, Research and development, Human Resources and so on.  The role of finance in marketing and advertising are as follows:

1.     Pricing The development and pricing of a product or service is a financial decision. Cost benefit analysis is to be done before deciding the price. The price should recover all the costs incurred in developing, producing and marketing the product and also earn reasonable returns.

2.     Sales and Marketing budget Preparing the sales or marketing budget with details like number of units likely to be sold, selling expenses, and advertising cost and so on requires the use of finance function of budgeting.

3.     Brand valuation Brand valuation is an important marketing function which requires application of financial tools.

4.     Cost control Controlling the selling costs like advertising, publicity etc has an impact on the profitability of the organization.  It requires financial parameters to monitor and control these costs.

5.     Marketing strategy The selection of storage facilities, distribution channels, media planning and such other aspects of marketing requires evaluation and comparison of cost involved. Hence finance function is important in these areas of marketing strategies.

6.     Inventory control The purchase, storage and issue of inventory, tracking of movement of stock, stock valuation are all important aspects of marketing in which finance has a key role to perform. These decisions depend on inventory holding cost, warehouse cost, processing and handling costs etc.

What is a budget? Explain the different types of budgets.

The term ‘budget’ is derived from a French word ‘Bougetts’ which means the purse in which funds are collected for anticipated expenses.

Budget is a cost plan for a period of time. Time/period is the most important factor in a budget and it provides the plan in terms of cost. Cost is the value of economic resources. Therefore, Budget is essentially a resource plan in terms of value, for a fixed future period.

Budget Period is the period of time for which the budget is prepared and followed to attain the objective. Budget period will depend upon the type of budget concerned and on the circumstances.

Budgetary Control implies the use of various budgets in planning and controlling.

Budgetary Control is a process of comparing actual results with the corresponding budget data in order to approve accomplishments or to remedy differences either by adjusting the budget estimates or correcting the causes of the differences. A budget is the means and budgetary control is the end result.

There are various types of budgets. Budgets can be broadly classified in to (a) Functional Budgets and (b) Master Budgets

Functional budget in one which relates to any of the functions of activities of an organization.  The functions determine the scope of activities of various departments. Each department has to prepare its own budget.  Sales Budget, Production Budget, Production Cost Budget, Plant Utilization budget, Capital expenditure budget, Selling cost budget, Purchase budget, Cash budget are some examples of Functional budgets.

Cash Budget:  It is a type of functional budget.  A functional budget is one which relates to any of the functions or activities of a department of an organization.

Cash budget represents the cash receipts and payments and estimated cash balance for the period for which the budget is prepared. Cash budget serves the following purposes i) to ensure that sufficient cash is available whenever required. ii) To point out any possible shortage of cash so that necessary steps can be taken to meet the shortage by making arrangement with the bank for overdraft or loan. iii) To point out the surplus cash so that management can invest it in interest fetching securities.

Cash Budget is prepared for cash management which is one of the functions of financial management.

Usually the responsibility of preparing cash budget lies on the Treasurer or other financial executive. Cash Budget has to be prepared by estimating cash receipts and payments.

Sales budget

This budget is prepared by the head of the Sales department.  It is one of the most important budgets and all other budgets depend upon the sales budget. Sales budget is prepared in terms of expected quantity of product to be sold and the expected price at which it may be sold.  The Sales budget is based on the products, the market, the types of consumers, the salesmen etc. The sales manager has to analyse the past sales, do market analysis, study the customer preferences, and study the general trade and business conditions, likely special conditions etc before preparing the sales budget.

Production budget

The production budget is prepared by the production manager.  It shows the quantity of products to be manufactured and is based on the Sales budget, Capacity of factory, Stock requirements etc. While preparing the production budget allowances for normal loss in production is considered. The production budget is prepared as per the following format:

ParticularsQuantity
Closing stock requiredxx
Add: Sales requirementxx
Add: Free samples (if any) to be distributedxx
Less: Opening stockxx
Net productionxx
Add: Normal lossxx
Budgeted productionxx

A Production Cost budget is also known as Manufacturing budget and it considers the quantity of good to be produced in terms of cost.  It consists of Material Cost budget, Labour cost budget and Manufacturing cost budget.

Material budget

Material budget is prepared by the Stores department to forecast the requirement of materials to be purchased for production.  It basically considers the Production budget and the materials consumed for the process of production. The level of inventory of material and normal loss in spoilage is also considered.  The material budget is also referred to as Purchase budget. The material budget can be prepared as per the following format:

ParticularsQuantity
Closing stock requiredxx
Add: Consumption of materialxx
Less: Opening stockxx
Material Purchase requiredxx
Add: Normal lossxx
Budgeted Purchase of materialxx

Fixed and Flexible Budget

Budget can be classified on the basis of flexibility as fixed and flexible budgets.

A fixed budget remains unchanged irrespective of the level of activity i.e. A budget prepared for a particular level of activity is called as a fixed budget.  A flexible budget is capable of furnishing the budgeted cost at any level of activity. It recognizes the behaviour of costs and classifies them into variable, fixed and semi variable.  On the basis of this the budget is designed to change in relation to the level of activity attained. Flexible budgets are normally prepared in tabular form.

Master Budget

A master budget incorporates all its components i.e. all functional budgets. It means the master budget can be prepared only when all the functional budgets are prepared and approved.

Explain the advantages and disadvantages of budget.

Advantages:

1.     Budgeting helps in planning and decision making.

2.     It is an important aspect of managerial control over production, sales, marketing, financing and all management functions.

3.     It enables the company to meet its aims and objectives.

4.     Budgeting is an integral part of budgetary control of business operations.

5.     Budgeting ensures proper allocation of funds to all business functions.

6.     Budgeting is a standard for measurement of actual performance and rectifying deviations.

Disadvantages:

1.     Budgeting may not always be useful in case of frequent changes in business environment.

2.     Budgeting involves lot of time and efforts of senior managers.

3.     Budgetary control is not always possible because of lack of initiatives amongst the employees.

Explain the factors affecting working capital requirements.

Factors affecting Working Capital requirement:

1.     Duration of Operating cycle or Working capital cycle:

The operations of a company comprises of purchase of Raw material, conversion of Raw material in to finished goods, sale of finished goods and realization of accounts receivable.

(a) Nature of business: A manufacturing business will have a longer operating cycle as compared to a trading or service oriented business.

(b) Nature of product: A perishable product like milk, bread etc will have a short processing time as compared to a durable product.  A seasonal product like umbrella, school uniforms etc will have a longer stock holding period because it needs to be stored for a longer period till the season of demand.

(c) Credit cycle: Collection of debts from credit customers depends on the credit policies of the company.  If they follow stringent credit policies, the average credit period allowed will be shorter and if they are lenient then the duration of credit cycle will be longer.

(d) Availability of Raw material:  If the Raw material is not easily available then it has to be purchased and stored in large quantity.  This will increase the stock holding period of raw material. If the raw material is easily available, then it need not be stocked.

2.     Level of activity:

The number of units manufactured / purchased or sold will also affect the working required by the company.  A large scale operation will require more working capital as compared to a smaller scale of business. The working capital required depends on the planned output.

3.     Cost structure: The Raw material cost, labour cost and Overheads cost also affects the working capital.  These costs depend on the process of production and facilities in the factory, competency of the workers, etc. The nature of product also affects its cost of production.

What are the types of working capital?

Meaning and types of Working capital

Working capital is the difference between current assets and current liabilities.  The excess of Current Assets over Current liabilities is called as working capital.  Current asset is an asset which will be realized or liquidated in the near future. Current liability is liability which will have to be paid in the near future.  Current assets and current liabilities arise in the course of normal operations of an enterprise. The amount of working capital is the margin of funds available to meet current liabilities as and when they arise.

GROSS AND NET WORKING CAPITAL

Gross working capital is the total current assets without deducting the current liabilities. It is the value of non fixed assets of a company and includes inventories like raw materials, work in progress, finished goods, spares and consumable stores, receivables, short term investments, advance to suppliers, loans given, sundry deposits with excise or customs, cash and bank balances, prepaid expenses, incomes receivable etc.  Gross working capital is the quantum of working capital available to meet current liabilities.

Net working capital is the excess of current assets over current liabilities.  This concept of working capital is widely accepted, in financial management and normally for granting finance banks consider Net working capital concept. Since a part of the gross working capital is financed by the current liabilities such as creditors for goods, bills payable and creditors for expenses.  Therefore, Net working capital is equal to Gross working capital – Current liabilities = Current Assets – Current liabilities

POSITIVE AND NEGATIVE WORKING CAPITAL

Working capital is said to be positive when current assets exceed current liabilities.  That means current assets can be utilized to pay off the current liabilities. Working capital becomes negative when current liabilities exceed current assets. It is a situation where long term fixed assets may have to be utilized for payment of current liabilities.  This will affect the liquidity position of the firm and is not desirable.

PERMANENT AND TEMPORARY (VARIABLE) WORKING CAPITAL

Permanent working capital is the minimum aggregate working capital in the form of cash, inventory and receivables which are required to be maintained at any point of time for the business to function smoothly.  Any amount of working capital over and above the permanent working capital which fluctuates according to the seasonal variation in market is called as variable working capital. During peak period, company may require more working capital and during off seasons, less working capital is required.  Sometimes to tide over some market fluctuations, more working capital may be required. The part of working capital which fluctuates is called as temporary or variable working capital.

Explain operating cycle.

Duration of Operating cycle or Working capital cycle:

It is the time taken for completion of the operations i.e. purchase Raw material, conversion of Raw material in to finished goods, sale of finished goods and realization of accounts receivable. The duration of operating cycle depends on the following:

(a) Nature of business: A manufacturing business will have a longer operating cycle as compared to a trading or service oriented business.

(b) Nature of product: A perishable product like milk, bread etc will have a short processing time as compared to a durable product.  A seasonal product like umbrella, school uniforms etc will have a longer stock holding period because it needs to be stored for a longer period till the season of demand.

(c) Credit cycle: Collection of debts from credit customers depends on the credit policies of the company.  If they follow stringent credit policies, the average credit period allowed will be shorter and if they are lenient then the duration of credit cycle will be longer.

(d) Availability of Raw material:  If the Raw material is not easily available then it has to be purchased and stored in large quantity.  This will increase the stock holding period of raw material. If the raw material is easily available, then it need not be stocked.

The operating cycle comprises of (1) Inventory cycle – Time taken from the date of readying the stock till sale of stock to customer. In case of Raw material it is the time taken from purchase of raw material till it is issued to factory for production.  It is also called as Stock holding period.

(2) Production cycle – It is the time taken to convert the raw material to finished goods.

(3) Credit cycle – It is the time taken by customers to make payment.

Explain classification of overheads.

Overhead:  The term overhead includes indirect material, indirect labour and indirect expenses.  Thus all indirect costs are overheads. A manufacturing organization can be broadly divided in three divisions:

·        Factory or works where production is done;

·        Office and administration, where routine as well as policy matters are decided; and

·        Selling and distribution, where products are sold and finally dispatched to the customer

Factory overheads includes

Indirect material used in the factory such as lubricants, oil, consumable stores etc.

Indirect labour such as gate-keeper’s salary, time-keeper’s salary, works manager’s salary etc.

Indirect expenses such as factory rent, factory insurance, factory lighting, etc.

Office and Administration overheads includes

Indirect material used in the office such as printing and stationery material, brooms and dusters etc.

Indirect labour such as salaries payable to office manager, office assistants, clerks etc.

Indirect expenses such as rent, insurance, lighting of the office etc.

Selling and Distribution expenses includes

Indirect material used such as packing material, printing and stationery material etc.

Indirect labour such as salesman and sales manager’s salary

Indirect expenses such as commission, advertising, distribution etc

Write short note on Fixed cost and Variable cost.

Fixed, variable and semi-variable costs:

The cost which varies directly in proportion to every increase or decrease in the volume of output or production is known as variable cost.  The cost which does not vary but remains constant within a given period of time and range of activity in spite of the fluctuations in production, is known as fixed cost.  The cost which does not vary proportionately but simultaneously cannot remain stationary at all times is known as semi-variable cost or semi-fixed cost. Fixed cost are sometimes called as period cost and variable cost as product cost. E.g. of fixed cost are rent, insurance, management salary etc.

e.g. of variable cost are direct material, labour, power etc. e.g. of semi-variable are depreciation, repairs etc.

Explain the importance of costing.

Importance / Advantages of cost accounting:

  1. It helps management in controlling costs, reducing avoidable expenditure and minimising wastages and losses.  Thus, Cost Accounting ensures optimum utilisation of men, material and other resources.
  2. It helps management in decision-making like which products to produce more, how much to produce, whether to make or buy a component, what selling price should be quoted and so on.
  3. It provides useful data for financial accounting by arriving at cost of closing stock of raw materials, work-in-progress and finished products.
  4. It provides a database for reference by Government (for fixing fair prices for products like drugs / fertilisers which are under price control), Wage Tribunals and Trade Unions (for deciding wages, bonus etc.)
  5. Cost Accounting enables the management of the concern to ascertain the cost and profitability of each individual product / service / contract / division / branch seperately.  It focuses attention on the profitability of each product or service.

What do you mean by Break even analysis?

Marginal cost is the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. Marginal costing means the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs.  Marginal costing is not a method of costing. It is a technique of cost control by establishing the relationship between profit and volume.

Break even analysis refers to analyzing the point at which the Total Cost is equal to Total Sales. It is the point at which there is no profit or no loss.  The sales are just sufficient to recover the costs. Once the sales exceed the break even point, the company starts earning profits. Till the sales reach the break even point, the company will incur loss. It is an important tool of decision making to plan the volume of output, measure contribution of different product mix, take decisions like accept or reject orders and make or buy decisions and so on.

Features of Break even analysis:

·        The elements of costs are differentiated between fixed costs and variable costs.

·        Only variable or marginal costs are considered while calculating product costs.

·        Contribution is the difference between sales and variable cost.

·        Profitability of various products is determined in terms of contribution.

·        Fixed costs are not part of product cost, it is considered as period cost.

·        Break even analysis and cost volume profit analysis is integral part of marginal costing.

What is ratio analysis? What are its advantages and limitations?

Ratio-analysis:

Ratio-analysis enables to establish the relationship between any two items in the financial statements.  Ratios can be expressed as pure ratio, percentages or rates.

Accounting ratios can be classified according to their functions as follows-

  1. Liquidity/Short-term solvency ratios – Current ratio, Quick ratio, Stock to working ratio etc.
  2. Leverage/Long term solvency/Capital Structure ratio – Proprietary ratio, Debt-Equity ratio, Capital gearing ratio etc.
  3. Profitability ratios –

(a)   Trading/Operating efficiency ratios – Gross profit ratio, Operating ratio, Operating profit ratio, Operating expenses ratio, Net profit ratio etc.

(b)   Overall profitability ratios – Return on capital employed/total assets/investments, Return on proprietor’s/own funds, Return on equity capital etc.

  1. Activity/Turnover ratios – Stock turnover ratio, Debtors turnover ratio, Creditors turnover ratio etc.
  2. Coverage ratios – Dividend payout ratio, Interest coverage ratio, Debt service coverage ratio etc.

Advantages : (Why ratio analysis is considered as a tool for financial analysis)

  1. Ratios can be used for analyzing the financial position of a company. (explained as above – functional classification)
  2. Ratios can be used for comparisons like inter-firm comparison, inter-period comparison, comparison with standards etc.

Limitations of Ratio analysis:

  1. Ratio analysis is based on financial statements.   So reliability of ratios depends upon the reliability of financial statements.
  2. Ratios may not always help in making meaningful inter-firm comparisons because different firms follow different accounting policies and they also differ in terms of age, size etc.
  3. Ratios may not always help in making meaningful inter-period comparisons because of changes in price levels.
  4. Sometimes same ratios may have different terms/formulas which may result in different conclusions.
  5. Ratios are mostly interpreted by comparing it with standards. Establishment of standards are difficult because of different circumstances in different firms/industries etc.
  6. Since ratios are calculated on the basis of financial statements, it considers only year-end data. Changes occurring during the accounting year are ignored in ratio-analysis.

Preference Share capital

Types Kind of Shares

1) Equity Share

2) Preference Share

a) Participating & Non Participating

b) Redeemable & Non Redeemable

c) Cumulative & Non Cumulative

d) Convertible and Non Convertible

Types of Preference Shares

1)      On the basis of participating rights objectives of finance management

a)      Participating preference shares such as shareholders enjoy the right to participate in the excess profits made by the unit over & above fixed percentage.

b)      Non Participating preference shares – such share holders are entitled to receive only the fixed % of dividend.

2)      On the basis of redemption

a)      Redeemable preference shares – such share capital shall be repayed back to the share – holder after a specific period mentioned in the contract

b)      Irredeemable preference shares – such share capital is payed back only at the time of winding up of the company.

3)      On the Basis of Accumulation

a)      Cumulative preference shares – such shareholders enjoy the privilege of accumulating the dividend over the number of

years. If during a gun year a unit does not enjoy profits, then the dividend can be carried forward to the next year.

b)      Non Cumulative preference shares – Such shareholders cannot accumulate the dividend. If the unit suffers a loss during a year then they have to forego their dividend for that year.

4)      On the basis of convertibility

a)      Convertible preference shares – such shares enjoy the privilege of getting converted into equity shares after a specific period, such an option is left to the discretion of the preference shareholder.

b)      Non convertible shares – such shares cannot change their status & they would remain as preference share capital throughout their life.

Reserves & Surplus (Ploughing back of profits)

Every Company sets aside a certain sum of money as reserves & surplus out of profits. Such an amount is called “Revenue reserve” which is meant for emergency requirements.

Such reserves have a special benefits such as :-

a)      They are readily available with the company

b)      They do not require any external administrative procedure

c)       They do not involve any external financial cost for acquisition

d)      They do not dilute the control of the company.

e)      Such results act as a cushion to absorb all the foreseen emergencies.

The practise of using the reserves & surplus as a source of finance is technologically referred to as ploughing back of profits.

Borrowed Funds

A)     Debenture

B)     Term Loans

C)     Lease Contract

D)     Hire Purchase

E)     Subsidies

A)     Debentures

“a legal acknowledgement of debentures (borrowing) by a company to a specific individual or an institution it contains a contract for the repayment of the principle sum with interest at a stipulated time.” It is a part of a company borrowed funds.

Advantages :-

1)      They help the company achieve ‘Trading the Equity’.

2)      They do not dilute the control of the company.

3)      Enable the company to enjoy tax benefits.

4)      Debenture holder enjoys a definite rate of return on his loan rent. Types

A)     On the Basis of registration

1)      Bearer Debenture – such debentures are highly negotiable & the holder of a bearer debenture is entitled to receive the interest.

2)      Registered Debentures – in this case the company maintains an official register to record the names of registered debenture holders. Such debentures cannot be sold by mere delivery they have to follow the registration procedure. The registered number alone can receive the interest.

B)     On the basis of redemption

1)      Redeemable Debentures – these are repayable after a short period

2)      Irredeemable Debentures – these are repaid only at the time of winding up the company or after a long duration.

C)     On the basis of security

1)      Secured Debentures – certain debentures are specifically issued inorder to purchase certain properties. Such debentures are secured to the extent of the value of that property in the event of winding up the m2o obtained from the sale of that property would be used to repay such debenture holders.

2)      Unsecured Debentures – such debenture holders only enjoy a general claim over the properties (assets) of the company unlike the secure debenture holders.

D)     On the basis of convertibility

1)      Convertible Debentures – these debenture holders are gun the option to convert their debentures into preference shares after a specific period.

2)      Non Convertible Debentures – such debenture holders cannot enjoy any ownership status in the company.

Term Loans

These are institutional loans provided by financial institution to the corporate units. Such loans may be borrowed on a short tem (1-3 Years), medium term (3-5 years), long term (5 and above years). Such loans inject funds into the capital structure & increase the sources of funds. A term loan involves a contract between a financial institution & a company. The contract will specify certain covenants to be observed by the borrower:-

A)     Interest covenant: – this would indicate the rate of interest & the mode of payment (half yearly , annual, etc.) During the borrowing period.

B)     Liability Covenant:- this condition would restrict the borrower from increasing his liability through additional borrowing from other units. If the borrower wishes to borrow from other units then he would be required to get the permission of the original institution which provided the term loans.

C)     Asset Related Covenant – this condition would require the borrower to take the permission of the financial unit before selling any profit of the unit.

D)     Repayment Covenant – a term loan may adopt either a balloon repayment or equated monthly installement method of repayment (EMI) – In India the EMI method is normally being adopted by the financial institutions.

E)     (newly added) Management related Covenant – by which a lending institution can send its member to participate in the proceedings

Term loans provide long term liquidity they facilitate research & innovation activities. They support growth & diversification; they enhance the institutional image in the market. This term loans are considered to be a valuable source of finance

Lease Contract

Facilities like lease contracts, hire purchase agreements, deferred credits & subsidies support the companies to utilize their available funds in the most profitable manner.

Lease contract would enable a company to use a property without owning the same. Since the lease rent would be a nominal amount a company can enjoy the benefit of the property without blocking M2o to buy it. Thus a lease becomes a source of finance. It is also referred to as off – balance sheet finance.

A lease agreement normally involves two parties namely the

a)      ‘lessor’ – owner of the property

b)      ‘lessee’ – user of the property

The lessor & the lessee enter into an agreement regarding

A)     Type of lease contract

B)     Amount of lease contract

C)     Duration of lease contract

Types (classified under 2 specific categories)

1)      Operating Lease – these contracts are for a short duration & they can be cancelled by either of the 2 parties without prior notice, in such a lease the lessor cannot recover the value of the properly through a single lease contract.

2)      Financial Lease – these are long term agreements of a non – cancellable nature. These inturn may be classified under 3 types :-

a)      Direct Lease – in such a contract, the owner of the property gives a long term lease to the lesser. Eg:- Citco land lease – 99 years

b)      Sale & Lease back agreement – the owner of a property may enter into a contract with the buyer in the form of “sale & lease back”. Wherein the seller will become the lessee & the buyer will become the lessor. This enables location benefit of the unit without blocking his funds.

c)       Leverage Lease – a leasing company may borrow loan from a financial institution in order to buy lease properties. The lessor’s banker would act as a guarantee & provide the support to get the loan. He would also be a party to the lease contract.

A financial lease will enable the lessor to recover the m20 invested in the property through a single contract

Hire Purchases

Hire purchases involves a hirer (potential buyer) & a hire(potential seller) of a property. Such contracts will involve an initial down payment in cash once it is payed the ownership title would be transferred in a temporary manner in favour of the hirer. When the last instalment of the hire charges is paid, the hirer will become the full fledged owner of such a property. In the event of default the hiree cannot take back the property hired out without court permission. The hire would enjoy all the ownership rights however he would receive a tax budget only for the interested portion of the hire charges.

LeaseHire Purchase
1) Right to use an asset1) Right to own an asset
2) No down payment needed2) Down Payment needed
3) Lessor gets salvage benefit3)Hirer gets salvage benefit
4) Financial lease involves 3parties4)Interest alone is taxdeductible
5) Lease rent is tax deductible5)Interest alone is tax deductible
6) Involves huge amounts6)Small amounts

Subsidies

a)      Subsidy is a welfare measure provided by the government.

b)      Promotes export

c)       Protects agricultural products from market fluctuations in prices

d)      Promotes consumer welfare

e)      Promotes educational facilities

f)         Promotes credit

g)      They are given for merits and non merit goods & services.

Types

1)      Cash subsidies – the government support the farmers by paying a cash subsidy & thus enable them to receive a fair price for their products.

2)      Intrest Subsidies – these are being paid to framers & small scale units to enable them to get institutional loans.

3)      Tax Subsidies – these encourage the exports to earn more foreign exchange & enjoy the benefit of lower rate taxation

4)      Regulatory Subsidies – these are associated with petroleum, cement & power supply facilities. These ensure the availability of such products & services to the weaker sections of the society

5)      Procurement Subsidies – such subsidies encourage import substitution & the subsidy will enable the manufacturer to import material equipment or technology to support import substitution activity.

These subsidies act as an internal source of finance to the general public.

Sources of Finance

1)      Borrowed

2)      Owned

a)      Reserves and Surplus

b)      Shared

1)      Equity

2)      Preference

Sources of finance refer to broad sources from where funds can be procured by the financer manger.

1)      Owned Sources

2)      Borrowed Sources

Owned Sources comprise of a distinct elements

a)      Share Capital

b)      Reserves & surplus (ploughing back of profits)

A)     Share Capital

As per companies act of 1956 a share means a share in the share capital of a company & includes stock except where a distinction between stock and share is expressed or implied.

–            Share Capital is broadly classified into 2 categories

–            Equity Share capital and Preference share capital

–            Authorized, issued, subscribed, and called-up, paid-up – classes of share capital.

Classification of Share Capital

1)      Authorized Share capital – refers to maximum amount of share capital which a company is legally permitted to raise from the market during its lifetime

2)      Issued share Capital – refers to value of shares issued to the public by the company at a given point of time.

3)      Subscribed Share Capital – refers to the amount of share capital which the public is willingly to take up from the company. In the case of highly reputed promoters, an oversubscription may be experienced. New companies promoted by unknown individuals will experience under – subscription.

4)      Called-up share capital – the Board of Director of a company may require the subscribers to pay a certain sum of the share capital within specific time. Such an amount to be paid by the shareholders is referred to as ‘called-up’ share capital.

5)      Paid-up Share Capital – the public would respond to the call made by the Board & make payments towards share capital. The total amount actually paid towards share capital is referred to as paid-up share capital. For all practical purposes, this amount represents the actual funds available.

If certain individuals default the payment, their shares will be forfeited & reissued to others.

Equity Share Capital – a full fledged ownership document of a company. Rights of Equity Share holders:-

1)      Right to vote : an equity shareholder can cast a vote in proportion to the number of shares held by him

2)      Right to receive dividend shareholder enjoys the right to receive a share in the profits of the unit in proportion to the amount of share capital contributed by him.

3)      Right to pre-emption: when an existing company issues additional shares to raise more share capital, the existing shareholder has the right to buy those shares before they are offered to outsiders. Thus the existing shareholders can previously empty such new issue before they are offered to outsiders.

4)      Right to share assets – at the time of winding up of the company, the equity share holder has the right ti share the assets in exchange of share capital contributed by him.

Advantages of Equity Share Capital

1)      Equity share capital is a permanent source of finance for the company.

2)      Dividend payment is made depending on the availability of funds for such distribution. It is not a legal compulsion

3)      Holding a large amount of equity capital promotes the credibility of the unit in the market.

4)      It facilitates the shareholders to retain control over the unit.

Disadvantages of Equity Share Capital

1)      The source of equity share capital involves many procedures

2)      Such an issue is a time consuming process

3)      Often the cost of raising such capital is high

4)      New companies may not get which contribution from the public in the form of equity share capital.

5)      Excessive issue of equity share capital will dilute control of the unit.

Functions of Finance Manager

1)      Procurement Function – a finance manager procures both long and short term finance for his unit. Such procurement comprises of both owned and borrowed funds.

2)      Investment function – this requires the finance manager to take capital budgeting decisions and portfolio management. Decisions in a judicious manner.

3)      Dividend Distribution decision – the finance manager decides the manner in which the earnings & profits of a unit is to be distributed. This involves the determination of volume and types of reserves to be maintained by the unit, the volumes of such reserve & the percentage of dividend to be declared for various types of shareholders as well as the mode of dividend distribution.

Investment Function Decisions

1)      Fixed Asset Investment decisions – long term assets such as land, buildings, etc are called fixed assets. The types of such investments & the amount to be invested in them are to be decided by the finance manger.

2)      Current Asset Investment decision – short term assets like stock, cash, etc are called current or liquid assets. Their volume & value should be decided by the finance manger.

3)      Capital Budgeting Decision – a finance manager has to be exercise his choice among alternative investment options to invest the funds of the company. Such is called a capital budgeting.

4)      Portfolio management Decision – a finance manager invests the funds of his company in various financial investment which are collectively called as ‘portfolio’. He should exercise ‘risk return trade off’ in such decision.

Dividend Distribution Decisions

1)      Reserve funds decisions – all units keep aside a certain portion of their profits as a ‘reserve’ to meet emergencies its volume is to be decided.

2)      Dividend % decision – the percentage of dividend to be declared on equity shares has to be decided by the finance manager in consultation with board of director’s.

3)      Mode of Dividend distribution – the finance manager has to decide the form, in which the dividend should be distributed, some companies may distribute it in the form of dividend warrants which are liquid assets while others may issue a part of the dividend in the form of company shares.

Non Commercial decisions

Decisions regarding CSR- globalisation have inculcated the CSR culture in the corporate world. The finance manager decides about the specific projects to be undertaken in this connection.

Scope of Financial management

The term ‘scope’ refers to the impact & influence of financial management in various areas of operation

1)      Impact on accounting – financial management provides the basic data model to determine the various ‘cost’ elements.

2)      Impact on management decisions – financial management is the basics for the field of management accounting which aids management decision making.

3)      Influence investor decision – potential investors read & analyse the financial statement in order to evaluate the strength & weakness of the unit.

4)      Basis for corporate rating – credit rating institutions & financial rating institutions use financial information as a tool to determine the credit worthiness & solvency of a unit.

5)      Basics for taxation – financial data is used by the government for levying corporate taxes.

6)      Profit & wealth maximisation – precedent financial management ensure maximisation of profits in the short run & maximisation of wealth in the long-run.

Inter – relationship with other financial areas:-

A)     Financial production management –production as a field of activity involves the purchase of raw materials. It also requires the acquisition of equipments, recruitment of skilled workforce & the creation of adequate infrastructure. Each one of these factors would require financial support. Subsequently the production unit may have to dispose of the scrap material or recycle the waste. This would again involve a financial allocation. Activities like quality control, safety procedures, pollution control measures & storage facilities would also require funds. Thus every aspect of production is closely related with a financial commitment. Besides the control of production cost can be achieved only through efficient financial management.

B)     Finance and Marketing – The field of marketing covers a variety of activities such as research, transportation, warehousing, insurance, channel distribution, promotional activities. It includes research & innovation, production improvement & withstanding competition. Each one of the above activities would require a financial commitment. Certain related activities like the appointment of agents, legal experts, and financial consultants for global trade could also require a huge financial commitment. Each one of the promotional techniques would require a separate budgeting allocation. Thus sales promotion measures may involve expenditure on gift items. Advertising would involve the payment on creative & media charges. Direct marketing may require extensive sales force training. Thus successful marketing would be the outcome of sufficient funds allocated for marketing processes.

C)     Finance and Advertising – The term advertising is being popularly referred to as “any paid form of non – personal communication” & this implies a financial commitment for promotional purposes. The two

broad categories of advertising are ‘above the line & below the line’ – they have their own explicit & implicit cause. Normally, mass communication through mass media involves a very heavy budget in addition to media cost. Creative expenditure should also be incurred for advertising purposes. Off late, the field of advertising has emerrged its scope & has included consultancy & creative services. Such consultancy may have to be paid a highly large salary. Thus finance has a direct impact on advertising expenditure and advertising impact.

Finance

“Finance is the provision of money at the time it is needed” – F.W. Paish

“ finance function is associated with the optimal administration of cash & credit inflows & outflows of a unit during any given period of time” – Howard Upton

1)      Profit Maximization – this is a commercial goal achieved through the maximisation of the revenues by increasing sales of the unit.

2)      Shareholder’s wealth maximisation – if a company earns huge profits then its reputation in the market increases. This goodwill increases the market value of its shares. Such an increase in the market value maximizes the wealth of its shareholder’s

3)      Risk return trade off – every financial decision involves a certain degree of risk as well as a return. The finance manager has to achieve a delicate balance between risk & return. He should achieve maximum return with minimum risk.

4)      Safety & Solvency – the term ‘safety’ refers to the investment of company’s funds in a judicious manner. ‘Solvency’ refers to the ability of a unit to meet its financial commitments to outsider’s on time.

5)      Economy – finance manager should manage to procure borrowed funds at low interest. Rates & thus reduce the ‘cost’ of funds. He should also ensure optimum usage of funds & avoid wasteful expenditure.

6)      Liquidity – refers to availability of ready cash to meet day to day expenses. The finance manager should ensure the availability of such liquid cash.

7)      Corporate Social Responsibility – every year the finance manager expected to allocate a certain sum towards the discharge of social service activities of the unit.

8)      Institutional image building – the finance manager has a great role to play in building the image of the company in the market. This enables a unit to attract both FDI – foreign direct investment & FII – foreign institutional investments.

Financial Decisions

1)      Commercial

A)     Procurement function

B)     Investment

C)     Dividend Distribution

2)      Non – Commercial

A)     CSR

1)      Commercial Decision

A)     Procurement function decisions

1)      Capitalisation decision – the finance manger has to decide about the volume of long term funds to be invested in the business.

2)      Capital Gearing Decisions – the ratio ‘owned’ & ‘borrowed’ funds is also to be decided by the finance manager this ratio is referred to as ‘gearing ratio’

3)      Types of financial instruments decision – the finance manager has to decide about the difference types of shares & debentures to be issued by the company & the terms & conditions of their issue.

Ratio Analysis

Financial Statements

Every unit records the financial transaction either in a horizontal format or in a vertical format

Horizontal Format

The horizontal format also knows as the “T” shaped format. It comprises of 2 statements namely:-

1)      Trading and Profit & loss account

2)      Balance sheet

The trading & profit & loss account indicates the profit or loss made by the unit during a given year.

The balance sheet indicates the financial status of the unit during a gun year

The balance sheet comprises of liabilities & assets – Liabilities = what the firm owes to share holders & outsiders.

Assets = what the firm owns over a period of time.

The Basic accounting equation is expressed as liabilities = assets

Vertical Format

This is the most modern way of presenting financial statements, it comprises of income statement which indicates the profit or loss made during a given year. A position statement indicates financial status of a unit as of a gun date.

Sources = methods through which funds have been raised. Applications = methods in which funds have been used.

Format of balance sheet of…as on…..

Liabilities Rs.Assets Rs.
Share CapitalFixed Assets
Reserve & SurplusInvestment
Long Term Loans(Current assets loan andadvances)
Current liabilities &provisions
TotalTotal

Income statement of-for the year ended…

Rs

·       Net sales

·       Less cost of goods sold

·       Less operating expenses

·       Add operating income +

·       Operating Profit

·       Less non – operating expenses

·       Add non- operating income

·       Net profit before taxation & reserves

·       Less tax

·       Net Profit after tax before reserves

·       Less reserves

·       Net profit (net income of the year)

Position statement of – as on

Rs

·       Sources of funds

·       Owned Funds

A)     Share Capital

B)     Reserves & surplus

·       Borrowed Funds

A)     Debentures

B)     Term Loans

C)     A – B other Borrowings

Total sources of funds                                                                —

Application of funds                                               Rs

1)      Fixed assets less depreciation

2)      Investment

3)      Working capital (current – current liabilities)

4)      Miscellaneous expenditure

Financial Statement Analysis

Ratios

In Ratios involved the comparison of 2 details presented in the financial statements in order to access various assets, liquidity etc. Such ratios maybe prepared in pure as well as % form. Ratios are broadly classified into 3 categories:-

a)      Balance sheet ratios

b)      Profitability or income statement ratios

c)       Inter – statement ratios

Uses of ratio analysis

·       It indicates the liquidity of unit

·       It reveals solvency of the unit

·       It shows how effectively the firm is using its fixed & current assets

·       It indicates overall efficiency of unit

·       It is very useful tool for investors & lending institutions to evaluate a unit.

Limitations of ratio analysis

·       Since the ratios consider 2 elements at a gun time, their accuracy is dependent on the correctness & reliability of the data. eg:- Satyam Scam

·       Different companies interpret ratio formula in a different manner. Lack of uniformity makes inter – firm comparison very difficult in practise.

·       Ratios do not reveal intangible factors like customer satisfaction, employee motivation, institutional goodwill which are crucial to Access Company. Hence ratios can be used as a supplementary device to evaluate company over a period of time.

Profitability Ratios

1)      Gross Profit Ratio – Gross profit/net sales

Gross profit = net sales – cost of goods sold

2)      Net profit ratio = net profit after tax/net sales Net sales = sales – sales returns

3)      Operating ratio = (cost of goods sold + operating expenses) / Net sales Cost of goods sold = net sales – gross profit

Operating expenses = administration + selling + financial expenses Net sales = sales – sales return

Inter Statement ratios

1)      Stock to working capital ratio = closing stock/working capital Working capital = current assets – current liabilities

In case opening stock & closing stock details are given then value of average stock should be considered to calculate the ratio.

Average stock = opening + closing stock/2

2)      Debtors turn over ratio = Credit sales/ (debtors + bills receivable) Credit sales = total sales – cash sales

In case opening balances of debtors & bills receivable are also available then to calculate the ratios average, debtors average bills receivable should be considered.

Debtors collection period = 365/debtors turn over

3)      Creditors turn over ratio = Credit purchases / (creditors + bills payable)

Credit purchases= total purchases – cash purchases

In case opening creditors & bills payable are given then average creditors & average bills payable should be considered.

Creditors payment period = 365/creditors turn over

Costing

Definition

Cost refers to the amount of expenditure incurred in the production of a product or creation of a service or completion of a contract. It comprises of direct & indirect cost.

Incremental Cost – cost centre means a location (factory), person (mason), or equipment (computer) for which cost is ascertained.

Cost unit means the unit in which a production or service is measured or expressed for commercial purposes. Eg- cloth in metres, paper in ream, transport cost/ passenger

Indirect costs are the costs which cannot be identified with and allocated to specific cost centres & hence it is apportioned to the cost centres on a suitable basis.

Direct costs are costs which can be identified & allocated to specific cost centres

Functions of costing / 5 A’s

1) Ascertain cost – collect & determine the details of all expenses relating to a particular production.

2)  Analyse Costs – classify the expenses under various heads such as material, labour, etc.

3)  Allocate costs: Charge the direct expenses to the production or process or contract.

4)  Apportion costs : distribute the indirect expenses to all products / processes / contracts on a suitable basis

5)  Absorb cost : The expenses of a department area absorbed by its products

Advantages of costing

1)  Costing benefits the owners/ managers through cost control

2)  It facilitates production mix decisions.

3)  It is the basis of pricing decisions

4)  It is used for the preparation of budgets.

5)  It is used for accessing labour performance to determine bonus & incentives

6)  It helps the government in the fixation of price & taxes.

7) Costing reduces the expenditure & enables price reduction. This benefits the consumers at large.

Cost Classification

ElementsBehaviourTimeGenera
Material CostFixed CostHistorical CostMarginal Cost
Labour costVariable CostPred –determined costReplacement Cost
OverheadsSemi – variablecostStandard CostOppurtunity Cost
Budgeted CostNotional imputedcost
Sunk Cost
Controllable Cost
Uncontollablecost
Relevant Cost
Irrelevant Cost
Discretionary Cost
Diffrential Cost
Shut Down cost

Classification on the basis of elements :-

Elements are broadly classified under 3 categories

1)  Material

2)  Labour

3)  Overheads ( expenses)

These 3 elements are further classified under 2 broad categories namely direct cost & indirect cost based on their traceability into products.

Direct material cost refers to expenditure incurred on the cost of raw material & primary packing material which facilitates production

Indirect material Cost refers to expenditure incurred on certain facilitating items such as spare parts, lubricants etc. They also include secondary material used for sale such as cotton waste, thermocol, etc.

Direct labour Cost – is associated with the wages paid to the labourers directly associated with manufacturing operation.

Indirect labour cost – this expenditure is incurred in the form of the wages & salaries paid to the support staff who facilitate production such as sweepers / watchman’s salary, etc.

Direct overheads – also called ‘direct expenses’ these comprise of expenses such as carriage expenses on raw material custom duty/ octroi on raw material, patent charges, design charges, royalty on production, etc.

Indirect expenses / overheads – comprises of factory expenses such as

A)     Factory rent, lighting, depreciation, factory managers’ salary, factory repairs, etc.

B)     Office administrative overheads – office rent, stationary, fees, printing, insurance, lighting, etc.

C)     Selling & administrative overheads – ad’s, carriage outwards, warehouse charges, packing & forwarding charges, royalty on sale, salesman’s commission, etc.

Classification on basis of Behaviour

Cost can be classified on the basis of behaviour in 3 broad categories

1)  Fixed Cost

2)      Variable Cost

3)      Semi- variable cost

Fixed Cost – these are otherwise referred to as period costs or time costs. They remain stable & fixed over a period of time. They do not change with change in volume of activity. All indirect cost items are fixed cost items – rent, insurance, salary, etc.

Variable Cost –refers to the expenditure incurred on certain items which changes with the volume of activity thus any increase in production will automatically involve an increase in direct material labour & expenses thus variable cost are associated with the prime cost elements.

Semi – variable cost – certain expenses comprise of a fixed cost element as well as a variable component eg:- electricity, phone charges, etc.

Such expenses which partially vary in amount are referred to as semi – variable cost.

Classification on the basis of time:-

On the basis of time costs are classified under 2 broad categories mainly historical costs & pre determine cost

Historical costs – refers to expenditure incurred on the acquit ion of an asset whose benefits are not expired in full. Eg : cost of machinery, furniture etc which are still in use.

Pre – determined cost – also called ‘future costs’ – it is an estimation of the expenditure to be incurred in future. Such an estimate can be classified into 2 categories:-

1)      Standard cost – refers to the ideal cost which can be incurred for acquiring an asset procuring a service.

2)      Budget Cost – it refers to the cost which a unit can afford to spend in procuring a service or purchasing an asset based on the available funds.

General Classification

Marginal – refers to expenditure incurred on the creation of an additional (marginal) unit of production.

Opportunity Cost – this refers to the cost & benefit incurred on account of spending the m20 in the purchase of a specific asset or service by comparing the cost & benefit of various options the management chooses a specific investment. It is very useful in corporate decision making.

Replacement Cost – refers to the expenditure incurred on replacing an asset on a service at the prevailing market rates.

Notional/ imputed cost – refers to expenses which exist merely for record purpose. They are not recorded for the sake of tax concession & similar benefits. Eg:- rent paid for running office from one’s own house, etc.

Sunk Cost – refers to expenditure incurred on an asset whose benefit has fully expired eg:- cost of unused obsolete machinery, depreciation expenses, etc

Controllable costs – this deals with certain items of expenditure which can be totally influenced by the decision of a single individual eg: raw material cost decided by production manager.

Uncontrollable costs – these are general expenses over which no single individual can exercise control. Eg : office rent, telephone charges, etc.

Relevant Costs – these refer to the expenses which are highly essential & crucial for taking a specific decision eg :- cost of sugarcane in sugar manufacturing industry.

Irrelevant Cost – refers to certain expenses which are relatively insignificant for decision making purposes. Eg: type of lighting expenses incurred for sugar manufacturer unit.

Discretionary Cost – these are expenses of a secondary significance their mostly luxuries 7 not necessities for running a unit. Eg: interior decoration, AC etc. for running a factory, etc.

Differential Cost – this refers to any increase or decrease in overall expenditure on account of changing volume of operation. All variable costs are differential.

Shutdown Cost – the expenditure which a unit has to incur even when no productive activity is being carried out such as rent, security, maintenance, etc.

Classify the following transactions on the basis of traceability to product

1)      Legal Expenses – indirect cost

2)      Overtime wages – indirect cost

3)      Cost of buttons & thread in garment manufacturing factory – indirect cost

4)      Depreciation of office furniture – indirect cost

5)      Cost of speakers used in radio – direct cost

6)      News print cost in newspaper – direct cost

7)      Bottles and containers used for soft drink manufacturing – direct cost

8)      Freight inward charges – direct cost

9)      Factory supervision charges – indirect cost

10)                              Import duty on raw materials – direct cost

11)                              Oil used for lubrication – indirect cost

12)                              Cost of wire for electric motors – direct cost

13)                              Gunny bags for filling sugar – direct cost

14)                              Salary paid to sweepers – indirect cost

On the basis of behaviour to change in volume of activity

1)      Purchase commission at 1% per kg

2)      Office rent

3)      Cost of milk used in ice cream – variable cost

4)      Managers salary / directors fees – fixed cost

5)      Repairs & maintenance – semi variable cost

On the basis of function

1)      Dealers commission – selling & distribution overhead

2)      Sales stationary expenses – selling & distribution overhead

3)      Legal expenses – office administration

4)      Rent of warehouse – selling & distribution Nature of capital Budgeting

·       Capital budgeting involvers long term, irreversible, investment decision of a unit.

·       It involves the selection of long term investments by a unit each investment would involve a huge outflow of cash at present & a regular inflow of cash in future years.

·       Selection is done by comprising & the actual cash inflows earned out of various investments.

·       A variety of investment appraisal techniques are being used for such a selection

True value of money

Capital budgeting decisions are normally made targeting into account the concept of time value of m2o. In a general sense m2o experience an increment in value when it is invested I an asset. Such an increment in value occurs on account of the interest factor earned by the investment. This increase in value is referred to as the compounding value of m2o. However on account of information over a period of time. Monet suffers a decrease in purchasing power & gets discounted In real terms. Thus the present value of money may be much more than future value of the same amount. Since any investment is bound to result in future cash inflows(incomes). Their present value is calculated & the purpose of evaluating investment proposals. Such an evaluation is done with the help of annuity factor/discount factor which is provided corresponding to greater rate of interest.

Investment appraisal Techniques:-

1)      Technique which recognizes pay back of capital employed :- Pay back period method

2)      Technique which considers accounting profit:- Accounting rate of return

3) Technique which recognize time value of money :- Net present value of method, Profitability index method internal rate of return method. Discounted pay back method

Pay back method

·       Initial outlay = cost of an investment an asset

·       Yearly cash flow = profit after taxation + depreciation

This amount can be uniform year after year or it may vary from year to year.

·       Cumulative CFAT = CFAT of precious years added to current years CFAT

·       Pay back period – number of years in which the CFAT covers the cost of investment asset.

COST ACCOUNTING

II.   CLASSIFICATION OF COST

CLASSIFICATION OF COST

By Nature                      By function         By variability

                                                               Or

                                                               Behavioral

classification in relation to level of output

I.     BY NATURE:

       The costs are classified into 2 (1) Direct Cost  (2) Indirect cost.

       1)    Direct Cost:

              Direct Cost is the cost which is directly identifiable in a product.  It is a cost which is directly chargeable to a product.

              The Direct Cost are classified into 3 (1) Direct Material Cost (2) Direct Labour Cost (3) Direct Expense

(1)   Cotton used in producing cotton cloth Direct material & amount paid on cotton is a Direct Material Cost.

(2)   Worker producing cotton cloth Direct Labour & wages paid to the worker is Direct Labour Cost.

(3)   A machine is hired for producing cloth Rental paid for the machine is Direct Expense.

              A Separate meter is attached to the machine producing the cost cloth & meter shows that during the day 200 unit of power has been consumed.  The rate of power is Rs.3 per unit & the entire power cost Rs.600 (200 x Rs.3) is a Direct Factory Expense.

              Thus Direct Cost are the costs which are Directly identifiable with a cost unit i.e. cost unit may be product, process, job, contract.

Direct cost are also known as Prime Cost.

The elements of Prime Cost are

(a)   Direct Material

(b)   Direct Labour

(c)   Direct Expenses

(a)   Direct Material

Direct Materials are those which can be identified in the product and which can be measured and directly charged to the product. Thus the material which can be used directly in the manufacture of the product.

For e.g. (1) A Company producing Rubber tyre under this the components of Direct Materials are

(a) Rubber (b) Chemical (c) Fabric (d) Steel Wire (f) Carbon Black

(2)   Cane sugar used in sugarcane industry.

(3)   Cotton consumed in a Textile Industry.

(4)   Vegetable oil for the manufacture of vanaspati.

(5)   Iron ore used in manufacturing of Steel Industry.

Similarly these are also cases where though the material do not enter or form a part of the finished product. They are treated as Direct Material.

Thus while judging of direct material due consideration must be given to the nature of material.

For e.g.

(i)    Tooth paste carton  is not used directly in the Paste but it is treated as Direct Material as well as Packing Material. This is because without the carton it cannot be sold.

(ii)   Acid bottles used for preservation of acid is also treated as Direct Material.

(iii)  Bottles in Chemical Industry are also treated as direct material.

(iv)  In Capsule Industry, the bottle as well as the plastic coated cap where the medicine is preserved is also treated as Direct Material.

(b)   Direct Labour / Wages :

The people who are engaged directly in the process of Manufacture are called as Direct Labour. Wages paid to them are treated as Direct Wages.

For e.g. In a manufacturing concern the Labourers can be divided into 2 department.

Production Department                            Service Department

Under Production Dept.             Under Service Department

we have                                    we have

1)   Mixing Department             1)  Boiler Department

2)   Filtration Department          2)  Power House Department

3)   Packaging Department        3)  Maintenance Department

                                                4)  Accounts Department

                                                5)  Cost Account Department

In the above example the workmen coming under the production department and filtration dept., Mixing dept, Packaging department Constitute, Direct Labour and their wages are called Direct Wages. This is because they work directly with the product.

The workmen coming under the service department, there labourers constitute indirect labour and their wages are termed or indirect wages. This is because the people who are not concerned with the production directly. These labourers are aiding the manufacturer by way of supervision, maintenance, tool setting etc.

However, in certain special cases where the circumstances so warrant, the wage paid to the supervisors, inspector ete. are also treated as Direct Labour. This means that a labourer is hired for the manufacture of a specific product only & the amount spend can be directly measured without much effort then the labour cost is treated as Direct Labour.

Similarly if the cost of laborer is insignificant like those of wages to the trainee, then in these cases even if the labour is directly spend on the product it is not created as direct labour but it is treated as Indirect Labour.

(3)   Direct Expenses :

All expenses other than direct materials or direct labour that are specifically incurred as a particular product or processes are classified as Direct Expenses. Example of Direct Expenses are

(i)    Cost of Drawing incurred on a Specific product.

(ii)   In a factory 500 wheels are to be manufactured to manufacture of wheels a wooden mould in prepared and on it Rs.5000/- expenses are incurred. Now since this cannot be used in any other job and this can’t be Direct material or Direct labour since it is not in the product. But it is treated as Direct Expenses because the expenses incurred on the mould can be used only in that job. After this job is over it becomes useless and so it is treated as Direct expenses.

Prime Cost – Prefix or Key Word for prime cost is Direct.

2)    Indirect Cost / Overheads:

       Indirect Cost is a cost which is not directly identifiable in a product but is indirectly related to a product.

       The indirect costs are classified into (i) Indirect Material (ii) Indirect Labour (iii) Indirect Overheads.

i)     Indirect Material:

A Garment factory is producing T. Shirts, Shirts, Pants, Jeans.   Different Colours of dyes are used. Assume there are 100 kg of blue dye in a drum in the morning.  The cost of the dye was Rs.200 per kg. Throughout the day workers from these four producing departments look away whatever quantity of dye they required.  At the end of the day only 20 kg. of blue remained in the drum. That means 80 kgs. of dye costing Rs.16,000 has been used for these 4 product. Now this cost need to the distributed to the 4 products, may be in the ratio of number of units of products or in the ratio of length of cloth used or in the rates of weight of cloth or garment.  Thus Dyes Cost is neither wholly for any one product nor it can be identified with any product. This is an example of Indirect Material Cost.

ii)    Indirect Labour Cost:

A foreman might be supervising 4 different machines producing 4 different product.  The wages paid to him are not for any 1 product but are common to all the 4 product.  Wages paid to him are to be distributed to the 4 products on some reasonable basis i.e. in the ratio of time spent by him on 4 product.  It is an example of Indirect Labour Cost.

iii)   Indirect Expense:

A company is having centralized A.C. and entire A.C. power cost may be distributed to (apportioned to ) different department on the basis of No. of A.C. in each department.   It is an example of Indirect Power Cost which is a part of Indirect Factory Expenses or Factory overheads.

II.   CLASSIFICATION  BY FUNCTION /

FUNCTIONAL CLASSIFICATION:

       According to the functional classification the cost are classified into

       1)    Factory overheads / production overheads.

       2)    Office and Administration overheads.

       3)    Selling and Distribution overheads.

III.  CLASSIFICATION BY VARIABILITY :

       On the basis of variability the cost are classified into 3 (1) Fixed Cost  (2) Variable Cost

(3) Semi-fixed / semi Variable.

1)    FIXED COST:  Fixed Cost is a cost  which remains fixed

irrespective of the level of production.

              Fixed cost remain fixed in total but it varies per unit.

Salient Features of Fixed Cost:

1)    Higher Risk

2)    Large in value

3)    Long life

4)    Indivisible

5)    Costing characteristics

6)    Irreversible

7)    Controllability

8)    Image value

1)    Higher Risk: Fixed cost is high, the firm will find out a high level of sale to reach no profit, no loss level of activity i.e. to reach break even.

2)    Large in value: Fixed cost associated with 4 Bldg. Plant & machinery etc. are of a large value running in crores of rupee.

3)    Long Life: Fixed assets have long life. 20 yrs., 50 yrs. or even 100 year for asset like L/Bldg. Hence larger the time period for which you get tied to a decision greater is the care & caution required while taking such a decision.  For ex. You may not give much thought while deciding whether to go for a dinner with a boy or girl friend but you will analyse all pros & cons very carefully before deciding to marry him or her. why? Because the decision is irrevocable and also binds you for a long time may be entire life.

4)    Indivisible: Fixed cost are of indivisible character.  They cannot be broken into small penny packet.  For ex. The smallest machine required for production may cost Rs.20,00,000 & the next bigger machine with double the capacity may cost Rs.36,00,000.  Thus there is no choice between no investment and investment of Rs.20,00,000. In the same way, there is no choice between Rs.20,00,000 & 30,00,000. Decision to invest Rs.20,00,000 or jump to 36,00,000 become it is crucial.

5)    Costing Characteristic: Fixed costs are mostly indirect cost i.e. overhead.  They need to the apportioned to different department on some reasonable basis.  There is an element of arbitrariness regarding distribution of fixed cost.

6)    Irreversible: Fixed cost decision, once taken & implemented are of irreversible character.  Irreversible mean that one cannot go back to the original position except at a very heavy loss.  For ex. A Building has been constructed for an Educational Institute. After the Building was ready, it was considered that starting a hotel at that place could be more profitable.  The building constructed for an Educational Institution may not be suitable for a hotel. It may require total demolition & reconstruction a real heavy loss. Hence the decision is irreversible.  Fixed cost decision require greater thought & analysis due to their irreversibility.

7)    Controllability:  The degree of controllability is less regarding fixed cost as compared with variable cost.  Secondly fixed cost are controllable mostly at top level management.

8)    Image Value: Large fixed cost expenditure has a high image value.Q.    Explain the different types of Fixed Cost.

A)    The following are the different types of fixed cost.

1)    Cash Fixed Cost:

       Those fixed cost which are periodically incurred in cash are known as cash fixed cost.  For ex. Factory Rent, Insurance, Manager’s Salary, Lease rent etc. These fixed cost are paid in cash, generally on monthly, quarterly or annual basis.  Cash fixed cost have a greater role in decision making in case of a running business.

2)    Non-cash Fixed Cost:

       Those fixed cost which are not periodically paid in cash are non-cash fixed cost.  Depreciation in the most important example. It is considered for decision making at the planning stage, but once the plant has been installed, day to day decisions are not guided by depreciation.

3)    Avoidable or unapportioned fixed Cost:

       Those fixed cost which will be saved i.e. which will not have to be incurred, if production of a particular product, process, job or service is wholly or partially abandoned, are called avoidable or unapportioned fixed cost.  For ex. In a garment factory there is a general manager and four departmental manager for 4 different products – Shirt, T-shirts, Trouser, Jeans. If production of T-shirts is permanently stopped, it may be possible to get rid of the service of manager of T-Shirt.  In this case the salary of manager T-shirt is avoidable fixed cost. It is also called unapportioned fixed cost because salary of manager T-shirt is exclusively for production of T-shirt. It is not distributed to other product. It is also called escapable fixed cost.

4)    Unavoidable or Apportioned Fixed Cost:

       Those fixed cost which will confirm to be incurred even if production of a product is closed down, are called unavoidable fixed cost.  In the above example even if production of T-shirt is disposed with, the general manager will continue to get the same salary which he was getting when all the 4 products were produced.  Therefore the general managers salary is unavoidable fixed cost. Since this cost is not for any single product, but is distributed over all the 4 products, it is also called apportioned fixed cost of production of one product is stopped; it is merely re-apportioned to remaining product.  It is also called inescapable cost.

       Distribution between avoidable & unavoidable F.C. is important for ‘make’ or ‘buy’ decision & for deciding whether to close down product temporarily.

5)    Committed Fixed Cost:

       These costs are incurred for maintaining physical & legal existence of the undertaking. These cost relate to maintaining physical facilities & management set up.  These costs are unavoidable in the short term. For ex. Salaries of Top Management, Rent, Depreciation on Plant & Machinery. These costs cannot be easily changed.  The management has little discretion regarding such cost. These cost are determined by the past decision. Management has no control over during the current period.

6)    Programmed or Discretionary Fixed Cost:

       These cost are not directly related to current level of activity.  These are programmed or planned by the management based on their own policy decision.  They are subject to management discretion & control and can be increased or decreased in short run ex. R.& D Cost, Advertising cost.  These are also called as policy cost.

       Distinction between committed & discretion Cost is important for cost control & policy making.

VARIABLE COST:

Variable cost is a cost which vary as per the level of production attained.

Variable cost vary in total, but it remain fixed per unit.

Total Output (unit)V.C. per unitTotal V.C.
2000501,00,000
4,000502,00,000
10,000505,00,000
15,000507,50,000

3.     SEMI-VARIABLE / SEMI FIXED COST:

These cost increase with increase in output but less than proportionately & decrease with decrease in output but less than proportionately.  For ex. Telephone bill there is a fixed rental & beyond this the cost increase on per call basis.

This cost remain constant upto certain level of activity & register change afterwards.  These cost vary in some degree with volume but not in direct or some proportion.

BREAK EVEN ANALYSIS:

Break-even analysis is a technique widely used by production management and management accountants. It is based on categorising production costs between those which are “variable” (costs that change when the production output changes) and those that are “fixed” (costs not directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the “break-even point”).

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the “break-even point” and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity (“output”). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.

Break-Even Analysis  Limitations

  • It is only an aid and can be seen as too simplistic
  • The model assumes that all output is sold and on stocks are held – this is not the case in the real world of business
  • Break-even analysis is based on a static model – in business conditions change daily both internal and external
  • The effectiveness of break-even analysis depends on the quality and accuracy of the data used to construct the charts

It assumes that the costs and revenue are linear – we know that in business that they are not – think of economies of purchasing

ASSUMPTIONS OF BREAK EVEN ANALYSIS

It is assumed that all cost/revenue functions (such as fixed cost, variable cost, sales, etc.) are linear with respect to production-volume. However, non-linear functions may also be considered in special cases.

Another assumption in break-even-analysis is related to cost-volume information. All information related to cost are assumed to be deterministic.

We also assume that the influence of a variety of non-volume factors on cost data is of no significance in break-even-analysis.

Assumptions in BEA

1. Linearity of cost/revenue functions with respect to production volume.

2. Deterministic cost/volume/revenue information.

3. Functions other than volume-dependent cost (or revenue cost) are ignored.

4. Single product firm.

5. Constant product mix.

6. Unconstrained conditions.

CAPITAL BUDGETING OR CAPITAL EXPENDITURE

SYNOPSIS

1.        MEANING & DEFINITION

2.        FEATURES

3.        KINDS OF CAPITAL EXPENDITURE

4.        PROCESS OF CAPITAL BUDGETING

5.        METHODS OF EVALUATION

MEANING AND DEFINITION:

“Planning & Control of capital expenditure is termed as Capital Budgeting”.

“Capital Budgeting is an Art of Funding Assets that are worth more than they cost to achieve a predetermined Goal” i.e. Optimising the wealth of the Business Enterprise.

“Capital Budgeting is the process of Identifying Analysing and selecting investment projects whose returns are expected beyond one year”.

The Capital Budgeting involves a current outlay or series of outlays of cash resources in return for an anticipated flow of future benefits.  In other words, the system of Capital Budgeting is employed to evaluate expenditure decisions which involves current outlays but are likely to produce benefits over a period of longer than one year.  These benefits may be either in the form of increased revenues or reduction in cost.

FEATURES:

1.        HEAVY SUBSTANTIAL OUTLAY

2.        HIGH DEGREE OF RISK

3.        LARGE ANTICIPATED BENEFITS

4.        HIGH GESTATION PERIOD i.e. RELATIVE LONG TERM PERIOD BETWEEN INTIAL OUTLAY AND ANTICIPATED RETURN

5.        IRREVERSIBLE DECISION

KINDS OF CAPITAL BUDGETING PROPOSALS OR CAPITAL EXPENDITURE PROPOSALS

1.           MANDATORY INVESTMENTS

ex. A) Pollution control Equipments

B) Medical Dispensary

C) Fire fighting Equipments

D) Creche in Factory

2.        REPLACEMENT PROJECTS:  For cost reduction

3.        EXPANSION PROJECT

         Eg.           A) Increase the capacity

                        B) Widen the distribution network

4.        DIVERSIFICATION PROJECT

         Eg. Producing new product

5.        RESEARCH AND DEVELOPMENT

6.        STRATEGIC INVESTMENT PROJECTS

PROCESS OF CAPITAL BUDGETING

1.        IDENTIFICATION OF POTENTIAL INVESTMENT OPPORTUNITIES

         Here planning body (committee or individual) estimate future sales.

         A)       They monitor external environment.

         B)       Do SWOT analysis

         C)       Motivate employee to make suggestion

2.        ASSEMBLING OF INVESTMENT PROPOSALS

3.        EVALUATING THE VARIOUS INVESTMENT PROPOSALS

4.        PREPARATION OF CAPITAL BUDGET

5.        IMPLEMENTATION

6.        FOLLOW-UP

METHODS OF EVALUATION

METHODS OF EVALUATION
                                 
                         TRADITIONAL                                               MODERN

PAY BACK                                A.R.R.                        (DISCOUNTED CASHFLOW)

                                                              N.P.V.                     P/I           I.R.R.

PAY BACK PERIOD

“It is the number of years required to recover the original cost invested in a project from the cash inflow.”

By this method the investor will know how much time it will take to recover its original cost i.e. how many years it will take for the cash benefits to pay the original cost of an investment, normally disregarding the salvage value.

(A)  When cash inflows are equal/even/same every year.

Example:

Project AProject BProject C
Initial investmentRs.10 LacsRs.20 LacsRs.25 Lacs
Cash flow every yearRs.3 LacsRs.5 LacsRs.10 Lacs
Life of the project10 years10 years10 years
Pay back period10/3 = 3 1/3 yrs.20/5 = 4 yrs.25/10 = 2½ yrs.

Therefore,

                                        Initial investment

Pay back period =                         ————————

                                                            Annual cash inflow

Cash inflow = NPAT + Depreciation & Write Offs

CONCLUSION:

In the above example project C has the shortest pay back and is more desirable.

B)        UNEVEN CASH INFLOWS

In case of uneven cash inflows the payback period is found out by adding the inflows i.e. cumulative cash inflows.

ACCEPT / REJECT CRITERIA

1)        FOR SINGLE PROJECT

           If the pay back is less than the estimated life then accept it

           If the pay back is more than estimated life then reject it.

2)        FOR TWO OR MORE PROJECTS

           If 2 more projects – project with the

           Shortest pay back accept it.

ADVANTAGES

1.        SIMPLE METHOD

         This is the most simple method very easy and clear to understand.  This does not involve tedious mathematical calculation.

2.        CUSHION / SHIELD FROM OBSOLESCENCE:

         This method reduces the possibility of loss on account of obsolescence as the method prefers investment in short term project.

3.        CONSERVATIVE PRINCIPLES

         This method makes it clear that no profit arises till the pay back period is over.  This helps the new companies they should start paying dividends.

4.        PREFERRED BY EXECUTIVES WHO LIKES SNAP ANSWERS, FOR SELECTING THE PROPOSALS.

LIMITATIONS:

1.        CASH FLOW AFTER THE PAY BACK PERIOD

         This method does not consider cash inflow generated after the pay back period.  There are many capital intensive projects which generate substantial cash inflows in the later years than the initial years.  In the above example ‘project B’ which is rejected now may generate huge cash inflows in later years but still it is rejected.

FOR EXAMPLE:-

ParticularsProject AProject B
Initial InvestmentRs.10000Rs.10000
Cash inflows
Year 140003000
Year 240003000
Year 320003000
Year 43000
Year 53000
Pay back period3 years3.3 years

In the above example project ‘A’ is having short pay back that must be accepted but is does not give return afterwards but project ‘B’ gives constant returns even after its pay back period.  So on the whole project ‘B’ is profitable still ‘A’ is accepted under this method.

Thus cash inflow after pay back period is ignore.

2.        TIMING AND MAGNITUDE NOT CONSIDERED.

CostRs.15000Rs.15000
Cash flowYear 1 Rs.10000 RS.1000
Year 2Rs.4000Rs.4000
Year 3Rs.1000Rs.10000

3.        PROFITABILITY

         The pay back period method does not take into account the measure of profitability.  It is only concerned with the projects capital recovery.

4.        TIME VALUE OF MONEY

         This method does not consider time value of money i.e. it ignores the interest which is an important factor in making sound investment decisions.  A rupee borrowed tomorrow is worth less than a rupees today.

Ex. There are projects A & B the cost of the project is Rs.30000 in each case.

YearCashinflow
Project ‘A’Project ‘B’
1Rs.10000Rs.2000
2Rs.10000Rs.4000
3Rs.10000Rs.24000

In both the cases the pay back period is 3 years however project ‘A’ should be preferred as compared to project ‘B’ because of speedy recovery of the initial investment.

5.        LIQUIDITY OF ONLY INITIAL INVESTMENT.

         It gives importance only to its liquidity of the initial investment.  It does not consider the liquidity of the company’s total span of life.

6.        DOESN’T CONSIDER THE ENTIRE LIFE OF THE PROJECT.

USES AND APPLICATION:

1.        For project having high risk and uncertainty / Hazy long term outlook

         This method is useful in evaluating those projects which involve high risk and uncertainty.  For eg. Those projects which have the risk of rapid technological development of cheap substitute, political instability etc. for these projects these method is more suitable for e.g. fashion garment industry.

2.        FIRMS SUFFERING FROM LIQUIDITY CRISIS

         Firms which suffer from liquidity crisis are more interested in quick returns of funds rather than profitability pay back period method suits them most because it emphasizes on quick recovery of funds.

3.        FIRMS EMPHASIZING SHORT TERMS EARNING PERFORMANCE

         This method it suitable for firms which emphasize on short term earnings performance rather than its long term growth.

4.        USED FOR PROJECTS HAVING HIGH DEGREE OF OBSOLESCENCE.

CONCLUSION:

PAY BACK METHOD IS A MEASURE OF LIQUIDITY OF INVESTMENT THAN

PROFITABILITY

ACCOUNTING RATE OF RETURN (A.R.R.)

THIS METHOD IS BASED ON AVERAGE ANNUAL ACCOUNTING PROFITS OF A PROJECT.  IT IS EXPRESSED AS NET ACCOUNTING PROFIT AS A% OF CAPITAL INVESTED.

A.R.R. =     Average Annual Profits

                                                                     AFTER TAX

                                                         ——————————- x 100

                                                                    AVERAGE OR

                                                              INITIAL INVESTMENT

Average Investment =                                   COST – SALVAGE

                                                                  ————————-  + SALVAGE

                                                                            2

Average Investment =                         COST – SALVAGE                                  Release of

                                    ——————————————– + SALVAGE + working

                                                                 2                                              capital

NOTE: If the sum states that return is to be calculated on the original investment them instead of Average Investment, cost itself is to be considered.

MERITS:

1)       SIMPLE AND EASY TO CALCULATE

2)       Consider income from the project throughout its life & not just the initial years unlike payback period.

3)       When a number of capital investments proposals are considered, a quick decision can be taken by use of ranking the investment.

DEMERITS:

1)       It does not consider the time value of money.

2)       This method do not differentiate the projects with different size of investment may have the same A.R.R. and the firm will not be able to take the required decision.

NET PRESENT VALUE METHOD

PRESENT VALUE :

         If you invest Rs.1000/- for 3 years in a savings A/c. that pays 10% interest per year.  If you let your interest income be reinvested, your investment will grow as follows.

        Rs.
First YearPrincipal at the beginningInterest for the year(10/100*1000)principal at the end 1000100 1100
Second YearPrincipal at the beginningInterest for the year(10/100*1100)principal at the end 1100110 1210
Third YearPrincipal at the beginningInterest for the year(10/100*1210)principal at the end1210121 Rs.1331

The process of investing Money as well as reinvesting the interest earned thereon is called compounding.  The future value or compounded value of an investment after ‘n’ years when the interest rate is ‘r’ is

F.V. = P.V. (1 + r) n

Where,          r           = Rate of Interest

                   N           = No. of Years

                   P.V.       = Present Value

                   F.V.        = Future Value

Ex.      You deposit Rs.1000 today in a bank which pays 10% interest compounded annually, how much will the deposit grow to after 8 years & 12 years?

F.V. 8 yrs. hence                    = 1000 (1.10)8

                                          = 1000 (2.144)

                                          = Rs.2144

F.V. 12 yrs. hence                  = 1000 (1.10)12

                                          = 1000 (3.138)

                                          = Rs.3138

Q.       A firm can invest Rs.10,000 in a project with a life of 3 years.  The projected cash inflows are

YearsRs.
14000
25000
34000

The cost of capital is 10% p.a. should the investment be made?

Answer:-

         The discount factor can be calculated based on Re. 1 received in with ‘r’ rate of interest in 3 years.

    1     .

(1 + r)n

Year 1 =                      Re. 1                             =        1/(1.10)1                  = 0.909

                            (1+10/100)1

Year 2 =                      Re. 1                             =        1/(1.10)2                  = 0.826

                            (1+10/100)2

Year 3 =                      Re. 1                             =        1/(1.10)3                  = 0.751

                            (1+10/100)3

YearCash Inflow (Rs.)Discount FactorPresent Value
140000.9093,636
250000.8264,130
340000.7513,004
Total P.V.10,770

NET PRESENT VALUE (NPV) METHOD

         This method recognizes that the cash flows at different point of time differ in value and are comparable only when they are first brought down to a common denominator.  i.e. Present Values. For this purpose every cash inflow and cash outflow are first discounted to bring them down to their present value. The discounting rate normally equals to its opportunity cost of capital.

         The NPV is the DIFFERENCE BETWEEN the present values of cash inflows and the present values of cash outflows.

NPV = S PV of inflow – S PV of outflow

DECISION RULE

ACCEPT : if NPV is positive i.e. NPV > 0

REJECT : if NPV is negative i.e. NPV < 0

DEFINITION:

The NPV of an investment proposal may be defined as “The sum of the Present Values of all the cash inflows – The sum of the Present Values of all the cash outflows”

Accept / Reject Criteria:

If                  NPV of inflow > NPV of outflow

Then             Accept the project.

i.e. If NPV of a project is positive Accept the project & If NPV of a project is negative reject the project.

MERITS:

1.        Considers Time Value of Money.

2.        Considers Total Cash Inflows. i.e. entire life.

3.        Best Decision Criteria for Mutually Exclusive Project.

4.        NPV technique is based on the cash flows rather than the Accounting profits and thus helps in analyzing the effect of the proposal on the wealth of the shareholders in a better way.

Thus, it satisfies one of the basic objective of Financial Management i.e. Wealth Maximization

LIMITATIONS:

1.       It is more difficult method than the Pay Back or ARR method.

2.        Consider only Initial Investment:

         The NPV is expressed in absolute terms rather than relative term.  Project A may have a NPV of Rs.5000/- while project B has a NPV of Rs.2,500/-, but project a may require an investment of Rs.50,000 whereas project B may require an investment of just Rs.10,000.  Advocate of NPV argue that what maths is the surplus value irrespective of what the investment outlay is.

3.        Life of the project is not considered:

         The NPV method do not consider the life of the project.  Hence when mutually exclusive projects with different lives are being considered, the NPV rule is biased in favour of long-term project.

4.       Calculation of the desired rate of return presents serious problems.  Generally cost of Capital is the basis of determining the desired rate.  The calculation of cost of Capital is itself complicated. Moreover desired rate of return will vary term year to year.

The following are the steps in Calculating NPV:

1)       Calculation of cash flows i.e. both Inflow & Outflow (preferably after tax) over the full life of the Asset.

2)       Discounting the Cash flows by the disc factor.

3)       Aggregating of discounted Cash inflow

4)       Sept 3 – Outflow (i.e. total present value of cash inflow – total present value of cash outflow)

         a.        If positive in step 4. Accept the project

         b.        If negative in step 4. Reject the project

PROFITABILITY INDEX (P/I)

  • THIS IS THE REFINEMENT OF NPV METHOD
  • IT IS A VARIANT OF NPV TECHNIQUE WHICH IS ALSO KNOWN AS BENEFIT COST RATIO OR PRESENT VALUE INDEX OR EXCESS PRESENT VALUE INDEX.

                 TOTAL OF P.V. OF CASH INFLOW

P/I   =     —————————————————

                 TOTAL OF P.V. OF CASH OUTFLOW

ACCEPT / REJECT CRITERIA:

ACCEPT THE PROJECT IF P/I > 1

REJECT THE PROJECT IF P/I < 1

ADVANTAGES:

1.        THE NPV DO NOT GIVE TRUE PICTURE WHEN SELECTION AMONG THE PROJECTS HAS TO BE MADE AND THE INVESTMENT SIZE IS DIFFERENT.

A PROJECT A & B HAVING COST RS.1,00,000 AND 80,000 RESPECTIVELY.  PRESENT VALUE OF INFLOW OF THE PROJECT ARE RS.1,20,000 & RS.1,00,000 BOTH HAVE NPV OF RS.20,000 AND AS PER NPV THEY ALIKE.

HERE P/I TECHNIQUE SEEMS TO GIVE A BETTER RESULT.

                   1,20,000                                                         1,00,000

P/I (A) =    ————— = 1.20                                 P/I (B) =  ————- = 1.25

                  1,00,000                                                            80,000

CONCLUSION: IN TERMS OF NPV BOTH PROJECT ARE EQUAL BUT IN TERM OF P/I ACCEPT PROJECT B.

2.        IT CONSIDERS TIME VALUE OF MONEY.

3.        IT CONSIDERS THE ENTIRE CASH INFLOW AND ALL CASH OUTFLOW IRRESPECTIVE OF THE TIMING OF THE OCCURRENCE.

4.        IT IS BASED ON CASH OUTFLOW RATHER THAN THE ACCOUNTING PROFIT AND THUS HELPS IN ANALYZING THE EFFECT OF THE PROPOSAL ON THE WEALTH OF THE SHAREHOLDER.

DISADVANTAGES:

1.        IT INVOLVES DIFFICULT CALCULATION.

2.        THIS BEING AN EXTENTION OF NPV WHERE THE PREDETERMINATION OF THE REQUIRED RATE OF RETURN ‘K’ ITSELF IS A DIFFICULT JOB. IF THE VALUE OF ‘K’ IS NOT CORRECTLY TAKEN THEN WHOLE EXERCISE OF NPV MAY GO WRONG.

PROJECT APROJECT B
Initial cash outflow1,50,0001,10,000
P.V. of cash inflow2,10,0001,65,000
NPV60,00055,000
AS PER NPV ACCEPT PROJECT A
P/I2,10,000 = 1.4:11,50,0001,65,000 = 1.5:11,10,000
AS PER P/I ACCEPT PROJECT B

IN SUCH A CASE FOLLOW NPV UNLESS THERE IS CAPITAL RATIONING.  THIS IS BECAUSE IF THE FIRM HAS FUNDS OF RS.1,50,000 TO INVEST THEN AS PER NPV TECHNIQUE PROJECT A IS TO BE ACCEPTED BECAUSE IT WILL RESULT IN INCREASE IN SHAREHOLDERS WEALTH TO THE EXTENT OF RS.60,000 AGAINST PROJECT B WHICH WILL INCREASE IN SHAREHOLDERS WEALTH ONLY BY RS.55,000.

THE BETTER PROJECT IS ONE, WHICH ADDS MORE TO THE WEALTH OF THE SHARE HOLDER.

TERMINAL VALUE (TV)

  • The other variant of the NPV technique is known as terminal value technique.
  • Here the future cash inflows are discounted to make them comparable.
  • In terminal value technique the future cash flows are first compounded at the expected rate of interest for the period from their occurrence till the end of the economic life of the project.
  • The compound values are then discounted at an appropriate discount rate to find out the present value.
  • Then the present value is compared with initial outflow to find out the suitability of the project.

Steps:

1.        Find the compounded value

YearCash inflowRemaining yearP.V. factorCompounded value
1 3
2 2
3 1
4 0
S

2.        The above compound value to be discounted at a discount factor and the P.V. is to be found out.

3.        The above (2) to be compared with initial investment to get NPV.

INTERNAL RATE OF RETURN (IRR)

The IRR is that rate at which the sum of discounted cash inflows equals to the sum of discounted cash outflows.

In other words, it is the rate at which it discounts the cash flow to zero.

         S Cash inflow

Or                                     =  1

         S Cash outflow

Thus I.R.R. is also known as marginal rate of return or time adjusted rate or return.

Thus under this method the discount rate is not known but the cash inflow and cash outflow are known.

For Eg

IF a sum of Rs.800 is invested in a project and become Rs.1000 at the end of a year, the rate of return come to 25% which is calculated as under:

I =    C

    (1 + r)

I  = Initial investment

C = Cash inflow

R = I.R.R.

i.e. 800 =        1000

(1 = r)

800 (1 + r) = 1000

800 + 800r = 1000

800r = 200

r = 200 = 1 = 0.25 = 25%

     800    4

ACCEPT / REJECT CRITERIA

In order to make a decision on the basis of IRR technique the firm has to determine in the first instance, its own required rate of return.

This rate ‘K’ is also known as cut off rate or the hurdle rate.  A particular proposal may be accepted.

If its IRR ‘r’ is MORE THAN the MINIMUM REQUIRED RATE ‘K’ ACCEPT IT.

IF the IRR ‘r’ is just Equal To the Minimum Required Rate ‘K’ than the firm may be INDIFFERENT.

If the IRR ‘r’ is LESS THAN the MINIMUM REQUIRED RATE ‘K’ the project is altogether rejected.

In case of mutually exclusive project the project with highest IRR is given top priority.

MERITS:

1.        The method considers the entire economic life of the project.

2.        It gives due weightage to time factor. I.e. It consider time value of money.

3.        Like NPV technique, the IRR technique is also based on the consideration of all the cashflows occurring at any time. The salvage value, the working capital used and released etc. are also considered.

4.        IRR is based on cashflows rather than accounting profit.

DEMERITS:

1.        It involves complicated trial and error procedure.

2.        It makes an implied assumption that the future cash inflows of a proposal are reinvested at a rate equal to IRR for ex. In case of mutual exclusive proposal say A & B, having IRR of 18% and 16% respectively, the IRR technique make an implied assumption that the future cash inflows of project A will be reinvested at 18% while the cash inflow of project B will reinvested at 16%.

3.        It is imaginary to think that the same firm will have different reinvestment opportunities depending upon the proposal accepted.

CAPITAL BUDGETING OR CAPITAL EXPENDITURE

SYNOPSIS

1.        MEANING & DEFINITION

2.        FEATURES

3.        KINDS OF CAPITAL EXPENDITURE

4.        PROCESS OF CAPITAL BUDGETING

5.        METHODS OF EVALUATION

MEANING AND DEFINITION:

“Planning & Control of capital expenditure is termed as Capital Budgeting”.

“Capital Budgeting is an Art of Funding Assets that are worth more than they cost to achieve a predetermined Goal” i.e. Optimising the wealth of the Business Enterprise.

“Capital Budgeting is the process of Identifying Analysing and selecting investment projects whose returns are expected beyond one year”.

The Capital Budgeting involves a current outlay or series of outlays of cash resources in return for an anticipated flow of future benefits.  In other words, the system of Capital Budgeting is employed to evaluate expenditure decisions which involves current outlays but are likely to produce benefits over a period of longer than one year.  These benefits may be either in the form of increased revenues or reduction in cost.

FEATURES:

1.        HEAVY SUBSTANTIAL OUTLAY

2.        HIGH DEGREE OF RISK

3.        LARGE ANTICIPATED BENEFITS

4.        HIGH GESTATION PERIOD i.e. RELATIVE LONG TERM PERIOD BETWEEN INTIAL OUTLAY AND ANTICIPATED RETURN

5.        IRREVERSIBLE DECISION

KINDS OF CAPITAL BUDGETING PROPOSALS OR CAPITAL EXPENDITURE PROPOSALS

1.           MANDATORY INVESTMENTS

ex. A) Pollution control Equipments

B) Medical Dispensary

C) Fire fighting Equipments

D) Creche in Factory

2.        REPLACEMENT PROJECTS:  For cost reduction

3.        EXPANSION PROJECT

         Eg.           A) Increase the capacity

                        B) Widen the distribution network

4.        DIVERSIFICATION PROJECT

         Eg. Producing new product

5.        RESEARCH AND DEVELOPMENT

6.        STRATEGIC INVESTMENT PROJECTS

PROCESS OF CAPITAL BUDGETING

1.        IDENTIFICATION OF POTENTIAL INVESTMENT OPPORTUNITIES

         Here planning body (committee or individual) estimate future sales.

         A)       They monitor external environment.

         B)       Do SWOT analysis

         C)       Motivate employee to make suggestion

2.        ASSEMBLING OF INVESTMENT PROPOSALS

3.        EVALUATING THE VARIOUS INVESTMENT PROPOSALS

4.        PREPARATION OF CAPITAL BUDGET

5.        IMPLEMENTATION

6.        FOLLOW-UP

METHODS OF EVALUATION

METHODS OF EVALUATION
                                 
                         TRADITIONAL                                               MODERN

PAY BACK                                A.R.R.                        (DISCOUNTED CASHFLOW)

                                                              N.P.V.                     P/I           I.R.R.

PAY BACK PERIOD

“It is the number of years required to recover the original cost invested in a project from the cash inflow.”

By this method the investor will know how much time it will take to recover its original cost i.e. how many years it will take for the cash benefits to pay the original cost of an investment, normally disregarding the salvage value.

(A)  When cash inflows are equal/even/same every year.

Example:

Project AProject BProject C
Initial investmentRs.10 LacsRs.20 LacsRs.25 Lacs
Cash flow every yearRs.3 LacsRs.5 LacsRs.10 Lacs
Life of the project10 years10 years10 years
Pay back period10/3 = 3 1/3 yrs.20/5 = 4 yrs.25/10 = 2½ yrs.

Therefore,

                                        Initial investment

Pay back period =                         ————————

                                                            Annual cash inflow

Cash inflow = NPAT + Depreciation & Write Offs

CONCLUSION:

In the above example project C has the shortest pay back and is more desirable.

B)        UNEVEN CASH INFLOWS

In case of uneven cash inflows the payback period is found out by adding the inflows i.e. cumulative cash inflows.

ACCEPT / REJECT CRITERIA

1)        FOR SINGLE PROJECT

           If the pay back is less than the estimated life then accept it

           If the pay back is more than estimated life then reject it.

2)        FOR TWO OR MORE PROJECTS

           If 2 more projects – project with the

           Shortest pay back accept it.

ADVANTAGES

1.        SIMPLE METHOD

         This is the most simple method very easy and clear to understand.  This does not involve tedious mathematical calculation.

2.        CUSHION / SHIELD FROM OBSOLESCENCE:

         This method reduces the possibility of loss on account of obsolescence as the method prefers investment in short term project.

3.        CONSERVATIVE PRINCIPLES

         This method makes it clear that no profit arises till the pay back period is over.  This helps the new companies they should start paying dividends.

4.        PREFERRED BY EXECUTIVES WHO LIKES SNAP ANSWERS, FOR SELECTING THE PROPOSALS.

LIMITATIONS:

1.        CASH FLOW AFTER THE PAY BACK PERIOD

         This method does not consider cash inflow generated after the pay back period.  There are many capital intensive projects which generate substantial cash inflows in the later years than the initial years.  In the above example ‘project B’ which is rejected now may generate huge cash inflows in later years but still it is rejected.

FOR EXAMPLE:-

ParticularsProject AProject B
Initial InvestmentRs.10000Rs.10000
Cash inflows
Year 140003000
Year 240003000
Year 320003000
Year 43000
Year 53000
Pay back period3 years3.3 years

In the above example project ‘A’ is having short pay back that must be accepted but is does not give return afterwards but project ‘B’ gives constant returns even after its pay back period.  So on the whole project ‘B’ is profitable still ‘A’ is accepted under this method.

Thus cash inflow after pay back period is ignore.

2.        TIMING AND MAGNITUDE NOT CONSIDERED.

CostRs.15000Rs.15000
Cash flowYear 1 Rs.10000 RS.1000
Year 2Rs.4000Rs.4000
Year 3Rs.1000Rs.10000

3.        PROFITABILITY

         The pay back period method does not take into account the measure of profitability.  It is only concerned with the projects capital recovery.

4.        TIME VALUE OF MONEY

         This method does not consider time value of money i.e. it ignores the interest which is an important factor in making sound investment decisions.  A rupee borrowed tomorrow is worth less than a rupees today.

Ex. There are projects A & B the cost of the project is Rs.30000 in each case.

YearCashinflow
Project ‘A’Project ‘B’
1Rs.10000Rs.2000
2Rs.10000Rs.4000
3Rs.10000Rs.24000

In both the cases the pay back period is 3 years however project ‘A’ should be preferred as compared to project ‘B’ because of speedy recovery of the initial investment.

5.        LIQUIDITY OF ONLY INITIAL INVESTMENT.

         It gives importance only to its liquidity of the initial investment.  It does not consider the liquidity of the company’s total span of life.

6.        DOESN’T CONSIDER THE ENTIRE LIFE OF THE PROJECT.

USES AND APPLICATION:

1.        For project having high risk and uncertainty / Hazy long term outlook

         This method is useful in evaluating those projects which involve high risk and uncertainty.  For eg. Those projects which have the risk of rapid technological development of cheap substitute, political instability etc. for these projects these method is more suitable for e.g. fashion garment industry.

2.        FIRMS SUFFERING FROM LIQUIDITY CRISIS

         Firms which suffer from liquidity crisis are more interested in quick returns of funds rather than profitability pay back period method suits them most because it emphasizes on quick recovery of funds.

3.        FIRMS EMPHASIZING SHORT TERMS EARNING PERFORMANCE

         This method it suitable for firms which emphasize on short term earnings performance rather than its long term growth.

4.        USED FOR PROJECTS HAVING HIGH DEGREE OF OBSOLESCENCE.

CONCLUSION:

PAY BACK METHOD IS A MEASURE OF LIQUIDITY OF INVESTMENT THAN

PROFITABILITY

ACCOUNTING RATE OF RETURN (A.R.R.)

THIS METHOD IS BASED ON AVERAGE ANNUAL ACCOUNTING PROFITS OF A PROJECT.  IT IS EXPRESSED AS NET ACCOUNTING PROFIT AS A% OF CAPITAL INVESTED.

A.R.R. =     Average Annual Profits

                                                                     AFTER TAX

                                                         ——————————- x 100

                                                                    AVERAGE OR

                                                              INITIAL INVESTMENT

Average Investment =                                   COST – SALVAGE

                                                                  ————————-  + SALVAGE

                                                                            2

Average Investment =                         COST – SALVAGE                                  Release of

                                    ——————————————– + SALVAGE + working

                                                                 2                                              capital

NOTE: If the sum states that return is to be calculated on the original investment them instead of Average Investment, cost itself is to be considered.

MERITS:

1)       SIMPLE AND EASY TO CALCULATE

2)       Consider income from the project throughout its life & not just the initial years unlike payback period.

3)       When a number of capital investments proposals are considered, a quick decision can be taken by use of ranking the investment.

DEMERITS:

1)       It does not consider the time value of money.

2)       This method do not differentiate the projects with different size of investment may have the same A.R.R. and the firm will not be able to take the required decision.

NET PRESENT VALUE METHOD

PRESENT VALUE :

         If you invest Rs.1000/- for 3 years in a savings A/c. that pays 10% interest per year.  If you let your interest income be reinvested, your investment will grow as follows.

        Rs.
First YearPrincipal at the beginningInterest for the year(10/100*1000)principal at the end 1000100 1100
Second YearPrincipal at the beginningInterest for the year(10/100*1100)principal at the end 1100110 1210
Third YearPrincipal at the beginningInterest for the year(10/100*1210)principal at the end1210121 Rs.1331

The process of investing Money as well as reinvesting the interest earned thereon is called compounding.  The future value or compounded value of an investment after ‘n’ years when the interest rate is ‘r’ is

F.V. = P.V. (1 + r) n

Where,          r           = Rate of Interest

                   N           = No. of Years

                   P.V.       = Present Value

                   F.V.        = Future Value

Ex.      You deposit Rs.1000 today in a bank which pays 10% interest compounded annually, how much will the deposit grow to after 8 years & 12 years?

F.V. 8 yrs. hence                    = 1000 (1.10)8

                                          = 1000 (2.144)

                                          = Rs.2144

F.V. 12 yrs. hence                  = 1000 (1.10)12

                                          = 1000 (3.138)

                                          = Rs.3138

Q.       A firm can invest Rs.10,000 in a project with a life of 3 years.  The projected cash inflows are

YearsRs.
14000
25000
34000

The cost of capital is 10% p.a. should the investment be made?

Answer:-

         The discount factor can be calculated based on Re. 1 received in with ‘r’ rate of interest in 3 years.

    1     .

(1 + r)n

Year 1 =                      Re. 1                             =        1/(1.10)1                  = 0.909

                            (1+10/100)1

Year 2 =                      Re. 1                             =        1/(1.10)2                  = 0.826

                            (1+10/100)2

Year 3 =                      Re. 1                             =        1/(1.10)3                  = 0.751

                            (1+10/100)3

YearCash Inflow (Rs.)Discount FactorPresent Value
140000.9093,636
250000.8264,130
340000.7513,004
Total P.V.10,770

NET PRESENT VALUE (NPV) METHOD

         This method recognizes that the cash flows at different point of time differ in value and are comparable only when they are first brought down to a common denominator.  i.e. Present Values. For this purpose every cash inflow and cash outflow are first discounted to bring them down to their present value. The discounting rate normally equals to its opportunity cost of capital.

         The NPV is the DIFFERENCE BETWEEN the present values of cash inflows and the present values of cash outflows.

NPV = S PV of inflow – S PV of outflow

DECISION RULE

ACCEPT : if NPV is positive i.e. NPV > 0

REJECT : if NPV is negative i.e. NPV < 0

DEFINITION:

The NPV of an investment proposal may be defined as “The sum of the Present Values of all the cash inflows – The sum of the Present Values of all the cash outflows”

Accept / Reject Criteria:

If                  NPV of inflow > NPV of outflow

Then             Accept the project.

i.e. If NPV of a project is positive Accept the project & If NPV of a project is negative reject the project.

MERITS:

1.        Considers Time Value of Money.

2.        Considers Total Cash Inflows. i.e. entire life.

3.        Best Decision Criteria for Mutually Exclusive Project.

4.        NPV technique is based on the cash flows rather than the Accounting profits and thus helps in analyzing the effect of the proposal on the wealth of the shareholders in a better way.

Thus, it satisfies one of the basic objective of Financial Management i.e. Wealth Maximization

LIMITATIONS:

1.       It is more difficult method than the Pay Back or ARR method.

2.        Consider only Initial Investment:

         The NPV is expressed in absolute terms rather than relative term.  Project A may have a NPV of Rs.5000/- while project B has a NPV of Rs.2,500/-, but project a may require an investment of Rs.50,000 whereas project B may require an investment of just Rs.10,000.  Advocate of NPV argue that what maths is the surplus value irrespective of what the investment outlay is.

3.        Life of the project is not considered:

         The NPV method do not consider the life of the project.  Hence when mutually exclusive projects with different lives are being considered, the NPV rule is biased in favour of long-term project.

4.       Calculation of the desired rate of return presents serious problems.  Generally cost of Capital is the basis of determining the desired rate.  The calculation of cost of Capital is itself complicated. Moreover desired rate of return will vary term year to year.

The following are the steps in Calculating NPV:

1)       Calculation of cash flows i.e. both Inflow & Outflow (preferably after tax) over the full life of the Asset.

2)       Discounting the Cash flows by the disc factor.

3)       Aggregating of discounted Cash inflow

4)       Sept 3 – Outflow (i.e. total present value of cash inflow – total present value of cash outflow)

         a.        If positive in step 4. Accept the project

         b.        If negative in step 4. Reject the project

PROFITABILITY INDEX (P/I)

  • THIS IS THE REFINEMENT OF NPV METHOD
  • IT IS A VARIANT OF NPV TECHNIQUE WHICH IS ALSO KNOWN AS BENEFIT COST RATIO OR PRESENT VALUE INDEX OR EXCESS PRESENT VALUE INDEX.

                 TOTAL OF P.V. OF CASH INFLOW

P/I   =     —————————————————

                 TOTAL OF P.V. OF CASH OUTFLOW

ACCEPT / REJECT CRITERIA:

ACCEPT THE PROJECT IF P/I > 1

REJECT THE PROJECT IF P/I < 1

ADVANTAGES:

1.        THE NPV DO NOT GIVE TRUE PICTURE WHEN SELECTION AMONG THE PROJECTS HAS TO BE MADE AND THE INVESTMENT SIZE IS DIFFERENT.

A PROJECT A & B HAVING COST RS.1,00,000 AND 80,000 RESPECTIVELY.  PRESENT VALUE OF INFLOW OF THE PROJECT ARE RS.1,20,000 & RS.1,00,000 BOTH HAVE NPV OF RS.20,000 AND AS PER NPV THEY ALIKE.

HERE P/I TECHNIQUE SEEMS TO GIVE A BETTER RESULT.

                   1,20,000                                                         1,00,000

P/I (A) =    ————— = 1.20                                 P/I (B) =  ————- = 1.25

                  1,00,000                                                            80,000

CONCLUSION: IN TERMS OF NPV BOTH PROJECT ARE EQUAL BUT IN TERM OF P/I ACCEPT PROJECT B.

2.        IT CONSIDERS TIME VALUE OF MONEY.

3.        IT CONSIDERS THE ENTIRE CASH INFLOW AND ALL CASH OUTFLOW IRRESPECTIVE OF THE TIMING OF THE OCCURRENCE.

4.        IT IS BASED ON CASH OUTFLOW RATHER THAN THE ACCOUNTING PROFIT AND THUS HELPS IN ANALYZING THE EFFECT OF THE PROPOSAL ON THE WEALTH OF THE SHAREHOLDER.

DISADVANTAGES:

1.        IT INVOLVES DIFFICULT CALCULATION.

2.        THIS BEING AN EXTENTION OF NPV WHERE THE PREDETERMINATION OF THE REQUIRED RATE OF RETURN ‘K’ ITSELF IS A DIFFICULT JOB. IF THE VALUE OF ‘K’ IS NOT CORRECTLY TAKEN THEN WHOLE EXERCISE OF NPV MAY GO WRONG.

PROJECT APROJECT B
Initial cash outflow1,50,0001,10,000
P.V. of cash inflow2,10,0001,65,000
NPV60,00055,000
AS PER NPV ACCEPT PROJECT A
P/I2,10,000 = 1.4:11,50,0001,65,000 = 1.5:11,10,000
AS PER P/I ACCEPT PROJECT B

IN SUCH A CASE FOLLOW NPV UNLESS THERE IS CAPITAL RATIONING.  THIS IS BECAUSE IF THE FIRM HAS FUNDS OF RS.1,50,000 TO INVEST THEN AS PER NPV TECHNIQUE PROJECT A IS TO BE ACCEPTED BECAUSE IT WILL RESULT IN INCREASE IN SHAREHOLDERS WEALTH TO THE EXTENT OF RS.60,000 AGAINST PROJECT B WHICH WILL INCREASE IN SHAREHOLDERS WEALTH ONLY BY RS.55,000.

THE BETTER PROJECT IS ONE, WHICH ADDS MORE TO THE WEALTH OF THE SHARE HOLDER.

TERMINAL VALUE (TV)

  • The other variant of the NPV technique is known as terminal value technique.
  • Here the future cash inflows are discounted to make them comparable.
  • In terminal value technique the future cash flows are first compounded at the expected rate of interest for the period from their occurrence till the end of the economic life of the project.
  • The compound values are then discounted at an appropriate discount rate to find out the present value.
  • Then the present value is compared with initial outflow to find out the suitability of the project.

Steps:

1.        Find the compounded value

YearCash inflowRemaining yearP.V. factorCompounded value
1 3
2 2
3 1
4 0
S

2.        The above compound value to be discounted at a discount factor and the P.V. is to be found out.

3.        The above (2) to be compared with initial investment to get NPV.

INTERNAL RATE OF RETURN (IRR)

The IRR is that rate at which the sum of discounted cash inflows equals to the sum of discounted cash outflows.

In other words, it is the rate at which it discounts the cash flow to zero.

         S Cash inflow

Or                                     =  1

         S Cash outflow

Thus I.R.R. is also known as marginal rate of return or time adjusted rate or return.

Thus under this method the discount rate is not known but the cash inflow and cash outflow are known.

For Eg

IF a sum of Rs.800 is invested in a project and become Rs.1000 at the end of a year, the rate of return come to 25% which is calculated as under:

I =    C

    (1 + r)

I  = Initial investment

C = Cash inflow

R = I.R.R.

i.e. 800 =        1000

(1 = r)

800 (1 + r) = 1000

800 + 800r = 1000

800r = 200

r = 200 = 1 = 0.25 = 25%

     800    4

ACCEPT / REJECT CRITERIA

In order to make a decision on the basis of IRR technique the firm has to determine in the first instance, its own required rate of return.

This rate ‘K’ is also known as cut off rate or the hurdle rate.  A particular proposal may be accepted.

If its IRR ‘r’ is MORE THAN the MINIMUM REQUIRED RATE ‘K’ ACCEPT IT.

IF the IRR ‘r’ is just Equal To the Minimum Required Rate ‘K’ than the firm may be INDIFFERENT.

If the IRR ‘r’ is LESS THAN the MINIMUM REQUIRED RATE ‘K’ the project is altogether rejected.

In case of mutually exclusive project the project with highest IRR is given top priority.

MERITS:

1.        The method considers the entire economic life of the project.

2.        It gives due weightage to time factor. I.e. It consider time value of money.

3.        Like NPV technique, the IRR technique is also based on the consideration of all the cashflows occurring at any time. The salvage value, the working capital used and released etc. are also considered.

4.        IRR is based on cashflows rather than accounting profit.

DEMERITS:

1.        It involves complicated trial and error procedure.

2.        It makes an implied assumption that the future cash inflows of a proposal are reinvested at a rate equal to IRR for ex. In case of mutual exclusive proposal say A & B, having IRR of 18% and 16% respectively, the IRR technique make an implied assumption that the future cash inflows of project A will be reinvested at 18% while the cash inflow of project B will reinvested at 16%.

3.        It is imaginary to think that the same firm will have different reinvestment opportunities depending upon the proposal accepted.



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