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Product may become outmoded due to improved products, changes in customer choices, particularly in high style merchandise, changes in requirements. Then this is a major risk and it may affect in terms of huge revenue loss. It is costly for the firms whose resources are limited and tied up in slow moving inventories. Firms may like to buy and stock the inventory in the quantity which is more than needed for production and sales purposes. It is done to get the advantages in terms of quantity discounts connected with bulk purchasing or expected price rise. The banks send a deposit slip together with the list of payments and other enclosures to the firm by way of proof record and information after crediting the respective account of the firm.
- Besides several benefits, there are some drawbacks of holding inventory.
- At breakeven in EPS but above this point debt increases EPS via leverage and decreases EPS below this point.
- At the minimum, an investment should beat the inflation and there should be some real income.
- In these cases, the option with the highest BCR may be the least unprofitable implementation scenario.
- Therefore rational investors will start arbitrage until the values of both the firms become equal.
Investment decision goes in favor of employing assets having fixed costs because fixed operating costs can be used as a lever. The arbitrage process is retarded by the institutional investors e.g., Life Insurance Corporation of India, Commercial Banks; Unit Trust of India etc., i.e., they do not encourage personal leverage. At present these institutional investors dominate the capital market. Capital structure of a company is also affected by the purpose of financing. If the funds are required for manufacturing purposes, the company may procure it from the issue of long- term sources. When the funds are required for non-manufacturing purposes i.e., welfare facilities to workers, like school, hospital etc. the company may procure it from internal sources.
Capital Budgeting Discounted Method # 2. Internal Rate of Return Method:
The income may be conserved for meeting the increased requirements of working capital or future expansion. The declaration of dividends involves some legal as well as financial considerations. From the point of legal considerations, the basic rule is that dividend can only be paid out profits without the impairment of capital in any way. But the various financial considerations present a difficult situation to the management for coming to a decision regarding dividend distribution. The present value of benefits of a series of cash flows equals the likewise discounted costs.
- Federal Reserve, while longer-dated government bond yields have moved at a slower pace amid concerns that policy tightening may hurt the economy.
- The net present value method is a modern method of evaluating investment proposals.
- In concentration banking, cheques are received by collection centres and deposited in the bank after processing so that mailing float is reduced.
- Thus, in this way, it is estimated that there will be a saving of approximately one day in mailing time.
When profits of the firm swell, management may decide to distribute a part of the increased earnings as extra dividend instead of increasing regular dividend pay-out ratio. The equity of the shareholders in the corporation increases. Stock dividends do not alter the cash position of the company. They serve to commit the retained earnings to the business as a part of its fixed capitalization.
What is management of cash?
Hence, an improvement over this method can be made by employing the discounted pay-back period method. Under this method the present values of all cash outflows and inflows are computed at an appropriate discount rate. The present values of all inflows are cumulated in order of time. 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. Capital expenditure involves not only large amount of funds but also funds for long-term or more or less on permanent basis.
A financial manager is a person who takes care of all the important financial functions of an organization. The person in charge should maintain a far sightedness in order to ensure that the funds are utilized in the most efficient manner. His actions directly affect the Profitability, growth and goodwill of the firm. One-sided approach-It is more considerate towards the fund procurement and the issues related to their administration; however, it pays no attention to the effective utilization of funds.
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The next step is to analyze the proposal’s uncertainty and risk involved in it. Since the benefits are to be accrued in the future, the uncertainty is high with respect to its returns. Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting. There are certain factors like morale of the employees, goodwill of the firm, etc., which cannot https://1investing.in/ be correctly quantified but which otherwise substantially influence the capital decision. To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals. Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.
- However, one alternative gives more profits in earlier years; while the other one gives more profits in later years.
- Since interest on debentures have to be paid on certain predetermined intervals at a fixed rate and also debentures get priority on repayment at the time of liquidation, they are very well suited to cautious investors.
- There are certain factors like morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.
Post Pay-back Period method takes into account the period beyond the pay-back method. This method is also known as Surplus Life over Pay-back method. It saves in cost, it requires lesser time and labour as compared to other methods of capital budgeting. Urgency is another limitation in the evaluation of capital investment decisions. All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular circumstances.
Model # 2. Optimum Cash Balance using Inventory Model:
The investment made in the current assets or short term assets is termed asWorking Capital Management. The working capital management deals with the management of current assets that are highly liquid in nature. The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized what is the geometric mean of 4 and 9 at different points of time in future. In simple language we may say that a capital expenditure is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in future. The firm’s ability to cover the aggregate of fixed operating and financial charges is termed as combined leverage.
In real-world situation, however, firms do not take a larger amount of debt and creditors/lenders also are not interested to supply loan to highly levered firms due to the risk involved in it. According to some critics the arguments which were advocated by MM, are not valued in the practical world. We know that cost of capital and the value of the firm are practically the product of financial leverage. In other words, the cost of borrowing funds is comparatively less than the contractual rate of interest which allows the firm regarding tax advantage. Ultimately, the benefit is being enjoyed by the equity-holders and debt-holders. If corporate taxes are considered the MM approach will be unable to discuss the relationship between the value of the firm and the financing decision.