MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS ALL 5 UNITS
Essay
type questions
UNIT-1
1) Explain how economics is linked with financial accounting
and management
Managerial
economics relationship with other disciplines:-
Many
new subjects have evolved in recent years due to the interaction among basic disciplines.
They are
1.
Economics:
Managerial economics is the offshoot
of economics and hence the concepts of managerial economics are basically
economic concepts. If economics deals with theoretical concepts, managerial
economics is the application of these in the real life. Functions such as
demand function, cost function, revenue function and so on are extensively
used. Mainly these two concerned with the problems and scarcity and resource
allocation.
2.
Accountancy:
The accountant provides accounting
information relating to costs, revenues, receivables, payables etc. The main
objective of accounting function is to record, classify and interpret the given
accounting data. The managerial economist depends up on accounting data for
decision making and forward planning.
3.
Mathematics:
Estimating and predicting the
relevant economic factors for decision making and forward planning. In this
process, he extensively makes use of the tools and techniques of mathematics
such as “algebra, calculus, vectors, input-out tables and such other.
4.
Statistics:
Statistics
deals with different techniques useful to analyze the cause and effect
relationships in a given variable or phenomenon. The business environment for
the managerial economist is full of risk and use of the statistical techniques
such as “averages, correlation, regression, and time series” and so on.
5.
Operation Research:
Decision
making is the main focus in operation research. If managerial economics focus
on “problems of decision making”, operation research focuses on solving the
“managerial problems”. The operations models are “liner programming, queuing,
transportation, optimization techniques” and so on. It mainly focuses on to
solve managerial problems.
6.
Psychology:
Consumer
psychology is the basis, how the customer reacts to a given change in price or
supply and its consequential effect in demand/profits. Psychology contributes
towards understanding the behavioral implications, attitudes and motivations of
each microeconomic variable.
7.
Organizational Behavior:
Organizational
behavior enables the managerial economist to study and develop behavioral
models of the firm integrating the manager’s behavior with that of the owner.
2) Define
law of demand and write its exceptions?(OR)Write about demand schedule and
exceptions of law of demand?
LAW
OF DEMAND
Law
of demand shows the relation between price and quantity demanded of a commodity
in the market. In the words of Marshall, “the amount demand increases with a
fall in price and diminishes with a rise in price”.
A rise in the
price of a commodity is followed by a reduction in demand and a fall in price
is followed by an increase in demand, if a condition of demand remains
constant.
The law of demand may be explained
with the help of the following demand schedule.
Demand Schedule.
|
Price
of Appel (In. Rs.) |
Quantity
Demanded |
|
10 |
1 |
|
8 |
2 |
|
6 |
3 |
|
4 |
4 |
|
2 |
5 |
EXCEPTIONS
OF LAW OF DEMAND:-
1.
Giffen
or Inferior Goods:
The Giffen good
or inferior good is an exception to the law of demand. When the price of an
inferior good falls, the poor will buy less and vice versa. For example, when
the price of size falls, the poor are willing to spend more on superior goods
than on maize if the price of size increases, he has to increase the quantity
of money spent on it. Otherwise he will have to face starvation. Thus a fall in
price is followed by reduction in quantity demanded and vice versa. “Giffen”
first explained this and therefore it is called as Giffen’s paradox.
2.
Veblen or Demonstration effect:
‘Veblen’ has
explained the exceptional demand curve through his doctrine of conspicuous
consumption. Rich people buy certain good because it gives social distinction
or prestige for example diamonds are bought by the richer class for the
prestige it possess. It the price of diamonds falls poor also will buy is hence
they will not give prestige. Therefore, rich people may stop buying this
commodity.
3.
Ignorance:
Sometimes, the
quality of the commodity is Judge by its price. Consumers think that the
product is superior if the price is high. As such they buy more at a higher
price.
1.
Speculative
effect:
If the price of
the commodity is increasing the consumers will buy more of it because of the
fear that it increase still further, Thus, an increase in price may not be
accomplished by a decrease in demand.
5.
Fear of shortage:
During the times
of emergency of war People may expect shortage of a commodity. At that time,
they may buy more at a higher price to keep stocks for the future.
6.
Necessaries:
In the case of
necessaries like rice, vegetables etc. people buy more even at a higher price.
3)
Define
elasticity of demand and write about types of elasticity of demand?
ELASTICITY
OF DEMAND
Elasticity of
demand explains the relationship between a change in price and consequent
change in amount demanded. “Marshall” introduced the concept of elasticity of
demand. Elasticity of demand shows the extent of change in quantity demanded to
a change in price.
Elasticity of
demand can be defined as “The elasticity of demand in a market is great or
small according as the amount demanded increases much or little for a given
fall in the price and diminishes much or little for a given rise in Price”
Elastic demand:
A small change in price may lead to a great change in quantity demanded. In
this case, demand is elastic.
In-elastic
demand: If a big change in price is followed by
a small change in demanded then the demand in “inelastic”.
Types
of Elasticity of Demand:
There are three
types of elasticity of demand:
1. Price
elasticity of demand
2. Income
elasticity of demand
3. Cross
elasticity of demand
1.
Price elasticity of demand:
Marshall was the first economist to
define price elasticity of demand. Price elasticity of demand measures changes
in quantity demand to a change in Price. It is the ratio of percentage change
in quantity demanded to a percentage change in price.
Proportionate change in
the quantity demand of commodity
Price elasticity
=
------------------------------------------------------------------
Proportionate change in the price of commodity
There are five cases of price
elasticity of demand or Measurements.
A.
Perfectly elastic demand:
When small
change in price leads to an infinitely large change is quantity demand, it is
called perfectly or infinitely elastic demand. In this case E=∞
The demand curve DD1 is horizontal
straight line. It shows the at “OP” price any amount is demand and if price
increases, the consumer will not purchase the commodity.
B.
Perfectly Inelastic Demand
In this case,
even a large change in price fails to bring about a change in quantity
demanded.
When price increases from ‘OP’ to
‘OP’, the quantity demanded remains the same. In other words the response of
demand to a change in Price is nil. In this case ‘E’=0.
C.
Relatively elastic demand:
Demand changes
more than proportionately to a change in price. i.e. a small change in price
loads to a very big change in the quantity demanded. In this case
E > 1. This demand curve will be
flatter.
When price falls
from ‘OP’ to ‘OP’, amount demanded in crease from “OQ’ to “OQ1’ which is larger
than the change in price.
D.
Relatively in-elastic demand.
Quantity
demanded changes less than proportional to a change in price. A large change in
price leads to small change in amount demanded. Here E < 1. Demanded carve
will be steeper.
When price falls
from “OP’ to ‘OP1 amount demanded increases from OQ to OQ1, which is smaller
than the change in price.
E.
Unit elasticity of demand:
The change in demand is exactly
equal to the change in price. When both are equal E=1 and elasticity if said to
be unitary.
When price falls
from ‘OP’ to ‘OP1’ quantity demanded increases from ‘OP’ to ‘OP1’, quantity
demanded increases from ‘OQ’ to ‘OQ1’. Thus a change in price has resulted in
an equal change in quantity demanded so price elasticity of demand is equal to
unity
4)
what do you understand by demand
forecasting? explain different methods of
demand forecasting?
Demand Forecasting
Introduction:
Demand
forecast is the activity of estimating the quantity of a product or service
that consumers will purchase. Demand forecasting may be used in making pricing
decisions, in assessing future capacity requirements or in making decisions on
whether to enter new market. Forecast means future.
The
information about the future is essential for both new firms and those planning
to expand the scale of their production. Demand forecasting refers to an
estimate of future demand for the product.
Methods
of forecasting:
Several methods
are employed for forecasting demand. All these methods can be grouped under
survey method and statistical method. Survey methods and statistical methods
and other methods are further subdivided in to different categories.
1.
Survey Method:
Under this
method, information about the desires of the consumer and opinion of exports
are collected by interviewing them. Survey method can be divided into three
type’s viz., consumers’ survey method, sales force opinion method and experts
opinion method.
I.)
Consumers survey method.
The
consumers are contacted personally to know about their plans and preferences
regarding the consumption of the product. He/She would be asked the proportion
in which he intends to buy. Though this method gives first hand information. It
is a very costly and difficult method.
Consumers
survey method as three types they are, complete enumeration, sample survey and
end-use method.
2.
Statistical Methods:
Statistical
method is used for long run forecasting. In this method, statistical and
mathematical techniques are used to forecast demand. This method relies on post
data.
3.
Other Methods
The other methods are divided into
four types, they are, expert opinion, test marketing, controlled experiments
and judgmental approach
4)What is the significance of
elasticity of demand?
Significance
of Elasticity of Demand
The
concept of elasticity is very useful to the producers and policy-makers alike.
Ø Prices of factors of
production
The factors of production are land, labour,
capital organization and technology. These have a cost. We have to pay rent,
wages, interest, profits and price of these factors of production. The
elasticity here depends on the supply of each of the factors vis-Ã -vis the
demand for each of them respectively.
Ø Price fixation
The manufacturer can decide the amount
of price that can be fixed for his product on the concept of elasticity. If
there is no competition, because the manufacturer free to fix his price for
their product.
Ø Government policies
These can be classified
as five types they are.,
a.) Tax policy-
Government extensively depends on this concept to finalize its polices relating
to taxes and revenues. The elasticity concept of identify the various products
and services where the taxes can be levied.
b.) Rising of bank
deposits- If the government wants to mobilize
larger deposits from the customer, it proposes to raise the rates of fixed
deposits marginally and vice versa.
c.) Public utilities-
Government uses the concept of elasticity in fixing charges for the public
utilities such as electricity tariff, water charges, ticket fare in case of
road or rail etc.,
d.) Revaluation or
devaluation of currencies- The impact of
revaluation or devaluation on the interests of the exporters and importers.
Ø Forecasting demand
Income elasticity is used to forecast
demand for a particular product. The demand for the products can be forecast at
a given income level. The impact of changing income levels on the demand of the
product can be assessed with the help of income elasticity.
5)
DEFINE DEMAND ANALYSIS AND EXPLAIN FACTORS INFLUENCING DEMAND?
DEMAND
ANALYSIS
Demand
analysis is used to identify who wants to buy a given product, how much they
are likely to pay of it, how many units they have purchase and other factors
that can be used to determine product design, selling cost and advertising
strategy for a product.
Factors Affecting OR
Determinants of Demand:
There are
factors on which the demand for a commodity depends. These factors are
economic, social as well as political factors.
1.
Price
of the Commodity:
The most
important factor-affecting amount demanded is the price of the commodity. The
amount of a commodity demanded at a particular price is more properly called price
demand. The relation between price and demand is called the Law of Demand. It
is not only the existing price but also the expected changes in price, which
affect demand.
2.
Income
of the Consumer:
The second most
important factor influencing demand is consumer income. In fact, we can
establish a relation between the consumer income and the demand at different
levels of income, price and other things remaining the same. The demand for a
normal commodity goes up when income rises and falls down when income falls.
3.
Prices
of related goods:
The demand for a
commodity is also affected by the changes in prices of the related goods also.
Related goods can be of two types:
(i). Substitutes which can
replace each other in use; for example, tea and coffee are
substitutes. The change in price of a
substitute has effect on a commodity’s demand
in the same direction in which
price changes. The rise in price of
coffee shall raise
the demand for tea;
(ii).
Complementary foods are those which are jointly demanded, such as
pen and ink. In
such cases complementary goods have
opposite relationship between price of one
commodity and the amount demanded
for the other. If the price of pens goes up,
their demand is less as a result of
which the demand for ink is also less. The price
and demand go in opposite
direction.
4. Tastes of the
Consumers:
The amount
demanded also depends on consumer’s taste. Tastes include fashion, habit,
customs, etc. A consumer’s taste is also affected by advertisement. If the
taste for a commodity goes up, its amount demanded is more even at the same
price. This is called increase in demand. The opposite is called decrease in
demand.
5.
Population:
Increase in
population increases demand for necessaries of life. The composition of
population also affects demand. Composition of population means the proportion
of young and old and children as well as the ratio of men to women. A change in
composition of population has an effect on the nature of demand for different
commodities.
7. Government
Policy:
Government
policy affects the demands for commodities through taxation. Taxing a commodity
increases its price and the demand goes down. Similarly, financial help from
the government increases the demand for a commodity while lowering its price.
8. Expectations
regarding the future:
If consumers
expect changes in price of commodity in future, they will change the demand at
present even when the present price remains the same. Similarly, if consumers
expect their incomes to rise in the near future they may increase the demand
for a commodity just now.
9. Climate
and weather:
The climate of an area and the
weather prevailing there has a decisive effect on consumer’s demand. In cold
areas woolen cloth is demanded. During hot summer days, ice is very much in
demand. On a rainy day, ice cream is not so much demanded
6)
What is significance of managerial economics?
Managerial economics serves several purposes in business
decision-making. To start with, managerial economics provides a logical and
experiential framework for analyzing the question. To the somewhat vague
question of "what or how much should I make, and who should I sell it
to?", or "should I try to retail something like 'this'?", it provides
the framework for applying to your question concepts such as supply and demand,
market segmentation, competition, and so on. It takes your question from
something vague and applies tested concepts to frame a more precise question
(and answer).
Second, it provides an opportunity for a quantitative
question: "how much should I make?" or "what price should I
charge?" Rather than punting at an answer, managerial economics provides
either a pre-existing framework for obtaining a direct answer, or at least
provides a framework for testing volume or pricing in this case. Here we
have to know the types of economics,they are
Microeconomics
The study of an
individual consumer or a firm is called microeconomics (also called the Theory of Firm). Micro means ‘one millionth’. Microeconomics
deals with behavior and problems of single individual and of micro
organization. Managerial economics has its roots in microeconomics and it deals
with the micro or individual enterprises.
Macro
Economics
Macroeconomics examines the economy as a whole to explain broad aggregates and their interactions "top down", that is, using a simplified form of general-equilibrium theory. Such aggregates include national income and output, the unemployment rate, and price inflation and sub aggregates like total consumption and investment spending and their components. It also studies effects of monetary policy and fiscal policy.
Main decisions of economics:
a)production decisions
b)investment decisions
c)business expansion decisions
d)selling/buying decisions
e)demand decisions etc.
UNIT-II
1Define production function
and explain cobb douglas production function
Production
Function:-
The production
function expresses a functional relationship between physical inputs and
physical outputs of a firm at any particular time period. The output is thus a
function of inputs. Mathematically production function can be written as
Q=
f (A, B, C, D)
Where “Q” stands
for the quantity of output and A, B, C, D are various input factors such as
land, labour, capital and organization. Here output is the function of inputs.
Hence output becomes the dependent variable and inputs are the independent
variables.
Definition
Michall R. Baye
“the function which defines the maximum amount of output that can be produced
with a given set of inputs.”
Cobb-Douglas
production function:
Production
function of the linear homogenous type is invested by Junt wicksell and first
tested by C. W. Cobb and P. H. Dougles in 1928. This famous statistical
production function is known as Cobb-Douglas production function. Originally
the function is applied on the empirical study of the American manufacturing
industry. Cobb – Douglas production function takes the following mathematical
form.
Y=
(AKX L1-x)
Where
Y=output
K=Capital
L=Labour
A, ∞=positive
constant
Assumptions:
It has the following assumptions
- The
function assumes that output is the function of two factors viz. capital
and labour.
- It
is a linear homogenous production function of the first degree
- The
function assumes that the logarithm of the total output of the economy is
a linear function of the logarithms of the labour force and capital stock.
- There
are constant returns to scale
- All
inputs are homogenous
- There
is perfect competition
- There
is no change in technology
2) EXPLAIN ISOQUANTS
AND WRITE ITS FEATURES
Isoquants
An
isoquant is a curve representing the various combinations of two inputs that
produce the same amount of output. An isoquant curve is also known as
iso-product curve, equal-product curve and production indifference curve. A
curve which shows the different combinations of the two inputs producing a
given level of output.
An isoquant may be explained with
the help of an arithmetical example.
|
Combinations |
Labour (units) |
Capital (Units) |
Output (quintals) |
|
A |
1 |
10 |
50 |
|
B |
2 |
7 |
50 |
|
C |
3 |
4 |
50 |
|
D |
4 |
4 |
50 |
|
E |
5 |
1 |
50 |
Combination ‘A’ represent 1 unit of
labour and 10 units of capital and produces ‘50’ quintals of a product all
other combinations in the table are assumed to yield the same given output of a
product say ‘50’ quintals by employing any one of the alternative combinations
of the two factors labour and capital. If we plot all these combinations on a
paper and join them, we will get continues and smooth curve called Iso-product
curve as shown below.
Labour is on the
X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which shows
all the alternative combinations A, B, C, D, E which can produce 50 quintals of
a product.
Features
of Isoquant
- Downward sloping-
Isoquants are downward sloping curves because, if one input increases, the
other one reduces. There is no question of increase in both the inputs to
yield a given output. A degree of substitution is assumed between the
factors of production.
- Convex to origin-
Isoquants are convex to the origin. Because the input factors are not
perfect substitutes. One important factor can be substituted by the other
input factor in a “Diminishing
marginal rate.”
If the input factors were perfect
substitutes, the isoquants be a falling straight line.
- Do not intersect-
Two isoproducts do not intersect with each other.
- Do not touch axes-
The isoquants touches neither X-axis nor Y-axis, as both inputs are
required to produce a given product.
3)Explain isocosts amd MRTS
ISOCOSTS
The cost curve that represents the combination of inputs that will
cost the producer the same amount of money (or)
each isocost denotes a particular level of total cost for a given level of
production. If the level of production changes, the total cost changes and thus
the isocost curve moves upwards, and vice versa.
Least Cost Factor Combination or Producer’s
Equilibrium or Optimal Combination of Inputs
The firm can achieve maximum profits by choosing that combination of factors which will cost it the least. The choice is based on the prices of factors of production at a particular time. The firm can maximize its profits either by maximizing the level of output for a given cost or by minimizing the cost of producing a given output. In both cases the factors will have to be employed in optimal combination at which the cost of production will be minimum. The least cost factor combination can be determined by imposing the isoquant map on isocost line. The point of tangency between the isocost and an isoquant is an important but not a necessary condition for producer’s equilibrium. The essential condition is that the slope of the isocost line must equal the slope of the isoquant. Thus at a point of equilibrium marginal physical productivities of the two factors must be equal the ratio of their prices. And isoquant must be convex to the origin. The marginal rate of technical substitution of labour for capital must be diminishing at the point of equilibrium.
Marginal Rate of
Technical Substitution (MRTS):
Definition:
Prof. R.G.D. Alien and
J.R. Hicks introduced the concept of MRS (marginal rate of substitution) in the
theory of demand. The similar concept is used in the explanation of producers’
equilibrium and is named as marginal
rate of technical substitution (MRTS).
Marginal
rate of technical substitution (MRTS) is: "The rate at which one factor can
be substituted for another while holding the level of output constant".
The slope of an
isoquant shows the ability of a firm to replace one factor with another while
holding the output constant. For example, if 2 units of factor capital (K) can
be replaced by 1 unit of labor (L), marginal rate of technical substitution
will be thus:
MRTSLK = ΔK
ΔL
It means that the marginal
rate of technical substitution of factor labor for factor capital (K) (MRTSLK)
is the number of units of factor capital (K) which can be substituted by one
unit of factor labor (L) keeping the same level of output.
5)Explain law of returns and
break even analysis
Law
of Returns
Laws
of returns to scale refer to the long-run analysis of the laws of production.
In the long run, output can be increased by varying all factors. Thus, in this
section we study the changes in output as a result of changes in all factors.
In other words, we study the behavior of output in response to changes in the
scale. When all factors are increased in the same proportion an increase in
scale occurs.
Types of returns to scale: constant, increasing and
decreasing.
.1. Constant Returns to Scale
If
output increases in the same proportion as the increase in inputs, returns to
scale are said to be constant. Thus, doubling of all factor inputs causes
output; tripling of inputs causes tripling of output to scale is sometimes
called linear homogenous production function.
2. Increasing returns to scale
When
the output increases at a greater proportion than the increase in inputs,
returns to scale are said to be increasing. Scale are increasing, the distance
between successive isoquants becomes less and less, that is, Oa >ab >bc.
It means that equal increases in output are obtained by smaller and smaller
increments in inputs. In other words, by doubling inputs the output is more
than doubled.
3. Decreasing returns to scale
When
the output increases in a smaller proportion than the increase in all inputs
returns to scale are said to be decreasing. In other words, if the inputs are
doubled, output will increase by less than twice its original level. The
decreasing returns to scale are caused by diseconomies of large scale
production.
6) EXPLAIN ECONOMIES OF
SCALE AND IT TYPES
ECONOMIES
OF SCALE
Marshall has
classified these economies of large-scale production into internal economies
and external economies.
Internal
economies are those, which are opened to a single factory or a single firm
independently of the action of other firms. Hence internal economies depend
solely upon the size of the firm and are different for different firms.
External
economies are those benefits, which are shared in by a number of firms or
industries when the scale of production in an industry or groups of industries
increases. Hence external economies benefit all firms within the industry as
the size of the industry expands.
Internal
Economies:
Internal economies may be of the following
types.
A).
Technical Economies.
Technical
economies arise to a firm from the use of better machines and superior
techniques of production. As a result, production increases and per unit cost
of production falls. A large firm, which employs costly and superior plant and
equipment, enjoys a technical superiority over a small firm. Technical
economies may also be associated when the large firm is able to utilize all its
waste materials for the development of by-products industry. This increases the
productive capacity of the firm and reduces the unit cost of production.
B).
Managerial Economies:
These economies
is developed in a firm or they tremendously growth developed and also expand
the firm or organization they need qualified persons to handling each
functional specialists. For example- Marketing, HR, Finance, Operation etc., on
these persons experience the firm will developed and also they can reduce the
wastage and increasing production in the long-run.
C).
Marketing Economies:
The large firm
reaps marketing or commercial economies in buying its requirements and in
selling its final products. The large firm generally has a separate marketing
department. It can buy and sell on behalf of the firm, when the market trends
are more favorable. In the matter of buying they could enjoy advantages like
preferential treatment, transport concessions, cheap credit, prompt delivery
and fine relation with dealers. Similarly it sells its products more
effectively for a higher margin of profit.
D).
Financial Economies:
The large firm
is able to secure the necessary finances either for block capital purposes or
for working capital needs more easily and cheaply. It can barrow from the
public, banks and other financial institutions at relatively cheaper rates. It
is in this way that a large firm reaps financial economies.
E).
Risk bearing Economies:
The large firm
produces many commodities and serves wider areas. It is, therefore, able to
absorb any shock for its existence. For example, during business depression,
the prices fall for every firm. There is also a possibility for market
fluctuations in a particular product of the firm. Under such circumstances the
risk-bearing economies or survival economies help the bigger firm to survive
business crisis.
F).
Economies of Research:
A large firm
possesses larger resources and can establish it’s own research laboratory and
employ trained research workers. The firm may even invent new production
techniques for increasing its output and reducing cost.
G).
Economies of welfare:
A large firm can
provide better working conditions in-and out-side the factory. Facilities like
subsidized canteens, crèches for the infants, recreation room, cheap houses,
educational and medical facilities tend to increase the productive efficiency
of the workers, which helps in raising production and reducing costs.
External
Economies.
Business firm enjoys a number of
external economies, which are discussed below:
A).
Economies of Concentration:
When an industry
is concentrated in a particular area, all the member firms reap some common
economies like skilled labour, improved means of transport and communications,
banking and financial services, supply of power and benefits from subsidiaries.
All these facilities tend to lower the unit cost of production of all the firms
in the industry.
B).
Economies of Information
The industry can
set up an information centre which may publish a journal and pass on
information regarding the availability of raw materials, modern machines,
export potentialities and provide other information needed by the firms. It
will benefit all firms and reduction in their costs.
C).
Economies of Welfare:
An industry is
in a better position to provide welfare facilities to the workers. It may get
land at confessional rates and procure special facilities from the local bodies
for setting up housing colonies for the workers. It may also establish public
health care units, educational institutions both general and technical so that
a continuous supply of skilled labour is available to the industry. This will
help the efficiency of the workers.
D).
Economies of Disintegration:
The firms in an
industry may also reap the economies of specialization. When an industry
expands, it becomes possible to spilt up some of the processes which are taken
over by specialist firms.
Thus
internal economies depend upon the size of the firm and external economies
depend upon the size of the industry.
7) EXPLAIN COST ANALYSIS AND IT’S TYPES
Cost Analysis
Profit is the
ultimate aim of any business and the long-run prosperity of a firm depends upon
its ability to earn sustained profits. Profits are the difference between
selling price and cost of production. In general the selling price is not
within the control of a firm but many costs are under its control. The firm
should therefore aim at controlling and minimizing cost. Since every business
decision involves cost consideration, it is necessary to understand the meaning
of various concepts for clear business thinking and application of right kind
of costs.
COST
CONCEPTS:
A managerial economist must have a clear
understanding of the different cost concepts for clear business thinking and
proper application. The several alternative bases of classifying cost and the
relevance of each for different kinds of problems are to be studied. The
various relevant concepts of cost are:
1.
Opportunity Cost
Opportunity cost
implies the earnings foregone on the next best alternative, has the present
option is undertaken. This cost is often measured by assessing the alternative,
which has to be scarified if the particular line is followed. The opportunity
cost concept is made use for long-run decisions. This concept is very important
in capital expenditure budgeting. If there is no alternative, Opportunity cost
is zero.
The opportunity cost of any action is
therefore measured by the value of the most favorable alternative course, which
had to be foregoing if that action is taken.
2.
Fixed and variable costs:
Fixed cost is
that cost which remains constant for a certain level to output. It is not
affected by the changes in the volume of production. But fixed cost per unit
decrease, when the production is increased. Fixed cost includes salaries, Rent,
Administrative expenses depreciations etc.
Variable is that
which varies directly with the variation is output. An increase in total output
results in an increase in total variable costs and decrease in total output
results in a proportionate decline in the total variables costs. The variable
cost per unit will be constant. Ex: Raw materials, labour, direct expenses,
etc.
3.
Explicit and Implicit costs:
Explicit costs are those costs that involve an actual payment to other parties.
Therefore, an explicit cost is the monitory payment made by a firm for use of
an input owned or controlled by others. Explicit costs are also referred to as
accounting costs.
On the other hand, implicit
costs represent the value of foregone opportunities but do not involve an
actual cash payment. Implicit costs are just as important as explicit costs but
are sometimes neglected because they are not as obvious. This implicit cost
generally is not reflected in accounting statements, but rational
decision-making requires that it be considered.
4. Out-of-pocket costs and Book costs
Out of pocket costs are those costs that improve current cash payments to outsiders.
The out-of-pocket costs are also called explicit costs. For example, wages and
salaries paid to the employees are out-of pocket costs. Other examples of
out-of-pocket costs are payment of rent, interest, transport charges, etc. On
the other hand,
Book costs are those business costs, which do not involve any cash payments
but for them a provision is made in the books of account to include them in
profit and loss accounts and take tax advantages. Book costs are called
implicit or imputed costs. Book costs can be converted into out-of-pocket costs
by selling assets and leasing them back from buyer. Thus, the difference
between these two categories of cost is in terms of whether the company owns it
or not. If a factor of production is owned, its cost is a book cost while if it
is hired it is an out-of-pocket cost.
5.
Post and Future costs:
Post costs also
called historical costs are the actual cost incurred and recorded in the book
of account these costs are useful only for valuation and not for decision
making.
Future costs are
costs that are expected to be incurred in the futures. They are not actual
costs. They are the costs forecasted or estimated with rational methods. Future
cost estimate is useful for decision making because decision are meant for
future.
6.
Traceable and common costs:
Traceable costs
otherwise called direct cost, is one, which can be identified with a products
process or product. Raw material, labour involved in production is examples of
traceable cost.
Common
costs are the ones that common are attributed to a particular process or
product. They are incurred collectively for different processes or different
types of products. It cannot be directly identified with any particular process
or type of product
8) EXPLAIN BREAKEVEN ANALYSIS
BREAKEVEN
ANALYSIS
The study of
cost-volume-profit relationship is often referred as BEA. The term BEA is
interpreted in two senses. In its narrow sense, it is concerned with finding out
BEP; BEP is the point at which total revenue is equal to total cost. It is the
point of no profit, no loss. In its broad determine the probable profit at any
level of production.
Assumptions:
- All
costs are classified into two – fixed and variable.
- Fixed
costs remain constant at all levels of output.
- Variable
costs vary proportionally with the volume of output.
- Selling
price per unit remains constant in spite of competition or change in the
volume of production.
- There
will be no change in operating efficiency.
- There
will be no change in the general price level.
- Volume
of production is the only factor affecting the cost.
- Volume
of sales and volume of production are equal. Hence there is no unsold
stock.
- There
is only one product or in the case of multiple products. Sales mix remains
constant.
BREAK
EVEN POINT
An analysis to determine the point
at which revenue received equals the costs associated with receiving the
revenue. Break-even analysis calculates what is known as a margin of safety,
the amount that revenues exceed the break-even point. This is the amount that
revenues can fall while still staying above the break-even point.
Merits:
- Information
provided by the Break Even Chart can be understood more easily then those
contained in the profit and Loss Account and the cost statement.
- Break
Even Chart discloses the relationship between cost, volume and profit. It
reveals how changes in profit. So, it helps management in decision-making.
- It
is very useful for forecasting costs and profits long term planning and
growth
- The
chart discloses profits at various levels of production.
- It
serves as a useful tool for cost control.
- It
can also be used to study the comparative plant efficiencies of the
industry.
- Analytical
Break-even chart present the different elements, in the costs – direct
material, direct labour, fixed and variable overheads.
Demerits:
1. Break-even
chart presents only cost volume profits. It ignores other considerations such
as capital amount, marketing aspects and effect of government policy etc.,
which are necessary in decision making.
2. It
is assumed that sales, total cost and fixed cost can be represented as straight
lines. In actual practice, this may not be so.
3. It
assumes that profit is a function of output. This is not always true. The firm
may increase the profit without increasing its output.
4. A
major draw back of BEC is its inability to handle production and sale of
multiple products.
5. It
is difficult to handle selling costs such as advertisement and sale promotion
in BEC.
6. It
ignores economics of scale in production.
7. Fixed
costs do not remain constant in the long run.
8. Semi-variable
costs are completely ignored.
9. It
assumes production is equal to sale. It is not always true because generally
there may be opening stock.
10. When
production increases variable cost per unit may not remain constant but may
reduce on account of bulk buying etc.
11. The
assumption of static nature of business and economic activities is a well-known
defect of BEC.
9) Explain all the
variables of break even analysis or break-even point and write the importance
of break even analysis
Various variables used
in BEP, they are:-
- Fixed
cost
- Variable
cost
- Contribution
- Margin
of safety
- Profit
volume ratio
- Break-Even-Point
1.
Fixed
cost: Expenses that do not vary with the
volume of production are known as fixed expenses. Eg. Manager’s salary, rent
and taxes, insurance etc. It should be noted that fixed changes are fixed only
within a certain range of plant capacity.
The
concept of fixed overhead is most useful in formulating a price fixing policy.
Fixed cost per unit is not fixed.
2.
Variable
Cost:
Expenses that vary almost in direct proportion to the volume of production of
sales are called variable expenses. Eg. Electric power and fuel, packing
materials consumable stores. It should be noted that variable cost per unit is
fixed.
3.
Contribution:
Contribution is the difference between sales and variable costs and it
contributed towards fixed costs and profit. It helps in sales and pricing policies
and measuring the profitability of different proposals. Contribution is a sure
test to decide whether a product is worthwhile to be continued among different
products.
Contribution
= Sales – Variable cost
Contribution
= Fixed Cost + Profit.
4.
Margin
of safety:
Margin of safety is the excess of sales over the break even sales. It can be
expressed in absolute sales amount or in percentage. It indicates the extent to
which the sales can be reduced without resulting in loss. A large margin of
safety indicates the soundness of the business. The formula for the margin of
safety is:
Present
sales – Break even sales or
Margin
of safety can be improved by taking the following steps.
1. Increasing
production
2. Increasing
selling price
5.
Profit
Volume Ratio is usually called P. V. ratio. It
is one of the most useful ratios for studying the profitability of business.
The ratio of contribution to sales is the P/V ratio. It may be expressed in
percentage. Therefore, every organization tries to improve the P. V. ratio of
each product by reducing the variable cost per unit or by increasing the
selling price per unit. The concept of P. V. ratio helps in determining break
even-point, a desired amount of profit etc.
The
formula is,
6.
Break
– Even- Point: If we divide the term
into three words, then it does not require further explanation.
Break
Even Point refers to the point where total cost is equal to total revenue. It
is a point of no profit, no loss. This is also a minimum point of no profit, no
loss. This is also a minimum point of
production where total costs are recovered. If sales go up beyond the Break
Even Point, organization makes a profit. If they come down, a loss is incurred.
1. Break
Even point (Units) =
2. Break
Even point (In Rupees) =
Significance
of BEP
Breakeven point
analysis is a very important tool, especially if you are preparing a business plan,
to figure out the volume of sales your arts and crafts business needs to make
in order to cover both your variable and fixed costs. At breakeven point, your
arts and crafts business has made or lost no money.
Important info
for you the business owner as you have to be able to hand craft your arts and
crafts items at a price that your customers will pay while still providing an
adequate amount of income to cover your personal living expenses. Once you get
the hang of it you will find it quick and easy to figure breakeven point using
an Excel spreadsheet.
UNIT-III
|
1)
DEFINE JOINT STOCK COMPANY AND EXPLAIN |
2)
EXPLAIN PARTNERSHIP AND IT TYPES
The different kinds of Partners that are found in Partnership Firms are as follows!
1. Active or managing partner:
A person who takes active interest in the conduct and management of the business of the firm is known as active or managing partner.He carries on business on behalf of the other partners. If he wants to retire, he has to give a public notice of his retirement; otherwise he will continue to be liable for the acts of the firm.
2. Sleeping or dormant partner:
A sleeping partner is a partner who ‘sleeps’, that is, he does not take active part in the management of the business. Such a partner only contributes to the share capital of the firm, is bound by the activities of other partners, and shares the profits and losses of the business. A sleeping partner, unlike an active partner, is not required to give a public notice of his retirement. As such, he will not be liable to third parties for the acts done after his retirement.
3. Nominal or ostensible partner:
A nominal partner is one who does not have any real interest in the business but lends his name to the firm, without any capital contributions, and doesn’t share the profits of the business. He also does not usually have a voice in the management of the business of the firm, but he is liable to outsiders as an actual partner.
Sleeping
vs. Nominal Partners:
It may be clarified that a nominal partner is not the same as a sleeping partner. A sleeping partner contributes capital shares profits and losses, but is not known to the outsiders.
A nominal partner, on the contrary, is admitted with the purpose of taking advantage of his name or reputation. As such, he is known to the outsiders, although he does not share the profits of the firm nor does he take part in its management. Nonetheless, both are liable to third parties for the acts of the firm.
4. Partner by estoppel or holding out:
If a person, by his words or conduct, holds out to another that he is a partner, he will be stopped from denying that he is not a partner. The person who thus becomes liable to third parties to pay the debts of the firm is known as a holding out partner.
There are two essential conditions for the principle of holding out : (a) the person to be held out must have made the representation, by words written or spoken or by conduct, that he was a partner ; and (6) the other party must prove that he had knowledge of the representation and acted on it, for instance, gave the credit.
5. Partner in profits only:
When a partner agrees with the others that he would only share the profits of the firm and would not be liable for its losses, he is in own as partner in profits only.
6. Minor as a partner:
A partnership is created by an agreement. And if a partner is incapable of entering into a contract, he cannot become a partner. Thus, at the time of creation of a firm a minor (i.e., a person who has not attained the age of 18 years) cannot be one of the parties to the contract. But under section 30 of the Indian Partnership Act, 1932, a minor ‘can be admitted to the benefits of partnership’, with the consent of all partners. A minor partner is entitled to his share of profits and to have access to the accounts of the firm for purposes of inspection and copy.
He, however, cannot file a suit against the partners of the firm for his share of profit and property as long as he remains with the firm. His liability in the firm will be limited to the extent of his share in the firm, and his private property cannot be attached by creditors.
On his attaining majority, he has to decide within six months whether he will become regular partner of withdraw from partnership. The choice in either case is to be intimated through a public notice, failing which he will be treated to have decided to continue as partner, and he becomes personally liable like other partners for all the debts and obligations of the firm from the date of his admission to its benefits (and not from the date of his attaining the age of majority). He also becomes entitled to file a suit against other partners for his share of profit and property.
7. Other partners:
In partnership firms, several other types of partners are also found, namely, secret partner who does not want to disclose his relationship with the firm to the general public. Outgoing partner, who retires voluntarily without causing dissolution of the firm, limited partner who is liable only up to the value of his capital contributions in the firm, and the like.
However, the moment public comes to know of it he becomes liable to them for meeting debts of the firm. Usually, an outgoing partner is liable for all debts and obligations as are incurred before his retirement. A limited partner is found in limited partnership only and not in general partnership.
3) EXPLAIN PRICING METHODS
AND STRATEGIES
Here are some of the various strategies that businesses
implement when setting prices on their products and services.
1. Pricing at a Premium
With premium pricing, businesses set costs higher than their
competitors. Premium pricing is often most effective in the early days of a
product’s life cycle, and ideal for small businesses that sell unique goods.
Because customers need to perceive products as being worth
the higher price tag, a business must work hard to create a value perception.
Along with creating a high-quality product, owners should ensure their marketing
efforts, the product's packaging and the store's décor all combine to
support the premium price.
2. Pricing for Market Penetration
Penetration strategies aim to attract buyers by offering
lower prices on goods and services. While many new companies use this technique
to draw attention away from their competition, penetration pricing does tend to
result in an initial loss of income for the business.
Over time, however, the increase in awareness can drive
profits and help small businesses to stand out from the crowd. In the long run,
after sufficiently penetrating a market, companies often wind up raising their
prices to better reflect the state of their position within the market.
3. Economy Pricing
Used by a wide range of businesses including generic food
suppliers and discount retailers, economy pricing aims to attract the most
price-conscious of consumers. With this strategy, businesses minimize the costs
associated with marketing and production in order to keep product prices down.
As a result, customers can purchase the products they need without frills.
While economy pricing is incredibly effective for large
companies like Wal-Mart and Target, the technique can be dangerous for small
businesses. Because small businesses lack the sales volume of larger companies,
they may struggle to generate a sufficient profit when prices are too low.
Still, selectively tailoring discounts to your most loyal customers can be a
great way to guarantee their patronage for years to come.
4. Price Skimming
Designed to help businesses maximize sales on new products
and services, price skimming involves setting rates high during
the introductory phase. The company then lowers prices gradually as competitor
goods appear on the market.
One of the benefits of price skimming is that it allows
businesses to maximize profits on early adopters before dropping prices to
attract more price-sensitive consumers. Not only does price skimming help a
small business recoup its development costs, but it also creates an illusion of
quality and exclusivity when your item is first introduced to the marketplace.
5. Psychology Pricing
With the economy still limping back to full health, price
remains a major concern for American consumers. Psychology pricing
refers to techniques that marketers use to encourage customers to respond on
emotional levels rather than logical ones.
For example, setting the price of a watch at $199 is proven
to attract more consumers than setting it at $200, even though the true
difference here is quite small. One explanation for this trend is that consumers
tend to put more attention on the first number on a price tag than the last.
The goal of psychology pricing is to increase demand by creating an illusion of
enhanced value for the consumer.
6. Bundle Pricing
With bundle pricing, small businesses sell multiple products
for a lower rate than consumers would face if they purchased each item
individually. Not only is bundling goods an effective way of moving unsold
items that are taking up space in your facility, but it can also increase the
value perception in the eyes of your customers, since you’re essentially giving
them something for free.
Bundle pricing is more effective for companies that sell
complimentary products. For example, a restaurant can take advantage of bundle
pricing by including dessert with every entrée sold on a particular day of the
week. Small businesses should keep in mind that the profits they earn on the
higher-value items must make up for the losses they take on the lower-value
product.
4)
EXPLAIN FEATURES OF PERFECT COMPETITION MARKET
PERFECT COMPETITION
Imagine yourself as a street food vendor, selling tacos
topped with fried onions, ground meat, cheese, fresh tomatoes and dollops of
guacamole and spicy sauce in the main plaza of a town close to the border of
Mexico. There are three other taco vendors on other corners of the plaza
selling the exact same thing of the same quality. None of the other vendors
(nor you) can change the price, because everyone knows that the deal is 3 tacos
for $5. Anyone else who wants to sell tacos on the street can do so, and if you
want to quit and sell something else one day (or sell your tacos at one of the
many other public spaces in your town), no one is stopping you. A business
expert might describe this as perfect competition (or a perfect market
or pure competition), which means an equal level for all firms involved in the
industry. But what does that really mean?
Characteristics of Perfect
Competition
In order to attain perfect competition, several factors need
to be met. The following list outlines some of the main factors:
- Knowledge
is available to all buyers and sellers, and no individual has control over
the prices.
- Buyers
and sellers have no barriers to enter or leave the market.
- Buyers
and sellers want to maximize profit.
- There
are too many sellers and buyers to take control of the market.
- All
goods are homogeneous.
- The
government does not get involved.
- There
are no costs associated with transportation.
Benefits of Perfect Competition
Now that the factors have been introduced, you might be
asking, what are the benefits to a perfect market? Let's look at some of the
benefits in more detail:
- All
of the knowledge, such as price and information pertaining to the goods,
is equally dispersed among all buyers and sellers. In other words, there
are no secrets, and communication about the products is shared evenly,
preventing corruption.
- Since
there are no barriers to enter the market, this makes it impossible for a
monopoly to occur.
- Advertisement
is not needed in a perfect competition because all goods are the same and
customers have all the knowledge pertaining to those goods.
Examples of Perfect Competition
This leads to the next question: is perfect competition in a
market realistic in the real world? The answer is no, not really. There aren't
any 100% perfect markets, but there are some industries that come close. Like
we mentioned earlier, street food vending (more common in developing countries)
has many of the factors required of a perfect market. Agricultural markets are
examples of nearly perfect competition as well. Imagine shopping at your local
farmers' market: there are numerous farmers, selling the same fruits,
vegetables and herbs. You can easily find out the prices for the goods, but
they are usually all about the same.
5)
Explain features of imperfect completion market
Some of the main characteristics of Imperfect Competition are as follows:
The concept of imperfect competition was propounded in 1933 in England by Mrs. Joan Robinson and in America by E.H. Chamberlin.
It is an important market category where the individual firms exercise their control over the price to a smaller or larger degree. Prof. Chamberlin called it “Monopolistic competition”.
Under imperfect competition, there are large number of buyers and sellers. Each seller can follow its own price-output policy. Each producer produces the differentiated product, which are close substitutes of each other. Thus, the demand curve under monopolistic competition is highly elastic.
Characteristics:
1.
Large number of Sellers and Buyers:
There are large numbers of sellers in the market. All these firms are small sized. It means that each firm produces or sells such an insignificant portion of the total output or sale that it cannot influence the market price by its individual action. No firm can affect the sales of any other firm either by increasing or reducing its output; so there is no reaction from other firms. Every firm acts independently without bothering about the reactions of its rivals. There are a large number of buyers and none of them can affect price by his individual action.
2.
Product Differentiation:
Another important characteristic is product differentiation. The product of each seller may be similar to, but not identical with the product of other sellers in the industry. For example, a packet of Verka butter may be similar in kind to another packet of Vita butter, but because of the idea that there are differences, real or imaginary, in the quality of these two products, each buyer may have a definite preference for the one rather than for the other. As a result, each firm will have a group of buyers who prefer, for one reason or another, the product of that particular firm.
3.
Selling Costs:
Another important characteristic of the monopolistic competition is existence of selling costs. Since there is product differentiation and products are close substitutes, selling costs are important to persuade buyers to change their preferences, so as to raise their demand for a given article. Under monopolistic competition, advertisement is not only persuasive but also informatory because a large number of firms are operating in the market and buyer’s knowledge about the market is not perfect.
4.
Free Entry and exit of Firms:
Firms under monopolistic competition are free to join and leave the industry at any time they like to. The implication of this characteristic is that by entering freely into the market, the firms can produce close substitutes and increase the supply of commodity in the market. Similarly, the firm commands such a meager amount of resources that in the event of losses, they may easily quit the market.
5.
Price-makers:
In the monopolistic competitive market, each firm is a price-maker as it can determine the price of its own brand of the product.
6.
Blend of Competition and Monopoly:
In this market, each firm has a monopoly power over its product as it would not lose all customers if it raises the price as its product is not perfect substitute of other brands. At the same time, there is an element of competition because the consumers treat the different firms’ products as close substitutes. Hence, if a firm raises the price of its brand, it would lose some customers to other brands.
6)
EXPLAIN ECONOMIC ENVIRONMENT
The economic environment in which a business
operates has a great influence upon it. In this lesson, you'll learn about the
economic environment in business, including its various factors and importance.
A short quiz follows.
Economic
Environment Defined
The economic environment consists of external factors in a business' market and the broader economy that can influence a business. You can divide the economic environment into the microeconomic environment, which affects business decision making - such as individual actions of firms and consumers - and the macroeconomic environment, which affects an entire economy and all of its participants. Many economic factors act as external constraints on your business, which means that you have little, if any, control over them. Let's take a look at both of these broad factors in more detail.
Macroeconomic influences are broad economic factors that either directly or indirectly affect the entire economy and all of its participants, including your business. These factors include such things as:
- Interest rates
- Taxes
- Inflation
- Currency exchange rates
- Consumer discretionary income
- Savings rates
- Consumer confidence levels
- Unemployment rate
- Recession
- Depression
Microeconomic factors influence how your business will make decisions. Unlike macroeconomic factors, these factors are far less broad in scope and do not necessarily affect the entire economy as a whole. Microeconomic factors influencing a business include:
- Market size
- Demand
- Supply
- Competitors
- Suppliers
- Distribution chain, such as
retailer stores
Why Is
the Economic Environment Important?
The economic environment of business will play a pivotal role in determining the success or failure of a business.
Let's first consider some macroeconomic factors. If interest rates are too high, the cost of borrowing may not permit a business to expand. On the other hand, if unemployment rate is high, businesses can obtain labor at cheaper costs. However, if unemployment is too high, this may result in a recession and less discretionary consumer spending resulting in insufficient sales to keep the business going. Tax rates will take a chunk of your income and currency exchange rates can either help or hurt the exporting of your products to specific foreign markets.
7)
EXPLAIN LIBERALIZATION, PRIVATIZATION AND GLOBALIZATION
|
Liberalization,
Privatization and Globalization. |
|
The economy of India had
undergone significant policy shifts in the beginning of the 1990s. This new
model of economic reforms is commonly known as the LPG or Liberalisation, Privatisation
and Globalisation model. The primary objective of this model was to make the economy of India
the fastest developing economy in the globe with capabilities that help it
match up with the biggest economies of the world.
The chain of
reforms that took place with regards to business, manufacturing, and financial
services industries targeted at lifting the economy of the country to a more
proficient level. These economic reforms had influenced the overall economic
growth of the country in a significant manner.
Liberalisation
Liberalisation
refers to the slackening of government regulations. The economic liberalisation
in India denotes the continuing financial reforms which began since July 24,
1991.
Privatisation and Globalisation
Privatisation refers to the participation of private entities in businesses and
services and transfer of ownership from the public sector (or government) to
the private sector as well. Globalisation stands for the consolidation of the
various economies of the world.
LPG and the Economic Reform Policy of India
Following its freedom on August 15, 1947, the Republic of India stuck to
socialistic economic strategies. In the 1980s, Rajiv Gandhi, the then Prime
Minister of India, started a number of economic restructuring measures. In
1991, the country experienced a balance of payments dilemma following the Gulf
War and the downfall of the erstwhile Soviet Union. The country had to make a
deposit of 47 tons of gold to the Bank of England and 20 tons to the Union Bank
of Switzerland. This was necessary under a recovery pact with the IMF or
International Monetary Fund. Furthermore, the International Monetary Fund
necessitated India to assume a sequence of systematic economic reorganisations.
Consequently, the then Prime Minister of the country, P V Narasimha Rao
initiated groundbreaking economic reforms. However, the Committee formed by
Narasimha Rao did not put into operation a number of reforms which the
International Monetary Fund looked for.
Dr Manmohan Singh, the present Prime Minister of India, was then the Finance
Minister of the Government of India. He assisted. Narasimha Rao and played a
key role in implementing these reform policies.
Narasimha Rao Committee's Recommendations
The recommendations of the Narasimha Rao Committee were as follows:
- Bringing in the Security
Regulations (Modified) and the SEBI Act of 1992 which rendered the
legitimate power to the Securities Exchange Board of India to record and
control all the mediators in the capital market.
- Doing away with the Controller
of Capital matters in 1992 that determined the rates and number of stocks
that companies were supposed to issue in the market.
- Launching
of the National Stock Exchange in 1994 in the form of a computerised share
buying and selling system which acted as a tool to influence the
restructuring of the other stock exchanges in the country. By the year
1996, the National Stock Exchange surfaced as the biggest stock exchange
in India.
- In
1992, the equity markets of the country were made available for investment
through overseas corporate investors. The companies were allowed to raise
funds from overseas markets through issuance of GDRs or Global Depository
Receipts.
- Promoting FDI (Foreign Direct
Investment) by means of raising the highest cap on the contribution of
international capital in business ventures or partnerships to 51 per cent
from 40 per cent. In high priority industries, 100 per cent international
equity was allowed.
- Cutting down duties from a mean
level of 85 per cent to 25 per cent, and withdrawing quantitative
regulations. The rupee or the official Indian currency was turned into an
exchangeable currency on trading account.
- Reorganisation of the methods
for sanction of FDI in 35 sectors. The boundaries for international
investment and involvement were demarcated.
The outcome of these reorganisations can be estimated by the fact that the
overall amount of overseas investment (comprising portfolio investment, FDI,
and investment collected from overseas equity capital markets ) rose to $5.3
billion in 1995-1996 in the country) from a microscopic US $132 million in
1991-1992. Narasimha Rao started industrial guideline changes with the
production zones. He did away with the License Raj, leaving just 18 sectors
which required licensing. Control on industries was moderated.
Highlights of the LPG Policy
Given below are the salient highlights of the Liberalisation, Privatisation and
Globalisation Policy in India:
- Foreign
Technology Agreements
- Foreign
Investment
- MRTP
Act, 1969 (Amended)
- Industrial
Licensing
- Deregulation
- Beginning
of privatisation
- Opportunities
for overseas trade
- Steps
to regulate inflation
- Tax
reforms
- Abolition
of License -Permit Raj
8)
DEFINE MONOPOLY AND EXPLAIN IT’S TYPES AND FEATURES
Monopoly
The word monopoly is
made up of two syllables, Mono and poly. Mono means single while poly implies
selling. Thus monopoly is a form of market organization in which there is only
one seller of the commodity. There are no close substitutes for the commodity
sold by the seller. Pure monopoly is a market situation in which a single firm
sells a product for which there is no good substitute.
FEATURES
OF MONOPOLY
The following are the features of monopoly.
- Single
person or a firm: A single person
or a firm controls the total supply of the commodity. There will be no
competition for monopoly firm. The monopolist firm is the only firm in the
whole industry.
- No
close substitute: The goods sold by
the monopolist shall not have closely competition substitutes. Even if
price of monopoly product increase people will not go in far substitute.
For example: If the price of electric bulb increase slightly, consumer
will not go in for kerosene lamp.
- Large
number of Buyers: Under monopoly,
there may be a large number of buyers in the market who compete among
themselves.
- Price
Maker: Since the monopolist controls
the whole supply of a commodity, he is a price-maker, and then he can
alter the price.
- Supply
and Price: The monopolist can fix either
the supply or the price. He cannot fix both. If he charges a very high
price, he can sell a small amount. If he wants to sell more, he has to
charge a low price. He cannot sell as much as he wishes for any price he
pleases.
- Downward
Sloping Demand Curve: The demand curve
(average revenue curve) of monopolist slopes downward from left to right.
It means that he can sell more only by lowering price.
Types
of Monopoly
Monopoly may be classified into various types. The
different types of monopolies are explained below:
- Legal
Monopoly: If monopoly arises on account
of legal support or as a matter of legal privilege, it is called Legal
Monopoly. Ex. Patent rights, special brands, trade means, copyright etc.
- Voluntary
Monopoly: To get the advantages of
monopoly some private firms come together voluntarily to control the
supply of a commodity. These are called voluntary monopolies. Generally,
these monopolies arise with industrial combinations. These voluntary
monopolies are of three kinds (a) cartel (b) trust (c) holding company. It
may be called artificial monopoly.
- Government
Monopoly: Sometimes the government will
take the responsibility of supplying a commodity and avoid private
interference. Ex. Water, electricity. These monopolies, created to satisfy
social wants, are formed on social considerations. These are also called
Social Monopolies.
- Private
Monopoly: If the total supply of a good
is produced by a single private person or firm, it is called private
monopoly. Hindustan Lever Ltd. Is having the monopoly power to produce Lux
Soap.
- Limited
Monopoly: if the monopolist is having
limited power in fixing the price of his product, it is called as ‘Limited
Monopoly’. It may be due to the fear of distant substitutes or government
intervention or the entry of rivals firms.
- Unlimited
Monopoly: If the monopolist is having
unlimited power in fixing the price of his good or service, it is called
unlimited monopoly. Ex. A doctor in a village.
- Single
Price Monopoly: When the
monopolist charges same price for all units of his product, it is called single
price monopoly. Ex. Tata Company charges the same price to all the Tata
Indiaca Cars of the same model.
- Discriminating
Monopoly: When a Monopolist charges
different prices to different consumers for the same product, it is called
discriminating monopoly. A doctor may take Rs.20 from a rich man and only
Rs.2 from a poor man for the same treatment.
- Natural
Monopoly: Sometimes monopoly may arise
due to scarcity of natural resources. Nature provides raw materials only
in some places. The owner of the place will become monopolist. For Ex.
Diamond mine in South Africa.
9)
DEFINE MONOPOLISTIC COMPETITION MARKET AND WRITE ITS FEATURES?
Monopolistic
competition
Perfect competition and
pure monopoly are rate phenomena in the real world. Instead, almost every
market seems to exhibit characteristics of both perfect competition and
monopoly. Hence in the real world it is the state of imperfect competition
lying between these two extreme limits that work. Edward. H. Chamberlain
developed the theory of monopolistic competition, which presents a more
realistic picture of the actual market structure and the nature of competition.
Characteristics
of Monopolistic Competition
The important characteristics of monopolistic
competition are:
- Existence
of Many firms: Industry consists
of a large number of sellers, each one of whom does not feel dependent
upon others. Every firm acts independently without bothering about the
reactions of its rivals. The size is so large that an individual firm has
only a relatively small part in the total market, so that each firm has
very limited control over the price of the product. As the number is relatively
large it is difficult for these firms to determine its price- output
policies without considering the possible reactions of the rival forms. A
monopolistically competitive firm follows an independent price policy.
- Product
Differentiation: Product differentiation
means that products are different in some ways, but not altogether so. The
products are not identical but the same time they will not be entirely
different from each other. These products are relatively close substitute
for each other but not perfect substitutes. Consumers have definite
preferences for the particular verities or brands of products offered for
sale by various sellers. Advertisement, packing, trademarks, brand names
etc. help differentiation of products even if they are physically
identical.
- Large
Number of Buyers: There are large
number buyers in the market. But the buyers have their own brand
preferences. So the sellers are able to exercise a certain degree of
monopoly over them. Each seller has to plan various incentive schemes to
retain the customers who patronize his products.
- Free
Entry and Exist of Firms: As in the
perfect competition, in the monopolistic competition too, there is freedom
of entry and exit. That is, there is no barrier as found under monopoly.
- Selling
costs: Since the products are close
substitute much effort is needed to retain the existing consumers and to
create new demand. So each firm has to spend a lot on selling cost, which
includes cost on advertising and other sale promotion activities.
- Imperfect
Knowledge: Imperfect knowledge about the
product leads to monopolistic competition. If the buyers are fully aware
of the quality of the product they cannot be influenced much by
advertisement or other sales promotion techniques. But in the business
world we can see that thought the quality of certain products is the same,
effective advertisement and sales promotion techniques make certain brands
monopolistic.
- The
Group: Under perfect competition the
term industry refers to all collection of firms producing a homogenous
product. But under monopolistic competition the products of various firms
are not identical through they are close substitutes.
10)
DEFINE MARKET AND EXPLAIN MARKET STRUCTURE
MARKET
Market is a place where
buyer and seller meet, goods and services are offered for the sale and transfer
of ownership occurs. Economists describe a market as a collection of buyers and
sellers who transact over a particular product or product class (the housing
market, the clothing market, the grain market etc.). For business purpose we
define a market as people or organizations with wants (needs) to satisfy, money
to spend, and the willingness to spend it.
Definition
According
to Philip Kotler “Market is a societal process by which individuals and
groups obtain what they need and want through creating, offering and freely
exchanging products and services of value with others”.
Size of market
The
size of market depends on many factors such as nature of products nature of
their demand, tastes and preferences of the customers, their income levels,
technology, infrastructure including telecommunication and information
technology. The technology development of buyers and sellers very close to each
other.
Market
Structure
Market structure
describes the competitive environment in the market for any good or service. A
market consists of all firms and individuals who are willing and able to buy or
sell a particular product. This includes firms and individuals currently
engaged in buying and selling a particular product, as well as potential
entrants. These are the main areas in the market, they are
·
Seller contribution
·
Buyer contribution
·
Product differentiation
·
Conditions of entry
into the market.
TYPES
OF COMPETITION
The
market can be divided into two types.,
11) EXPLAIN PRICE DETERMINATION
UNDER BOTH PERFECT AND IMPERFECT COMPLETION
Pricing under perfect competition
The price or
value of a commodity under perfect competition is determined by the demand for
and the supply of that commodity.
Under perfect
competition there is large number of sellers trading in a homogeneous product.
Each firm supplies only very small portion of the market demand. No single
buyer or seller is powerful enough to influence the price. The demand of all
consumers and the supply of all firms together determine the price. The
individual seller is only a price taker and not a price maker. He classified
the time into four periods to determine the price as follows.
- Very
short period or Market period
- Short
period
- Long
period
- Very
long period or secular period
Very short period: It
is the period in which the supply is more or less fixed because the time
available to the firm to adjust the supply of the commodity to its changed
demand is extremely short; say a single day or a few days. The price determined
in this period is known as Market Price.
Short Period: In
this period, the time available to firms to adjust the supply of the commodity
to its changed demand is, of course, greater than that in the market period. In
this period altering the variable factors like raw materials, labour, etc can
change supply. During this period new firms cannot enter into the industry.
Long period: In
this period, a sufficiently long time is available to the firms to adjust the
supply of the commodity fully to the changed demand. In this period not only
variable factors of production but also fixed factors of production can be
changed. In this period new firms can also enter the industry. The price
determined in this period is known as long run normal price.
Secular Period: In
this period, a very long time is available to adjust the supply fully to change
in demand. This is very long period consisting of a number of decades. As the
period is very long it is difficult to lay down principles determining the
price.
12) DEFINE
OLIGOPOLY LAND DUOPOLY?
Oligopoly
The term oligopoly is
derived from two Greek words, oligos meaning a few, and pollen meaning to sell.
Oligopoly is the form of imperfect competition where there are a few firms in
the market, producing either a homogeneous product or producing products, which
are close but not perfect substitute of each other.
Duopoly
Duopoly refers to a
market situation in which there are only two sellers. As there are only two
sellers any decision taken by one seller will have reaction from the other Eg.
Coca-Cola and Pepsi. Usually these two sellers may agree to co-operate each
other and share the market equally between them, So that they can avoid harmful
competition.
The duopoly price, in
the long run, may be a monopoly price or competitive price, or it may settle at
any level between the monopoly price and competitive price.
13) EXPLAIN PRICE – OUTPUT DETERMINATION
UNDER PRICING UNDER MONOPOLY
Price – Output Determination under Pricing
under Monopoly
Monopoly refers
to a market situation where there is only one seller. He has complete control
over the supply of a commodity. He is therefore in a position to fix any price.
Under monopoly there is no distinction between a firm and an industry. This is
because the entire industry consists of a single firm.
Being
the sole producer, the monopolist has complete control over the supply of the
commodity. He has also the power to influence the market price. He can raise
the price by reducing his output and lower the price by increasing his output.
Thus he is a price-maker. He can fix the price to his maximum advantages. But
he cannot fix both the supply and the price, simultaneously. He can do one thing
at a time. If the fixes the price, his output will be determined by the market
demand for his commodity. On the other hand, if he fixes the output to be sold,
its market will determine the price for the commodity. Thus his decision to fix
either the price or the output is determined by the market demand.
The market
demand curve of the monopolist (the average revenue curve) is downward sloping.
Its corresponding marginal revenue curve is also downward sloping. But the
marginal revenue curve lies below the average revenue curve as shown in the
figure. The monopolist faces the down-sloping demand curve because to sell more
output, he must reduce the price of his product. The firm’s demand curve and
industry’s demand curve are one and the same. The average cost and marginal
cost curve are U shaped curve. Marginal cost falls and rises steeply when
compared to average cost.
Price output determination (Equilibrium
Point)
The monopolistic
firm attains equilibrium when its marginal cost becomes equal to the marginal
revenue. The monopolist always desires to make maximum profits. He makes
maximum profits when MC=MR. He does not increasing his output if his revenue
exceeds his costs. But when the costs exceed the revenue, the monopolist firm
incur loses. Hence the monopolist curtails his production. He produces up to
that point where additional cost is equal to the additional revenue (MR=MC).
Thus point is called equilibrium point. The price output determination under
monopoly may be explained with the help of a diagram.
In the diagram
6.12 the quantity supplied or demanded is shown along X-axis. The cost or
revenue is shown along Y-axis. AC and MC are the average cost and marginal cost
curves respectively. AR and MR curves slope downwards from left to right. AC
and MC and U shaped curves. The monopolistic firm attains equilibrium when its
marginal cost is equal to marginal revenue (MC=MR). Under monopoly, the MC
curve may cut the MR curve from below or from a side. In the diagram, the above
condition is satisfied at point E. At point E, MC=MR. The firm is in
equilibrium. The equilibrium output is OM.
The above diagram (Average revenue) = MQ
or OP
Average cost = MR
Profit per unit = Average
Revenue-Average cost=MQ-MR=QR
Total Profit = QRXSR=PQRS
The area PQRS represents the maximum
profit earned by the monopoly firm.
But it is not
always possible for a monopolist to earn super-normal profits. If the demand
and cost situations are not favorable, the monopolist may realize short run
losses.
Through the
monopolist is a price marker, due to weak demand and high costs; he suffers a
loss equal to PABC.
If AR > AC -> Abnormal or super
normal profits.
If AR = AC -> Normal Profit
If AR < AC -> Loss
In the long run the firm has time to
adjust his plant size or to use existing plant so as to maximize profits.
Unit
IV
FINANCIAL
ACCOUNTING
Every business organization wants to know its business
results at the end of the year. For this purpose organization has been prepared
a financial statement which is known as profit and loss statement. The business
organization also wants to know its assets and liabilities at the end of the
year. For this purpose it has to prepare another statement which is known as
balance sheet. To prepare these two financial statements, you want to require
some accounting concepts and principles.
ACCOUNTING:
It is an art of recording
classifying and summarizing business transactions in a systematic manner for
the benefit of management and outsider such as share holders creditors,
bankers, government etc.
Significance
of accounting:
Maintain its own records of business Monitor the business activity
Calculate
profit and use of business for a given period
It shows financial position of business for a given period Communicates the information to the interested persons
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Accounts |
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Personal |
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Impersonal |
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Receiver
(debited) Giver (credited) |
Real |
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Nominal |
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Coming into business |
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going |
losses |
income |
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KEY
WORDS IN BOOK-KEEPING |
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TRANSACTIONS:
Any sale or purchase of goods of services is called the transaction. Transactions are two types.
[a]. Cash
Transaction: cash transaction is one where cash receipt or payment is
involved in the exchange.
[b]. Credit Transaction: Credit
transaction will not have cash, either received or paid, for something given or
received respectively.
GOODS: Fill those things which a firm
purchases for resale are called goods.
PURCHASES: Purchases means purchase of goods, unless it is stated
otherwise it also represents the Goods
purchased.
SALES: Sales means sale of goods, unless it is stated otherwise
it also represents these goods sold. EXPENSES:
Payments for the purchase of goods as services are known as expenses.
REVENUE: Revenue is the amount realized or
receivable from the sale of goods or services.
ASSETS: The valuable things owned by the business are known as
assets. These are the properties Owned
by the business.
LIABILITIES: Liabilities are the obligations or debts payable by the
enterprise in future in the term Of
money or goods.
DEBTORS: Debtors means a person who owes
money to the trader.
CREDITORS: A creditor is a person to whom
something is owned by the business.
DRAWINGS: cash or goods withdrawn by the proprietor from the
Business for his personal or Household
is termed to as “drawing”.
RESERVE: An amount set aside out of profits
or other surplus and designed to meet contingencies.
ACCOUNT: A summarized statements of
transactions relating to a particular person, thing, Expense or income.
DISCOUNT: There are two types of discounts..
a. Cash discount: An allowable made to encourage
frame payment or before the expiration
of the period allowed for credit.
b. Trade discount: A deduction from the gross or
catalogue price allowed to traders who
buys them for resale.
There are 3 branches of accounting
1. Financial accounting
2. Cost accounting
3. Management accounting
Financial
accounting:
The science and art of recording and classifying business
transactions and preparing profit and loss account and balance sheet, it tells
the profitability position and financial position of business.
Cost
accounting:
The purpose of cost accounting is the classifying and
appropriate allocation of expenditure for the determination of the cost of
products and for the presentation of suitable arranged data for the purpose of
control and guidance of management.
Management
accounting
The
purpose of management accounting is to guide the management in taking policy
decision. For example pricing decision, making or buy decision, capital
expenditure
Double entry book keeping:
It is an accounting technique that records the two folds
aspects of the transactions by using scientific method. i.e., it records each
transaction as a debit and a credit. A credit entry represents the sources of
finance and debit entries represent the usage of the finance. Since each credit
entry has one or more corresponding debit and vice – versa, the system of
double entry bookkeeping always leads to a set of balanced ledger credit and
debit account.
Advantages of double – entry book keeping 1. Information
about every account:
Under double entry system both aspects of transaction are
being recorded in the book of accounts. Hence information about every account
is available in the books of account as all accounts are to be found in the
ledgers under double entry system. Under single entry system, only a few
accounts such as cash account, debtors account, and creditors’ accounts are
maintained.
2. Help to know the receivables and payables
It
helps to know how much is owed to the creditors and how much is due from
debtors. Also if focuses on the bills payable and receivables.
3. Arithmetical accuracy:
The arithmetical accuracy can be ascertained by preparing a
statement of debit and credits called trail balance and this is possible
because both debit aspects and credit aspects of ever transaction are recorded.
4. Helps to locate errors:
Trail balance can reveal the errors that
creep in accounts while recording the business
information.
5. Helps to ascertain profit / loss:
The profit and loss statement can be
prepared with out much difficult under double entry system unlike in single
entry system.
6. Helps to know the financial position:
Double
entry system helps to prepare balance sheet that reveals the financial position
of the business as on particular date.
7. Monitoring and auditing made easier:
With
double entry system the scope for frauds and misappropriations is less,
provided proper internal audit system is in place.
Because of these advantages double
entry system is very much popular all over the world.
Journal:
Journal is a book in which
transactions are recorded in the order in which they occur i.e the transactions
are recorded in chronological order. It is called as the book of “prime
entry/original entry”. Because all the business transactions are first entered
into it, An entry made into journal is called as “journal entry” and the
process of recording is called journalizing.
Format:
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Date |
Particulars |
L.F |
Debit
(Rs) |
Credit (Rs) |
Date column:
This column records the date on which the transactions are entered.
Particulars: This column records the two
aspects of a transaction. First it records the accounts to be debited and then account to credited. It also
records the narration (a brief explanation about the transaction)
L.F (ledger Folio): This column records the ledger page
number containing relevant accounts. Debit
column: This column records the amount to debited
Credit column: This column records the amount to be credited.
All accounts are divided in to 3 types
1.
Personal account
2.
Real account
3.
Nominal account
1.
Personal account:
All persons can be divided in to two
categories namely receiver and giver
Receivers are the persons who
receive benefit from business on the other hand givers are a person who gives
benefits to the business.
Debit:
The Receiver
Credit:
The Giver
2.Real account:
All assets can be divided in to two
categories namely
1. Assets coming in to business
2. Assets going out of business
The account of assets coming into
business must be debited and the account of assets going out of business must
be credited.
Debit:
What comes in
Credit:
What goes out
3.
Nominal account:
The account of expenses and losses of
the business must be debited and the account of all incomes and
gains business must be credited.
Debit:
Expenses and losses
Credit:
incomes and gains
Journalize
the fallowing transactions 2009
i.
Vamsi
commenced business with Rs.100000
ii. Deposited Rs.40000 with bank
iii. Purchased goods worth Rs.15000 from
Mr. A
iv. Purchased goods worth Rs.5000 from
Mr. B
v. Sold goods to Mr. Z for cash Rs.
5500
vi. Paid rent by cheque worth Rs. 8000
vii. Goods returned by Mr. Z worth Rs.250
Viii Returned defective goods worth Rs.900
to Mr. A
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S.No |
Particulars |
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L.F |
Debit Rs. |
Credit Rs. |
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i. |
Cash A/c |
(Dr) |
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1,00,000 |
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To Capital A/c(being commencement
of |
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1,00,000 |
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business) |
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ii. |
Bank A/c |
(Dr) |
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40,000 |
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To Cash A/c (being cash deposited
in the |
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40,000 |
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ban) |
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iii. |
Purchase A/c |
(Dr) |
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15,000 |
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To Mr. A (goods on credit Purchase |
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15,000 |
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from A) |
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iv |
Purchase A/c |
(Dr) |
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5,000 |
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To Mr. B (goods on credit Purchase |
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5,000 |
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from B) |
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v. |
Cash A/c |
(Dr) |
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5,500 |
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To Sales A/c (sales of goods to
Mr. Z) |
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5,500 |
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vi. |
Rent A/c |
(Dr) |
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8,000 |
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To Bank A/c ( Cheque no cash) |
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8,000 |
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vii |
Sales returns A/c |
(Dr) |
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250 |
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To Mr. Z ( goods returned by Mr.
Z) |
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250 |
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vii |
Mr. A A/c |
(Dr) |
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900 |
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i. |
To Purchase Returns |
(defective goods |
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900 |
Journal the following transactions
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Jan 1 |
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Bought goods from Rao |
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500 |
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Jan 2 |
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Sold goods for cash |
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150 |
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Jan 5 |
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Sold goods to Murthy |
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300 |
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Jan 12 |
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Bought goods for cash |
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750 |
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Jan 18 |
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Bought furniture for cash |
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200 |
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Jan 20 |
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Bought machinery for cash |
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250 |
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Jan 25 |
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Received from Murthy on a account |
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175 |
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Jan 28 |
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Paid Rao on account |
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225 |
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Jan 31 |
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Paid land lord rent |
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4500 |
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S.No |
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Particulars |
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L.F |
Debit Rs. |
Credit Rs. |
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Jan 1 |
Purchase A/c |
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(Dr) |
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500 |
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To Mr. Rao (goods on credit
Purchase |
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500 |
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from Rao) |
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Jan 2 |
Cash A/c |
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(Dr) |
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150 |
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To Sales A/c |
(sales of goods for cash) |
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150 |
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Jan 5 |
Murthy A/c |
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(Dr) |
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300 |
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To Sales A/c |
(sales of goods to Murthy |
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300 |
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on credit) |
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Jan 18 |
furniture A/c |
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(Dr) |
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200 |
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To Cash A/c (furniture Purchase
for |
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200 |
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cash) |
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Jan 20 |
Machinery A/c |
(Dr) |
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250 |
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To Cash A/c (machinery Purchase
for |
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250 |
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cash) |
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Jan 25 |
Bank A/c |
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(Dr) |
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175 |
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To Murthy A/c (receipt of cash
from |
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175 |
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murthy ) |
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Jan 28 |
Cash A/c |
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(Dr) |
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225 |
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To Rao A/c(cash paid to Rao) |
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225 |
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Jan 31 |
Land lord A/c |
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(Dr) |
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4500 |
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To Cash A/c ( rent paid ) |
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4500 |
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Balance
Sheet |
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Transaction |
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Books
of original entry |
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Cash
book |
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Trade or profit |
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Journal |
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Purchase
book |
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And |
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Sales book |
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Loss account |
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Purchase
returns book |
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Sales
returns book |
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Bill receivable book |
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Trial balance |
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Ledger |
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Bills
payable book |
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Ledger:
Ledger is
a principle book that contains all the accounts to which the transactions
recorded in the books of original entry (journal) are transferred. it is called
as the “book of final entry”, as it is the destination into which all the
transactions taken place in a business are recorded. Event it is considered as
a permanent record and is more frequently referred. A ledger is kept in the
form of found books or CDs, DVDs.
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Format: |
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(Dr) |
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(Cr) |
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Date |
Particulars |
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L.F |
Amount |
Date |
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Particulars |
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L.F |
Amount |
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Date |
Transactions |
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Rupees |
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Mar 1 |
Goods sold for cash |
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2600 |
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Mar 2 |
Goods purchases for cash |
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200 |
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Mar 3 |
Purchase of goods from Kumar |
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3000 |
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Mar 4 |
Sales of goods to manikyam |
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4000 |
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Mar 5 |
Cash received from manikyam |
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2500 |
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Mar 7 |
Cash payed to kumar |
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2700 |
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Mar 8 |
Furniture purchased for cash |
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300 |
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Date |
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Particulars |
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L.F |
Debit Rs. |
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Credit Rs. |
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Date |
Particulars |
LF |
Amount |
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Date |
Particulars |
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LF |
Amount |
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12
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No |
in Rs. |
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No |
in Rs. |
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Mar 2 |
To Cash A/c |
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200 |
Mar 31 |
By balance C/d |
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3200 |
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Mar 3 |
To Kumar A/c |
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3000 |
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3200 |
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To balance B/d |
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3200 |
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(Dr) |
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Sales
A/C |
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(Cr) |
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Date |
Particulars |
LF |
Amount |
Date |
Particulars |
LF |
Amount |
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No |
in Rs. |
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No |
in Rs. |
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Mar 31 |
To balance C/d |
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6600 |
Mar 1 |
By cash |
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2600 |
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Mar 4 |
By Manikyam |
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4000 |
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6600 |
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By balance B/d |
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6600 |
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(Dr) |
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Kumar
A/C |
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(Cr) |
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Date |
Particulars |
LF |
Amount |
Date |
Particulars |
LF No |
Amount |
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No |
in Rs. |
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in Rs. |
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Mar 7 |
To cash |
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2700 |
Mar 3 |
By purchase |
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3000 |
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Mar 31 |
To balance C/d |
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300 |
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3000 |
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3000 |
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By balance B/d |
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300 |
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Manikyam
A/C
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Date |
Particulars |
LF |
Amount |
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Date |
Particulars |
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LF No |
Amount |
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No |
in Rs. |
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in Rs. |
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Mar 4 |
To sales |
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4000 |
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Mar 5 |
By cash |
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2500 |
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By balance C/d |
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1500 |
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1500 |
4000 |
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||||||||||||||
Furniture
A/C
|
Date |
Particulars |
LF |
Amount |
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Date |
Particulars |
LF No |
Amount |
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No |
in Rs. |
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|
in Rs. |
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Mar 8 |
To cash |
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300 |
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Mar 31 |
By balance C/d |
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300 |
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To balance B/d |
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300 |
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300 |
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TYPES
OF SUBSIDIARY BOOKS:
-- Subsidiary books are divided into eight types. They are,
1. Purchases Book
2. Sales Book
3. Purchase Returns Book
4. Sales Returns Book
5. Cash Book
6. Bills Receivable Book
7. Bills Payable Book
8. Journal proper
1. PURCHASES BOOK:
- This book records all credit purchases only. Purchase of goods for cash and purchase of assets for cash. Credit
will not be recorded in this book. Purchases book is otherwise called Purchases
Day Book, Purchases Journal or Purchases Register.
2. SALES BOOK :-This
book is used to record credit sales only. Goods are sold for cash and sale of
assets for cash or credit will not
be recorded in this book. This book is otherwise called Sales Day Book, Sales
Journal or Sales Register.
3. PURCHASE RETURNS BOOK: - This book is used to record the
particulars of goods returned to the supplier’s
.This book is otherwise called Returns Outward Book.
4.
SALES RETURNS BOOK:
- This book is used to record the particulars of goods
returned by the customers. This book
is otherwise called Returns Inward Book.
5.
CASH BOOK:
- All cash transactions, receipts
and payments are recorded in this book. Cash includes cheques, money orders etc.
6.
BILLS REECEIVABLE BOOK: - This book is used to record all
the bills and promissory notes arereceived from the customers.
7.
BILLS PAYABLE BOOK: - This book is used to record all
the bills or promissory notes accepted to the suppliers.
8.
JOURNAL PROPER :- This is used to record all the transactions that cannot
be recorded in any of the above
mentioned subsidiary books.
FORMAT
FOR PURCHASE BOOK
|
Date |
Name of supplier |
Invoice |
Lf no |
Details |
Amount(Rs.) |
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No |
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FORMAT FOR SALES BOOK |
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Date |
Name of customer |
Invoice |
Lf no |
Details |
Amount(Rs.) |
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No |
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|||||
FORMAT
FOR PURCHASE RETURNS BOOK
|
Date |
Name of supplier |
Debit |
Lf no |
Details |
Amount(Rs.) |
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|
note |
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No |
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FORMAT
FOR SALES RETURNS BOOK
|
Date |
Name of supplier |
Credit |
Lf no |
Details |
Amount(Rs.) |
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|
note |
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No |
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Trail Balance |
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||
|
Specimen of trial balance |
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1 |
|
Capital |
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Credit |
Loan |
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2 |
|
Opening stock |
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|
Debit |
Asset |
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3 |
|
Purchases |
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|
Debit |
Expense |
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4 |
|
Sales |
|
|
Credit |
Gain |
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5 |
|
Returns inwards |
|
|
Debit |
Loss |
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6 |
|
Returns outwards |
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|
Debit |
Gain |
|
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7 |
|
Wages |
|
|
Debit |
Expense |
|
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|
8 |
|
Freight |
|
|
Debit |
Expense |
|
|
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|
9 |
|
Transport expenses |
|
|
Debit |
Expense |
|
|
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|
10 |
|
Royalties on production |
|
Debit |
Expense |
|
|
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|
11 |
Gas, fuel |
|
Debit |
Expense |
|
|
|
|
|
12 |
Discount received |
|
Credit |
Revenue |
|
|
|
|
13 |
Discount allowed |
|
Debit |
Loss |
|
|
|
|
14 |
Bas debts |
|
Debit |
Loss |
|
|
|
|
15 |
Dab debts reserve |
|
Credit |
Gain |
|
|
|
|
16 |
Commission received |
|
Credit |
Revenue |
|
|
|
|
17 |
Repairs |
|
Debit |
Expense |
|
|
|
|
18 |
Rent |
|
Debit |
Expense |
|
|
|
|
19 |
Salaries |
|
Debit |
Expense |
|
|
|
|
20 |
Loan Taken |
|
Credit |
Loan |
|
|
|
|
21 |
Interest received |
|
Credit |
Revenue |
|
|
|
|
22 |
Interest paid |
|
Debit |
Expense |
|
|
|
|
23 |
Insurance |
|
Debit |
Expense |
|
|
|
|
24 |
Carriage outwards |
|
Debit |
Expense |
|
|
|
|
25 |
Advertisements |
|
Debit |
Expense |
|
|
|
|
26 |
Petty expenses |
|
Debit |
Expense |
|
|
|
|
27 |
Trade expenses |
|
Debit |
Expense |
|
|
|
|
28 |
Petty receipts |
|
Credit |
Revenue |
|
|
|
|
29 |
Income tax |
|
Debit |
Drawings |
|
|
|
|
30 |
Office expenses |
|
Debit |
Expense |
|
|
|
|
31 |
Customs duty |
|
Debit |
Expense |
|
|
|
|
32 |
Sales tax |
|
Debit |
Expense |
|
|
|
|
33 |
Provision for discount on debtors |
Debit |
Liability |
|
|
|
|
|
34 |
Provision for discount on
creditors |
Debit |
Asset |
|
|
|
|
|
35 |
Debtors |
|
Debit |
Asset |
|
|
|
|
36 |
Creditors |
|
Credit |
Liability |
|
|
|
|
37 |
Goodwill |
|
Debit |
Asset |
|
|
|
|
38 |
Plant, machinery |
|
Debit |
Asset |
|
|
|
|
39 |
Land, buildings |
|
Debit |
Asset |
|
|
|
|
40 |
Furniture, fittings |
|
Debit |
Asset |
|
|
|
|
41 |
Investments |
|
Debit |
Asset |
|
|
|
|
42 |
Cash in hand |
|
Debit |
Asset |
|
|
|
|
43 |
Cash at bank |
|
Debit |
Asset |
|
|
|
|
44 |
Reserve fund |
|
Credit |
Liability |
|
|
|
|
45 |
Loan advances |
|
Debit |
Asset |
|
|
|
|
46 |
Horse, carts |
|
Debit |
Asset |
|
|
|
|
47 |
Excise duty |
|
Debit |
Expense |
|
|
|
|
48 |
General reserve |
|
Credit |
Liability |
|
|
|
|
49 |
Provision for depreciation |
Credit |
Liability |
|
|
|
|
|
|
|
|
|
|
|
|
|
Bills receivable |
Debit |
Asset |
|
|
51 |
Bills payable |
Credit |
Liability |
|
52 |
Depreciation |
Debit |
Loss |
|
53 |
Bank overdraft |
Credit |
Liability |
|
54 |
Outstanding salaries |
Credit |
Liability |
|
55 |
Prepaid insurance |
Debit |
Asset |
|
56 |
Bad debt reserve |
Credit |
Revenue |
|
57 |
Patents & Trademarks |
Debit |
Asset |
|
58 |
Motor vehicle |
Debit |
Asset |
|
59 |
Outstanding rent |
Credit |
Revenue |
EX:
1 UNDER THE FOLLOWING TRANSACTIONS PREPARE TRIAL BALANCE
|
Electricity - 14,000 |
Land – 1,40,000 |
Interest paid - 16,000 |
|
|||||||
|
Wages – 50,000 |
Opening stock – 20,000 |
Rent – 24,000 |
|
|||||||
|
Purchases – 3,00,000 |
Office expenses – 30,000 |
Building – 4,00,000 |
|
|||||||
|
Salaries – 90,000 |
Power and water – 65,000 |
Debtors – 60,000 |
|
|||||||
|
Commission received – 15,000 |
Discount received – 7000 |
Sales – 8,00,000 |
|
|||||||
|
Capital – 3,00,000 |
Bills payable – 17,000 |
Creditors – 70,000 |
|
|||||||
|
|
Trial balance |
|
|
|
|
|
|
|||
|
|
|
|
|
|
|
|
|
|||
|
|
Transaction |
|
Debit |
|
credit |
|
|
|||
|
Electricity |
|
14000 |
|
|
|
|
||||
|
Land |
|
140000 |
|
|
|
|
||||
|
Interest paid |
|
16000 |
|
|
|
|
||||
|
Wages |
|
50000 |
|
|
|
|
||||
|
Opening stock |
|
20000 |
|
|
|
|
||||
|
Rent |
|
24000 |
|
|
|
|
||||
|
Purchase |
|
300000 |
|
|
|
|
||||
|
Office expenses |
|
30000 |
|
|
|
|
||||
|
Buildings |
|
400000 |
|
|
|
|
||||
|
Salaries |
|
90000 |
|
|
|
|
||||
|
Power and water |
|
65000 |
|
|
|
|
||||
|
Debitors |
|
60000 |
|
|
|
|
||||
|
|
|
|
|
|
|
|
|
|||
|
|
|
|
|
|
|
|||||
|
|
15000 |
|
|
Discount received |
|
7000 |
|
Sales |
|
800000 |
|
Creditors |
|
70000 |
|
Capital |
|
300000 |
|
Bills payable |
|
17000 |
|
|
12,09,000 |
12,09,000 |
EX:
2 UNDER THE FOLLOWING TRANSACTIONS PREPARE TRIAL BALANCE
|
Fixtures – 3000 |
Machinery – 8000 |
Stock - 4000 |
|
Over draft – 1000 |
Purchases – 8000 |
Wages – 2000 |
|
Interest allowed – 40 |
Creditors - 3000 |
Debitors – 4000 |
|
Sales returns – 300 |
Rent and taxes – 500 |
Drawings – 500 |
|
Salaries – 1000 |
Bad debts – 300 |
Sales – 27200 |
|
Discount allowed – 60 |
Capital – 10,000 |
Carriage – 900 |
|
Purchase returns – 400 |
Commission – 600 |
Carriage
outward - 200 |
FINAL
ACCOUNTS
In
every business, the business man is interested in knowing whether the business
has resulted in profit or loss and what the financial position of the business
is at a given time. In brief, he wants to know (i)The profitability of the
business and (ii) The soundness of the business.
The
trader can ascertain this by preparing the final accounts. The final accounts
are prepared from the trial balance. Hence the trial balance is said to be the
link between the ledger accounts and the final accounts. The final accounts of
a firm can be divided into two stages. The first stage is preparing the trading
and profit and loss account and the second stage is preparing the balance sheet.
TRADING
ACCOUNT
The
first step in the preparation of final account is the preparation of trading
account. The main purpose of preparing the trading account is to ascertain
gross profit or gross loss as a result of buying and selling the goods.
Trading account of MR……………………. for
the year ended ……………………
|
Particulars |
Amount |
Particulars |
Amount |
|
|
|
|
|
|
Xxxx |
By sales xxxx |
|
||
|
To purchases |
xxxx |
|
Less: returns xxx |
Xxxx |
|
Less: returns |
xx |
Xxxx |
By closing stock |
Xxxx |
|
To carriage inwards |
Xxxx |
|
|
|
|
To wages |
|
Xxxx |
|
|
|
To freight |
|
Xxxx |
|
|
|
To customs duty |
Xxxx |
|
|
|
|
To gas, fuel, coal, |
|
|
|
|
|
Water |
|
Xxxx |
|
|
|
To factory expenses |
xxxx |
|
|
|
|
To manufacturing expenses |
Xxxx |
|
|
|
|
To other man. Expenses |
Xxxx |
|
|
|
|
To productive expenses |
xxxx |
|
|
|
|
To gross profit c/d |
Xxxx |
|
|
|
|
|
|
Xxxx |
|
|
|
|
|
|
|
|
|
|
|
|
|
xxxx |
|
|
|
Xxxx |
|
|
|
|
|
|
|
|
Prepare the trading account on December 31 2009 the
following information was available from the books of Krishna.
|
1. |
Stock |
20,000 |
|
|
|
|
|
|
2. |
Sales |
1,
90,000 |
|
|
|
|
|
|
3. |
Carriage
inwards |
5000 |
|
|
|
|
|
|
4 |
Wages |
25000 |
|
|
|
|
|
|
5. |
Purchase
returns |
20,000 |
|
|
|
|
|
|
6. |
Sales
returns |
10,000 |
|
|
|
|
|
|
(Dr) |
|
|
Trading Account |
(Cr) |
|||
|
|
|
|
|
|
|
|
|
|
Particulars |
|
Amount |
|
Particulars |
Amount |
|
|
|
|
|
|
|
|
|
|
|
|
To opening stock |
|
20000 |
|
By sales |
1,90,000 |
|
|
To purchases |
180000 |
|
|
(-) |
10,000 |
1,80,000 |
|
(-) |
20,000 |
160000 |
|
|
|
|
|
To carriage inwards |
5000 |
|
By closing stock |
60,000 |
||
|
To wages |
|
25000 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2,10,000 |
|
|
|
|
|
To gross profit C/d |
|
30,000 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2,40,000 |
|
|
|
2,40,000 |
Prepare the trading account on December 31 2009 the
following information was available from the books of Raju.
|
Capital |
24,500 |
drawings |
|
|
2000 |
General expenses |
2500 |
|
||
|
Buildings |
11,000 |
Machinery |
|
|
9340 |
opening stock |
16,250 |
|
||
|
Power |
2240 |
taxes and insurance |
1315 |
Wages |
7200 |
|
||||
|
Debitors |
6280 |
Creditors |
|
|
2500 |
charity |
105 |
|
||
|
Bad debts |
550 |
loan |
|
|
7780 |
sales |
65360 |
|
||
|
Purchases |
47,000 |
scooter |
|
|
2000 |
bad debts provision |
900 |
|
||
|
Commission |
1320 |
scooter expenses |
1800 |
bills payable |
3850 |
|
||||
|
Cash |
80 |
bank overdraft |
3300 |
closing stock |
23,500 |
|
||||
|
|
(Dr) |
|
TRADING
ACCOUNT |
(Cr) |
|
|||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Particulars |
|
Amount |
|
Particulars |
|
|
Amount |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
To opening stock |
|
16,200 |
|
By sales |
|
|
65360 |
|
|
|
|
To Purchase |
|
47,000 |
|
By closing stock |
|
23500 |
|
||
|
|
To wages |
|
7,200 |
|
|
|
|
|
|
|
|
|
To power |
|
2,240 |
|
|
|
|
|
|
|
|
|
|
|
72640 |
|
|
|
|
|
|
|
|
|
|
|
16220 |
|
|
|
|
|
88860 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
88860 |
|
|
|
|
|
|
|
|
PROFIT AND LOSS ACCOUNT |
|
|
|
|
|
|
|
|
||
|
|
|
|
|
|
|
|
||||
The
business man is always interested in knowing his net income or net profit.Net
profit represents the excess of gross profit plus the other revenue incomes
over administrative, sales, Financial and other expenses. The debit side of
profit and loss account shows the expenses and the credit side the incomes. If the
total of the credit side is more, it will be the net profit. And if the debit
side is more, it will be net loss.
PROFIT
AND LOSS A/C OF MR…………………….FOR THE YEAR ENDED…………
|
PARTICULARS |
AMOUNT |
PARTICULARS |
AMOUNT |
|
TO office salaries |
Xxxxxx |
By gross profit b/d |
Xxxxx |
|
TO rent,rates,taxes |
Xxxxx |
Interest received |
Xxxxx |
|
TO Printing and stationery |
Xxxxx |
Discount received |
Xxxx |
|
TO Legal charges |
|
Commission received |
Xxxxx |
|
Audit fee |
Xxxx |
Income from investments |
|
|
TO Insurance |
Xxxx |
Dividend on shares |
|
|
TO General expenses |
Xxxx |
Miscellaneous |
Xxxx |
|
TO Advertisements |
Xxxxx |
investments |
Xxxx |
|
TO Bad debts |
Xxxx |
Rent received |
|
|
TO Carriage outwards |
Xxxx |
|
xxxx |
|
TO Repairs |
Xxxx |
|
|
|
TO Depreciation |
Xxxxx |
|
|
|
TO interest paid |
Xxxxx |
|
|
|
TO Interest on capital |
Xxxxx |
|
|
|
TO Interest on loans |
Xxxx |
|
|
|
TO Discount allowed |
Xxxxx |
|
|
|
TO Commission |
Xxxxx |
|
|
|
TO Net profit------- |
Xxxxx |
|
|
|
(transferred to capital a/c) |
|
|
|
|
|
xxxxxx |
|
Xxxxxx |
|
|
|
|
|
FROM
THE TRIAL BALANCE PREPARE THE TRADING AND PROFIT AND LOSS ACCOUNT
|
|
Transaction |
|
Debit |
credit |
|
|
|
|
|
|
|
|
|
Rams capital |
|
|
29000 |
|
|
|
Rams drawing |
|
760 |
|
|
|
|
Purchase |
|
8900 |
|
|
|
|
Sales |
|
|
15000 |
|
|
|
Sales returns |
|
280 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
450 |
|
|
Opening stock |
1200 |
|
|
Wages |
800 |
|
|
Building |
22000 |
|
|
Freight and carrying inward |
2000 |
|
|
Trade expenses |
200 |
|
|
Advertisement |
240 |
|
|
Interest |
|
350 |
|
Taxes & insurance |
130 |
|
|
Debtors |
6500 |
|
|
Creditors |
|
1200 |
|
Bills receivable |
|
1500 |
|
Bills payable |
700 |
|
|
Cash at bank |
1200 |
|
|
Cash in hand |
190 |
|
|
salaries |
800 |
|
|
|
|
|
|
|
46,700 |
46,700 |
|
|
|
|
|
Adjustments stock on 31 March
2010Rs. 1500 |
|
|
|
|
|
|
|||||||
|
(Dr) |
|
|
|
|
TRADING
ACCOUNT |
|
|
(Cr) |
|
||||
|
|
|
|
|
|
|
|
|
|
|
|
|
||
|
|
PARTICULARS |
|
|
|
AMOUNT |
|
PARTICULARS |
AMOUNT |
|
||||
|
|
To purchase |
8900 |
|
|
|
|
|
|
By sales |
15000 |
|
|
|
|
|
|
(-) 450 |
|
|
8450 |
|
|
|
(-) 280 |
|
14720 |
|
|
|
|
To wages |
|
|
|
800 |
|
|
|
|
|
|
|
|
|
|
To freight and carriage |
|
|
2000 |
|
|
By closing stock |
1500 |
|
||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
12450 |
|
|
|
|
|
|
|
|
|
|
To gross profit C/d |
|
|
|
3770 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
16220 |
|
|
|
|
|
16220 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dr) |
|
PROFIT
AND LOSS ACCOUNT |
|
|
(Cr) |
|
|||||||
|
|
|
|
|
|
|
|
|
|
|
|
|||
|
|
|
||||||||||||
|
AMOUNT |
PARTICULARS |
AMOUNT |
|||||
|
To trade expenses |
200 |
|
By gross profit b/d |
3770 |
|
||
|
To advertisement |
240 |
|
By interest |
350 |
|
||
|
To taxes and insurance |
130 |
|
|
|
|
|
|
|
To salaries |
800 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
1370 |
|
|
|
|
|
|
To net profit C/d |
2750 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
4120 |
|
|
|
4120 |
|
BALANCE SHEET
The second point of final accounts
is the preparation of balance sheet. It is prepared often in the trading and
profit, loss accounts have been compiled and closed. A balance sheet may be
considered as a statement of the financial position of the concern at a given
date.
DEFINITION: A balance sheet is an item wise list
of assets, liabilities and proprietorship of a business at a certain state.
J.R.botliboi: A balance sheet is a statement with
a view to measure exact financial position of a business at a particular date.
Thus, Balance sheet is defined as a
statement which sets out the assets and liabilities of a business firm and
which serves to as certain the financial position of the same on any particular
date. On the left-hand side of this statement, the liabilities and the capital
are shown. On the right-hand side all the assets are shown. Therefore, the two
sides of the balance sheet should be equal. Otherwise, there is an error
somewhere.
|
|
BALANCE
SHEET OF ………………………… AS ON ……………………………………. |
|
|||||
|
|
Liabilities
and capital |
Amount |
|
Assets |
Amount |
|
|
|
|
|
|
|
|
|
|
|
|
|
Creditors |
Xxxx |
|
Cash in hand |
Xxxx |
|
|
|
|
Bills payable |
Xxxx |
|
Cash at bank |
Xxxx |
|
|
|
|
Bank overdraft |
Xxxx |
|
Bills receivable |
Xxxx |
|
|
|
|
Loans |
Xxxx |
|
Debtors |
Xxxx |
|
|
|
|
Mortgage |
Xxxx |
|
Closing stock |
Xxxx |
|
|
|
|
Reserve fund |
Xxxx |
|
Investments |
Xxxx |
|
|
|
|
Capital xxxxxx |
|
|
Furniture and fittings |
Xxxx |
|
|
|
|
Add: |
|
|
Plats & machinery |
|
|
|
|
|
Net Profit xxxx |
|
|
Land & buildings |
Xxxx |
|
|
|
|
------- |
|
|
Patents, tm ,copyrights |
Xxxx |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||
|
|
Goodwill |
Xxxx |
|
|||
|
-------- |
|
Prepaid expenses |
|
|
||
|
|
|
Outstanding incomes |
Xxxx |
|
||
|
Less: |
|
|
Xxxx |
|
||
|
Drawings xxxx |
Xxxx |
|
Xxxx |
|
||
|
--------- |
|
|
|
|
||
|
XXXX |
XXXX |
From
the following information from Krishna traders prepare the final accounts
|
Transaction |
Debit |
credit |
|
3,80,000 |
|
|
|
Carriage and freight |
90,000 |
|
|
Rent, rate and taxes |
46,000 |
|
|
Printing and stationary |
54,000 |
|
|
Trade expenses |
1,10,000 |
|
|
Postage and telegraphs |
80,000 |
|
|
Salaries and wages |
4,20,000 |
|
|
Cash in hand |
75,000 |
|
|
Cash at bank |
2,25,000 |
|
|
Capital |
|
2,80,000 |
|
Creditors |
|
4,50,000 |
|
Returns |
|
20,000 |
|
Rent received |
|
2,80,000 |
|
Fees and commission |
|
2,20,000 |
|
Other income |
|
70,000 |
|
Sales |
|
18,00,000 |
|
|
31,20,000 |
31,20,000 |
|
Adjustments: |
|
|
|
Stock on 312/12/2009 5, 80, 00 |
|
|
|
Depreciation 20% on furniture 10 %
on plant and machinery |
|
|
|
Outstanding salaries and wages
90,000 |
|
|
|
Fee and commission were prepaid
50,000 |
|
|
|
(Dr) |
TRADING
ACCOUNT |
|
(Cr) |
||||||||||||||||||||
|
|
|
|
|
|
|
||||||||||||||||||
|
|
PARTICULARS |
AMOUNT |
PARTICULARS |
AMOUNT |
|
||||||||||||||||||
|
|
|
|
|
|
|
|
|||||||||||||||||
|
|
|
|
|||||||||||||||||||||
|
|
|
|
|
|
|
|
|||||||||||||||||
|
To purchase |
6,70,000 |
|
|
|
|
|
By sales |
18,00,000 |
|
|
|
|
|
|
|
|
||||||||
|
|
|
(-) 20,000 |
|
6,50,000 |
(-) |
50,000 |
|
17,50,000 |
|
|
|
|
||||||||||||
|
|
To opening stock |
|
|
2,30,000 |
|
|
|
|
|
|
|
|
|
|
|
|
||||||||
|
|
To carriage and freight |
|
90,000 |
|
|
By closing stock |
5,80,000 |
|
|
|
|
|||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||
|
|
|
|
|
9,70,000 |
|
|
|
|
|
|
|
|
|
|
|
|
||||||||
|
|
To gross profit C/d |
|
13,60,000 |
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
||||||||
|
|
|
|
|
23,30,000 |
|
|
|
|
|
23,30,000 |
|
|
|
|
||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||
|
(Dr) |
|
PROFIT
AND LOSS ACCOUNT |
|
|
|
|
(Cr) |
|
||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||
|
|
PARTICULARS |
|
|
|
AMOUNT |
|
|
PARTICULARS |
|
|
AMOUNT |
|
|
|||||||||||
|
|
To rent, rate and taxes |
|
|
46,000 |
|
|
By gross profit B/d |
|
|
13,60,000 |
|
|
|
|
||||||||||
|
|
To printing and stationary |
|
|
54,000 |
|
|
|
|
|
|
|
|
|
|
|
|
||||||||
|
|
To trade
expenses |
|
|
|
1,10,000 |
|
|
By rent received |
|
|
2,80,000 |
|
|
|
|
|||||||||
|
|
To postage and telegraph |
|
|
80,000 |
|
|
By fees and commission |
|
|
1,70,000 |
|
|
|
|
||||||||||
|
|
To wages and salaries |
|
|
5,10,000 |
|
|
2,20,000
– 50,000 |
|
|
|
|
|
|
|
||||||||||
|
|
(4,20,000 + 90,000) |
|
|
|
|
By other income |
|
|
70,000 |
|
|
|
|
|||||||||||
|
|
To depreciation on furniture |
|
|
34,000 |
|
|
|
|
|
|
|
|
|
|
|
|
||||||||
|
|
1,70,000 * 0.2 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
||||||||
|
|
To
depreciation |
on plant |
and |
|
52,000 |
|
|
|
|
|
|
|
|
|
|
|
|
|||||||
|
|
machinery |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||
|
|
5,20,000 * 0.1 |
|
|
8,86,00 |
|
|
|
|
|
|
|
|
|
|
|
|
||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
||||||||
|
|
|
|
|
|
9,94,00 |
|
|
|
|
|
|
|
|
|
|
|
|
|||||||
|
|
|
|
|
|
18,80,00 |
|
|
|
|
|
|
|
18,80,00 |
|
|
|
|
|||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||
|
|
BALANCE
SHEET FOR KRISHNA TRADERS |
|
|
||
|
|
|
|
|
|
|
|
|
LIABILITIES |
AMOUNT |
ASSETS |
AMOUNT |
|
|
|
|
|
|
|
|
|
|
|
||||
|
|
|
plant and machinery |
|
|||
|
Capital |
2,80,000 |
|
|
5,20,000 |
|
|
|
|
(+)
9,94,000 |
12,74,000 |
|
(-) |
52,000 |
4,68,000 |
|
Creditors |
|
4,50,000 |
Furniture |
|
|
|
|
Outstanding salaries |
90,000 |
|
1,70,000 |
|
||
|
Fees and commission |
50,000 |
|
(-) |
34,000 |
1,36,000 |
|
|
|
|
|
Debtors |
|
|
3,80,000 |
|
|
|
|
Cash at bank |
|
|
2,25,000 |
|
|
|
|
Cash in hand |
|
|
75,000 |
|
|
|
|
Closing stock |
|
5,80,000 |
|
|
|
|
|
|
|
|
|
|
|
|
18,64,000 |
|
|
|
18,64,000 |
|
|
|
|
|
|
|
|
UNIT-
V
CAPITAL AND CAPITAL
BUDGETING
INTRODUCTION
Finance
is the prerequisite to commence and vary on business. It is rightly said to be
the lifeblood of the business. No growth and expansion of business can take
place without sufficient finance. It shows that no business activity is
possible without finance. This is why; every business has to make plans
regarding acquisition and utilization of funds.
However efficient a firm may be in
terms of production as well as marketing if it ignores the proper management of
flow of funds it certainly lands in financial crunch and the very survival of
the firm would be at a stake.
FUNCTION
OF FINANCE
According
to B. O. Wheeler, Financial Management is concerned with the acquisition and
utiliasation of capital funds in meeting the financial needs and overall
objectives of a business enterprise. Thus the primary function of finance is to
acquire capital funds and put them for proper utilization, with which the
firm’s objectives are fulfilled. The firm should be able to procure sufficient
funds on reasonable terms and conditions and should exercise proper control in
applying them in order to earn a good rate of return, which in turn allows the
firm to reward the sources of funds reasonably, and leaves the firm with good
surplus to grow further. These activities viz. financing, investing and dividend
payment are not sequential they are performed simultaneously and continuously.
Thus, the Financial Management can be broken down in to three major decisions
or functions of finance. They are: (i) the investment decision, (ii) the
financing decision and (iii) the dividend policy decision.
INVESTMENT
DECISION
The
investment decision relates to the selection of assets in which funds will be
invested by a firm. The assets as per their duration of benefits, can be
categorized into two groups: (i) long-term assets which yield a return over a
period of time in future (ii) short-term or current assents which in the normal
course of business are convertible into cash usually with in a year.
Accordingly, the asset selection decision of a firm is of two types. The
investment in long-term assets is popularly known as capital budgeting and in
short-term assets, working capital management.
CAPITAL BUDGETING: Capital budgeting – the long –
term investment decision – is probably the
most crucial financial decision of a firm. It relates to the selection of
an assent or investment proposal or course of action that benefits are likely
to be available in future over the lifetime of the project.
The long-term investment may relate
to acquisition of new asset or replacement of old assets. Whether an asset will
be accepted or not will depend upon the relative benefits and returns
associated with it. The measurement of the worth of the investment proposals
is, therefore, a major element in the capital budgeting exercise. The second
element of the capital budgeting decision is the analysis of risk and
uncertainty as the benefits from the investment proposals pertain the future,
which is uncertain. They have to be estimated under various assumptions and
thus there is an element of risk involved in the exercise. The return from the
capital budgeting decision should, therefore, be evaluated in relation to the
risk associated with it.
The third and final element is the
ascertainment of a certain norm or standard against which the benefits are to
be judged. The norm is known by different names such as cut-off rate, hurdle
rate, required rate, minimum rate of return and so on. This standard is broadly
expressed in terms of the cost of capital is, thus, another major aspect of the
capital; budgeting decision. In brief, the main elements of the capital
budgeting decision are: (i) The total assets and their composition (ii) The
business risk complexion of the firm, and (iii) concept and measurement of the
cost of capital.
Working Capital Management: Working capital management is
concerned with the management of the
current assets. As we know, the short-term survival is a pre-requisite to
long-term success. The major thrust of working capital management is the
trade-off between profitability and risk (liquidity), which are inversely
related to each other. If a firm does not have adequate working capital it may
not have the ability to meet its current obligations and thus invite the risk
of bankrupt. One the other hand if the current assets are too large the firm
will be loosing the opportunity of making a good return and thus may not serve
the requirements of suppliers of funds. Thus, the profitability and liquidity
are the two major dimensions of working capital management. In addition, the
individual current assets should be efficiently managed so that neither
inadequate nor unnecessary funds are locked up.
WORKING
CAPITAL ANALYSIS
Finance is required for two purpose
viz. for it establishment and to carry out the day-to-day operations of a
business. Funds are required to purchase the fixed assets such as plant,
machinery, land, building, furniture, etc, on long-term basis. Investments in
these assets represent that part of firm’s capital, which
is
blocked on a permanent of fixed basis and is called fixed capital. Funds are
also needed for short-term purposes such as the purchase of raw materials,
payment of wages and other day-to-day expenses, etc. and these funds are known
as working capital. In simple words working capital refers that part of the firm’s
capital, which is required for financing short term or current assets such as
cash, marketable securities, debtors and inventories. The investment in these
current assets keeps revolving and being constantly converted into cash and
which in turn financed to acquire current assets. Thus the working capital is
also known as revolving or circulating capital or short-term capital.
CONCEPT
OF WORKING CAPITAL
There
are two concepts of working capital:
Gross
working capital
Net
working capital
Gross
working capital:
In
the broader sense, the term working capital refers to the gross working
capital. The notion of the gross working capital refers to the capital invested
in total current assets of the enterprise. Current assets are those assets,
which in the ordinary course of business, can be converted into cash within a
short period, normally one accounting year.
Examples of current assets:
3. Cash in hand and bank balance
4. Bills receivables or Accounts
Receivables
5. Sundry Debtors (less provision for
bad debts)
6. Short-term loans and advances.
7. Inventories of stocks, such as:
Raw
materials
Work
– in process
Stores
and spares
Finished
goods
8. Temporary Investments of surplus
funds.
9. Prepaid Expenses
10. Accrued Incomes etc.
Net
working capital:
In a narrow sense, the term working
capital refers to the net working capital. Networking capital represents the
excess of current assets over current liabilities.
Current
liabilities are those liabilities, which are intend to be paid in the ordinary
course of business within a short period, normally one accounting year out of
the current assets or the income of the business. Net working capital may be
positive or negative. When the current assets exceed the current liabilities
net working capital is positive and the negative net working capital results
when the liabilities are more then the current assets.
Examples
of current liabilities:
4. Bills payable
5. Sundry Creditors or Accounts
Payable.
6. Accrued or Outstanding Expanses.
7. Short term loans, advances and
deposits.
8. Dividends payable
9. Bank overdraft
10. Provision for taxation etc.
CLASSIFICATION
OR KINDS OF WORKING CAPITAL
Working capital may be classified in
two ways:
2. On the basis of concept.
3. On the basis of time permanency
On the basis of concept, working
capital is classified as gross working capital and net working capital is
discussed earlier. This classification is important from the point of view of
the financial manager. On the basis of time, working capital may be classified
as:
2. Permanent or fixed working capital
3. Temporary of variable working
capital
3. Permanent or fixed working capital: There is always a minimum level of
current assets, which is
continuously required by the enterprise to carry out its normal business
operations and this minimum is known as permanent of fixed working capital. For
example, every firm has to maintain a minimum level of raw materials, work in
process; finished goods and cash balance to run the business operations
smoothly and profitably. This minimum level of current assets is permanently
blocked in current assets. As the business grows, the requirement of permanent
working capital also increases due to the increases in current assets. The
permanent working capital can further be classified into regular working
capital and reserve working capital. Regular working capital is the minimum
amount of working capital required to ensure circulation of
current assets from cash to
inventories, from inventories to receivables and from receivable to cash and so
on. Reserve working capital is the excess amount over the requirement for
regular working capital which may be provided for contingencies that may arise
at unstated period such as strikes, rise in prices, depression etc.
4. Temporary or variable working capital: Temporary or variable working
capital is the amount of working
capital, which is required to meet the seasonal demands and some special
exigencies. Thus the variable working capital can be further classified into
seasonal working capital and special working capital. While seasonal working
capital is required to meet certain seasonal demands, the special working
capital is that part of working capital which is required to meet special
exigencies such as launching of extensive marketing campaigns, for conducting
research etc.
Temporary working capital differs
from permanent working capital in the sense that it is required for short
periods and cannot be permanently employed gainfully in the business. Figures
given below illustrate the different between permanent and temporary working
capital.
IMPORTANCE
OF WORKING CAPITAL
Working capital is refereed to be
the lifeblood and nerve center of a business. Working capital is as essential
to maintain the smooth functioning of a business as blood circulation in a
human body. No business can run successfully with out an adequate amount of
working capital. The main advantages of maintaining adequate amount of working
capital are as follows:
1.Solvency of the business: Adequate working capital helps in maintaining
solvency of the business by
providing uninterrupted flow of production.
2.Good will: Sufficient working capital enables
a business concern to make prompt payment
and hence helps in creating and maintaining good will.
3.Easy loans: A concern having adequate working
capital, high solvency and good credit standing
can arrange loans from banks and others on easy and favorable terms.
4.Cash Discounts: Adequate working capital also
enables a concern to avail cash discounts
on the purchases and hence it reduces costs.
5.Regular supply of raw materials: Sufficient working capital ensures
regular supply of raw materials and
continuous production.
6.Regular payments of salaries wages
and other day to day commitments: A company which has ample working capital can make regular payment of
salaries, wages and other day to day commitments which raises the morale of its
employees, increases their efficiency, reduces wastage and cost and enhances
production and profits.
7.Exploitation of favorable market
conditions:
The concerns with adequate working capital
only can exploit favorable market conditions such as purchasing its
requirements in bulk when the prices are lower.
8.Ability to face crisis: Adequate working capital enables a concern to face business
crisis in emergencies.
9.Quick and regular return on
Investments:
Every investor wants a quick and regular
return on his investment. Sufficiency of working capital enables a concern
to pay quick and regular dividends to its investors, as there may not be much
pressure to plough back profits. This gains the confidence of its investors and
creates a favorable market to raise additional funds in the future.
10High morale: Adequacy of working capital creates an environment of
security, confidence, and high
morale and creates overall efficiency in a business. Every business concern
should have adequate working capital to run its business operations. It should
have neither redundant excess working capital nor inadequate shortage of
working capital. Both, excess as well as short working capital positions are
bad for any business. However, out of the two, it is the inadequacy of working
capital which is more dangerous from the point of view of the firm.
The
need or objectives of working capital
The
need for working capital arises mainly due to the time gap between production
and realization of cash. The process of production and sale cannot be done
instantaneously and hence the firm needs to hold the current assets to fill-up
the time gaps. There are time gaps in purchase of raw materials and production;
production and sales: and sales and realization of cash. The working capital is
needed mainly for the following purposes:
1.
For
the purchase of raw materials.
2. To pay wages, salaries and other
day-to-day expenses and overhead cost such as fuel, power and office expenses,
etc.
3.
To
meet the selling expenses such as packing, advertising, etc.
4.
To
provide credit facilities to the customers and
5. To maintain the inventories of raw
materials, work-in-progress, stores and spares and finishes stock etc.
Generally,
the level of working capital needed depends upon the time gap (known as
operating cycle) and the size of operations. Greater the size of the business
unit generally, larger will be the requirements of working capital. The amount
of working capital needed also goes on increasing with the growth and expansion
of business. Similarly, the larger the operating cycle, the larger the
requirement for working capital. There are many other factors, which influence
the need of working capital in a business, and these are discussed below in the
following pages.
Factors
determining the working capital requirements
There
are a large number of factors such as the nature and size of business, the
character of their operations, the length of production cycle, the rate of
stock turnover and the state of economic situation etc. that decode requirement
of working capital. These factors have different importance and influence on
firm differently. In general following factors generally influence the working
capital requirements.
1. Nature or character of business: The working capital requirements
of a firm basically depend upon the
nature of its business. Public utility undertakings like electricity, water
supply and railways need very limited working capital as their sales are on
cash and are engaged in provision of services only. On the other hand, trading
firms require more investment in inventories, receivables and cash and such
they need large amount of working capital. The manufacturing undertakings also
require sizable working capital.
2. Size of business or scale of operations: The working capital requirements
of a concern are directly influenced
by the size of its business, which may be measured in terms of scale of
operations. Greater the size of a business unit, generally, larger will be the
requirements of working capital. However, in some cases, even a smaller concern
may need more working capital due to high overhead charges, inefficient use of
available resources and other economic disadvantages of small size.
3. Production policy: If the demand for a given product
is subject to wide fluctuations due to seasonal
variations, the requirements of working capital, in such cases, depend upon the
production policy. The production could be kept either steady by accumulating
inventories during stack periods with a view to meet high demand during the
peck season or the production could be curtailed during the slack season and
increased during the peak season. If the policy is to keep the production
steady by accumulating inventories it will require higher working capital.
4. Manufacturing process/Length of production cycle: In manufacturing business, the requirements of working capital will
be in direct proportion to the length of manufacturing process. Longer the process
period of manufacture, larger is the amount of working capital required, as the
raw materials and other supplies have to be carried for a longer period.
5. Seasonal variations: If the raw material availability is
seasonal, they have to be bought in bulk
during the season to ensure an uninterrupted material for the production. A
huge amount is, thus, blocked in the form of material, inventories during such
season, which give rise to more working capital requirements. Generally, during
the busy season, a firm requires larger working capital then in the slack
season.
6. Working capital cycle: In a manufacturing concern, the
working capital cycle starts with the purchase
of raw material and ends with the realization of cash from the sale of finished
products. This cycle involves purchase of raw materials and stores, its
conversion into stocks of finished goods through work–in progress with
progressive increment of labour and service costs, conversion of finished stock
into sales, debtors and receivables and ultimately realization of cash. This
cycle continues again from cash to purchase of raw materials and so on. In
general the longer the operating cycle, the larger the requirement of working
capital.
7. Credit policy: The credit policy of a concern in
its dealings with debtors and creditors influences considerably the requirements of working capital. A concern that
purchases its requirements on credit requires lesser amount of working capital
compared to the firm, which buys on cash. On the other hand, a concern allowing
credit to its customers shall need larger amount of working capital compared to
a firm selling only on cash.
8. Business cycles: Business cycle refers to alternate
expansion and contraction in general business activity. In a period of boom, i.e., when the business is
prosperous, there is a need for larger amount of working capital due to
increase in sales. On the contrary, in the times of depression, i.e., when
there is a down swing of the cycle, the business contracts, sales decline,
difficulties are faced in collection from debtors and firms may have to hold
large amount of working capital.
9. Rate of growth of business: The working capital requirements
of a concern increase with the growth
and expansion of its business activities. The retained profits may provide for
a part of working capital but the fast growing concerns need larger amount of
working capital than the amount of undistributed profits.
SOURCE
OF FINANCE
Incase of proprietorship
business, the individual proprietor generally invests his own savings to start
with, and may borrow money on his personal security or the security of his
assets from others. Similarly, the capital of a partnership from consists partly
of funds contributed by the partners and partly of borrowed funds. But the
company from of organization enables the promoters to raise necessary funds
from the public who may contribute capital and become members (share holders)
of the company. In course of its business, the company can raise loans directly
from banks and financial institutions or by issue of securities (debentures) to
the public. Besides, profits earned may also be reinvested instead of being
distributed as dividend to the shareholders.
Thus
for any business enterprise, there are two sources of finance, viz, funds
contributed by owners and funds available from loans and credits. In other
words the financial resources of a business may be own funds and borrowed
funds.
OWNER
FUNDS OR OWNERSHIP CAPITAL:
The
ownership capital is also known as ‘risk capital’ because every business runs
the risk of loss or low profits, and it is the owner who bears this risk. In
the event of low profits they do not have adequate return on their investment.
If losses continue the owners may be unable to recover even their original
investment. However, in times of prosperity and in the case of a flourishing
business the high level of profits earned accrues entirely to the owners of the
business. Thus, after paying interest on loans at a fixed rate, the owners may
enjoy a much higher rate of return on their investment. Owners contribute risk
capital also in the hope that the value of the firm will appreciate as a result
of higher earnings and growth in the size of the firm.
The
second characteristic of this source of finance is that ownership capital
remains permanently invested in the business. It is not refundable like loans
or borrowed capital. Hence a large part of it is generally used for a acquiring
long – lived fixed assets and to finance a part of the working capital which is
permanently required to hold a minimum level of stock of raw materials, a
minimum amount of cash, etc.
Another
characteristic of ownership capital related to the management of business. It
is on the basis of their contribution to equity capital that owners can
exercise their right of control over the management of the firm. Managers
cannot ignore the owners in the conduct of business affairs. The sole
proprietor directly controls his own business. In a partnership firm, the
active partner will take part in the management of business. A company is
managed by directors who are elected by the members (shareholders).
Merits:
Arising out of its characteristics,
the advantages of ownership capital may be briefly stated as follows:
1. It provides risk capital
2. It is a source of permanent capital
3. It is the basis on which owners
‘acquire their right of control over management
4. It does not require security of
assets to be offered to raise ownership capital
Limitations:
There are also certain limitations
of ownership capital as a source of finance. These are:
The
amount of capital, which may be raised as owners fund depends on the number of
persons, prepared to take the risks involved. In a partnership confer, a few
persons cannot provide ownership capital beyond a certain limit and this
limitation is more so in case of proprietary form of organization.
A
joint stock company can raise large amount by issuing shares to the public. Bus
it leads to an increased number of people having ownership interest and right
of control over management. This may reduce the original investors’ power of
control over management.
Source
of Company Finance
Based
upon the time, the financial resources may be classified into (1) sources of
long term (2) sources of short – term finance. Some of these sources also serve
the purpose of medium – term finance.
I.
The source of long – term finance
are:
1. Issue of shares
2. Issue debentures
3. Loan from financial institutions
4. Retained profits and
5. Public deposits
II.
Sources of Short-term Finance are:
1. Trade credit
2. Bank loans and advances and
3. Short-term loans from finance
companies.
Sources
of Long Term Finance
1.Issue of Preference Shares: Preference share have three
distinct characteristics. Preference shareholders
have the right to claim dividend at a fixed rate, which is decided according to
the terms of issue of shares. Moreover, the preference dividend is to be paid
first out of the net profit. The balance, it any, can be distributed among
other shareholders that is, equity shareholders. However, payment of dividend
is not legally compulsory. Only when dividend is declared, preference
shareholders have a prior claim over equity shareholders.
Preference shareholders also have
the preferential right of claiming repayment of capital in the event of winding
up of the company. Preference capital has to be repaid out of assets after
meeting the loan obligations and claims of creditors but before any amount is
repaid to equity shareholders.
Holders of preference shares enjoy
certain privileges, which cannot be claimed by the equity shareholders. That is
why; they cannot directly take part in matters, which may be discussed at the
general meeting of shareholders, or in the election of directors.
Depending upon the terms of
conditions of issue, different types of preference shares may be issued by a company
to raises funds. Preference shares may be issued as:
1. Cumulative or Non-cumulative
2. Participating or Non-participating
3. Redeemable or Non-redeemable, or as
4. Convertible or non-convertible
preference shares.
In the case of cumulative preference
shares, the dividend unpaid if any in previous years gets accumulated until
that is paid. No cumulative preference shares have any such provision.
Participatory shareholders are
entitled to a further share in the surplus profits after a reasonable divided
has been paid to equity shareholders. Non-participating preference shares do
not enjoy such right. Redeemable preference shares are those, which are repaid
after a specified period, where as the irredeemable preference shares are not
repaid. However, the company can also redeem these shares after a specified
period by giving notice as per the terms of issue. Convertible preference shows
are those, which are entitled to be converted into equity shares after a
specified period.
Limitations:
The limitations of preference shares
relates to some of its main features:
1. Dividend paid cannot be charged to
the company’s income as an expense; hence there is no tax saving as in the case
of interest on loans.
2. Even through payment of dividend is
not legally compulsory, if it is not paid or arrears accumulate there is an
adverse effect on the company’s credit.
3. Issue of preference share does not
attract many investors, as the return is generally limited and not exceed the
rates of interest on loan. On the other than, there is a risk of no dividend
being paid in the event of falling income.
1.
Issue of Equity Shares: The most important source of
raising long-term capital for a company is the issue of equity shares. In the case of equity shares there is no
promise to shareholders a fixed dividend. But if the company is successful and
the level profits are high, equity shareholders enjoy very high returns on
their investment. This feature is very attractive to many investors even
through they run the risk of having no return if the profits are inadequate or
there is loss. They have the right of control over the management of the
company and their liability is limited to the value of shares held by them.
From the above it can be said that
equity shares have three distinct characteristics:
1. The holders of equity shares are the
primary risk bearers. It is the issue of equity shares that mainly provides
‘risk capital’, unlike borrowed capital. Even compared with preference capital,
equity shareholders are to bear ultimate risk.
2. Equity shares enable much higher
return sot be earned by shareholders during prosperity because after meeting
the preference dividend and interest on borrowed capital at a fixed rate, the
entire surplus of profit goes to equity shareholders only.
3. Holders of equity shares have the
right of control over the company. Directors are elected on the vote of equity
shareholders.
Merits:
From the company’ point of view;
there are several merits of issuing equity shares to raise long-term finance.
1. It is a source of permanent capital
without any commitment of a fixed return to the shareholders. The return on
capital depends ultimately on the profitability of business.
2. It facilities a higher rate of
return to be earned with the help borrowed funds. This is possible due to two
reasons. Loans carry a relatively lower rate of interest than the average rate
of return on total capital. Secondly, there is tax saving as interest paid can
be charged to income as a expense before tax calculation.
3. Assets are not required to give as
security for raising equity capital. Thus additional funds can be raised as
loan against the security of assets.
Limitations:
Although there are several
advantages of issuing equity shares to raise long-term capital.
1. The risks of fluctuating returns due
to changes in the level of earnings of the company do not attract many people
to subscribe to equity capital.
2. The value of shares in the market
also fluctuate with changes in business conditions, this is another risk, which
many investors want to avoid.
2.
Issue of Debentures:
When
a company decides to raise loans from the public, the amount of loan is
dividend into units of equal. These units are known as debentures. A debenture
is the instrument or certificate issued by a company to acknowledge its debt.
Those who invest money in debentures are known as ‘debenture holders’. They are
creditors of the company. Debentures are therefore called ‘creditor ship’
securities. The value of each debentures is generally fixed in multiplies of 10
like Rs. 100 or Rs. 500, or Rs. 1000.
Debentures carry a fixed rate of
interest, and generally are repayable after a certain period, which is
specified at the time of issue. Depending upon the terms and conditions of
issue there are different types of debentures. There are:
a. Secured or unsecured Debentures and
b. Convertible of Non convertible
Debentures.
It
debentures are issued on the security of all or some specific assets of the
company, they are known as secured debentures. The assets are mortgaged in
favor of the debenture holders. Debentures, which are not secured by a charge
or mortgage of any assets, are called unsecured debentures. The holders of
these debentures are treated as ordinary creditors.
Sometimes under the terms of issue
debenture holders are given an option to covert their debentures into equity
shares after a specified period. Or the terms of issue may lay down that the
whole or part of the debentures will be automatically converted into equity
shares of a specified price after a certain period. Such debentures are known
as convertible debentures. If there is no mention of conversion at the time of
issue, the debentures are regarded as non-convertible debentures.
Merits:
Debentures
issue is a widely used method of raising long-term finance by companies, due to
the following reasons.
1. Interest payable on Debentures can
be fixed at low rates than rate of return on equity shares. Thus Debentures
issue is a cheaper source of finance.
2. Interest paid can be deducted from
income tax purpose; there by the amount of tax payable is reduced.
3. Funds raised for the issue of
debentures may be used in business to earn a much higher rate of return then
the rate of interest. As a result the equity shareholders earn more.
4. Another advantage of debenture issue
is that funds are available from investors who are not entitled to have any
control over the management of the company.
5. Companies often find it convenient
to raise debenture capital from financial institutions, which prefer to invest
in debentures rather than in shares. This is due to the assurance of a fixed
return and repayment after a specified period.
Limitations:
Debenture issue as a source of
finance has certain limitations too.
1. It involves a fixed commitment to
pay interest regularly even when the company has low earnings or incurring
losses.
2. Debentures issue may not be possible
beyond a certain limit due to the inadequacy of assets to be offered as
security.
Methods of Issuing Securities: The firm after deciding the amount
to be raised and the type of securities
to be issued, must adopt suitable methods to offer the securities to potential
investors. There are for common methods followed by companies for the purpose.
When
securities are offered to the general public a document known as Prospectus, or
a notice, circular or advertisement is issued inviting the public to subscribe
to the securities offered thereby all particulars about the company and the
securities offered are made to the public. Brokers are appointed and one or
more banks are authorized to collect subscription.
Some times the entire issue is
subscribed by an organization known as Issue House, which in turn sells the
securities to the public at a suitable time.
The company may negotiate with large
investors of financial institutions who agree to take over the securities. This
is known as ‘Private Placement’ of securities.
When an exiting company decides to
raise funds by issue of equity shares, it is required under law to offer the
new shares to the existing shareholders. This is described as right issue of
equity shares. But if the existing shareholders decline, the new shares can be
offered to the public.
3. Loans from financial Institutions:
Government with the main object of
promoting industrial development has set up a number of financial institutions.
These institutions play an important role as sources of company finance.
Besides they also assist companies to raise funds from other sources.
These
institutions provide medium and long-term finance to industrial enterprises at
a reason able rate of interest. Thus companies may obtain direct loan from the
financial institutions for expansion or modernization of existing manufacturing
units or for starting a new unit.
Often,
the financial institutions subscribe to the industrial debenture issue of
companies some of the institutions (ICICI) and (IDBI) also subscribe to the
share issued by companies.
All such institutions also
underwrite the public issue of shares and debentures by companies. Underwriting
is an agreement to take over the securities to the extent there is no public
response to the issue. They may guarantee loans, which may be raised by
companies from other sources.
Loans
in foreign currency may also be granted for the import of machinery and
equipment wherever necessary from these institutions, which stand guarantee for
re-payments. Apart from the national level institutions mentioned above, there
are a number of similar institutions set up in different states of India. The
state-level financial institutions are known as State Financial Corporation,
State Industrial Development Corporations, State Industrial Investment
Corporation and the like. The objectives of these institutions are similar to
those of the national-level institutions. But they are mainly concerned with
the development of medium and small- scale industrial units. Thus, smaller
companies depend on state level institutions as a source of medium and
long-term finance for the expansion and modernization of their enterprise.
4. Retained Profits:
Successful
companies do not distribute the whole of their profits as dividend to shareholders
but reinvest a part of the profits. The amount of profit reinvested in the
business of a company is known as retained profit. It is shown as reserve in
the accounts. The surplus profits retained and reinvested may be regarded as an
internal source of finance. Hence, this method of financing is known as
self-financing. It is also called sloughing back of profits.
Since profits belong to the
shareholders, the amount of retained profit is treated as ownership fund. It
serves the purpose of medium and long-term finance. The total amount of
ownership capital of a company can be determined by adding the share capital
and accumulated reserves.
Merits:
This source of finance is considered
to be better than other sources for the following reasons.
1. As an internal source, it is more
dependable than external sources. It is not necessary to consider investor’s
preference.
2. Use of retained profit does not
involve any cost to be incurred for raising the funds. Expenses on prospectus,
advertising, etc, can be avoided.
3. There is no fixed commitment to pay
dividend on the profits reinvested. It is a part of risk capital like equity
share capital.
4. Control over the management of the
company remains unaffected, as there is no addition to the number of
shareholder.
5. It does not require the security of
assets, which can be used for raising additional funds in the form of loan.
Limitations:
However, there are certain
limitations on the part of retained profit.
1. Only well established companies can
be avail of this sources of finance. Even for such companies retained profits
cannot be used to an unlimited extent.
2. Accumulation of reserves often
attract competition in the market,
3. With the increased earnings,
shareholders expect a high rate of dividend to be paid.
4. Growth of companies through internal
financing may attract government restrictions as it leads to concentration of
economic power.
5. Public
Deposits:
An important source of medium – term
finance which companies make use of is public deposits. This requires advertisement
to be issued inviting the general public of deposits. This requires
advertisement
to
be issued inviting the general public to deposit their savings with the
company. The period of deposit may extend up to three yeas. The rate of
interest offered is generally higher than the interest on bank deposits.
Against the deposit, the company mentioning the amount, rate of interest, time of
repayment and such other information issues a receipt.
Since the public deposits are
unsecured loans, profitable companies enjoying public confidence only can be
able to attract public deposits. Even for such companies there are rules
prescribed by government limited its use.
SOURCES
OF SHORT TERM FINANCE
The major sources of short-term
finance are discussed below:
1. Trade credit: Trade credit is a common source of
short-term finance available to all companies. It refers to the amount payable to the suppliers of raw materials,
goods etc. after an agreed period, which is generally less than a year. It is
customary for all business firms to allow credit facility to their customers in
trade business. Thus, it is an automatic source of finance. With the increase
in production and corresponding purchases, the amount due to the creditors also
increases. Thereby part of the funds required for increased production is
financed by the creditors. The more important advantages of trade credit as a
source of short-term finance are the following:
It is readily available according to
the prevailing customs. There are no special efforts to be made to avail of it.
Trade credit is a flexible source of finance. It can be easily adjusted to the
changing needs for purchases.
Where there is an open account for
any creditor failure to pay the amounts on time due to temporary difficulties
does not involve any serious consequence Creditors often adjust the time of
payment in view of continued dealings. It is an economical source of finance.
However, the liability on account of
trade credit cannot be neglected. Payment has to be made regularly. If the
company is required to accept a bill of exchange or to issue a promissory note
against the credit, payment must be made on the maturity of the bill or note.
It is a legal commitment and must be honored; otherwise legal action will
follow to recover the dues.
2. Bank loans and advances: Money advanced or granted as loan
by commercial banks is known as bank
credit. Companies generally secure bank credit to meet their current operating
expenses. The most common forms are cash credit and overdraft facilities. Under
the cash credit arrangement the maximum limit of credit is fixed in advance on
the security of goods and materials in stock or against the personal security
of directors. The total amount drawn is not to
exceed the limit fixed. Interest is
charged on the amount actually drawn and outstanding. During the period of
credit, the company can draw, repay and again draw amounts with in the maximum
limit. In the case of overdraft, the company is allowed to overdraw its current
account up to the sanctioned limit. This facility is also allowed either
against personal security or the security of assets. Interest is charged on the
amount actually overdrawn, not on the sanctioned limit.
The advantage of bank credit as a
source of short-term finance is that the amount can be adjusted according to
the changing needs of finance. The rate of interest on bank credit is fairly
high. But the burden is no excessive because it is used for short periods and
is compensated by profitable use of the funds.
Commercial banks also advance money
by discounting bills of exchange. A company having sold goods on credit may
draw bills of exchange on the customers for their acceptance. A bill is an
order in writing requiring the customer to pay the specified amount after a
certain period (say 60 days or 90 days). After acceptance of the bill, the
company can drawn the amount as an advance from many commercial banks on
payment of a discount. The amount of discount, which is equal to the interest
for the period of the bill, and the balance, is available to the company. Bill
discounting is thus another source of short-term finance available from the
commercial banks.
3. Short term loans from finance companies: Short-term funds may be available
from finance companies on the
security of assets. Some finance companies also provide funds according to the
value of bills receivable or amount due from the customers of the borrowing
company, which they take over.
CAPITAL
BUDGETING
Capital Budgeting: Capital budgeting is the process of
making investment decision in long-term assets or courses of action. Capital expenditure incurred today is
expected to bring its benefits over a period of time. These expenditures are
related to the acquisition & improvement of fixes assets.
Capital
budgeting is the planning of expenditure and the benefit, which spread over a
number of years. It is the process of deciding whether or not to invest in a
particular project, as the investment possibilities may not be rewarding. The
manager has to choose a project, which gives a rate of return, which is more
than the cost of financing the project. For this the manager has to evaluate
the worth of the projects in-terms of cost and benefits. The benefits are the
expected cash inflows from the project, which are discounted against a
standard, generally the cost of capital.
Capital
Budgeting Process:
The
capital budgeting process involves generation of investment, proposal
estimation of cash-flows for the proposals, evaluation of cash-flows, selection
of projects based on acceptance criterion and finally the continues revaluation
of investment after their acceptance the steps involved in capital budgeting process
are as follows.
1. Project generation
2. Project evaluation
3. Project selection
4. Project execution
1.
Project generation: In the project generation, the company has to identify the
proposal to be undertaken depending
upon its future plans of activity. After identification of the proposals they
can be grouped according to the following categories:
a. Replacement of equipment: In this case the existing outdated
equipment and machinery may be
replaced by purchasing new and modern equipment.
b. Expansion: The Company can go for increasing additional capacity in the
existing product line by purchasing
additional equipment.
c. Diversification: The Company can
diversify its product line by way of producing various products and entering
into different markets. For this purpose, It has to acquire the fixed assets to
enable producing new products.
d. Research and Development: Where the
company can go for installation of research and development suing by incurring
heavy expenditure with a view to innovate new methods of production new
products etc.,
2.
Project evaluation: In involves two steps.
a. Estimation of benefits and costs:
These must be measured in terms of cash flows. Benefits to be received are
measured in terms of cash flows. Benefits to be received are measured in terms
of cash in flows, and costs to be incurred are measured in terms of cash flows.
b. Selection of an appropriate
criterion to judge the desirability of the project.
3.
Project selection: There is no standard administrative procedure for approving
the investment decisions. The
screening and selection procedure would differ from firm to firm. Due to lot of
importance of capital budgeting decision, the final approval of the project may
generally rest on the top management of the company. However the proposals are scrutinized
at multiple levels. Some times top management may delegate authority to approve
certain types of investment proposals. The top
management
may do so by limiting the amount of cash out lay. Prescribing the selection
criteria and holding the lower management levels accountable for the results.
4. Project Execution: In the project execution the top management or the project
execution committee is responsible
for effective utilization of funds allocated for the projects. It must see that
the funds are spent in accordance with the appropriation made in the capital
budgeting plan. The funds for the purpose of the project execution must be
spent only after obtaining the approval of the finance controller. Further to
have an effective cont. It is necessary to prepare monthly budget reports to
show clearly the total amount appropriated, amount spent and to amount unspent.
Capital
budgeting Techniques:
The
capital budgeting appraisal methods are techniques of evaluation of investment
proposal will help the company to decide upon the desirability of an investment
proposal depending upon their; relative income generating capacity and rank
them in order of their desirability. These methods provide the company a set of
norms on the basis of which either it has to accept or reject the investment
proposal. The most widely accepted techniques used in estimating the
cost-returns of investment projects can be grouped under two categories.
1. Traditional methods
2. Discounted Cash flow methods
1. Traditional
methods
These
methods are based on the principles to determine the desirability of an investment
project on the basis of its useful life and expected returns. These methods
depend upon the accounting information available from the books of accounts of
the company. These will not take into account the concept of ‘time value of
money’, which is a significant factor to determine the desirability of a
project in terms of present value.
A. Pay-back period method: It is the most popular and widely
recognized traditional method of evaluating
the investment proposals. It can be defined, as ‘the number of years required
to recover the original cash out lay invested in a project’.
According to Weston & Brigham,
“The pay back period is the number of years it takes the firm to recover its
original investment by net returns before depreciation, but after taxes”.
According
to James. C. Vanhorne, “The payback period is the number of years required to
recover initial cash investment.
The pay back period is also called
payout or payoff period. This period is calculated by dividing the cost of the
project by the annual earnings after tax but before depreciation under this
method the projects are ranked on the basis of the length of the payback
period. A project with the shortest payback period will be given the highest
rank and taken as the best investment. The shorter the payback period, the less
risky the investment is the formula for payback period is
Cash outlay (or) original cost of
project
Pay-back period = -------------------------------------------
Annual cash inflow
Merits:
1. It is one of the earliest methods of
evaluating the investment projects.
2. It is simple to understand and to
compute.
3. It dose not involve any cost for computation
of the payback period
4. It is one of the widely used methods
in small scale industry sector
5. It can be computed on the basis of
accounting information available from the books.
Demerits:
1. This method fails to take into
account the cash flows received by the company after the pay back period.
2. It doesn’t take into account the
interest factor involved in an investment outlay.
3. It doesn’t take into account the
interest factor involved in an investment outlay.
4. It is not consistent with the
objective of maximizing the market value of the company’s share.
5. It fails to consider the pattern of
cash inflows i. e., the magnitude and timing of cash in flows.
B. Accounting (or) Average rate of
return method (ARR):
It
is an accounting method, which uses the accounting information repeated by the
financial statements to measure the probability of an investment proposal. It
can be determine by dividing the average income after taxes by the average
investment i.e., the average book value after depreciation.
According to ‘Soloman’, accounting
rate of return on an investment can be calculated as the ratio of accounting
net income to the initial investment, i.e.,
|
Average net income after taxes |
|
|
ARR= ----]--------------------------------- |
X 100 |
Average Investment
Total
Income after Taxes Average net income after taxes = -----------------------------
No. Of
Years Total Investment
Average investment = ----------------------
2
On
the basis of this method, the company can select all those projects who’s ARR
is higher than the minimum rate established by the company. It can reject the
projects with an ARR lower than the expected rate of return. This method can
also help the management to rank the proposal on the basis of ARR. A highest
rank will be given to a project with highest ARR, where as a lowest rank to a
project with lowest ARR.
Merits:
1. It is very simple to understand and
calculate.
2. It can be readily computed with the
help of the available accounting data.
3. It uses the entire stream of earning
to calculate the ARR.
Demerits:
1. It is not based on cash flows generated
by a project.
2. This method does not consider the
objective of wealth maximization
3. IT ignores the length of the
projects useful life.
4. It does not take into account the
fact that the profits can be re-invested.
II: Discounted
cash flow methods:
The
traditional method does not take into consideration the time value of money.
They give equal weight age to the present and future flow of incomes. The DCF
methods are based on the concept that a rupee earned today is more worth than a
rupee earned tomorrow. These methods take into consideration the profitability
and also time value of money.
A. Net present value method (NPV)
The NPV takes into consideration the
time value of money. The cash flows of different years and valued differently
and made comparable in terms of present values for this the net cash inflows of
various period are discounted using required rate of return which is
predetermined.
According to Ezra Solomon, “It is a
present value of future returns, discounted at the required rate of return
minus the present value of the cost of the investment.”
NPV is the difference between the
present value of cash inflows of a project and the initial cost of the project.
According
the NPV technique, only one project will be selected whose NPV is positive or
above zero. If a project(s) NPV is less than ‘Zero’. It gives negative NPV
hence. It must be rejected. If there are more than one project with positive
NPV’s the project is selected whose NPV is the highest.
The formula for NPV is
NPV= Present value of cash inflows –
investment.
|
|
C1 |
C2 |
C3 |
Cn |
|
NPV = |
------ + |
-------
+ |
--------
+ ------- |
|
|
|
(1+K) |
|
|
|
Co- investment
C1, C2, C3… Cn= cash inflows in
different years.
K= Cost of the Capital (or)
Discounting rate
D= Years.
Merits:
1. It recognizes the time value of
money.
2. It is based on the entire cash flows
generated during the useful life of the asset.
3. It is consistent with the objective
of maximization of wealth of the owners.
4. The ranking of projects is
independent of the discount rate used for determining the present value.
Demerits:
1. It is different to understand and
use.
2. The NPV is calculated by using the
cost of capital as a discount rate. But the concept of cost of capital. If self
is difficult to understood and determine.
3. It does not give solutions when the
comparable projects are involved in different amounts of investment.
4.
4. It does not give correct answer to a
question whether alternative projects or limited funds are available with
unequal lines.
B. Internal
Rate of Return Method (IRR)
The
IRR for an investment proposal is that discount rate which equates the present
value of cash inflows with the present value of cash out flows of an
investment. The IRR is also known as cutoff or handle rate. It is usually the
concern’s cost of capital.
According to Weston and Brigham “The
internal rate is the interest rate that equates the present value of the
expected future receipts to the cost of the investment outlay.
When compared the IRR with the
required rate of return (RRR), if the IRR is more than RRR then the project is
accepted else rejected. In case of more than one project with IRR more than
RRR, the one, which gives the highest IRR, is selected.
The
IRR is not a predetermine rate, rather it is to be trial and error method. It
implies that one has to start with a discounting rate to calculate the present
value of cash inflows. If the obtained present value is higher than the initial
cost of the project one has to try with a higher rate. Like wise if the present
value of expected cash inflows obtained is lower than the present value of cash
flow. Lower rate is to be taken up. The process is continued till the net
present value becomes Zero. As this discount rate is determined internally,
this method is called internal rate of return method.
|
P1 |
- Q |
|
IRR = L+
--------- |
X D |
|
P1 |
–P2 |
L- Lower discount rate
P1 - Present value of cash inflows
at lower rate.
P2 - Present value of cash inflows
at higher rate.
Q- Actual investment
D- Difference in Discount rates.
Merits:
1. It consider the time value of money
2. It takes into account the cash flows
over the entire useful life of the asset.
3. It has a psychological appear to the
user because when the highest rate of return projects are selected, it
satisfies the investors in terms of the rate of return an capital
4. It always suggests accepting to
projects with maximum rate of return.
5. It is inconformity with the firm’s
objective of maximum owner’s welfare.
Demerits:
1. It is very difficult to understand
and use.
2. It involves a very complicated
computational work.
3. It may not give unique answer in all
situations.
C. Probability Index Method (PI)
The
method is also called benefit cost ration. This method is obtained cloth a
slight modification of the NPV method. In case of NPV the present value of cash
out flows are profitability index (PI), the present value of cash inflows are
divide by the present value of cash out flows, while NPV is a absolute measure,
the PI is a relative measure.
It
the PI is more than one (>1), the proposal is accepted else rejected. If
there are more than one investment proposal with the more than one PI the one
with the highest PI will be selected. This method is more useful incase of
projects with different cash outlays cash outlays and hence is superior to the
NPV method.
The formula for PI is
Present Value of Future Cash Inflow
Probability index =
----------------------------------------
Investment
Merits:
1. It requires less computational work
then IRR method
2. It helps to accept / reject
investment proposal on the basis of value of the index.
3. It is useful to rank the proposals
on the basis of the highest/lowest value of the index.
4. It is useful to tank the proposals
on the basis of the highest/lowest value of the index.
5. It takes into consideration the
entire stream of cash flows generated during the useful life of the asset.
Demerits:
1. It is some what difficult to
understand
2. Some people may feel no limitation
for index number due to several limitation involved in their competition
3. It is very difficult to understand
the analytical part of the decision on the basis of probability index.
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