Scdl - Pgdba - Finance - Sem 4 - Strategic Finance

Strategic Finance

Sem. IV

Q.3 With the help of models explain inventory control for working capital management. Ans INVENTORY MANAGEMENT Introduction: Inventories are stock of the product a company is manufacturing for sale and components that make up the product. Nature of Inventories: The various forms in which inventories exists in manufacturing company are • Raw Materials: are basic inputs that are converted into finished product through the manufacturing process. •

Work-in-Progress: inventories are semi-manufactured products.

•

Finished Goods: inventories are those completely manufactured products, which are ready for sale.

Need to hold Inventories: • Transactions motive: emphasizes the need to maintain inventories to facilitate smooth production & sales operation. •

Precautionary motive: necessitates holding of inventories to guard against the risk of unpredictable changes in demand & supply forces & other factors.

•

Speculative motive; influences the decision to increase or reduce inventory levels to take advantage of price fluctuations.

Objective of Inventory Management • To maintain a large size of inventory for efficient and smooth production & sales operations. •

To maintain a minimum investment in inventories to maximise profitability.

The firm should always avoid a situation of over investment or under investment in inventories. The major dangers of over investment are: a) Unnecessary tie up of the firm’s funds and loss of profit, b) Excessive carrying costs, c) Risk of liquidity. The major dangers of under investments are: a) Production hold-ups. b) Failure to meet delivery commitments. An effective inventory management should: • Ensure a continuous supply of raw materials to facilitate uninterrupted production. •

Maintain sufficient stocks of raw materials in periods of short supply and anticipate price changes,

•

Maintain sufficient finished goods inventory for smooth sales operation, and efficient customer service,

•

Minimize the carrying cost and time, and

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Control investment in inventories and keep it at an optimum level.

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Strategic Finance

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Q.4. With the help of models explain cash control for working capital management. Ans CASH MANGEMENT Cash is the most important current asset in any business operations. The term cash includes coins, currency and cheques held by the firm, and balances in its bank account. Cash management is concerned with managing of 1. cash flow into and out of the firm 2. cash flows within the firm 3. cash balances held by the firm by financing deficit or investments of surplus cash All these activities are to be done at minimum cost. Facets of Cash management: Cash planning: Cash inflows and outflows should be planned to project cash surplus or deficit for each period of planning period. Cash budget is prepared for this purpose. Managing cash flows: Cash flow should be properly managed. Inflow of cash should accelerate while outflow should decelerate as far as possible. Optimum cash level: The firm should determine optimum cash level considering the cost of excess cash and danger of cash deficiency. Investing surplus cash: Surplus cash should be properly invested in short term opportunities like deposits, corporate lending, marketable securities to earn profits. Motives of Holding Cash Transaction motive The transaction motive requires a firm to hold cash to conduct its business in ordinary course to make payments for purchases, wages, other operating expenses, taxes etc. Transaction motive mainly refers to holding cash to meet anticipated payments whose timing is not perfectly matched with cash receipts. Precautionary motive It is needed to hold cash for contingencies in future. It gives cushion to withstand the unexpected emergency. Less cash is required to be maintained for emergency if cash flows are fairly accurate. The precautionary balance is kept in cash form or marketable securities. Speculative motive It is holding cash for investing it in profit making opportunities as and when they arise. Cash forecasting. Short-term forecasting. Short-term forecasting is done for the following reasons. To determine operating cash requirements. To anticipate short-term financing: which is generally obtained from bank.

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To manage investment of surplus cash : which help managers to study the market and invest in better yield investments. Short-term forecasting methods 1. Receipts and disbursement method This sources of cash inflow like operating, non operating and financial inflows etc. are considered on receipt side. Whereas on disbursement side cash outflows like operating expenses, capital expenditure, contractual payments, taxes and likes are considered to come to work out cash requirements. Receipt and disbursement method is sound tool as it gives clear picture of all items. 2. Adjusted net income method This method involves tracing of working capital flows. Its objectives are to project company’s need for cash at a future date and to show whether the company can generate it internally or borrow from market. Long term cash forecasting: It is generally for the period of 3 to 5 years. It is not as detail as short term forecast. It helps company to find future financial needs and improves corporate planning. Determining the optimum cash balance: Organisation should keep enough liquidity so that operations do not suffer and should not loose profit due to high liquidity. Then how one should decide on optimum cash balance? There are two situations, which are explained below. Optimum Cash balance Graphical approach : Holding Cost Cost

Transaction Cost Cash Balance

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Strategic Finance

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Q.7 What are the reasons for restructuring through share buybacks? Explain Indian context and regulations. Ans. The provisions regulating buy back of shares are contained in Section 77A, 77AA and 77B of the Companies Act,1956. These were inserted by the Companies (Amendment) Act,1999. The Securities and Exchange Board of India (SEBI) framed the SEBI(Buy Back of Securities) Regulations,1998 and the Department of Company Affairs framed the Private Limited Company and Unlisted Public company (Buy Back of Securities) Regulations,1998 pursuant to Section 77A(2)(f) and (g) respectively. Objectives of Buy Back: Shares may be bought back by the company on account of one or more of the following reasons i. To increase promoters holding ii. Increase earning per share iii. Rationalize the capital structure by writing off capital not represented by available assets. iv. Support share value v. To thwart takeover bid vi. To pay surplus cash not required by business Infact the best strategy to maintain the share price in a bear run is to buy back the shares from the open market at a premium over the prevailing market price. Resources of Buy Back A Company can purchase its own shares from (i) free reserves; Where a company purchases its own shares out of free reserves, then a sum equal to the nominal value of the share so purchased shall be transferred to the capital redemption reserve and details of such transfer shall be disclosed in the balance-sheet or (ii) securities premium account; or (iii) proceeds of any shares or other specified securities. A Company cannot buyback its shares or other specified securities out of the proceeds of an earlier issue of the same kind of shares or specified securities. Conditions of Buy Back (a) The buy-back is authorised by the Articles of association of the Company; (b) A special resolution has been passed in the general meeting of the company authorising the buyback. In the case of a listed company, this approval is required by means of a postal ballot. Also, the shares for buy back should be free from lock in period/non transferability.The buy back can be made by a Board resolution If the quantity of buyback is or less than ten percent of the paid up capital and free reserves; (c) The buy-back is of less than twenty-five per cent of the total paid-up capital and fee reserves of the company and that the buy-back of equity shares in any financial year shall not exceed twenty-five per cent of its total paid-up equity capital in that financial year;

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(d) The ratio of the debt owed by the company is not more than twice the capital and its free reserves after such buy-back; (e) There has been no default in any of the following i. in repayment of deposit or interest payable thereon, ii. redemption of debentures, or preference shares or iii. payment of dividend, if declared, to all shareholders within the stipulated time of 30 days from the date of declaration of dividend or iv. repayment of any term loan or interest payable thereon to any financial institution or bank; (f) There has been no default in complying with the provisions of filing of Annual Return, Payment of Dividend, and form and contents of Annual Accounts; (g) All the shares or other specified securities for buy-back are fully paid-up; (h) The buy-back of the shares or other specified securities listed on any recognised stock exchange shall be in accordance with the regulations made by the Securities and Exchange Board of India in this behalf; and (i) The buy-back in respect of shares or other specified securities of private and closely held companies is in accordance with the guidelines as may be prescribed. Disclosures in the explanatory statement The notice of the meeting at which special resolution is proposed to be passed shall be accompanied by an explanatory statement stating (a) a full and complete disclosure of all material facts; (b) the necessity for the buy-back; (c) the class of security intended to be purchased under the buy-back; (d) the amount to be invested under the buy-back; and (e) the time-limit for completion of buy-back Sources from where the shares will be purchased The securities can be bought back from (a) existing security-holders on a proportionate basis; Buyback of shares may be made by a tender offer through a letter of offer from the holders of shares of the company or (b) the open market through (i). book building process; (ii) stock exchanges or (c) odd lots, that is to say, where the lot of securities of a public company, whose shares are listed on a recognized stock exchange, is smaller than such marketable lot, as may be specified by the stock exchange; or (d) purchasing the securities issued to employees of the company pursuant to a scheme of stock option or sweat equity.

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Filing of Declaration of solvency After the passing of resolution but before making buy-back, file with the Registrar and the Securities and Exchange Board of India a declaration of solvency in form 4A. The declaration must be verified by an affidavit to the effect that the Board has made a full inquiry into the affairs of the company as a result of which they have formed an opinion that it is capable of meeting its liabilities and will not be rendered insolvent within a period of one year of the date of declaration adopted by the Board, and signed by at least two directors of the company, one of whom shall be the managing director, if any: No declaration of solvency shall be filed with the Securities and Exchange Board of India by a company whose shares are not listed on any recognized stock exchange. Register of securities bought back After completion of buyback, a company shall maintain a register of the securities/shares so bought and enter therein the following particulars a. the consideration paid for the securities bought-back, b. the date of cancellation of securities, c. the date of extinguishing and physically destroying of securities and d. such other particulars as may be prescribed Where a company buys-back its own securities, it shall extinguish and physically destroy the securities so bought-back within seven days of the last date of completion of buy-back. Issue of further shares after Buy back Every buy-back shall be completed within twelve months from the date of passing the special resolution or Board resolution as the case may be. A company which has bought back any security cannot make any issue of the same kind of securities in any manner whether by way of public issue, rights issue up to six months from the date of completion of buy back. Filing of return with the Regulator A Company shall, after the completion of the buy-back file with the Registrar and the Securities and Exchange Board of India, a return in form 4 C containing such particulars relating to the buy-back within thirty days of such completion. No return shall be filed with the Securities and Exchange Board of India by an unlisted company. Prohibition of Buy Back A company shall not directly or indirectly purchase its own shares or other specified securities (a) through any subsidiary company including its own subsidiary companies; or (b) through any investment company or group of investment companies; or Procedure for buy back a) Where a company proposes to buy back its shares, it shall, after passing of the special/Board resolution make a public announcement at least one English National Daily, one Hindi National daily and Regional Language Daily at the place where the registered office of the company is situated.

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b) The public announcement shall specify a date, which shall be "specified date" for the purpose of determining the names of shareholders to whom the letter of offer has to be sent. c) A public notice shall be given containing disclosures as specified in Schedule I of the SEBI regulations. d) A draft letter of offer shall be filed with SEBI through a merchant Banker. The letter of offer shall then be dispatched to the members of the company. e) A copy of the Board resolution authorising the buy back shall be filed with the SEBI and stock exchanges. f) The date of opening of the offer shall not be earlier than seven days or later than 30 days after the specified date g) The buy back offer shall remain open for a period of not less than 15 days and not more than 30 days. h) A company opting for buy back through the public offer or tender offer shall open an escrow Account. Penalty If a company makes default in complying with the provisions the company or any officer of the company who is in default shall be punishable with imprisonment for a term which may extend to two years, or with fine which may extend to fifty thousand rupees, or with both. The offences are, of course compoundable under Section 621A of the Companies Act,1956.

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Strategic Finance Q.8. Ans

Sem. IV

How is CAPM model helpful? Detail out the model and its theory. Capital Asset Pricing Model (CAPM)

Introduction: The capital Asset Pricing Model (CAPM) is an equilibrium model, which describes the pricing of assets, as well as derivatives. The model concludes that the expected return of an asset(or derivative) equals the riskless return plus a measure of the assets non-diversifiable risk (“beta”) times the market-wide risk premium (excess expected return of the market portfolio over the riskless return). That is: Expected security return = Riskless return + beta x (expected market risk premium) It concludes that only the risk, which cannot be diversified away by holding a well-diversified portfolio (e.g. the market portfolio) will affect the market price of the asset. This risk is called systematic risk, while risk that can be diversified away is called diversifiable risk. The CAPM asks what is the value of an asset (or derivative) relative to the return of the market portfolio. Because of this, the option models are often referred to as “relative” valuation models, while the CAPM is considered an “absolute” valuation model. However the model is only valid within a special set of assumptions. Assumptions of CAPM Investors are risk averse individuals who maximize the expected utility of their end of period wealth. Implication: The model is a one period model. • Investors have homogenous expectations (belief) about asset returns. Implication : all investors perceive identical opportunity sets. This is, everyone have the same information at the same time. • Asset returns are distributed by the normal distribution. • There exists a risk free asset and investors may borrow or lend unlimited amounts of the asset at a constant rate: the risk free rate (k). • There is a definite number of assets and their quantities are fixed within the one period world. • All assets are perfectly divisible and priced in a perfectly competitive marked. Implication: e.g. human capital is non-existing. • Asset markets are frictionless and information is costless and simultaneously available to all investors. • There are no market imperfections such as taxes, regulations or restrictions on short selling. Rationale of CAPM: This method of valuing assets and calculating the cost of capital for an alternative i.e. the capital asset price model (CAPM) has come to dominate modern finance. The rationale of the CAPM can be simplified as follows. Investors can eliminate some sorts of risk known as Residual risk or alpha, by holding a diversified portfolio of assets. These alpha risks are specific to an individual asset, for example, the risk that a company’s managers will turn out to be no good. Some risks, such as that of a global recession cannot be eliminated through diversification. So even a basket of all the shares in a stock market will still be risky. People must be rewarded for investing in such a risky basket by earning returns on average above those that they can get on safer assets, such as treasury bills. Assuming investors diversify away alpha risks, how an investor values any particular asset should depend crucially on how much the asset’s price is affected by the risk of the market as a whole.

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Strategic Finance

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The market’s risk contribution is captured by a measure of relative volatility. BETA, which indicates how much an asset’s price is expected to change when the overall market changes. Safe investments have a beta close to zero: economists call these assets risk free. Riskier investments, such as a share, should earn a premium over the risk free rate. How much is calculated by the average premium for all assets of that type, multiplied by the particular asset’s beta. Pronounced as though it were spelled cap-m, this model was originally developed in 1952 by Harry markowitz and fine tuned over a decade later by others, including William Sharpe. CAPM describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities. CAPM says that the expected return of a security or a portfolio equals the rate on a risk free security plus a risk premium. If this expected return does not meet or beat our required return, the investment should not be undertaken. The commonly used formula to describe CAPM relationship is as follows: Required (expected return)= RF rate + (Market return – RF rate)* Beta Implications of CAPM • Investors will always combine a risk free asset with a market portfolio of risky assets. They will invest in risky assets in proportion to their market value. • Investors will be compensated only for that risk which they can’t diversify. This is the market related risk. • Investor can expect returns from their investment according to the risk. The concept of risk and return as developed under CAPM have intuitive appeal and they are quite simple to understand. Financial managers use these concepts in a number of financial decision making such as valuation of securities, cost of capital measurement, investment risk analysis etc. Limitations of CAPM: • Unrealistic assumptions: CAPM is based on a number of assumptions that are far from the reality. For e.g. its very difficult to find a risk free security. A short term, highly liquid govt. security is considered as a risk free security. Its unlikely that govt. will default but inflation causes uncertainty about the real rate of return.

•

•

The assumption of the equality of the lending and borrowings is also not correct. In practice these rates differ. Further, investors may not hold highly diversified portfolios or the market indices may not be well diversified. Under these circumstances, CAPM may not accurately explain the investment behavior of investors and beta may fail to capture the risk of investment. Testing CAPM Most of the assumptions of CAPM may not be very critical for its practical validity. What we need to know therefore, is the empirical validity of CAPM. We need to establish that beta is able to measure the risk of security and that there is a significant correlation between beta and the expected return. Stability of BETA : Beta is a measure of a security’s future risk. But investors don’t have the future data to estimate beta. What they have are past data about the share prices and the market portfolio. Thus, they can only estimate beta based on historical data. Investors can use historical beta as the measure of future risk only if its stable over time. This implies that historical betas are poor indicators of the future risk of securities.

CAPM is a useful device for understanding the risk return relationship inspite of its limitations. It provides a logical and quantitative approach for estimating risk. Its better than many alternative subjective methods of determining risk and risk premium. One major problem in the use of CAPM is that many times the risk of an asset is not captured by beta alone.

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Strategic Finance

Sem. IV

Q.9 What are the different dividend theories? Explain their application with the Indian context. Ans Different Dividend theories: •

Bird in Hand Theory: The conclusions of Miller and Modigliani- that, dividend policy does not matter – presented a strong challenge to the conventional wisdom of that time. Finance theorists and corporate mangers believed that investors preferred dividends to capital gains and that a firm could increase (or at least support) the market value of its shares by choosing a generous dividend policy. At that time, the most popular argument for dividend was the “Bird in the hand”- Theory. It holds that dividends (a bird in the hand) are preferred to retained earnings (a bird in the bush) because the latter never materialize as future dividends (it can fly away). This is obvious as the risk of having money today is definitely less than risking your money for returns in the future. At first glance, this theory seems to be reasonable, especially in the light of the fact that a higher dividend stocks tend to be lower on the risk spectrum of common stocks. And other things being equal, less risky stocks are more expensive than higher risk stocks with the same expected future cash flow. This theory from Myron Gordon is rather an argument about investment policy than about dividends.

•

Smoothing Theory One of the first papers on the subject dividend policy, was published by John Lintner in 1956. He conducted a series of interviews with mangers about their thinking on the determination of dividend policy. His results can be summarized in four stylized facts: 1. Firms have long-run target dividend payout ratios. Mature companies with stable earnings generally pay out a high proportion of earnings; growth companies have low payouts. 2. Managers focus more on dividend changes than on absolute levels. Thus, paying a Rs. 2.0 dividends is an important financial decision if last year’s dividend was Re. 1.00, but no big deal if last year’s dividend was Rs. 2.00. 3. Dividend changes follow shifts in long run, sustainable earnings. Managers “smooth” dividends. Transitory earnings changes are unlikely to affect dividend payouts. This also helps to keep investors happy. 4. Managers are reluctant to make dividend changes that might have to be reversed. They are particularly worried about having to rescind a dividend increase.

•

Tax Differential Theory According to this theory, since dividends are effectively taxed at higher rates than capital gains in most countries, investors require higher rates of return on stocks with high dividend yields. The theory says, a firm should pay a low (or zero) dividend in order to minimize its cost of capital and maximise its value. The tax system may tend to favour retention of profit and limit dividend. Thus low dividend yield shares have been likely to be in great demand by high rate taxpayers,

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who prefer a low dividend payout and a high rate of earnings retention in the hope of an appreciation in the capital value of the company. Small shareholders may prefer relatively high dividend pay out rate. The dividend policy of such a firm may be a compromise between a low and a high payout. •

Residual Theory According to residual theory of dividends, the firm should follow its investment policy of accepting all positive NPV projects and paying out dividends if and only if funds are available. The focus is on growth. The discounting factor in the calculation of NPV would be equal to greater than the cost of capital K. If the firm treats dividend as a residual, then the dividend can vary highly from period to period depending upon the opportunities available and the investment plan and operating results of the firm. If a firm attracts investors falling into a particular dividend clientele, it suggests that the firm should maintain fairly stable dividend policy. The residual dividend policy is used by most firms to set a long run target payout.

•

Span of Control Theory: Managers in an organization look at the cash flows generated from the operations as an important and convenient source of new capital. The professional managers prefer to have a large span of control as measured by the number of employees, sales, market value, total assets or total expenditure. In pursuit of managerial objective of increasing the span of control, directors are expected to prefer retention of profits to distributions. Retention increases status, remuneration and security of mangers. Also increases in the firm’s investment schedule should result in growth in the value of shares to the extent that retained cash flows are reinvested in profitable projects.

•

Investor Rationality Theory Shefrin and Statman (1984) supported their argument based on the psychological preferences of individual investor. Their argument is that an investor who wishes to conserve his/her long run wealth could stipulate that portfolio capital should not be consumed, only dividends. The investor can select dividend payout ratio that conforms to his/her desired consumption level. Thus even though taxes and transaction costs may favor capital gains, an investor may find cash dividends attractive and hence be willing to pay the appropriate premium. The investor then would invest in a portfolio of shares to meet h\this need. Some of the investments would be in shares with high payout ration for consumption needs and others with low payout ratio for capital appreciation.

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Q.10 Explain the importance of working capital management and the different approaches/strategies. Ans. Working capital management is management for the short-term. This is of critical importance to a firm. As pointed out in the text, managers spend about 70% managing for the short-term. This makes sense. Every day companies take in money, write receipts, balance checkbooks, record receivable records, manage inventory and the like. Also, short-term management should not be discounted. As the old saying goes, "If you can make it in the short-term long enough, you don't need to worry about the long-term.”Cash Budgets” may be utilized in managing working capital. Working capital has to do with the short-term accounts of a firm — current assets and current liabilities. Net Working capital is defined as current assets less current liabilities. The secret to good working capital management is simple — "use someone else's money every chance you get and don't let anyone else use yours." Within reason, of course. To do that, the following strategies might be employed; again within reason. A company wouldn't want to stretch out its payables for so long a period that it's forced out of business. • •

Stretch out accounts payable as long as possible. If a bill is due on the 13th, don't pay it on the 10th. If a company has enough clout, they can negotiate longer terms with vendors. Turn receivables as quickly as possible. Make it easy for customers to pay. Lockboxes, prepaid envelopes, discounts, etc. may be utilized.

Turn inventories as quickly as possible. Inventories may be a big investment for a firm and they earn no interest. Just-in-time inventory methods and some other strategies are used to hold down a firm's investment in inventories. Factors Influencing Working Capital Requirements: • Nature of Business: A service firm, like an electrical undertaking or a transport corporation, which has a short operating cycle and sells predominantly on cash basis, has a modest working capital requirement. On the other hand, a manufacturing concern like a machine tools unit which has a long operating cycle and which sells largely on credit, has a very substantial working capital requirement. • Seasonality of Operations: Firms which have marked Seasonality in their operations usually have highly fluctuating working capital requirements. For example, the sale of ceiling fans reaches a peak during the summer months and decrease significantly during the winter period. Therefore, working capital needs of such a firm are likely to increase considerably during the summer months and decrease significantly during the winter period. • Production policy: A firm marked by pronounced seasonal fluctuation in its sales may pursue a production policy, which may reduce the sharp variations in the working capital requirements. • Market Conditions: The degree of competition prevailing in the market place has an important bearing on the working capital needs. When competition is high, a larger inventory of finished goods may be required to be maintained to serve the customers promptly and for extending the generous credit terms. • Conditions of Supply: The stock of inventory of raw materials, spares and store which is required to be maintained depends on their conditions of supply. If the supply is prompt and adequate, the firm can manage with small inventory.

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Strategic Finance

Sem. IV

Importance Of Working Capital Management The management of working capital is very important. Excessive levels of current assets can easily result in a firm realizing a substandard return on investment. However, firms with too few current assets may incur shortages and difficulties in maintaining smooth operations. Thus, it is important to ensure proper management of working capital because of the following reasons: •

Investment in current assets represents a substantial portion of total investment.

•

Investment in current assets and the level of current liabilities have to be quickly adjusted to changes in sales.

•

Fixed assets cannot generate income unless they are used with the help of working capital. Therefore, working capital is considered as lifeblood of an enterprise.

The following are the different approaches: 1. CONSERVATIVE APPROACH

Short-term Funds

Permanent current assets

Long Term Funds

Fixed assets

Financing is more dependent on long term sources in financing short assets. There is less risk of shortage of funds. As the addition to the current assets in the form of extra cash, stock, receivables will raise the denominator and there will not be any significant rise in the numerator the ROI will be low in this case. 2. AGGRESSIVE APPROACH

Short Term Funds Permanent current assets

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Sem. IV Term Funds

Fixed assets

Financing is more dependent on short-term sources for some long-term needs and short-term financing is dominant. There is a very large risk of shortage of funds, leading to liquidity problems.

3.

Restrictive or Aggressive Policy: Investments in current assets is low in this case. This may cause frequent production stoppages, delayed deliveries to customers, and loss of sales. But ROI will be relatively high in this case. The optimal level of current assets involves a trade off between costs that rise with current assets and the costs that fall with current assets. The former is referred to as carrying costs and the latter as shortage costs. The carrying costs are mainly in nature of the cost of financing a higher level of current assets. Shortage costs are mainly in the form of disruption in production schedule, loss of sales, and loss of customer goodwill. The minimum cost points towards the optimum level of current assets. Minimum cost Cost

Cost of Liquidity

Cost of Liquidity Level of current assets Optimum level of current assets The Figure shows the behaviour of the two costs in relation to the level of current assets. CA denotes the optimal level of current assets as the total costs of carrying and shortage are minimized at that level. Often the total cost curve is flat around the optimal level. 4. MATCHING APPROACH

Short Term Funds Permanent current assets

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Strategic Finance

Sem. IV Term Funds

Fixed assets

Financing is more dependent on long term sources for long term needs and short term for financing short term needs. There is a small risk of shortage of funds, as exact matching is difficult in practice.

STRATERGIES: Several Strategies are available to a firm for financing its capital requirements. Strategy A: Long term financing is used to meet fixed asset requirement as well as peak working capital requirement. When the working capital is less than its peak level, the surplus is invested in liquid assets like cash and marketable securities. Strategy B: Long term financing is used to meet fixed asset requirements, permanent working capital requirement, and a portion of fluctuating working capital requirement. During seasonal upswings, short-term financing is used: during seasonal downswings, surplus is invested in liquid assets. Strategy C: Long term financing is used to meet fixed asset requirement and permanent working capital requirement. Short-term financing is used to meet fluctuating working capital requirement.

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Q.12 Explain the accounting standards for investments in brief. Ans Introduction: 1. This Statement deals with accounting for investments in the financial statements of enterprises and related disclosure requirements. Shares, debentures and other securities held as stock-in-trade (i.e., for sale in the ordinary course of business) are not ‘investments’ as defined in this Statement. However, the manner in which they are accounted for and disclosed in the financial statements is quite similar to that applicable in respect of current investments. Accordingly, the provisions of this Statement, to the extent that they relate to current investments, are also applicable to shares, debentures and other securities held as stock-in-trade, with suitable modifications as specified in this Statement. 2. This Statement does not deal with: a) the bases for recognition of interest, dividends and rentals earned on investments which are covered by Accounting Standard 9 on Revenue Recognition; b) operating or finance leases; c) investments of retirement benefit plans and life insurance enterprises; and d) mutual funds and/or the related asset management companies, banks and public financial institutions formed under a Central or State Government Act or so declared under the Companies Act, 1956. Definitions The following terms are used in this Statement with the meanings assigned: Investments are assets held by an enterprise for earning income by way of dividends, interest, and rentals, for capital appreciation, or for other benefits to the investing enterprise. Assets held as stockin-trade are not ‘investments’. A current investment is an investment that is by its nature readily realisable and is intended to be held for not more than one year from the date on which such investment is made. A long-term investment is an investment other than a current investment. An investment property is an investment in land or buildings that are not intended to be occupied substantially for use by, or in the operations of, the investing enterprise. Fair value is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Under appropriate circumstances, market value or net realisable value provides an evidence of fair value. Market value is the amount obtainable from the sale of an investment in an open market, net of expenses necessarily to be incurred on or before disposal. Explanation Forms of Investments 3. Enterprises hold investments for diverse reasons. For some enterprises, investment activity is a significant element of operations, and assessment of the performance of the enterprise may largely, or solely, depend on the reported results of this activity.

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4. Some investments have no physical existence and are represented merely by certificates or similar documents (e.g., shares) while others exist in a physical form (e.g., buildings). The nature of an investment may be that of a debt, other than a short or long term loan or a trade debt, representing a monetary amount owing to the holder and usually bearing interest; alternatively, it may be a stake in the results and net assets of an enterprise such as an equity share. Most investments represent financial rights, but some are tangible, such as certain investments in land or buildings. 5. For some investments, an active market exists from which a market value can be established. For such investments, market value generally provides the best evidence of fair value. For other investments, an active market does not exist and other means are used to determine fair value. Explanation Classification of Investments 6. Enterprises present financial statements that classify fixed assets, investments and current assets into separate categories. Investments are classified as long term investments and current investments. Current investments are in the nature of current assets, although the common practice may be to include them in investments. 7. Investments other than current investments are classified as long term investments, even though they may be readily marketable. Explanation Cost of Investments 8. The cost of an investment includes acquisition charges such as brokerage, fees and duties. 9. If an investment is acquired, or partly acquired, by the issue of shares or other securities, the acquisition cost is the fair value of the securities issued (which, in appropriate cases, may be indicated by the issue price as determined by statutory authorities). The fair value may not necessarily be equal to the nominal or par value of the securities issued. 10. If an investment is acquired in exchange, or part exchange, for another asset, the acquisition cost of the investment is determined by reference to the fair value of the asset given up. It may be appropriate to consider the fair value of the investment acquired if it is more clearly evident. 11. Interest, dividends and rentals receivables in connection with an investment are generally regarded as income, being the return on the investment. However, in some circumstances, such inflows represent a recovery of cost and do not form part of income. For example, when unpaid interest has accrued before the acquisition of an interest-bearing investment and is therefore included in the price paid for the investment, the subsequent receipt of interest is allocated between pre-acquisition and post-acquisition periods; the pre-acquisition portion is deducted from cost. When dividends on equity are declared from pre-acquisition profits, a similar treatment may apply. If it is difficult to make such an allocation except on an arbitrary basis, the cost of investment is normally reduced by dividends receivable only if they clearly represent a recovery of a part of the cost. 12. When right shares offered are subscribed for, the cost of the right shares is added to the carrying amount of the original holding. If rights are not subscribed for but are sold in the market, the sale proceeds are taken to the profit and loss statement. However, where the investments are acquired on cum-right basis and the market value of investments immediately after their becoming ex-right is lower than the cost for which they were acquired, it may be appropriate to apply the sale proceeds of rights to reduce the carrying amount of such investments to the market value. Carrying Amount of Investments Current Investments 13. The carrying amount for current investments is the lower of cost and fair value. In respect of investments for which an active market exists, market value generally provides the best evidence of fair value. The valuation of current investments at lower of cost and fair value provides a prudent method of determining the carrying amount to be stated in the balance sheet. 14. Valuation of current investments on overall (or global) basis is not considered appropriate. Sometimes, the concern of an enterprise may be with the value of a category of related current

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investments and not with each individual investment, and accordingly the investments may be carried at the lower of cost and fair value computed categorywise (i.e. equity shares, preference shares, convertible debentures, etc.). However, the more prudent and appropriate method is to carry investments individually at the lower of cost and fair value. 15. For current investments, any reduction to fair value and any reversals of such reductions are included in the profit and loss statement. Carrying Amount of Investments Long-term Investments 16. Long-term investments are usually carried at cost. However, when there is a decline, other than temporary, in the value of a long term investment, the carrying amount is reduced to recognise the decline. Indicators of the value of an investment are obtained by reference to its market value, the investee’s assets and results and the expected cash flows from the investment. The type and extent of the investor’s stake in the investee are also taken into account. Restrictions on distributions by the investee or on disposal by the investor may affect the value attributed to the investment. 17. Long-term investments are usually of individual importance to the investing enterprise. The carrying amount of long-term investments is therefore determined on an individual investment basis. 18. Where there is a decline, other than temporary, in the carrying amounts of long term investments, the resultant reduction in the carrying amount is charged to the profit and loss statement. The reduction in carrying amount is reversed when there is a rise in the value of the investment, or if the reasons for the reduction no longer exist. Investment Properties 19. The cost of any shares in a co-operative society or a company, the holding of which is directly related to the right to hold the investment property, is added to the carrying amount of the investment property. Disposal of Investments 20. On disposal of an investment, the difference between the carrying amount and the disposal proceeds, net of expenses, is recognised in the profit and loss statement. 21. When disposing of a part of the holding of an individual investment, the carrying amount to be allocated to that part is to be determined on the basis of the average carrying amount of the total holding of the investment. Reclassification of Investments 22. Where long-term investments are reclassified as current investments, transfers are made at the lower of cost and carrying amount at the date of transfer. 23. Where investments are reclassified from current to long-term, transfers are made at the lower of cost and fair value at the date of transfer. Disclosure 24. The following disclosures in financial statements in relation to investments are appropriate:— a) the accounting policies for the determination of carrying amount of investments; b) the amounts included in profit and loss statement for: i) interest, dividends (showing separately dividends from subsidiary companies), and rentals on investments showing separately such income from long term and current investments. Gross income should be stated, the amount of income tax deducted at source being included under Advance Taxes Paid; ii) profits and losses on disposal of current investments and changes in carrying amount of such investments; iii) profits and losses on disposal of long term investments and changes in the carrying amount of such investments; c) significant restrictions on the right of ownership, realisability of investments or the remittance of income and proceeds of disposal;

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d) the aggregate amount of quoted and unquoted investments, giving the aggregate market value of quoted investments;

e) other disclosures as specifically required by the relevant statute governing the enterprise. Q.13 Explain the accounting standards for inventories in brief. Ans Objective A primary issue in accounting for inventories is the determination of the value at which inventories are carried in the financial statements until the related revenues are recognised. This Statement deals with the determination of such value, including the ascertainment of cost of inventories and any writedown thereof to net realisable value.

Scope 1. This Statement should be applied in accounting for inventories other than: a) work in progress arising under construction contracts, including directly related service contracts (see Accounting Standard (AS) 7, Accounting for Construction Contracts); b) work in progress arising in the ordinary course of business of service providers; c) shares, debentures and other financial instruments held as stock-in-trade; and d) producers’ inventories of livestock, agricultural and forest products, and mineral oils, ores and gases to the extent that they are measured at net realisable value in accordance with well established practices in those industries. 2. The inventories referred to in paragraph 1 (d) are measured at net realisable value at certain stages of production. This occurs, for example, when agricultural crops have been harvested or mineral oils, ores and gases have been extracted and sale is assured under a forward contract or a government guarantee, or when a homogenous market exists and there is a negligible risk of failure to sell. These inventories are excluded from the scope of this Statement.

Definitions 3. The following terms are used in this Statement with the meanings specified: Inventories are assets: a. held for sale in the ordinary course of business; b. in the process of production for such sale; or c. in the form of materials or supplies to be consumed in the production process or in the rendering of services. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. 4. Inventories encompass goods purchased and held for resale, for example, merchandise purchased by a retailer and held for resale, computer software held for resale, or land and other property held for resale. Inventories also encompass finished goods produced, or work in progress being produced, by the enterprise and include materials, maintenance supplies, consumables and loose tools awaiting use in the production process. Inventories do not include machinery spares which can be used only in connection with an item of fixed asset and whose use is expected to be irregular; such machinery spares are accounted for in accordance with Accounting Standard (AS) 10, Accounting for Fixed Assets.

Measurement of Inventories 5. Inventories should be valued at the lower of cost and net realisable value.

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Cost of Inventories 6. The cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

Costs of Purchase 7. The costs of purchase consist of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase.

Costs of Conversion 8. The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour. 9. The allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. The actual level of production may be used if it approximates normal capacity. The amount of fixed production overheads allocated to each unit of production is not increased as a consequence of low production or idle plant. Unallocated overheads are recognised as an expense in the period in which they are incurred. In periods of abnormally high production, the amount of fixed production overheads allocated to each unit of production is decreased so that inventories are not measured above cost. Variable production overheads are assigned to each unit of production on the basis of the actual use of the production facilities. 10. A production process may result in more than one product being produced simultaneously. This is the case, for example, when joint products are produced or when there is a main product and a by-product. When the costs of conversion of each product are not separately identifiable, they are allocated between the products on a rational and consistent basis. The allocation may be based, for example, on the relative sales value of each product either at the stage in the production process when the products become separately identifiable, or at the completion of production. Most by-products as well as scrap or waste materials, by their nature, are immaterial. When this is the case, they are often measured at net realisable value and this value is deducted from the cost of the main product. As a result, the carrying amount of the main product is not materially different from its cost.

Other Costs 11. Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include overheads other than production overheads or the costs of designing products for specific customers in the cost of inventories. 12. Interest and other borrowing costs are usually considered as not relating to bringing the inventories to their present location and condition and are, therefore, usually not included in the cost of inventories.

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Exclusions from the Cost of Inventories 13. In determining the cost of inventories in accordance with paragraph 6, it is appropriate to exclude certain costs and recognise them as expenses in the period in which they are incurred. Examples of such costs are: a. abnormal amounts of wasted materials, labour, or other production costs; b. storage costs, unless those costs are necessary in the production process prior to a further production stage; c. administrative overheads that do not contribute to bringing the inventories to their present location and condition; and d. selling and distribution costs.

Cost Formulas 14. The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs. 15. Specific identification of cost means that specific costs are attributed to identified items of inventory. This is an appropriate treatment for items that are segregated for a specific project, regardless of whether they have been purchased or produced. However, when there are large numbers of items of inventory which are ordinarily interchangeable, specific identification of costs is inappropriate since, in such circumstances, an enterprise could obtain predetermined effects on the net profit or loss for the period by selecting a particular method of ascertaining the items that remain in inventories. 16. The cost of inventories, other than those dealt with in paragraph 14, should be assigned by using the first-in, first-out (FIFO), or weighted average cost formula. The formula used should reflect the fairest possible approximation to the cost incurred in bringing the items of inventory to their present location and condition. 17. A variety of cost formulas is used to determine the cost of inventories other than those for which specific identification of individual costs is appropriate. The formula used in determining the cost of an item of inventory needs to be selected with a view to providing the fairest possible approximation to the cost incurred in bringing the item to its present location and condition. The FIFO formula assumes that the items of inventory which were purchased or produced first are consumed or sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. Under the weighted average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the enterprise.

Techniques for the Measurement of Cost 18. Techniques for the measurement of the cost of inventories, such as the standard cost method or the retail method, may be used for convenience if the results approximate the actual cost. Standard costs take into account normal levels of consumption of materials and supplies, labour, efficiency and capacity utilisation. They are regularly reviewed and, if necessary, revised in the light of current conditions. 19. The retail method is often used in the retail trade for measuring inventories of large numbers of rapidly changing items that have similar margins and for which it is impracticable to use other costing methods. The cost of the inventory is determined by reducing from the sales value of the inventory the appropriate percentage gross margin. The percentage used takes into consideration inventory which has been marked down to below its original selling price. An average percentage for each retail department is often used.

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Net Realisable Value 20. The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices have declined. The cost of inventories may also not be recoverable if the estimated costs of completion or the estimated costs necessary to make the sale have increased. The practice of writing down inventories below cost to net realisable value is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use. 21. Inventories are usually written down to net realisable value on an item-by-item basis. In some circumstances, however, it may be appropriate to group similar or related items. This may be the case with items of inventory relating to the same product line that have similar purposes or end uses and are produced and marketed in the same geographical area and cannot be practicably evaluated separately from other items in that product line. It is not appropriate to write down inventories based on a classification of inventory, for example, finished goods, or all the inventories in a particular business segment. 22. Estimates of net realisable value are based on the most reliable evidence available at the time the estimates are made as to the amount the inventories are expected to realise. These estimates take into consideration fluctuations of price or cost directly relating to events occurring after the balance sheet date to the extent that such events confirm the conditions existing at the balance sheet date. 23. Estimates of net realisable value also take into consideration the purpose for which the inventory is held. For example, the net realisable value of the quantity of inventory held to satisfy firm sales or service contracts is based on the contract price. If the sales contracts are for less than the inventory quantities held, the net realisable value of the excess inventory is based on general selling prices. Contingent losses on firm sales contracts in excess of inventory quantities held and contingent losses on firm purchase contracts are dealt with in accordance with the principles enunciated in Accounting Standard (AS) 4, Contingencies and Events Occurring After the Balance Sheet Date. 24. Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. However, when there has been a decline in the price of materials and it is estimated that the cost of the finished products will exceed net realisable value, the materials are written down to net realisable value. In such circumstances, the replacement cost of the materials may be the best available measure of their net realisable value. 25. An assessment is made of net realisable value as at each balance sheet date.

Disclosure 26. The financial statements should disclose: a. the accounting policies adopted in measuring inventories, including the cost formula used; and b. he total carrying amount of inventories and its classification appropriate to the enterprise.

27. Information about the carrying amounts held in different classifications of inventories and the extent of the changes in these assets is useful to financial statement users. Common classifications of inventories are raw materials and components, work in progress, finished goods, stores and spares, and loose tools.

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Q.14 Explain the concept of Human Resources Accounting. Ans Human Resource Accounting (HRA): HRA as an approach was originally defined as the process of identifying, measuring and communicating information about human resources in order to facilitate effective management within an organisation. It is an extension of the accounting principles of matching costs and revenues and of organizing data to communicate relevant information in financial terms. The accounting of human resources can be seen as just as much a question of philosophy as of technique. This is one of the reasons behind the variety of approaches. It is further underlined by the broad range of purposes for which accounting human resources can be used. For example, it can be used as an information tool for internal and/or external use (employees, customers, investors, etc.) and as a decision-making tool for human resource management. The reasons for developing HRA methods can be summarized in the following six points: • Inadequacy of traditional balance sheets in providing sufficient information on enterprise performance, • Measuring problems deriving from the valuation of human resources, • Redistribution of social responsibilities between the public and private sectors, • Security versus flexibility in employment, • Improved human resource management, • Formal learning versus in-firm competency acquirement. The Policy Dimension The focus on HRA in enterprises has lead to a growing interest by stakeholders who have started to identify and formulate their positions. The main stakeholders, such as the enterprises, investors, employees, trade unions and governments, are therefore gradually becoming aware of the potential of HRA, albeit from different perspectives. The basic questions in this perspective are: • Should HRA be mandatory for enterprises alongside financial statements, i.e. should law and/or social partner agreements regulate HRA? • If mandatory, what kind of information should be included in such statements? • If voluntary, how to secure the interests of, say the employees, at enterprise level? If, and this is still a big if, the public sector, nationally or internationally, decides to promote HRA, three ways forward can be identified: • The voluntary market-based method i.e. develop a consistent framework which can be operational across sectors and countries and promote this through a rewarding and image campaign, • The voluntary rewarding method, i.e. develop a consistent framework supported by rewarding mechanisms once it is introduced and approved at enterprise level, • The compulsory method i.e. identify disclosure of human resources as a societal concern and prepare international regulations.

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HRA is not a new issue in economics. Economists consider human capital as a production factor, and they explore different ways of measuring its investment in education, health and other areas. Accountants have recognized the value of human assets for at least 70 years. Research into true human resource accounting began in the 1960s. Performance Ratios/Indicators for HRM What data might we use when accounting for human assets? • FTEs – Full time equivalent staff • Headcount (H) e.g. total FTEs at month end • Revenues(R) – total operating income (total sales) • Expenses (E)- Operating expenditure exac. Tax, interest and extraordinary items • Profit-R Less E • Cash Like rewards (C)- emoluments: salaries, wages, overtime, bonuses, commissions, including NI contributions. • Benefits (B) –other rewards which may or may not be taxed as “benefit in kind” – cars, pensions, company loans etc. Staffing Performance Indicators Internal: 1. Sales per employee – indicates general employee productivity. Compare SPE this year over last year and with SPEs of rival organisations. Their turnover may be smaller but they may have a better SPE. SPE = R/H H may increase if the business expands. Was the growth was worth it (SPE)? 2. Recover Rate Aggregate compensation and benefits then divide by revenue. LRR compares staffing costs with revenues delivered. Are we obtaining better or worse returns on each RR of staff expenditure? A decreasing RR is desirable. RR = (C+B)/R Unravelling influences on RR can be difficult e.g. is it the staff turnover or a new marketing approach or manufacturing plant? The impact on additional investment should show through in RR later – revenue increases whilst staffing costs fall. 3. Utilisation % - can be applied e.g. to a consultancy company or school whose main business is allocating or selling the time of its staff. We assume that an increase in U% is desirable – is this always the case? U%= R/(C+B) R (revenue) can be substituted by another measurable output e.g. wagons delivered, dustbins emptied, examination results (points). Calculation must include staff costs of the whole business unit – direct and support staff. External: 4. Profit per Head like RoCE, shareholders and business analysts may use profit per head or profit before tax per head to focus on employee related costs and returns. PpH= P/H A firm’s PpH rating may highlight under-achievement and profit potential when compared to industry competitors. Corporate preditors may be attracted. 5. Compensation per Re. Profit. This evaluates profit against cost/employee rather than headcount. Interpretation can be difficult. CpP can swing with profits e.g. where there are close links between profits and staff compensation (profit related bonuses). CpP= (C+B)/P

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CpP is negative where a firm is making a loss. What if CpP is a small positive number and CpP a small negative number? CpP may indicate that better management could improve costeffectiveness or controls. 6. Personnel services expenses (PSE). What are the total operating expenses of the personnel/HRM section. 7. Personal Services Headcount (PSH) – total FTE for the personal/HR section in the calculation period. 8. Personal Service Cost %. (PSC) Divide PSE by total operating expenses (E) to identify rends and to influence budgeting processes. PSC =PSE/E Q.15 What are the various models and theories for valuation of shares and goodwill? Ans Theories for valuation of Shares: a) Value of assets: In this approach the focus for the valuation of the shares will be on the assets. The net value of the assets, i.e. the value of the assets less the liabilities will be used. For computation of valuation of shares, the total value of all the assets will be divided by the total number of shares. But in this approach, i) Non trading assets should be included ii) If the company is having outstanding preference shares, their value should be deducted to calculate the net asset available to the equity shareholders. iii) There may a lot of intangible assets in the balance sheet like preliminary expenses, deferred revenue expenditure, discount on issue of shares/debenture etc. These should normally be excluded from the value of total assets. This approach has certain limitations. Firstly the book value of the assets is directly dependent on the accounting policies followed by the company. This is more so in the area of booking depreciation, methods of provisioning adopted by the company, and valuation of inventory. Second, in the valuation of intangible assets, there are no standard procedures. This is for intangible assets like goodwill, patents etc.

b) Realizable or liquidation of value: To overcome some of the limitations in the book value approach, here the value of assets is taken to be the market value. Thus the value chosen is the one which can be had by selling the assets. It is also known as the liquidation value. This may be estimated for the company as whole, as it would be misleading or even irrelevant to look at individual assets. The value would be equivalent to estimated net amount that will be received by sale of assets less liabilities. The method is as follows Net Estimated value of assets = Estimated market value of assets – Liabilities Value of the share = Net Estimated value of assets/ Number of Equity shares

c) Replacement or reproduction value: In this approach, we move away from both the book value as well as the market value. Instead, we focus on the assumption that if the assets were to be replaced or reproduced all over again, what will be the value required. Thus the value of assets is taken to be on the basis of replacement cost rather than historical cost and market value. This replacement cost is estimated by competent authorities, like chartered engineers, other competent authorities. Again, there is

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and most likely a possibility that the replacement value may differ from authority to authority depending on the process, competency in valuing all the assets, person related factors and the assumptions that they make. The method is as follows Net Replacement value of assets = Estimated replacement value of assets – Liabilities Value of the share = Net replacement value of assets/Number of equity shares Some of the limitations: First- replacement value of certain assets that are no longer available, or of an older technology may not be possible. Second- estimating impact of depreciation on the replacement cost is difficult.

d) Yield/Earnings Approach: This approach assumes that the investors are interested in the income an investment would generate in the future. Often past earnings and income also have a bearing on the expected income in the future. Then the priced- i.e. the valuation of the share that they are prepared to pay depends upon the dividends, which they are expected to earn. As such the value of share is calculated as: Price = Rate of dividend x paid up value of share/ Normal rate of return VALUATION OF GOODWILL Goodwill is the value or the amount of reputation/standing/credibility of the business in respect of additional profit expected in future over and above the normal level of profit earned by a company – normally in the same class of business.

i) Super Profit Approach: In this approach, the future expected profits of the company are compared with normal profits, had their not been goodwill. There would some adjustments to be made for known factors affecting the profitability. Normal profit indicates the profit, which would have been earned by an average firm without goodwill. Normal profits can be calculated by multiplying the average capital employed by the average rate of return. The difference between future expected profit and normal profit is in the form of super profits, which is the measure of extra profits earned by the firm due to goodwill. Goodwill is calculated by multiplying the super profit by the certain number of years. The number of years to be taken into account would differ from investor to investor, from company to company and also would differ from industry to industry. It is a highly judgmental. Normally 3 to 5 years are considered. ii) Capitalisation Method: Total value of the business is calculated using the actual average profits after taking into account all factors based on normal expectation. The value of the goodwill is the difference between capitalized value and the net assets of the business.

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