Management of Funds and Assets

LESSON - 1
FINANCIAL PLANNING OF FUNDS

OBJECTIVES
The objectives of the lesson are to impart adequate knowledge pertaining to basics of
management of funds, namely meaning have funds, importance of funds and allocation
of funds.
STRUCTURE
1.1 Introduction
1.2 Financial planning
1.3 Meaning of funds
1.4 Importance of funds
1.5 Planning for funds
1.6 Raising of funds
1.7 Allocation of funds
1.8 Benefits of effective allocation of funds
1.9 Dangers of misallocation of funds
1.10 Summary
1. 11 Review Questions
1.12 Assignment Questions
1.13 Key concepts
1.1 INTRODUCTION
Finance refers to the use and the control of money. In fact the term fund has a
marvelous ability to evoke different concepts in the minds of different persons. For the

convenience of analysis, different viewpoints on finance have been categorized into
three major groups.
a) The first approach incorporates the views of all those who contend that finance
concerns with acquiring funds on reasonable terms and conditions to settle bills. This
approach covers study of financial institutions and instruments from which funds can be
secured, the types and duration of obligations to be issued, the timing of the borrowings,
the amounts required and cost.
b) The second category holds that finance is concerned with cash as almost all business
transactions are expressed ultimately in terms of cash. Every activity within the firm is
the concern of the financial manager.
c) The third approach to finance looks on finance as being concerned with acquisitions
of funds and wise utilization of these funds. As money involves cost, the central task of
the fund manager while allocating resources, is to match the advantages of potential
uses against the cost of alternative sources to maximize the value of the firm. This is the
managerial approach, known as problem-centered approach, as it emphasises that funds
manager, to his endeavor to maximize the value of the firm has to deal with key
problems of the firm, namely, what capital expenditures should the firm make? What
volume of funds should the firm invest? How should the desired funds be financed?
How can the firm maximize its profitability from existing purpose commitments?
According to Bonneville and Dewey financing consists of the raising, providing and
managing of all the money, capital or funds any kind to be used in connection with the
business.
Financial planning includes the planning and the management of funds. It consists of
the determination of total amount of capital required and selecting the best possible
source of funds any kind to be used in connection with the business.
1.2 FINANCIAL PLANNING
Financial planning includes the planning and the management of funds. It consists of
the determination of total amount of capital required and selecting the best possible
source of funds after considering set of alternate sources, the management of funds
through the techniques of financial analysis, budgets, standard costs, forecasting
establishment of financial objectives and arranging the financial procedures.
Meaning of funds
The term ‘funds’ has been defined to the following ways:
i) Cash
ii) Cash and marketable securities (short term investments)
iii) Cash and marketable securities and Accounts Receivables minus current liabilities.

iv) Current assets minus current liabilities while some view fund as mere cash, others
view fund as all asset items of balance sheet representing use of Funds .The working
capital concept of funds lied in between these two extremes an is operational in a
meaningful way.
1.3 IMPORTANCE OF FUNDS
According to J. Batty, an adequate balance and flow of cash is essential; at all times a
business must be able to meet its commitments. More than this a business cannot afford
to stand still. In any competitive field it will be essential to affect Improvements to
introduce new products and to expand. Experience has shown that a business does not
remain static; there is a tendency to go forward or backward, but not to stagnate. If
expansion is to take place, then there must be adequate financial resources. The need for
management of funds arises to ensure the following:
i) Availability of sufficient cash for meeting expenditure, emergencies and fluctuations
in the level of working capital
ii) To maintain liquidity throughout the year
iii) To indicate the surplus resources available for expansion or external investments.
iv) To judge the timing for requirement of funds
v) To provide ahead for any more funds needed
Presently, the fund manager is expected to see that a firm has sufficient funds to carry
out its plans as well as to ensure wise application financial activities of planning, raising,
allocating, and controlling of funds.
Recurring Finance function encompasses all such financial activities as are carried out
regularly for the efficient conduct of a firm. Planning for and raising of funds, allocation
of funds and income and controlling the uses of funds are contents of recurring finance
functions.
1.5 PLANNING FOR FUNDS
The initial task of the manager of funds in a new or going concern is to formulate a
financial plan for the company. Financial plan is the act of deciding to advance the
quantum of fund requirements and its duration and the make-up of such requirements
to achieve the primary goal of the enterprise. While planning for funds requirements the
fund manager has to aim synchronizing the cash inflows with cash outflow so that the
firm does not have any resources lying unutilized.
Since in actual practice such a synchronization is not possible, the financial manger
must maintain some amount of working capital in reserve so as to ensure solvency of the
firm. The magnitude of this reserve is the function of the amount of risk that the firm

can safely assume in given economic and business conditions. Keeping in view the long term goals of the company the fund manager has to determine the total fund
requirements, duration of such requirement and the forms in which the required funds
will be obtained. Decision with respect to fund requirements is reflected in
capitalization. While determining fund requirements for the enterprise the financial
manager must keep in mind the various considerations, viz, purpose of the business,
state of economic and business conditions, management attitude towards risks,
magnitude of future investment programmes, state regulation, etc.
Broadly speaking there are two methods of estimating funds requirements:
Balance sheet method and cash budget method. In balance sheet method, total
capital requirements are arrived at after totaling the estimates of current, fixed and
intangible assets. In contrast with this, a forecast of cash inflows and cash outflows is
made month-wise and cash deficiencies are calculated to find out the financial needs.
With the help of cash budget amount, funds requirements at different time intervals can
be calculated. Having estimated total funds requirements the financial executive decides
as to how here requirements will be met, viz, forms of financing funds requirements,
such decisions are taken under 'capital structure'. While there may be various patterns
of capital structure, the manager of funds must select the one that best suits the
enterprise. Keeping in mind the cardinal principles of cast, risk, control, flexibility and
timing, the fund manager should decide upon the most suitable pattern of capital
structure for the enterprise.
1.6 RAISING OF FUNDS
The second responsibility of manager of funds is that of procurement of necessary
capital to meet the business requirements. If the company decides to raise the needed
funds by means of security issues, the manager of funds has to arrange the issue of the
prospectus for the flotation of issues. In order to ensure quick sales of securities
generally the stock brokers, who deal in securities in the stock and who are in constant
touch with the clients are approached.
Even after the issues are floated in the stock market, there is no certainty that the
security issues will bring in the desired amount of capital because public response to
security issues is difficult to estimate. If a business entrepreneur fails to assemble the
desired amount of funds through security issues, the enterprise is plunged into grave
financial trouble. In order to overcome this problem the fund manager has to make such
an arrangement as may protect the issue against its failure. For that matter he has to
approach underwriting firms whose main job is to provide the guarantee of buying the
shares placed before the public in the event of non-subscription of the shares. For these
services, they charge underwriting commission.
Thus if an underwriter is satisfied with the issuing company, an underwriting agreement
is entered into between the company and the issuing company. The obligation of the
underwriter as per the agreement arises only when the event of non-subscription of
issues by the public takes place. Where the size of the security issue is too large to be

handled by a single underwriter, the issuing company may enter into agreement with a
number of underwriting firms.
Where the company decides to borrow money from financial institutions including
commercial banks and special financial corporation, the fund manager had to negotiate
with the authorities. He has to prepare the project for which the loan is sought and
discuss it with the executives of the financial institutions along with the prospects of
repayment of the loan. If the institution is satisfied with the desirability of the proposal
an agreement is entered buy the financial executive on behalf of the company.
1.7 ALLOCATION OF FUNDS
The third major responsibility of the manager of funds is to allocate funds among
different assets. In allocating the funds consideration must be given to the factors such
as competing uses, immediate requirements, management of assets profit prospects and
overall management plans. It is true that the management of fixed assets is not the
direct responsibility of the fund manager. However, he has to acquaint the production
executive who is primarily seized with the task of acquiring fixed assets with
fundamentals of capital expenditure projects and also about the availability of capital in
the firm, but the efficient administration of the manager of funds.
The financial executive has also to see that only that much of fixed assets are required
that could meet the current as well as the increased demand of the company's products.
But at the same time he should take steps to minimize the level of buffer stock of fixed
assets that the company is required to carry for the whole year to satisfy the expanded
demands. While managing cash, the fund manager should prudently strike a golden
mean between these two conflicting goals of profitability and liquidity of the
corporation. He has to set minimum level of cash so that the company's liquidity is not
jeopardized and at the same time its profitability is maximised. Alongside this, the fund
manager has to ensure proper utilization of cash funds by taking such steps as help in
speeding up the cash inflows, on the one hand and slowing such outflows, on the other.
1.8 BENEFITS OF EFFECTIVE ALLOCATION OF FUNDS
1. The economy in which the modern firm operated is marked by cut throat competition
and the consequent narrow margin of profit. Proper allocation of funds to the required
heads would enhance better utilisation of funds leading to profitability.
2. Proper allocation of funds would result in elimination of waste of operations by
providing closer coordination of different operative functions.
3. Planned allocation of funds would enable implementation of expansion /
diversification of enterprise in time. As expansion/diversification calls for more
financial resourced, i.e. funds, allocation of funds well in advance, would facilitate the
management to start implementing the projects.

4. When funds are allocated to fixed assets and current assets, it would be possible for
the enterprise to carry on the work smoothly without any paucity of funds.
5. If funds are not allocated, certain areas, projects, proposals, would not deserve
attention, which are otherwise important for the smooth functioning of the enterprise.
1.9 DANGER OF MIS-ALLOCATION OF FUNDS
1. The survival and growth of an enterprise is possible only when the enterprise
apportion its funds in an optimum manner.
2. Misallocation of funds would result many times result in closing down of business.
3. Non-allocation of funds to vital project proposals and ms-allocation of funds to wrong
project proposals would result In mismanagement of funds and the consequences would
follow.
4. Misallocation of funds would mean pursuing wrong policies of financial plan and
would result in improper utilization of funds. This would damage the credit worthiness
of the enterprise. Allocation of income of the company as between different uses is the
executive responsibility of the fund manager. Income may be retained for financing of
expansion of business or it may be distributed to the owners as dividend as a return of
the capital. Decision in these regards is taken on the basis of financial position of the
company, present and future fund requirements of the firm, and the like.
The fund manager is required to control the uses of funds to ensure that cash is flowing
as per plan. The fund manager has to look into deviation between actual and estimated.
He is required to evaluate performance of receivables management to judge how the
credit department is carrying out credit and collection policies laid down by the firm
effectively. Important tools that are employed to control the uses of funds are Budgetary
Reports, Projected Financial Statements, Funds and Statement and Break-even
Analysis.
1.10 SUMMARY
The term 'fund' has a marvelous ability to evoke different concepts in the minds of
different persons. There are mainly three views on finance, while the first approach
incorporates the views of all those who contend that finance concerns with acquiring
funds the second approach views that finance is concerned with mere cash. The third
approach looks at finance as being concerned with acquisition of funds and wise
utilization of these funds. Financial planning includes the planning and the
management of funds.
The term 'funds' has been defined in the following ways:
i) Cash

ii) Cash and marketable securities
iii) Cash and marketable securities and accounts receivables must current liabilities.
iv) Current assets mines current liabilities while some view fund as a more cash, others
view fund as all asset items of balance sheet representing use of funds.
The need for management of funds arises to ensure the following:
i) Availability of sufficient cash for meeting expenditure, emergencies and fluctuation in
the level of working capital.
ii) To maintain liquidity throughout the year.
iii) To indicate the surplus resources available for expansion or external investments.
iv) To judge the timing for requirement of funds.
v) To provide ahead for a more funds needed.
The fund manager is expected to ensure that a firm has sufficient funds to carry out its
plan as well as to ensure wise application of funds in the productive process. The
manager of funds is concerned with all financial activities of planning, raising, allocating
and controlling of funds. Finally the fund manager is required to control the used of
funds to ensure that cash is flowing as per plan and if there is any deviation between the
actuals and estimates, the same is dealt with a manner compatible with the continued
financial health of the enterprise.
KEY CONCEPTS
i) Bonds - long time debt instrument
ii) Equity capital - long term finds provided by the owners of an enterprise and consists
of ordinary share capital and retained earnings.
iii) Financial Risk of not being able to cover fixed financial costs the use of debt exposes
the ordinary shareholders to financial risk.
iv) Retained Earnings - the portion of the after-tax profits that are no paid out to the
shareholders as dividends.
v) Cash Flows - the actual receipts and payments by a firm.
vi) Financial Planning - it is the art of deciding in advance the financial activities that
are necessary if the firm is to achieve its primary and long-term goal of wealth
maximization.

1.11 REVIEW QUESTIONS
1. Define the term 'funds. Explain the concept of management of funds.
2. Critically analyse the function of manager of funds in a large-scale industrial
establishment.
3. Explain the objectives and significance of management of funds.
4. What are the broad areas of management of funds? Explain.
1.12 ASSIGNMENT QUESTION
1. What are the precautions to be taken by the fund manager, while making fund related
decisions.
1.13 KEYWORDS
Bonds, Equity capital, Retained Earnings, Securities, Underwriter.

- End of Chapter LESSON - 2
MANAGEMENT OF FUNDS

OBJECTIVE
The objective of the lesson is to know the varied aspects of management of funds and to
study its relationship with other financial areas of the enterprises.
STRUCTURE
2.1 Introduction
2.2 Management of Funds
2.3 Summary
2.4 Review Questions

2.5 Assignment Question
2.6 Key words
2.1 INTRODUCTION
The basic objectives of management of funds are to ensure that enough capital is
procured at the minimum cost to maintain adequate cash on hand to meet the required
current and capital expenditure and to put it into most productive channels so as to
maximize profits.
2.2 MANAGEMENT OF FUNDS
In order to achieve these basic objectives, the fund manager is required to concentrate
on the following aspects of management of funds.
i) Estimating the capital requirement of the various functions involved
ii) Determining its capital structure
iii] Finalising the choice of source of finance
iv) Taking decisions regarding investing of funds m the most productive channels
v) A judicious distribution of surplus
vi) A wise and efficient management of funds
vii) Implementation of effective control of funds.
The various aspects of management of funds are discussed below.
2.2.1 Estimating the Capital Requirements of the Concern
The fund manager is expected to exercise maximum care in estimating the financial
requirement of this enterprise. In order to ensure long-term financial stability, growth
and progress, he has to make use of long-range planning techniques. This is inevitable,
because every business enterprise calls for funds, not only for long term purposes for
investment in fixed assets, but also for short-term so as to have sufficient working
capital He can do this job properly if he can prepare budgets of various activities for
estimating the fund requirement of his enterprise. If his enterprise is suffering on
account of paucity of funds, it cannot successfully meet its commitments in time. On the
other hand if it has acquired excess funds, the task of managing such excess capital may
not only prove very costly but also tempt the management to spend unwisely.
2.2.2 Determining the Capital Structure of the Enterprise

The capital structure finalized by the management decides the final choice between the
various sourced of finance. The fund manager can decide the kind and proportion of
various sources of capital only after the requirement of capital funds has been decided
The decisions regarding an ideal mix of equity and debt as well as short-term and longterm debt ratio will have to be taken in the light of cost of meeting such funds from
various sources, the period for which the funds are required and so on. Care should be
exercised to arrange sufficient long-term capital in order to finance the fixed assets.
2.2.3 Finalising the Choice as to the Sourced of Finance
The capital structure finalized by the management decides the final choice between the
various sources of finance. The important sources are shareholders, debenture-holders,
bank and other financial institutions, public deposits and so on. The final choice actually
depends upon a careful evaluation of the costs and other conditions involved in these
sources. For instance, although public deposits carry higher rate of interest than on
debentures, certain enterprises prefer them to debentures, as they do not involve the
creation of any charge on any of the company's assets. Likewise, companied that are not
willing to dilute ownership, may prefer other sources instead of investors in its share
capital.
2.2.4 Deciding the Pattern of Investment of Funds
The manager of fund must prudently invest the funds procured, in various assets in such
a judicious mariner as to optimize the return on investments without jeopardizing the
long-term survival of the enterprise. Two important techniques – i) capital budgeting;
and ii) opportunity cost analysis - can guide him in finalising the investment of longterm funds by helping him in making a careful assessment of various alternatives. A
portion of the long-term funds of the enterprise should be earmarked for investment in
the company's working capital also. He can take proper decisions regarding the
investment of funds only when he succeeds in striking an ideal balance between the
conflicting principles of safety, profitability and liquidity. He should not attach all the
importance only to the canon of profitability. This is particularly because of the fact that
the company's solvency will be in jeopardy, in case major portion of its funds are hooked
in highly profitable but totally unsafe projects.
2.2.5 Distribution of Surplus Judiciously
The manager of funds should decide the extent of the surplus that is to be retained for
pushing back and the extent of the surplus to be distributed as dividend to shareholders.
Since decisions pertaining to disposal of surplus constitute a very important area of
management of funds, he must carefully evaluate such influencing factors as (a] the
trend of earnings of the company; (b] the trend of the market price of its shares; (c] the
extent of funds required for meeting the self financing needs of the company; (d] the
future prospectus; e] the cash flow position, etc.
2.2.6 Efficient Management of Cash

Cash is absolutely necessary for maintaining enough liquidity. The company requires
cash to (a] pay off creditors; (b] buy stock of materials; (c] make payments to labourers;
and (d] meet routine expenses. It is the responsibility of the Fund manager to make the
necessary arrangements to ensure that all the departments of the Enterprise get the
required amount of cash in time for promoting a smooth flow of all operations. Shortage
on any particular occasion is sure to damage the creditworthiness of the enterprise. At
the same time, it is not advisable to keep idle cash flow. Idle cash should be invested in
near cash assets that are capable of being converted into cash quickly without any loss
during emergencies. The exact requirements of cash during various periods can be
assessed by the manager of funds by preparing a cash-flow statement in advance.
If we try to classify the need for funds of an enterprise on the basis of time, we may
conveniently divide it among long-term, medium-term; it is very difficult to define.
According to R.H.Vessel, the line of demarcation between long-term and medium term
is very vague, thin and invisible. Generally, the need of funds not more than for 1 year
are included in short-term needs, for more than one year but not exceeding five years
are included in medium-term and over five years they are included in long-term needs.
Some authorities on finance include the need of fund between 3 to 10 years in mediumterm needs and over ten years as long-term while below three years as short-term
requirement. But as far as the relevancy is concerned, the first clarification seems to be
more sound. Actually, the need for funds is not informally distributed over time. The
fluctuations in fund requirements are of varying character hence different methods are
resorted to meet them.
Long-term needs of funds: Long-term funds are needed by the firm either to replace
existing capital assets or to add its existing capacity or both. The nature of long-term
needs of fund it static and permanent. As a matter of fact, this is the capital bearing the
ultimate risk of the business. That's why, a major portion of long-term capital is
collected through the sale of equity shared, preference shares and obtaining the lingterm loans, Equity share constitute the first source of funds to a new business and the
base of support for existing firm's borrowing. After some time, the radiated earning may
also be good source of firm's long-term requirements of funds. As we saw that long-term
needs are not satisfied only with the shares, the long-term loans are also utilized. So the
real basis for the division of fund requirements is the time, conditions of its use and the
degree of risk attached to it.
If management gets ample time to plan and provide for the repayment of funds, if
management can appropriate this funds for a very long time, it must be certainly
included in long-term financing no matter it is ownership claim or a creditorship claim.
Medium-term Financing: It is defined as debt originally scheduled for repayment in
more than one year but less than five years. Anything shorter is a current liability and
falls in the class of short-term sourced of funds, while obligations due in more than five
year are thought of as long-term debt. Though this distinction is arbitrary, of course, but
generally popular. The major sources of medium-term financing include [1] term-loans,
[2] conditional sales contracts, [3] redeemable preference shares of debentures, and [4]
lease financing. A term loan is a business loan with a maturity of more than one year.

Ordinarily, systematic repayments often called amortization procedure over the life of
the loan retire these term loans. The primary lenders on term credit are commercial
banks, insurance companies, pension and provident funds of employees. In India, there
is one more popular source of medium-term funds, i.e., public deposits. Now-a-days, it
has become very attractive and popular, from borrower and leader is point of view.
Short-term Financing: It is popularly known as short-term credit also. It is defined
as debt originally scheduled for repayment within one year. In other words, short-term
credit is equal to liabilities minus the current maturities of long-term debt. There are
three main sources of short-term funds: [1] trade credit between firms, [2] short-term
loans from commercial banks, and [3] commercial papers. This pattern of funds
requirements is determined on the basis of considerations relating to the long-term
financial planning. The problem of pattern of funds can be conveniently divided into
four main groups-the determination of its scope, the factors determining its urgency as
valuation of possible resource and finally developing an optimum, balanced as well as
flexible capital structure of the firm. Each aspect of this problem has its own importance
and needs careful consideration. In addition, to these factors, the nature of industry,
technological innovations, expected volume of sales general financial, position of the
firm, business circles, general price level and state policies are also some important
confederations to be taken into account. This analysis of fund requirements is
significant from the various points of views - cost of funds, timing and prices of issued,
the balancing of income, risk and control of the enterprise, etc.
2.3 SUMMARY
Management of short-term assets and liabilities are important taste of the finance
manager. The basic objectives of management of funds are to ensure that enough capital
is procured at the minimum cost to maintain adequate cash on hand to meet the
required current and capital expenditure. Efficient management of cash is classified by
long term management of funds, medium term and short-term financing.
2.4 REVIEW QUESTIONS
1. Explain the various aspects of management of funds.
2. Write a note on Long-term, medium term and short-term financing
2.5 ASSIGNMENT QUESTION
Discuss elaborately about the estimation of capital requirement of a large scale industry.
2.6 KEYWORDS
Paucity of funds, jeopardy, debenture, term loans lease financing, redeemable, equity
shares, demarcation

- End of Chapter LESSON - 3
ORGANISATION OF FUNDS MANAGEMENT AND ITS RELATIONSHIP
WITH OTHER FUNCTIONAL AREAS OF ENTERPRISE

OBJECTIVE
This lesson discusses about the organization's of funds management and its relationship
with other functional areas of an enterprise.
STRUCTURE
3.1 Introduction
3.2 Functions of Fund Manager
3.3 Key functions
3.4 Summary
3.5 Review Questions
3.6 Assignment Questions
3.7 Keywords
3.1 INTRODUCTION
In every organization, funds are required for various ventures are project. The quantum
of allocation (how much), the timing of allocation (when) and manner of allocation
(how) of funds to a particular project deserves special mention in the case of every firm.
The management has to look into the pros and cons of each project, the amount of funds
necessary for them and the sources from which to raise or augment the required
resources. In the present competitive changing corporate scenario, the fund manager is
required to act as an intermediary, standing between the firm's operations and capital
markets, where the firm's securities are traded. The Fund manager is expected to know
well the mechanism of capital markets. The market timings for resource mobilization,
the uses of funds in the firm's operations, the generation of funds by the firm's
operations and the investment of funds in the most profitable channel are important
aspects of management of funds.

3.2 FUNCTION OF FUND MANAGER
The Fund manager cannot avoid coping with time and uncertainty. Concern often have
the opportunity to invest in assets which cannot pay their way in the short run and
which exposes the concern and its shareholders to considerable risk. The investment, if
undertaken, may have to be financed by debt, which cannot be fully repaid for many
years. The concern cannot walk away from such choices - someone has to decide
whether the opportunity is worth more than it costs and where the additional debt
burden can be safely borne. In fact the Fund Managers are subject to the scrutiny of
specialists. Their actions are monitored by the Board of Directors; they are also reviewed
by banks and financial institutions, which keep an eye on the progress of fir receiving
their loans. The Fund manager is required to take the role of a financial planner.
Financial planning is necessary because investment and financing decisions interact and
should not be made independently. In fact, financial planning helps to establish
concrete goals 0 motivate the fund managers and provide standards for measuring
performance. Financial planning is a process of:
1. Analyzing the financing and investment choices open to the firm
2. Projecting the future consequences of present decisions in order to avoid surprises
and understand the link between present and future decisions
3. Deciding which alternatives to undertake
4. Measuring subsequent performance against the goals set
A completed financial plan for a large company is an important document. The plan
should present proforma balance sheets, income statements and statements
enumerating sources and used of cash. The plan must describe planned capital
expenditure and by division or line of business. Most plans contain a summary of
planned financing together with narrative backup as necessary. This part of the plan
should logically include discussions on areas where funds are to be used and specify
varied avenues for generation of funds. Of course, there is no theory or model that leads
straight to the optimal financial strategy. Many different strategies may be projected
under a range of assumptions about the future before one strategy is finally chosen.
3.3 KEY FUNCTIONS
Along with planning and procurement of funds, the fund manager is expected to
coordinate the finance function with other functions of the enterprise. A close and
proper co-ordination between the functional heads is as important as the financial
department alone. The key functions that are usually performed by fund managers are
summarized below.
i) Estimation of capital requirements
ii) Ensuring a fair rate of return to investors

iii) Determining the suitable source of funds
iv) Laying down the optimum and suitable capital structure for the enterprise.
v) Co-coordinating the operations of various departments
vi) Preparation, analysis and interpretation of financial statements
vii) Negotiating for outside financing
Because of the vital importance of the fund decision, it is essential to set up a sound and
efficient organization for the finance functions. The ultimate responsibility of carrying
out the fund decision lies with top management. With the growth in the size of the
organization degree of specialization of finance function increases. In medium sized
undertakings funding activities are handled by senior management executive. He is
generally given the change of credit and collection departments and accounting
department, investment departments and auditing department. He is also responsible
for preparing annual financial reports. He reports directly to the President and Board of
Directors. However, in large concerns the Fund manager is a top management executive
who participates in various decision making function like raising of funds, acquisition of
firms, refinancing of matured debt, floating public issues, entering into sale and lease
back arrangements. In most of the cases, the fund manager holds the rank of Vice
President reporting directly to the president and the board of directors. The reason for
entrusting the fund related matters to the hands of top management is attributed to the
following factors:
1. Fund decisions are crucial for the survival of the firm. The growth and development of
the enterprise is directly influenced by the decisions taken by the fund manager.
2. The decisions of a fund manager determine the solvency of the enterprise. As solvency
is determined by the flow of funds, which is the result of the various financial activities,
top management being in a position to coordinate these activities retains funds related
functions in its control.
3. The nature of the organization of management of funds will differ from firm to firm. It
depends on factors like size of the firm, nature of business, funding operation, and
funding philosophy of the firm. The designation of the manager of funds also differs
from firm to firm. While in some cases he may be known as manager of funds, in other
cases be is known as Vice President of finance or Director (Funds operations). The main
function of the fund manager is to manage the firm's funds. His principal duties include
planning of funds, administering the flow of funds, managing credit floating corporate
securities for generation of funds, maintaining relations with financial institution and
protecting funds and securities. The management of funds - a very valuable resource - is
a business activity calling for extra-ordinary skill and aptitude on the part of fund
manager.
3.4 SUMMARY

The basic purpose of management of funds is to ensure that sufficient capital is
procured at the minimum cost of maintaining adequate cash on hand to meet the
required current and capital expenditure and to put it in to most productive channels so
as to maximize profits. The carried aspects of management of funds include
(i) estimating the capital requirement of the various functions involved,
(ii) determining its capital structure, (iii) finalising the choice of source of finance,
(iv) taking decisions regarding investment of funds in the productive channels,
(v) a wise and efficient management of funds, (vi) implementation of effective financial
control.
In every origination, funds are required for various ventures and projects. The quantum
of allocating the timing of allocation and manner of allocating of funds to a particular
project deserves special mention in the case of every firm. The management has to loan
into the pros and cons of each project, the amount of funds necessary for them and the
sources from which to raise/augment the required resources. In the present competitive
changing corporate scenario, the fund manager is required to act as intermediary,
standing between the firm's operations and capital markets. The market timings for
resource mobilization, the use of funds in the firm's operations, the generation of funds
by the firm's operations and the investment of finds in the most profitable channel are
important aspects of management of funds.
The Funds manager is required to take the role of a financial planner. Financial
planning is necessary because investment and financing decisions interact and should
not; be made independently. In fact, financial planning helps to establish concrete goals
to motivate the fund managers and provide standards for measuring performance. The
key functions that are usually performed by fund managers are summarized below:
i) Estimation of capital requirements
ii) Ensuring a fair rate of return to investors
iii) Determining the suitable source of funds
iv) Laying down the optimum and suitable corporal structure for the enterprise.
v) Coordinating the operations of various departments
vi) Preparation, analysis and interpretation of financial statements
vii) Negotiating for outside financing.
The reason for entrusting the fund related matters in the hands of top management is
attributed to the following factors:

Fund decisions of a fund manager determine the solvency of the enterprise. As solvency
is determined by the flow of funds, which is the result of the various financial activities,
top management being in a position to coordinate these activities retains funds related
functions in its control.
KEY CONCEPTS
i) Capital Expenditure - outlay rewired for acquiring an asset from which benefits would
be available beyond one year.
ii) Collection Period - The average period taken to collect receivables. It is equal to the
average credit sales divided by the number of days in a year.
iii) Conversion Costs - These are incurred each time when marketable securities are
converted into cash.
iv) Present value - the value of sums received in future being discounted by an
appropriate capitalization rate.
v) Market Value - It is determined on the basis of the stock market quotations of the
company's securities.
vi) Opportunity Cost - The return that would have been obtained from an alternative
investment.
3.5 REVIEW QUESTIONS
1. Discuss the varied aspects of management of funds.
2. Explain the organizations of funds management of funds management and its
relationship with other functional areas of an enterprise.
3. What are the key functions of a manager of funds?
4. Do you think that there exists a pressing need to achieve a prefer coordination
between the department of management of funds are the other departments of a
business concern? Explain.
3.6 ASSIGNMENT QUESTIONS
Write shorts on:
·
·
·
·

Financial planning
Finalising the choice as to the sources of finance
Short term and long-term requirements of funds
Significance of management of funds

3.7 KEYWORDS
Optional, interpretation, vital, public issues solvency, negotiating, opportunity cost,
market value.

- End of Chapter LESSON - 4
FINANCIAL SYSTEM AS A BAROMETER OF BUSINESS CONDITIONS

OBJECTIVES
The objective of the lesson is to understand the nature of financial system and its role as
a barometer of business of business conditions.
STRUCTURE
4.1 Introduction
4.2 Meaning of financial system
4.3 Structure of financial system
4.4 Financial system and economic developments
4.5 Changing trends in financial sector
4.6 Fund utilization
4.7 Summary
4.8 Review Questions
4.9 Assignment Question
4.10 Keywords
4.1 INTRODUCTION

Savings mobilization and promotion and promotion of investment are functions of the
stock and capital markets, which are a part of the organized financial system in India. It
will be art to start with the nature and function of the financial system. The objective of
all economic activity is to promote the well being and standard of living of the people,
which depends on the income and distribution of income in terms of real goods and
services in the economy. The production of output, which is vital to the growth process
in the economy, is a function of the many inputs used in the productive process. These
inputs are material inputs (in the form of physical materials, viz. raw materials, plant,
machinery, etc.), human inputs (in the form of labour and enterprise) and financial
inputs (in the form of capital, cash and credit). The easy availability of financial inputs
promotes the growth process through proper co-ordination between human and
material inputs. The financial inputs emanate from the financial system while real goods
and services are part of the real system. The interaction between the real system (goods
and services) and the financial systems (money and capital) is necessary for the
productive process. Trading in money and monetary assets constitute the activity in the
financial markets and are referred to as the financial system.
4.2 MEANING OF FINANCIAL SYSTEM
The financial system of any country consists of specialize and non-specialized financial
institutions, of organized and unorganized financial markets, of financial instruments
and services which facilitate transfer of funds. Procedures and practices adopted in the
markets and financial inter-relationships are also part of the system. These parts are not
always mutually exclusive. For example, financial institutions operate in financial
markets and are, therefore a part of such markets.
Financial institutions are business organizations that act as mobilizes and depositories
of savings and as purveyors of credit or finance. They also provide various financial
services to the community. They differ from non-financial (industrial and commercial)
business organisations in respect of their wares, i.e., while the former deal in financial
assets such as deposits, loans, securities and so on, the latter deal in real assets such a
machinery equipments stocks of good, real estates and so on. The activities of different
financial institutions may be either specialized or they may overlap; quite often they
overlap.
Yet, we need to clarify financial institutions and this is done on such bases as their
primary activity or the degree of their specialisation with relation to savers or the
borrowers with whom they customarily deed to the manner of their creation. In other
words, the functional, geographic sectorial scope of activity or the type of ownership are
some of the criteria which are often used to classify a large number and variety of
financial institutions which exist in the economy.
4.3 STRUCTURE OF FINANCIAL SYSTEM
Financial institutions are also classified as intermediaries and non-intermediaries. As
the term indicates, intermediaries intermediate between savers and investors, they lend
money as well as mobilize savings; their liabilities are towards the ultimate savers, while

their assets are from the investors or borrowers. Non-intermediaries institutions do the
loan business but their resources are not directly obtained from the savers. All banking
institutions are intermediaries. Many nonbanking institutions also act as intermediaries
and when they do so they are known as non-banking financial intermediaries (NBFI,
UTI, LIC, and GTC) are some of the NBFI's in India. Non-intermediary institutions like
IDBI, IFCI and NABARD have come into existence because of governmental efforts to
provide assistance for specific purposes, sectors and regions; their creation as a matter
of policy has been motivated by the philosophy that the credit needs of certain
borrowers might not be otherwise adequately met by the usual private institutions.
4.4 FINANCIAL SYSTEM AND ECONOMIC DEVELOPMENT
The role of money and finance in economic activities is a much-discussed topic among
economists. The issue has been looked at differently in various branches of economics.
Is it possible to influence the level of economic activities than the level of national
income, employment, and so on, through variations in the supply and volume of money
and credit? How far can economic fluctuations or business cycles be controlled by
manipulating the period of production on the one hand and the monetary factors on the
other? How far is development a matter of financing capital formation? The role of
financial system is to accelerate the rate of economic development and thereby improve
the general standard of living and increase the social welfare. This is achieved through
the mobilization and increase of savings and investment, i.e., by stimulating the
accumulation of capital and by allocating capital efficiently for socially desirable and
productive purposes. This, in turn, is achieved by financial markets by performing a
number important and useful proximate functions or by; providing a number of services
such as (i) enabling economic units to exercise their time preference, (ii) separation,
distribution, diversification and reduction for risk, (iii) efficient operation of payment
mechanism, (iv) transformation of financial claims so as to suit preferences of the savers
and borrowers, (v) enhancing liquidity of financial claims through securities trading and
(vi) portfolio management.
Economic development is to a very great extent dependent on the rate of investment or
capital formation, which, in turn, depends on, whether finance is made available in time
and the quantity of it and the terms on which it is made available. In any economy, in a
given period of time, there are some people whose urgent expenditures are less than
their current incomes, while there are others whose current expenditures exceed their
current incomes.
A financial system also directly helps to increase the volume and rate of savings by
supplying diversified portfolio of financial instruments, offering investment
inducements and choices, which are in keeping with the array of savers preferences. It
becomes possible for the deficit spending units to undertake more investment
expenditure because the financial system enables them to command more capital.

Financial System
As Schum Peter has said, without the transfer of purchasing power to him, an
entrepreneur cannot become the entrepreneur.
A financial system not only encourages investment, it also efficiently allocates resources
in different investment channels. It helps to sort out and investment projects by
sponsoring, encouraging and selective supporting of business units or borrowers
through projects appraisal, feasibility studies, monitoring and generally keeping a watch
over the execution and management of projects. It plays a positive and catalytic role by
providing finance or credit through creation of credit in anticipation of savings. This to a
certain extent ensures the independence of investment from saving in a given period of
time.
Another contribution of a well-developed financial system is to facilitate the normal
production process and exchange of goods and to enlarge markets over space and time.
In other words, financial system enhances the efficiency of the function of medium of
exchange and thereby helps in economic development. The relationship between
economic development and financial development is symbiotic or mutually reinforcing.
In the words of Schum Peter, 'the money markets is always... the head quarters of the
capitalist system, from which orders go out to its individual divisions, and that which is
debited and decided there is always in I essence the settlement of plans for further
development. All kinds of credit requirements come to this market; all kinds of
economic project are first brought into relation with each other and contend for their
realization in it; all kinds of purchasing power flows to it to be sold. This gives rise to a
number of arbitrage operations and intermediate maneuvers, which may easily veil the
fundamental thing.... Thus, the main function of the money or capital market is trading
in credit for the purpose of financial development. Development creates and nourishes
this market. In the course of development, it becomes the market for sources of income
themselves.

The Indian Financial System was fairly well developed even on the eve of planning. The
politico-economic background of the financial development in India had been
determined by the nature of our planned, mixed economic system. Some of the marked
features of Indian economy during the past forty years are continuous inflation,
increasing internal (fiscal) and external deficits, industrialization, urbanization and
significant structural transformation. Functioning within these parameters all sectors of
the economy has undergone significant changes including the financial markets.
The average maturity period of financial claims in India has tended to increase over a
period of time. This has been due to
a) An increase in savings in the ling-term claims like life policies provident funds,
National savings, Certificates National Savings Scheme and a variety of papers.
b) Lengthening of the average maturity period of the marketable debt of the government
and
c) Lengthening of the average maturity period of bank deposits.
The financial system has now become much more integrated than ever before. The
dividing lines between the so-called organized and unorganized sectors between the
busy and slack seasons are getting increasingly imperceptible. Among the factors that
are behind greater integration are:
a) The government entry in a very big way in the wholesale trading of a large number of
commodities
b) An unprecedented expansion of the network of rural branches of banks
c) The transformation in the perception of the role of financial institutions.
4.5 CHANGING TRENDS IN FINANCIAL SECTOR
The financial sector in India today, is almost entirely owned and controlled by the
government. The policies of public ownership administrative regulations and controls
and consolidation have led to the growth of monopolistic/oligopolistic market structure
sin the Indian Financial sector. The unparalleled government control of financial
institutions can hardly be said to have served the objectives of social justice. The
government-owned and government controlled financial system has in fact promoted
the interests of large private business organizations; it has helped rather than curbed the
concentration of economic power in the hands of the powerful. The authorities gave
removed certain regulations in respect of the stock market and the interest rate ceiling
in the call money market. Banks have been relieved from ceiling on their lending rates;
the credit Authorization Scheme has been discontinued.
The Indian Financial System is still far away from being internationalized and
globalized. But there has been an increase in the extent of participation by India in the
international financial markets. This was possible through flows of funds to India from

abroad on many levels. The foreign business of domestic commercial banks and foreign
banks business in India have increased. Institutions have Unit Trust of India have
created funds to mobilize financial resources abroad. The numbers of foreign
collaborations and joint ventures abroad have contributed to the establishment of
linkages between Indian and foreign financial markets. There has been a remarkable
transformation in the perception regarding the roles of different financial institutions.
Statutory financial institutions which have been established to provide long term finds
to the private sector, medium and large-sized units, how to provide funds including
working capital funds to the small-scale units. The public sector units now raise large
amount of funds directly from the capital market through bonds and deposits.
The growth of the financial system would appear to have the following elements:
i) Sometimes it has taken place in sports, cycles, temporary booms and unusual ways
and had not been long-lasting
ii) It has taken place at the initiative so the government
iii) It has been boosted by fiscal concessions
iv) It had an element of internal contradiction
4.6 FUND UTILISATION
Many companies used to boost their profits with the help of trading income cheap funds
were raised abroad and invested in the local financial markets and quick profits were
made rather than to invest in projects. Foreign investors have started voicing their
concern about how funds raised through GDRs are often misused by Indian companies.
Now that such investments have turned illiquid, companies are unable to convert the
funds back to productive investments. The demand for funds from government through
ad hoc treasury bills has considerably reduced funds available for private sector.
According to statistics, in April, 1995, the Central Government borrowed Rs.11,050
crores which is 4-times the Rs.2,524 crores borrowed in April 1994. The level of adhere
treasury bills issued by the Government crossed the 'within the year ceiling' of Rs 9000
crores forcing the Reserve Bank to issue fresh Government paper to bring down the ad
hoc creation.
Privatisation and Liberalisation
The India corporate sector is now experiencing a new kind of transition and it is gearing
well to adopt this transaction smoothly and without disturbing the pace of progress.
Experts fear that long-term damage of Asia's environment and warn that failure to input
environmental costs into infrastructure and development may harm the quality of life.
Many Asian countries are too busy trying to catch up with richer neighbors and the west
and often leave environmental issues to be dealt with after becoming richer. This
pollute-now-pay later principle is turning farms into commercial property, while rice,
paddy fields, plantations and hillsides are being turned into sugar highways and

shopping malls. Getting Du Pont out of Goa on environmental ground is a welcome step
but is a unwelcome step as far as Tamilnadu is concerned.
We have to avoid our traditional approach of "end of the pope solution" and adopt
"womb to tomb" approach where every aspects right from the conceptual stage to
disposal stage are studied carefully to avoid environment pollution and try recycling of
wastes to produces useful products from them.
Rating
The foreign investors who can be classified into equity investors and debt financiers are
guided by the overall rating by established agencies like 'Moody's and 'Standard and
Poor', it is to be pointed out that India has maintained its BBT long-term foreign
currency rating according to 'Standard and poor'.
Financial Services
India's gain in the recently concluded negotiations in Financial Services under the
Uruguay Round, especially in movement of personnel is yet to be assessed. According to
our Finance Minister, Mr. P. Chidambaram, the rule-banded World Trade Organization
will help developing countries. Thus in the emerging global scenario, there could be no
barriers to the flow of goods, services and capital between countries.
The IMF is focusing its attention on the health and viability of financial systems because
all national economies are integrating into one global financial network. For this, one
needs to integrate national policies with the rest of the world and this is important both
in trade in goods and services and financial services. In most industrialized countries
capital moves very freely and in order to survives in such an environment countries have
to focus on monetary policies and mechanisms through which they are implemented.
According to statistics, the revenue deficit stayed at around 2.6 to 2.7% of GDP during
the entire period of 1985-90 while it ranged lower between 0.2 - 1.8% of GDP in 1980-85
whereas it has set to sharp increase now. Hence, while many of the financial such
reforms are desirable, one should not come to a negative conclusion against the policy of
eighties just because it does not suit no According to IMF," the continuing large deficit
and high level of public debated less raise concerns about the sustainability of fiscal
policy. Increasing pressures on real interest rates have already emerged and these
threaten to crow out private investment. These fiscal pressures underscore the need to
strengthen State finances given the risk that fiscal adjustment at the central level could
be undermined by expansionary policies by states". Social welfare schemes such as food
and fertilizer subsidy, higher government wages will add to the burden. Foreign
exchange reserve has come down by two billion. FIIs are expected to wait and watch
before sloughing further fund into the capital market in the wake of sharp depreciation
in the value of rupee against US dollar. Market experts feel that inflow of money from
FIIs might come down in the near future. This development will enhance the
inflationary rate, which can be controlled only by RBI taking stringent measures with
the objective of maintaining the value of the rupee. The RBI can emulate its counterpart

in Germany, the Bundles bank, which could address itself firmly to its Central objectives
of maintaining the value of the Deutschemark. In the 1992 currency crisis in Europe, the
DM stood strongly in its place because the Bundles bank helps on to a high interest rate
in spite of the large borrowing programmed of government to finance reconstruction in
Eastern Germany.
According to Dr. Sukhamoy Chakravarthy, "The Indian Planning and Fiscal System are
fragile and may not be able to stomach sky high interest rates, especially for the
infrastructure". This holds good even today.
4.7 SUMMARY
This term financial system is a set of complex and closely intermixed financial
institutions, markets, instruments, services, practices and procedures. The financial
inputs emanate from the financial system while real goods and services are part of the
real system. The interaction between the real system (goods and services) and the
financial systems (money and capital is necessary for the productive process. Trading in
money and monetary assets constitute the activity in the financial markets and are
referred to as the financial system. The financial system of any country consists of
specialised and non-specialized financial institutions, of organized and unorganized
financial markets, of financial instruments and services, which facilitate transfer of
funds. Procedures and practices adopted in the markets, and financial interrelationships are also part of the system. These parts are not always mutually exclusive.
For example, financial institutions operate in financial markets and are therefore a part
of such markets. The word 'System, so the term 'financial system' implies a set of
complex and closely connected are intermixed institutions, agents, practices, markets,
transactions, claiming and liabilities in the economy.
Financial institutions are business organizations that act as mobilizes and depositories
of savings and as purveyors of credit or finance. They differ from non-financial
(industrial and commercial) business organizations in respect of their wares, i.e., while
the former deal in financial assets such as deposits, loans, securities, and so on, the
latter deal in real assets such as machinery equipment, stocks of good, real estates and
so on. The activities of different financial institutions may be either specialized or they
may overlap; quite often they overlap.
The role of financial system is to accelerate the rate of economic development and
thereby improve the general standard of living and increase the social welfare. This is
achieved through the mobilization and increase of savings and investment, i.e., by
stimulating the accumulation of capital and by allocating capital efficiently for socially
desirable and productive purposes. This, in turn, is achieves by financial markets by
performing a number of important and useful proximate functions or by providing a
number of services such as (i) enabling economic units to exercise their time preference,
(ii) separation, distribution, diversification and reduction of risk, (iii) sufficient
operation of payment mechanism, (iv) transmutation or transformation of financial
claims so as to suit preferences of the savers and borrowers, (v) enhancing liquidity of
financial claims through securities trading and (iv)port folio managements.

A financial system not only encourages investment, it also efficiently allocates resources
in different investment channels. It helps to sort out and investment projects by
sponsoring, encouraging and selective supporting of business units or borrowers
through projects appraisal, feasibility studies, monitoring and generally keeping a watch
over the execution and management of projects. The financial system has now become
much more integrated than ever before. The dividing lines between the so-called
'organised' and ‘unorganized’ sectors between the busy and slack seasons are gearing
increasingly imperceptible. The growth of the financial system would appear to have the
following elements:
i) Sometimes it has taken place in sports, cycles, temporary booms and unusual ways
and has not been long-lasting
ii) It has taken place at the initiative of the government
iii) It has been boosted by fiscal concessions
iv) It had an element of internal contradiction
KEY CONCEPTS
Financial System: It is a set of complex and closely intermixed financial institutions,
markets instruments, services, practices, and procedures.
Financial Markets: they are centers or arrangement that provides facilities for buying
and selling of financial claims and services.
Financial Integration: It refers to the establishment of close and close inter-linkages
between various parts and subparts of the financial system so that interest rates
differentials are minimized.
Financial Liberalization: It refers to the policy so reducing or removing completely
the legal restrictions, physical to administrative or direct controls, restrictions on flows
of funds etc.
4.8 REVIEW QUESTIONS
1. Define “Financial System" system.
2. Explain the nature and structure of financial
3. Explain the role of financial system in business conditions. Bring out the relationship
between financial system and economic development.
4. Write short notes on:
a) Financial markets

b) Financial integration
c) Financial liberalization
4.9 ASSIGNMENT QUESTION
1. Explain the part played by Indian financial system in economic development of India.
4.10 KEYWORDS
Surplus, deficit, mobilization NABARD, institution diversification, liberalization, fiscal
policy, foreign investors.

- End of Chapter LESSON - 5
FINANCIAL PLANNING, ANALYSIS AND CONTROL

OBJECTIVES
The main objective of the lesson is to acquire adequate knowledge on financial planning,
financial analysis and control.
STRUCTUE
5.1 Introduction
5.2 Financial Planning - Meaning
5.3 Need for financial planning
5.4 Steps involved in financial planning
5.5 Financial analysis - Meaning
5.6 Significance of financial analysis
5.7 Object of analysis

5.8 Procedure of analysis
5.9 Main tools/techniques of financial analyses
5.10 Financial control - meaning
5.11 Aims of control
5.12 Techniques of financial control
5.13 Summary
5.14 Review Questions
5.15 Assignment Questions
5.16 Keywords
5.1 INTRODUCTION
Management of funds is properly viewed as an integral part of overall management
rather than as a staff especially concerned with the fund-raising operations only.
Though, the financial executive is deeply involved in this process, his main
responsibility in respect of such decisions is to provide all the necessary accounting
information analysis and discuss the various alternatives and to suggest suitable
solutions.
5.2 FINANCIAL PLANNING MEANING
Financial planning involves the determination of objectives policies and procedures
relating to the function of finance. The financial policy and procedure that are
incorporated in sound financial planning act as broad guides in the procurement,
administration and disbursements of funds. Financial planning is an essential function
that is to be performed by the financial manger not only in the case of an entirely new
enterprise, but also in the case of an established one. This is because financial planning
is part of the overall planning of any business. An ideal financial planning is expected to
ensure not only the simply of adequate and proper funds at minimum possible cost, butalso take the necessary steps for its proper utilization and administration. The function
of financial planning is first performed by the promoter at the time of the flotation of the
company, which is later on taken care of by the financial manager and the top
management in subsequent stages. Financial planning is the question of a firm's longterm growth and profitability and investment and financing decisions. It focuses on
aggregative capital expenditure programmes and debt - equity mix rather than the
individual projects and sources of finance.
5.3 NEED FOR FINANCIAL PLANNING

The need for financial planning in a concern cannot be over emphasized. As a shortterm aspect of financial planning, it ensures the balanced flow of funds so that the firm
may be able to meet its commitments. As a long-term aspect of planning, it becomes a
tool of efficient use of financial resources. The need for financial planning arises to
ensure the following.
i) Availability of sufficient cash for meeting expenses, emergencies and contingencies.
ii) To maintain the necessary liquidity throughout the year.
iii) To indicate the point of time when funds will be required and how much.
iv) To indicate the surplus resources available for expansion or external investments.
v) To provide ahead for any more funds, if required
vi) To increase the confidence in the minds of the suppliers of funds by adopting
suitable financial policies.
Financial Forecasting and Planning
1. Financial forecasting and planning calls for a considerable expertise and special skill
on the part of the financial manager/controller. It involves three major aspects
(activities), viz.
2. Making a clear-cut and reliable financial analysis so as to ascertain the capabilities
and needs of the enterprise.
3. Making systematic prediction of the needs for funds over the short-run operating
period, including (a) cash flow (b) cash budgets (c) sources of current capital.
4. Ascertaining the actual need for funds over along run period including (a) investment
fund flow (b) capital budgets (c) alternative capital expenditure proposals (d) cost of
capital and (e) conditions of the capital market.
Financial forecasting and planning involves two major activities, viz. (1) Financial
Analysis and (2) Evaluation of investment opportunities.
Financial planners are not concerned solely with forecasting for they need to worry
about unlikely events as well as likely ones. If you think ahead about what could go
wrong, then you are less likely to ignore the danger signals and you can react faster to
trouble. Financial planning does not attempt to minimize risk. Instead it is a process of
deciding which risks to take and which are unnecessary or not worth taking.
5.4 STEPS IN FINANCIAL PLANNING
The following steps are involves in financial planning:

1. Analysis of the firm's past performance to ascertain the relationship between financial
variables, and the firm's financial strengths and weaknesses.
2. Analyses of the firm's operating characteristics product, market, competition, and
production and marketing policies, control systems, operating risk etc. to decide about
its growth objective.
3. Determining the firm's investment needs and choices, given its growth objective and
overall strategy.
4. Forecasting the firm's revenues and expenses and need for funds based on its
investment and dividend policies.
5. Analysis financial alternatives within its financial plans for the long-term health and
survival to firm.
6. Evaluating the consistency of financial policies with each other and with the corporate
strategy.
5.5 FINANCIAL ANALYSIS
Financial Analysis is concerned with the analysis of financial statements such as
balance sheet profit and loss account, etc. Broadly, the term financial analysis is applied
to almost any kind of detailed inquiry into profitability of the firm and to plan for future
operations. For all this, they have to study the relationship among various financial
variables in a business as disclosed in various financial statements. The analysis of
financial statements is an attempt to determine the significance' and meaning of the
financial statements data so that the forecast may be made of the future prospects for
earnings, ability to pay interest and debt maturities (both current and long term) and
profitability.
5.6 SIGNIFICANCE OF FINANCIAL ANALYSIS
Users of financial statements can get better insight about financial strengths and
weaknesses of the firm it they properly analyses information reported in these
statements. Management should be particularly interested in knowing financial
strengths of the firm to make their best use and to be able to spot out financial
weaknesses of the firm to take suitable corrective actions. The future plans of the firm
should be laid down in view of the firm's financial strengths and weaknesses. Thus,
financial analyses is the starting point for making plans, before using and sophisticated
and planning procedures.
The first task of the financial analysis is to select the information relevant to the
decisions under consideration from the total information contained in the financial
statement. The second step involved in financial analysis is to arrange the information
in a way to highlight significant relationships. The final step is interpretation and
drawing of inferences and conclusions.

5.7 OBJECTS OF FINANCIAL ANALYSIS
The following are the main objectives of the analysis of financial statements.
1. To estimate the earning capacity of the firm.
2. To gauge the financial position and financial performance of the firm.
3. To determine the long-term liquidity of the funds as well as solvency.
4. To determine the debt capacity of the firm.
5. To decide about the future prospects of the firm.
5.8 PROCEDURE OF ANALYSIS
A common procedure of analysis of financial statements, whether done by any
interested party, will be as follows:
1. Deciding upon the Extent of Analysis
First of all the depth, object and extent of analysis will be determined by the analyst.
The determination of these basic facts determines the scope of analysis, tool of analysis
and the amount and quality of financial data to be required. For example, to measure
the financial position of the firm, the balance sheet of the firm will be analyzed.
2. Going through the Financial Statements
Before analyzing and preparing any statements or composing financial ratios, it is
necessary for the analyst to go through the various financial statements of the subject
firm.
3. Collection of Necessary Information
The analyst should collect other useful information from the management, which is
useful for analysis but not being revealed from the published financial statements.
4. Rearrangement of Financial Data
Before making actual analysis and interpretation, the analyst must rearrange the data
provided by these statements in useful manner. The approximation of figures, reclassification of items, etc. is done in this step.
5. Analysis
Now the actual analysis is made. For analysis any of the above technique may be used.

6. Interpretation and Presentation
After analyzing the statements the statements the interpretation is made and the
inferences drawn from these analyses are presented in the shape of reports to the
management, etc.
Financial Analysis
It involves three things, viz.,
1. Arriving at financial ratios to make effective comparative evaluation of several aspect
having bearing on the financial requirements of the enterprise.
2. Making funds flow analysis including the preparation of a cash flow statement
determining the requirements of
i) Working capital for short - range, and
ii) Fixed capital for long range and
3. Assessing cost of capital and return on investment.
The analysis gives an indication of – i) the operating weaknesses of the firm; ii) its
potential capacity as well as, iii) the volume and types of financing required for enabling
the enterprise in question to accomplish the management's objectives. Let us try to
know more about these aspects.
5.9 MAIN TOOLS OF ANALYSIS (TECHNIQUES OF ANALYSIS)
To analysis the financial statements of a firm the popular tools of analysis are as follows:
1. Construction of Financial Ratios or Ratios Analysis
2. Preparation of comparative statements
3. Preparation of fund flow statement
4. Study of average
5. Trend study
Ratio Analysis
Financial analysis can be made very effectively on the basis of (i) the historical
accounting records of the enterprise and (ii) the appropriate industry standards.
Financial ratios are to be arrived at in this regard because they serve as guide - posts for
the management by enabling it to identify the areas requiring financial attention. The

Financial Manager can prepare a check-list to make an effective comparison of the
performance of his enterprise with the norms that are applicable to the concerned
industry as a whole. For instance an imaginary check - list which is given below in the
following table can give same minimum idea to the financial manger in his attempt to
make an effective financial analysis. He can, of course strengthen the utility of these
comparisons with the appropriate data applicable for several consecutive accounting
periods. It should, however, be remembered that norms that are made use of in the
following Table are jest for illustrative purposes only. As such, in practice, he should
obtain the norms from sources that collect information on the specific industry with
which he is concerned.
Measures for Evaluating Financial Performance:
Name of the Ratio and Suggested Formula:
1. Liquidity Ratio: They measure the ability of the firm to meet its maturing
obligations. They are also called Measures of solvency. They include:

(A 2:1 ratio of current assets to current liabilities is generally accepted as satisfactory)

(A 1:1 ratio of cash and its equivalent to current liabilities is generally acceptable as
satisfactory)
2. Leverage Ratios: They measure the contribution of financing by owners compared
with financing provided by creditors.
Total debt
i) Debt to Equity Ratio = ----------------Equity

Net profit before fixed charges
ii) Coverage of Fixed Charges Ratio = --------------------------------------Fixed charges

Current Liability
iii) Current Liability to Equity Ratio = ----------------------Equity

3. Activities Ratio: Measure of inventory turnover, they measure the effectiveness of
employment of resources and include:
Cost of goods sold (sales)
i) Inventory Turnover Ratio = ----------------------------------------------Inventory i.e. coverage annual inventory

Sales
ii) Net Working Capital Turnover Ratio = ---------------------------Net working capital

Sales
iii) Fixed Assets Turnover Ratio = ---------------------Fixed Assets
Receivable
iv) Average Collection Period Ratio = ------------------------Average sales per day

Sales
v) Equity Capital Turnover Ratio = -----------Equity

4. Equity Capital / Common Stock Ratios: They are measures regarding equity
shares / stock and include:
Net income
i) Earnings Per Equity Share Ratio = -----------------------------------------No. of outstanding Equity shares

Average market price of equity share
ii) Price Earnings Ratio = -------------------------------------------------Earning per Equity share

5. Profitability Ratio: They include the degree of success in achieving the desired
profit levels. This group includes:
Gross operating profit
i) Gross Operating Margin Ratio = --------------------------------Sales

Net operating profit
ii) Net Operating Margin Ratio = ------------------------------Sales

Net profit (income) after taxes
iii) Sales Margin Ratio = -------------------------------------------Net sales

Net income less tax
iv) Assets Productivity Ratio = -------------------------Total assets

Net profit after taxes
v) Rate of Return on Equity capital = -----------------------------Equity capital

Net income (profit) after losses
vi) Rate of Return on Total Invested Capital = -------------------------------------------Total invested capital
Funds Flow Analysis is a technique of determining the working and fixed capital
requirements. The operating weaknesses as well as potential capacity of the enterprise
can be clearly understood only when the financial manager succeeds in making an
effective funds flow analysis. Funds flow analysis refers to the analysis of the financial
statements of an enterprise (i.e. its profit and loss account or income and expenditure
account and balance sheet) for assessing its funds flow and cash flow movements. The
fund flow analysis indicates the changes in the company's financial requirements during
the current periods besides giving an idea of the sources that were used to meet the
same. In other words, it indicates the net changes in the assets, liabilities and the net
worth of the enterprise. Besides this it points out the effect of the same upon the
enterprise's financial condition pertaining to various types of transactions involved. For
instance, an increase in the net value of fixed assets hints at an application of funds,
whereas an increase in the liabilities drives our attention towards the sources of funds
from which the additional liabilities might have resulted.

The manager of funds may have to establish some measure of quantitative economic
relationships in order to succeed in properly evaluating the relative merits of the
alternative investment projects. In other words, he has to establish a criterion, which
can help him in deciding the ranking of these alternative investment projects so that he
can successfully take a final decision so that he can successfully take a final decision to
select the best. Following are the important methods/approaches that can be made use
of by the financial manager in evaluating the investment opportunities and measuring
the productivity of capital.
Whatever the approach or methods be, he should find the difference between the net
benefits that accrue from each alternative and the financial burden incurred, and secure
such benefits.
Among others, those methods or criteria that are regarded as popular can be grouped
under the following two categories, viz.,
Traditional Criteria
1. Payback Period
2. Accounting rate of return
3. Discounted Cash Flow (DCF) Criteria
a) Net present value
b) Internal rate of return
c) Profitability index or benefit -cost ratio.
5.10 FINANCIAL CONTROL
Financial control techniques essentially deal with the execution of the financial plan. It
reveals and measures the extent to which the plan has been pursued and points out the
deviations well in time so that the needed action may be taken. It can therefore be
treated as an essential ingredient of a successful financial plan.
By its nature financial control is a thorough control over the cash flows – cash account
and other items, which have a direct bearing over the cash position. As in the business
enterprise, every activity directly or indirectly is bound to have its repercussion over the
cash resources. So broadly speaking the term financial control can fairly cover the entire
operating activity. Basically it is expenditure control technique and like management
control. It has the following phases:
1. Establishing financial standards: These standards will be set up after financial
costing and engineering studies. The ratios and budgets or past historical data etc, can
be used for this purpose.

2. Evaluation of performance: It relates with the measuring of actual expenditure
with the planned expenditure. The cost trend in relation to the volume of activity is
studied.
3. Reporting: These reports points out the causes for deviations and suggest the
possible corrective action.
It is exercised through various techniques involving budgets, ratios, statements, charts
and other non-financial procedures. It ensures that the income earned and expenditure
incurred conforms to the financial plan as laid down.
5.11 AIMS OF FINANCIAL CONTROL
Financial control makes it possible to attain the financial objective of the business
enterprise as set by its financial plan. Its objectives are therefore the same as that of
financial plan. It has to serve faithfully like a servant to its master. The maintenance of
solvency calls for a thorough control over the cash flow. Cash must be available to meet
the liabilities as and when they mature. This cash flow control requires control over the
investments in all types of assets, and expenditures incurred. Any deviation in the cash
receipts from the budgeted level is also to be brought under strict vigilance, cash
budgeted is usually used as an instrument of control for this purpose.
5.12 TECHNIQUES OF FINANCIAL CONTROL
Financial control can be secured by applying techniques of budgeting, ratio analysis,
statements, control charts and reports etc.
As all income and expenditure flow through the cash, cash budget serves as one of the
major instruments of control. It lays down the standard to be achieved, measures the
performance with the standards thus asset through budget variations, reports these
variations and suggests the corrective action proposed. To convert cash budget as an
instrument control, monthly budgets are prepared to show the receipts and expenditure.
Thus the monthly budgets are prepared to show the receipts and expenditure. Thus -the
monthly budgets will show the change in the cash position. It will also depict the
amount of cash, which is available to meet the projected needs or the expected
borrowing needed. Besides cash budget flexible budget can also be used as an
instrument of financial control. It most widely recognized method of financial control
based on the ratio analysis is Du Pont System. This is very much popular in America. It
ensures the realization of the major enterprise objective-profitability as if uses return on
investment as a technique of control.
In this connection the Du Pont organization has developed a series of charts as a part of
its technique of financial control. These carts provide a framework for working back
from return on investment so as to check at, each critical control point in the operative
activity of the business firm.

The net income of the firm, often expressed as a return on capital investment, depends
upon two factors: Turnover of investment and the Margin of profit on sales. This can be
depicted below in the form of a formula:

The investment turnover ratio measures the relationship of total investment as shown
by total assets to the total sales. It is virtually the contribution of total assets employed
towards sales. Each item of investment is to be properly controlled. The profit margin is
the ratio of profit to sales. It calls for control of each item the expense on the one hand
and vigilance on the sales volume on the other hand.
5.13 SUMMARY
Financial planning involves the determination of objective policies and procedure
relating to the function of finance. The financial policy and procedure that are
incorporated in sound financial planning act as broad guides in the procurement,
administration and disbursements of funds. Financial planning is an essential function
that is to be performed by the financial manager not only in the case of an entirely new
enterprise, but also in the case of an established one.
Financial forecasting and planning involves two major activities, viz., 1. Financial
Analysis is concerned with the analysis of financial statements such as balance sheet,
profit and loss account etc. Broadly, the term financial analysis is applied to almost any
kind of detailed inquiry into financial data. A financial executive has to evaluate the past
performance, present financial position, liquidity situation, enquire into profitability of
the firm and to plan for future operations.
Financial control techniques essentially deal with the execution of the financial plan. It
reveals and measures the extent to which the plan has been pursued and points out the
deviations well in time so that the needed action may be taken. It can therefore be
treated as an essential ingredient of a successful financial plan as without it, a plan will
be pious with but a dead letter. Financial control makes it possible to attain the financial
objective of the business enterprise as set by its financial plan. Financial control can be
secured by applying techniques of budgeting ratio analysis, statements, control charts
and reports etc.
5.14 REVIEW QUESTIONS
1. Explain the need for the financial analysis.
2. How does the ratio technique helpful in financial analysis?

3. Distinguish between financial planning and financial analysis.
5.15 ASSIGNMENT QUESTIONS
1. "Financial planning is the key to successful business operations" – bring out the
significance and features of financial planning.
2. Explain the various methods to be employed for evaluations of financial performance
of a concern.
3. What is financial control? Explain the objectives and techniques of financial control.
5.16 KEY WORDS
Financial Planning: It is a process of determining the financial requirements and
financial structure necessary to support a given set of plans in other areas.
Financial Analysis: It is analyzing the financial data to evaluate the financial position
of a firm
Financial Control: It is a technique used to measure the extent to which the plan has
been pursued and identifies the deviations for the purpose of taking corrective action.

- End of Chapter -

LESSON - 6
DEVELOPMENT AND EVALUATION OF PROFITABLE OPPORTUNITIES

OBJECTIVES
The primary objective of the lesson is to get to know the availability of profitable
opportunity, the development and evaluation of profitable opportunities for the purpose
of allocation of funds.
STRUCTURE
6.1 Introduction

6.2 Investment Proposals/profitable Opportunities
6.3 Factors Influencing Investment Proposals
6.4 Investment Evaluation Criteria
6.5 Methods Assessing Profitability of Investment Proposals
6.6 Summary
6.7 Review Questions
6.8 Assignment Questions
6.9 Keywords
6.1 INTRODUCTION
The selection of the most profitable assortment of capital investment can be considered
one of the important functions of the manager of funds. Decisions taken by the
management in this area affect the operations of the firm for many years to come. In
most of the business enterprises, there are innumerable investment proposals for a
capital project than the firm is able and willing to fund them. The paucity of resources
compels the management to choose the most profitable proposal. By choosing the most
profitable capital project, the management can maximize the worth of equity
shareholder's funds. The significance of allocation of funds to most profitable
opportunity can be explained in the following paragraph:
i) While making investment proposals management loses his flexibility and liquidity of
funds. Hence every investment proposal has to be considered thoroughly in all its
respects.
ii) The funds available to a business concern is always in scarcity. The advent of science
and technology, modernization, mechanization, competition, government policy all
require balanced and properly planned allocation of scarce capital resources to the most
profitable investment opportunities. The managers of funds have to exercise utmost care
and caution while making investment proposals.
6.2 INVESTMENT PROPOSALS/PROFITABLE OPPORTUNITIES
A firm may have several investment proposals for its considerations. It may adopt one of
them, some of them or all of them depending upon whether they are independent,
contingent or dependent or mutually exclusive.
i) Independent Proposals: These are proposals which do not compete with one
another in a way that acceptance of one precludes the possibility of acceptance of
another. In case of such proposals the firm may straightening accept or reject a proposal

on the basis of a minimum return on investment required. All those proposals which
give a higher return than a certain desired rate of return are accepted and the rest are
rejected.
ii) Contingent or dependent proposals: These are proposals whose acceptance
depends on the acceptance of one or more other proposals. For example, a new machine
may have to be purchased on account of substantial expansion of plant. In this case
investment in the machine is dependent upon expansion of plant. When a contingent
investment proposal is made, it should also contain the proposal on which it is
dependent in order to have a better perspective of the situation.
iii) Mutually exclusive proposals: These are proposals, which compete with each
other in a way that the acceptance of one preludes the acceptance of other or others. For
example, if a company is 'considering investment in one of two-temperature control
systems acceptance of one system will rule out the acceptance f another. Thus, two or
more mutually exclusive proposals cannot both or all be accepted. Some technique has
to be used for selecting the better or the best one. Once this is done, other alternatives
automatically get eliminated.
Manager of funds faces a number of alternative profitable opportunities proposals,
which compete for allocation of funds. His main task is to rank the different proposals,
delineate the funds for each and then take the decision. The problem of ranking of
different proposals depends upon the availability of systematic statistical data. This data
is analysed and condensed by the judgment and skill of the management accountant
who on the basis of such analysis of tern tenders this opinion to the top management.
In most firms, there are more investment proposals for projects than the firm is able or
willing to finance. Some proposals are good, others are poor or some method must be
developed for distinguishing between them. Many technique for evaluating competitive
investment proposal is a major determinant of capital budgeting decision, there are
some other factors too which are considered by the management while deciding upon
them.
6.3 FACTORS INFLUENCING INVESTMENT PROPOSALS
They are as enumerated below:
1. Urgency of the project: This criterion argues that certain projects are essential to
the survival of the firm and therefore should be exempted from the rigours of objective
evaluation (profitability) tests. For example, if there is a breakdown in production
process due to loss of any component, the management takes decision at once to buy the
available one to avoid the delay.
2. Availability of Funds: Generally, capital projects are capital intensive. They
require huge amounts. So the availability of funds, their liquidity, and lesser payback
period is taken into account rather than their profitability.

3. Fuller utilization of Funds: If a firm has vast funds to invest, it may lose a project
which is less remunerative but will exhaust the funds fully rather than a project more
remunerative bur less utilisation of funds.
4. Future Expectation of Earnings: If management has plans for some time
afterwards, it may choose less remuneration but having lesser payback period. In such
circumstances the management will be able to invest funds in the future in most
profitable projects.
5. Some intangible factors: The goodwill of the firm, the morale of the employers are
given in tangible factors affecting managerial investment decisions. These factors have
nothing to do with profitability of the firm, but they cannot be overlooking, for example
are given in tangible factors affecting managerial investment decisions. These factors
have nothing to do with profitability of the firm, but they cannot be overlooked, for
example, construction of a grand building of company's maiden office, labour welfare
projects, etc.
6. Decision of Certainty in net income: Some managements prefer such low
profitable projects which assure less but a regular flow of income in comparison to high
but unstable income.
7. Risk of Obsolescence: Though the risk of obsolescence cannot be measured
exactly, the managements give due weight to this consideration also and they prefer
those opportunities which have lesser payback periods.
6.4 INVESTMENT EVALUATION CRITERIA
Three steps are involved in the evaluation of an investment:
1. Estimation of cash flows
2. Estimation of the required rate of return
3. Application of a decision rule for making the choice.
The investment decision rules may be referred to as capital budgeting techniques, or
investment criteria. A sound appraisal technique should be used to measure the
economic worth of an investment project. The essential property of sound technique is
that it should maximize the shareholders wealth.
The following other characteristics should also be possessed by a sound investment
evaluation criterion:
1. It should consider all cash flows to determine the true profitability of the project.
2. It should provide for an objective and unambiguous way of separating good
opportunities from bad opportunities.

3. It should help ranking of opportunities according to their true profitability.
4. It should recognize the fact that bigger cash flows are preferable to smaller ones and
early cash flows are preferable to later ones.
5. It should help to choose among mutually exclusive projects that proper which
maximizes the shareholders wealth.
6. It should be a criterion, which is applicable to any conclusive investment project
independent of others.
6.5 METHODS FOR ASSESSING PROFITABILITY OF INVESTMENT
PROPOSALS
The following are the various methods usually employees for assessing the profitability
of investment proposals:
(1) Average Rate of Return (ARR)
The average rate of return (ARR) method of evaluating proposed profitable opportunity
is also known as the accounting information rather than cash flow. There is no
unanimity regarding the definition of the rate of return. There are a number of
alternative methods for calculating the ARR. The most common usage of the average
rate of return (ARR) is expressed as follows:

The average profits after taxes are determined by adding up the after tax profit expected
for each year of the project's life and dividing the result by the number of years. In the
case of annuity, the average after-tax profits are equal to any year's profits.
The average investment is determined by dividing the net investment by two. This
averaging process assumes that the firm is using straight-line depreciation, in which
case the book value of the asset declined at a constant rate from its purchase price to
zero at the end of its depreciable life. This means, that on the average, firms will have
one-half of their initial purchase price in the books. Consequently, if the machine has
salvage value, them only the depreciable cost (cost-salvage value) of the machine should
be divided by two in order to ascertain the average net investment, as the salvage money
will be recovered only at the end of the life of the project. Therefore, an amount
equivalent to the salvage value remains tied up in the project throughout its lifetime.
Hence, no adjustment is required to the sum of salvage value to determine the average
investment. Thus, the average investment consists of the following.

Average Investment = Net Working Capital + Salvage Value + 1/2 (Initial Cost of
Machine - Salvage Value)
From the following information, calculate average investment:
Initial Investment (purchase of machine) Rs.11,000
Salvage value Rs.1,000
Working capital Rs.2,000
Service life 5 years
The straight-line method of depreciation is adopted.
The average investment is:
Rs.1,000 + Rs.2,000+1/2 (Rs.11,000 - Rs.1,000) = Rs.8,000
(2) Payback Method
It gives the number of years in which the total investment in fixed assets pays back itself.
The method is based on the theory that every capital expenditure pays itself back after a
lapse of certain period. It means that it generates or propels income within a certain
period, adequate enough, to recover the entire cost invested in it. When the total
earnings from investment equal the total outlay, that period is the payback period of the
capital investment. Under this method we actually find out the number of years within
which earnings will recover the cost of outlay. This is a plant purchased for Rs.10,000/and for the first year earnings are Rs.1,000/-, second year Rs. 7,000/- and third year
Rs.3,000/-, the total earnings are Rs. 11,000/- in three years, which fairly covers the
cost invested in the plant. Hence the pay-back period is 3 years the no. of years required
to return the original investment by savings before depreciation and after taxes.
The payback period is ascertained in the following manner:
1. The net earnings before depreciation and after taxes are ascertained by deducting cost
of maintenance and repairs from the total earnings on the capital project.
2. Find out the original cost of assets. The original cost excludes the cost of land and
working capital, as they are recoverable.
3. Calculation of the number of years required for paying back the outlay invested in the
asset is as below:

4. An asset that pays back itself early comparatively is to be preferred. The decision
criterion is "Shortest Pay Back".
Example
There are two projects A and B before the Management Accountant. Each project
required an investment of Rs.10,000/-. The following is the other relevant data.
Net earnings (Before Depreciation) and after tax
Years
1st
2nd
3rd
4th
5th
6th

A
Rs. 1000.00
Rs. 2000.00
Rs. 3000.00
Rs. 4000.00
Rs. 5000.00
Rs. 6000.00

B
Rs. 1000.00
Rs. 3000.00
Rs. 6000.00
Rs. 7500.00
Nil
Nil

On the basis of the steps given back we find that the payback period for B is three years
while that of A 4 years. Hence C is better.
(3) Discounted Cash Flow (DCF) Method or Time Adjusted Technique
The Discounted Cash Flow technique is an improvement on the payback period method.
It takes into account both the interest factor as well as the return after the payback
period. The method involves three stages:
i) Calculation of cash flows (i.e.) both inflows and outflows (preferably after tax) over the
full life of the asset.
ii) Discounting the cash flows so calculated by a discount factor.
iii) Aggregating of discounted cash inflows and comparing the total with discounted
cash outflows.
Discounted cash flow technique thus recognised that Re. 1 of today (the cash outflow) is
worth more than Rs.1 received at a future date (cash inflow). Discounted cash flow
methods for evaluating capital investments proposals are of three types as explained
below:

The Net Present Value (NPV) method: This is generally considered to be the best
method for evaluating the profitable investment proposals. In this method, cash inflows
and cash outflows associated with each project are first worked out. The present values
of these cash inflows and outflows are then calculated at the rate of return acceptable to
the management. This rate of return is considered as the cut-off rate and is generally
determined on the basis cost of capital suitably adjusted to allow for the risk element
involved in the project at various points of time. The working capital is taken, as a cash
outflow in the year the project starts commercial production. Profit after tax but before
depreciation represents cash inflows. The Net, Present Value is the difference between
the total present value of future cash inflows and the total present value of future cash
outflows.
The equation for calculating NPV in case of conventional cash flows can be put as
follows:

R1

R2

R3

Rn

NPV = ---------- + ---------- + ---------- + …. + ---------(1+k)

(1+k)2

(1+k)3

(1+k)n

In case of non-conventional cash inflows (i.e. where there are a series of cash inflows as
well cash outflows) the equation for calculating NPV is as follows:
R1

R2

R3

Rn

NPV = ---------- + ---------- + ---------- + …. + ---------(1+k)

(1+k)2

I1

(1+k)3

I2

(1+k)n

I3

In

NPV = I0 + ---------- + ---------- + ---------- + …. + ---------(1+k)

(1+k)2

(1+k)3

(1+k)n

Where NPV = Net Present Value, R = Cash inflows at different time periods, K = Cost of
capital or cut-off rate, I = Cash outflows at different time periods.

Accept or Reject Criterion
The Net Present Value can be used as an accept or reject criterion. In case, the NPV is
positive (i.e., present value of cash inflows is less than the present value of cash
outflows), the project should be rejected. Symbolically, the accept / reject criterion can
be put as follows:
Where, NPV > Zero, accept the proposal;
NPV < Zero, reject the proposal
(4) Internal Rate of Return (IRR)
Internal Rate Return Method of evaluating investment projects considers:
i) Cash flows in all the years of the life of a project and
ii) Time value of money
IRR method is also called as yield method. Internal rate of return is the rate of yield
which will equate the present value of cash inflows from an investment, with the present
value of cash outflows for that investment.
There are two steps in the determination of IRR
a) Determination of annual cash flow
b) Determination of IRR
This technique is also known as yield on investment, marginal efficiency of capital,
marginal productivity of capital, rate of return, time adjusted rate of return and so on. In
the case of the present value method, the discount rate is the required rate of return and
being a pre-determined rate, usually the cost of capital, its determinants are external to
the proposal under consideration where as the IRR is based on facts which are internal
to the proposal. In other words, while arriving at the required rate of return for finding
out present values the cash flows - inflows as well as outflows - are not considered. But
the IRR depends entirely on the initial outlay and the cash proceeds of the project,
which is being evaluated for acceptance or rejection. It is, therefore, appropriately
referred to as internal rate of return.
The internal rate of return is usually the rate of return that a project earns. It is defined
as the discount rate ‘r’ which equates the aggregate present value of the net cash inflow
is with the aggregate present value of cash outflows of a project. In other words, it is that
rate which gives the project NPV of zero.
Assuming conventional cash flows, mathematically the IRR is represented by that rate,
r, such that

N
CO0 = ∑
T=1

n

CFt

Sn + Wn

------------ + ----------------(1+r)T

CFt

(1+r)n

Sn + Wn

Zero = ∑ --------- + ----------------- - COn
t=1

(1+r)t

(1+r)n

For unconventional cash flows, the equation would be,
N

Sn + Wn

n

CO0

= ∑ CFt (1+r) + ---------------- - ∑ -----------t=1

n

(1+r)n

Sn + Wn

t=0

(1+r)t

n

= ∑ CFt (1+r)t + ---------------- - ∑
t=1

(1+r)n

t=0

where,
r = The internal rate of return
CFt = Cash inflows at different time periods
Sn = Salvage value

COt
------------(1+r)t

Wn = Working capital adjustments
COt = Cash outlay at different time periods
Accept - Reject Decision
The use of the IRR, as a criterion to accept capital investment decisions involves a
comparison of the actual IRR with the required rate of return, also known as the cut-off
rate or hurdle rate. The project would qualify to be accepted if the IRR exceeds the cutoff rate. If the IRR and the required rate of return are equal, the firm is indifferent as to
whether to accept or reject the project.
(5) Profitability Index (PI)
This index can be computed only if NPV method has been used. It is the rule that project
with the highest positive NPV should be selected. But this rule cannot be applied when
the amounts of investments in projects differ. For example, investment project 'A'
costing Rs.20,000 gives NPV of Rs. 5,000 and investment project '8' costing Rs. 50,000
gives NPV of Rs. 8,000, B will be selected on the basis of NPV. But this decision is with
flaw (mistake). The investment in B is 2½ times the investment in A, but NPV of B is
much less than 2½ times the NPV of A. If there are two investment opportunities of A
type, then by investing Rs. 40,000 (20,000+20,000), the NPV will be Rs.I0,000 which
is greater than NPV (Rs.8,000) on investment of Rs. 50,000 (B). This is the flaw in the
decision based on NPV, when investment amounts differ in size.
To remove this flaw, PI is computed where investment sizes differ. PI is the method to
neutralize the effect of different sizes of investments on decision making. It puts all
different sized investments on a common footing. PI is a ratio and has all properties of a
relative measurement. Method of computing PI is given below:
Present Value of inflows
Profitability Index = ------------------------------------------------Present value of outflows (investments)

The computation and use of PI are illustrated in the following example:
Example
A firm is considering two projects A and B; its cost of capital (Ko) is 10%. Other
information relative to projects is given below:

Invest (outflow)
Cash inflows
Year 1
Year 2

Project A
Rs. 10,000

Project B
Rs.20,000

Rs. 8,000
Rs. 5,000

Rs. 15,000
Rs. 10,000

Compute the NPV, and rank the proposals. Also compute PI and rank the proposals.
Advise which of the projects should be selected.
Solution
(i) NPV
NPV of Project A
PV of Cash inflows:
Rs. 8,000 x 0.909 at 10% = 7,272
Rs. 5,000 x 0.825 at 10% = 4,130
---------Total

11,402
----------

NPV = Rs.11,402 - 10,000 = Rs.1,402

NPV of project B
PV of cash inflows:
Rs. 15,000 x 0.909 = 13,635
Rs. 10,000 x 0.826 = 8,260
------------Total

21,895
-------------

NPV = Rs.21,895 - 20,000 = Rs. 1,895

Ranking on NPV
B – 1st, with greater NPV
A – 2nd
But this ranking is not scientific as investment amounts differ

ii) Profitability Index
11,402
PI for A = ---------- = 1.1402
10,000

21,895
PI, for B = ----------- = 1.095
20,000

Ranking on PI
A – 1st, with greater value
B – 2nd
Thus, this ranking is different than the ranking on NPV basis. This ranking is more
appropriate from the point of view of maximizing the value of the firm. The firm should
select project A. It requires substantially smaller cash commitment/investment. A
higher PI shows a higher profitability. PI emphasizes on efficiency in the sense of
inputs-output relationships.
(6) Terminal Value Method

This approach separates the timing of the cash inflows and outflows more clearly. It
assumes that each cash inflows is reinvested in other assets at certain rate) of return
from the moment it is received until the termination of the project. Then the present
value of the sum total is calculated and it is compared with the initial cash inflow. The
decision rule is that if the present value of the sum total' of reinvested cash inflows is
greater than the present value of cash outflows, the proposed project is accepted
otherwise rejected.
6.6 SUMMARY
In most of the business enterprises, there are innumerable investment proposals for a
capital project than the firm is able and willing to fund them. The paucity of resources
compels the management to choose the most profitable proposal. By choosing the most
profitable capital project, the management can maximize the worth of equity
shareholders funds. Manager of funds faces proposals of a number of alternate
profitable opportunities, which compete for allocation of funds. His main task is to rank
the different proposals, delineate the funds for each and then take the decision. The
problem of ranking of different proposals depends upon the availability of systematic
statistical data. This data is analysed and condensed by the judgment and skill of the
management accountant who on the basis of such analysis after tenders his opinion to
the tap management.
There are various method are various methods which can be used for ascertaining the
profitability of an investment proposal. However there is no best method. In fact each
method is used for ranking them, so that a judicious decision can be undertaken. The
following are the various methods usually employed for assessing the profitability of
investment proposals: (1) ARR (2) Payback (3) DCF (4) IRR (5) PI (6) Terminal Value
Method.
6.7 REVIEW QUESTIONS
1. Explain the various methods of ranking varied profitable opportunities.
2. Explain the various considerations another than profitability to be considered while
taking decisions in respect of profitable opportunities.
3. Contrast the IRR and the PV methods.
4. Discuss the problems of ranking profitable opportunities with varying economic lives,
sizes and partners of cash outflows and inflows.
6.8 ASSIGNMENT QUESTIONS
1. For most investment decisions that the firm faces, NPV is either a superior decision
criterion or is at least as good as the competing techniques. In what investment situation
is the profitability index better than the net present value.

2. What does the profitability signify? What is the criterion for judging the worth of
investments based on the profitability index?
3. What are the mutually exclusive projects?
4. How do you calculate the accounting rate of return? What are its limitations?
6.9 KEY WORDS
Accept-reject Criterion: Evaluation of profitable investment opportunities to
determine whether the project under consideration satisfies the minimum acceptance
standard and should be accepted.
Accounting Rate of Return: It is computed by deciding the average income after
taxes divided by the initial outlay of a project. It is used as a technique to evaluate
profitable investment opportunities.
Capital Expenditure: Outlay required for acquiring an asset from which benefits
would be available beyond one year.
Discounted Cash flow: Profitable opportunities technique that adjusts cash flow over
the life of the project proposal for the time value of money.
Discounting: The process of finding the present value of series of future cash flows. It
is called present value analysis.
Mutually Exclusive Projects: A group of profitable opportunities that compete with
one another in such a way if one is selected all others cannot be selected.
Present Value: The value of sums received in future being discounted by an
appropriate capitalization rate.
Payback Period: The number of years required to recover the investment required by
a project.

- End of Chapter LESSON - 7
RISK ANALYSIS

OBJECTIVE
The objective of this lesson is to acquire knowledge on risk analysis of the various
methods of measurement of risk and incorporating risk factor in profitable
opportunities.
STRUCTURE
7.1 Introduction
7.2 Meaning
7.3 Measurement of risk
7.4 Summary
7.5 Review Questions
7.6 Assignment Questions
7.7 Keywords
7.1 INTRODUCTION
The investment proposal decision is based on the benefits derived from the project.
These benefits are measured in terms of cash flows. These cash flows are estimates. The
estimation of future returns is done on the basis of various assumptions. The actual
returns in terms of cash flows depends on a variety of factors like government policies,
technological changes, project life, inflation, demand of the products, prices of raw
material s and inputs, manufacturing costs, sales volume. The accuracy of the estimates
of future returns and therefore the reliability of the investment decision would largely
depend on the precision with which these factors are forecast. But practically the actual
returns will vary from the estimates. This is the risk. The concept risk with reference it
investment decisions may therefore be defined as the variability in the actual returns
emanating from an project in future over its working life in relation to the estimated
return as forecast at the time of the initial capital budgeting decision.
7.2 MEANING
Risk arises in investment evaluation because we cannot anticipate the occurrence of the
possible future events with certainty and consequently, cannot make any correct
prediction about the cash flow sequence. The risk is associated with the variability of
future returns of a project. The greater the variability of the expected returns, the riskier
is the project. The decision situations as to risk may be analysed as
i) Certainty

ii) Uncertainty
iii) Risk
A risk situation is one in which the probability of particular event occurring are known
while an uncertain situation is one where those probabilities are not known. In respect
of uncertainly, the future loss cannot be for seen. However for the purpose of this
analysis, no distinction is made between risk and uncertainty. There are innumerable
factors which give rise to risk and uncertainty in capital investment, like company
factors industry factors, general economic conditions, competition, technological
developments, changes in consumer preference, political factors. The certain outcome of
these factors is that the revenues cost and economic life of a particular investment is less
than certain.
A firm's ability to make the correct accept - reject decision for a new asset depends on its
ability to perceive future events that affect the profitability of the asset. Generally, firm
may be satisfied with a small expected return from an investment if the uncertainty
connected with it is also small and the firms may be attracted to high yielding
investments and ignore the uncertainty connected with income from investment. Two
elements of uncertainty to be considered in making an investment proposal decision are
(a) what is the profitability that the estimate of cash flows are correct, (b) what is the
effect on projected profit if the actual events differ from predicted events. A capital
expenditure decision may not be sound if taken on the basis of only one set of
assumptions as regards the profitability, without perceiving the risk and uncertainty
connected with the assumptions.
7.3 MEASUREMENTS OF RISK
The measurement of risk is an arduous task. Experts have suggested several techniques
to measure the risk. Risk is present In all investment opportunities and use of
mathematical techniques can enable the manager of funds to measure the risk and deal
with it in a better way than those who depend on only quantitative techniques. Proper
blending of quantitative techniques and intuition is the best approach to risk assessment
of opportunities. However, incorporation of risk factor in evaluating various investment
opportunities is a difficult task. Some of the popular techniques used for this purpose
are
a) General Techniques
b) Quantitative Techniques
While the general techniques include risk adjusted discount rate and certainty
equivalent co-efficient quantitative techniques, include sensitivity analysis, standard
deviation probability assignment, co-efficient of variation, and decision tree.
7.3.1 General Techniques

Many methods have been developed to adjust risk. A risk averter when given a choice
between two projects promising the same rate of return but different in risk, would
prefer the one with the least perceived risk. Hence, when a firm accepts a project that
would change the risk complexions of the firm, its overall value of the firm, it must
require a higher rate of return on project involving greater than that or the less risk of
project. The most common methods in adjust risk are informal method, risk adjusted
discount rate method and the certainty equivalent method.
1. Informal Method
The manager of funds recognizes that some projects are more riskier than others. He
also funds that riskier projects would yield more than what risk free or less risky
projects promise. To select a project carrying greater risk as against the less risky one he
decides on subjective basis (by using his discretion) the margin of diffidence in rate of
return of both types of projects
2. Risk Adjusted Discount Rate Method
Another deceives for adjustment risk is to vary the discount rate in correspondence with
change in amount of risk. The discount rate may be increased for the project carrying
greater risk and reduce it when the risk attached with the project is low. That is if the
time preference for money is to be recognized by discounting estimated future cash
flows at some risk free rate, to their present value, then to allow for the riskiness, of
those future cash flows a risk premium rate may be added to risk- free discount rate.
Such a composite discount rate will allow for both time preference and risk preference
and will be a sum of the risk- free rate and the risk premium rate reflecting the investor's
attitude towards risk. The risk adjusted discount rate method can be normally expressed
as follows:
N

NCFt

NPV = ∑ -----------T=1

(I+K)t

Where K is a risk-adjusted rate, i.e.,
Risk adjusted discount rate = Risk free rate + Risk premium
The risk adjusted discount rate accounts for risk by varying the discount rate depending
on the degree of risk of investment projects. A higher rate will be used for riskier
projects and a lower rate for less riskier projects. If the risk free rate is assumed to be 10
percent, some rate would be added to it, say 5 percent as compensation for the risk of
the investment and the composite 15 percent rate would be used to discount the cash
flows.
3. Certainty Equivalents

This is an alternative method to risk-adjusted rate of return in which the adjustment is
done for risk in the expected future cash flows before arriving of the present value. The
expected uncertain cash flows of each year are modified by modified by multiplying
them with what is known as certainty equivalent coefficient to remove the element of
uncertainty. This coefficient is determined by management's preference with respect to
risk.
For instance, assume that the expected cash flow from an investment at the end of first
year is Rs. 10,000 and that the management ranked this investment on par with another
alternative investment with a certain cash flows of Rs. 7,000. The CEC in this case is 0.7
= certain cash flows/uncertain cash flows.
Similarly a CEC can be assigned to every year with expected uncertain cash flows and
convert them into certainty equivalents and the proceed to calculate the rate of return or
NPV. This approach is superior to risk adjusted rate of return because distant discount
rate implied that increases at a constant rate with time which is not realistic. The
following steps are taken to compensate for risk under this approach:
a) Determining the degree of risk inherent in the cash flows by means of standard
deviation or co-efficient of variation.
b) Calculating certainty equivalent co-efficient of each cash flows.
7.3.2 Quantitative Techniques of Measurement of Risks
1. Standard Deviation
If two projects have the same costs and the same NPV then comparison of the standard
duration of cash inflows of the projects will be done to judge the degree of their risks.
The project showing higher standard duration is most risky. The greater the standard
duration, the greater is the dispersion of outcomes around the expected value. Standard
deviation is measured that indicated the degree of uncertainty (dispersion) of a cash
flow and is one measure of risk.
2. Co-efficient of Variation
The standard deviation can be misleading in comparing the uncertainty of alternatives
projects, if they differ in size. The coefficient of variation is a correct technique in such
cases. It is computed to measure the degree of risk, if the two projects, have the same
cost, but different Net present values. If the projects have different costs, then risk
return quotient is computed to compare their risks. Risk return quotient equal to ratio
of standard deviation to profitability index.

Standard Deviation
Coefficient of variation = ---------------------------Expected cash flow
7.4 SUMMARY
A risk situation is one in which the probabilities of a particular event occurring are
known while an uncertain situation is one where such probabilities are not known. In
respect of uncertainty, the future loss cannot be foreseen. However for the purpose of
this analysis, no distinction is made between risk and uncertainty. There are
innumerable factors which give rise to risk and uncertainty in capital investment, like
company factors, industry factors, general economic conditions, competition,
technological developments, changes in consumer preferences, political, factors etc. The
certain outcome of these factors is that the revenues cost and economic life of a
particular investment is less than certain.
The measurement of risk is an arduous task. Experts have suggested several techniques
to measure the risk. Risk is present in all investment opportunities and use of
mathematical techniques can enable the manager of funds to measure the risk and deal
with it in a better way than those who depend on only quantitative techniques. Proper
blending of quantitative techniques and intuition is the best approach to risk assessment
of opportunities. However, incorporation of risk factor popular techniques used for this
purpose are:
a) General techniques
b) Quantitative Techniques
While the general techniques include risk adjusted discount rate and certainty
equivalent co-efficient, quantitative techniques, include sensitivity analysis, standard
deviation, probability assignment, co-efficient of variation, and decision tree.
7.5 REVIEW QUESTIONS
1. Explain the concept of risk. How can risk be measured?
2. What makes risk important in the selection of projects? Discuss the various methods
of evaluating risky projects.
3. What is sensitivity analysis? State its advantages and disadvantages?
4. What is the sensitivity approach for dealing with project risk? What is one of the most
common methods used to evaluate projects using sensitivity analysis?
7.6 ASSIGNMENT QUESTIONS

1. Define risk and uncertainty. Discuss the various methods available for considering
risk and uncertainty in capital budgeting decisions.
2. How can the probability theory be used in analyzing risk of investment project?
3. Discuss different methods of incorporating risks in investment decisions.
4. How would you evaluate an investment proposal under conditions of risk and
uncertainty? Distinguish between risk and uncertainty.
7.7 KEY WORDS
Certainty Equivalent: The return required with certainly to make investors the different
between the certain return and a particular uncertain (risky) return.
Risk: Viability of return associated with prospect.

- End of Chapter LESSON - 8
SENSITIVITY ANALYSIS

OBJECTIVE
The objective of the lesson is to acquire knowledge on sensitivity analysis
STRUCTURE
8.1 Profitability Analysis
8.2 Decision Tree Analysis
8.3 Capital Rationing
8.4 Summary
8.5 Review Questions
8.6 Assignment Questions

8.7 Keywords
8.1 INTRODUCTION
It means the analysis of the effect of change in certain variable on an outcome to
estimate the variability of the outcome or risk associated with a project or a situation.
Sensitivity analysis is a way of analyzing change in the projects NPV or IRR for a given
change in one of the variables. The more sensitive the NPV, the more critical is the
variable. The following three steps are involved in the use of sensitivity analysis:
1. Identification of these variables, which have an influence on the projects NPV (or
IRR).
2. Definition of the underlying (mathematical) relationship between the variables.
3. Analysis of the impact of the change in each of the variables on the project’s NPV.
The decision maker while performing sensitivity analysis computes the projects NPV (or
IRR) for each forecast under these assumptions:
a) Pessimistic
b) Expected and
c) Optimistic
Sensitivity analysis boils down to expressing cash flows in terms of unknown variables
and then calculating the consequences of misestimating the variables. It forces the
manager to identify the underlying variables, indicates where additional information
would be most useful and helps to expose, confused or inappropriate forecasts. One
drawback to sensitivity analysis is that it always gives somewhat ambiguous results.
Another problem with sensitivity analysis is that the underlying variables are likely to be
interrelated. What sense does it make to look at the effect in isolation of an increase in
market size? If market exe exceeds expectations it is likely that demand will be stronger
than you anticipated and unit prices will be higher. And why look in isolation at the
effect of an increase in price? If inflation pushes prices to the upper end of our range, it
is quite profitable that costs will also be inflated.
Probability Analysis
The probability distribution of cash flows over time provides valuable information about
the expected value of return and the dispersion of the probabilities distribution of
possible returns. In the light of this information, an accept/reject decision can be taken.
The application of probability distribution in analysing risk in capital budgeting
depends upon the behaviors of cash flows from the point of view of behavior cash flows

being independent or dependent when cash flows in one period depend upon the cash
flow in previous periods they are referred to as dependent cash flows.
One can make use of the normal probability distribution to analyse further the element
of risk in capital budgeting. The use of the normal probability distribution will enable
the decision makers to have an idea of probability of different expected values of NPV,
i.e. the probability of the NPV of having the value of zero or less; greater than zero
within the range of the values, say Rs. 1,000 and Rs.l,500 and so on. If the probability of
having NPV of zero or less is considerably low, say, .01, it implies that the risk in the
project is negligible. Thus, the normal probability distribution is an important statistical
technique in the hands of decision-makers for evaluating the riskiness of the project.
8.2 DECISION TREE ANALYSIS
The decision tree approach to the evaluation of risk and uncertainty rests on the impact
of all probabilistic estimates of potential outcomes. In other words, when using
decision-tree analysis every potential event is weighted in probabilistic terms and that is
the basis for evaluation. The decision-tree is an analytical technique used especially in
sequential decisions, where various decision points are studied in relation to subsequent
events. A decision-tree is a pictorial presentation in a tree from indicating the
magnitude, probability and inter-relationship of all possible outcomes.
8.3 CAPITAL RATIONING
Capital rationing refers to a situation where a firm is not in opposition to invest in allprofitable projects due to the constraints on availability of funds. We know that the
resources are always limited and demand for them fear exceeds their availability. It is
for this reason that the firm cannot take up all the projects, through profitable and has
to select the combination of proposal that will yield the greatest profitability.
Capital rationing takes place when (i) there is ceiling on budget-amount in an
accounting year (ii) the firm has a policy of investing only internally generated funds
(receiver etc) in capital projects, (iii) a division of a large firm is allowed to invest in
projects up to a specified amount.
With the limits on amounts to be invested in capital projects, the firm selects that
combination of investment projects, which will provide the highest profitability. The
following example illustrates the use of criterion of highest profitability in a capital
rationing situation.
Example
A firm has the following investment proposals, economically viable. Their profitability
indices CPV / investment and investment costs are given below:

Projects
A
B
C
D
E
F

Investment Profitability
Costs (Rs.)
Index
2,00,000
1.25
50,000
1.18
87,500
1.20
62,500
1.10
1,10,000
1.15
50,000
1.05

The firm imposed a ceiling on capital expenditure upto Rs. 5,00,000 in the current year.
What projects will be approved for investments?
Solution
This is a capital rationing situation. All the projects are attractive as PI is greater than 1
for these projects. But there is a limit of Rs. 5,00,000 imposed on investments to
projects. The projects will be arranged in order of profitability index:
Cumulative
Project PI
A
B
C
E
F

1.25
1.20
1.18
1.15
1.05

Investment
2,00,000
87,500
50,000
1,10,000
50,000

Total (Rs.)
2,00,000
2,87,500
3,37,500
4,47,500
4,97,500

D project will not be taken up even through its PI (1.10) is higher than PI of F(1.05), due
to constraint of Rs. 5,00,000. If project D is taken up for investment, in place of project
F, the total capital expenditures will be (4,47,500 + 62,500 = 5,10,000) which exceeds
by Rs. 10,000 over Rs. 5,00,000 limit.
Projects can be ranked by their profitability index, and top ranked projects are chosen
until funds are exhausted. The procedure fails when capital is rationed in more than one
period or when there are other constraints on project choice. The only general solution
is linear or integer programming.
Hard Rationing
Soft rationing should never cost the firm anything. If capital constraints become tight
enough to hurt in the sense that projects with significant positive NPVs are passed up
then the firm raises more money and loosens the constraint. But when if it can't raise
more money what if it faces hard rationing?

Hard rationing implies market imperfections, but that does not necessarily mean we
have to throwaway net present value as a criterion for capital budgeting. It depends on
the nature of the imperfection.
8.4 SUMMARY
Sensitivity analysis spoils down to expressing cash flows in terms of unknown variable
and then calculating the consequences of misestimating the variables.
Probability analysis distribution of ash flows over time provides valuables information
about expected value of return and the dispersion of the probabilities distribution of
possible returns.
8.5 REVIEW QUESTIONS
1. Explain the objectives and significance of management of funds.
2. Explain the organization of funds management and its relationship with other
functional areas of an enterprise.
3. Discuss the role of financial system in business conditions.
4. Explain the various methods of ranking varied profitable opportunities.
5. What does the profitability index signify? What are mutually exclusive projects?
8.6 ASSIGNMENT QUESTIONS
1. What is meant by optimum capital structure? Explain the factors which influence
planning of capital structure
2. Discuss the causes and effects of (i) over-capitalization (ii) under capitalisation.
3. Explain the various methods employed for evaluation of financial performance of a
business enterprise.
4. Write short notes on:
(i) Capital Rationing (ii) Risk and uncertainty (iii) Sensitivity analysis (iv) Decision tree
analysis
8.7 KEY WORDS
Capital Rationing: A situation in which due to financial constraints, the limited funds
are allocated to a number of mutually exclusive profitable opportunities.

Certainty Equivalents: The return required with certainty to make investors in
different between the certain return and a particular uncertain (risky) return.
Coefficient of Variation: A relative measure of variability of the outcomes associated
with an event. It is computed by dividing standard deviation of a distribution by the
mean.
Decision Tree: Analytical technique to set forth graphically the pattern of relationship
between decisions and chance events. It is generally used to handle risk situations.
Independent Projects: Investment opportunities that compete with each other but
acceptance of one does not preclude the acceptance of others.
Internal Rate of Return: The rate of return that equates the present values of future
cash flows to the initial investment on the project.
Net Present Value: it represents the difference between the present value of future
cash flows associated with a project and the present value of the initial investments to
acquire that project.
Profitability Index: The present value of future cash inflows divided by the present
value of the initial outlay.
Risk: Variability of returns associated with a project.
Risk Adjusted Discount Rate: A discount rate used in capital expenditure decisions
that has been adjusted for risk. It is determined by adding an appropriate risk premium
to the riskless rate of return.

- End of Chapter LESSON - 9
TERM FINANCING - AN EVALUATION

OBJECTIVES
The objectives of this lesson are:
·
·

To explain the nature, need, conditions and assessment of term financing
To analyse the various sources of finance such as shares, debentures, etc

·

To pinpoint broad implications and highlight the managerial issues of various
sources of long term finance.

STRUCTURE
9.1 Introduction
9.2 Need for Long term financing
9.3 Conditions of term financing
9.4 Assessment of Term Loan
9.5 Sources of Long Term finance
9.6 Share capital
9.7 Debentures
9.8 Term Loans
9.9 Summary
9.10 Review Questions
9.11 Assignment Questions
9.12 Keywords
9.1 INTRODUCTION
Capital is the predominant factor of production. It is the life blood of modern industry.
The more modern the production technology, the more the need for capital investment.
With technological advancement and increasing cost of capital, medium and long term
financing decisions are becoming more and more intricate. Such decisions have long
term implications as they have effect on future profits for over number years and
influence the risk complexion of the business. P.C. Bhattacharya in his speech on "The
changing Landscape of Banking" invites the attention of commercial banks to the aspect
of structural change in the employment of bank funds and the interest, which banks
have been showing in the term financing needs of the industry.
In the competitive and complex financial environment of today, management of funds is
becoming more critical area of financial management. The fund’s manager is
encountering with new challenge from time to time as the choice of sources of funds and
instrument s of finance are more and more. The success or failure of a business
ultimately depends upon the effectiveness of management of funds. The evaluation of

term financing and different sources of long term financing, and their critical evaluation
are discussed in this lesson.
Term Financing - Meaning
Securing capital directly from lender in the form of a negotiated contract containing all
the details of the agreement is referred to as "Term Financing". The evolution and the
increased relative importance of this form of lending, is partly attributable to changes in
the structure of the capital market. Depending upon the nature of activity to be
financed, business requires short-term, medium-term and long-term financing.
9.2 NEED FOR LONG TERM FINANCING
As a company grows, it requires funds and larger amounts to finance its long term
requirement s. But the owner's personal funds may not be adequate or that the supply of
internally generated capital is insufficient. In that condition, the owner or the industrial
unit may look for other sources available to finance its business operations. Leasing,
bank loans and term borrowing provide the answer to some extent. At some point in
their growth, most businesses turn to the public market for funds. But it should be noted
that bolstering company finances is not the only reason for going public. In a number of
instances, the desire to avoid burden of some estate taxes for ones survivors has
promoted public offering of stock.
Inheritance taxes, particularly in the case of closely held corporations can be so
burdensome that often a family has to sell the business to pay taxes, Public offering of
share sis not the complete solution for the burden some tax problem. Term financing is
regarded as an important source of finance. Moreover, term financing, which is
considered as the most traditional source of finance is also, treated as the cheapest
source of finance amount he various sources of finance. Keeping this in view, companies
for their expansion, modernization, diversification and replacement or any other
investment purposes, are depending more on term financing.
9.3 CONDITIONS OF TERM FINANCING
The price paid for term finance is just one of the several factors decided upon by
negotiation. The interest rate depends upon the general level of rates, the financial
positions of the company, the length and payment method and protection given to the
lender in the contract. As maturity of the loan is lengthened, its repayment potential
depends less upon present structure. Borrower cannot determine objectively how far he
is a good candidate for term loan. The following factors are considered of major
importance to lender.
1. Length of Business Experience
Length of the business experience counts a lot to determine the prospects of the lender.
A new firm is a poor candidate for a larger loan. One with long record of success is a
more logical outlet for term loan funds.

2. Size and Diversification
Size and diversification are important, as both may determine ability of reserves to
enterprises, which is very important in term lending.
3. Relative Efficiency and place at the firm in Industry
Certain industries are relatively stable but marginal firms in the industry are not
physical efficiency of company and its stability to withstand strains of competition
during poor business conditions make the firm with good prospects for such a loan.
4. Attitude of Management
Term lenders are aware that management quality is the prime determinant of the
strength of their loans. While nature of future changes is not known, the dynamic
character of the market ensures that firms will have to adapt to changes in order to
prosper. This adaptation is largely dependant upon ability of management to assess
change and its willingness to meet these changes by competitive action continuity of
management, control and definite plans of management succession are important in
term loan analysis.
7. Long term financial plans
Term loan is repaid over several years. It is important to lender as well as the borrower
to assess probable future financial needs. It is not logical for the lender to tie the
borrower upon a loan agreement that will prevent coverage of future needs.
9.4 ASSESSMENT OF TERM LOANS
Term loans are not intended to be repaid out of sales proceeds of fixed assets, which are
given as security for loan. Assessment of earning potential and generation of cash
surpluses to repay loan is the vital ingredient in appraisal of term loans. Approach for
assessment of term loan proposal has to be suitably oriented. The assessment of term
loan should take in to account the future trends of production and sales, estimates of
costs, volume and profits and their inter relationships, estimates of cash flow during the
term loan period etc. However, the sound term loan proposal to be acceptable should
satisfy the following requirements.
1. Technical Feasibility
Technical feasibility analysis of a project is an attempt to determine how well technical
requirements of the industry can· be met. Technical feasibility is the precondition for
setting up a project.

2. Management Feasibility
Appraisal of management is in fact the touchstone of term credit analysis. Strengths and
weaknesses of the management should be carefully analysed. Effective management can
offer make a weak project strong at the same time a weak management many may fail
strong project.
3. Economic and Financial Feasibility
Economic and financial feasibility affects the earnings capacity of the project. Financial
feasibility is the exercise of assessing the financial worthiness of the project proposal.
The most important aspect of term loan is the financial aspect. Every term lending
institution should thoroughly appraise the financial prospects of the project proposal
without which it is not possible to grant term loans. Term lending institutions while
appraisal of the project proposal for term loan must ensure that the estimated cost of
the project is reasonable and complete and has a fair chance of materializing,
comprehensive financial arrangement without any gaps, realistic estimate of costs and
earnings and the borrower's repaying capacity.
The lender after analyzing the strengths and weaknesses of the project should try to
make up for deficiencies by stipulating suitable terms and conditions like security,
period, rate of interest, personal guarantees, follow-up and supervision for term loan to
make them safe and also to infuse necessary discipline expected of project
implementation and operations.
Principles of Term-financing
There are two basic and broad principles for term financing, they are:
a) The broad goal, of finance, that is to benefit the common stockholders, and
b) While taking a long-term point of view in finance, corporate executives must place
and ever increasing emphasis on the subject of handling capital. Today, the finance
officer would certainly be inadequately equipped. He knows only how to raise money.
A new, broader concept has grown up over the years, which encompasses three parts:
i) Financing: How to raise money - "Financing" in its narrow sense.
ii) Investor relations: How to keep investors informed about the operations of a
company.
iii) Cost of capital: How much should be earned on plant, equipment and other assets in
order to adequately compensate the investors the basic goal for investment in new
projects. It can also be called profit planning and profit goal.

Term finance - Role of term lending institutions and commercial banks
Term lending institutions perform specialized functions. They provide medium and long
term credit required for creation of industrial capacity either by selling up of new units
or by expansion, or modernization or diversification of existing units. Commercial banks
on the other hand, mainly provide working capital credit for operating the units and
utilizing the capacity that has been created. Banks and term lending institutions thus
perform complementary roles but without systematic coordination. Commercial banks
also provide term loans for small amounts on their own and for larger amounts in
participation with term lending institutions. Over a period, the involvement of
commercial banks in term lending either in participation with term lending institutions
or otherwise has gradually increased thereby emphasizing the need for close coordination. The term lending institutions and commercial banks have established a
close rapport and coordination due to growing sickness and need for rehabilitation of
affected units. Commercial banks and term lending institutions have shared in
exchanging the securities.
Commercial banks can engage themselves in term loans only if they possess requisite
resources. Depending upon the banks overall position. Term finance should be within a
modest limit. Borrowers’ credit worthiness throughout credit period should be carefully
analysed while extending term loan. In addition to the size of paid up capital and
reserves in relation to total business, existing debt equity structure, balance between
current assets, and current liabilities extent of availability of refinancing or
rediscounting facilities or capacity for granting term loans should also be actively
considered in granting the term finance.
Financial institutions analyse a major part of their loans to new projects. For example,
ICICI plays a special role in the area as bulk of its finance goes to the new enterprises. In
fact term lending institutes have become a major source of finance for new enterprises.
Financial institutions emerged as leaders in term financing while banks playa
supplementary role.
However, there is a lot of scope for coordinating the functioning of term financing
agencies with commercial banks in order to make a better appraisal of borrowing needs
of industries as also to exchange information for ensuring efficient use of capital. In a
country like India, committed to rapid industrial development, availability of finance for
new ventures assumes crucial importance. A finance manager has to assemble funds
from numerous sources to meet financial requirement of the firm. A firm needs longterm funds to acquire fixed assets to ensure uninterrupted and smooth flow of business
activity. It requires short-term funds to cover day-to-day business needs. Frequently a
firm may need medium term capital for a period of three to five years for financing
aggressive advertising campaign and for complete overhauling of its machines and
equipments. Among these different kinds of capital requirements, capital needs for
acquiring fined assets are of considerable significance because tidy amount of funds has
to be arranged for a long period of time. A firm procures funds from external sources to
float new ventures and to expand existing ones. Thus, general investing public,
government and financial institution are approached frequently for this purpose. The

most popular media of acquiring funds from these sources are shares and debenture.
Considering varied notions and desires of numerous investors, the firm floats different
kinds of securities to acquire saving of investors. These securities therefore constitute
forms of raising long-term capital.
9.5 SOURCES OF LONG TERM FINANCING
The sources of long-term finance have found their outlet in various ways. Earlier, the
traditional source of finance was share capital including ordinary share capital and
preference share capital. Over a period of time preference share capital lost its shine and
later on the equity share capita too could not last long, which has given way partly to
public deposits and partly to debentures. Debentures as a source of long-term finance
surpassed the source of share-capital within no time.
In the democratic setup of the Indian economy, the government would not prefer to
declare any source of finance as illegal, since in the interest to the industrial economy of
the country, the corporate sector should be able to attract public response. In this
peculiar situation, long-term finances have to for the come in large proportions so as to
cope up with corporate expansion and diversification. The corporate sector has to
encourage non-traditional and even innovative sources of finance such as attracting
funds from the non-resident Indian leasing etc.
Various source of finance are depicted in chart No. 9.1

In the present capital market of India, different sources of long-term finance are
available to meet the corporate capital requirements. The various sources and
instruments of long-term finance are discussed below.
1. Share capital - Equity and preference capital

2. Borrowing - Debenture capital
3. Term loans
9.6 SHARE CAPITAL
Share capital is the universal and typical form of raising long-term capital from capital
market. Every company has a statutory right to issue shares to raise capital after
incorporating provisions in its capital clause of Memorandum of Association. Capital
acquired through flotation of shares is termed as "ownership capital".
The amount of capital that a company can potentially issue as per its memorandum
represents the authorized capital. The amount of offered by the company to the
investors is called the issued capital. The part of issued capital, which has been
subscribed to by the investors, represents the subscribed capital. The actual amount
paid up by the investors is called paid up capital- typically the subscribed and paid up
capital are the same.
Types of Share Capital
Shares are like commodity, which is sold by the company to acquire capital. Like all
other commodities, it should be made as attractive as possible so as to sell them quickly
at fairly good price. In capital market, there are investors with varying notions with
respect to income, control and risk. Venture a some investors will happily take greater
risk for the sake of higher income. Contrary to this, continuous investors have strong
desire to take investment promising low but certain income. In many instances,
investors invest money in a company in order to get the control regardless of earnings of
the company. Several classless of shares providing different combinations of three
elements income, risk and control - should, therefore, be issued to attract funds from
different types of investors. As per section 86 of the Indian companies act, a company
can issue only two kinds of shares, viz:
i) Common Equity shares and
ii) Preference shares
1. Common Equity Shares
Common Equity Share Capital is regarded as the cornerstone of financial structure of a
company without which a company cannot be founded. Equity capital represents
ownership capital, as equity shareholders collectively own the company. The common
shares resources of permanent capital since they do not have maturity date. The
shareholders are the legal owners of the company. They enjoy the rewards as well as
bear the risks of the ownership. However, their liability unlike the liability of the owner
in a proprietary firm and the partners in a partnership concern is limited to their capital
contributions.

Calculation of Value of Equity Share
The total paid up share capital is equal to the issue price of an equity share multiplied by
the number of equity shares. The issue price may include two components: the par value
and the share premium. The par value of an equity share is the value stated in the
memorandum and written on the share scrip. The par value of equity shares is generally
Rs. 10 or Rs. 100. Any amount in excess of the par value is called the share premium. An
existing company may sometime set its issue price higher than the par value. W, Merck
(India) Limited, for example, set its issue price at Rs. 13 per share as against the par
value of Rs. 10 per share. The company's earnings, which have not been distributed to
shareholders and have been retained in the business, are called reserves and surplus.
They belong to owners - equity shareholders. The book value of an equity share is equal
to paid up equity capital + reserves and surplus + Number of outstanding equity shares.
Quite naturally, the book value of an equity share tends to increase as the ratio of
reserves and surplus to paid up capital increases.
Characteristics of Equity Shares
Equity shares represent the owner's equity. The holders of equity shares are residual
owners who have unrestricted claim on income and assets and who posses all the voting
powers in the company. The following are' the most significant features of equity shares:
i) Maturity : Equity shares provide permanent capital to the company, which is not
under contractual obligation to refund it during its lifetime. Shareholders can demand
their capital only in the event of liquidation and that too when funds are left after
conveying all prior claims. Company can also not force the shareholders to sell back
their shares if they were fully paid up and shareholders were not engaged in business
competitive to the business of the company. Shareholders can, indeed, be persuaded to
sell their shares.
ii) Claims on Income : Equity shareholders are residual owners whose claims on
income arise only when claims of creditors and preferred stock owners are met. In many
instances, residual owners do not get anything if income of the firm was just sufficient to
satisfy the claims of creditors. Even if the company has sufficient income left after
meeting all obligations, equity shareholders cannot legally force the company to pay
dividends to them. The management has full right to utilize business income in
whatever manner it likes. In fact, there is no contractual agreement between the
company and residual owners with respect 0 payment of dividend at fixed rate. In actual
practice, amount of dividend payable to equity shareholders depends essentially on
earning position of the firm.
iii) Claim of Assets : Being residual owners, equity shareholders are the last
claimants to assets of the firm. In the event of winding up of the firm's business, assets
are disposed off to satisfy the claims of the creditors and also preferred shareholders
prior to equity shareholders. They are, however entitled to receive all left after meeting

the business obligations. Being last in the priority of claims, equity share holds capital
provides a cushion for creditors to absorb losses on liquidation.
iv) Control : The risk of loss associate with equity share is compensated to some extent
by controlling power that rests with residual owners. Equity shareholders have
unchallenged voice in management. Whatever control the shareholders retain is
exercised primarily through the voting privilege. Every equity shareholders has the right
to vote on every resolution placed before the company and his voting right on a poll is in
proportion to his share of the paid up capital of the company.
Sometimes, a shareholder who does not attend the meeting authorizes a person to act
and voter for him at a meeting. Although a company is managed by Board of Directors
who control and direct the affairs of the organization, supreme control is endowed with
equity shareholders.
v) Pre-emptive Right: Although equity shareholders have no legal recourse to compel
the company to distribute profit, they have been given power to maintain their
proportionate interest in the assets, earnings and control of the company and for that
purpose they have been given right to purchase additional issues of equity shares. The
company is under legal compulsion to offer new issue to the existing equity shareholder
before placing them in the market for public subscription. Such a right of the equity
shareholders to purchase newly issued equity stock is termed as "preemptive right" and
sale of equity stock to the existing stockholders as a matter of privilege is known as right
offering.
Evaluation from Firm's Point of View
As the most important source of long term financing, equity capital offers the following
advantages:
1. It represents permanents capital. Hence there is no liability for repayment.
2. It does not involve any fixed obligation for payment of dividends.
3. It enhances the credit worthiness of the company.
The disadvantages of raising funds by way of equity capital are:
1. The cost of equity capital is high. The rate of return expected by equity
shareholders is generally higher than the rate of return paid to other investors.
2. Equity dividends are payable from post tax earnings. They are not tax
deductible payments.
3. The underwriting commission, brokerage costs and other issue expenses are
high for equity capital.

4. Sale of equity stock to outsiders may result the dilution of control of existing
shareholders.
Evaluation from Shareholder's Point of View
The advantages of equity investment from the shareholders point of view are:
1. Equity shareholders enjoy the controlling power over the firm.
2. The liability of equity shareholders is limited to the extent of their capital
contribution.
3. The rewards of equity capital, representing the ownership interest, can be very
high.
4. Equity dividends are accorded preferential tax treatment.
The disadvantages of equity investment from the shareholders point of view are:
1. Though equity shareholders enjoy the controlling power over the firm in theory,
the real control exercised by them is often weak because they are usually scattered
and ill organized.
2. Equity shareholders cannot contest the dividend decision of the board of
directors.
3. Equity shareholders have a residual claim to income as well as assets they enjoy
the lowest priority.
4. Equity stock prices tend to fluctuate rather widely, making equity investment
risky.
2. Preference Shares
As the name implies, preference shares represent that part of share capital of a
company, which carry preferential rights and privileges with respect to income and
assets over equity stock. Preference capital represents a hybrid form of financing it has
some characteristics of equity and some attributes of debentures.
i) It resembles equity in the following ways:
·
·

Preference dividend is payable only out of distributable profits.
Preference dividend is not a tax-deductible payment.

ii) Preference capital is similar to debentures in several ways:
·

The dividend rate on preference shares is usually fixed

·
·

The claim of preference shareholders is prior to the claim of equity shareholders,
Preference shareholders do not normally enjoy the right to vote.

Features of Preference Shares
The features attached to preference shares may vary along the following dimensions:
1. Fixed Dividend
The dividend rate is fixed in the case of preference shares, and preference dividends are
not tax deductible. The preference dividend rate is expressed as a percentage of the par
value. Preference share is called fixed income security because it provides a constant
income to investors. The payment of preference dividend is not a legal obligation
usually; a profitable company will honor its commitment of paying preference dividend.
2. Cumulating of Dividends
Preference shares may be cumulative or non cumulative with respect to dividends.
Barring a few exceptions, preference shares in India carry a cumulative feature with
respect to dividend is resumed. For example, if the dividend payment on a 15%
cumulative preferred share is skipped for 3 years, a dividend arrear of 45% is payable. It
may be noted that a company cannot declare equity dividends unless preference
dividends are paid with arrears.
3. Call Feature
The terms of preference share issue may contain a call feature by which the issuing
company enjoys the right to call the preference share, wholly or partly at a certain price.
The call price may decrease with the passage of time.
4. Convertibility
Preference shares may be convertible or non-convertible into equity shares. The holders
of convertible preference shares enjoy the option converting preference shares into
equity shares at a certain ratio during a specified period. For example, the preference
shareholders may enjoy the option of converting preference shares into equity shares in
the ratio of 1:5 after 2 years for a period of 3 months.
5. Redeemability
Preference shares may be perpetual or redeemable. A perpetual preference share has no
maturity period, whereas a redeemable preference share has a limited life after which it
is supposed to be retired in accordance with the promise of the company even where a
definite redemption time is specified.
6. Participation in surplus profits and Assets

Companies may issue participating preference shares, which entitle preference
shareholders to participate in surplus profits every year and residual assets in the event
of liquidation.
For example, a preference share issue may carry the following participation feature:
i) It is entitled to an extra dividend equal to 20% of the equity dividend in excess of
12%.
ii) It is entitled in the event of liquidation, to 10% of the assets left after meeting all
claims excepting that of equity shareholders.
Evaluation from Firm's Point of View
There are some advantages in issuing preference capital from the company's point of
view:
1. There is no legal obligation to pay preference dividend. A company does not face
bankruptcy or legal action if it skips preference dividend.
2. There is no redemption liability in the case of perpetual preference shares.
3. Preference capital is generally regarded as a part of net worth. Hence, it
enhances the credit worthiness of the firm.
4. Preference shares do not, under normal circumstances, carry the voting right.
Hence there is no dilution of control.
5. No collateral is pledged in favor of preference shareholders. Hence, the
mortgage able assets of the firm are conserved.
Preference capital, however suffers from some serious shortcomings:
1. Compared to debt capital, it is a very expensive source of financing because the
dividend paid to preference shareholders is not, unlike debt interest, a taxdeductible expense.
2. Though there is no legal obligation to pay preference dividend, skipping them
can adversely affect the image of the firm in the capital market.
Evaluation from Shareholder's Point of View
Investor may find some attraction in preference capital because
1. It earns a stable dividend rate.

2. For a corporate investor, preference dividend income is to extent of the dividend paid
out.
The disadvantages of preference shares seem to be considerable:
1. Preference shareholders are vulnerable to arbitrary managerial actions. They cannot
legally enforce their right to dividend or even their right to repayment in case of
redeemable preference shares.
2. Preference dividend rate is rather modest.
3. Price fluctuations of preference shares are greater than the price fluctuations of
debentures.
9.7 DEBENTURES
Debentures are one of the frequently used methods by which a business can procure
long-term funds for its initial financial needs or for its sequent requirements of growth
and modernization. Funds acquired by means of debenture represent debt and its
holders are the company's creditors:
In common parlance, debenture is merely a written instrument signed by the company
under its common seal, acknowledging the debt due by it to its holders. Through this
instrument the company promises to pay a specific amount of money as stated therein
at a fixed date in future together with periodic payment of interest to compensate the
holders for the use of the funds. Since debenture is a long term promissory note and
lenders have great stake, long term agreement is entered into between the company and
creditors and a deed is executed to set term of borrowing. Such a deed is known 'as
indenture or 'trust deed'.
Characteristics of Debentures
Certain distinguishing features of debenture as a form of security are mentioned below:
1. Trustee
When a debenture issue is sold to the investing public a trustee is appointed through a
deed. The trustee is usually a bank or an insurance company or a reputable firm of
attorneys. Entrusted with the role of protecting the interest of debenture holders the
trustee is responsible to encsure that the borrowing firm fulfills its contractual
obligations.
2. Convertibility
A company may issue debentures, which are convertible into equity shares at the option
of the debenture holders. The ratio of conversion and the period during which

conversion can be effected are specified at the item of debenture issue. More commonly,
the debentures are compulsorily convertible in to equity shares.
3. Security
Often debentures are secured by a charge on the immovable properties, both present
and future, of the company by way of an equitable mortgage. Debentures not protected
by any security are called unsecured or naked debentures.
4. Call feature
Debenture issues sometimes carry a call feature, which provides issuing company the
option to redeem debentures at a certain price before the maturity date. Often the call
privilege is exercisable after a lapse of sometime after the issue. The call price may
exceed the par value by 5%.
5. Redemption
Debentures are usually redeemable - perpetual debentures are very rare. The
redemption talked place in a pre specified manner. Typically it occurs between the 7th
year and 10th year at a 5% premium.
6. Interest Rate
The interest rate on a debenture is fined and known. It is called the contractual or
coupon rate of interest. It indicates the percentage of the par value of the debenture that
will be paid out annually in the form of interest. Thus regardless of what happens to the
market price of a debenture with 15% coupon interest rate, and a Rs.100 par value, it
will payout Rs. 150 annually in interest until maturity Payment of interest is legally
binding on a company. Debenture interest is tax deductible for computing company's
corporate tax.
Evaluation from Company's Point of View
Debentures offer the following advantages to the issuing company:
1. The specific cost of debt capital, represented by debentures, is low than the cost
of preference or equity capital. This is because the interest on debentures is tax
deductible and hence the effective cost of debentures is lower.
2. Debenture financing does not result to dilution of control since debenture
holders are not entitled to vote.
3. The fixed monetary burden associated with debenture financing irrespective of
changes in price level, has appeal to many companies.
The disadvantages of debenture financing are:

1. The debenture interest and capital repayment are obligatory payments.
2. Debenture financing enhances the financial risk associated with the firm. This
may increase the cost of equity capital.
Evaluation from Shareholder's Point of View
Debenture investment looks attractive to investors for the following reasons:
1. It earns a stable rate of return.
2. It enjoys a high under of priority in the event of liquidation.
3. It is protected by various provisions of the debenture trust deed.
4. I generally have a fixed maturity period.
Debenture investment however has the following disadvantages:
1. The interest on debentures is fully tenable.
2. Debenture prices are vulnerable to increase in interest rates.
3. Debentures do not carry the right to vote.

9.8. TERM LOANS
Term loan, also referred to as term finance, represents a source of debt finance which is
generally repayable in more than one year but less than 10 years. They are employed to
finance acquisition of fixed assets "and working capital margin. Term loans differ from
short-term bank loans, which are employed to finance short-term working capital needs
and termed to be, self-liquidating over a period of time, usually less than one year.
The following features of term loans may be discussed.
1. Security
Term loans are always secured. Specifically the assets acquired using term loan funds
secure them. This is called primary security. Term loans are also generally secured by
the company's current and future assets. This is called secondary or collateral security.
Also, the lender may create either fixed or floating charge against the firm's assets. Fixed
charges mean mortgage of specific assets. For creating a fixed charge, the firm has to
pay a heavy stamp duty, which may be equal to 2 ½ % of the amount of loan. Floating
charge is a general mortgage converting all assets. In this case, stamp duty is monthly

WYO. Floating charge provides the firm with relative flexibility as it can deal with its
assets in the normal course of business without obtaining lender's approval.
2. Interest Payment and Principle Repayment
The interest on tem loan is a statutory obligation that is payable irrespective of the
financial situation of the firm. To the general category of borrows, financial institutions
presently charge an interest rate of 18.5 to 20% whereas commercial bank charge an
interest rate on around 20%. A confessional rate, which is usually lower than the normal
rate, is charged to units located in backward areas and other units that may be accorded
preferential treatment. Lending institutions used to offer and interest rebate of 1 to 1.5%
to include prompt payment. Of late, financial institutional e imposing a penalty for
defaults. In case of default of payment of installments of principal or interest the
borrower is liable to pay by way of liquidated damages additional interest calculated at
the rate of 2% p.a. for the period of default on the amount of principal or interest in
default. In addition to interest, lending institutions levy a commitment fee on the
unutilized loan amount.
The principal amount of term loan is generally repayable over a period of 6 to 8 years
after an initial grace of 1 to 2 years. Typically term loans provided by financial
institutions are repayable in equal semi. annual installments, whereas term longs
granted by commercial banks is repayable in equal quarterly installments.
It may be noted that the interest burden declines over times, whereas the principal
repayment remains constant. This means that the total debt-servicing burden declined
over time. This pattern of debt servicing burden, typical in India, differs from the
pattern obtained in western economies where debt is amortized in equal periodic
installments. The latter, pattern is relatively more acceptable to borrowers because it
does not result in a heavy debt-servicing burden in earlier years. The World Bank has
also recommended it. Presently financial institutions in India, however, do not follow
the scheme for equal periodic amortisation, yet they try to ensure, by suitably modifying
the debt repayment schedule within limits, that the debt servicing burden is not
excessive.
Restrictive Covenants
In addition to the asset security, lender would like to protect itself further. Therefore,
Financial Institution (FIs) and a number of restrictive covenants. A financially weak
firm attracts stringent terms of loan from lenders. The borrowing firm has generally to
keep the lender informed by furnishing financial statements and other information
periodically. The restrictive covenants may be categorized as follows.
a) Asset - Related Covenants
Lender would like the firms to maintain its minimum asset base. Therefore, restrictions
may include to maintain minimum working capital position in terms of a minimum

current ratio and not to sell fixed assets without the lender's approval. The firm may also
be required to refrain from creating any additional charge on its assets.
b) Liability - Related Covenants
The firm may be restrained firm incurring additional debt or repay existing loan. It may
be allowed to do so with the concurrence of the lender. The firm may also be required to
reduce its debt equity ratio by issuing additional equity and preference capital. The
freedom of promoters to dispose of their shareholdings may also be limited.
a) Cash flow - Related Covenants
Lenders may restrain the firm's cash outflow by restricting cash dividends, capital
expenditures, salaries and perks of managerial staff etc.
d) Control - Related Covenants
Lenders expect that the firm's management will be competent enough to manage its
operations. They may therefore e provide for the effective organizational set up and
appointment of suitable staff and the board of directors. One special feature of term
loans in this regard is the provision for the appointment of nominee director by FIs.
Evaluation from Company's Point of View
Term loans offer the following advantages to the borrower.
a) In post-tax terms, the cost of term loans is lower than the cost of equity capital
or preference capital.
b) Term loans do not result in dilution of control; lenders do not have the right to
vote.
The disadvantages of term loans from the borrower's point of view are as follows:
a) The interest and principal repayment are obligatory payments. Failure to meet
these payments may threaten the existence of the firm.
b) Term loan contracts carry restrictive covenants, which may reduce managerial
freedom. Further, they entitle the lender to put their nominee on the board of the
borrowing company.
c) Term loans increase the financial risk of the firm. This is turn, tends to raise the
cost of equity capital.
Evaluation from Lender's Point of View
Term loans appear attractive to the lender for the following reasons:

a) Term loans can have a definite maturity period.
b) Term loans represent secured lending.
c) Term loans carry several restrictive covenants to protect the interest of the
lender.
The disadvantages to the lender of the term loan are as follows:
a) Term loans do not carry the right to vote.
b) Term loans are to represent by negotiable securities.
New institutional are ushered in with further ambitious objectives. New institutions are
setup to provide inclusive attention to develop certain specified sector e.g. EXIM Bank
and NABARD. There is also need for an exclusive institution in India to develop the
capital market. It is necessary that the financing institutions take a thorough study of
the projects seeking their assistance. Unless financing institutions strengthen their
project lending activities, there is every possibility that marginal units will continue to
be setup in India. Such units cannot generate enough surpluses to be competitive in the
modern setup. Unless efforts are made to nurture healthy corporate sector units in
India, the public confidence in the issues of corporate sector units cannot be revived.
There is a great need for upgrading the performance of corporate units. Many corporate
units have not even been able to meet their debt obligation, let alone declaring any
dividends. The mushroom growth of corporate sector units, on the one hand and the
poor performance of many such units, on the other, cannot develop confidence in the
minds of the household investors. The Indian experience has shown in unmistakable
terms that profitably and well managed companies have found no difficulty in raising
funds in the open market.
9.9 SUMMARY
Share Capital has its own advantage and disadvantage. The corporate view Equity
Capital is the best capital for short-term purpose debenture is the best source of longterm finance. These are many types of debenture is available in the market. Each has its
merits and demerits. The opinion about share and debenture will may from corporate to
corporate.
9.10 REVIEW QUESTIONS
1. Compare Equity Capital with term loans and suggest which can be opted.
2. Discuss the Cardinal Features of debentures as a means of financing and evaluate the
potentiality of debentures as source of raising long term capital.
9.11 ASSIGNEMENT QUESTIONS

1. Critically evaluate the best source of long term finance in corporate point of view.
2. Examine the merits and demerits of Debenture Capital
3. Discuss the important features term loans in India
9.12 KEYWORDS
Equity Share, Preference Share, Debenture, Term Loan pre-captive Right

- End of Chapter LESSON - 10
MUTUAL FUNDS

OBJECTIVES
·
·

The know the origin and growth of mutual funds
To know the present condition of mutual funds

STRUCTURE
10.1 Introduction
10.2 Origin and growth of Mutual Funds
10.3 Factors responsible for the growth of Mutual Funds
10.4 Growth of Mutual Fund operations in India
10.5 Prospect and problems of Mutual Funds in India
10.6 Summary
10.7 Review Questions
10.8 Assignment Questions
10.9 Keywords

10.1 INTRODUCTION
Banking and non-banking institutions are offering wide range of financial services in
India by diversifying their activities to attract large number of customers. Mutual funds
emerged as one of such dynamic financial services offered by public sector, private
sector and non-banking institutions in recent times.
Mutual fund provides a new concept on the Indian investment scene. Mutual funds have
succeeded in the USA. It is necessary get an understanding of their nature, significance
and potential in our country.
Mutual fund is basically an institutional arrangement for resource mobilization from the
small investors. Mutual fund is a fund contributed by public for the purpose of collective
investment in capital market in the listed securities of the companies paying high
returns. These funds offer the individual saving advantages of reasonable dividends,
capital appreciation, coupled with safety and liquidity by investing them in various
securities after careful analysis of financial reports.
A mutual fund combines the capital of many investors with employment of an
experienced agent in purchasing securities of various companies, thereby providing
diversification and supervision, which the investors may not be in opposition to afford
individually.
10.2 ORIGIN AND GROWTH OF MUTUAL FUNDS
Mutual funds are very much popular in USA with large number of investors
participating in that. It is also equally popular in UK where the mutual fund is referred
to as an "Investment Trust". Such mutual funds are the most popular forms for small
investors in developed countries since last 20 to 25 years. However, this concept in
India is still in an infant stage but growing very fast due to the help and support
provided by the Government especially by way of offering benefits to the investors from
income tax, risk and return points of view.
The suitability of mutual funds for investors in India has been legitimized by the union
government by amending the Banking Regulations Act, Reserve Bank of India by issuing
its guidelines, tax advantages on income from mutual funds under section 80 of the
Income Tax Act 1961.
Mutual funds have taken many turns and now the profile of this financial institution is
assuming new shape. With the renaissance of mutual funds, a change is taking place in
the composition of investors. The traditional investors, who used to invest in mutual
funds, keeping in view the college education for children and retirement age, are giving
way to younger generation with shorter time horizon and greater expectations. While
expectations are increasing, the industry is working with old software. The six mutual
funds of USA, which recorded high growth rated in 1983, provide some glimpse in to
working of successful mutual funds.

The realization that no single investment pattern could meet all the financial needs of
investors has led the mutual funds to develop. During eighties, the mutual fund business
experiences a big change. Investor emphasis on yield and relative safety moved mutual
funds in the direction of income oriented portfolio as against growth oriented
investment. The industry introduced money funds, municipal bond funds and bond
funds.
10.3 FACTORS RESPONSIBLE FOR THE GROWTH OF MUTUAL FUNDS
Mutual funds have gained popularity over the years all over the country. The impetus to
the growth and popularity has basically come from the following factors:
1. Lack of Knowledge and Awareness of Capital Market
The individual investor with lack of risk- bearing capacity and because of unsure capital
market behaviors was both keen on investing any substantial amount directly in the
share market instruments. But now the public sector financial institutions such as UTI,
LIC, SBI, Canara Bank, Indian Bank, Punjab National Bank and many other private
sector asset management companies with their expertise and professional manpower
are rendering excellent financial services by investing the funds so collected in profitable
securities on behalf of the investors.
2. Better Yield
Banks were earlier unable to tap the capital market for funds or to invest their deposits
in the capital market. Banks working under RBI guidelines could not provide growth
with better yield to the investing public and were losing out in the competition. But by
adopting innovative, new market instruments, these banks are offering better yields
compared to savings and interest on fixed deposits.
3. Wide Variety of Investment Opportunities
The main advantage of this mutual fund facility is that it brings a variety of securities
within the reach of the common and small investors. It confers the further advantage of
free liquidity at any time when an investor wants to dispose of his holdings.
In the public sector, UTI, which was established in 1964, is in close association with
mutual fund, which is in private sector. The performance of UTI was not very impressive
in its initial years but it has improved steadily and substantially in the recent past.
During 1963 and 1984, there has been a new surge of enthusiasm about mutual funds.
Most of the mutual funds are entered in Western and Southern India. The efforts of big
business houses like TATAS, Birlas and Reliance to tap the Non-Resident India funds
indicate anew dynamism to take advantage of the available opportunities. The progress
achieved by the mutual funds show that they are still in their infant stage but promises
to grow at a fast rate.
4. Mutual Fund Operations

The institutions with the help of their expert knowledge, professional approach, and rich
experience in stock exchange operations, invest and disinvest the funds on daily basis so
as to get maximum returns as well as higher capital appreciation. Nowadays, the mutual
funds have very important links with the stock market and help the same to remain in
always a healthy state. If there is a recession period in stock exchange, mutual funds will
come forward to make bulk purchases resulting in a break in the price fall trend. On the
other hand in boom situation, mutual funds help to a bike in share prices. So the
operations of mutual funds on day-to-day basis play extremely an important role in
stock exchange functioning.
Mutual funds can have a diversified portfolio management by investing it in different
companies. Therefore the risk definitely spreads over to number of scripts instead of
concentrating on an individual. Mutual funds can underwrite new issues of share and
thereby can earn an additional income by way of underwriting commission. In addition,
mutual funds are authorized to issue rights as well as bonus shares to their
shareholders.
The healthy competition among various mutual funds generates more and more tangible
and intangible benefits to the small investors. Every recent scheme of mutual funds
launched with new but unique features attracting more and more investors and thus
imparting more and more benefits to the investors.
10.4 GROWTH OF MUTUAL FUND OPERATIONS IN INDIA
Public Sector
Though the importance of mutual funds is well recognised, yet it took nearly three
decades to reach the present stage. UTI was the pioneering institution to launch the
mutual fund scheme in 1963. From them onwards UTI has launched number of schemes
to suit the obligations of different small and medium investors. The endeavor of the UTI
got tremendous pace with the government awarding tax concessions on investment in
mutual funds. For a quite long time, UTI remained as the only institution dealing with
the mutual fund operations.
Thereafter some of the public sector commercial banks with their expertise in the field
of merchant banking and resource mobilization successfully participated in the mutual
funds. The State Bank of India, Canara Bank, Bank of India, Indian Bank, and Punjab
National Bank are the principal trustees of the mutual funds floated by the banks. All
schemes are serving the investors in tax saving, insurance coverage, capital
appreciation, regular income etc.
When the performance of mutual funds in India is considered, one can fund that in the
seventies on an average just Rs. 90 crores from the new issue of capital which
substantially raised to Rs. 6000 crores in 1989-90 and to Rs. 10000 crores in 1992-93.
The number of shareholders has risen from about 10 lakhs in 1979-80 to about 1.2
crores in 1989-90. Excellent financial services and corporate results have attributed to
the upward trend in mutual funds in India.

As far as individual institutions are concerned, Indian Bank mutual funds stood first
interims of capital appreciation and distributing dividends. But, can bank mutual funds
occupy the top position in term of number of schemes and amounts mobilization. The
performance of State Bank of India Mutual funds is also quite impressive.
Non Banking Fund Companies
In addition to the public sector banking institutions, non-banking institutions like the
UTI, LIC, and GIC are also serving the customers in the way of mutual funds. UTI
introduced some individual oriented and close ended schemes viz., Deferred Income
Unit Scheme 90 (DIUS - 90), Unit growth scheme 200 (UGS - 2000), Master Equity
Plan - 91 (MEP) etc. Manager gain scheme launched by UTI has set a record by floating
Rs. 4500 crores. During 1991-92, another 11,249 agents were appointed taking the total
number of agents to 65,506 to mobilize the funds from 10 million investors. LIC has also
launched different schemes.
The overall performance of mutual fund business is not satisfactory during the recent
times. The performance of various schemes offered by different mutual fund companies
showed a negative result. The declining trend of stock market after stock scam may be
one of the reasons for this.
Private and Joint Sectors
In India, till sometime back, all the mutual funds are operated by public sector banks
and financial institutions. The presence of nearly hundred mutual funds has showed
some encouraging sign buy this is not up to the mark when compared to Britain, where
there are more than thousand mutual funds.
The reasons for the slow growth of mutual funds in India is that the, mutual fund
operation is the monopoly of the public sector, in India.
Guidelines were issued to setup mutual funds in the private and joint sectors on 14th
February 1992 in the budget speech of 1991-92. According to these guidelines, mutual
funds are to be established in the form of trust under Indian Trust Act and are to be
operated by separate Asset management Company (AMC). The intention was to end the
monopoly of public sector in this critical area of the country’s financial sector and let the
private and joint sector assume a role.
About 100 mutual fund companies were set up in private and joint sectors. They include
the well-known groups like Tata, Birlas, Reliance capital Trust, Bajaj Auto infrastructure
leasing and Finance, Apple industry, Fair Growth Financial service, Citi Bank and Hong
Kong Bank etc. Birlas are engaged in non-resident investment. They launched a mutual
fund company in collaboration with Warburgs, a leading merchant bank of London. The
offshore funds raised from overseas Indians would be utilized for investment in shares
of Indian companies and eventually in ventures for setting up new projects particularly
those involving high technology.

The emergence of private sector mutual funds along with the existing public sector
mutual funds and the comprehensive guidelines framed by SEBI, which apply to both
the mutual funds, the investor henceforth will have a wider choice of services arising
from greater competition. SEBI is more cautious towards the mutual funds as there is
prima facie evidence for involvement of mutual funds in the recent stock scam. SEBI
may impose some more rigorous conditions for mutual funds both public and private.
10.5 PROSPECTS AND PROBLEMS OF MUTUAL FUNDS IN INDIA
Mutual funds business in India has got it momentum in the recent past despite its
origin in 1963. There are bright prospects in future for this business in India. Multifold
reasons may be attributed for this. India is one of the largest markets for mutual funds
and money management, outside the USA. Mutual funds develop an equity cult in
mullions of Indians and this number hails from those small towns and villages, which
are hitherto untouched and untapped in capital formation. Due to the effect of new
economic policy, more and more organizations are coming to the arena of mutual funds,
which create a competition among them, and thereby the investor is ensured more
efficient service by way of efficient use of funds and better return to the investor.
In spite of the above multifold financial benefits of the mutual funds, yet the small
investor has to keep in mind some important issues:
1. The efficiency of the professionals on which the investor is basing, if proved to be
inefficient and unproductive, funds would be blocked in adverse directions and as a
result, the investor will be the worst sufferer.
2. The benefit of managing diversified portfolio can be advantageous. However, exactly
reverse to this, i.e. while managing portfolio, the disadvantage of concentration on
investing in securities of few companies only, cannot be over looked.
3. Since the top authorities in mutual funds are in constant touch with their
counterparts in different companies, biased and prejudiced decisions of investment in
certain companies may to be avoided.
4. The depth and coverage of these funds have' been inadequate when compared to the
level of market operations and the rapidly growing size of the investing public.
5. The SEBI treated as a protector to the investors, has no power to take any direct
action on the companies, which violate the rules and guidelines.
The managers of the mutual funds have to accept the challenge to analyse the needs and
investment preference of the investors can devise schemes to suit their needs. The
government must also be cautions against the mushroom growth of mutual funds. It
should not allow unhealthy and unregulated growth like the leasing companies; it is the
duty of the government that mutual funds do not degenerate in the hands of
unscrupulous persons.

10.6 SUMMARY
During the year 1994-95, on an overall basis, all mutual fund schemes taken together
have registered an average growth of 3.89% over the previous year for all schemes.
It has now been accepted that mutual funds are the most convenient vehicles of
investment for small investors and going by the experience of developed countries, they
will be the most fancied instruments in India as well.
10.7 REVIEW QUESTIONS
1. Discuss the performance and progress of mutual funds in India
2. Identify the prospects and problems of mutual funds in India
10.8 ASSIGNMENT QUESTIONS
1. Explain the role of private mutual funds
2. State the factors responsible for growth of mutual funds
10.9 KEYWORDS
Mutual funds, Better yield, Non-banking fund companies.

- End of Chapter LESSON - 11
FINANCING OF LARGE SCALE INDUSTRIES

OBJECTIVES
The objectives of the lesson are:
• To analyse the purpose of financing large-scale industries
• To explain objectives, role and functioning of national level financial institutions like
IFCI, ICICI to financing the large-scale industries
• To describe the significance, role and functioning of development institutions like
IDBI, UTI, LIC and GIC in the financing of large-scale industries.

STRUCTURE
11.1 Introduction
11.2 Public sector Financial Institutions
11.3 IFCI
11.4 ICICI
11.5 IDBI
11.6 IRBI
11.7 UTI
11.8 LIC
11.9 Underwriting
11.10 Summary
11.11 Review Questions
11.12 Assignment Questions
11.13 Keywords
11.1 INTRODUCTION
The large-scale industries need funds for two purposes. First of all they require funds for
meeting block or fixed capital expenditure, that is, for the purpose of buying plant and
machinery, for the construction of factory and for extension and replacements. Secondly
they require funds for meeting working capital needs, as for instance, the purchase of
raw materials and stores, to meet production and marketing expenses and for meeting
their current expenses. Block capital or fixed capital required by an industry is generally
raised through the issue of shares and debentures to the general public. To a small
extent, a concern may depend upon the system of public deposits and plugging back of
profits also. In recent years, loans from the industrial finance corporations are becoming
important. We have already discussed about the issue of share capital, debentures,
public deposits etc, in the previous lessons. Let us now describe briefly about the origin
and performance of various financial institutions in India providing funds to large-scale
industries and also the functions and performance of some non-banking financial units.
Financial institutions operating in capital market are satisfying the long-term financial
needs of the large-scale industries. Financial institutions are the financial intermediaries
concerned with mobilizing resources from different sections of society for their

channelization in productive outlets. They pool the savings of myriad of people peculiar
characteristics and notions by means of different savings media offering various degrees
of the mix of liquidity, return and safety of the savings. These pooled savings are used by
them to cater to the needs of business enterprises. Financial institutions, while
themselves raising resources from a large number of small savers, make funds available
to business concerns in relatively bigger lots, and thus reduce their burden and
botheration involved in raising resources directly from individual powers. In this way,
financial institutions act as conducts through which scattered savings are first collected
and then invested in business firms. That is why financial institutions are regarded as
"gap fillers". In India a battery of financial institutions are operating in capital market,
and engaged directly and indirectly in the task of rendering financial assistance to need
enterprises.
11.2 PUBLIC SECTOR FINANCIAL INSTITUTIONS
Since the sources of industrial finance we have discussed earlier (shares, debentures
etc,) funds by the industrial sector at the time of independence, the government of India
set up in 1948, the Industrial Finance Corporation of India (IFCI). The Government
followed it up by setting up a series of other credit and investment corporations to
finance the medium and large industrial units: ICICI in 1955, IDBI in 1964, UTI in 1964,
IRBI in 1971, Exim Bank in 1982 and so on. At the state level, the State Financial
Corporations SFCS and the State Industrial Development Corporations (SIDCs) were set
up. All these institutions have come to be known as Public Sector financial Institutions
or term lending institutions. The Narasimhan Committee has called them Development
Finance Institutions (DFIs).
11.3 INDUSTRIAL FINANCE CORPORATION OF INDIA (IFCI)
With the end of the Second World War, the urge to speedier industrial extensions was
great. At the same time, there is also a great need for modernization and replacement of
obsolete machinery in already established industries. The usual agencies meant to
provide finance for large scale industries were either apathetic or were found inadequate
and hence the Government of India came forward and set up the Industrial Finance
Corporation of India (IFCI) in July 1948 under a special Act. The Union Government
has guaranteed the repayment of Capital and the payment of a minimum annual
dividend. The corporation is authorized to issue bonds and debentures in the open
market, to borrow foreign currency from the World Bank and other organisations,
accept deposits from the public and also borrow from the RBI.
Functions of IFCI
The corporation is expected to perform three important functions:
1. In the first phase it grants loans and advances to industrial concerns and subscribes to
the debenture floated by them.
2. Secondly, it guarantees loans raised by the industrial concerns in the capital market.

3. Thirdly, it underwrites the issue of stocks, shares, bonds and debentures of industrial
concerns provided such stocks, shares etc. are disposed of by the corporation within a
period of seven years from the time of acquisition. It also subscribes to the equity and
preference share and debentures of companies.
The corporation is authorized to give long and medium term finance only to companies
engaged in manufacturing, mining, shipping and generation and distribution of
electricity. The limit of assistance to any single concern is now Rs. 1 crore (earlier it was
Rs. 50 lakhs) and under certain circumstances, this can be exceeded with the permission
of the government. The period of loans is not to exceed 25 years.
Before granting loans to any industrial concern applying for financial add, the
corporation scrutinizes the application carefully and the following points are evaluated.
a) The importance of the industry to the national economy
b) The feasibility and the cost of the scheme for which aid is required
c) The competence of the management
d) The nature of the security offered
e) The adequacy of the supply of technical personnel, raw materials.
While lending, the corporation requires the security of fixed assets such as land,
buildings, plant and machinery, and it does not normally lend against raw materials or
finished products. It has also the right to appoint two directors to the board of
management of the borrowing concern in order to ensure interest of the corporation.
Working at the IFCI
During the last 43 years, the monetary situation was characterized by scarcity of funds
relative to their demand for finance from trade, commerce and industry, particularly as
regards long-term investment. The total financial assistance sanctioned by IFCI since its
inception in 1948 up to March 1992 aggregated to Rs.14,300 crores. Among the many
industries, which have received financial assistance from IFCI are those, which are of
high national priority such as fertilizers, cement power generation, paper, industrial
machinery etc.
In recent years, IFCI has started new promotional scheme such as:
a) Interest subsidy scheme for women entrepreneurs
b) Consultancy fee subsidy schemes the providing marketing assistance to small-scale
units.
c) Encouraging modernization of tiny, small-scale units.

d) Control of pollution in the small and medium scale units.
IFCI is also diversifying its activities in the field of merchant banking to encompass
other financial services, particularly project counseling, syndication of loans,
formulation of rehabilitation programmers, etc. Up to the end of March 1991, the
Merchant Banking department of IFCI has helped to mobilize funds of the order of
Rs.1390 crores through public issues.
Finally, we should refer to the growing concern of IFCI in the development of backward
districts in the country. In recent years, nearly 50% of IFCI assistance flowed to projects
located in backward districts.
Criticism of the Working of the IFCI
Initially, the working of the Industrial Finance Corporation came in for a large measure
of criticism at the hands of politicians and businessmen. In the first place, the rate of
interest that the corporation charged was extremely high viz. 11% with the rebate of half
percent for regular payment of installments. But the corporation's rate can be compared
favorably with the prevailing rate on debentures.
Secondly, there was great delay in sanctioning loans and in making the amount of the
loans available.
Thirdly, the corporation's insistence on the personal guarantee-managing agents in
addition to the mortgage of property was considered wrong.
Finally, the corporation had unnecessarily shown too much interest in giving loans to
sugar mills and cotton textile factories.
It may be mentioned that some of the criticisms were well founded but it should not be
forgotten that the corporation had been making steady progress in the last two decades.
It has entered into new lines of activity, viz. underwriting debentures and shares and
guaranteeing of deferred payments in respect of imports from abroad of plant and
equipment by industrial concerns and subscribing to stocks and shares of industrial
concerns directly. Thus, though the corporation has not achieved anything spectacular,
its performance has been creditable enough. Besides, the performance of IFCI, together
with the work of other public sector financial institutions, has been extremely credit
worthy in the last two decades.
11.4 INDUSTRIAL CREDIT AND INVESTMENT CORPORATION OF INDIA
(ICICI)
The Industrial Credit and Investment Corporation was sponsored by admission from the
World Bank for the purpose of developing small and medium industrial in the private
sector. It was registered in January 1955 under the Indian Companies Act with an
authorized capital of Rs. 22 crores. Its issued capital has been subscribed by Indian

banks, insurance companies and individuals and corporations of the United States, the
British eastern exchange banks and other companies and the general public in India.
The aim of ICICI is to stimulate the promotion of new industries, to assist the expansion
and modernization of existing industries and to furnish technical and managerial aid so
as to increase production and afford employment opportunities.
The corporation grants:
a) Long term or medium term loans, both rupee loans and foreign currency loans.
b) Participants in equity capital and the debentures and underwrites new issues of
shares and debentures.
c) Guarantees loans from other private investment sources
d) Apart from the above direct assistance, ICICI provides financial services such as
deferred credit leasing credit, installment sale, asset credit and venture capital.
ICICI has so far assisted industries manufacturing paper, chemicals, and
pharmaceuticals, electrical equipment, textile sugar, metal ore, lime and cement works,
glass manufacture etc. The total financial assistance sanctioned by the corporation since
its inception in 1955 up to March 1992 amounted to Rs. 21,130 crores while its
disbursements amounted to Rs.12,950 crores. This assistance comprised of foreign
currency loans, rupee loans, guarantees and subscription of shares and debentures.
In recent years, the corporation has shown increasing interest in the development of
new industries in backward regions. During 1990-91, the corporation has sanctioned
loans worth Rs. 1,270 crores to backward areas. The ICICI is also participating in the
soft loan schemes.
The corporation assists industrial concerns with loans and guarantees for loans either in
rupees or in any foreign currency. Besides, it underwrites ordinary and preference
shares and debentures and it also subscribes directly to ordinary and preference shares
issues. A significant function performed by the corporation is the provision of foreign
currency loans and advances to enable Indian industrial concerns to secure essential
capital goods from foreign countries.
ICICI commenced leasing operation in 1983. It provides leasing assistances for
computerization, moderation replacement of equipment, energy conservation, export
orientation, pollution control etc. The industries included under leasing included
textiles, engineering, chemicals, fertilizers, cement, sugared. Between 1983 and 1991,
ICICI had sanctioned nearly Rs.720 Crores as leasing assistance.
ICICI has promoted the following companies and institutions in recent years:

1. Credit Rating Information Services of India Limited (CRISIL) set up by ICICI in
association with Unit Trust of India to provide credit rating service to the corporate
sector.
2. Technology Development and Information Company of India Limited (TDICI)
promoted by ICICI, to finance the transfer and up gradation of technology and provide
technology information.
3. Programme for Acceleration of Commercial Energy Research (PACER) funded by US
aid with a grant of US$ 20 million to support selected research and technology
development proposals in Indian energy sector, was launched by ICICI.
11.5 THE INDUSTRIAL DEVELOPEMNT BANK OF INDIA (IDBI)
The industrial Development Bank of India is another in the series of specialized
institutions set up since 1947 to provide long-term finance in industry. IFCI, SFC, ICICI,
NIDC and the Refinance Corporation of India have been functioning for several years
with the objective of providing direct loans, subscribing to shares and bonds and
guaranteeing of loans and deferred payments. The volume of long-term finance
provided by these institutions has been substantial and has been steadily increasing too,
but it was found inadequate to meet the requirements of new and growing industrial
enterprises. On one side, the needs of rapid industrialization necessitated the
establishment of a new institution with large financial resources. On the other side,
there was the provision of finance for industrial development. It was to fulfill this twofold objective that the Government decided to establish the Industrial Development
Bank of India, which formally came into existence in July 1964.
The IDBI, which is now the open institution providing term finance, was a wholly owned
subsidiary of the RBI till 1976. The general direction, management and superintendence
of the IDBI were vested in a Board of Directors, which was the same as the Central
Board of Directors of RBI. The Governor and Deputy Governor of the RBI were the
Chairman and Vice-Chairman of the Development Bank. In 1976, IDBI was delinked
from the RBI and was taken over by the Government of India.
Functions of the IDBI
The main function of the Industrial Development Bank as its name suggests, is to
finance industrial enterprises such as manufacturing, mining, processing, shipping and
other transport industries and hotel industry.
i) Direct Assistance
The Development Bank grants direct assistance by way of project loans, underwriting of
and direct subscription to industrial securities, soft loans, technical refund loans and
equipment finance loans. It subscribes to purchase and underwrite the issue of stocks,
shares and bonds or debentures. The loans and advances which the Industrial
Development Bank makes to any industrial concern may be converted into equity stocks

and shares at the option of the Development Bank. The bank is also empowered to
guarantee loans raised by industrial concerns in the open market from scheduled banks,
the state co-operative banks, IFCI and other notified financial institutions. The bank can
also accept, discount or rediscount bonafide commercial bills or promissory, notes of
industrial concerns. In direct lending, the Bank resembles IFCI and ICICI.
ii) Indirect Assistance
The IDBI can assist industrial concerns in an indirect manner also, that is, through
other institutions. First of all it can refinance term loans to industrial concerns
repayable within 3 to 25 years given by the IFCI, SFC. Secondly, it can refinance term
loans repayable between 3 and 10 years given by scheduled banks or state co-operative
banks. Thirdly it can refinance export credit given by the scheduled banks and state
cooperative banks. Thus, the development bank finances those banks and financial
institutions, which are leading to industrial concerns. Further, the Bank can subscribe to
stocks, share bonds or debentures of IFCI or any other financial institutions and
increase their financial resource and enable them to provide large assistance to industry.
iii) Special Assistance
The IDBI Act 1964 has provided for the creation of a special fund known as the
Development Assistance Fund. This fund is to be used by the Development Bank to
assist those industrial concerns, which are not able to secure funds in the normal course
because of low rate of return.
It is interesting to note that unlike the other existing statutory financial corporations,
the Development Bank has no restrictions imposed regarding the nature and type of
security, which it should accept.
The Operations of the IDBI
The Industrial Development Bank provides direct loans to industrial concerns refinance
of industrial loans and export credits, rediscounting of bills, underwriting of and direct
subscription to share and debentures of industrial units and direct loans or exports.
Since its establishment in July 1964 till the end of March 1992, IDBI has sanctioned
financial assistance of nearly Rs.56,200 crores and disbursed nearly Rs.40,420 crores.
IDBI has become the most important institution assisting industrial units. During 199192 alone, IDBI had sanctioned Rs.7640 crores of financial assistance.
Refinance Facilities by IDBI
The Development Bank took over the Refinance Corporation of India in November 1964
and is providing refinance facilities to industrial units through member banks. As an
open institution, the IDBI assists SFCs, ICICI and others working in the field or
industrial finance by subscribing to their shares and banks.
Assistance to Small Scale Sector

The IDBI extended assistance to the small-scale industries and small road transport
operators indirectly through State level institutions and commercial banks by way of
refinance of industrial loans.
IDBI also launched the National Equity Fund scheme in 1968 for providing support in
the nature of equity tiny and small-scale industrial units engaged in manufacturing cost
not exceeding Rs.5 lakhs.
Since 1970 IDBI introduced in 1978 the soft loan scheme to provide financial assistance
to productive units in selected industries viz. cotton textiles, jute, sugar and certain
engineering industries on concessional terms to enable them to overcome the backing in
modernization, replacement and renovation of their plant and equipment so as to
achieve higher and more economic levels of production. The scheme is administered by
IDBI with financial participation by IFCI and ICICI.
Re-structuring of IDBI
From the very beginning, IDBI demonstrated its usefulness as the open institution in
the country in the sphere of medium and long-term finance. The IDBI co-ordinate the
operation of term financing institution on an active and systematic basis and initiate
new facilities for industrial finance to meet complex needs of industrialization in a
developing economy. But some critics were dissatisfied with the working and
achievements of IDBI. According to them IDBI had failed to serve as an effective
development bank and had not sufficiently accelerated the process of industrialization
in the country. The basic causes for the ineffectiveness of IDBI were:
a) Its close association with RBI both having common board of directors.
b) The Governors and the Deputy Governors were incapable of shouldering the
responsibility of cost on them and
c) The management of RBI had made IDBI a slave of procedures.
The Government of India delinked IDBI from RBI and made it an autonomous
corporation from Feb. 1976. IDBI has a separate Board of Directors representing
Government, the banks, financial institutions and other interests. IDBI has recorded an
impressive performance in its operations after it has become autonomous. It is issuing
discount bonds, which are tax deductible, and retirement benefits. IDBI is the major
source of funds in as much as its sanctions and disbursements constituted 40% to 45%
of the total sanctions and disbursements by all the term lending institutions.
11.6 INDUSTRIAL RECONSTRUCTION BANK OF INDIA (IRBI)
In recent years, several industrial units, particularly in the Eastern Region, were in
severe difficulties and were on the verge of closing down. Lack of adequate demand,
managerial imprudence, labour troubles, shortage of raw material and import
restrictions were some of the reasons responsible for this state of affairs. In view of their

importance to the national economy and the needs of employment of large work force,
these units have to be assisted financially. The Government of India setup the Industrial
Reconstruction Corporation of India (IRCI) in April, 1971 under the Indian companies
Act mainly to look after special problems of sick units and provide assistance for their
speedy reconstruction and rehabilitation, if necessary by undertaking the management
of the units and developing infrastructure facilities like those of transport marketing etc.
In August 1984, the Government of India passed an Act converting the Industrial
Reconstruction Corporation of India (IRCI) into the industrial Reconstruction Bank of
India (IRBI). IRBI has to function as the principal all India Credit and re construction
agency for industrial revival assisting and promoting industrial development and
rehabilitating industrial concerns. It has also to coordinate similar work of other
institutions engaged in this field.
During 1991-92, IRBI had sanctioned Rs. 280 crores mainly in the form of term loans,
for modernization, diversification, expansion, renovation etc. Cumulatively till March,
1992, IRBI had sanctioned total term loans exceeding Rs.1520 crores to sick and weak
units. Formerly IRCI had extended assistance to sick small-scale units also. While
extending financial assistance, IRBI emphasizes the need for continuing modernization,
improving productive capacity and upgrading of technology in industrial units for their
survival. The constitution of IRBI to industrial revival is quite significant. For instance,
the value of industrial output reported by 263 assisted units of IRBI during 1988-89 was
Rs. 9500 crores and these units employed nearly 4,00,000 persons.
IRBI had diversified its activities into ancillary lines such as consulting services,
merchant banking and equipment leasing. All these activities are industrial an allied to
its task of rehabilitation of sick industrial units. Through its merchant banking services,
IRBI enables units in the process of amalgamation, merger, and reconstruction,
equipment leasing.
11.7 INVESTMENT INSTITUTIONS: THE UNIT TRUST OF INDIA
The Unit Trust of India was formally established in February 1964. The initial capital of
the Trust was Rs.5 crores, which was subscribed fully by the Reserve Bank of India, the
LIC, the SBI and the scheduled banks and other financial institutions. The general
superintendence, direction and management of the affairs and business of the Trust are
vested in a Board of Trustees.
The primary objective of the Unit Trust of India is twofold:
a) Stimulate and pool the savings of the middle and low-income groups.
b) To enable them to share the benefits and prosperity of the rapidly growing
industrialization in the country.
The two fold objectives would be achieved through a three-fold approach:

i) By selling units of the Trust among as many investors as possible in different parts of
the country
ii) By investing the sales proceeds of the units in industrial and corporate securities.
iii) By paying dividends to those who have bought the units of the Trust.
Thus the Unit Trust of India is the institution to extend facilities of investment in equity
capital of companies by the large and growing number of small investors in the middleincome groups of the community.
OPERATION OF THE UNIT TRUST
The Unit Trust of India has completed 28 years of operation in June 1992. The total
number of applications for units in the first years was nearly 1,35,000 and the aggregate
amount subscribed was about Rs.19 crores. After a sharp slump in the second year of the
existence, the operations of the trust pack up continuously in the succeeding years. The
total number of unit holders registered with the Trust as at the end of June 1992 was
nearly 2 millions, whose holdings amounted to nearly Rs. 22,000 crores.
The Trust has backup a portfolio of investment s, which is balanced between the fixed
income bearing securities and variable income bearing securities the main objectives of
the Trust being maximum income consistent with safety of capital.
Nearly 20% of the Trust funds are invested in ordinary shares and corporate sector, thus
making a total of 60%. The balance of the Trust funds is in the form of deposits with
banks. The Trust has invested in securities of about 300 sound concerns, which are on a
regular dividend paying basis. Barring investment in hands of public corporations, the
Trust funds are invested in financial, public utility and manufacturing enterprises.
Advantages of the Units
The units of the Trust have four distinct advantages and they are:
a) Investment in units is safe, since the risk is spread over a wide range of securities
(fixed income bearing and variable income bearing)
b) The unit holders receive a steady and decent income. Nine-tenth of the income of the
Unit Trust is distributed
c) Dividend income from the Unit Trust enjoys various tax concessions.
d) The units are highly liquid in the sense that an investor can cash them whenever he or
she wants. The units can be sold back to the Trust any time at price fixed by the Trust.
An Assessment of the Unit Trust of India

The commencement of sale of units by the Unit Trust from July 1964 was acclaimed as a
landmark in the development of India's capital market. In principle the aim of the UTI is
praiseworthily since it seeks to mobilize the community saving for investment in trade
and industry. The Trust, being a public enterprise, has created confidence among the
general public. Besides, it has received a number of tax concessions from the
Government. Not only the capital is safe but it is highly liquid in the sense that any unit
bolder can return his units and get back cash from the Trust. The operation of the UTI
has shown that the return for unit holders is reasonable. The response of investors
especially of the small and medium income groups, to the unit scheme has been very
encouraging and it seems that the unit trust has to some extent met the genuine needs
of a large number of investors by providing a form of investment which is safe brings in
steady income and is liquid enough to realize when investors are in need of money
11.8 LIFE INSURANCE CORPORATION OF INDIA (LIC)
Life insurance funds occupy a key position in the capital market of a country. By making
a judicious investment of the vast amount of life funds, the larger interests of a country
can be served. Life Insurance has played and continues to play a major role in every
industrially advanced country of the West. Life Insurance organization helps in the
mobilization of small savings of individuals. If the average premium paid by an
individual policyholder is taken into account, it may be noted that this is an amount so
small that the policyholder may not be able to invest it on a classified basis. To India, in
the context of the planned development of the country, the investment of the insurance
funds is of major importance.
A well conceived, integrated and diversified investment plan, while furthering the
interest of the policyholders, has great potentialities of effecting a balanced development
of the country. Since the large funds at the disposal of particular life insurance
organization are in the nature of trust money, they should be invested in such securities,
which do not diminish in value and give the highest possible return. In other words,
yield consistent with security should be the guiding principle. It thus becomes
imperative that the investment be in un-impeachable securities and properly distributed
as to class as well as maturity and must in every other aspect, be in the best interest of
policyholders. In other words, while investing life insurance funds, principles of safety,
yield liquidity and distribution must be taken into consideration. Absolute security of
trust money is vital, because a life office cannot venture putting money on speculative
and risky investments in the countries where Governments have imposed severe
restrictions on the investment policyholders. Speaking probably, environment of life
funds is guided by a compromise between maximum yield and absolute security and
convertibility. The role of the life insurance funds in the national economy cannot be
overemphasized since they form an integral part of national finance. This is more so far
an underdeveloped country like India where normal channels of capital formation are
not activated to an adequately high degree. They can contribute immensely in financing
industrial ventures and thus add to the strength and stability of the national economy by
filling up a high gap in our financial resources.

The Life Insurance Corporation Act, which came into force on July 1, 1956 transferred
all the assets and liabilities pertaining to life insurance business of existing insurance
companies to a statutory corporation which began its functioning on September 1, 1956
when the corporation was constituted, it was confronted with the task of integrating the
controlled business of 243 units, which differed widely in age, size and organisation. The
amount of savings accumulated in the form of the insurance each year is represented by
additions to the life fund.
LIC had been extending direct assistance to industries in the form of loans and direct
subscription to shares and debentures of industrial concerns. It is engaged in normal
investment operations by way of sale, and purchase of securities in stock markets. For
granting loans to companies in the private sector, it considers proposals from public
limited companies and cooperative societies. LIC extends resources support to the term
lending institutions by way of subscription to their bonds. Thus it contributes to
industrial financing in an indirect manner. It also helps in small and medium industries
by granting loan for setting up industrial estates.
It is interesting to note that investment of LIC in corporate securities in the 7 industrial
groups has accounted for 2/3rds of investment in corporate securities of private sector
engineering cotton textile, dues, chemicals and pharmaceuticals, electricity, electrical
goods, iron and steel etc.
11.9 UNDERWRITING
Underwriting of capital issues forms an important part of the corporation's investment
policy. Its assistance to the new issue market through its underwriting operations has
been on a substantially increased scale. The corporation has underwritten those items
(particularly debentures), which may be acquired for its investment portfolio. LIC looks
upon its underwriting as only a part of the investment activity and it subscribes in the
public issue to the full extent of its underwriting. It is thus different from the
development in the issues, which they underwrite and precede to subscribe only to the
extent of their liability after the list is closed. The role of LIC an underwriter of equity
and preference issue has been very insignificant after 1980. It is on the other hand,
concerned with rating on underwriting of bonds and debentures of all India financial
institutions, state electricity boards and central cooperative land development banks.
Debentures of companies in the private sector are also not favoured.
The general pattern of investment of life insurance fund in India has changed
significantly in the recent part, LIC has played an important role in the development of
the country's infrastructure such as electricity, water supply, sewerage, housing, etc,
which are basic to economic and industrial progress. LIC had to undertake massive
investment in these directions because there were very few institutions providing
finance for such socially desirable enterprises. Over the years, LIC has advanced loan
assistance to State Government, open cooperative housing and finance societies, state
housing boards and other agencies for the construction of houses. In addition to this
investment, it has undertaken on its own the construction of housing colonies at some of
the important centers in the country for outright sale to its policyholders.

LIC also assists the development of industrial estates which is essential for the growth of
small and medium scale industries. But this activity has not developed as much as
expected.
LIC is the largest single investor in the stock exchange securities. Apart from its
investments in Government securities, bonds issue of Government-sponsored bodies, it
has a substantial investment s in debentures, preference shares and equity shares of
companies. It has acquired these corporate securities as a result of its underwriting and
also by direct purchases from the market. It is vitally interested in broadening the
activity on the stock exchanges because of the size of its investments.
The LIC's percentage holding of equity capital is significantly higher among the large
companies than among smaller ones. Until recently, the size of LIC's shareholding
aroused interest mainly from the viewpoint of the supply of finance. Now a new
dimension has been added, that is the potential control of the LIC over private industrial
enterprises through its shareholding. It is worth noting that LIC had made a substantial
investment in large groups registered under MRTP Act. Percentage of such investment
to the total investments in the private sector made by LIC amounted to 63 nearly 2/3rd
of the total investment in private sector was in large houses. In case of equity shares,
percentage figures at 75. Thus concentration of investment of LIC in large houses can be
appreciated.
11.10 SUMMARY
From the above discussions, it is quite clear that apart from issuing shares and
debentures large scale organizations secure funds from some financial institution to
meet their financial needs. Their medium and long term financial requirements can be
met from well known public sector financial institutions like IFCI, SFC, ICICI, IDBI,
IRBI, etc., providing long term source of finance to industries which require finance for
their operations. Hence, in India the importance of these financial institutions is
growing fast along with banking sector. As they are able to provide quick finance
facilities by introducing various schemes and policies which suit to different categories
of people, many industrial units are coming forward to borrow funds from these
institutions which is a good sign for the rapid development of industrial sector in a
developing economy like India.
11.11 REVIEW QUESTIONS
1. What is the purpose of financing large-scale industries?
2. Explain the objectives role and functioning of IDBI in financing the large-scale
industries.
3. What are the objectives and functions of national development banks In India in
industrials financing?
11.12 ASSIGNMENT QUESTIONS

1. Discuss the role on UTI in industrial financing.
2. Describe the way in which LIC and GIC are mobilizing funds for industrial sector in
India.
11.23 KEYWORDS
UTI, LIC, IDBI, ICICI, IFCI, IRBI

- End of Chapter LESSON - 12
MARKET FOR LONG TERM SECURITIES

OBJECTIVES
The objectives of the lesson are
·
·
·

To evaluate the market for long term securities in India
To analyses the role of stock exchange as a market for long term securities in
India
To explain the role of SEBI in the development of an orderly stock exchange.

STRUCTURE
12.1 Introduction
12.2 New financial Intermediaries in Securities Market
12.3 Stock Exchange
12.4 Development of Stock exchange in India
12.5 Growth of New Issue Market
12.6 Weakness of Stock Exchange
12.7 Suggestion for stock exchange Reform
12.8 The Role of SEBI

12.9 Summary
12.10 Review Questions
12.11 Assignment Questions
12.12 Keywords
12.1 INTRODUCTION
The long-term industrial securities market refers to the market for shares and
debentures and securities of other type, either old or new. Like shares and debentures
and securities market in India is also composed of those who borrow funds such as
industry, commerce and trade and those who lend funds such as individual savers,
institutional investors, commercial banks, insurance companies, specialized financial
agencies and the government. An ideal securities market attempts to provide adequate
capital at reasonable rate of return for any business or industrial proposition, which
offers a prospective yield high enough to make borrowing worthwhile.
The market for long term securities in India may be divided into two segments, i.e., the
primary market and secondary market, primary market otherwise known as new issues
market refers to the raising of new capital in the form of shares, debentures and other
securities. The secondary market also called as old capital market on the other hand,
deals with the securities already issued to the market is much more important from the
point of view of economic growth. However, the functioning of the new issue market will
be facilitated only when there are abundant facilities for transfer of existing securities.
Thus both the primary market and secondary markets are interdependent and
individuals and one cannot exist without the other.
The Gilt-edged Market and the Industries Security Market
The secondary market is composed of industrial securities market or stock exchange in
which industrial securities are bought and sold and the gilt edged market in which the
government and semi government securities backed by Reserved Bank of India are
traded. The securities traded in this market are stable in value and are much sought
after by banks and other institutions.
The gilt-edged differs from the industrial securities market in many respects.
In the first place, there are no uncertainties regarding yield, management, and capital
appreciation, and therefore, there is much less speculation in this market.
Secondly, the investors in the gilt-edged market are predominantly institutions, which
are often compelled by law to invest a certain portion of their funds in these securities.
The commercial banks, LIC, GIC and provident funds come under this category. These
are often referred to as the captive market for government securities.

Thirdly, the average value of the transactions in the gilt-edged market is very much
larger than in the case of industrial securities market. Often a single transaction in the
government securities may run into several hundreds of crores.
Fourthly, the securities market, unlike the market for shares, is not an auction market
but an "over the counter" market. The average size of the transactions is so large that
each transaction has to be negotiated.
Finally, the Reserve Bank of India plays a dominant role in the gilt-edged market
through its open market operations which are governed by the twin objectives of
monetary and stability and of ensuring the success of government's borrowing
programme.
Market for Long term Securities and Special Financial Institutions
Government of India after attaining independence set up a series of financial
institutions to be of special help to the private sector industries in the matter of finance.
IFCI was the first these institutions (1948). Later, ICICI was established in 1955, IDBI in
1964, LIC was set up in 1956 to mobilize individual savings and to invest part of the
savings in the capital market. Many more specialized financial institutions have been set
up and are called public sector financial institutions.
These institutions have been playing significant role in creating the market for long term
securities such as shares, debentures etc. of new and old companies, in giving loan
assistance, in underwriting new issues and so on. Investment institutions like LIC and
UTI mobilize resources from public and lace them at the, disposal of the capital market.
The development financial institutions (DFIs) are engaged n providing funds to the
private sector industries. The total assistance sanctioned by the term lending
institutions had increased from Rs. 230 crores in 1970-71 to Rs. 2550 crores in 1980-81,
and over 30,000 crores in 1992-93.
Long-term Securities and Commercial Banks
Commercial banks are important constituents of the Indian capital market, but their
operation have so far been confined to the purchase and sale of government and other
trust securities. Their role in marketing (either sale or purchase) of long term industrial
securities, viz, shares and debenture are very small Commercial banks, with the
approval of the RBI, are setting up financial subsidiaries, known as merchant houses,
mutual funds, venture capital companies, leasing companies etc, to mobilize funds for
investment in industrial securities.
12.2 NEW FINANCIAL INTERMEDIARIES IN SECURITIES MARKET
There was considerable specialization as regards promotion, issuing, underwriting and
distribution of securities in western countries, whereas specialized agencies did not exist
in India for a long time. The following are some of the new financial intermediaries
floated recently with a view to create wider market for long-term individual securities.

1. Merchant Banking
Commercial Banks directly involved in merchant banking operations through their
subsidiaries established for this purpose. Merchant banks in India manage and
underwrite new issues, undertake syndication of credit, they advise in fund raising and
other financial aspects. Merchant banking emerged as an important intermediary in the
marketing of long-term securities in India in the recent times.
2. Mutual Funds
Mutual Funds are the most important among the newer capital market institution in the
recent past. Several public sector banks and financial institutions have set up mutual
funds on a tax - exempt basis. Mutual funds have been playing significant role in
securities market by attracting strong investor support. In the light of economic reforms,
private sector and joint sector mutual funds have also entered in this field in the recent
past.
12.3 STOCK EXCHANGE
The stock exchange is the market where stocks, shares and other securities are bought
and sold. The joint stock company or the corporate form of organization is ideally suited
to secure large amount of capital from all those who have surplus funds and who are
willing to take risks in investing in companies. An investor who puts his savings in a
company by buying securities cannot get the amount back from the company directly.
The only way the capital invested in stocks and shares of a joint stock company may be
realized from its owner is by the sale of those stocks and shares to others through the
stock exchange.
Economic Functions of Stock Exchanges
Stock exchange is an essential pillar of private sector corporate economy. It discharges
essential functions in the process of capital formation, in raising resources for the
corporate sector and in creating the effective market for corporate securities. It is
indispensable for the corporate form of enterprise. It performs the following functions:
1. The organized stock exchange provides a continuous and ready market for purchase
and sale of securities viz, shares, bonds and debentures. It therefore ensures the free
transferability of securities, which is an essential basis for the joint stock enterprise
system.
2. The stock exchange provides the linkage between the savings in the household sector
and the investment in the corporate economy. It mobilizes savings and channelises
them as securities into those enterprises which are favoured by the investors on the
basis of such criteria as future growth prospects, good returns and appreciation of
capital.

3. The stock exchange brings about the fairest and the most accurate prices for shares
and debentures and the prices reflect as closely as possible the present and future
income yielding prospects of the various companies. A company whose share prices are
high in the stock exchange will find it easier to raise additional funds for expansion.
Thus the stock exchange
quotations help in directing the flow of savings into the lines of production.
4. Besides mobilizing the surplus funds of the community, the stock exchange facilitates
distribution of funds between different firms and industries, and in certain cases even
between different countries on the world.
5. The stock exchange enables the investors to shift from securities of one industry to
another. The stock market quotations enable the investors to know the approximate
worth of their securities. The stock exchange lessens the risk which investors have to
bear, by providing continuous market, high negotiability of securities, correct evaluation
and facility to liquidate investment.
6. All the functions and services will be made available only if organized stock exchange
works under a code of well defined rules and regulations and is able to minimize the
dangers inherent in speculative transactions and manipulations.
7. It induces companies to raise their standard of performance as the share prices
quotations of different securities reflect the operational performance of the
management.
8. The market values of the securities of a company are required for computing the cost
of capital. Such values can be obtained from stock exchange quotation. Hence the stock
exchange offers guidance on cost of capital.
12.4 DEVELOPMENT OF STOCK EXCHANGE IN INDIA
In, a growing country like India, dynamic, well-structured and systematically organized
capital market is essential for providing finance for long-term financial requirements
and also to meet diversified industrial needs.
The origin of the stock exchange in India goes back to the end of the eighteenth century
when long-term negotiable securities were first issued. However, for all practical
purposes, the real beginning occurred in the middle of the nineteenth century after the
enactment of companies Act in 1850, which introduced the feature of limited liability
and generated investor interest in corporate securities. An important early event in the
development of stock market in India was the formation of Native Share and Stock
Brokers' Association in Bombay in 1875, which later developed as the present day
Bombay Stock Exchange. This was followed by the formation of exchange in Ahmedabad
(1894), Calcutta Stock Exchange (1903) and Madras Stock Exchange (1937), Hyderabad
in 1943, Delhi 1947 and Bangalore in 1957. The corporate forms of stock exchanges at
some places are in the form of joint stock companies, in other places in the form of an

association. By July 1992, there were 22 stock exchanges recognized by the central
government.
The establishment of the Over The Counter Exchange of India (OTCEI) marked the
dawn of a new era in the history of stock exchanges in India. The OTCEI is a blessing for
the small, both existing and new securities and for investors, particularly small
investors. The OTCEI has been promoted jointly by ICICI, UTI, IFCI, IDBI, SBI capital
market Limited, Canara Bank Financial services Limited, GIC and LIC. The OTCEI is
meant primarily to trade securities of the listed companies, like other stock exchanges.
The buyers and sellers living apart from each other trade in corporate securities over the
telephone. These OTCEI market are fully automated exchanges where transactions are
completed through a network of computers. The fraudulent practices manipulations,
which frequently occur in other stock exchanges, may be found in OTCEL.
The establishment of National Stock Exchange of India (NSEI) is another milestone in
the development of stock market. The NSEI was set up by financial institutions and
banks with IDBI as the nodal agency. The NSEI is expected to serve as model exchange
integrating the stock markets all over the country by providing nation-wide stock
trading facilities and electronic clearing and settlements.
There has been phenomenal growth in the operations of the stock exchange in India,
particularly in the last ten years or so. This is very clear from the increase in consents to
capital issues. The aggregate market capitalisation increased more than twenty folds
from 1975 to
1990 - a performance which has very few parallels elsewhere in the world.
12.5 GROWTH OF NEW ISSUE MARKET
There are three ways in which a company may raise capital in the primary market:
1. Public issue
This involves sale of securities to public. It is the most important mode of issuing
securities.
2. Right Issue
This is a method of raising further funds by issue of securities to the existing
shareholders and debenture holders on a pre-emptive basis.
3. Private Placement
As the name suggests, it involves selling securities privately to a group of investors.
There is no need for a formal prospectus as well as an underwriting arrangement. The
terms of the issue are negotiable. In the private placement, securities are sold mainly to
institutional investors. The private placement market has grown phenomenally in recent

years. The rate of growth of private placement issue in primary market has been much
higher than that of public issue as well as rights issue because of their accessibility,
flexibility, speed, and lower issue costs etc. The aggregate value of securities i.e., shares
and debentures granted by the controller of capital issues for non-Government public
limited companies rose from Rs.620 crores in 1981-82 to Rs.1700 crores in 1984-85 and
to Rs.4,200 crores in 1990-91. Public sector bonds issued in 1989-90 were Rs.3700
crores which phenomenally rose to Rs.4500 crores in 1990-91. The term lending public
sector financial institutions sanctioned assistance to the tune of Rs.19,900 crores during
1990-91 as compared to Rs. 2550 crores during 1980-81. Many "mega issues" from
Reliance petro-chemicals, Larsen Turbo, Usha Rectifiers and Bindal Agro released in to
the market.
Growth of Industrial Securities Market
The industrial securities market showed a mixed trend. The market experienced a severe
setback since July 1974, because of the restrictions imposed on dividend distribution,
rise in the short-term interest rate and also in the rate offered on deposits by nonbanking companies. The index number of all India Security Prices for ordinary shares
(1970-71 = 100), which stood at 133 in July 1974, reached a low of 90 by the end of June
1975. The index number of security prices had risen to 203 by June 1984. From
December 1984, a sustained, upward trend in equities was witnessed, which gained
momentum after the presentation of the union budget for 1985-86. The RBI's All India
index number of ordinary share prices rose from 203 in June 1984 to 640 in 1986.
During 1987-88 however, the stock exchange literally crashed with the crash of Reliance
shares. The market was in doldrums for some time. From 1988-89 onwards, there was a
upward swing in the stock market, spearheaded by an excellent performance by market
leaders, industry friendly policies by successive government. RBI's all India index
number of industrial ordinary share prices (with base 1980-81 = 100) rose to 308 at the
end of March 1989 to 400 at the end of March 1990 and 528 at the end of March 1991.
The upward trend displayed by market in the previous three year was given a big boost
by 1991-92 budgets, which announced various policy measures relating to the financial
sector, SEBI, Stock Exchange, Mutual Funds, and Foreign Investment for the healthy
development of capital market. At the same time, the liberal industrial policy, changes in
trade policy gave future boost to the capital market. By October 1991, the RBI index of
ordinary share prices had crossed 644 and touched 1,000 in the beginning of February
1992. The BSE Sensitive Index (SENSEX) which reflects the mood in 30 of the key and
most traded scripts in the country in Bombay, touched nearly 1960 on 1st January 1992.
The market friendly measures initiated in the 1992-93 Budget brought out tremendous
changes in stock market when it is already going in an upward direction. The SENSEX,
which was nearly 200 in January 1992, crossed 3,550 on 9 March 1992 and on 20th
April 1992 it has crossed 4,300. The RBI's index of ordinary share prices shot up to
1000 in February, 1400 in March 1992 and rose to 2000 in April 1992. It is in this
period that there was acute shortage for good scripts in the country, since more than
50% of the shares are held by public sector financial institutions, mutual funds and the

company management. There were very few good floating shares in the market and the
money chasing for these shares is too much. The position was so acute that even
absolutely worthy scripts of companies like Metal Box, Karnataka Ball Bearings,
Titaghar Paper Mills etc., were in great demand. The real reason for the artificial boom
in stock market is that some brokers with nearly Rs. 3075 crores placed by banks at their
disposal through the mechanism of Banker's Receipts cornered the limited floating
shares of leading companies, pushed up their prices sky-high and made the people
believe that the rise in share prices was genuine an based on actual market conditions.
The recent upsurge of primary market has created serious problems of interfacing with
the secondary market, viz., and the stock exchange, which still by and large, continues
with the same old infrastructure and ways of working which suited to the very narrow
base of the capital market in the yester years.
The imbalance facilitated the 'Scam' of 1992 caused by reckless speculation, rampant
dishonesty and fraudulent manipulation of banking system. Unless the secondary
market is reoriented so as the discharge the new responsibilities cast on it by the recent
developments and the means of ramifications, this will act as a drag on the future
growth of primary market itself. Investors who are anxious to buy new securities are
bound to get disenchanted if they face serious problems while trying to buy or sell
scraps.
The phenomenal expansion of the market form 1980 brought out in sharp focus on the
infrastructural and legal inadequacies in dealing with large volume of business. There
were company law restrictions on transfer of shares, and transferability of shares when
Indian share market largely meant for the metropolitan towns and few for other centers.
They are hopelessly inadequate to deal with vastly enlarged number of securities of all
types covering the length and breadth of the country. According to one estimate, the
total number of shareholders in India in 1983 was about 15 million. These shareholders
are now scattered all over the country. The existing stock exchange regulations, the
Banking Regulations, the conditions of delivery and the FERA Regulations relating to
NRI shareholders are totally inadequate to deal with tile tasks and responsibilities which
have been imposed on the Stock Exchange by vastly increased market size.
12.6 WEAKNESSES OF STOCK EXCHANGE
The stock market in India suffers from several weaknesses. The principal ones are
discussed below:
1. Poor Communication System and Lack on Integration:
The communication system of the stock exchanges in India is rather poor. This is clear
from the following:
i) Brokers often do not report their transactions to the stock exchange authorities.

ii) Volume data are collected only for a few securities, often this information is not
available.
iii) Clients do not know how much commission the brokers charge.
iv) Prices quoted may be empty of meaning because of unofficial money transactions.
v) There is no proper integration between all the stock exchanges with too much
variation in prices of shares in different markets.
2. Dominance of Financial Institutions
The stock market in India is significantly influenced by the actions of financial
institutions (mainly UTI, LIC and GIC). Even though the operations of these institutions
are confined to a small group of stores, their impacts are often quite pervasive under the
influence of institutional buying. It may be mentioned that financial institutions in welldeveloped economies too have a significant influence on the stock market. However
there are two key differences:
(i) There are hundreds of financial institutions (pension funds, mutual funds, insurance
companies etc.) in the well developed economies, which compete with each other
whereas there are just a few financial institutions in India, which often act in union
(ii) Financial institution in the developed economies are very active in buying and
selling securities, where as financial institutions in India have been mostly buying not
selling.
3. Poor Liquidity
The Indian stock exchanges suffer from poor liquidity barring a small proportion of
shares (specified shares), which are actively traded, and highly liquid most are traded
infrequently (non specified shares) and hence, lack of liquidity. About 90% of the total
transactions on the stock exchanges are confined to 200 to 250 actively traded scrips.
The remaining scrips do not enjoy high liquidity.
4. Weak Regulation
Even through the Securities Contracts and Regulations Act vests the government with
substantial powers, the regulation in practice tends to be somewhat ineffective. The
stock exchange division of the Ministry of Finance, which is supposed to supervise and
control the stock exchanges, appears to be grossly understaffed and overburdened. Even
with the best of intentions, it seems humanly impossible for the small group of persons
to monitor and supervise the functioning of 22 stock exchanges spread all over the
country. There appears to be a crying need to strengthen the regulatory machinery
because of phenomenal growth in volume of trading.
5. Preponderance of speculative trading

There is a preponderance of speculative trading, where the primary motive is to derive
benefit from short-term price fluctuations. It appears that a very small fraction of
transactions, perhaps between three to five percent on the Bombay Stock Exchange and
the premier market in the country represents purchases/sales by genuine investors. The
rest are carries forward (badla) transactions, which are driven mainly by the
speculative; motive. While the extent of speculative trading may be less on the other
stock exchanges it is certainly not insubstantial. Overall, it is estimated that genuine
investment transactions represent hardly 8 -10 percent of the total transactions.
6. Scarcity of Floating Stocks
There is a scarcity of floating stocks in India in general; this seems to be caused by the
following resources:
1) Joint stock companies, financial institutions and large individual investors who
collectively own about 76% of the equity capital in the private sector generally do not
offer their holdings for trading.
2) Indian investors traditionally have stocky portfolio habits.
3) Investing institutions like UTI and insurance companies have been mainly buying
share rather than selling them. Due to the scarcity of floating stocks, the market tends to
be highly volatile and more easily amenable to manipulation.
7. Price Distortion
Due to speculative influence and other irrationalities and imperfections, stock prices
tend to get distorted.
8. Kerb Trading
Transaction between brokers who assemble outside the stock exchange after market
hours are referred to as ‘Kerb’ transactions. Though considered a punishable offense,
kerb trading flourishes and the issues whether it is legal or illegal is considered
irrelevant by most brokers. In fact, brokers often report kerb transactions along with
transactions done during official business hours. Kerb trading tends to be highly price
sensitive. A few transactions are often enough to bring about significant price changes.
Hence kerb trading provides a fertile ground for the action of speculators.
12.7 SUGGESTIONS FOR STOCK EXCHANGE REFORM
A number of measures are suggested for action visiting market for industrial securities
so that larger flow of households sector's savings is available to corporate sector. Term
lending institutions, in conformity with their objectives, need to be given greater
importance than in the past for encouraging growth of capital market. As a major step in
this direction, institutions need to reconsider their policy of holding on to their sizeable
investment s in easily marketable industrial securities. Bulk of the investment s of

institutions in shares and debentures are the result of development or part issues
underwritten by them in the past and also rights issue.
With a view to creating wider market for industrial securities as also for recycling funds
required for their growing volume operations, institutions should give greater attention
to unloading of their holding. Financial institutions due to their financial constraints
have reduced their support tot capital market and term loans. The resource constraints
arisen partly because of increased financial commitments entered on to by IDBI and
other financial institutions. Companies, particularly those having considerable
creditworthiness and reputation, are advised by financial institutions to approach
capital market directly to raise funds.
Number of policy measures has been suggested by different committees, individual
experts and practitioners, right from G.S. Patel Committee in 1984 to Dr. L.C. Gupta in
1992. Government of India also appointed a high-powered committee under the
chairmanship of M.J. Pherwani in 1991 to recommend suggestions for reforming the
stock exchange operations. The main suggestions are given below:
1. Categorization of Stock Exchanges
All stock exchanges should be categorized as principal regional and additional trading
floors.
2. Establishment of Securities Facilities Support Corporation
This is to implement tasks relating to networking of all stock exchanges and additional
trading floors, installation and maintenance of hardware software for all exchange and
the settlement and depository functions entrusted to the Stock Holding Corporation.
3. Introduction of Uniform Settlement
All stock exchanges in the country should follow a uniform system of one-week
settlement. This will unify all the stock exchanges on national basis and reduce the risk
exposure of participants due to price fluctuations in shares. Uniformity will make intermarket transactions easier and reduce cost and delay. Finally it will assure markets
financial integrity and promotes investors confidence.
4. Abolition of Carry Forward System
The carry forward system is the most important factor for over speculation in India.
Uniform one-week settlement and the adoption of marking to the market system
automatically disappears the carry forward system.
5. Market Making
There are market makers in all leading stock exchanges like London and New York.
These market makers assume the responsibility of buying and selling at a given price.

They are an integral part of the trading mechanism and arrangements. The marketmakers protect the investors from being exploited by stockbrokers and ensure that the
transactions are carried out at the best market rate in addition to creating liquidity for
the securities.
6. Management Information System
The information related to price, trading volume, trading concentration of each stock
exchange should be made available to all stock exchanges. Proper management
information system will ensure the smooth functioning of stock exchanges and avoid
fraudulent practices of stockbrokers.
7. Management of Stock Exchange
The executive director of a stock exchange should be appointed by the Government or by
SEBI on the advice of panel of independent experts, so as to make him independent
control of stockbrokers. The broker director and non-broker directors should be equal in
number in the Governing Body. This will satisfy the broad interests of all the sections.
12.8 THE ROLE OF SEBI
The Securities and Exchange Board of India (SEBI) was set up as a now statutory body
but in January 1992 it was a made statutory body. The Role of SEBI in the smooth and
orderly functioning of stock exchange is worth mentioning. SEBI is playing an active
and constructive role in regulating merchant banks on issue activity, supervising and
regulating the working of mutual funds. SEBI has taken a number of steps during 199194 to introduce improved practices and greater transparency in stock market operations
in the interest of investing public and health development of the capital market. Some of
the steps initiated by SEBI are as follows:
1. Introducing free pricing of public issues and ensure better disclosure of material facts
about the issue.
2. Setting up advisory panels for primary and secondary markets.
3. Inspecting the affairs of stock exchanges, registered stockbrokers.
4. Developing the norms for insider trading and putting ban on kerb trading to protect
the integrity of stock exchanges.
5. Controlling the Foreign Institutional Investors (FIIs) or portfolio management
companies.
6. Developing a code for mergers and takeovers.
7. Launching education campaign.

12.9 SUMMARY
The well-established and well-organized capital markets are very much essential for the
orderly flow of capital. Both the primary and secondary markets are interdependent and
one cannot exist without the other. Indeed, the capacity of a nation to channelise savings
into long-term securities is central to the maintenance of a free enterprise market
economy. Stock markets and stock exchanges are the mechanisms for the long-term
securities market. In spite of the significant role played by the stock exchanges in
creating the market for long-term securities both in new issue market and industrial
securities market, there are some hurdles and obstacles come in the way. The recent
reforms introduced by the government and its statutory bodies, hopefully, will make the
way crystal clear and ensure congenial and healthy market for long-term securities.
12.10 REVIEW QUESTIONS
1. Discuss briefly the development of stock market for long-term securities in India.
2. Explain the role of stock exchanges in marketing securities.
12.11 ASSIGNMENT QUESTIONS
1. Explain in detail about the weakness of stock exchanges.
2. Critically evaluate the reforms introduced in stock exchange.
3. Explain the role of SEBI in the orderly maintenance of stock exchange.
12.12 KEY WORDS
Stock Exchange, SEBI, New Issue Maker.

- End of Chapter –

LESSON-13
LEASE FINANCING - AN OVERVIEW

OBJECTIVES
The main objectives of this lesson are:

·
·
·

To identify the forms of lease financing.
To evaluate leasing decisions from the point of view of both lesser and lessee.
To analyze the growth and performance of lease financing in India.

STRUCTURE
13.1 Introduction
13.2 Definition and Meaning of Leasing
13.3 Nature of Lease Financing
13.4 Types of Leases
13.5 Summary
13.6 Review Questions
13.7 Assignment Questions
13.8 Keywords
13.1 INTRODUCTION
Leasing emerged as one of the important sources of long term financing. The purpose of
this chapter is to analyze various basic concept the nature & importance of leasing. The
critical evaluation of various types of leasing and the economics of leasing are also
thoroughly discussed in this chapter for in depth understanding of the students.
With technological advancement and increasing cost of capital medium and long term
investment decisions are becoming more and more intricate such decisions have long
term implications as, they have effect on project's future profits for over number of years
and influence the risk complexion of the business.
Essentially, such projects involve huge amount of capital investment. High rate of
inflation, high cost escalation, heavy taxation, diseconomies of operation, high rate of
technological obsolescence and meager internal resources have forced many companies
to look for the alternative means of financing so that their skyrocketing capital
equipment costs are financed. In this context different techniques and methods of
financing the acquisition of capital equipment have been emerged. One such method of
financing the acquisition of capital equipment is leasing. As a unique concept, leasing
facilitates a company to grow faster today instead of waiting for an uncertain tomorrow.
Lease financing has been encouraged in western countries by providing specific
monetary and fiscal incentives for companies to lease out equipments. Equipment
leasing has changed the magnitude of industrial finance as it accounts nearly 30% in
financing all new-plant and machinery in the developed and developing countries of the
world.

13.2 DEFINITION AND MEANING OF LEASING
Leasing in its most essential form implies the use of one's property by another for a fee.
A lease is defined as; a contract for the exclusive possession of property (usually but not
necessarily land and building for a determinate period or at will. The person making the
grant is called the lessor and the person receiving the grant is called the lessee. Two
important requirements for a lease are that the lessee has exclusive possession (non exclusive possession would call for a license) and the lessor's term of interest in the
property be longer than the term of the lease (a grant involving an equal term or period
would comprise a conveyance or assignment, not a lease).
"Lease is a form of contract transferring the use or occupancy of land, space, structure of
equipment in consideration of a payment usually in the form of a rent". (Dictionary of
Business Management).
"Lease is an agreement whereby the legal owner of real property gives another person
the possession of that property with freedom to use it as he wishes, though possibly
under certain conditions, in return for regular specified payments referred to as rent".
In a lease contract there are two parties involved i.e. the lessor (owner of the equipment)
and the lessee (the user). The lessee acquires the use of the asset by paying a lease rent
to the lessor, either monthly quarterly, half yearly or annually at predetermined rates.
The lessee can be a company; a co-operative society, partnership firm or an individual
engaged in manufacturing and allied activities. The lessee can be even a sector or any
other specialist who uses costly equipment for the practice of this profession. On the
other hand, a lessor is called a lease packager. Packager may either directly lease or
arrange to bring the lessor and the lessee together. A lessor mayor may not be a
manufacturer. If the leasing company (lessor) is not a manufacturer, the lessor either
through his owned or borrowed funds purchases the equipment from the manufacturer
or supplier by paying for the cost (including duties and taxes), thereby becoming its
owner. The lessor capitalizes the equipment in his books and gives it out on lease to the
lessee i.e., the user.
By resorting to leasing equipment, the lessee company is able to exploit the economic
'value of the equipment by using it as if the owned it without having to pay for its capital
cost, for which he may not be having long term funds, borrow incapacity or cash flow,
Lease rentals can conveniently be paid over the lease period out of profit earned form
the use of the equipment and the rental is 100 percent tax deductible.
But it is an essential for the lessee to endure that the leased equipment is put to use soon
after its receipt and its capacity utilization is kept at a high level so that sufficient profits
are generated not only to pay the lease rent regularly but also to show a-reasonable
margin-of profit after meeting all other expenses.

PROPERTY
The concept of property has a significant meaning and role particularly in lease
financing. The concept of property connotes different meanings depending on the
situation. In wider sense there are two types of properties namely (a) Freehold property
(b) Leasehold property.
a) Freehold property
A free hold property is an absolute possession of its owner or freeholder for a period of
indefinite duration that has the right to use the property at his free will subject to ht e
law of land. The free holder is inherently the absolute owner of the property; he holds it
without any payment in the nature of rent. He may sell the property, divide it, develop it
or donate it or grant it or lease at his will. Being a legal estate, a freehold can only be
transferred on the execution of deed.
b) Leasehold Property
Long-term rental arrangements are usually called leases. Leasing is a method of
acquiring; the right to use equipment for a consideration, a lease is a contract whereby
the owner of an asset (the lessor) grants to another party (the lessee) the exclusive right
to use the asset, usually for an agreed period of time, in turn for the payment of rent.
From the points of view of financing and accounting the unique feature of a leasing
contract is that although the lessee is entitle to the use of the asset, legal title is retained
by the lessor, who continues to own it. Thus the user of the property cannot allow it
among his assets and periods obligations to pay rent or not shown as liabilities until
they become due. At the same time, the value of the property appears on the balance
sheet of the lessor, who is the owner of the legal title.
13.3 NATURE OF LEASE FINANCING
A lesser can be individual or a firm interested on the use of an asset without owning the
asset. Lessors may be equipment manufacturers or leasing companies who bring
together the manufactures and the users. The lease contract typically specifies some
kind of option to the assesses at expiration. The lessee has the right to renew the lease
for another lease period either at the same rent or at a different, usually lower rent. The
option might be to purchase the asset at expiration.
Because of the contractual nature of financial lease obligation it a must be regarded as a
firm of financing. It is used in the place of other methods of financing to acquire the use
of an asset. An alternative method of financing might be to purchase the asset and
finance its acquisition with debt. Lease financing and debt financing are very similar
from standpoint of analyzing the firm to service fixed obligations.
The lessor is the legal owner of the leased property and the lessee bears the risk and
enjoys the returns. The lessee benefits if the leased asset operates profitably and suffers
if the asset fails to perform profitably. In United States, equipment manufacturers are

the largest group of lessors followed by banks in India; independent leasing companies
form the major group in the leasing industry. Since banks in India have been allowed to
enter the leasing industry, they together with financial institution such as the ICICI are
also becoming an important group of lease finance.
A number of large sized leasing companies have entered the leasing industry in India. A
significant competitive pressure comes from the financially strong commercial banks
that have recently started leasing through their subsidiary companies established for
this purpose. Several financial institutions such as ICICI,
IRCI< SICOM< GIIC< KSIDC have also started lease financing. The industrial financial
corporation with the support of large companies in each of the four regions - Western,
Eastern, Southern and Northern and in collaboration with Twentieth century and bank
on India has entered the leasing industry in a big way.
So have TVS group and the SBI, National Insulated Cables and the united commercial
bank etc.
13.4 TYPES OF LEASES
Generally, leases are classified into (1) Financial Leases (2) Operating Leases (3)
Leverage Leases and (4) Sale and Lease Back Leases. However, other types of leases are
also prevalent in industries particularly in the United States of America, e.g., net and
triple let leases, closed- and open-ended -leases, percentage leases, master leases and
tax credit leases. All types of leases have been discussed in detail.
Classification of leases can also be made both from the view point of the lessor and the
lessee which is shown below:

1. FINANCIAL LEASE
A financial lease is also known by various names e.g. full payout lease, capital lease,
long-term lease, and net lease. In a financial lease, the contractual period between, the
lessee and the lessor is general equal to the expected full economic life of the equipment.
The lessee selects the equipment, settles the price and terms of the sale, and arranges
with a leasing company to but it. The lessee takes the equipment on lease by entering

into an irrevocable (non-cancelable) contractual agreement with the leasing company.
The lessee pays lease rentals on a periodic basis over the period of lease. The lessee uses
the equipment exclusively, maintains it, insures and avails of the after sales service and
the warranty backing it.
Over and above this, the lessee also bears the risk of obsolescence, as it stands
committed to pay thy rentals for the entire lease period even though the equipment
becomes obsolete during the period of lease.
Thus, this type of lease transfers substantially the entire substantially risks and rewards
incident to ownership from the lessor to the lessee.
The contractual period in a finance lease can be a split up into two or three periods over
the life of the equipment. The lease during the first period is called the primary lease
which is for a pre-determined period of say five years (during which the leasing
company recovers the complete cost of equipment along with its recovery of cost of
capital and profit) followed by a perpetual lease on nominal terms/taken rental for the
remaining period of the life of the asset. The primary lease of five years can alternatively
be followed by a Secondary lease of another 3 to 4 years. The lease rental will
accordingly stand reduced during the secondary period.
The finance lease could also be with purchase option, where at the end of the predetermined lease period, the lessee has the option to buy the equipment at a predetermined value or at a nominal value or at fair market value and the lease rentals will
be adjusted accordingly. However, such an arrangement is not being incorporated in the
lease agreements as it is reported that there will be tax complications because a lease
with purchase option is constructed to e a hire purchase transaction. In such case, the
lease rentals will, for tax purposes, be split into principal and interest components. Only
the interest portion will be allowed as a deduction to the lessee instead of entire lease
rentals. A financial lease also contains a non-cancelable clause, which means that the
lessee is committed to continue making lease rental payments to the lessor over the
periods of leas. Thus, in this kind of lease transaction, one can very confidently contend
that in substance the ownership of the asset gets transferred to the lessee.
Under a financial lease, the rate of lease rental would be fixed based on the kind of
financial lease taken, the period of lease, periodicity of rental payment and the rate of
depreciation and other tax benefits available. The periodicity of lease rentals could be
monthly, quarterly or half yearly. Usually an advance of three to four month's rental is
taken by ht leasing company and is adjusted at the end of the lease period. The leasing
company also changes nominal service changes, management fees to cover legal and
other costs. Usually 1% to 2% of the cost of equipment id charge as management fees.
The leasing company may also insist on collaterals or bankers guarantees in individual
cases.
As elsewhere-financial leases are popular in India and high cost equipments are leased
under it. Office equipments, diesel generators, earth moving equipments, plant and

machinery, machine tools, printing presses, textile machinery, containers, locomotives,
hotel equipments etc., are the equipments being leased under financial leases.
2. OPRATING LEASE
An operating lease is also known by short term service, maintenance or true lease. The
contractual period between the lessor and the lessee is generally less than the fullexpected useful economic life of the equipment. This means that the lease period could
be insignificant as compared to the life of the equipment. It contains a cancelable clause.
The risk of obsolescence is that of the lessor who gives the equipment out on lease to
another lessee for short periods. Therefore, in and operating lease, substantially all the
risks and rewards incident to ownership are not transferred to the lessee from the lessor.
Several lessees may enjoy the benefit arising from the economic Sale of the asset before
it is finally sent to the scrap heap.
Thus under an operating or full service lease package, the lessor provides not only the
equipment but also services like the following:
1. Writing specification to meet the client's requirements.
2. Purchasing and financing the equipment and handling all warranty claims.
3. Paying all property and other pertinent taxes
4. Obtaining all necessary Licenses and permits.
5. Scheduling and performing maintenance.
6. Providing extra vehicles (in case of vehicle leases) for the customer's peak Seasons.
7. Keeping complete records of data pertaining to the customer's equipment. Operating
leases are most suitable and popular for computers, copy machines and other office
equipments, vehicles, material handling equipments etc., Equipments like computers,
electronic etc., which are highly sensitive to obsolescence are usually taken on operating
lease basis. Presently, in USA, operating leases are very popular in the truck leasing
market through IBM evolved such leases for its computers.
According to the Truck Renting and Leasing Association (TRALA) of USA nearly 10% of
all commercial trucks in America are leased under operating leases because of the
complexities of managing a private fleet, particularly of complying with the state and
federal licensing, taxation, and record keeping requirements.
The period of lease under an operating lease can be for one month, sex ' months, one
year or for three years. In India, operating leases are being written for a period of three
to five years. The shorter the leases contract period, the higher will be the lease rentals.
FINANCIAL LEASING VS OPERATING LEASE:

Financial leasing differs from operating leasing in different factors right from definition
to role, responsibility, risk, period of lease etc. The distinction between financial lease
and operating lease in various factors is discussed below.

3. LEVERAGE LEASE
A leverage lease is desired to provide financing for assets, which requires huge capital
outlay. This outlay for purchase costs of the asset generally varies e.g., from Rs. 50 lakhs
to Rs. 2crore and having economic life of 10 years or more. Using the above criteria, a
wide range of equipments could be used for these years of financing. Such equipments
include aircraft, rail road rolling stock, coal mining, electric power generation plants,
pipe lines, ships, etc. Under leverage lease, the equipment is usually purchased by an
equity contributor or a group of contributors who invest usually 20 to 50% in the cost of
equipment. The lessor is the equity participant. The balance of purchase cost is met
through the sale of a fixed interest rate, long-term mortgage debt, usually to the
institutional investors. This loan is secured by a first lien in the equipment, by an
assignment of leased equipment, and by assignment of the leased rental payments.
In its simplest form, a leverage lease transaction would proceed in the following
chronological steps: 1. A prime company, the lessee, would select equipment needed in its operation and
would seek appropriate financing.
2. A company with excess funds to invest, the lessors, would determine if the leverage
lease would fit its investment needs and commit itself to the negotiated term with the
lessee. This commitment would be made simultaneously with the receipt of a
commitment from the lender.
3. The necessary documentation would be executed and the equipment would be
purchased with the funds by the lessor (20 to 50% of the cost), and the lender (50 to
80% of the cost). The lessor will receive the title to the equipment and the investment
allowance (though it is a disputed issue yet most of the leasing companies are claiming
this allowance).
4. Thus, a typical leverage lease involves three parties; the lessor-owner trustee; the
lessee, and the institutional lender e.g., a bank, and insurance company or any other
financial institution. Parties involved in leverage lease are shown in the chart
5. Periodic rental payments would be made by the lessee, with the rental being
appropriately divided between the lender (interest and principal) and the lessor (return
on investment). Upon termination of the lease, the lender would be fully paid, as to
interest and principal and the lessor would own the equipment which could then be
should or rented as its fair market value. The lessee would normally have the right of the
first refusal as to the purchase or continued renting to the equipment.
The above each chronological step would require a number of experts from various
areas. Exerts in Law, Accounting, Insurance Equipment and Financing must be brought
together in order to successfully enter into a multi-million rupee leverage lease.

Involvement of Parties in a Leverage Lease

TAX IMPLICATIONS
For the owner of the equipment under a leverage lease, there are also some attractive
investment features in the form of an after-tax consequence. The gearing principles
itself has great impact on the lessor's tax consequences. The gearing principles itself has
great impact on the lessor's tax. By investing say, 20% of the cost of an asset, the lessor
is entitled to the 1005 of the allowance for depreciation plus the investment allowance.
In addition, the interest expenses related to his borrowing of the other 80% of asset cost
looks solely to the lessee for amortization of its loan through the payment of lease
rentals. The lessor is in a non-recourse position; its only exposure is to the risk of losing
equity contribution.
From the viewpoint of the lessee, lease rentals are deductible in full as an operating
expense, whereas, only the interest portion and none of the principal retirement of a
direct loan would qualify as a legitimate cost of doing business. Assuming a loan that is
fully amortized by the assignment of lease rentals, the lessee will be, in effect, writing
off80% of cost over the term of the lease. This can have a very significant impact in
terms of after-tax cash flow projection for new capital projects.

In addition, it is usually found that the after-tax cost of leasing is higher than the cost of
direct ownership. However, this does not constitute a very strong deciding factor to
accept or reject a lease-buy decision. The timing of lease payments and lack of down
payment and lack of down payments can result in a lower net present value of cash
outlay than the outright purchase.
And the degree of leverage i.e. debt -equity ratio varies depending upon the type and
nature of the equipment finance, risk coverage or the credit worthiness of the userlessee. If the lessor carries with him a high credit standing the cost of loan will be lower
which should be reflected in the lower rental payment by the lessee.
4. SALE AND LEASE BACK
As the name suggests, under this form of lease arrangement, the firm sells an assets
already owned by is to another firm/party and hires it back from the buyer. The lessor is
ordinarily a financial institution such as commercial bank, development bank, insurance
company or leasing company. Usually, the asset is sold at approximately its market
value. The firm receives the sale price in cash and the economic use of the asset during
the basic lease period. In turn it contracts to make periodic lease payments and gives up
little to the asset. As a result the lessor realizes any residual value; the asset might have
at the end of the lease period, whereas before, this value would have been realized by the
firm. The firm may realize an income at an advantage if the asset involves a building or
owned land. Owned land is not depreciable if owned outright. Leased payments are tax
deductible, so the firm indirectly is able to amortize the value of the land. A sale lease
back arrangement is normally initiated / preferred by a firm, which is suffering from the
shortage of funds for its operations or is faced with liquidity crisis. By such an
arrangement, the firm can not only salvage its liquidity position, but also retain the
services of the asst for the life of the lease. The lease provisions are generally similar to
those of the financial leases.
For example in April, 1989, SCICI purchased Great Eastern Shipping Company's bulk
carrier, Jaghater, for Rs. 12.5 crores and then leased it back to Great Eastern on five year
lease, rentals being Rs. 28.13 lakhs per month. The ships written down value were Rs.
2.5 crores. The option of purchasing the leased asset by the lessee is not incorporated
into his lease contract in India because if such an option is provided, the lease is legally
considered to be a hire purchase agreement.
TAX IMPLICATIONS
Sale and lease back arrangements offer some tax saving that result from the sale of
property at a loss arising due to the difference between written-down and the sale of
property. This loss may be claimed as terminal depreciation. If the sale value is more
than the written-downer value but not exceeding the original cost of the asset, such
profit is taxed at the normal business tax rate. If the sale value is more than the original
cost of the asset, the difference is calculated as capital gain and attracts capital gain tax,
which is always lower than the normal business tax. At the same time taking the

property on lease basis, and paying the agreed rentals, which are also admissible for tax
deduction. Therefore, this type of lease offers tremendous tax savings.
The main points of difference between the four main types of leases are shown below:

OTHER TYPES OF LEASE
In addition to the above discussed forms of lease, some more types of lease are also
prevalent throughout in India but in other advanced countries. These are discussed
below:
1. Direct Lease
In contrast to the sale and lease back arrangement; under direct leasing the lessee does
not already own the equipment. He acquires it either from the manufacturing company
directly or arranges the desired equipment to be purchased by the leasing company. In
the former situation, the manufacturing company itself acts as lessor. A wide variety
directs leasing arrangements meet various needs of firms. For leasing arrangements
involving all but manufacturers, the vendor sells the asset to the lessor, who in turn
leases it to the lessee.
2. Net and triple net Lease
The term net lease (same as financial lease) and triple net lease generally refers to leases
in which the lessee is obligated to pay the following typical executor costs in addition to
and separate from the basic lease payment;
(i) Sales tax; (ii) property tax; (iii) Insurance; (iv) Maintenance and servicing; (v) repair;
(vi) temporary replacement property; (vii) parts and accessories; and (viii) licenses and
registration. In the net-net lease, the lessee is further obligated to guarantee a certain
residual value to the lessor at the end of the lease. The lessor sells the returned asset and
the lessee must make up any deficit between the salvage proceeds and the guaranteed
residual amount.

3. Closed and Opened-Ended-Lease
Close-end or "walk away" leases are usually structured on a net lease basis and at the
end of the lease, the equipment is returned to the lessor. The full risk of residual value
loss rests with the lessor. Ownership possibilities are "closed" to the lessee. Open-endleases are generally net leases, where title to the asset passes to the lessee upon
exercising of a purchase option of payment of a guaranteed residual. Frequently, these
leases are structured like financial leases on a full payment basis; part of the risk of
residual value is passed onto the lessee. Ownership possibilities are 'open' to the lessee.
4. Percentage Lease
Under this lease, the lessee is required to pay a fixed amount of rent each period plus a
percentage of gross revenue received during the previous period. Usually the additional
percentage rent is calculated as a percentage of revenue received above a minimum base
amount, such lease arrangement help to compensate lessees in part for the effects of
inflation since percentage leases are generally structured for the long term use of
commercial real estate.
5. Master Lease
Master leases are structured for lessees who either will be leasing numerous pieces of
equipment to the received over a period of time or leasing equipment that requires
frequent substitution. The master lease-per-establishes lease rates and terms for
equipment received or substituted as needed. Leasing of auto or truck to a single lessee
is frequently accomplished on a master lease bases in the United Stated of America.
6. Tax Credit Leases
Tax credit lease is a means of buying and selling certain tax benefits associated with
asset purchase in the guise of lease agreement. The lessor is typically the owner of the
asset for tax purposes only the lessee retains the title to the asset. In contrast to a
financial lease in which cash lease payments pass between the lessee and the lessor, only
cash payment for tax benefits occur in a tax credit lease. This type of lease is found only
in the United Stated of America where lease is an agreement between the nationals of
two countries. The lessor may be of one country and the lessee may be of another
country.
Much of the export leasing Business are undertaken by subsidiaries of manufacturers for example - Williams and Glyn's leasing of U.K. set up in 1975 two off shore leasing
subsidiaries specializing in exporting of containers. A number of American banking
groups, including Bank of America, Citi corp, and Manufacturers Handover Leasing
Corporation, Have been mostly involved in developing the cross border market, cross
border leased are yet to be popularized in India.
There are certain problems associated with cross border leases e.g. credit assessment
(due to different accounting practices), political risks, currency complications,

registration requirements, differences in commercial laws and fiscal systems of the two
countries. However, on the initiative of EEC, the International institute for the
unification of private Law (UNIDROIT) is actively engaged in preparing draft of uniform
rules for leasing in different countries.
13.5 SUMMARY
Leasing emerged as one of the important sources of long term financing. It facilitates a
company to grow faster today instead of waiting for an uncertain tomorrow.
13.6 REVIEW QUESTIONS
1. Describe leasing and explain its nature and growth
2. Explain the types of lease financing in India with suitable examples.
13.7 ASSIGNMENT QUESTION
1. Compare and Contrast financial lease and operating lease
13.8 KEYWORDS
Leasing, leasehold property, lease, lessor

- End Of Chapter LESSON-14
ECONOMICS OF LEASING

OBJECTIVE
·

Leasing is a complex financial activity and before a transaction is concluded the
economics of leasing should be carefully worked out both by the lessor and the
lessee.

STRUCTURE
14.1 Introduction
14.2 Practical aspects of Economics of leasing

14.3 Risk associated with lease financing
14.4 Buy versus lease - evaluation
14.5 Summary
14.6 Review Questions
14.7 Assignment Questions
14.8 Keywords
14.1 INTRODUCTION
Real awareness of leasing industry both to entrepreneurs and to users seems to have
taken place in mid - 83 in India. Probably this was part of general trend of economic
liberation prevailing in the country. Through tools of finance are not yet liberalized but
if the present thinking continues that day may not be too far. If industrial liberation
takes place, leasing industry will be the first to create more resources for industrial
growth at the least cost. One of the welcome steps taken into his regard is permitting
leasing companies to borrow upto ten times the net worth.
Leasing has become single - most important source of funding world over in recent
years. It will be interesting to note that in USA, where leasing industry is the oldest,
largest, and most matured. It contributed 74.4 billion dollars in 1984, out of the total
business investment of 285.4 billion dollars. In ship - building, aircrafts, motor vehicles,
railroads and computers' market and material handling equipments, more than 25% of
total funding was by leasing. Thus it is apparent that leasing is a dominating asset
funding and products which are standardized and uniform. Especially operating leases
have become the favorite of users. Similar trend is likely to arise in India also.
14.2 PRACTICAL ASPECTS OF ECONOMICS OF LEASING
Now it is proposed to discuss some practical aspects of economics of leasing under
various heads as under.
A. Advantages of Leasing over other modes of funding
1. It is no margin funding. Leasing frees working capital for more productive use since
the money is not tied up in-low yielding fixed assets.
2. Depending on tax structure of the lessee it may cost less than other methods of
acquiring equipment.
3. It may permit more amortization of the equipment than would be possible using
various methods of depreciation.

4. Leasing avoids restrictions frequently found in loan agreements. Leasing might allow
the company a degree of flexibility in additional financing that might not be available
when resorting to debt financing. Banks and other financial institutions frequently
impose restrictions prohibiting future financing, whereas the lease agreement will
usually not impose such restrictions. The lessor's financial interest is considered secured
by equipment or property itself. Banks would require more security in the same
situation.
5. Leasing establishes only a restricted and fixed obligation against the company, which
may be satisfied by the payment of rent.
6. Leasing may increase long-term ability to acquire funds. It is an additional source of
credit.
7. Leasing does not appear as a liability on the lessee's balance sheet hence do not
disturb ratios/norms of term lenders.
8. Leasing arrangements may be tailored to the lessee's needs more easily than ordinary
financing. Variable payment leases can aid lessees who experience wide seasonal
fluctuations in their revenues. Thus, lease payments can be structured to match the
lessee's revenue curve or skipped during the months where revenue is expected to be
low.
9. Leasing companies will frequently lease to poorer risks than banks since the lessor
looks to the equipment value as compensation for risk. Thus, leasing might be the only
available alternative to a new small, risky company.
10. It permits organizations to acquire new equipment without going through formal
scrutiny procedures. Lease funding is speedier.
11. In India leasing offers an ideal avenue for companies which want to invest in fresh
plants and equipments but do not want to go for fresh equity or loans from financial
institutions because of fear of takeover or because of the convertible clause.
B. Indian Factor
1. Leasing in Indian context has certain special advantages. Assets in Lease do not come
within the definition of "assets owned" for MRTP. Though with recent increase in MRTP
ceiling limit to Rs. 100 crores this advantage may not be very material for large section
of customers.
2. Funding to non - priority sectors like distilleries, confectionary units, bottles from
financial institutions and baking sector is severally restricted. Leasing can meet these
requirements. Similarly for acquisition of office or restaurant premises no organized
funding is available. Here leasing industry can fund along with tax benefits. These are
the sectors with good in cash flow and therefore leasing is better suited.

C. Business Advantage of leasing
1. It permits hedging of business risks. Primarily risk of obsolescence can be shifted on
the lessor.
2. Leasing minimize danger of being oversold.
3. Assets on operating lease assure adequate servicing and better asset management.
4. Leasing is a hedge against inflation.
5. Flexibility of operations and control over fixed overheads is easier if assets are leased
than owned.
6. Leased asset pays for it is generating revenue.
7. A lease makes cash budgeting easier by permitting accurate prediction of cash
expenses compared to the financing of equipment with short terms borrowing which
requires constant financings at unpredictable interest rates; the fixed nature of lease
payments is helpful in forecasting cash requirements.
D. Social Benefits
1. As a sales tool the growth of vendor programmers and of capital leasing companies is
a testimony to leasing importance in marketing. This generates higher demand.
2. Leasing supports industrial modernization for small business adds startup companies
and accelerates investment decisions and industrial modernization and productivity.
3. Leasing add to the implementation of industrial and fiscal policies. As companies go
through cycles in their ability to use tax incentives for capital investment and cycles in
access to other sources of funds, leasing provides an important intermediation function
to allow for the most efficient acquisition of equipment.
4. The source of economic advantages of financial activity lies in the separation of
ownership of resources from their management. Leasing gives this asset transmutation
effect in maximum way. With the growth, leasing industry diversifies into offering better
asset management services, which hold value to user of the assets. For example, cars are
offered with services of insurance, tames replacement and even repairs. Thus, it creates
important social benefits for society at large.
5. Leasing maximizes tax incentives and accelerates government objective of converting
tax-incentives in economic activity by reducing net cost of asset formation to user.
Lessees liable for higher tax can lease the asset from lessors liable for lower tax and
obtain in return a lower tax incidence. Similarly, lessee’s eligible for higher tax
allowances, but not in a position to take full advantage of these could allow the lessors to
obtain the advantage and obtain reduced rentals in the bargain. Thus leasing company

becomes the media for equalizing tax-benefits. Above discussion does establish
importance of leasing but a user must evaluate other options open to him of funding and
its related benefits. Important checklist for the lessee can be listed as under.
1. Tax-incidence on buys or lease option.
2. DCF net of taxes of buy-loan and lease proposals. The effects of fixed cash outlay on
current and projected profitability must be carefully evaluated.
3. Asset evaluation with regard to its risk of obsolescence, service cost, use, residual
value, productive life and its relation to owning or leasing. Through as it stand s today,
most of the leasing is on financial lease basis a where this considerations may not be of
much importance.
4. Selection of the lessor is equally important. Leasing company being the owner of the
asset, its financial strength, supported services offered, future, relationship etc., are
important.
5. Legal checking from lease documentation to the effect of leasing under MRTP, SSI
registration, customs duty, ST., FERA, labour laws etc., requires to be seen. It will be
better to take professional advice preferably of one who is active in leasing business.
Law on leasing is not developed in India and it may take couple of years before disputes
between the lessor and the lessee come to head. In USA most of the transactions being
concluded by new and established old leasing companies appears to be in legal form,
which can be held in court as conditional sale. If that happens then the lessor cannot
claim depreciation, cannot recover asset, and cannot borrow on security of that asset.
14.3 RISK ASSOCIATED WITH LEASE FINANCING
In spite of the multifold advantages, there are certain risks associated with financial
leasing. They are summarized below.
1. Risk of being deprived of the use of Equipment
The lessee has only the right to use the asset as the ownership lies with lessor. If the
lessor's financial condition deteriorates or if the leasing company is wound up, the
lessee may be deprived of the use of equipment interrupting its normal manufacturing
operations.
2. Alteration/change in the asset
Under the lease, the lessee is generally prohibited from making alterations,
improvements on the leased asset without the prior approval of the lesser. Moreover,
the lessor may impose certain restrictive conditions regarding the use of the asset, which
may create problems to the lessee.
3. Terminal value of an asset

In the case of assets (such as land and buildings), which have higher terminal value at
the end of the lease term, it would be more appropriate to own the assets than to lease it
as the salvage value belongs to the lessor.
There are certain risks connected to leasing which require close scrutiny. For example,
sale-lease back can be treated as sharp transaction. Criminal-liability on vehicles on
lease can be saddled on the lessor and legal right to claim rentals in case of shortfall is
not free from doubts. If either the lessee or the lessor becomes bankrupt, the lessor
should make proper documentation and safeguard to protect its interest. Further, lease
evaluation techniques require to be established in industry. Abroad, specialized software
package is available to work out sensitive analysis on different variables. Sterling has
perfected such software and will be marketed soon. The most important part of business
is matching of lease rental inflow with fund repayment outflow. The importance of
credit evaluation in leasing cannot be less than in banking. The lessor will have to
judiciously weigh all the parameters of risk and benefits and then take a decision.
The above analysis as only thrown a few pointers for the lessor just as to show the risks a
lessor is taking.
14.4 BUY VERSUS LEASE-EVALUATION
Financial managers are frequently involved in the decision-making process relating to
the acquisition of long-term assets carrying colossal amount of capital expenditure. As a
result of the emergence of leasing, the important decision for most of the firms is
whether to acquire the property, plant and equipment through outright purchase or
leasing arrangement. The decision process appropriates much of the valuable time of
the financial manager and requires his critical bent of mind.
In the parlance of business finance, a decision is classified either as a financing decision
or an investment decision. In case of financing decision, the object is to select the best
source of finance involving minimum cost. In case of an investment decision, the object
is to select the best available outlet, which will minimize the return on investment after
taking into account the risk factor associated with the project. If a firm is deciding
between leasing and borrowing, it is purely a financing decision. If a firm is deciding
between leasing and buying, it is a combination of both investment and financing
decision. It may be said that leasing is both a way of acquiring the use of an asset and a
way of financing that acquisition. In essence, leasing is such a capital budgeting decision
that does not involve initial cash outlay. Since it is possible to acquire plants and
equipments by outright purchase or by leasing, the financial manager will attempt to
achieve the most profitable combination. Leasing decision should be considered both a
capital budgeting decisions as well as a financial structure decision.
14.5 SUMMARY
In fine, it can be said that lease financing is a contractual arrangement under which the
owner of the asset called the lessor allows the use of asset by lessee in consideration for
lease rent. In other words, leasing provides an enterprise with the use of and control

over assets without receiving title to them. Leasing has come to stay in India and it will
play its important role in asset formation as it has been doing in other developed
countries. However being infant, it requires to be nurtured by the government.
14.6. REVIEW QUESTIONS
1. How lease financing is different from debt financing and state the merits and demerits
of leasing.
2. Describe the economics of leasing.
14.7. ASSIGNMENT QUESTION
1. What are the typical contents of lease agreement? Narrate the process of lease
agreement.
14.8. KEYWORDS
Business Advantage, Social Benefit, financial structure decision.

- End Of Chapter LESSON -15
LEASING DECISIONS

OBJECTIVES
The important objectives of this lesson are:
To evaluate leasing decisions from the point of view of both the lessor and lessee, by
giving suitable examples.
To find the determinants of success of leasing in India.
To narrate the problems and prospects of leasing in India.
STRUCTURE
15.1 Introduction
15.2 Financial Evaluation of Leasing

15.3 Summary
15.4 Review Questions
15.5 Assignment Questions
15.6 Keywords
15.1 INTRODUCTION
Leasing is a two-step decision for the firm (Lessee). First it has to evaluate the economic
viability of the asset as an investment. If the asset has a positive net present value, the
company should proceed to acquire the asset. Once it has decided to do so, the firm can
compare the cost of financing the asset through leasing with that of normal sources of
financing. Given the nature and size of its investment decision, a firm has to evaluate
whether it will purchase an asset or acquire it on lease basis. Since lease rental payments
are similar to payments of interest on debt, leasing, in essence, is an alternative to
borrowing. The lease financing decisions, thus involve a choice between debts financing
versus lease financing. In this lesson, an evaluation of lease financing is made from the
viewpoint of lessee and lessor.
15.2 FINANCIAL EVALUATION OF LEASING
1. Financial Evaluation from the lessee's point of view:
To evaluate an asset that can be taken on lease as per Lessee's view, the analysis must be
expanded to consider the lease financing option in addition to the conventional debt and
equity financing. Such and analysis requires the standard capital budgeting type of
analysis for two alternative financing packages.
Under lease, the lessee has no initial cash outlay for acquiring assets by way of margin
money. The lessee is not required to make disclosure regarding the finance raised
through lease package. Leasing provide an effective hedge against inflation to lessee.
The lessee gets an opportunity for tax planning regarding the fixation of rentals. Leasing
releases funds for investment in working capital. It enables the lessee to pay for fixed
assets out of the earnings of the assets acquired on lease. A lessee with a very low tax
rate may like to have capital equipment by negotiating educed rentals. Leasing allows
the lessee a greater degree of flexibility in additional financing as against debt financing.
The valuation of lease financing form the viewpoint of Lessee involved the following
steps:
1. Determine the after tax cash outflows for each year under the lease alternatives. This
is arrived at by multiplying the lease rental payment (L) by (I-tax rate t)
2. Determine the after tax cash outflows for each year under the buying alternative
based on borrowing.

3. Compare the present value (PV)of the cash outflows associate with leasing (step 1)
and buying (step 2) alternative by employing after tax cost of debt (Kd) as the discount
rate for the purpose.
4. Decide whether the asset should be purchased or leased or the investment proposal
rejected.
The following decision rules may be employed to decide whether to (i) purchase the
equipment or (ii) lease or (iii) reject the proposal altogether (P=purchase L=lease)
i) If NPV (P) is positive and also greater than (NPV(L)) - purchase.
ii) If NPV (L)is positive and also greater than NPV (P) -lease.
iii) If NPV (P) as well as NPV (L)is negative - Reject the proposal.
To illustrate the above procedure, let us consider an example
Example
Omega Company is thinking of installing a computer. It is to decide whether the
computer is to be purchased outright (through 14% borrowings or to be acquired on
lease rent basis.
The firm is in the 50% tax bracket. The other data available are:
Purchases of Computer
Purchase price
Annual Maintenance (to be paid in
advance)
Expected economic useful life
Depreciation
Salvage value

Rs. 20,00,000
Rs. 50,000 per year
6 Years Straight-line
method
Rs. 2,00,000

Leasing of Computer
Lease charges (to be paid in
advance)
Maintenance expenses
Payment of Loan

Rs. 4,50,000
To be borne by
lessor
6 year - end equal
Installments of Rs. 5, 14,271.

Rs. 2,00,000
You are required to advice the company as to whether it should purchase the computer
or acquire it on lease.
Solution
Lease payment

= Rs. 4, 50,000

Less Maintenance = Rs. 50,000
----------------Expenses

4, 00,000
-----------------

Leasing Alternative
Calculation of the Net present value of the leasing option
Lease
(Net)
Year end

1
0
1-5
6

Payment
Rs.
2
4,00,000
4,00,000
4,00,000

Buying Alternative

Cash out
Tax shield

PV factor@
flows after
7%
taxes

3
2,00,000
2,00,000

4
4,00,000
2,00,000

5
1,000
4,100
0.666

Total (Col)
4
(Col) 5 Rs.
6
4,00,000
8,20,000
1,33,320
10,86,800

Schedule of Debt Payment
Principal
Loan

Loan at the

Installment beginning of
Year end
Rs.
1
1
2
3
4
5
6

2
5,14,271
5,14,271
5,14,271
5,14,271
5,14,271

the year
3
20,00,000
17,65,729
14,98,660
11,94,201
8,471,118
4,51,443

Payment

Principal

Interest

Repayment

Loan (Col 3- (Co1 2-Col
4)
*14%)
4
2,00,000
2,47,202
2,09,812
1,67.188
3,67,596
62,828

5
2,34,271
2,67.069
3,04,459
3,47,083
3,95,675
4.51,443

20, 00,000 - 2, 00,000
Depreciation = ------------------------------- =3, 00,000
6

Outstanding
at the end
of the year
Col (5) Rs.
6
17,65,729
14,98,660
11,94,201
8,47,118
4,51,443
-

Recommendation
Leasing alternative should be preferred (Rs. 10, 86,800) to buying (Rs. 11, 51,526) as it
involves less cash outflows.
2. Lease Rate Determination by the lessor
For the lessor, leasing forms an activity with a lower gestation period as compared to
other investment opportunities. The lessor is entitled to depreciation including
additional depreciation and investment allowance on the total cost of the asset.
The lessor will undertake cost benefit analysis of leasing out the assets. He will be
willing to go for leasing agreement only in the event when the asset earns return which
exceeds his weighted averages cost of capital (Ko). In other words, after-tax cash inflows
accruing to him must generate a rate of return, which is greater than Ko. In operational
terms, NPV should be positive. The following is the list of steps required for financial
evaluation from his point of view:
i) Determination of Cash outflows
Cash outflows would constitute cost of the asset minus tax advantages due to investment
allowance, if any.
ii) Determination of Cash inflows
Lease Revenue (Gross Cash Inflows)
Less tax on lease revenue
Add tax shield on depreciation
iii) Selection
Decide for leasing if PV of cash inflows exceeds PV of cash outflows.
Other Consideration in Leasing Decisions
In addition to the financial considerations discussed above, there are several other
considerations which may be relevant in a buying leasing decision situation. Some of the
important among them are:
1. Borrowing Capacity of the firm
Lease financing and debt financing both result in fixed financial commitments yet it
appears that leases are not properly acknowledged in judging financial leverage.

To illustrate the above point, consider a firm kushaal company which presently has Rs. 1
crore of assets financed by Rs. 50 lakhs of equity and Rs. 50 lakhs debt. The firm
requires Rs. 50 lakhs of additional assets. If Rs. 50 lakhs of new assets were obtained on
lease, its balance sheet would remain unchanged. Its debt equity ratio, too as
conventionally calculated would remain unchanged at 1:1. If Kushaal were to acquire
these assets with debt finance, its balance sheet would show a different picture; assets
would increase by Rs. 50 lakhs (and liabilities would increase by Rs. 50 lakhs). As a
result the debt equity ratio of the firm would increase from 1:1 to 2: 1.
2. Matching of Lease Rentals to Cash Flow Capability
The pattern of debt servicing burden with a certain amount of term loan is more or less
uniform for all types of borrowers. This is because a term loan is typically repayable in
16 equal semi-annual installments and the interest is payable on the outstanding loan
amount's against this, lease financing companies claim that they can reduce lease
rentals to match the cash flow capability of the lessee. They offer the following patterns
of lease rentals:
Seasonal lease rentals have appeal to firms, which have pronounced seasonality in their
operations.
Stepped up lease rentals are suitable for firms, which are likely to experience a gradual
increase in their revenue over period of time. Deferred lease, rentals can be applied
when there is a long gestation period before revenues are generated.
3. Ownership versus Leasing
A lease, because of its fixed obligations, must be regarded as a form of borrowing by a
potential lessee; its desirability can only be tested against the alternative of borrowing of
an equivalent amount of funds. In practice, one compares with alternatives that are
possible. They may call for payments on slightly different terms. In core to focus only on
the tax distinguishing features of leases, we assume the alternative of a debenture debt
for the whole amount.
Example
The Anna stores lease the property for a cash price of Rs. 2, 25,000; to avoid paying out
this sum, the firm accepts the schedule to pay Rs. 22,035 annually at the end of each of
the first 10 years and Rs. 11,583 at the end of years 11 to 25. The internal rate of return
worked out from these figures is 6% before taxed, which reduces to 3.12% after a 48%
tax shield is taken into account.

Solution

Explanation
The above example gives an opportunity to compare ownership with leasing with
repayment terms and interest rate in an instance where the differences are confined to
the tax treatment, which is afforded the lease payments, as contrasted with the
depreciation, which is granted with ownership, and to the ownership of the terminal
value.
The schedule of after tax cash flows demanded by the lease is easily derived, for if the
lease is used, all of the annual rent is a tax-deductible expense. In each of the first 10years, the payment of Rs. 22,035 results in a tax shield of Rs10, 577 (@ 48%) so threat
the net cash flow is Rs. 11,458 (Rs. 22,035 - 10,577). In the ensuing period, the annual
rent is Rs. 11,583 and the net cash is Rs. 6,023. These net cash, outflows called for by the
lease are pictured cumulatively, in this following Graph-1, The total of the yearly after
tax figure over the 25 years period is Rs. 2,04,925.
To make a schedule of the after Tax cash flows for the borrowing is more difficult
because not all the annual payment is to be treated as expense for tax purposes. Instead,
a tax shield must be computed from the total of the interest paid on the loan plus the
allowable depreciation expense. This total is then deducted from the before -tax
payment to produce the after-tax cash outflow to be compared with the lease. The
cumulative figures appear in the chart.
The assumed loan, following the payment pattern established by the lease, contains two
parts. One part is a fixed loan for the first 10 years of Rs. 1,12,500, Amortized in years
11-25 by the annual payment of Rs. 11,583. In each of the first 10 years, it requires
interest expenses at 60% of Rs. 6750. The second part of the loan is also Rs. 1, 12,500 to
be amortized in the first 10 years.
GRAPH -1
ACCUMULATED AFTER TAX CASH OUTFLOWS IN
BORROW Vs LEASE METHODS OF FINANCING AN INVESTMENT

The first annual payment of Rs. 22,035 may be subdivided as follows:
Rs.
6750 Interest on the first (constant) part of the loan
6750 Interest on the first (constant) part of the loan
13,500 Total interest expense
8535 The balance, used to reduce the principal of the Second part of loan
---------22,035 Total
---------The second annual payment reflecting the-reduction of the second part-of the loan by
Rs. 8535 from Rs. 1, 12,500 to 103965 may be subdivided as follows:
Rs.
6750 Interest on constant part of the loan
6238 Interest on reducing part of the loan
12,988 Total interest expenses
9,047 The balance used to reduce the principal
22,035 Total
Following this procedure, the interest expense for each of the 25 years may be
computed.

Having obtained the interest expense, one must also know the depreciation expense in
order to have the total expenses from which the tax shield can be computed year by year.
In the case of ownership of the Rs. 2, 25,000 investment, Rs. 25,000 cost of land may
not be depreciated. The new guidelines permit a 10-year schedule for the equipment and
40years for the building. The greatest tax advantage lies in using one of the accelerated
methods now available and we can use the double-declining balance shifting to straightline scheme. On this basis, the depreciation for the first year is Rs. 10,000 and Rs. 8,000
for the second year on the equipment costing Rs. 50,000. It is Rs. 7500 for the first year
and Rs. 7,125 for the second year for the Rs. 1, 50,000 building.
The tax deductable expenses for the first 2 years appear in the accompanying table,
together with a computation related to loan for each of the 25 years; we find the total of
the outflows to be Rs. 2, 36,282 which is Rs. 31357 larger than the total of after tax
outflows demanded by the lease. This difference may be due to the difference in tax
shields because, other possible variables such as the rate of interest and the schedule of
payments were assumed to be the same. The lease permits the tenant to take as expense
all of the Rs. 2, 25,000 invested in the property. But in the case of ownership only the
equipments is fully depreciated. Therefore only the first 25 years of the 40-ye81
'schedule for the building has been used, totaling Rs. 1, 09,672. And the land is not
depreciated at al. These figures show that in 25 years ownership will develop a tax a
shield.
Nevertheless, it must be remembered that the question of termina1values is always
present. Where the tax advantages of a lease are not as great as in the above example,
some bargaining over the matter can be expected, resulting in terms of a lease more
favorable to the lessee. It is more and more being recognized that the Rs. 2,25,000 in
funds provided by the lease is only for the use of the property and that a lessee who gives
up ownership is in reality adding the forgone terminal value to the more easily seen
cost's of this lease.
It is advised to the managers of the Anna stores to take the lease arrangement as it tells
that lease form of providing its needs will leave the firm with funds for other uses.
15.3 SUMMARY
We can summaries the place of the financial lease in the area of bargaining for funds by
saying that its obligations are to be regarded as a form of debt, treated in financial
analysis in the same way as the burden of a bond issue. Leases are used for both small
and large transactions and other-variety is great. They are often used by large
companies to finance specific projects when the property is available on favorable terms.
A firm may prefer to lease rather than by in view of the manifold advantages it offers; it
shifts the risk of technological obsolescence to the lessor, it is a convenient source of
financing fixed assets particularly in situations when the lessee finds difficult to borrow
money on his own. It conserves borrowing capacity through off the balance sheet
financing. However, these potential/possible advantages of leasing must be weighed
against its cost in terms of the possibility of being deprived of the use of equipment,

alteration/ change in the asset and terminal value of the asset. The question of
ownership versus leasing becomes one of the finding convenient sources of funds, rather
than one of cost advantages, for the tax shield pattern will be unchanged. It is on the
basis of comparison of the quantitative as well as the qualitative monist ad demerits that
a firm should choose between the two financing alternatives: "Leasing and Borrowing".
15.4 REVIEW QUESTIONS
1. Describe the procedure for evaluating lease alternative to buying alternative.
2. An industrial unit desires to acquire a diesel generating" set costing Rs. 20 lakhs
which has an economic life of 10 years at the end of which the asset is not expected to
have any residual value. The unit is considering the alternative choices of
a) Taking the machinery on lease or
b) Purchasing the asset outright by raising loan Lease payments are to be made in
advance and the lessor requires the asset to completely amortized over its useful period
and the asset will yield him a return of 10%
The cost if debt us worked at 16% per annum, the lender requires the loan to be rapid in
10 equal annual installments, each installment becoming due at the beginning of the
year. Average rate of income Tax is 50%. It is expected that the operating costs would
remain the same under either method. The firm follows straight-line method of
depreciation. Advice the unit, which alternative leasing or purchasing is preferable.
15.5 ASSIGNMENT QUESTIONS
1. ABC constructions and company needs to acquire a crane for construction business
and is considering whether to buy or lease. The crane costs Rs. 20, 00,000 and it’s
subject to straight-line method of depreciation to zero salvage value at the end of 5
years. In contrast, the lease rent is Rs. 4, 40,000 per year to be paid in advance each
year for five years. The ABC constructions can raise debt at 14% payable in five equal
annual installments, each installment becoming due at the beginning of the year. It is in
50% tax bracket. Adverse the company, whether to lease or borrow.
2. A firm proposes to lease an asset of Rs. 30, 00,000. The annual, lease rentals at the
end of the year will be Rs. 6, 00,000 per year for 5 years. The firm is not in a position to
pay tax for next 5 years. The depreciation rate is 25% per year. If the asset is bought,
investment allowance could be available at 20 percent in the first year. The lessor's
marginal tax rate is 50 percent. Calculate the present value of lease to the lessee and the
lessor. What are the break-even rentals to the lessee and the lessor? How can both
benefit from the deal? Would your answer change of investment allowance is not
available? Furnish the computations.
3. Describe the effect of leasing on borrowing capacity of a firm.

15.6 KEYWORDS
Initial cash outlay, cash inflows, lease rentals.

- End Of Chapter LESSON -16
LEASE FINANCING IN INDIA

OBJECTIVE
·

The basic objective of this chapter is to analyze the growth of lease financing in
India. The determinants of success of leasing in India are also discussed. The
present status of leasing in India, the reasons for it is elaborated in this chapter
for thought knowledge of the students. The potentially of leasing, the future
prospects of leasing in India and the role of government are also described in this
chapter for the in depth study of the students.

STRUCTURE
16.1 Introduction
16.2 Finance to Various Sectors
16.3 Growth of Lease Financing in India
16.4 Reason for Slow Growth of Leasing in India
16.5 Determinants of Success of Leasing
16.6 Potentiality of Leasing
16.7 Role of Government
16.8 New Challenges and Opportunities
16.9 Summary
16.10 Review Questions
16.11 Assignment Questions

16.12 Keywords
16.1 INTRODUCTION
Leasing has proved to be an effective system of financing capital equipment in Europe,
Japan and USA. It is now gaining popularity in India also. Of course, land leasing has
been quite prevalent in our country from old times. However, leasing of capital
equipment is of recent origin. As a formal instrument of industrial finance, the country
witnessed the emergence of leasing companies in the early 70's. The pioneer in this field
was 'First leasing company of India Limited' (FIC) based in Madras. The company
started its business in 1973 and it has slowly grown over years. Since then, a number of
other leasing companies have come in to existence. They are Mazda leasing company,
pioneer leasing, Twentieth Century Leasing Company, Express leading company etc. as
a matter of fact, in the last five years, the pace at which the number of companies are
entering into the leasing business, it can be said that there is a mushroom growth of
leasing companies. With the amendment in the Banking Regulation Act 1949, a large
number of nationalized banks are also participating directly in the leasing business.
In 1979, 20th century leasing private limited was incorporated which decided that
leasing would be a major growth is in industrial financing. The Jaybharat credit and
Investment Company involved in the hire purchase business took the plunge to enter
the leasing business in 1981. Later on Sundaram Finance of the TVS group, Mazda
Leasing, Cholamandalam investment and finance company entered the area. The recent
amendments to the banking Regulation Act 1949 will also empower commercial banks
to establish subsidiaries with approval of RBI for carrying leasing activities.
16.2. FINANCE TO VARIOUS SECTORS
A major sector expected to avail of leasing is the service consisting of computer services,
transport operators, construction equipment, hospital services, firms dealing in
consumer durables etc. Where the new entrepreneurship is being attracted, the leasing
companies have to provide the complementary support.
Among the existing enterprises, the small and medium sized units rather than large
units are likely to provide the main market for leasing.
16.3 GROWTH OF LEASE FINANCING IN INDIA
The reasons for the slow progress of leasing in India up to the end of seventies are
important to note. India, among the less developed countries, had an extremely well
developed financial infrastructure with term lending institutions that provided adequate
resources to industry restricted the growth of leasing business. But the scenario over the
past decade changed drastically forcing industry out of the existing financial framework
into alternative sources of financing. Leasing is one such source. The development of
equipment leasing has taken a fairly long time in India. The interest in leasing has come
more as a result of certain institutional constraints operating in the commercial and

development banks. These constraints were felt at a time when inflationary pressures
were being built up requiring the industry to seek unconventional methods of financing.
The growth of leasing companies has been made possible by proper segmentation of the
market, identification of areas of specialization and providing a need-based service to
the new emerging industries. Some of the successful leasing companies are in a position
to provide their clients with wide range of consultancy services in addition to their
involvement in leasing business. The Nagarjuna group of Hyderabad is one such new
comer. The group claims to be interested in providing a financial package.
Leasing of imported equipment has become a big growth field. The leasing companies
can now import equipment on behalf of the actual user for the purpose of leasing.
Mazda leasing has already tied-up with British Equipment leasing company for
imported equipment. The Non Resident Indian groups in foreign countries should be
interested in this area.
Lease financing has been a welcome development as it has widened and deepened the
capital market. The possible entry of banks and the International finance corporations
in this scenario is a significant development. It is hoped that the leasing companies
would play an important role in generating internal resources. The First Leasing
Company which remained dormant through the seventies, found the pace more
comfortable in the eighties joined with 20th century leasing. The published profit
figures of these new leading leasing companies for 1981 triggered off a boom. The
financial institutions like the ICICI, IRCI and others jumped into leasing business.
In 1982, leased assets accounted for barely RS. 15 crores, But 1983 saw a huge spurt and
reportedly over Rs.50 crores of assets were leased. Indian industry has found in leasing
a painless way of working around the high taxation rates further, the off-balance sheet
aspects of leasing added to its glitter. Leasing has found supporters in the MRTP and
FERA companies whose capacities the government closely monitors. The MRTP ACT
does not cover investment companies within its scope. Thereby, a leasing company can
conveniently continue to grow and mobiles resources without the MRTP Act being
applicable. Not only the big companies, the small sector has also taken to leasing with
good reason. A large segment of the small-scale sector prefers to show a low turnover on
books. The leasing makes it possible by adjusting lease rents at very low levels which is
not possible by adjusting lease rents at very low levels which is not possible if the
amount s were borrowed from banks. Because banks take into consideration the book
turnover and book profits to grunts loans. Hence the small-scale sector prefers leasing.
Although the Indian businessmen are well known for their inclination to get ownership
first rather than to take assets on lease basis, yet due to certain hassles in institutional
financing, they have been reducing their dependence on institutional financing.
The leasing industry is steadily gaining popularity in India on account of the following
reasons:

1. A greater role in industrial investment has been envisaged in the 8th land for private
sector.
2. Greater emphasis on priority sector lending by banks has resulted in reduced
availability of bank finance for private sector.
3. Reduced availability of funds for private lending with financial instauration and
greater emphasis by the government the private sectors to generate its own resources
4. As a consequent if withdrawal of investment allowances, w.e.f. April 1, 1990, it is
more beneficial for a manufacturer to get the plant and equipment and other fixed
assets on lease as compared to purchasing it.
16.4 REASON FOR SLOW GROWTH OF LEASING IN INDIA
The following are some of the difficulties faced by leasing companies with their number
creeping up rating problems both to the existing and new companies:
1. The mushroom growth of leasing companies has resulted in as rate war. There are
signs of desperation among some of the leasing companies. If the rate war gets
intensified, then only a few companies with good finance will survive. There is a need to
have norms of maximum and minimum lending rates as they exist for banks.
2. The long-term viability of the new entrants remains a question mark.
3. Lease rentals in cases of some companies have dipped very low making difficult to get
a fair return on their investment. In some cases even the investment in the lease may
not be recovered. Some leasing companies are raising the promoter's share of capital by
making the private placement, which is unofficial, management of leasing companies
should not be allowed to earn at the expense of the public. Leasing is a sophisticated
concept and promoters should first run the companies with their own money to prove
themselves.
4. The growth of leasing companies faces a resource crunch, as many of these companies
in India are not linked to any primary resource base. Many leasing companies have
started labeling themselves as hire purchase companies as well, in order to take
advantage of the relaxed limit of public deposits up to 10 times of the net worth, which
may create a serious cash flow problem.
5. Leasing companies have been entering into tie-up arrangement with foreign banks for
funds in return for guarantees and letters of credit. The IDBI refuses refinance to leasing
companies on the ground that leasing companies are not the actual users of assets. This
itself on their resource base.
6. Given the strength and orientation of the existing financial structure, leasing
companies are unlikely to emerge as major competitors for funds of households.

In spite of the number of problems encountered in the development of lease financing in
India - reasonable growth opportunities exist for leasing companies to play a
complementary role fin financing of industry. There is a need to develop the requisite
managerial manpower for an efficient and effective functioning of leasing companies.
Financing decisions of leasing companies require rigorous exercise in the analysis and
forecasting of cash flows environment. They wish to diversify into merchant banking,
mutual funds and other related areas without considering their financial and managerial
resources. Leasing companies have to develop expertise and sophistication in handling
the new types of business.
16.5 DETERMINANTS OF SUCCESS OF LEASING
Leasing is a source of financing and emerged as an alternative to borrowing in industrial
financing. The success achieved in this regard witnessed a slow growth. Success of
leasing business in India in dependent upon the fulfillment of certain conditions as
discussed below:
1. Availability of Qualified and Experienced Personnel
Leasing is a complicated lending activity requiring due attention to all formalities like
appraisal, judging integrity and capability of the borrower, examination of legal
complications before financing the deal. Leasing companies are badly in need of
qualified and experienced personnel particularly at the top level. The key to success lies
in the right type of people to guide the corporate business and manage It., Leasing being
a new business in India, trained staffing this line is in short supply.
2. Effective Board of Direction
The Board is and apex body and lays down guideline and norms on which the
organization has to function. The directors should comprise of energetic people who can
look after the interest of the company. The object of promoters in including popular
figures is to have a good response to public issues whereas the retired executives are
finding the offers as retirement benefits. It cannot be expected that these members will
give the necessary direction t the company in all respects.
3. Appraisal of Lease Proposal
A proper assessment of the credit worthiness of the lease is a primary factor along with
appraisal of the equipment taken of lease. The equipment has to be looked at from the
point of view of residual value at the end of the period of lease. A truly professional
leasing company should be able to give a tailor made leasing package. A professionally
managed company can score over other leasing companies by giving an attractive lease
package to suit the specific requirement of a lessee.
4. Effective follows up

The follow-up of the lease contract to ensure that the amount is used for the purpose for
which it was intended become imperative. Watchful eye should be kept both by the
executive of the leasing company and its board about the regular payment of the lease
rentals. Timely legal action should be taken for recovery where warranted. It is
dangerous for an impression to go around that the lessors are soft on recovery.
5. Adequacy of Promoter's Contribution
The promoters of a leasing company should have a fair and reasonable stake. But they
have failed to give attention to the profitability of the project. Due to lack of planning,
some companies end-up in failure either due to promoter's abrupt withdrawal from the
scene on lack of needed interest in company's activities. It has been found that the
promoters entered the field with sheer enthusiasm to take advantage of the leasing
boom and did not make the necessary detailed market study. This has introduced a basic
deficiency in the financial structure of many leasing companies in India.
6. Adequacy of financial Resources
Most of the leasing companies have started with smell capital base and have found it
difficult to raise the anticipated fixed deposits. Though the leasing companies can raise
fixed deposits upto 10 times of their own capital and reserves, But only a very few
leasing companies have so far achieved this target. It is suggested that a minimum paid
up capital of Rs.1 crore should be prescribed for leasing companies, as this will enable
them to accept proposals of reasonable amounts. Management of leasing companies
should transfer a good part of their earnings to strengthen their equity base.
7. Regulation of Competition
As a number of leasing companies entered the field almost tat the same period, this has
resulted in cutthroat competition. In this process, lease rentals have come down to
uneconomical levels being very much below the average cost of capital. The association
of the leasing companies can play a positive and constructive role in many areas to
regulate competition. It should also organize training and development programmes for
the personnel of leasing companies.
8. Low Administration Costs
Keeping the administration costs at a low level will help in improving the profitability of
leasing companies. General administration costs should be restricted to 10% of the gross
income of leasing company, which can effectively operate with a limited staff from a
small office.
16.6 POTENTIALITY OF LEASING
Growth and stability are the main strategies for any business as the modern business
environment becoming more complex. Besides some limitations are in the way of lease
financing. The potentiality of lease financing in India is bright. While borrowing in the

form of debentures whether convertible or non-convertible, public deposits etc., are
becoming increasingly attractive source of finance. However there are certain
restrictions and disadvantages attached to this form of borrowing e.g., heavy stamp
duty, creation of mortgage on assets etc. The issues that express bright prospects for
lease financing are discussed below.
1. Companies whose investment in fixed assets is approaching Rs. 20 crores in case of
MRTP companies and small sector companies whose assets are approaching Rs. 20
lakhs can avail the offer off-balance sheet financing from leasing.
2. High-geared companies whose debt-equity ratio is in the region of 2: 1 may see in
leasing a good source of finance. Leasing for this market offers a means of keeping debt
capacity unaffected.
3. Companies with allow rate that may not find it worthwhile availing the benefits of
ownerships with respect to deductions for investment allowance, depreciation and
interest may pass on the benefits of ownership to lessors with higher tax rates who can
utilize them and pass on some of the benefits back to the lessee in the form of reduced
rentals.
4. Small companies which are unable to provide the margins required for raising term
finance find the lease financing a convenient alternative.
5. Companies with an urgent need for capital equipment like the acquisition of diesel
generating sets to tide over severe power shortage" problems are making an effective use
of lease financing. Such companies value the absence of procedural delays in leasing
which are so common with the financial institutions granting term loans.
6. Sluggishness in new issue market due to unfavorable economic conditions may show
better potentiality for lease finance in India.
7. Rapid inflation rate has to cost escalation of capital equipment over the
years. Significant escalation.xin machinery price over the years is a deterrent, which has
made it difficult for companies to acquire new equipments and modernize their assets.
It is in this context lease finance will acquire its prominence.
8. Indian companies are not able to generate sufficient internal surplus due to high rates
of corporate taxation.
Conventionally, Indian businessmen are interested in convenient means of procuring
funds even if it may involve slightly higher cost of financing. Leasing offers tremendous
flexibility and the capital within 15 days. The multifold advantages of leasing perhaps
have attracted many lessees to resort to leasing.
FUTURE OF LEASING

As the credit system in India is tightly controlled lease financing becomes an effective
source available in industry. The following prospects for leasing companies would
improve considerably:
1. Every time the Reserve Bank of India announces more stringent credit controls, they
freeze a part of the funds, which may be borrowed from banks and financial institutions.
2. Even if institutional finance is available, corporate management is hesitant to avail of
it. Lease finance is considered preferable to institutional finance. In the former case,
there are no strings attached. There is no question of any convertibility clause or
nominee directors bring trust on the borrowers.
3. The companies may prefer off-Balance Sheet forms of finance, especially when they
are close to the limit of Rs. 20 crores.
4. Leasing companies can claim depreciation at the rate of 37.5% assuming that the
plant and machinery have been worked triple shift and the normal rate of depreciation
of 15% is applicable. This is in view of the extra shift depreciation allowance and the
initial depreciation allowance. Some of the assets can be depreciated at higher rate,
which could be as high as 100% as in the case f energy saving devices.
5. Experience of industry in other countries needs to be considered. For example in the
U.S.A., England, West Europe and Japan, many companies sell their equipment on the
basis of vendor plans, by providing lease finance. These companies have forged strong
links with the leasing companies thereby spreading the leasing gospel very quickly.
Banks in these countries have gone into leasing in a big way and this has not in any way
affected the growth prospects of private leasing companies. It has been estimated that
nearly 20% of all equipment used in these countries is acquired on a lease basis.
6. The Government of India has been positive in its approach to leasing. It has been
publicly announced that the dependence on institutional finance should diminish with
the passage of time. The positive attitude to leasing fits in with the objective of the
government to promote industrial growth.
Lease finance would encourage companies to re-equip themselves with new ones. It
could also be used for acquiring balancing equipment to help existing companies to
increase their profitability.
On a conservative basis it has been estimated that the need for lease finance is around
Rs. 2,000 crores per annum. At present, there are about 15 leasing companies having at
their disposal not more than Rs. 300 crores. There is thus a gap between the availability
of lease finance and the demand for it. At present, industrial leasing companies are
prepared to offer any type of asset. The use of land warehouses, manufacturing facilities,
retail stores, jet engines, computers, trucks, and other industrial equipment can all be
acquired on lease.
16.7 ROLE OF GOVERNMENT

The government has unfortunately not come out with clear-cut rules and regulations
regarding leasing business.
1. Investment Allowance
It has not so far given the clarification with regard to the investment allowance. The
controversy with respect to leasing is whether the lessors, as owner of the leased asset,
are entitled to the benefit "of- investment allowance. The investment allowance is
denied to a number of non-priority industries. Moreover, to claim the investment
allowance benefit, the asset has to be on lease for a minimum period of 8 years. That
may exceed the useful life of the equipment. Technological obsolescence may render it
economically enviable and the lease may back out of commitments. If leasing is to
become a force to reckon with in Indian industry, the investment allowance should bone
made available on a wide range of assets.
2. Tax Implications
Equally important is the sales tax implication for leasing companies. These companies
today do not have the benefit of 'C' for m and hence pay the full sales tax on inter-state
purchases. They are thus placed at a considerable disadvantage due to higher sales-tax
incidence on the asset.
3. Accounting Standards
The accounting standards in India have proved inadequate to cope with growing
challenge offered by the adoption 'of leasing as a financing instrument. There is a
controversy whether leasing transactions should be shown at their capitalized value in
the' books of lessee. There are two schools of thought regarding the reporting of
capitalized value of lease payments in the books of the lessee. Those who are in favour of
reporting argue that a correct picture of the company's financial position cannot be
obtained unless the obligations caused by the long term leases are suitably incorporated
in the asset structure of the company. On the other hand, the opponents suggest that it
is unrealistic to reflect the expected effect of events relating to future period in current
accounts and thereby give false picture of authenticity. It would be more meaningful to
leave the Balance Sheet as it was and not to attempt to capitalize arbitrary amounts.
4. Private Placement
Promoters of-a leasing company should subscribe at least 20% of the equity. Some of
the promoters have made offers of private placement of shares before the actual public
issue is made. In some cases they may sell off their interest and leave the company and
its other shareholders to their fate. Such a development may erode the confidence of
investors in leasing companies. There is need of proper guidelines to regulate the growth
of the leasing industry for the sustained flow of funds for industrial development.
5. Check on Unhealthy Growth

The government should come out with regulations to control the unbridled - growth of
leasing companies resulting in the cheating of innocent investors. Certain unethical
practices have been adopted by some unscrupulous businessmen who have started using
the leasing concept for tax evasion. This should be put to an end by the government by
amending the tax laws.
6. Refinancing Facility
It is necessary that the government should play a motivating role by providing refinancing facilities to the leasing companies.
The clarifications on investment allowance and sales tax concessional rate should be
made available to leasing companies without any delay. It should also adopt a
moderating role by requiring the companies having leased assets to give information by
way of footnote in their Balance Sheets not only regarding the amount of the leased
equipment but also the impact of lease transactions on their cash flow. It would help in
making a meaningful financial analysis of the companies having leased assets.
CRITICAL APPRAISAL
Doubts have been expressed regarding the utility and important of leasing in India. In is
argued that the emergence of the activity would make a net addition to the cost of
production because the rentals charged by the leasing companies are bound to be high.
The industrial cost structure would be saddled with another superfluous element which
drains social resources for the benefit of those running leasing companies. The leasing
companies split up the capitalistic-function by creating a new-specialized line of
business activity. The phenomenon of leasing companies created an additional category
of capitalistic income imposing an additional burden on the consumers. The leasing
companies can be critically appraised on the following grounds:
1. The leasing companies offer a diversified line for the corporate promoters. All kinds of
linkage formal and informal, open and concealed are established between existing and
new companies on the one hand and leasing companies on the other. It is done to take
benefit at the cost of the shareholders, tax authorities and regulatory administration.
2. Leasing companies have an adverse impact on the maintenance of capital goods. With
hired machinery, maintenance of plant and machinery gets deteriorated. It may
aggravate industrial sickness as the proportion of the industrial capital stock supplied by
the leasing company’s increases.
3. Like temporary tenants in agriculture who lack the incentive to take good care of the
plots of land they cultivate, the incentive of the concerns having capital goods on lease to
take care of these goods is weakened. The recklessness with which such means of
production can be used is likely to go up.
Much of the above criticisms are exaggerated. One should have a balanced view. There is
need for regulation of these companies to protect the funds of the public can bank. The

chances are that if timely action is not taken, it may result in management or inadequate
understanding or unwillingness to follow some basic principles of lending. Many of
these leasing companies may get into difficulties. It may be stressed that leasing
business if properly conducted, has a bright future. Unfortunately, some of the leasing
companies have a feeling of over-crowding. As a result, they have started offering rates,
which are uneconomical. The capital market has not responded well to the issues of
leasing companies. The capital market has not responded well to the issues of leasing
companies. Those already in business are in a hurry to declare dividends after the first
year itself unmindful of the need to create reserves.
16.8 NEW CHALLENGES AND OPPORTUNITIES
The prospects for the leasing business have improved after the abolition of investment
allowance reserve from April 1, 1987. Lease finance market has grown by 15 to 20
percent in a five year phase (1982 -1986). Leasing companies disbursed nearly Rs. 900
crores till December 31, 1986.
The following are the challenges ahead for leasing companies in India:
1. In 1987, leasing business entered the slow growth phase. The main cause of the
showdown is the resource crunch. The only source of institutional credit open is the
credit authorization scheme (CAS) of commercial banks. The ceiling of Rs. 6 crores
under CAS indicates that leasing companies have to run around for funds. The RBI is
considering the recommendation of the Dahotre Committee on bank finance to leasing
and hire purchase companies.
2. Investors are no longer willing to commit funds to this industry, which is considered
to be full of high-fliers who could not sustain their flight. Most of the shared of leasing
companies are unsalable.
3. The levy of sales tax on lease rentals has enhanced the cost of leasing. The
governments of West Bengal, Bihar, Orissa, Haryana, Madhya Pradesh, Tamil Nadu and
Kerala have amended their sales tax laws to avail of this levy. This has raised several
sticky questions like, which is the appropriate state that can levy the tax on lease of
goods? Would it be the state in which the lease agreement is executed, or the state in
which lease rentals are payable, or the state in which the leasing company is located?
4. The 1987-88 Finance Act has directed that all companies reporting book Profits
would have to pay an effective tax of 15percent of book profits under section 11S(J) of
the Income Tax act with effect from April 1, 1987. This is another nail in the leasing
coffin.
5. The entry of the banks and financial institutions into leasing poses a real threat to this
business. As the list of bank promote leasing subsidiaries grows, the funding pattern of
leasing companies would change significantly. Some hanks have taken a policy decision
not to fund private sector leasing companies. Leasing is undergoing a metamorphosis.

6. A number of companies that are diversifying may perhaps be doing the sensible thing.
However, diversification into industry can be more difficult than management of money.
Diversification into industry may not be a viable alternative to every leasing company.
7. A parallel development that is likely to be visible in the years ahead is the continuing
rapid growth of cash profits in leasing companies, i.e. profits before depreciation, and
net profits will decline from existing levels. With the higher depreciation rates becoming
operative from 1987-88 fiscal year, the industry will be in a position to charge
substantial depreciation so that book profits exposed to tax will be minimum. But for
distributing dividends out of these bank profits, provision will have to be made under
see 115(J) involving imposition of an effective tax rate of 15 percent.
8. The industry is aggrieved by the proposal that leased assets be capitalized on the
books of the lessees, so that the lease rental liability became evident in the face of the
balance sheet, rather than as a footnote so as to alert financial analysis to the lease
rental obligation of lessees. Most countries have rejected this accounting standard as
being inappropriate and damaging to the growth leasing industry.
16.9 SUMMARY
In spite of these difficulties, the leasing business has a tremendous and bright future in
our country. It is therefore, necessary for all-Government public financial institutions
and leasing companies to join hands together if they wish to reap the maximum
benefits.
16.10 REVIEW QUESTIONS
1. Describe the growth of lease financing in India and analyze the reasons for the slow
growth.
2. Explain the determinants of success of leasing in India.
16.11 ASSIGNMENT QUESTIONS
1. Narrate the problems and prospects, future challenges of leasing in India.
2. Explain the role of government in the development of leasing in India.
16.12 KEYWORDS
Mushroom growth, financial infrastructure, market estimation.

- End Of Chapter LESSON -17

INVENTORY MANAGEMENT

OBJECTIVES
·
·

To know the importance of inventory management
To analyze the optimum level of inventory

STRUCTURE
17.1 Introduction
17.2 Kinds of Inventories
17.3 Benefits of Holding Inventory
17.4 Determining Optimum Level of Inventory
17.5 Summary
17.6 Review Questions
17.7 Assignment Questions
17.8 Keywords
17.1 INTRODUCTION
Inventory is nothing but goods held for eventual resale by the firm. As such inventories
are vital components of the firm to achieve the desired sales levels.
Depending upon the nature of the industry and firm, inventories may be classified as
a) Durable or Non-durable
b) Perishable or Non-perishable.
Whatever the nature of inventories, the accounting procedure is careful to distinguish
goods held for resale from the other current asset such as office supplies or furniture,
which are not sold but are used to help the firm conduct its business.
17.2 KINDS OF INVENTORIES
Generally inventories or stocks consists three items namely

a) Raw materials
b) Goods (or stocks) in process and
c) Finished goods
In the Balance Sheet inventories are assets which represent unsold goods or unexpired
costs relating to goods as on the closing day of the accounting period and are two steps
away from cash.
Since holding of inventories carries risks and costs, the finance manager must decide the
level of inventories after carefully examining the type and nature of each item and the
need for stocking. They should do observe and anticipate the risks and cost which go
with the inventories.
a) Raw materials
There are goods that have not yet been committed to production in manufacturing firm.
For Example
1. Iron ore waiting processing into steel
2. Electronic components to be incorporated into stereo amplifiers.
b) Goods or stocks in process
These are goods that are committed to production process but have Example
Components and sub-assemblies that are not yet ready to be sold.
c) Finished goods
These are completed products awaiting sale. In manufacturing firm they are the final
output of the production process. In a retail firm and sometimes wholesalers, they
merchandise inventory.
What are the reasons for maintaining inventories?
There are three major reason and they are
a) To satisfy production needs,
b) To satisfy safety needs and
c) For speculative purposes
a) To satisfy production needs

A firm should have inventories to have a continuous and unobstructed production. In
case inventories are not available insufficient quantity then the firm should go in for
spot purchases. But this system of purchasing on spot may be costly. This may also
result in not producing according to schedule. In fact, this under scheduled production
may lead customers or cancel orders because delivery schedules will not be according to
timetable.
b) To satisfy safety needs
The stocks provide cushion or safety to meet emergencies like supply breakdown,
production breakdown and even traffic breakdown or Acts of God.
c) For Speculative purposes
A firm can sell at a higher price in times of increasing cost if the firm has already
purchased when the price was low. Though inventories are essential, yet it is certainly a
socio-economic offence. It should also be observed that some risks are accompanying
with inventories.
Example:
There may be pilferage, damage (accidental or willful) deterioration in quality on
storage (spoilage) of even obsolescence or even theft may take place. These risks if
happen then will incur loss of revenue - and therefore considered as a form of indirect
costs.
17.3 BENEFITS OF HOLDING INVENTORIES
By holding inventories, the firm will be in a position to separate the process of
a) Purchasing
b) Production, and
c) Selling
No company can afford to plan to purchase raw material only when production and
sales are anticipated or expected.' Instead, it should have adequate raw materials and
finished goods so that it will be in a commanding position to deliver the goods on time.
Therefore, inventories provide safety. In fact, by having adequate inventories it can
make decisions on further purchasing production and sales.
Benefits
a) Avoid loss of sales

Once the finished goods or saleable goods are not available, it will lose sales. Obviously
some customers will purchase from competitors, and some will decide not to purchase
at all, if they have to wait for long time for delivery. Therefore a firm should be in a
position to gibe quick service and to provide prompt delivery. These things are tied to
the proper management of inventory.
b) Gaining quantity discounts
Some times to get larger discounts firms will go for larger inventories. Suppliers are also
will come forward to sell the goods at reduced prices if the firm orders for bulk
purchases. By getting discounts it will pay less any by paying Jess, the firm will be in a
position to increase profits as long as the costs of maintaining inventories are less than
the amount of discount.
For Example: If the cost of storing an item "X" for an extra time is estimated Rs. 1 and
the discount is Rs. 3, the firm will benefit by Rs. 2 per unit from the quantity discount.
c) Reducing order costs
It is common to see whenever a firm places an order it will have to bear the expenses
like typing, checking, approving and postal charges. Again, when goods are arrived they
must be accepted, inspected and counted, this needs some money.
The invoices must be checked and then sent the same to accounts department so that
supplier can be paid. Therefore, the firm should place bull orders than larger number of
small orders.
d) Achieving efficient production Runs
Adequate inventories protect against shortages that would stop/delay production. If
adequate inventories are not maintained, it may not only cost heavily to the firm but
also affect efficient production.
17.4 DETERMINING OPTIMUM LEVEL OF INVENTORY
To prevent cost of stock outs, and to minimize cost of carrying inventories, a skillful
finance manager must develop a policy of having appropriate amount of inventory. It is
because appropriate inventory will ensure uninterrupted production and minimize cost
of production, whereas a low inventory means lower carrying costs, but increased cost of
production. It is because it will lead to frequent production interruptions and also cost
of being out of stock.
Determining the right or appropriate quantity and quality of inventory needs an analysis
of gins from carrying additional inventory. Carrying cost of inventory may rise in
proportion to the amount of inventory but the same may out hold good in respect ofsavings from purchasing or producing in large lots.

The prudent finance manager must analysis different levels of inventory, which yields
the lowest total cost. This analysis would help to determine the economical size of
purchase order and the size of inventories. For this purpose, inventory Management
Techniques or Models have been evolved by experts.
17.5 SUMMARY
Inventories will be classified into raw materials, goods in progress, finished goods. The
reason for maintaining inventory is to satisfy production needs, safety needs, and
speculative needs. Benefits of holding inventory are for punching, production and
selling raw materials.
17.6 REVIEW QUESTIONS
1. State the classification of inventory with suitable example
2. Discuss the reasons, for maintaining inventory in an organization
17.7 ASSIGNMENT QUESTION
1. Explain in brief about the benefits of holding inventory,
17.8 KEYWORDS
Raw materials, goods in progress, finished goods. Safety needs production need,
speculative purpose.

- End Of Chapter LESSON-18
INVENTORY MODELS

OBJECTIVES
·
·

To know the type of inventory model
To know the techniques of inventory

STRUCTURE
18.1 Introduction

18.2 Economic order Quantity
18.3 Order Point
18.4 Stock Level Sub-system
18.5 Summary
18.6 Review Questions
18.7 Assignment Questions
18.9 Keywords
18.1 INTRODUCTION
While framing an inventory control policy, the management accountant of a firm rests
on inventory model. Inventory management can be defined as system, which minimizes
the cost relating to inventories while at the same time ensuring that in keeping with
business needs, there is adequate control and coordination for the smooth flow of
sufficient stocks hold in reserve.
Factors that influence to set up a type of inventory Model
The type of inventory model to be set up depends on the following
a) Whether the firm go in for a fixed order interval inventory system or
b) Whether the firm go in for or fixed order size inventory system or
c) Whether only one or multiple items are purchased or
d) Whether the same supplier will supply several items or only one, and how much cash
discount a can be availed of and so on.
Depending on the above-mentioned variables, Inventory Models can be established.
However, the finance manager should keep in mind the point namely minimizing the
costs to the firm and to manage inventories effectively. Normally a firm will utilize
systems approach for effective inventory management. This systems approach involves
three subsystems namely
a) Economic order quantity (EOQ)
b) Re-order point
c) Stock Level. Today Computer helps the Finance Manager to make inventory
decisions.

The following figure shows the subsystem of inventory Management System

Solution should be. If ending inventory is greater than the re-order point, do nothing. If
ending inventory is less than or equal to order point order point, order an amount equal
to Economic Order Quantity
18.2 ECONOMIC ORDER QUANTITY
EOQ is that quantify of order, which minimize the order costs, purchases price of items,
and carrying costs. With the help of differential calculus, the general equation for EOQ
can be obtained.
The variables one may assume are
a) Constant rate of usage of material
b) Complete exhaustion of (or zero) inventory at each ordering point, and
c) Immediate replenishment
Optimum Level of Investment in Inventory

According to EOQ optimum level of investment in inventory is one where total cost of
inventory comprising carrying all acquisition cost and total cost of different levels of
ordering inventories.
The logic is simple
For example: If a firm places unnecessary orders, it will have to bear unneeded order
costs. On the other, if it places too few orders, it will have to maintain large stocks of
goods and will have excessive carrying costs. By calculating an EOQ the firm identifies
the number of units to order that results in the results in the lowest total of these two
costs. Without attempting to derive a formula, a simple calculation may be made when
one assumes the following.
a) Demand is known
Though it may be difficult to predict accurate sales for individual items, yet a marketing
manager must provide a sales forecast by using past data and establish future plans. The
may be expressed in units sold per year.
b) Sales occur at a constant rate
Complicated model may be required for firms whose sales fluctuate in response to
seasonal factors. Otherwise ordinary model is enough.
c) Costs of running out of goods are ignored
Costs associated with shortages, delays or lost sales are not considered. These costs are
considered in the determination of safety level in the Re-order point subsystem.
d) Safety stock level is not considered
The safety stock level is the minimum level of inventory that the firm wishes to hold as a
protection against running out. Since the firm must always be above this level, the EOQ
formula need not consider the costs of maintaining the safety stock level.
The formula for calculating the EOQ for an item of inventory is
2* V(OC)
EOQ = ---------------(CC%) (PP)
Where
2 = Mathematical factor that occurs during the time of deriving of the formula

U = Units sole per year, a forecast provided by the Marketing Department
OC = Cost of placing each individual order for more Inventory, provided by cost
Accounting Department
CC% = Inventory carrying costs expressed as a percentage of the average of the savings
value of the inventory, as estimate usually provided by Cost Accounts Dept.
PP = Purchase price for each unit of inventory, applied by Purchasing Department.
As an example of the use of this formula a firm anticipates 50,000 units of annual sales
of a product that costs the firm RS. 10. The cost of placing an order is Rs. 10, and the
carrying costs have been estimated by Cost Accounting Department as 10% of the
inventory value.
2* (50,000) (10)

1,00,000

Then the EOQ is: ----------------------- = ------------ = 1000 units
(10%) (10)

1

Thus the firm should order 1000 units if it places an order to minimize the total over
costs.
Example
A firm has forecasted sales of 12, 50,000 units a product in the next 12 months. Each
order would cost the firm Rs. 10. The firm pays Rs. 20 per unit for the product and
estimate that inventory-carrying costs are 20% of the inventory value. What is the EOQ
for this order?
The formula and the answer are as follows:
2* (12,50,000) (10)

2,50,00,000

Then the EOQ is: -------------------------- = ------------------ = 25000 units
(20%) (20)

4

The same EOQ can be derived by applying an Equation form:
For Example total Annual Cost = annual Purchase Cost Price + Annual
Ordering Cost + Annual Carrying Cost.

N*P

Q

Thus C = ---------- + m* CT + ----- * C2
Q

2

Where,
C = Total Annual Cost
C1 = Order Cost of One Order
C2 = Annual carrying cost per unit
Q = Quantity to be purchased in one order
N= annual Demand (or usage)
P = price of each item
The total number of order to be placed in one year is nip and this factor multiplied by c1
(order cost of the year) gibes the total annual ordering cost. The average quantity carried
at any onetime is Q/2 (since into his example, it is assumed carry of inventory from zero
to Q) and this factor multiplied with C2 (carrying cost per unit) provides the total annual
carrying costs.
Calculating the total purchase price is simple; the factor (n*p) gives this figure.
2CI * N
Q=

-----------C2

If one assumes that the ordering cost of a component is Rs. 10, number of units required
annually is 2000 units and the carrying costs are Rs. 1, EOQ works out to about 200
units.
Q = 2*10 * 2000? 1 = 200 units
Thus in the example the Eoq is 200 units at a time.
II Re-order point or Ordering Level
The ordering level is also known as the RE-order point. The Re-order point is that in
time when a firm places an order for its Eoq so that the fresh stocks arrive by the time
the firm runs out of stocks.

18.3 ORDER POINT
"It is the level of inventory at which the firm places an order in the amount of the EOQ".
If the firm places an order when the inventory reached the Re-order point the new goods
will arrive before the firm runs out of goods to sell.
Before calculating the reorder point the management accountant must have knowledge
of the daily usage rate ® the lead time (71), that is the time gap between the placing and
receiving or an order, and the minimum level of inventory in the form of safety stocks,
expressed in terms of number of days (T2) (or cost of sales).
Thus Reorder Point = R*T1 + R*T2
If one assumes R as 100 units per day as 10 days and T2 as 15 days, one will have their
order point at 2500 units. That is, as soon as the stocking level comes down in 2500
units, the firm should place an order for its pre-determined EOQ.
Re-order point = 100 * 10 + 100 * 15 = 2500 units.
But this point needs more discussion
The basic question in any inventory management system is "When should an order be
placed, so that the firm does not run out of goods?”. The answer is available in the order
point sub-system.What information is needed to design a re-order point sub-system?
Generally one requires the following information
a) Usage Rate
This is the rate per day at which the item is consumed in production or sold to
customers. Generally it is expressed in units. It can be calculated by dividend annual
sales by 360 days. If the sales are 50,000 units, the usage rate is 50,000/360 or 140
units per day.
b) Lead Time
This is the amount of time between placing an order and receiving the goods. This
information will be available in purchase department. The time to allow for an order to
arrive may be estimated from a check of the company's records and the time taken in the
past for different suppliers to fill orders.
c) Safety Stock Level
This minimum level of inventory may be expressed in terms of number of day's sales.
The level can be calculated by multiplying the usage rate times and the number of days
that firm wants to hold as a safety against shortages.

For Example:
If a firm wishes to hold adequate inventory for 15 days of production in the event its
order for raw material does not arrive on time.
In this case the safety stock level is 15 days, and it is calculated in terms of units of
inventory by multiplying 15 times the daily usage rate.
What are the variables that determine the number of days of safety stock to hold?
For this some questions must be answered
a) How much variation exists in the usage rate and how likely is it the firm runs out of
the goods?
b) How much does it cost in terms of lost revenues and profits if the firm runs out for 1
day? 2days? Or 1 week?
c) At what point are the carrying costs higher than the lost revenues due to shortages?
Formula to calculate the Re-order point sub-system
Reorder point = (UR) (LT)+ (UR) (day of safety)
Where UR = Usage Rate LT + Lead Time
Days of Safety = Days of safety stocks desired by the firm. As an example of the use of
this formula.
Consider a firm with a usage rate of 140 units per day, a lead-time of 6 days, as a safety
stock desired of 8 days of sales.
The Reorder Point is (140) (6) + (8) = 840 + 1120 = 1960 units.
Another Example
A firm expects annual sales of 9000 units, desired to maintain a 12-say safety stock level
and has an 8-day lead tone for orders. What is the reorder point for the firm?
The formula is 9000/360 days = 25 units daily usage.
(25) (8) + (25) (12) = 500 units.
Answer 500 units.
18.4 STOCK LEVEL SUB-SYSTEM

This is system maintain records about the goods held by the firm, issuing of goods and
the arrival of order. In other words, stock level sub-system maintains records of the
current level of inventory. For any period of time, the current level is calculated be
taking the beginning inventory, adding the inventory received and then subtracting the
cost of goods sold. Whenever this sub-system reports that an item is at or below the
reorder point level the firm will begin to place an order for the item.
18.5 SUMMARY
Inventory System involves namely EOQ, Reorder Point, and Stock Level. EOQ is that
Quantity of order, which minimize the costs, purchases price of items, and carrying cost.
Reorder points is the level of inventory at which the firm places an order in the amount
of the EOQ. Stock level is the System to maintain records for issuing goods, and the
arrival of goods.
18.6 REVIEW QUESTIONS
1. Explain in detail how EOQ is calculated
2. Discuss the importance of Reorder Point
18.7 ASSIGNMENT QUESTION
1. Comment your views in inventory model and suggest which model should be adopted
in an organization
18.8 KEYWORDS
EOQ, Safety stock, order points, lead time, usage Rate.

- End Of Chapter LESSON - 19
WORKING CAPITAL GAP - VARIOUS COMMITTEES

OBJECTIVES
·
·

To know the need for working capital
To know the financing mix in working capital

STRUCTURE

19.1 Introduction
19.2 Dehejia study group
19.3 Sri P.L. Tandon Committee
19.4 Chore Committee
19.5 Fundamental Principles
19.6 Trade off between profitability and Risk
19.7 Summary
19.8 Review Questions
19.9 Assignment Questions
19.10 Keywords
19.1 INTRODUCTION
As long as security oriented system is followed by banking sector, it will favor the
customers (borrowers) who have strong financial background irrespective of their
economic function and or end use of their money. Naturally it is seen that banks were
frequently used by a few strong businessmen or units to build their inventories wither to
create artificial scarcity or to make speculative gains.
This created a situation where one section of the society enjoyed all the benefits that the
banks are providing and on the other, society experienced shortages of inputs, low
capacity utilization, higher cost of production and finally even breakdown of their
business or systems.
19.2 DEHEJIA STUDY GROUP
Based on the above background this study group was established. The group found the
diversion of short-term bank credit for the acquisition of long-term assets. The group
also pointed out that diversion of funds has taken places due to banks granting working
capital by way of cash credit limits. This system was practiced due to security-oriented
policy of the policy. It also observed that banks relate their credit limits to the security
offered and did not attempt to assess the overall financial position of the borrowed
through a cash flow analysis.
19.3 SRI P.L. TAN DON COMMITTEE

R.B.I appointed a study group, under the chairmanship of Tandon in August 1975. This
group, after carefully studying situation of the banking sector, gave the Following
recommendations.
Norms for inventory and Receivables
This committee envisaged that the entire system of credit planning has to be adjusted to
production planning. This was envisaged because there must be some rationality to hold
inventory to production requirement. In fact it has gone one-step ahead and said;
uncertainty in respect of procurement of the inventory could itself be a reason to plan.
The committee was of the opinion that the following should be taken into consideration
while fixing norms.
a) Bunch receipts of raw materials including imports
b) Power shortage.
c) Strike.
d) Transport Delays.
e) Lack of infrastructure facilities and other possible but unavoidable interruption to the
industry.
Criticism
The committee has taken the inventor receivable problem from an American banker
looking glass. But the fats are different. In India in large areas of Indian Industry,
inventory decisions are done by Government Policies and controls. Further, bankers per
suasion can work only if there are free assets to take decisions.
New Approach to Bank Lending
The committee was of the opinion that bankers should supplement the resources in
relation to production requirements. Therefore, total current assets should be carried
partly by a level of credit for purchases. The funds required to carry the remaining
current assets have been termed as working capital gap, as it has to be shared by partly
by borrower's own funds and partly by banked earnings. The committee worked out the
following alternatives to work out the minimum permissible level of borrowing.
a) The bank should finance a maximum of 75% of the working capital gap - i.e., owned
and term borrowings.
b) The borrower has to mobilize a minimum of 25% of total current assets out lo Longterm funds and the bank should provide the balance. However, the total current

liabilities including the borrowing from the bank should not exceed 75% of the current
assets.
c) Core assets should be financed out of long-term funds. The committee was of the view
that bank should start with first second and third method within a time bound
programme. Excess above Rs. 10 lakhs should be reviewed on an annual basis.
Style of Lending
The committee was critical about the existing credit system since it comes in the way of
credit planning. Therefore, it suggested that instead of giving entire limit as a cash credit
for a year, it should be bifurcated in to loan demand cash credit. Then it should be
reviewed annually. Under the new formula, the maximum, requirements of current
assets will be financed through a long account and the fluctuating levels of current
assets will be financed by a sub limit for cash credit or bill finance limit. This has been
advocated with an intention to make the borrower to plan his credit requirements
systematically and at the same time to make him to develop financial discipline in using
his bank credit. To ensure the success of this discipline, the committee has followed the
principle of behavioral science and has attempted to take advantages of cost
consciousness among the borrowers.
The committee also suggested that the demand portion of working capital finance might
be charged 1% above that of loan account. This suggestion will make the borrower to
keep as little capital as possible as idle. The committee further suggested that excess
drawings should be transferred to a term loan account and interest at a rate higher by
one a half percent over the demand position. Other suggestions were to encourage the
bill finance instead of cash credit against book debt.
Credit Information System
It is absolutely necessary to get some operational data to judge the total operations. For
this purpose the committee suggested to have a quarterly budgeting reporting system
for operational purposes on the basis of which the need for working capital can be
calculated for the borrowers future production needs. Based on this suggestion
borrowers should submit quarterly operating statement of current assets and current
liabilities. These should be submitted in the prescribed format, which are available in
banks. It is also necessary to submit monthly stock statement and projected balance
sheet and profit and loss account at the end of the financial year. The permissible level
of bank finance will be controlled through find flow statement.
Follow up - Supervision and Control
Follow up and control means to see whether the borrower is using the borrowed money
for the purpose for which it is borrowed. Generally this can be controlled or monitored
by verifying quarterly forms. Of course, large borrowers should submit a half-yearly
proforma Balance sheet and Profit and Loss Account.

For the purpose of controlling the committee suggested a five-point scale method such
as a. Excellent, b. Good, c. Average, d. Below average, e. Unsatisfactory. This scale will
help to watch the borrowers. Even for end use of money the committee felt that bankers
should get operational date and figures to financial position at periodical intervals.
Norms for Capital Structure
The committee felt that the banker should keep in mind the relationship of liquid to
long-term debt - net worth and total outside liabilities. The purpose was to make a
borrower to strength on his equity base at an early date.
19.4 CHORE COMMITTEE - CASH CREDIT SYSTEM
This committee's recommendations are aimed to increase the short-term loans and bill
financing system. This committee also opined to inculcate better financial discipline
among borrows by making them to submit quarterly projections or cash credit limits.
This committee suggested the following for banks while assessing credit requirements.
a) Fixing of separate limits wherever feasible for the normal non-peak level and also.
b) Peak level credit requirements indicating the periods during which the separate limits
would be utilized by the borrowers.
The group advised bankers not to encourage borrowers to approach for temporary needs
beyond sanctioned limits. Banks were also advised to charge one percent more in case
demand is there for money. The recommendations also include a higher rate to
encourage an early liquidation of working capital term loans and to freeze the account
without notice wherever default persists.
19.5 USEFUL GUIDELINES OT MANAGE WORKING CAPITAL (OR)
FUNDAMENTAL PRINCIPLES
1. Principles of Optimization
Finance manager must aim at selecting the level of working capital that optimizes the
firm's rate of return. This level is defined as that point at which the incremental cost
associated with a decline in. working capital incremental cost associated with a decline
in working capital increment is equal to incremental gain associated with it. This
principle is based on the premise that a definite relation exists between the degree of
risk that a firm assumes and the rate of return. The more the risk that a firm takes the
greater will be the opportunity and at the same time loss also.
2. Principle of Investment in Working Capital or Walker Principle

According to this principle capital should be invested in each component of working
capital as long the equity position of the firm increases. This will strength the financial
position of the firm and also reduce the risk involves in it.
3. Principle of Suitability
This should be followed while financing different components of working capital. In
order words, this principle stipulates that each asset should be offset with a financing
instrument of the same approximate maturity. This principle also says that seasonal
working capital should be financed by short-term borrowing and permanent working
capital with long-term sources.
Equity share are the permanent sources for long-term finance. It is because; it brings
permanent funds without any obligation of refunding the funds to its owners. However,
excessive reliance on equity financing deprives the firm of the benefits of trading of
equity.
Debentures have the advantages of getting higher return because of its being relatively
cheaper source of financing. Again, redemption of regular installments of debenture
issue entails a constant financial discipline for the management.
The firms can also have permanent working capital by ploughing bank of earnings. Of
course, firms at the earlier stages cannot make use of this sour of financing.
Trade credit a bank loans are the permanent source of short-term funds. Through shortterm funds temporary or varying working capital needs of the enterprise can be
financed.
19.6 TRADE OFF BETWEEN PROFITABILITY AND RISK
A good and experienced finance manager will be in a position to decide what parts of
current assets are temporary and what part are permanent.
There is conflict between Long-Term and Short-Term financing. The choice between the
two involves a tradeoff between long-term and short-term financing.
The choice between the two involves a Tradeoff between risk and return.
Some approaches
There are three approaches to finance working capital.
1. Matching Approach
When the concern follows matching approach as shown in the following figure, then
each asset will be offset by financing instrument of same approximate maturity. In other
words, a firm cannot adopt a financing g approach, which involves the matching of

expected life of assets with the expected life of source of funds raised to finance assets.
Thus a five-year loan may be raised in finance a Plant and machinery with on expected
life of five years.

Among these, the first such plan may be dependence on long term financing even for the
meeting an art of temporary current assets. By borrowing long-term funds to cover
short-term needs, the firm virtually assumes itself of having adequate capital all times.
Stock to be sold in one year may be financed with a one year bank loan and so on. Short
term or seasonal variation in current assets would be financed with long-term funds. To
finance short term needs with long term sources would necessitate the payment of
interest for the use of funds. With a matching approach of financing, the borrowing and
payment schedule for short term financing would be arranged to correspond to the
expected saving in current Assets. Fixed assets and the permanent component of current
assets would be financed with long-term source of funds.
2. Conservative Approach
An exact matching plan may not the practicable. Therefore, a firm may adopt a
conservative approach to finance its current assets and fixed assets.
If a firm relies more on the long-term sources for financing its requirements then it is to
be following conservative approach. The use of short-term funds should be limited only
to emergency situation or when there is an unanticipated outflow of funds.

Fig. 2 Conservative approach using Long-Term financing for part ShortTerm needs
While this plan of financing involves lies risk, yet it is relatively more cost because long
term funds are more expensive that short term funds. Further, long term financing lacks
flexibility. Under this approach, financing long-term fund is used to finance fixed assets
permanent current assets and a part of temporary current assets.
3. Aggressive approach
A firm may be aggressive in financing its current assets. An aggressive is said to be
followed by the concern when it uses more short-term sources of financing than
warranted by the matching plan. The firm finances apart of its permanent current assets
with short-term sources of funds. Some aggressive firms may finance a part of their
fixed assets with short-term sources of funds. The relatively greater use of short-term
funds makes the concern more risky.

Fig. 3 Aggressive Financing Plan or Approach
The conventional generalizations relating to the financing of working capital suggests
that an amount equal to the basic maximum of current assets should be financed from
long term sources and that only seasonal needs of working capital should be financed
from short term sources.
The finance manager should strike a balance between risk and return. Prudent finance
manager calls for holding as small among of working capital as possible. It is difficult on
the part of the finance minister to determine precisely the level of working capital
requirements particularly under conditions of uncertainty.
Therefore, he must consider all the factors that have a bearing on working capital like
cash, receivable and inventories.
19.7 SUMMARY
The working capital management will suggest the importance of committee report.
Further it deals with new approach called as trade of between Risk and Profitability.
19.8 REVIEW QUESTIONS
1. Discuss the importance of Tandon Committee
2. Explain the fundamental principles of working capital.

19.9 ASSIGNMENT QUESTIONS
1. Explain the approach to finance working capital in detail
19.10 KEY WORDS
Matching approach, Aggressive approach, Conservative Approach.

- End Of Chapter LESSON - 20
FACTORS THAT INFLUENCE THE LEVELS OF WORKING CAPITAL NEEDS

OBJECTIVES
·

To know the factors influencing of working capital

STRUCTURE
20.1 Introduction
20.2 Internal factors
20.3 External factors
20.4 Summary
20.5 Review Questions
20.6 Assignment Question
20.7 Keywords
20.1 INTRODUCTION
This can be categorized into two groups namely, a. Internal Factors, and b. External
Factors.
20.2 INTERNAL FACTORS

a) Depending on the type of Technology and Services that a Firm offers determine the
needs for working capital. As such generally no money will be ties up either in
receivables or inventories. Trading concerns need little fixed assets but more working
capital since they have to carry stocks and to maintain inventories.
Working capital requirements should be studied taking into consideration the trading
concern and services sector.
b) Size of business: firm's size either in the form of assets or in sales will also
determine the amount of working capital needs. Small firms may employ additional
current assets as a cushion against cash flow interruptions. In such a situation small
firms with more defaulters will be affected severely. On the other hand, large firms with
many sources may require less working capital in relation to total assets or sales:
c) Firm's production policy: When a firm has a continuous production, then it needs
should think both off season and season because it will involve more inventory and risk.
In this type circumstance the problem of working capital can be solved by pursuing a
policy of adjusting production plan to seasonal changes.
Therefore inventories should b kept without incurring a loss in production schedule to
suit the changing demand.
d) Firm's Credit Policy Credit Policy of the firm also influences the magnitude of the
working capital. If a firm has a liberal credit policy, the n that corporation requires
plenty of funds to carry book-debts. On the other, if the firm collects money
aggressively, then it wills fact the problem of liquidity. On the contrary, if a firm has a
strict credit policy then it needs less working capital. This is because less amount of
money will be blocked in receivables
e) Access to Money Market: If the firm is capable of getting credit and trade credit
facilities at liberal terms from financial institution then it needs working capital than
firm without such facilities.
f) Growth and Expansion of Business: Though there seems to be no definite
relationship between type volume of a company's business and growth it its working
capital, it is usually found in actual practice that a growing firm requires additional
funds to acquire additional fixed assets to sustain its growing production and sales. In
fact, additional current assets will be needed to support increased sale of operations. It
is also common to observe that a growing business needs additional funds continuously
to fulfill the increasing needs of the business.
g) Profit margin and Dividend Policy: The need for working capital also depends
on profit margin and dividend policy. High profit margin needs less working capital
because profit itself becomes a source of working capital because profit itself becomes a
source of working capital though the firm may not have all the profits for its working
capital purposes. Of courses dividend policy of the firm also affects the profits that will
be available for working capital. For example, if the gives more cash dividend then there

will be a drain on cash resources and thus reduces company's working capital to that
extent. On the other, if the firm follows conservative dividend policy the firm's working
capital position will be strengthened.
h) Depreciation Policy: Since tax benefits are available for depreciation. Higher the
amount of deprecation, lesser the tax liability and greater profits. On the other, if higher
amount of depreciation is charged then the amount of net profits will be less. Again if
the dividend policy is linked with net profits the firm can pay fewer dividends by
providing more depreciation. This in turn will increase the retained earnings and
strengthen the firm's working capital position.
i) Operation Efficiency of a Firm: If a firm controls its operating costs, then it will
be able to improve net profit margin which will in turn, release greater funds for
working capital purposes. Better operating efficiency reduces the cost.
j) Coordination of various activities of the firm: If production distribution
octaves are coordinated, then the pressure on working capital will be reduced.
20.3 EXTERNAL FACTORS
Business Fluctuations: When economic conditions are changing, business firm's will
naturally are fluctuating in demand for their products and services. Based on this factor
the need for working capital also varies. To cope with increased demand and
consequently increased production, firms will need additional working capital. On the
contrary in times of recessions the business enterprises will experience decline in sales.
Consequently, capital needs of these enterprises will tend to decline. If inventories are
locked, additional cash to meet operating expenses are needed. If recovery position is
bad, a shortage of working capital may develop.
Technology Developments: Technological developments in the area of production
can have a great effect on the need for working capital. If a firm adopts new technology
and produces the products, it may reduce the time involved in converting raw materials
into finished goods. This in turn reduces the inventory needs and also expenses on raw
materials.
Transport and Communication: If this facility is well developed, then the need to
maintain huge inventories of raw materials and other accessories will be reduced. This
will reduce the need for additional funds.
Import Policy: Working capital needs also depends on the policy of Government with
regard to Exim Policy. Otherwise, businesses firms have to arrange for funds to import
goods at specify times.
Taxation Policy: If liberal taxation policy is available, then the pressure on working
capital will be minimized.
20.4 SUMMARY

The internal factors namely size of Business, production Policy credit policy, dividend
policy. Depreciation policy will affect the working capital. The external policy namely
Business fluctuations Technology Development, Import Policy, Taxation Policy will
affect the working capital
20.5 REVIEW QUESTIONS
1. State the internal factors that affect the working capital requirement
20.6 ASSIGNMENT QUESTIONS
1. Discuss the external factor how it affect the working capital.
20.7 KEYWORDS
Taxation Policy, Dividend Policy, Import Policy.

- End Of Chapter LESSON -21
MANAGEMENT OF FIXED ASSETS AND CAPITAL BUDGETING
TECHNIQUES

OBJECTIVES
·
·

To know the importance of Capital Budgeting Techniques
To Analyze various method of capital budgeting techniques

STRUCTURE
21.1 Introduction
21.2 Importance
21.3 Prominent techniques of Banking Projects
21.4 Payback period method
21.5 ARR method
21.6 NPV method

21.7 Summary
21.8 Review Questions
21.9 Assignment Questions
21.10 Keywords
21.1 INTRODUCTION
"Capital budgeting may be defined as the decision making process by which firms
evaluates the purchase of major fixed assets, including buildings, machinery and
equipment."
It is a part of the firm's formal planning process for the acquisition and investment of
capital. Therefore capital budget includes the firm's formal plan for the expenditure of
money to purchase fixed assets. The capital deals with major investment portfolios and
is prepared to help the firm deal with the long term.
21.2 IMPORTANCE
Preparing a capital budget for the firm is highly important for the following reason
a) Substantial expenditure
Generally crores of rupees of expenditure will be there and therefore the very size of the
company underlies the importance to the firm.
b) Long Time Period
The effects of capital spending decision will be felt only in the long run because once it
jumps for longer activities it cannot go back. Therefore proper planning as required. The
long-term commitment adds a greater risk to the firm's capital budgeting decisions.
Again it is because the firms has to take decision whether to go in for heavy fixed assets
or sell the existing assets at a great loss.
c) Inflated sale forecasts
It is normal to spend money on a fixed asset hoping to have a better sales value.
However a balance is required. For example if a firm decides not to purchase a
particular machinery or building, then the firm may not be able to meet demand in the
future on the other excess purchases may struck the form with unnecessary funds or
assets or capacity. One of the important aspects of capital budgeting process in
forecasting sales, possibly for the next ears, say 5 to 10 years.
d) Over and under capacity

If the budget is prepared carefully, then it will improve the timing and quality of asset
acquisition. If planning and forethought is not there then it will the firm with large sums
of money on over capacity or under capacity and sometimes at the same time. What is
important is not to have idle assets in the company, idle assets in the company.
Prominent Techniques of Banking Projects
Over a period of time, a good number of techniques were developed for ranking projects.
In fact it is the duty of a good financial manager to rank the projects very carefully so
that he can decide about the desirability of a firm and use the given amount of money on
a more profitable way in profitable project. However, the following are the important
techniques.
a) Average Rate of Return Methods or Accounting Method
This will be calculated on the rate of return of each projector each project will earn over
its life. This method uses the accounting figures that are available in the financial
statements namely balance sheet and the income statement. The rate of return on
investment will be decided by following the process.
a) By dividing Average Income or / and
b) Earning after depreciation and taxes by the amount of investment originally made
sometimes even after taxes bur before depreciation may be related to original
investment figure to compute rate of return of the project. This to find the accounting
rate on the basis of original investment, one simple divides the expected average annual
amount of profit after depreciation and takes by the cost of the new facilities.
So the formula is
Average after Tax Annual Net Profit
Average Rate of Return = ----------------------------------------------(ARR) Original investment / 2
For example Management of Annamalai Electrical is contempt plating to buy a machine
for manufacturing purpose. There a presently tow machines available in the market
which could give the purpose. Details of these two machines are:
Machine X
Rs.
Cost

30,000

Machine Y
Rs.
30,000

Annual Income estimated after depreciation and Tax

Income

Income

I Year

5500

6100

II Year

8000

7200

III Year

8500

8400

IV Year

800

7000

V Year

9000

8800

5

5

Estimated life in years

Average Income Tax Rate 55%

55%

Which machine should the management buy? Assume that the management uses
Accounting Rate of Return for the project.
Answer:
Total income during the life of the project
Average Income = -----------------------------------------------------Life of the project
39,700
Average Income of Machine A = Rs. -------------- = Rs. 7,940
5 Years
38,200
Average Income of Machine B = Rs. -------------- = Rs. 7,640
5 years

Average Investment = Original Investment / 2

30,000
Average Invest of Machine A = --------------- = Rs. 15,000
2
7,940 * 100
A R R of Machine A = ------------------- = 52.93%
15,000
7,640 * 100
A R R of Machine B = -------------------- = 50.93%
15,000
Since the rate of return of Machine A is higher than Machine B, the finance Manager
should take a decision to go for Machine A.
Note: It should be noted that the income figure is not based on cash flows but upon the,
Reported Accounting profits.
However, certain principles are available which the finance manager should keep in
mind for example cut off Rate Principle.
Cut off Rate Principle
The finance manager should take a decision to accept or reject only after comparing the
Accounting Rate of Return of the project with pre-determined rate of return as cut off
Rate. Projects with the rate of return, than the cut off rate will be accepted. Those with
relatively lower rate of return will be liable for rejection. Before comparing the rate of
return of the projects with cur off rate, management should average projects in hanged
in order of their rate of return.
Evaluation and Limitation of the Method
a) The A.R.R method is very simple to calculate and to understand. In this method
direct comparisons can be made among proposed projects without a build in prejudice
in favor of short-term ventures.
b) Rate of return can be calculated according to Accounting procedure and concepts.
But this method has the following disadvantages or limitation

a) This method ignores time value of money. For example a sum of Rs.100 received now
can be invested at the going market rate of interest say10%and a year it should be RS.
110. In other words, future value of Rs.
100 received now will be Rs. 110. To put the same in other words, the present value in
Rs. 110 received a year later a year is equal to Rs. 100. The discounted cash flow (DCF)
criteria are devised to pay a due consideration for the impact of time value. This is a
normal system in the capital budgeting projects. In other words the profit to be received
a year from now and the profit to be received 5 years later from now is given equal
weight age which is not logical. This weakness of Accounting procedure is greater when
on given projects profits are expected to be less in the first few years and much larger in
the later years, since the average accounts may indicate quite attractive profit rates.
b) It fails to show yearly rate of return of the project. As such it is difficult to judge the
real worth of the projects. Real rate of return actually depends on the time pattern of the
fund flows.
c) Serious danger may develop if the finance manager accepts the projects whose
accounting rates are equal to or above some arbitrarily selected cutoff rate.
d) Accounting information may not always feasible to take a decision on investment
since accounting fails to distinguish cash flowing in and out of the company and
bookkeeping transaction.
II. Pay-Back Methods or period
In this method it is the period of time that is counted to get back the original net cash
outlay or the funds invested in the project. This method tells how quickly cash will
return to the firm. Therefore this is useful in high-risk situation or where the firm is
short in cash.
Limitation or Weaknesses
a) Two much emphasis on Liquidity
Since getting back the cash or pay back is the criteria, Liquidity will be given priority
over profitability and this may to be correct policy or long-term investments. As such the
goal of profit maximization takes a second places.
b) No recognition of cash flow variation
For Example
One project 'A' may have cash inflows of Rs. 3000 I Year
Rs. 4000 II Year

Rs. 5000 III Year
Another project 'B' may have cash

Rs. 5000 I Year
Rs. 4000 II Year
Rs. 3000 III Year

If both projects join, net cash outlay would be Rs. 12,000 and the any back period would
be 3 years for each. 'Here if one observes second project 'B' it would get more cash
earlier and would be more valuable. This kind of situation cannot be adequately handled
by pay back method.
c) Cannot handle projects of different Economic Lives
For Example:
If two projects A and B costs Rs. 2,50,000 and have Rs. 50,000 a year annual cash
inflows after taxes, the plough back period would be 5 years, for each. If one project had
an estimated life of 7 years, and the other a 10 years life, the additional revenues in years
8 to 10 would not be 'seen in the pay back system. But these revenues make the larger
project more valuable.
d) If ignores the time value of the money
For Example one rupee received four years from now is considered to be the same as
that of a rupee today. This technique can also be explained by giving the following
formula and illustration. The definition of pay back is the period of time required for a
proposal's initial cash outlay to be recovered by generating cash at the earliest. The cash
flow (after tax plus depreciation) is used in calculating the payback period.
Symbolically:
P.B.P = CO/CF
Where CO = Cash flow of the project
CF = Cash Inflow.
Thus, if a project requires an additional cash outlay of RS. 8000 and promises to get RS.
2000 per annum, the payback period would be 4 years.
i.e., Rs. 8000/2000 = 4 years.
Illustration

Murugan Paper Limited is trying to decide whether to buy a new machine, which
requires an investment of Rs. 14,000 and has eight-year life. The after tax cash saving
expected to be generated by the machine is as follows:

It is evident from the above that investment outlay of Rs. 14,000 will be recouped by the
projected cash earnings in four years. Hence payback period will be 4 years. Since the
payback period of the project is less that the cur off period may not be prudent. Despite
weakness, this method is very popular because the speed of capital investment recovery
is essential.
21.5 ADJUSTED RATE OF RETURN OR INTERNAL RATE OF RETURN
METHOD
Definition

It is that rate of return, which discounts all the future cash inflows to exactly equal to
outlay. In other words, the Internal Rate of Return is the rate of discount that sets the
net present value equal to zero. The net present value has to be zero if the present value
of the projects income streams is equal to the present value of the projects cash outlay.
This approach uses a Trial and Error method to find the discount factor (which is
actually the rate of return) that equates the original investment to the net cash benefit. If
we find that the 10% factor sets the budgets equal to the outlay, the internal rate of
return for the investment is 10%. As an example, of this technique, one can calculate the
Rate of Return for a 4-year stream as shown in the following figures.

Here, one set the net cash outlay equal to the net cash benefits times to appropriate
discount factors. The stream has an annuity of Rs. 6000 for 3 years and a single
payment in the years 4. This technique recognizes the time value of money. But it has
limitations.
1. It assumes that the funds received at the end of each year can be reinvested at the
same rate of return.
2. It does not provide weight age to the volume of funds committed in projects.
3. Under conditions of irregular cash flows, this method may give two or more answers.
21.6 NET PRESENT VALUE METHODS
This method uses a fixed cost of capital, which may be defined as the rate of return the
firm needs to realize from an investment to maintain or increase the value of the firm. In
this sense of maximizing wealth, the cost of capital must be high to cover the costs of
raising money, paying expenses for fixed charges, plus an additional profit to protect the
a value of stock and b. to give the shareholder growth and Dividends. Under this method
all projects are discounted at the same rate.
If the net present value of the benefits exceeds the outlays, the project value of the
benefits is less than the outlay; the project is acceptable since it has a higher return the
project is rejected. The calculation of present value is the same as discounted cash flow.
Difference between Internal Rate of Return and Net Present Value Methods

They give different results because they make different assumptions on the
reinvestments proceeds. IRR assumes that all proceeds are invested at the rate of return
whereas NPV method assumes that proceeds reinvested at the cost of capital.
21.7 SUMMARY
Payback period method is the period of time that is counted to get back the original net
cash out lay of the funds invested in the project. ARR in which discount all the future
cash inflows to exactly equal to out lay. NPV method uses a fixed cost of capital.
21.8 REVIEW QUESTIONS
1. Enumerate benefits of payback period method
2. Discuss the importance of ARR method
21.9 ASSIGNMENT QUESTIONS
1. Discuss the Role of NPV in selecting a project
21.10 KEYWORDS
ARR, IRR, PBP, NPV

- End Of Chapter LESSON-22
DIVISIONAL BUDGETS - IMPLEMENTING PROCEDURE

OBJECTIVES
The main objectives of this lesson are:
·
·
·

To trace the meaning of objectives of Budget
To compare divisional and functional organization
To identify the procedure for preparation of divisional Budget

STRUCTURE
22.1 Introduction

22.2 Budget-meaning
22.3 Objectives of Budget
22.4 Divisional Budgets
22.5 Preparation of Divisional Budgets Procedure
22.6 Conditions for Success
22.7 Reason for Divisionalisation
22.8 Summary
22.9 Review Questions
22.10 Assignment Questions
22.11 Keywords
22.1 INTRODUCTION
Budget is an important tool of financial planning and control. The technique used by the
management is to compare the actual performance with budgets. A budget is a formal
quantitative expression of management plans. Budget, as a tool of management, is an
integral part of the broader system of planning and control.
Budget can be visualized as the end result of the budgeting. Whole budgeting is the
procedure for preparing plan in respect of future financial requirements; the plan when
presented in written form is called 'Budget'. Budgeting, in fact is a managerial technique
and a business budget is like a written plan, in which all aspects of business operations
with respect to a definite future period are included. It is a formal statement of policy,
plan, objective and goal established by the top management in respect of some future
period.
22.2 BUDGED MEAING
A budget is defined as a comprehensive and coordinated plan, expressed in financial
terms, for the operations and resources of an enterprise for some specified period in
future. According to this definition, the following are essential elements of a budget. (a)
Plan (b) Operations and Resources (c) Financial terms (d) Specified future period (e)
Comprehensiveness (f) Coordination.
Nature of budget: Budget results from the predetermined standards setup for
carrying our plans according to objectives set for the entire operations. The essentials of
the business budget are as follows:

1. Budget is prepared in advance and based on future plan of actins.
2. Budget is based on objectives to be attained during a defined future period. A
budget related to a specified period of time, usually one year.
3. A budget is a mechanism to plan for the firms operations and resource the
operations are reflected in revenues and expenses. This means that budget is a
special form of statement in which revenues and expenses are numerically
expressed by a management plan.
4. Budget is a method of rationalization by which control function in respect of total
activities of the business is given effect.
5. Budget is a tool for developing the cooperation, co-ordination and control.
22.3 OBJECTIVES OF BUDGET
Budget serves as a guide to the conduct of operations and a basis for evaluation actual
results. Budgeting is a forward planning and serves basically as a tool for management
control. The main objectives of budgeting are:
i) To forecast and to plan for the future to avoid losses and to maximize profits i.e. to
help in planning.
ii) To coordinate different functions of the enterprise by correlating the efforts of all
concerned.
iii) To communicate or inform other of the goals and methods selected by top
management.
iv) To control actual actions by ensuring that actual are in tune with targets
22.4 DIVISIONAL BUDGETS
A divisional has been defined as a company unit headed by a man fully responsible for
the profitability of its operations, including planning, production, finance and
accounting activities, and who usually, although not always, has his own sales force. In a
divisional business, a divisional heads enjoys the authority to determine how the
operations under his control are to be carried out. More important, he determines, to a
great extent what operations are to be carried out. The essence of divisionalisation is
delegated profit responsibility.
A division may also be defined as any part of line of activity for which they analyses the
performance many proponents of responsibility accounting distinguish sharply between
the division as an economic investment and the manger as professional decision.
Escorts India Limited is organized into several divisions: automotive division agency,
sales division, motorcycles and scooters division, power and projects marketing
division. Similarly, Madura Coats Limited is organized into four division, textiles
divisions, and exports division. Modern Bakeries Limited, a concern having bakery
establishments in several locations, is organized into units located at Ahmedabad,

Bangalore, Cochin, Delhi, Hyderabad, Madras, Kanpur, Calcutta and Bombay.
Hindustan Machine Tools is divided into several business groups such as machine tools
group into several business groups such as machine tools group, watches division, lamps
division, tractors division, and exports division. Many such examples of divisionalised
companies may be given.
Budget is prepared for different, divisions of an organization so as to take care of the
situations and problems of prepared in harmony with each other. It may be recalled that
a budget with reference to planning and control refers to a comprehensive and
coordinated budget generally known as 'Master Budget'. In operational terms a
comprehensive or overall budget has several components.
DIVISIONAL ORGANISAITON VS FUNCTIONAL ORGANISATION
Budget for a period may also be classified according to functions carried on in a business
concern. To compare divisional organization with functional organization, let us look at
an organization chart - 1. The chart shows the organization in a somewhat abbreviated
form, of a functionally organized firm. The company manufactures two broad types of
consumer products and industrial products. In three different locations, these products
are marketed all over the country in several different markets. No department has
exclusive responsibility for any product or for any market.

The following chart 2 shows, in a summary form of a divisionally organized firm. The
company is organized into four divisions, which are fairly autonomous. Each divisional
general manager has freedom over production and marketing operations of his division
and it is accountable to the, top management for the profitability of the division.

As mentioned earlier, all functions are interrelated. The various forecasts for individual
function are coordinated and then consolidated to show the total effect of all the
functions. As such, budgets are prepared for each individual function and then summary
is prepared consolidating al functional budgets. The entire business organization can be
divided in to several divisions based on the functions. Budgets prepared on the basis for
approved forecasts for individual divisions or departments or functions are commonly
known as divisional budgets or functional budgets or departmental budgets. The
divisional budgets may vary in number from business to business depending upon the
size, nature of the business enterprise.
The manufacturing organization can be divided in to several.
Divisions based on the level of operations or area of operations.
Each division - future divided into several departments based on
The functions undertaken by each department. The budget of each Function is discussed
below.
1. Production Division: Production division is the division where the production pan
and the process will be undertaken. The procurement of materials and, relevant inputs
will also be taken care of in this division. The efforts of machine, material and relevant
men will be coordinated in the production division keeping in view the organizational
growth.
2. Administrative Division: it is the division, which is primarily responsible for the
overall administration or management of the business enterprise. The objective setting
and preparation of plans and designing the required strategies and their effective

implementation are undertaken by the administrative division. That is the reason why
administrative division is treated the central point for the total operations of the
business enterprises. Financial divisions deal with cash receipts and disbursements,
financial position including management of working capital. Ultimately the overall
financial management is under the responsibility and control of finance division.
3. Selling and Distribution Division: Once the production process is over, the very
next important activity is selling and distribution. The totals sales and distribution and
their related activities are undertaken by sales and distribution division.
4. Research and Development Division: Research and development of product,
technology, process of production is dealt by research and development division.
Generally the existence of research and development division may not be found in all
the organizations except some major business enterprises. The preparation of research
and development budget requires the allocation of expenditure for research and
development activities which is essentially a matter of policy. The nature of this budget
is ability - oriented and outlook based. Allocation should be done in a way that a limit is
placed on the amount, which can be spent.
22.5 PREPARATION OF DIVISIONAL BUDGETS - PROCEDURE
The procedure to be followed in the preparation of budget for any division may differ
from business to business however; a general procedure of budget preparation may be
drafted. Very commonly the following steps are involved in the preparation of divisional
budgets.
1. Formulation of Policy
Business policies can be considered as the base for budget construction. Therefore, the
policies in relation to various functions should be formulated before the construction of
budgets. These policies are mostly long range plans relating to sales, production,
inventory, capital expenditure and cash etc. Also, these policies differ from business to
business and to a greater extent depend upon the management efficiency. Actually
speaking, policy formulation is the work of management but not of the budget
committee.
2. Preparation of forecasts
After formulating the different policies;, forecasts- are prepared in respect of various
functions of the business particularly relating to: a) sales (b) Production (c) Inventory
(d) Costs (e) Cash (f) Credits (debtors and creditors) (g) Purchases and (h) Capital
expenditures.
These forecasts are not simply estimates; they are made after considering past and
present situations and also future expectations. Various scientific methods and
techniques are used for the estimation. "While making forecasts, proper weight age
must be given to key sector, if any.

i. Comparison of Alternative Combinations of Forecast
When forecasts are made and put for perusal alternative combination of forecasts is
compared and considered with a view of observe and to establish as which combination
would reap maximum profits by keeping long range financial stability intact. If any key
factor· is found useful in the accomplishment of a forecast, that must be kept in view and
remedies to get it over should also be designed. The forecast can be treated as final,
when the maximum profit yielding combination of forecast is selected. The budget
committee generally does the selection of final forecasts.
ii. Preparation of budget
The various forecasts selected as above are presented in a written from known as
budget. ON the basis for forecasts, different functional budgets can be prepared which
are coordinated and combined into one Master budget. After proper organization has
been set up for preparation and administration of budget and the budget period is being
selected, the actual preparation of the budget begins.
a) To analyze general market and business conditions.
b) To develop standard budget forms, for the insertion of production plans, estimated
income and cost for each division or department.
c) To formulate general policies on the basis of production and sales reports, general
business conditions, and forecast of future sales potentialities.
d) To consider the principal budget factor or limiting factors viz, short supply of
material, and labor, shortage of production capacity, space, capital etc.
22.6 CONDITIONS FOR SUCCESS
The success of divisional performance is subjected to the fulfillment of certain
conditions. They are:
1. The firm must have two or more units for which revenues and expenses can be
measured separately.
2. In order to make separate profit responsibility meaningful, each division should be
sufficiently independent of other divisions with respect to production, marketing and
other activities.
3. The relations between various divisions in a firm should be so regulated that it should
not be possible for a division to enhance its profits while hurting the interest of the true
autonomy of divisions.
22.7 REASON FOR DIVISIONALISATION

For the purpose of administrative convenience, many large and diversified organizations
tend to resort to divisionalisation. The reasons for divisionalisation and preparing
divisional budgets are as follows:
1. Profit responsibility: A manager being entrusted with profit responsibility makes
rational trade-offs between revenues and costs. It becomes very difficult to exercise
control over his day-to-day decisions without decentralized profit responsibility.
Divisional operations provide an excellent training ground for grooming top
management personnel.
2. Operational autonomy: The performance of a division or divisional manager can
be measured more accurately when a manager is given operational autonomy.
3. Strategy formulation and resource allocation: The information about a profit
performance of various divisions in relation to the company as a whole is helpful in
strategy formulation and resource allocation.
4. Decentralization: A divisional setup brings about a kind of decentralization, which
is pre-entirely suited to highly diversified firm of organization structure.
5. Measure of performance: A higher level of performance is attained when greater
scope for initiative is provided to responsible individuals who are in charge of various
divisions.
22.8 SUMMARY
A division IS a part of an organization or line of activity for which separate
determinations of revenue and cast is obtained. Divisional performance of all the
divisions constitutes the overall profitability of the firm. All major business
organizations prepare the budgets by division wise and each division will be located as
profit center and cost center. The divisional budget serves as a guide to the conduct of
operations and basis for evaluating actual results. Budgeting is a forward planning and
serves basically as a tool for management control. In the preparation of divisional
budget, a divisional head enjoys the authority to determine how the operation under his
control is to be carried out. The essence of divisionalisation is delegated profit
responsibility.
22.9 REVIEW QUESTIONS
1. Distinguish between divisional organization and functional organization.
2. Define the term division and explain various divisions in a large business
organization.
22.10 ASSIGNMENT QUESTIONS

1. Explain the procedure for divisional budgets and narrate the conditions success of
divisional performance.
2. Discuss the need for divisionalisation.
22.11 KEYWORDS
Quantitative expression of Management plans, forward planning, top management
Master Budget.

- End Of Chapter LESSON -23
HUMAN RESOURCE ACCOUNTING FOR EFFECTIVE USE OF MAN POWER

OBJECTIVES
The main objectives of this lesson are:
·
·
·

To trace the meaning & objectives of human resource accounting
To identify how human resource accounting controlling manpower
To analyze the problems, prospects of human resource accounting in India

STRUCTURE
23.1 Introduction
23.2 Objectives of Human Resource Accounting
23.3 Human Resource Accounting for Effective use of Manpower
23.4 Methods of Valuing Human Resource
23.5 Human Resource Accounting in India
23.6 Human Resource Accounting Problems
23.7 Human Resource Accounting Prospects
23.8 Summary

23.9 Review Questions
23.10 Assignment Questions
23.11 Keywords
23.1 INTODUCTION
In any organization the most important input is the human element. The success or
failure of a company very much depends on the persons who man the organization. It is
a common knowledge that capital issues of even new undertakings are oversubscribed, if
competent persons float them. This is because the investor in the capital market places
high value of the human ability rather than any other factors like net worth, yield, priceearnings ratio which are not available in the case of new company. Even among nations,
countries like Japan, West Germany and Korea are able to make rapid strides with
human resource not in terms of numbers but in terms of quality devotion' to work and
loyalty to the nation. This was possible because of the emphasis on the development of
human resources, Japan, a country that is not endowed with much of natural resources,
is not handicapped at all. With the help of its human resources, that nation can
surmount any difficulty. History is replete with examples of several great personalities
like Christ, Buddha, Prophet Mohammed, Sankara and Vivekanda to realize what single
individuals can achieve without any material resources. In business also the greatest
asset is the human resource of the enterprise and not the plant, equipment or the
magnificent building it owns. Alfred Marshal said long ago, that the most valuable of all
capital is that invested in human beings with the advent of scientific management, with
emphasis on quantitative methodology to make almost efficient use of all the resources,
attempts have been made in recent years to quantify data relating to human resources
and to develop models to explain its value for the management of organizations.
The principal failures of conventional accounting in n relation to human resources can
be listed as below:
1. The amount spent on human resources is completely treated as an expense, which is
not correct. The amount spent on acquisition, training and development with long-term
benefit should be capitalized.
2. Management has absolutely no in information regarding the total investment in
human resources.
3. Management needs data about the amount to be spent on acquisition of human
resources for purposes of planning and control, in the same way they need data about
other resources. Such information is not available under conventional accounting.
4. The failure of conventional accounting to recognize the talents, capabilities and
potential of the human resources resulted in high labour turnover, frustration among
the industrial work force.

MEAING AND DEFINITION
Human resource accounting is intended basically as an information system, which
reflects the charges in human resources over a time. Such information is vital to
management in the planning and control of human resources and budgeting of
personnel. It is the measurement of the cost fund value of people to an
organization and involves measuring the costs incurred by private firms and public
sector enterprises to recruit, select, hire, train and develop employees and judge their
economic value to the organization. Thus human resource accounting aims at
accounting for people as organization resources. In fact, human resource accounting is
primarily an information system that keeps the management abreast about the changes
that are taking place in the human resources of the organization.
The American Accounting Association's Committee on Human Resource Accounting
defines H.R.A. as follows:
‘Human Resources accounting are the process of identifying and measuring data about
human resources and communicating this information to interested parties’.
In the words of Geoffrey M.N. Baker, -'Human resources accounting is the term applied
by the accountancy profession to quantify the cost and value of employees to their
employing organization'.
Assumption
The human resource accounting makes up the deficiencies of the conventional
accounting and is based on the following assumptions:
1. Human resources are similar to financial and physical resources In the matter of
providing benefits to an organization.
2. An asset is defined as 'the right to receive future economic benefits'. In this sense,
'human resources can appropriately figure as accounting assets'.
3. Human resources can be acquired only at a cost. An organization incurs an out lay in
the acquisition of such resources because of the expected future economic benefits,
which are measurable.
4. It is theoretically possible to identify and measure human resource costs and benefits
within an organization. Information regarding human resources management in
planning, controlling organizational performance.
23.2 OBJECTIVES OF HUMAN RESOURCE ACCOUNTING
The primary purpose of Human Resource Accounting is to facilitate the management of
people as organizational resources. It can also be called s 'Human Resource

Management Accounting' i.e., the application of accounting to the Management of
human resources. The objectives of Human Resources Accounting system are:
5. is useful for the internal evaluating and predicting
1. To furnish human resource cost and value information for making management
decisions about acquiring, maintaining human resources in order organizational
objectives.
2. To allow Managerial personnel to monitor effectively the use of human allocating, to
attain developing and cost effective resources.
3. To provide a determination of asset control i.e., whether assets are conserved,
depleted or appreciated.
4. to aid in the development of 'management principles by clarifying the financial
consequences of various practices.
5. To help the persons interested in the organization to know whether the human
resources are producing a return equivalent to their worth or not.
Thus the objective of Human Resource Accounting is not just the recognition of value of
all resources used are controlled by a business entity but it also includes the
improvement of the management of human resources so that the quantity and quality of
goods and services are increased. The basic objective underlying human resource
accounting is to facilitate the effective and efficient management of human resources.
23.3 HUMAN RESOURCE ACCOUNTING FOR EFFECTIVE USE OF
MANPOWER
Managers receive a great deal of information about the physical and Financial resources
with which they are entrusted but very little information about human resources yet this
information is needed as correct decisions are to be made about alternative investments
in human resources. Role of human resources accounting as a managerial tool is clear
from the following:
1. HRA helps in budgeting human resource acquisition. It provides measurement s of
the standard costs of recruiting, selecting a hiring people which are used to prepare
human resource acquisition budgets.
2. HRA facilitates decisions involving the allocation of resources to human resource
development by measuring the expected rate of returns on proposed investments.
3. HRA is useful to management in formulating policy for human resource acquisition
and development. It provides estimates of the historical and current costs to acquire and
develop people for the various positions.

4. HRA is useful to management in making allocation decisions. Management can apply
the linear programming to determine an optimal a solution to the work force allocation
problem.
5. HRA can assist management in conserving its human organization by providing as
early warning system. It can measure and report certain social, psychological indicators
of the condition of the human organization and management can assess trends in these
variables prior to the actual occurrence of turnover.
6. HRA provides framework to help managers utilize human resources effectively and
efficiently. At present the management of human resources in organization is less
effective because it lacks a unified framework to guide it. HRA provides the goals and
the criterion for the management of human resources.
7. HRA is useful in the valuation process of human resources by developing reliable
methods of measuring the value of people to an organization. These methods include
both monetary and non-monetary measurements and permit human resource
management decisions to be based on a cost value basis.
8. HRA has an impact on the administration of rewards system, which is intended to
motivate and reinforce the optimal performance of people in achieving organizational
objectives.
9. HRA can be used to evaluate the efficiency of personnel management.
10. HRA furnishes information about the cost and value of people to and organization
and is a system of providing management with the information needed to manage
human resources effectively and efficiently.
11. HRA is a way of thinking about the management of an organization’s human
resources based on the notion that people are valuable organization’s human resources
based on the notion that people are valuable organizational resources.
12. HRA performs three major functions, i.e., it serves as a frame work to facilitate
human resource decision making, it provides numerical information about the cost and
value of people as organization resources and it motivated line management to adopt a
human resource perspective in their decisions involving people.
23.4 METHODS OF VALUING HUMAN RESOURCE
In measuring the value of human resources it is difficult to comply with the generally
accepted accounting principles. There are two approaches to valuation based on cost
which takes into account the costs incurred by an enterprise to recruit, hire, and train
and develop human assets. In this approach again the cost may be historical cost,
replacement cost, standard cost or opportunity cost. The second approach is to measure
the economic value of the resource based on capitalization of earnings. Some of these
methods are critically discussed below;

1. Acquisition cost
Under this method, the costs of acquisition, namely, the costs incurred in recruitment,
hiring and induction of employees are taken into account. The process involves
capitalization of historic costs. The cost so capitalized has to be written off over a period
of time for which the employee remains with the firm. If for some reason the employee
leaves the organization prematurely, the unamortized cost remaining in the books has to
be written off against the profit and loss account of the particular year.
This method is simple to understand by all concerned. It is also easy to implement. But
the most important drawback of this system is that historic costs are not relevant for
decision-making and are useless. The data may be of some use to managers in
calculating ROI in human resource development activities etc., but will be of no use to
investors because this method does not give a correct value of human resources. The
capitalized figure of human resources under this method merely represents the
unamortized balance of the costs and does not give any indication of the potential
benefits that accrue to the organization from the use of such resources.
2. Replacement cost
While in the case of acquisition cost, past costs are considered, under this approach one
takes into account how much it costs to replace a firms existing resources and thus
represents a current market conditions. But it is a difficult exercise as in many cases the
replacement may not be exactly similar. Replacement costs can be positional or
personal. Positional replacement costs are typical in nature and related to the position,
but not the individual who occupies it. Personal replacement costs are related to a
particular person.
3. Standard Cost
This is an application of standard cost principles to costs associated with recruitment,
hiring, training and development of human resources. The standards set for various
components are also helpful to compare the actual and analyze the variations from
standards.
4. Present Value of Future Earnings Method
This model is developed by Lev and Schwartz and is very popular in India. It is also
known as capitalization of salary methods. Under this method, the future earnings of an
employee or grades of employees are estimated up to the age of retirement and are
discounted at a rate appropriate to the person or the group in order to obtain the
present value. The model may be symbolically expressed as follows:

T 1(t)
Vy =

------------------T=y (1+r) t-y

Where Vy = The human capital value of a person 'y' years old.
T = The person's annual earnings up to retirement.
R = Discount rate specific to the person.
T = Retirement age.
When the calculation is made for a group, values are arrived at on the basis of average
earnings for each category of employees. Human capital calculated in this manner is
useful since comparison with non-human capital will give an idea about the degree of
labour intensiveness. Although this method is simple to understand, it suffers from
many drawbacks. They are:
1. It is very difficult to estimate the future earnings as some for the persons may occupy
higher posts than the 'ones anticipated by acquiring further qualification and skills’.
2. Since human capital is taken as equal to present value of total earnings, any over or
under-dilution of salary results in arriving at a wrong value of human capital.
3. The sum of the human capital values of individual employees does not add to the
human capital value of the organization, since it ignores the synergistic effect.
Teamwork is' something more than the sum of the values of individuals.
5. Herman son's un-purchased Goodwill Model
This is the earliest model developed in 1964. Herman son was the first to suggest that
human resources will come under the category of attritional assets although an
organization does not legally own the Herman son has developed two valuation methods
both of which are based on economic concept value. Under the un-purchased goodwill
method Herman son has suggested arriving at the value of human resources by
capitalizing the profits in excess of normal earnings. Normal earnings are based on the
normal rate of return to the economy as a whole. The computation would be as shown
below:
Average value of owned assets:

Rs. 30,000

Average net profit (after tax) @ 15% Rs. 4,500
Net income at normal rate say 12%

Rs. 3,600

Excess earnings over normal rate

Rs. 900

Value of human assets by capitalizing the excess earnings
Rs. 900 * 100
-------------------- = Rs. 7,500
12
This method also suffers from demerits. They are:
1. It is based on historic cost and therefore of little value for decision making.
2. It is not right to assume that the human resources are the only un-owned assets and
that the excess profits are entirely attributable to human resources.
3. This method assumes zero value to human resources when the earnings are normal.
6. Hermanson's Adjusted Discounted Future Wages Model
This is basically similar to the Lev and Schwartz model in discounting the future
compensation to determine the value of an individual. However, the value so arrived is
adjusted by using an efficiency ratio. The efficiency ratio is found by dividing the actual
average earnings of the firm by the normal earnings of all the firms. The ratio of 1
indicates that the firm's average rate of return is equal to the average rate of return for
the economy. If the ratio is more than 1, higher than normal earnings are indicated.
Conversely, when the ratio less than 1, the firm's earnings are less than the normal
earnings of all the firms.
7. Economic Value Method
The economist's concept of the value of an asset is equal to the present worth of its
estimated future economic benefits. This approach has a strong theoretical appeal. This
method involves the following steps:
a) Estimation of future benefits
b) Ascertaining the present value of such benefits by using an appropriate interest
(discount) rate.
It is very difficult to estimate the flow for future benefits unless the organization has a
single employee. It is equally difficult to establish the discount factor although cost of
capital suffices for practical purposes. In view of the measurement problems, resort is
made to use substitute measures such as replacement costs, opportunity costs etc.

8. Competitive Bidding Method
This is also known as the opportunity costs method. To overcome the deficiencies at
replacement cost, Hekimian and Jones have suggested the use of opportunity cost. It is
defined as the measurable value of benefits that could be obtained by choosing an
alternative course of action. In the case of HRA, opportunity cost is determined by a
process of competitive bidding in which various divisions and departments bid for the
services of various officers. This method can be applied only to resources that are scare.
This system is not suited to top management, which is not available for action.
23.5 HUMAN RESOURCE ACCOUNTING IN INDIA
Under Section 217 (2A) of the companies Act, 1956, companies are required to give the
particulars of employees earning Rs. 72, 000 or more per annum. However, companies
like BHEL, MMTC, ONGC, SAIL and SPIC have been giving information about human
resources on their own in there published accounts. The method of valuation adopted by
these companies is the value-based model developed by Lev and Schwartz. But the
discount rate varies from on e organization to another. While SAIL applies 14% rate,
MMTC has chosen 12% to arrive at the present value. In case of ONGC the earnings are
discounted at 12.25%., i.e., the rate at which Government of India is advancing loans to
ONGC. According to the category of employees such as managers, supervisors, skilled
workers, unskilled workers etc., the present value of the future earnings is shown. It
represents the value of human resources to the organization on the assets side and on
the liabilities side as social equity representing employee's contribution.
The information such as the ratio of human to non-human resources, ratio of
turnover/human resources and value added-per employee of human capital is also
provided in the reports. HRA information if properly developed will be useful to
managers at all levels regarding costs of turnover and inefficient utilization of human
resources which will lead to better decisions regarding personnel. Such information also
helps these organizations to understand the costs involved in fulfilling social
responsibilities such as training to the unemployed persons. Data could also be useful to
investors to judge the future performance of the enterprise.
23.6 HUMAN RESOUCE ACCOUNTING - PROBLEMS
Once the decision to report human assets in financial statements has been taken, there
are five major human resource accounting problems to be resolved which are as under:
1. Capitalisation of Human Resources Costs
This is a problem of classifying human resource costs into expense and asset
components. The basis criterion to decide whether a cost is an asset or an expense is
related to the notion of future service potential. Costs should be treated as expenses in
the period in which their benefits are derived. If expected benefits relate to future
period, they should be treated as assets.

2. Amortisaiton of Human Assets
This involves the measurement of the portion of the assets service life consumed during
an accounting period. For physical assets such as machines this process is known as
depreciation but for intangible assets and human assets it is known as amortization. The
principal objective of amortizing human assets is to match the consumption of an asset's
services with the benefits derived. Some human assets may have a service life equivalent
to a person's expected organizational tenure while others may have a service life
equivalent to the period a person is expected to occupy a certain position in the
organization. The organization should use both individual and group amortization i.e.,
group amortization for factory workers and clerical employees and individual
amortization for mangers.
3. Adjustment of Human Asset Accounts
There may e circumstances under which human assets accounts may have to be adjusted
e.g. Human assets may have to be written off as a result of employee turnover or
changes in service life estimates. Employee turnover may occur either voluntarily or
through layoffs, termination etc., and a person's expected service life may change
because of ill health, premature retirement and technological obsolescence. In each
case, the unamortized asset balance must be treated as a loss in the period it is incurred.
This right sown of human assets is analogous to a write down of physical assets.
4. Presentation of Human assets in Financial Statements
There is a problem of incorporating degree of uncertainty or realizing human services
into accounts while presenting human resources investment in financial statements.
This problem can be resolved by providing an allowance for expected turnover costs as
an offsets i.e., contra entry to gross investment in human assets. This technique is
analogous to the methods of creating reserve for bad and doubtful debts in respect of
sundry debtors in conventional accounts.
5. Manipulation of Earnings
This problem is concerned with the possibility of earnings manipulation. The potential
for manipulation of earnings exists not only if the investment s in people is capitalized
but also if one fails to capitalize them. The decision to capitalize and investment in
human asset depends on the degree of uncertainty in the specific situation. Under
certain circumstances it may not be useful to capitalize human assets because the future
benefits may be too tenuous but such circumstances should be viewed as the exception
and not as the general rule.
23.7 HUMAN RESOURCE ACCOUNTING PROSPECTS
The present and potential stock holders of a company and other users of accounting
information viz, management, investors, employees, leaders, customers, government
and their agencies and public have long been interested in obtaining information about

organization human assets. Due to conventional accounting treatment of human
resource outlays, which consists of expanding all human capital formation expenditures
and capitalizing similar outlays on physical capital, the information about human assets
of the business entity does not appear in conventional balance sheets. Now there
appears to be widespread interest for human resource accounting in future years
because of its potential role in facilitating the effective and efficient management of
human resources and improving quality of management and investor decisions.
23.8 SUMMARY
Every organization relies to a large degree on the contribution made by human skill and
judgment. Even the most highly mechanized plant is controlled and maintained by
human effort. In the absence of the human element, assets are no more than they will
realize at auction. In spite of the fact that people are the most important assets of an
organization, human resources are not ordinarily considered assets and are not reported
on the balance sheet under conventional accounting system. The modern thinking is
that all the assets of the company including the human assets must be properly treated
analyses and reported by as accounting system in view of the long term interests of the
organization. Human resource accounting is needed to disclose what is happening to the
energy of human beings and what the value to management is. The policy makers of an
enterprise are in a better position to understand and predict the aspects relating to the
management of human resources if a system of human resource accounting is designed
suitably an interpreted carefully. A well developed system of human resource accounting
can contributed significantly to internal decision making by management as well as
external decision making by stock holders and investors.
23.9 REVIEW QUESTIONS
1. Define Human Resource Accounting and state its objectives and assumptions.
2. Explain various methods of valuing human resource.
23.10 ASSIGNMENT QUESTIONS
1. How Human Resource Accounting is useful for effective use of manpower?
2. Discuss the problems and prospects in accounting the human resources.
3. Explain the status of Human Resources Accounting in India.
23.11 KEYWORDS
Cost and value information, Cost value, Economic value, Human Capital Formation
expenditure, capitalizing outlays.

- End Of Chapter LESSON - 24
REWARDING MANAGERIAL STAFF ON THE BASIS OF RATE OF RETURN
IN THE DIVISION

OBJECTIVES
The objectives of the lesson are:
·
·

To evaluate how the managerial staff are rewarded using on rate of return in the
division
To analyze how fu Pont system a useful in evaluation of a division.

STRUCTURE
24.1 Introduction
24.2 Profit Centre and Managerial Performance
24.3 Performance of a Division and Divisional Managers
24.4 Treatment of Corporate Assets
24.5 Assessment of ROI
24.6 ROI and Regarding the Managerial Staff
24.7 Criteria to Choose Rewards
24.8 Du Pont Analysis of ROI
24.9 Extension of Du Pont Analysis of ROI
24.10 Return on Equity (ROE)
24.11 Summary
24.12 Review Questions
24.13 Assignment Questions
24.14 Keywords

24.1 INTRODUCTION
As explained earlier, division means any part of an organization or line of activity for
which separate determination of revenue and costs is obtained. When they analyze the
performance, many proponents of responsibility accounting distinguish sharply
between the division (also known as segment department, store, and motel) as an
economic performance. For example, the manager of a division may be relatively
helpless if an energy crisis reduces automobile traffic or if unseasonable weather ruins
the sky season.
24.2 PROFIT CENTRE AND MANAGERIAL PERFORMANCE
A profit center is commonly misunderstood as decentralization. They are entirely
different concepts, although profit centers clearly are accounting devices that aim to
facilitate decentralization. However one can exist without the other. Some profit center
managers possess vast freedom to make decisions. A profit center is a responsibility
center in which in spites are measured in terms of revenues. In profit center the
measure of performance is broader than in an expense center because in an expense
centre, the accounting system measures only on element (cost) whereas in profit center
both the elements (cost and revenue) are measured in monetary terms. The difference
between revenue and costs is profit. Stated operationally, the profit center is a division
of an organization in which financial performance is measured on the basis of profits.
For the purpose of profit center performance, revenue represents a monetary measure
of output of a profit center in a given accounting period whether or not the firms
actually realize the revenue in the period. The profitability of a division is measured in
the form of rate of return in that division. It is possible to measure the effectiveness and
deficiency of performance in financial terms since there are financial measures of the
output as well in spite in a profit center. Profit analysis can be used as a basis for
evaluating the performance of a division as an entity and for evaluating the performance
of a divisional manager. A profit center requires all of the data needed in an expenses
center as well as additional data regarding revenue. Therefore management can
determine whether the division was efficient in the utilization of resource and further,
whether the division was effective in attaining its objectives. This objective is
presumably to earn a satisfactory profit.
The criterion for satisfactory profit army is budgeted profit/past profit in the division /
profits of other similar division/sale combination of two or more of these. Profit as a
performance measure of managerial staff, is based on revenue and expenses directly
traceable to the division and avoidable if the division were closed down. This concept of
divisional profit is referred to as 'Profit contribution' as it is the amount of profit
contributed directly by the division. It might also be described as incremental profit or
the additional profit earned solely as a result of operations of the division. This profit is
described as rate of return in the each division.
Another factor in the computation of profit as performance measurement for a profit
center relates to types of profit center. A profit centre e.g., a product division, uses
inputs (costs) and produce output (revenue). Such a profit center is like as independent

firm. It is called natural profit center. For example a computer center or data processing
department as independent department makes use in spite (cost) but it produces no
revenues (output) as it renders computer services to other department and does not sell
its products/services. This is logically an expense center. The cost avoided in purchasing
computer time from a data processing service, instead of owning a computer, is the
revenue to the firm. This is constructive profit. Divisional profit data may be used to
evaluate the performance of the division/ divisional manager in the case of naturalprofit centers alone.
The profits of all divisions thus calculated will not necessity to be equal to the profit of
the entire firm. The divergence would arise from the fact that costs not attributable to
any single division are excluded from the computation of divisional profits but they are
considered in determining the profits of the organization as a whole. Therefore it is
concluded that divisional profit is the result of rate of return in the division, designed to
serve specific managerial needs.
24.3 PERFORMANCE OF A DIVISON AND DIVISIONAL MANAGER
Could a valid distinction be made between the performance of a division as an entity
and the personal performance of divisional manager? The two may not be
distinguishable in the long run. In the short run, however, a very useful and necessary
distinction may be made. It is conceivable that a division may not have made a
satisfactory contribution to the goals of an organization. Yet the manager may be judged
to have discharged his responsibility very well. Motivating the divisional manager to
operate his division in a manner constant with the basic goals of the organization as a
whole is important. As observed earlier, any performance measurement system can be
expected to influence the behavior of managers affected by it. Divisional performance
measurement should be designed in such a way that, divisional managers will
simultaneously work to achieve the goals of the firm. This is called "goal congruence".
This can be ensured through system of incentives or rewards e.g. bonus for good
performance and so on.
REWARDING THE MANAGERAL STAFF
Rate of return and investment center
With the advancement in industry, companies grow in size, which leads to the creation
of decentralized units, for better control of the affairs of business by divisions providing
the authority the divisional managers. When the authority is delegated, the
responsibility is entrusted with the divisions and question of measuring the
performance of each division crops up. This measurement of performance is done
through return on investment (ROI) concept.
The investment center analysis can be used as basis for evaluating the contribution of a
division as an entity as also the performance of a divisional manager. The measure of
performance in an investment center is based on the relationship between the
profits/income and the amount of assets employed in generating the returns. The

divisional profitability is typically measured by combining profits and investment in to a
sing le performance measure. Two such measures popularly employed in practice are:
1. Return on investment and
2. Residual income
A favorite objective of top management is to maximize profitability. Too often, managers
stress net income or income percentage without typing the measure in to the investment
associated with the generating income in each division. Widely used devices for
reporting the performance of a division or divisional manager is the rate of return on
investment insets or simply return on investment (ROI). Rate of return on investment is
defined in general as a measure of income or profit. That is, given the same risks, for any
given amount of resource required the investor wants the maximum income.
For example project, 'A' has an income of Rs.2, 00,000 and project B has an income of
Rs.1, 50,000… is and insufficient statement about profitability. The required investment
in A may be Rs. 5, 00,000 and the required investment of B may be only Rs. 1, 50,000.
Based on rate of return all other of things being equal, A's return would be much less
than B's.
RETURN ON INVESTMENT (ROI)
Is defined simply as the ratio of profit to investment;
Investment in A may be Rs. 5, 00,000 and the required investment of B may be only
Rs.1, 50,000. Based on rate of return all other of things being equal, A's return would be
much less than B's.
RETURN ON INVESTMENT (ROI)
Is defined simply as the ratio of profit to investment;
Profit
ROI = ----------------Investment
Profit Measurement
It is very important to note that the measures f profit-and investment are clearly
understood to make use of ROI for managerial assessment. Different types of profit
measures have been suggested. The three important profit measures are net profit,
contribution margin, and controllable profit. These three measures can be readily
understood by examining the following table 24.1

Net profit either before or after tax is commonly used as a measure of divisional profit.
However, it has a serious short coming. It is a measure of profit calculated after
deducting certain items which are neither controllable at divisional level nor directly
related to divisional activity. Many executives are aware of his, yet they feel that the
divisional profit and loss account must bear an allocation of head office expenses so that
divisions cognizant of such expenses realize that the firm as a whole earns profit only
when such expenses are fully covered. Without such knowledge, the division may not
plan to contribute its due share to corporate profits while making its pricing and other
decisions. However this argument is not valid. As long as non-divisional expenses are
independent of divisional activity, a division should seek to maximize its profit prior to
the allocation of non-divisional expenses. Such an action is also optimal, from the point
of view of the company as a whole.
Thus, it is noted that net profit, either before or after tax is not a suitable measure of
profit. The choice between the remaining two alternatives: contribution margin and
controllable profit depends upon the factions of the profit measure.
Shilling law prefers controllable profit because he thinks that the primary purpose of
routine profit reporting is to guide and appraise the performance of division executives,
not to say whether the investment entrusted to them is profitable or unprofitable. He
argued that non controllable divisional expenses should not be included in the divisional
income statement. Shilling laws agreement may be agrees, but the classification of costs
in to controllable and non controllable categories at the divisional level depends on the
degree of freedom enjoyed by the division and the manner in which functions are
divided between the division and head office.

Measurement of Investment
The measurement of investment of a division requires the understanding of related
issues scope of divisional investment, valuation of fixed assets, and allocation of jointly
shared ad corporate-controlled assets.
The divisional investment refers to divisional total assets or net assets (total assets
minus total liabilities) or fixed assets plus net current assets. The total divisional assets
may be the most appropriate choice because the crucial issue is how effectively the
division uses the capital provided to it irrespective of the source from where the capital
is raised.
Valuation of fixed assets is another is important factor in the measurement of
investment of a division. Fixed assets may be valued at original cost or net book value
i.e. cost less accumulated depreciation or some appraised value like replacement value
or current market value.
Dupont company, a pioneer in the use of ROI analysis, reckons fixed assets at its
original and not at the net book value because of the fact that the earning power of a
fixed asset hardly has any relationship with its declining book value and if at all an asset
stated at net depreciated value and not at its original cost, earnings in each successive
period would be related to an ever-decreasing investment base, thereby creating the
illusion of increasing ROI.
24.4 TREATMENT OF CORPORATE ASSETS
In a divisionalised firm, there are certain corporate assets which serve divisions or
which are used for the central administration of various divisions. These include, among
other things, the fixed assets at the head office company research establishment, and
service facilities. In addition, two important current assets, viz. cash and accounts
receivable may be centrally controlled. There seems no point in allocating centrally held
and centrally used fixed assets to the divisions. Sometimes several divisions share the
same building and services investment in shared buildings may be allocated on the basis
of floor areas occupied by various divisions. Investment in shared services and facilities
may be allocated on the basis of proportionate usages. With regards to cash, many
divisionalised firms manage the bulk of their cash centrally for purpose of better
planning, utilization, and control.
Strictly speaking, in this case, cash balances held by the corporate office do not
represent divisionally controllable assets. Yet there seems to be astron need to allocate
central cash balance to various divisions because the quantum of case balance
maintained centrally is governed largely by divisional activity levels. Finally receivables
may be handled by the head office or the divisions themselves. Where credit control and
collection are the concern of head office, receivables do not represent divisional
controllable investment. The amount of receivables allocated to division should reflect
the total sales, proportion of credit sales to total sales and average collection period.

24.5 ASESSMENT OF ROI
The rate of return on investment of a division of is the result of the combination of two
items: Profit as percentage of revenue and investment turnover.
Profit

Sales

The ROI is represented as = ----------- x --------------Sales

Investment

The first component in this product is the profit margin and the second component is
the investment turnover. Hence the ROI of a division may be analyzed in terms of its
profit margin and investment turnover. For example consider a firm which has three
divisions, XY and Z. The management of the firm has established ROI goal at 24
percent, which is shown in the graph 5.1.
The target of 24 percent may be achieved by and combination of investment turnover
and profit margin which is depicted on the curve. For example, a 24 percent may be
achieved with an investment turnover of 2 and a profit margin of 12 percent. The ROI,
investment turnover, and profit margin for the three divisions are as follows in table
24.2.

The points corresponding to the three divisions are shown in graph 5.1. Comparing the
points for the three divisions with the target ROI curve, it is observed that (1) Divisions
X's ROI exceeds the target ROI (33%) which indicates that this division is performing
well (2) The Performance of division Y (22%) falls short of the desired performance.
Though the/investment turnover of this division seems satisfactory, but profit margin
appears to be low as a result the ROI is low.
The manager of this division should perhaps look in to its cost structure to identify areas
where cost reduction can be effected. The divisional performance if Z division also falls
short of target performance. Though the profit margin of this division seems adequate,
but investment turnover is substantially low. The manager of this division should
perhaps analyze the utilization of its assets. Perhaps there are some unproductive or idle
assets which can be put to more intensive use or which, if redundant, can be disposed of.

The type of analysis done in the above example indicates broad areas improvement but
not what actually needs to be done. Although understanding and analysis of the specific
situation and knowledge of the factors which have a bearing on investment turnover and
profit margin in the particular case are required to chalk out and programme for
improving the divisional performance by increasing the ROI.

Profit margin GRAPH 24.1
PERFORMANCE ASSESSMENT WITH ROI ANALYSIS

ROI ALTERNATIVE PROGRAMMES
As explained earlier ROI is the result of the combination of two items; Profit percentage
of sales and investment turnover. An improvement in one item without changing the
other will improve the rate of return on investment. Consider an example of the
relationships:

Alternative 1 is a popular way to improve performance. An alert management tries to
decrease expenses without reducing the sales in proportion or in to boost sales without
increasing related expenses in proportion. Alternative 2 is less popular, but it may be
quicker way to improve performance. Increasing this turnover of investment means,
generating higher revenue for each rupee invested in such assets as cash, receivables or
inventories. There is an optimal level of investment in these assets. Having too much is
wasteful but having too little may hurt credit standard and the ability to compete for
sales.
The ROI may also be increased by increasing the profit margin or by increasing the asset
turnover or by some combination of the two. Planning and evaluation of operations is
mare effective if each of these components is examined separately. For instance in a
retail grocery business, the profit margin is usually low but the assets turnover is high.
In contrast, in a heavy industry, the profit margin on sales is high but the assets
turnover slow. Therefore profit b investment method (ROI) has more analytical value in
assessing divisional performance.
ROI - An evaluation
ROI, as a useful measure of divisional performance, offers the following
Advantages:
1. ROI method is a comprehensive measure of divisional performance which is widely
accepted and understood.
2. As a measure for divisi6nal performance appraisal, ROI provides motivation for
optimal asset utilization.

3. ROI is conceptually easy to understand and interpret.
Disadvantages
ROI suffers from severallimitat10ns which may impair its utility considerably.
1. The first limitations with regard to computation of profit and investment. Many
subjective judgments are applied in competing divisional profit and divisional
investment. The application of ROI may distort allocation of resources to different
divisions in the firm. Allocation of additional resources to a division may increase the
return of that division. Yet, this allocation is not desirable from overall company's point
of view.
2. The methods employed in practice to calculate the investment base tend to motivate
managers to take decisions which may not be agreeable with larger interests of the firm.
Divisional fixed assets are generally included in the investment base at original cost or
net book value. If original cost value is used, a manager may dispose of a useful asset
whose profit contribution is less than the divisional ROI objective, because the disposal
of the asset leads to reduction in investment base equal to the original cost of the asset.
If net book value is used, the motivation to add a new asset is weakened because its book
value, to begin with is equal to its cost price.
24.6 ROI AND REGARDING THE MANAGERIAL STAFF
It is essential for every management of a business organization to know the degree of
return achieved out of the investment made in the business. The return is the reward of
efficiency of management in the form of profit. Profit and investment are to be studied
from different angles to ascertain the increase or decrease of ROI. The evaluation of
divisional manager's performance is based on ROI, the breakup of return into profit
margin and investment turnover will reflect the impact of divisions made by divisional
manager. Management must try to improve the rate of return into profit margin and
investment, turnover. ROI which is the measure of divisional performance can provide
incentive for optimum utilization of the assets of a firm in operational terms. ROI
encourages divisional managers to obtain assets that. Provide satisfactory return on
investment and discard off assets that are not giving acceptable returns.
ROI provides a basis for evaluating quality of the divisional manager's performance.
Could a valid distinction be made between the performance of a division as an entity
and the personal performance of a divisional manager? The two may not be
distinguishable in the long run. In the short run, however, a very useful and necessary
distinction may be made. It is conceivable that a division may not have made a
satisfactory contribution to the goals of the organization. Yet the manager may be
judged to have discharged his responsibility very well.
The involvement of the top management in functional decisions being made at the
divisional levels depends upon autonomy given to the division. If top management steps
in and forces transfers, it undermines autonomy. This may have to be done occasionally

but if top management imposes its will too after, the organization is in substance being
recentralized. Of course if the decisions were indeed not to give be autonomy, the
organization could be redesigned by combining the two sub-units. Top managers who
are proponents of decentralization will be more reluctant to impose their desires.
Instead, they will make sure that both divisional managers understand that all the facts
are good company citizens, and will make sacrifices for the company as a whole. If they
think of dysfunctional decision is going to be made anyway, some top managers swallow
hard and accept the divisional manager’s judgment.
USE OF REWARDS FOR MANAGERIAL STAFF
Being a good corporate citizens, may be one way to appeal to divisional managers to
make goal congruent decisions, but building in some formal rewards typically is far
more persuasive. As a result, some organizations would try various rewards. Using the
criterion of ROI of the division, top management chooses responsibility centers,
performance measure and rewards. A reward in this context is defined as something
given in return for a deed or a service rendered. Rewarding means, giving personal
satisfaction. The word incentive is also used with the some sense in this context. As used
in this context, incentives are defined as those informal and formal performance
measures and rewards that enhance goal congruence and managerial effort. The
performance measures may affect the manager's rewards.
The divisional performance measurement method specifically ROI has been discussed
in the preceding pages. Research about rewards has generated basic principle i.e. simple
and important individuals are motivated to perform in a way that leads to rewards.
Rewards are in the form of both monetary and non monetary. For example, the
divisional manager who shows excellent performance in the form of ROI may be
awarded by increasing the salary, bonuses and cash awards. Non monetary awards may
also be given to the divisional managers in the form of promotion, praise, self
satisfaction, elaborate officers, and provide dining rooms. Negative rewards may also be
imposed as punishment for under performance. The more objective the measures of
performance, the more likely the manager will provide effort. That is why accounting
measures are important. They provide relatively objective evaluations of performance.
Moreover, if individuals believe that their behavior fails to affect their measure of
performance, they will not see the connection between performance and rewards.
REWARDS AND EXECUTIVE EOMPENSATION PLANS
Executive compensation plans are one component of the reward system. They include a
diverse set of short-run and long-run sub-plans that detail the conditions under which
and the forms in which, compensation is to be paid to executive of the organization. A
major challenge in designing an executive compensation plan is achieving the
appropriate mix of (1) base salary, (2) annual incentives (for example cash bonuses,
based on annual reported income) (3) long term incentives for achieving a set level of
ROI by the end of the given period and (4) fringe benefits like insurance etc.

The basic objectives of designing the executive compensation plan are to provide
incentives for better current and future performance to reward past performance, and
also 1:0 retain superior manager and attract new managers. The challenge facing the
designer of an executive compensation package is to choose that mix of rewards and. the
timing of achieving the set of objectives chosen by the management.
ROLE OF ACCOUNTING MEASURES
In many executive compensation plans, accounting performance measures are key
components. Short-run plans can make the payments of a bonus contingent on attaining
a budgeted income of ROI figure. Some long run plans termed as performance plans,
make payments of a definite number of performance units (each assigned a fixed rupee
value). Contingent on the net income or ROI at the end of an extended time period,
being at a set level (for example being in the top 25% of a published a list of corporation.
ROI method need not induce managers to take a short run focus. The focus on the short
run in many compensation plans comes not from the ROI measure itself, but from a
plan that does not take into account of time periods longer than current years.
Accounting measures can be combined with non-accounting measures in an executive
compensation plan. The term profit sharing, a component of executive compensation
requires attainment of time goals at the company level.
24.7 CRITERIA TO CHOOSE REWARDS
Chart clearly shows the criteria and choices faced by top management when designing a
management control system. Using the criterion of cost benefit and the motivational
criteria of congruence and effort, top management chooses the responsibility center
(profit center versus cost center) performance measures, and rewards.

24.8 DU PONT ANALYSIS OF ROI
The operating efficiency of a firm in terms of the efficient utilization of resources is
reflected in the net profit margin. It has been observed that although a high profit
margin is a test of better performance a low margin does not necessarily imply lower
rate of return on investments if a firm has higher investment turnover.
Therefore the overall operating efficiency of a firm can be assessable on the bases of a
combination of the two. The combined profitability is referred to as earning power,
return on investment (ROI). The earning power of a firm may be defined as the overall
profitability of an enterprise. As explained in the preceding pages, the earning power
(ROI) is the combined effect of profit margin resulted from profitability on sales and
investment turnover resulted from profitability of investments. The earning power
(ROI) of a firm can be computed by multiplying the net profit margin and investment
turnover.
The earning power of a firm thus is
Net Profit Margin * Investment Turnover
Net profit after taxes
Net Profit Margin = -------------------------------Sales
Sales
And Investment Turnover = ----------------------Investment
The investment in this context may refer to (1) total assets (2) Capital employed (3)
Share holders equity. For the purpose of measuring return on investment is calculated
as follows:
Net profit after taxes
ROI =

Sales

---------------------------- x ----------------Sales

Total Assets

Net profit after taxes
=

---------------------------Total Assets

The basic elements of ROI or earning power of a firm are portrayed in chart. This Chart
is known as DU PONT CHART. The ROI is the central measure of the overall
profitability an operational efficiency of a firm. It shows the interaction of profitability
ratio and activity ratio. It implies that performance of affirm can be improved either by
that by generating more sales volume per rupee of investment or by increasing the profit
margin per rupee of sales.
The Du Pont company of the United States pioneered a system of financial analysis
which has received wide spread recognition and acceptance. As a useful system of
analysis, which considers important inter-relationship based on information found in
financial statement, it has been adopted by many firms in some form or the other.
At the apex of the Du Pont chart is the net return in total assets (Net profit margin X
Assets turnover). Such decomposition helps in understanding how the net return on
total assets is influenced by the net profit margin and the total assets turnover ratio. The
left side of the Du Pont chart shows the details underlying the net profit margin ratio.
An examination of this side may indicate areas where cost reductions may be effected to
improve the net profit margin. If this is supplemented by comparative common size
analysis, it becomes relatively easier to understand where cost control efforts should be
directed.
It implies that performance of affirm can be improved either by that by generating more
sales volume per rupee of investment or by increasing the profit margin per rupee of
sales.

Example
There are two divisions A and B, each having total assets amounting to Rs. 5, 00,000
and average net profits of 12% and 10% for divisions A and B respectively. Division A
has sales worth of Es. 5, 00,000 and division B have sales of Rs. 10, 00,000. Determine
the ROI or earning power of divisions A and B.

Solution

It is clear from the above solution that the ROI of division A is higher than division B.
While the investment turnover of division B is double to that of division A, the profit
margin of division A is more than double to that of division B. As a result the ROI of
division A is more than division B. This is due to the fact that ROI is affected by two
variables, namely, profit margin and investment turnover.
24.9 EXTENSION OF DU PONT ANALYSIS OF ROI
The right side of the Du Pont chart throws light on the determinants of the total assets
turnover ratio. If this is supplemented by a study of component turnover ratios either
inventory turnover ratio or receivables turnover ratio, or fixed assets turnover ratio,
deeper insight can be gained in to efficiencies, inefficiencies of asset utilization. The
basic Du Pont analysis may be extended to explore the determinants of the return
equity.
24.10 RETURN ON EQUITY (ROE)
Net Profit margin x Total assets turnover x (1 / (1 – DAR)
Net Profit

Sales

Total Assets

ROE = ------------------ x ------------------ x ---------------------Sales

Total Assets

Equity

The third component on the right side of the above equation needs a little explanation.
Total assets divided by equity is equal to one divided by one minus Debt Assets Ratio
(DAR). This is shown as follows:

Total Assets
-------------Equity

assets
=

-------------------Assets – debt

1 – debt
= -----------------Assets

1
=

------------------------1 – debt to assets ratio

The extension of Du Pont chart is above is shown in Chart

The usefulness of Du Pont type of analysis of ROI lies in the fact that it presents the
overall picture of the performance of a firm and also enables the management to identify
the factors, which have a bearing on profitability. In the above example, if the division is
able to increase the profit margin by 2 percent without changing the investment
turnover. ROI of division b will be (14%), 2 percent more than division is able to
increase the profit margin by 2 more than division A.
Similarly if division A can double its investment turnover, its ROI would be (24%), 14
percent more than division B. Increase in investment turnover indicates that the assets
are used more efficiently i.e. more sales per rupee of investment. Thus the ROI (earning
power) a ratio is highly significant ratio which can be used to assess the profitability of a
firm over a period of time, of its various its various divisions, as also for inter-firm and
inter-industry comparisons. The two components of this ratio namely, the profit margin
and the investment turnover ratio individually do not give an overall vie v as the former
ignores the profitability of investments, while the latter fails to consider the profitability
or sales.

The performance measurement system can be expected to influence the behaviors of the
managers. Divisional performance measurement such as ROI should be designed in
such a way that, in simultaneously work to achieve the goals of the firm. This is called
goal congruence. This can be ensured through a system of rewards and incentives. The
choice of rewards clearly belongs within an overall system is mainly the concern of top
managers, who frequently get advice from many sources besides accountants.
24.11 SUMMARY
Divisional performance measurement should be designed in such a way that, a
divisional manager will simultaneously work to achieve the goals of the Firm. This is
called goal congruence. The goal congruence can be ensured through a system of
incentives or rewards. It is essential for every management of a business organization to
know the degree of return achieved out of the investment made in the business. The
return is the reward of efficiency of management in the form of profit. Being a good
corporate citizen, divisional managers have to make goal congruence decision, but
building in some formal rewards typically is far more persuasive. As a result, managers
will be rewarded with financial and non-financial germs. Top management chooses
responsibility centers, performance measures and rewards. A reward is something that
gives personal satisfaction. Executive compensation plans are one component of the
reward system which provides incentives to better the current and future performance
and to reward past performance. ROI method is one of the best helpful to reward
managerial staff.
24.12 REVIEW QUESTIONS
1. Compare divisional organization and functional organization and explain the
conditions for the success of divisionalisation.
2. What are the pros and cons of ROI as a measure of divisional performance?

24.13 ASSIGNMENT QUESTIONS
1. Why do large diversified organizations resort to divisionalisation?
2. What are the problems involved in the calculations of ROI?
3. How the managerial staffs are rewarded on the basis of ROI of a division?
24.14 KEYWORDS
Return on investment, Profit measurement.

- End of Chapter -