Under this method, since the discount rate is determined internally, this method is called as the internal rate of return method. The internal rate of return can be defined as that rate of discount at which the present value of cash-inflows is equal to the present value of cash outflows. The time period at which the cumulated present value of cash inflows equals the present value of cash outflows is known as discounted pay-back period. The project which gives a shorter discounted pay-back period is accepted. One of the serious limitations of Pay-back period method is that it does not take into account the cash inflows earned after pay-back period and hence the true profitability of the project cannot be assessed. Hence, an, improvement over this method can be made by taking into account the returns receivable beyond the pay-back period.
An investor buys equity shares of a particular company as he expects a certain return (i.e. dividend). The expected rate of dividend per share on the current market price per share is the cost of equity share capital. Thus, the cost of equity share capital is computed on the basis of the present value of the expected future stream of dividends. The higher the debt content in the capital structure of a company, the higher will be the risk of variation in the expected earnings available to equity shareholders. If return on investment on total capital employed (i.e., shareholders’ fund plus long-term debt) exceeds the interest rate, the shareholders get a higher return. Once the requirement of capital funds has been determined, a decision regarding the kind and proportion of various sources of funds has to be taken.
It recognizes the fact that a rupee earned today is worth more than the same rupee earned tomorrow. This method also like pay-back period method ignores the time value of money as the profits earned at different points of time are given equal weight by averaging the profits. It ignores the fact that a rupee earned optimum credit term exists when today is of more value than a rupee earned an year after, or so. This method takes into account the earnings expected from the investment over their whole life. It is known as Accounting Rate of Return method for the reason that under this method, the Accounting concept of profit is used rather than cash inflows.
Traditional Approach
Thus, while issue of bond-dividend increases long-term obligation of the Company, current liability increases as consequence of issue of scrip dividends. In bond dividends stockholders have stronger claim against the company as compared to scrip dividends. Scrip dividend means payment of dividend in scrip or promissory notes. Sometimes companies need cash generated by business earnings to meet business requirements or withhold the payment of cash dividend because of temporary shortage of cash. Extra dividends are declared only in the year when the earnings exceed the annual dividend requirement by some given amount.
The operating cycle is the time period required for a business to acquire inventory, sell it, and convert the sale into cash. The first one which is granted by the creditors is considered unfit as it affects the credit reputation of the firm. Of course, in the absence of cash discounts, there is a good possibility that such costs are hidden in the prices of the goods which may be impossible to measure’. If discounts are available, the said amount of discount may be compared with the benefits which may accrue if the said payments are diverted elsewhere. Thus, a firm gets immediate payment for sales made on credit. A factor is a financial institution which offers services relating to management and financing of debts arising out of credit sales.
When the firm needs cash generated by earnings to cover its modernization and expansion programmers. The existence of legal sanction for distributing the accumulated earnings or reserves does not warrant the issue of stock dividends from the point of view of sound financial practice. Sometimes, a stock dividend is declared to protect the interests of old stock holders when a company is about to sell a new issue of stock . Covenants in existing loan agreements may restrict future borrowing. Furthermore, in the typical company; one would expect capital rationing to be largely self- imposed. Capital rationing may arise due to external factors like imperfections of capital market or deficiencies in market information which might have for the availability of capital.
- With this policy, the firm’s credit standing and so its share values are not likely to be adversely affected with omission of extra dividends in future.
- The net effect of this would be an increase in number of shares of the current stockholders but there will be no change in their total equity.
- Extra dividends are declared only in the year when the earnings exceed the annual dividend requirement by some given amount.
- This means that company assumes fixed obligation of interest payments annually on principal amount of bond at the maturity date.
The alternative means of accelerating the flow of funds is a lock-box arrangement. In concentration banking, cheques are received by collection centres and deposited in the bank after processing so that mailing float is reduced. The purpose of this system is to speed up the time in the collection process from customers. Customers in a particular geographic area are instructed to remit their payments to the specific collection centre in that area.
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Obliviously the results based upon wrong data may not be good. To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals. In other words, it occurs when a firm has more acceptable proposals than it can finance. At this point, the firm ranks the projects from highest to lowest priority and, as such, a cut-off point is considered. As such, cost of borrowing will be higher in case of an individual than a firm. As a result, the market value of both the firms will not be equal.
It is an internal source of finance and is most suitable for an established firm for its expansion, modernization and replacement etc. Issue of shares is the most important source for raising the permanent or long-term capital. A company can issue various types of shares as equity shares, preference shares and deferred shares. According to the Companies Act, 1956, however, a public company cannot issue deferred shares. Generally, the size of the company has a direct relation with the working capital needs. Big concerns have to keep higher working capital for investment in current assets and for paying current liabilities.
Profit arises due to many factors such as pricing, industry competition, state of the economy, mechanism of demand and supply, cost and output. A healthy mix of variable and fixed factors of production can lead to an increase in the profitability of the firm. A financial manager is a person who takes care of all the important financial functions of an organization.
Model # 2. Optimum Cash Balance using Inventory Model:
Functional managers of the firm particularly in regard to investment of funds. Investment in current assets affects the firm’s profitability. The company is controlled by the equity shareholders and they are entitled to vote in the meetings of the company. The equity shareholders have a residual claim on the company’s asset in case of liquidation. The Equity shareholders have the chance of earning good dividends in times of prosperity and run the risk of earning nothing in times of adversity.
And Nasr discussed working capital management and its effect on liquidity as well as on profitability of the firm. Debt ratio, size of the firm and financial assets to total assets ratio have been used as control variables. The results found that there is a strong negative relationship between variables of the working capital management and profitability of the firm. They found that there is a significant negative relationship between liquidity and profitability. They also found that there is a positive relationship between size of the firm and its profitability. There is also a significant negative relationship between debt used by the firm and profitability.
Will be maximized and the firm’s capital structure would be considered optimum. The share capital of the company is ideal for meeting the long term requirements. The financial decisions should be oriented to the maximisation of profits. So the dividend policy is to be determined in terms of its impact on shareholder’s value. Financing decision is concerned with the financing mix or capital structure.
Explain the term working capital. What is the primary objective of working capital management?
Their findings significantly depart from the various international studies conducted in different markets. The results reveal that working capital management and profitability is positively correlated in Indian companies. This method takes into consideration the earnings per share and the market price of share. Thus, the cost of equity share capital will be based upon the expected rate of earnings of a company. The argument is that each investor expects a certain amount of earnings whether distributed or not, from the company in whose shares he invests.
Through a judicious combination of debt and equity, a firm can increase its value and reduce the cost of capital. In this approach, the market value of a business is not affected by the capital structure changes and the value of the business remains constant irrespective of the debt-equity mix. Capital structure represents only long-term funds and excludes all short-term loans and advances. It is a set of patterns in which a company decides to finance its activities with a particular combination of debt, equity, or securities.
To increase opportunity cost of funds blocked in the receivables. Composition of total funds i.e. the proportion of each specific source in total capitalization. The question, however, becomes whether or not it may be a source of money flows for longer than that. At some time limit, there shall be no more inefficiencies left in the system and any further decreases in working capital can have unfavorable penalties for revenue progress and earnings. Though, the same can’t be stated concerning the adverse working capital.
Factoring is becoming popular all over the world on account of various services offered by the institutions engaged in it. Another method of raising short-term finance is through accounts receivable credit offered by commercial banks and factors. A commercial bank may provide finance by discounting the bills or invoices of its customers. A debenture is an instrument issued by the company acknowledging its debt to its holder. It is also an important method of raising long-term or permanent working capital.
The establishment and the selection of collection centres, however, depends upon the volume of business and geographic areas served. Under this system, when payments are received, they are deposited in the local account of the concerned collection centre after meeting local expenses. The other important technique for encouraging prompt payment is the practice of introducing cash discounts which is nothing but a saving to the customer.
Accounting, again, provides data to the finance manager for better and improved financial decision making in future. Despite a separate status financial management, is intermingled with other aspects of management. To some extent, financial management is the responsibility of every functional manager. Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders.
The seller draws a bill of exchange on the buyer of goods on credit. Such a bill may be either a clean bill or a documentary bill which is accompanied by documents of title to goods such as a railway receipt. The interest in case of cash credit is charged on the daily balance and not on the entire amount of the account.