Unit 3
Financial Management
Pricing is a controversial and difficult subject. It is not possible to lay down a general prescription about the price policy of PEs. The nature of different enterprises varies greatly: some are industrial and trading, some are developmental and promotional, and some others are either basic or provide essential services. Much also depends upon the competitive environment, domestic and international, in which an enterprise. In monopoly or near monopoly conditions, and with a less exacting financial discipline, PEs may have higher cost which is passed on to the consumer.
Need and importance of pricing policy-
The need is to ensure that PES keep their cost of operations at the lowest. Surplus labour and low productivity is characteristic of our PEs. Extra cost is often passed on to the consumer because of following: -
(i) amenities over and above those prescribed by the law,
(ii) excessive inventories,
(iii) neglected and unsystematic maintenance,
(iv) under-utilisation of capacity, and
(v) low level of overall managerial efficiency.
It should be ensured that PEs prices do not contain an unnecessarily large element of inefficient use of resources. Similar control should, of course, be applied on private enterprises which claim immunity on the facile and doubtful assumption of competition taking care of this aspect. It is stated that an ideal price policy should help in promoting a rational allocation of resources and thus accelerate balanced growth of the economy.
The following are some of the important principles of pricing which are suggested in the case of PEs:
1. Marginal Cost Basis:
Marginal cost is the cost of producing an additional unit of a product. The reasoning behind the ‘marginal cost basis of pricing policy, is that, if a consumer is willing to pay for an extra unit of a product, welfare of the community gets maximised when that extra or additional unit of product is made available to him.
It is argued that if a consumer is not willing to pay the cost of the additional unit (i.e., marginal cost), that additional unit should not be produced in the interest of maximising welfare of the community. It is also argued that if marginal cost basis is followed in pricing policy of PEs, resources of the community will automatically be allocated to the production of different goods that will lead to maximisation of the welfare of the community.
While considering ‘marginal cost’ in the short run, capital cost is fixed and only variable cost is taken into consideration therefore, called ‘short-term marginal cost’. In the case of long-term marginal cost, even fixed capital becomes variable capital and marginal cost has in that case to take note of both fixed capital cost and variable cost.
Criticism:
One criticism against the marginal cost principle of pricing of products of PEs is that, if strictly applied, it would result in deficit in the case of industries experiencing increasing returns or decreasing costs. Such deficits may have to be met by imposing taxes on other consumers who are not purchasing that commodity and this could reduce their welfare.
Surplus Revenue:
The principle of marginal cost would mean, in the case of industries which are functioning under conditions of decreasing costs, an increase in the price of commodity with every increase in production of that commodity. This would result in large surplus revenue. This surplus revenue, apart from inviting public protests, might also result in a demand for a rise in wages and bonus by workers in that unit of the PE.
Practical Difficulties:
The marginal cost principle may also be found unworkable because of the practical difficulties of calculating, with any degree of accuracy, the marginal cost in public utilities such as electricity, State transport services, post and telegraph and so on.
2.Pricing on the Basis of Average Cost:
‘Average cost pricing principle’ refers to fixing the price of a commodity on the basis of the average cost of population of the commodity. In the case of average cost pricing, total revenue obtained by selling a certain amount of commodity will be equal to its total cost of production. Thus, average cost pricing principle ensures that the entire cost of production is absorbed in to the price of the commodity.
It may be noticed that while calculating total cost of production, along with various other costs, normal profits is also included. On account of this, the price of a commodity is a little higher than the price based on the principle of ‘No profit, No losses.
3.‘No Profit, No Loss’ or ‘Break-Even’ Principle:
‘No profit. No losses or ‘Break-even’ principle of pricing of products or services of PEs maintains that the price should be fixed in such a way that there will be neither any profit, nor any loss for the concerned PE. In simple terms, price should just-cover all costs of production.
It is noted that in the case of marginal cost pricing, in the case of decreasing cost condition, the concerned-PE will suffer a loss which will have to be subsidized by taxing people to the extent of the deficit suffered by the PE. There is thus cross subsidization.
In the case of No profit, no loss’ principle of pricing of products of PEs there is no question of any loss and, therefore, no subsidizing the PE out of the government treasury or by taxing the people.
This means that when ‘No profit, no loss’ principle of pricing is adopted by a PE non-consumer of the commodity in question are not forced directly or indirectly to bear a ‘burden for the benefit of those who consume the product.
Arthur Lewis has advocated this principle of ‘No Profit No losses on the ground that the principle will prevent either over- expansion or under-expansion of a PE and will thus help avoid either inflationary or deflationary tendencies.
In India, the Damodar Valley Corporation (DVC) follows the principle of ‘No profit No loss’ in pricing. Other PEs which follow this principle of pricing are Hindustan Antibiotics, Hindustan Insecticides, Export Guarantee Corporation, etc.
4.Profit-Making Principle of Pricing:
Profit-making principle of pricing of the products or services of PEs maintains that the price charged should be such as to get for the concerned PE some surplus after absorbing all the cost elements, including normal profit. It is maintained that in developing countries like India, PEs are expected to generate as much surplus as possible so that these surplus funds can be further invested in developmental projects.
As we intend to measure the effectiveness of capital market regulation on the use of public debt and equity, we have first considered two measures of capital structure- first, the ratio of long-term debt to total asset where long term debt includes long-term borrowing from banks and financial institutions and public borrowing in form of debenture (secured and non-secured) and second, the ratio of equity to total asset where equity consists of paid-up equity capital plus share-premium reserves. We have not considered internal capital as equivalent to equity capital as this would not reflect firms’ public activities. The other reason for the choice of these two variables is as follows: The trade-off theory predicts that larger the firms’ tangible assets, lessen the chance of bankruptcy and higher value in liquidation; so tangible assets should be positively correlated with debt. On the other hand, information asymmetry theory says that higher tangible assets lead to reduction in asymmetry of information between ‘insiders’ and ‘outsiders’, and hence use of equity should increase. Considering these two dependent variables, we can distinguish between theories and the regression co-efficient on equity will particularly tell us the level of information a particular variable conveys in the market. One may argue that in a sense, debt and equity are substitutes and hence it is sufficient to consider only one of them as dependent variable. However, empirical estimation presented in Table 6 clearly shows that increase and decrease in these variables are not proportionate over time. One reason may be that retained profits are not considered. Nonetheless, given the observation that they do not increase or decrease in fixed proportion, one may get additional insights from running two separate regressions. Most importantly it helps us to derive clear indications regarding validity of the above-mentioned theories. However, the choice of explanatory variables is based on trade-off, pecking order, agency theory, control considerations as well as institutional factors. The predictions can be summarized as follows:
1. Age Trade-off Theory-It predicts that with passage of time, firms establish a historical record of honouring the financial obligations and this reputation increases the debt capacity of firms. Thus, mature firms can borrow under better terms, and the probable impact of age on debt is positive. In contrast, it may be argued that the greater availability of information on older firms tends to reduce information asymmetries associated with equity. Hence, in line with pecking order hypothesis, one can say that mature firms tend to use the capital market for equity relatively more compared to younger firms. Moreover, since mature firms are likely to have accumulated higher levels of past earnings, these firms need less of debt finance. We have calculated age as the difference between year of incorporation and the year in which firm exists in the sample.
2. Size Trade-off theory – It predicts that larger firms tend to be more diversified, and hence less risky and less prone to bankruptcy. Further, if maintaining control is important, then it is likely that firms achieve larger size through debt rather than equity financing. Thus, control considerations also support positive correlation between size and debt. However, it can also be argued that size serves as proxy for availability of information that outsiders have about the firm. From pecking order point of view, less information asymmetry makes equity issuance more appealing to the firm. Thus, a negative link between size and leverage is expected. This study uses natural logarithm of real sales as a proxy for size while some studies are found to have used natural logarithm of total assets as the proxy for size, though both yield the same result.
3. Asset Structure - The ratio of fixed assets to total assets represents the degree of asset tangibility. The trade-off theory postulates tangibility to be positively related to debt levels for two main reasons, namely, security and the cost of financial distress. First, tangible assets normally provide high collateral value relative to intangible assets, which implies that these assets can support more debt. Second, tangible assets often reduce the cost of financial distress because they tend to have high liquidation value. Information asymmetry theory predicts that larger firms disclose more information to outsiders than smaller firms. Larger firm with less information asymmetry problem should tend to have more equity than debt, and hence less leverage. Here we have introduced the ratio of gross fixed assets to total assets as the tangibility of firm’s assets.
4. Growth Opportunities- The term ‘growth opportunities’ means possible growth alternatives or future investment opportunities. This can be considered as intangible asset of the firms. The nature of intangibility creates the problem of information asymmetry between firm’s insiders and outsiders. Due to this information asymmetry, the firms with higher growth opportunities issue securities which have less problem of information asymmetry, e.g., short-term debt. However, it can also be argued that a system dominated by private lenders ought to have superior firm specific information that could reduce the problem of information asymmetry between private lenders and borrowers, even in the long-term. In a country like India, where the debt market is mostly dominated by private lenders, namely, banks and financial institutions, one can expect a positive relationship between growth and leverage. Myers (1977) has suggested using ratio of market value to the book value of assets as a proxy for growth opportunities. Moreover, Titman and Wessels (1988) have used the percentage change in total assets as a proxy for growth opportunities. In the absence of data for market value to book value of assets, this study uses the percentage growth of total assets as the proxy for growth opportunities.
5. Non-debt Tax shields - DeAngelo and Masulis (1980) argue that non-debt tax shields are substitutes for tax benefits of debt financing. Thus, a firm with high non-debt tax shields is likely to be less leveraged. This leads to prediction of negative correlation between non debt tax shields and debt. Therefore, this study uses the depreciation to gross fixed assets ratio as a proxy for non-debt tax shields.
6. Profitability- In the context of pecking order theory, profitable firms are likely to have sufficient internal finance that obviates the need to rely on external finance. Moreover, as per agency theory framework, if the contest for corporate control is inefficient, managers of profitable firms will use the higher level of retained earnings in order to avoid the disciplinary role of external finance. These two rationales point to a negative correlation between profitability and leverage. In addition, in an agency theory framework, if the market/contest for corporate control is efficient, managers of profitable firms will seek debt as a disciplinary device because debt is regarded as a commitment to pay out cash in the future. Agency theory also supports the positive correlation between profitability and leverage. On the other hand, trade-off theory postulates that firms with larger profits need to pay more taxes than firms with smaller profits. Therefore, firms with high profit should use more debt in their capital structure in order to get much more tax shields from interest payment. Hence, it can be said that trade-off theory postulates a positive relation between profitability and leverage. This study uses earnings before interest tax and depreciation to total assets as a measure of profitability.
7. Liquidity ratios may have a mixed impact on the capital structure decision. On one hand, firms with higher liquidity ratios might support a relatively higher debt ratio due to greater ability to meet short-term obligations when they fall due. This would imply a positive relationship between a firm’s liquidity position and debt ratio. On the other hand, firms with greater liquid assets may use these assets to finance their investments. Therefore, firm’s liquidity position should exert a negative impact on its leverage ratio. Moreover, as Prowse (1990) argues, liquidity of the company assets can be used to show the extent to which these assets can be manipulated by shareholders at the expense of bondholders. For the purpose of this study, the ratio of current assets to current liabilities is used as a proxy for liquidity.
8. Interest Cover Harris and Raviv (1990) have suggested that interest coverage ratio has negative correlation with leverage. They conclude that an increase in debt will increase default probability. Therefore, interest coverage ratio will act as a proxy of default probability, which means that a lower interest coverage ratio indicates a higher debt ratio. This study takes earnings before interest and tax to interest payment ratio as a measure of interest cover.
9. Exports - In developing countries, like India, firms which are net exporters are given credit benefits like export import credit facility, and forward letter of credit. This implies that firms which are net exporters may have lesser need of debt in their capital structure. Therefore, we can expect a negative relationship between exports and leverage. This study uses exports to total sales ratio as a measure of exports.
10. Labour Intensity- According to Modigliani-Miller’s (1958) capital structure irrelevance theorem, capital structure decision is independent of output, investment and employment decision, as real variables do not affect the financial variables and vice versa. Funke et al. (1999) have estimated the labour demand function for Germany and found that leverage is negatively related to the labour demand. The reason is that as debt increases, the cost of borrowing increases. On the other hand, as employment increases, productivity of capital decreases. Therefore, when marginal product of capital falls below marginal cost of borrowing, investment becomes unprofitable. So, the firm reduces its labour demand. Hence, financial decision and employment decision are interdependent. This study has used compensation to employees to fixed assets ratio as a measure of labour intensity in the production process.
11. Capital Market Regulation- Capital market regulation is aimed at reducing the information asymmetry between insiders and outside investors, and thereby reducing the cost of equity capital of the firms. This reduction in cost of equity capital leads to the development of equity market which will form a viable source of finance for the corporate sector. In this study, we are using a ‘regulation index’, which serves as an inverse proxy for information asymmetry, constructed through factor analytic approach as proxy for regulatory changes. Thus, we have explained the important independent variables to be considered in our analysis, and how they may impact our dependent variable. Also, the dependent variables may impact some of the independent variables in a later period, as is the case in most regressions. The impacts however are clearly not simultaneous.
Working capital management refers to the activities of a business’s current assets and current liabilities for the company’s effective operation.
Types of working capital-
According to the needs of business, the working capital may be classified into following two bases:
1) On the basis of periodicity
2) On the basis of concept
On the basis of periodicity: The requirements of working capital are continuous. More working capital is required in a particular season or the peck period of business activity. On the basis of periodicity working capital can be divided under two categories as under:
i. Permanent working capital
Ii. Variable working capital
(i) Permanent working capital: This type of working capital is known as Fixed Working Capital. Permanent working capital means the part of working capital which is permanently locked up in the current assets to carry out the business smoothly. The minimum amount of current assets which is required to conduct the business smoothly during the year is called permanent working capital.
For example, investments required to maintain the minimum stock of raw materials or to cash balance. The amount of permanent working capital depends upon the size and growth of company. Fixed working capital can further be divided into two categories as under:
a. Regular Working capital: Minimum amount of working capital required to keep the primary circulation. Some amount of cash is necessary for the payment of wages, salaries etc.
b. Reserve Margin Working capital: Additional working capital may also be required for contingencies that may arise any time. The reserve working capital is the excess of capital over the needs of the regular working capital is kept aside as reserve for contingencies, such as strike, business depression etc.
(ii) Variable or Temporary Working Capital: The term variable working capital refers that the level of working capital is temporary and fluctuating. Variable working capital may change from one asset to another and changes with the increase or decrease in the volume of business. The variable working capital may also be subdivided into following two sub-groups.
a. Seasonal Variable Working capital: Seasonal working capital is the additional amount which is required during the active business seasons of the year. Raw materials like raw-cotton or jute or sugarcane are purchased in particular season. The industry has to borrow funds for short period. It is particularly suited to a business of a seasonal nature. In short, seasonal working capital is required to meet the seasonal liquidity of the business.
b. Special variable working capital: Additional working capital may also be needed to provide additional current assets to meet the unexpected events or special operations such as extensive marketing campaigns or carrying of special job etc.
Factors determining working capital
The following factor determine the amount of working capital
1. Nature of Companies: The composition of an asset is a function of the size of a business and the companies to which it belongs. Small companies have smaller proportions of cash, receivables and inventory than large corporation. This difference becomes more marked in large corporations. A public utility, for example, mostly employs fixed assets in its operations, while a merchandising department depends generally on inventory and receivable. Needs for working capital are thus determined by the nature of an enterprise.
2. Demand of Creditors: Creditors are interested in the security of loans. They want their obligations to be sufficiently covered. They want the amount of security in assets which are greater than the liability.
3. Cash Requirements: Cash is one of the current assets which are essential for the successful operations of the production cycle. A minimum level of cash is always required to keep the operations going. Adequate cash is also required to maintain good credit relation.
4. Nature and Size of Business: The working capital requirements of a firm are basically influenced by the nature of its business. Trading and financial firms have a very less investment in fixed assets, but require a large sum of money to be invested in working capital. Retail stores, for example, must carry large stocks of a variety of goods to satisfy the varied and continues demand of their customers. Some manufacturing business, such as tobacco manufacturing and construction firms also have to invest substantially in working capital and a nominal amount in the fixed assets.
5.Time: The level of working capital depends upon the time required to manufacturing goods. If the time is longer, the size of working capital is great. Moreover, the amount of working capital depends upon inventory turnover and the unit cost of the goods that are sold. The greater this cost, the bigger is the amount of working capital.
6. Volume of Sales: This is the most important factor affecting the size and components of working capital. A firm maintains current assets because they are needed to support the operational activities which result in sales. They volume of sales and the size of the working capital are directly related to each other. As the volume of sales increase, there is an increase in the investment of working capital-in the cost of operations, in inventories and receivables.
7. Terms of Purchases and Sales: If the credit terms of purchases are more favourable and those of sales liberal, less cash will be invested in inventory. With more favourable credit terms, working capital requirements can be reduced. A firm gets more time for payment to creditors or suppliers. A firm which enjoys greater credit with banks needs less working capital.
8. Business Cycle: Business expands during periods of prosperity and declines during the period of depression. Consequently, more working capital required during periods of prosperity and less during the periods of depression.
9.Production Cycle: The time taken to convert raw materials into finished products is referred to as the production cycle or operating cycle. The longer the production cycle, the greater is the requirements of the working capital. An utmost care should be taken to shorten the period of the production cycle in order to minimize working capital requirements.
10. Liquidity and Profitability: If a firm desires to take a greater risk for bigger gains or losses, it reduces the size of its working capital in relation to its sales. If it is interested in improving its liquidity, it increases the level of its working capital. However, this policy is likely to result in a reduction of the sales volume, and therefore, of profitability. A firm, therefore, should choose between liquidity and profitability and decide about its working capital requirements accordingly. 11. Seasonal Fluctuations: Seasonal fluctuations in sales affect the level of variable working capital. Often, the demand for products may be of a seasonal nature. Yet inventories have got to be purchased during certain seasons only. The size of the working capital in one period may, therefore, be bigger than that in another.
Even though, the government has slashed the corporate income tax rate as follows:
1. All domestic companies to be allowed to pay corporation tax at the rate of 22% (effective rate 25.17% including cess and surcharge). This would be subject to the condition that these companies do not avail of any tax incentives or exemptions. Moreover, no Minimum Alternative Tax (MAT) would be imposed on these companies.
2. Any new domestic manufacturing company, incorporated on or after October 1, 2019, will be allowed to pay corporation tax at the rate of 15% (effective rate 17.01%). No MAT will be imposed on these companies either. This will be subject to the condition that the company does not avail of any tax incentives or exemptions and commences production by 31 March, 2023.
3. For companies who continue to avail exemptions/incentives, the rate of minimum alternate tax (MAT) has been reduced from 18.5 percent to 15 percent.
These changes in income tax rates are brought through an Ordinance which require legislative amendments as of now. They require Parliamentary ratification. When the Parliament is not in session, the government can bring these changes through an Ordinance and later bring a Bill when Parliament convenes. Under normal circumstances, income tax rate changes take place in the Union Budget during the passage of the Finance Bill. The government’s decision to bring about an ordinance mirrors the urgency attached to the economic situation. The next Parliament session—the Winter Session—is starting next month. The government did not want wait until Parliament convened for the Winter Session for bringing in these changes, given the economy’s wobbly state and the need to soothe frayed nerves of the corporate community. Though there is no stopping to get ratification from parliament to these changes.)
Tax planning for corporates comprises of means for reducing companies tax liabilities. The simplest way to achieve this is by taking into account expenses made on health insurance of employees, office expenses, business transport, employee child care expenses, charitable contributions retirement planning, etc.
By taking full benefit of various tax deductions and exemptions available under the Income Tax Act, 1961 corporates can considerably bring down their tax burden. Higher the growth of the corporate firm means growing profits of the corporate house resulting in higher taxes for the corporate firm. Under such a scenario a proper corporate tax planning activity it becomes of extreme importance. Corporate firms account team must take into account all the available sections of the income tax act, 1961 to bring down their tax burden. Proper and efficient tax planning activity by a corporate house leads to a reduction in payment of their direct and indirect taxes.
References:
- Sahai, Baldeo. (1989). Public Sector in India – Historical Perspective in SCOPE: Dynamics of Management of Public Enterprises (ed) Waris R.Kidwai and Baldeo Sahai.
- Laha, Chandra, Prakash. (1989). Public Sector: The Socio – Economic and Political Environment in SCOPE: Dynamics of Management of Public Enterprises (ed) Waris R.Kidwai and Baldeo Sahai.
- Nigam, K. Raj: Indian Public Sector at the Cross Roads.
- Dynamics of Management of Public Enterprises (ed) Waris R.Kidwai and Baldeo Sahai. New Standing conference on Public Enterprises, New Delhi.
- Rao, S.L. Ownership, Control and Management of Public Enterprises.
Unit 3
Financial Management
Pricing is a controversial and difficult subject. It is not possible to lay down a general prescription about the price policy of PEs. The nature of different enterprises varies greatly: some are industrial and trading, some are developmental and promotional, and some others are either basic or provide essential services. Much also depends upon the competitive environment, domestic and international, in which an enterprise. In monopoly or near monopoly conditions, and with a less exacting financial discipline, PEs may have higher cost which is passed on to the consumer.
Need and importance of pricing policy-
The need is to ensure that PES keep their cost of operations at the lowest. Surplus labour and low productivity is characteristic of our PEs. Extra cost is often passed on to the consumer because of following: -
(i) amenities over and above those prescribed by the law,
(ii) excessive inventories,
(iii) neglected and unsystematic maintenance,
(iv) under-utilisation of capacity, and
(v) low level of overall managerial efficiency.
It should be ensured that PEs prices do not contain an unnecessarily large element of inefficient use of resources. Similar control should, of course, be applied on private enterprises which claim immunity on the facile and doubtful assumption of competition taking care of this aspect. It is stated that an ideal price policy should help in promoting a rational allocation of resources and thus accelerate balanced growth of the economy.
The following are some of the important principles of pricing which are suggested in the case of PEs:
1. Marginal Cost Basis:
Marginal cost is the cost of producing an additional unit of a product. The reasoning behind the ‘marginal cost basis of pricing policy, is that, if a consumer is willing to pay for an extra unit of a product, welfare of the community gets maximised when that extra or additional unit of product is made available to him.
It is argued that if a consumer is not willing to pay the cost of the additional unit (i.e., marginal cost), that additional unit should not be produced in the interest of maximising welfare of the community. It is also argued that if marginal cost basis is followed in pricing policy of PEs, resources of the community will automatically be allocated to the production of different goods that will lead to maximisation of the welfare of the community.
While considering ‘marginal cost’ in the short run, capital cost is fixed and only variable cost is taken into consideration therefore, called ‘short-term marginal cost’. In the case of long-term marginal cost, even fixed capital becomes variable capital and marginal cost has in that case to take note of both fixed capital cost and variable cost.
Criticism:
One criticism against the marginal cost principle of pricing of products of PEs is that, if strictly applied, it would result in deficit in the case of industries experiencing increasing returns or decreasing costs. Such deficits may have to be met by imposing taxes on other consumers who are not purchasing that commodity and this could reduce their welfare.
Surplus Revenue:
The principle of marginal cost would mean, in the case of industries which are functioning under conditions of decreasing costs, an increase in the price of commodity with every increase in production of that commodity. This would result in large surplus revenue. This surplus revenue, apart from inviting public protests, might also result in a demand for a rise in wages and bonus by workers in that unit of the PE.
Practical Difficulties:
The marginal cost principle may also be found unworkable because of the practical difficulties of calculating, with any degree of accuracy, the marginal cost in public utilities such as electricity, State transport services, post and telegraph and so on.
2.Pricing on the Basis of Average Cost:
‘Average cost pricing principle’ refers to fixing the price of a commodity on the basis of the average cost of population of the commodity. In the case of average cost pricing, total revenue obtained by selling a certain amount of commodity will be equal to its total cost of production. Thus, average cost pricing principle ensures that the entire cost of production is absorbed in to the price of the commodity.
It may be noticed that while calculating total cost of production, along with various other costs, normal profits is also included. On account of this, the price of a commodity is a little higher than the price based on the principle of ‘No profit, No losses.
3.‘No Profit, No Loss’ or ‘Break-Even’ Principle:
‘No profit. No losses or ‘Break-even’ principle of pricing of products or services of PEs maintains that the price should be fixed in such a way that there will be neither any profit, nor any loss for the concerned PE. In simple terms, price should just-cover all costs of production.
It is noted that in the case of marginal cost pricing, in the case of decreasing cost condition, the concerned-PE will suffer a loss which will have to be subsidized by taxing people to the extent of the deficit suffered by the PE. There is thus cross subsidization.
In the case of No profit, no loss’ principle of pricing of products of PEs there is no question of any loss and, therefore, no subsidizing the PE out of the government treasury or by taxing the people.
This means that when ‘No profit, no loss’ principle of pricing is adopted by a PE non-consumer of the commodity in question are not forced directly or indirectly to bear a ‘burden for the benefit of those who consume the product.
Arthur Lewis has advocated this principle of ‘No Profit No losses on the ground that the principle will prevent either over- expansion or under-expansion of a PE and will thus help avoid either inflationary or deflationary tendencies.
In India, the Damodar Valley Corporation (DVC) follows the principle of ‘No profit No loss’ in pricing. Other PEs which follow this principle of pricing are Hindustan Antibiotics, Hindustan Insecticides, Export Guarantee Corporation, etc.
4.Profit-Making Principle of Pricing:
Profit-making principle of pricing of the products or services of PEs maintains that the price charged should be such as to get for the concerned PE some surplus after absorbing all the cost elements, including normal profit. It is maintained that in developing countries like India, PEs are expected to generate as much surplus as possible so that these surplus funds can be further invested in developmental projects.
As we intend to measure the effectiveness of capital market regulation on the use of public debt and equity, we have first considered two measures of capital structure- first, the ratio of long-term debt to total asset where long term debt includes long-term borrowing from banks and financial institutions and public borrowing in form of debenture (secured and non-secured) and second, the ratio of equity to total asset where equity consists of paid-up equity capital plus share-premium reserves. We have not considered internal capital as equivalent to equity capital as this would not reflect firms’ public activities. The other reason for the choice of these two variables is as follows: The trade-off theory predicts that larger the firms’ tangible assets, lessen the chance of bankruptcy and higher value in liquidation; so tangible assets should be positively correlated with debt. On the other hand, information asymmetry theory says that higher tangible assets lead to reduction in asymmetry of information between ‘insiders’ and ‘outsiders’, and hence use of equity should increase. Considering these two dependent variables, we can distinguish between theories and the regression co-efficient on equity will particularly tell us the level of information a particular variable conveys in the market. One may argue that in a sense, debt and equity are substitutes and hence it is sufficient to consider only one of them as dependent variable. However, empirical estimation presented in Table 6 clearly shows that increase and decrease in these variables are not proportionate over time. One reason may be that retained profits are not considered. Nonetheless, given the observation that they do not increase or decrease in fixed proportion, one may get additional insights from running two separate regressions. Most importantly it helps us to derive clear indications regarding validity of the above-mentioned theories. However, the choice of explanatory variables is based on trade-off, pecking order, agency theory, control considerations as well as institutional factors. The predictions can be summarized as follows:
1. Age Trade-off Theory-It predicts that with passage of time, firms establish a historical record of honouring the financial obligations and this reputation increases the debt capacity of firms. Thus, mature firms can borrow under better terms, and the probable impact of age on debt is positive. In contrast, it may be argued that the greater availability of information on older firms tends to reduce information asymmetries associated with equity. Hence, in line with pecking order hypothesis, one can say that mature firms tend to use the capital market for equity relatively more compared to younger firms. Moreover, since mature firms are likely to have accumulated higher levels of past earnings, these firms need less of debt finance. We have calculated age as the difference between year of incorporation and the year in which firm exists in the sample.
2. Size Trade-off theory – It predicts that larger firms tend to be more diversified, and hence less risky and less prone to bankruptcy. Further, if maintaining control is important, then it is likely that firms achieve larger size through debt rather than equity financing. Thus, control considerations also support positive correlation between size and debt. However, it can also be argued that size serves as proxy for availability of information that outsiders have about the firm. From pecking order point of view, less information asymmetry makes equity issuance more appealing to the firm. Thus, a negative link between size and leverage is expected. This study uses natural logarithm of real sales as a proxy for size while some studies are found to have used natural logarithm of total assets as the proxy for size, though both yield the same result.
3. Asset Structure - The ratio of fixed assets to total assets represents the degree of asset tangibility. The trade-off theory postulates tangibility to be positively related to debt levels for two main reasons, namely, security and the cost of financial distress. First, tangible assets normally provide high collateral value relative to intangible assets, which implies that these assets can support more debt. Second, tangible assets often reduce the cost of financial distress because they tend to have high liquidation value. Information asymmetry theory predicts that larger firms disclose more information to outsiders than smaller firms. Larger firm with less information asymmetry problem should tend to have more equity than debt, and hence less leverage. Here we have introduced the ratio of gross fixed assets to total assets as the tangibility of firm’s assets.
4. Growth Opportunities- The term ‘growth opportunities’ means possible growth alternatives or future investment opportunities. This can be considered as intangible asset of the firms. The nature of intangibility creates the problem of information asymmetry between firm’s insiders and outsiders. Due to this information asymmetry, the firms with higher growth opportunities issue securities which have less problem of information asymmetry, e.g., short-term debt. However, it can also be argued that a system dominated by private lenders ought to have superior firm specific information that could reduce the problem of information asymmetry between private lenders and borrowers, even in the long-term. In a country like India, where the debt market is mostly dominated by private lenders, namely, banks and financial institutions, one can expect a positive relationship between growth and leverage. Myers (1977) has suggested using ratio of market value to the book value of assets as a proxy for growth opportunities. Moreover, Titman and Wessels (1988) have used the percentage change in total assets as a proxy for growth opportunities. In the absence of data for market value to book value of assets, this study uses the percentage growth of total assets as the proxy for growth opportunities.
5. Non-debt Tax shields - DeAngelo and Masulis (1980) argue that non-debt tax shields are substitutes for tax benefits of debt financing. Thus, a firm with high non-debt tax shields is likely to be less leveraged. This leads to prediction of negative correlation between non debt tax shields and debt. Therefore, this study uses the depreciation to gross fixed assets ratio as a proxy for non-debt tax shields.
6. Profitability- In the context of pecking order theory, profitable firms are likely to have sufficient internal finance that obviates the need to rely on external finance. Moreover, as per agency theory framework, if the contest for corporate control is inefficient, managers of profitable firms will use the higher level of retained earnings in order to avoid the disciplinary role of external finance. These two rationales point to a negative correlation between profitability and leverage. In addition, in an agency theory framework, if the market/contest for corporate control is efficient, managers of profitable firms will seek debt as a disciplinary device because debt is regarded as a commitment to pay out cash in the future. Agency theory also supports the positive correlation between profitability and leverage. On the other hand, trade-off theory postulates that firms with larger profits need to pay more taxes than firms with smaller profits. Therefore, firms with high profit should use more debt in their capital structure in order to get much more tax shields from interest payment. Hence, it can be said that trade-off theory postulates a positive relation between profitability and leverage. This study uses earnings before interest tax and depreciation to total assets as a measure of profitability.
7. Liquidity ratios may have a mixed impact on the capital structure decision. On one hand, firms with higher liquidity ratios might support a relatively higher debt ratio due to greater ability to meet short-term obligations when they fall due. This would imply a positive relationship between a firm’s liquidity position and debt ratio. On the other hand, firms with greater liquid assets may use these assets to finance their investments. Therefore, firm’s liquidity position should exert a negative impact on its leverage ratio. Moreover, as Prowse (1990) argues, liquidity of the company assets can be used to show the extent to which these assets can be manipulated by shareholders at the expense of bondholders. For the purpose of this study, the ratio of current assets to current liabilities is used as a proxy for liquidity.
8. Interest Cover Harris and Raviv (1990) have suggested that interest coverage ratio has negative correlation with leverage. They conclude that an increase in debt will increase default probability. Therefore, interest coverage ratio will act as a proxy of default probability, which means that a lower interest coverage ratio indicates a higher debt ratio. This study takes earnings before interest and tax to interest payment ratio as a measure of interest cover.
9. Exports - In developing countries, like India, firms which are net exporters are given credit benefits like export import credit facility, and forward letter of credit. This implies that firms which are net exporters may have lesser need of debt in their capital structure. Therefore, we can expect a negative relationship between exports and leverage. This study uses exports to total sales ratio as a measure of exports.
10. Labour Intensity- According to Modigliani-Miller’s (1958) capital structure irrelevance theorem, capital structure decision is independent of output, investment and employment decision, as real variables do not affect the financial variables and vice versa. Funke et al. (1999) have estimated the labour demand function for Germany and found that leverage is negatively related to the labour demand. The reason is that as debt increases, the cost of borrowing increases. On the other hand, as employment increases, productivity of capital decreases. Therefore, when marginal product of capital falls below marginal cost of borrowing, investment becomes unprofitable. So, the firm reduces its labour demand. Hence, financial decision and employment decision are interdependent. This study has used compensation to employees to fixed assets ratio as a measure of labour intensity in the production process.
11. Capital Market Regulation- Capital market regulation is aimed at reducing the information asymmetry between insiders and outside investors, and thereby reducing the cost of equity capital of the firms. This reduction in cost of equity capital leads to the development of equity market which will form a viable source of finance for the corporate sector. In this study, we are using a ‘regulation index’, which serves as an inverse proxy for information asymmetry, constructed through factor analytic approach as proxy for regulatory changes. Thus, we have explained the important independent variables to be considered in our analysis, and how they may impact our dependent variable. Also, the dependent variables may impact some of the independent variables in a later period, as is the case in most regressions. The impacts however are clearly not simultaneous.
Working capital management refers to the activities of a business’s current assets and current liabilities for the company’s effective operation.
Types of working capital-
According to the needs of business, the working capital may be classified into following two bases:
1) On the basis of periodicity
2) On the basis of concept
On the basis of periodicity: The requirements of working capital are continuous. More working capital is required in a particular season or the peck period of business activity. On the basis of periodicity working capital can be divided under two categories as under:
i. Permanent working capital
Ii. Variable working capital
(i) Permanent working capital: This type of working capital is known as Fixed Working Capital. Permanent working capital means the part of working capital which is permanently locked up in the current assets to carry out the business smoothly. The minimum amount of current assets which is required to conduct the business smoothly during the year is called permanent working capital.
For example, investments required to maintain the minimum stock of raw materials or to cash balance. The amount of permanent working capital depends upon the size and growth of company. Fixed working capital can further be divided into two categories as under:
a. Regular Working capital: Minimum amount of working capital required to keep the primary circulation. Some amount of cash is necessary for the payment of wages, salaries etc.
b. Reserve Margin Working capital: Additional working capital may also be required for contingencies that may arise any time. The reserve working capital is the excess of capital over the needs of the regular working capital is kept aside as reserve for contingencies, such as strike, business depression etc.
(ii) Variable or Temporary Working Capital: The term variable working capital refers that the level of working capital is temporary and fluctuating. Variable working capital may change from one asset to another and changes with the increase or decrease in the volume of business. The variable working capital may also be subdivided into following two sub-groups.
a. Seasonal Variable Working capital: Seasonal working capital is the additional amount which is required during the active business seasons of the year. Raw materials like raw-cotton or jute or sugarcane are purchased in particular season. The industry has to borrow funds for short period. It is particularly suited to a business of a seasonal nature. In short, seasonal working capital is required to meet the seasonal liquidity of the business.
b. Special variable working capital: Additional working capital may also be needed to provide additional current assets to meet the unexpected events or special operations such as extensive marketing campaigns or carrying of special job etc.
Factors determining working capital
The following factor determine the amount of working capital
1. Nature of Companies: The composition of an asset is a function of the size of a business and the companies to which it belongs. Small companies have smaller proportions of cash, receivables and inventory than large corporation. This difference becomes more marked in large corporations. A public utility, for example, mostly employs fixed assets in its operations, while a merchandising department depends generally on inventory and receivable. Needs for working capital are thus determined by the nature of an enterprise.
2. Demand of Creditors: Creditors are interested in the security of loans. They want their obligations to be sufficiently covered. They want the amount of security in assets which are greater than the liability.
3. Cash Requirements: Cash is one of the current assets which are essential for the successful operations of the production cycle. A minimum level of cash is always required to keep the operations going. Adequate cash is also required to maintain good credit relation.
4. Nature and Size of Business: The working capital requirements of a firm are basically influenced by the nature of its business. Trading and financial firms have a very less investment in fixed assets, but require a large sum of money to be invested in working capital. Retail stores, for example, must carry large stocks of a variety of goods to satisfy the varied and continues demand of their customers. Some manufacturing business, such as tobacco manufacturing and construction firms also have to invest substantially in working capital and a nominal amount in the fixed assets.
5.Time: The level of working capital depends upon the time required to manufacturing goods. If the time is longer, the size of working capital is great. Moreover, the amount of working capital depends upon inventory turnover and the unit cost of the goods that are sold. The greater this cost, the bigger is the amount of working capital.
6. Volume of Sales: This is the most important factor affecting the size and components of working capital. A firm maintains current assets because they are needed to support the operational activities which result in sales. They volume of sales and the size of the working capital are directly related to each other. As the volume of sales increase, there is an increase in the investment of working capital-in the cost of operations, in inventories and receivables.
7. Terms of Purchases and Sales: If the credit terms of purchases are more favourable and those of sales liberal, less cash will be invested in inventory. With more favourable credit terms, working capital requirements can be reduced. A firm gets more time for payment to creditors or suppliers. A firm which enjoys greater credit with banks needs less working capital.
8. Business Cycle: Business expands during periods of prosperity and declines during the period of depression. Consequently, more working capital required during periods of prosperity and less during the periods of depression.
9.Production Cycle: The time taken to convert raw materials into finished products is referred to as the production cycle or operating cycle. The longer the production cycle, the greater is the requirements of the working capital. An utmost care should be taken to shorten the period of the production cycle in order to minimize working capital requirements.
10. Liquidity and Profitability: If a firm desires to take a greater risk for bigger gains or losses, it reduces the size of its working capital in relation to its sales. If it is interested in improving its liquidity, it increases the level of its working capital. However, this policy is likely to result in a reduction of the sales volume, and therefore, of profitability. A firm, therefore, should choose between liquidity and profitability and decide about its working capital requirements accordingly. 11. Seasonal Fluctuations: Seasonal fluctuations in sales affect the level of variable working capital. Often, the demand for products may be of a seasonal nature. Yet inventories have got to be purchased during certain seasons only. The size of the working capital in one period may, therefore, be bigger than that in another.
Even though, the government has slashed the corporate income tax rate as follows:
1. All domestic companies to be allowed to pay corporation tax at the rate of 22% (effective rate 25.17% including cess and surcharge). This would be subject to the condition that these companies do not avail of any tax incentives or exemptions. Moreover, no Minimum Alternative Tax (MAT) would be imposed on these companies.
2. Any new domestic manufacturing company, incorporated on or after October 1, 2019, will be allowed to pay corporation tax at the rate of 15% (effective rate 17.01%). No MAT will be imposed on these companies either. This will be subject to the condition that the company does not avail of any tax incentives or exemptions and commences production by 31 March, 2023.
3. For companies who continue to avail exemptions/incentives, the rate of minimum alternate tax (MAT) has been reduced from 18.5 percent to 15 percent.
These changes in income tax rates are brought through an Ordinance which require legislative amendments as of now. They require Parliamentary ratification. When the Parliament is not in session, the government can bring these changes through an Ordinance and later bring a Bill when Parliament convenes. Under normal circumstances, income tax rate changes take place in the Union Budget during the passage of the Finance Bill. The government’s decision to bring about an ordinance mirrors the urgency attached to the economic situation. The next Parliament session—the Winter Session—is starting next month. The government did not want wait until Parliament convened for the Winter Session for bringing in these changes, given the economy’s wobbly state and the need to soothe frayed nerves of the corporate community. Though there is no stopping to get ratification from parliament to these changes.)
Tax planning for corporates comprises of means for reducing companies tax liabilities. The simplest way to achieve this is by taking into account expenses made on health insurance of employees, office expenses, business transport, employee child care expenses, charitable contributions retirement planning, etc.
By taking full benefit of various tax deductions and exemptions available under the Income Tax Act, 1961 corporates can considerably bring down their tax burden. Higher the growth of the corporate firm means growing profits of the corporate house resulting in higher taxes for the corporate firm. Under such a scenario a proper corporate tax planning activity it becomes of extreme importance. Corporate firms account team must take into account all the available sections of the income tax act, 1961 to bring down their tax burden. Proper and efficient tax planning activity by a corporate house leads to a reduction in payment of their direct and indirect taxes.
References:
- Sahai, Baldeo. (1989). Public Sector in India – Historical Perspective in SCOPE: Dynamics of Management of Public Enterprises (ed) Waris R.Kidwai and Baldeo Sahai.
- Laha, Chandra, Prakash. (1989). Public Sector: The Socio – Economic and Political Environment in SCOPE: Dynamics of Management of Public Enterprises (ed) Waris R.Kidwai and Baldeo Sahai.
- Nigam, K. Raj: Indian Public Sector at the Cross Roads.
- Dynamics of Management of Public Enterprises (ed) Waris R.Kidwai and Baldeo Sahai. New Standing conference on Public Enterprises, New Delhi.
- Rao, S.L. Ownership, Control and Management of Public Enterprises.
Unit 3
Financial Management
Pricing is a controversial and difficult subject. It is not possible to lay down a general prescription about the price policy of PEs. The nature of different enterprises varies greatly: some are industrial and trading, some are developmental and promotional, and some others are either basic or provide essential services. Much also depends upon the competitive environment, domestic and international, in which an enterprise. In monopoly or near monopoly conditions, and with a less exacting financial discipline, PEs may have higher cost which is passed on to the consumer.
Need and importance of pricing policy-
The need is to ensure that PES keep their cost of operations at the lowest. Surplus labour and low productivity is characteristic of our PEs. Extra cost is often passed on to the consumer because of following: -
(i) amenities over and above those prescribed by the law,
(ii) excessive inventories,
(iii) neglected and unsystematic maintenance,
(iv) under-utilisation of capacity, and
(v) low level of overall managerial efficiency.
It should be ensured that PEs prices do not contain an unnecessarily large element of inefficient use of resources. Similar control should, of course, be applied on private enterprises which claim immunity on the facile and doubtful assumption of competition taking care of this aspect. It is stated that an ideal price policy should help in promoting a rational allocation of resources and thus accelerate balanced growth of the economy.
The following are some of the important principles of pricing which are suggested in the case of PEs:
1. Marginal Cost Basis:
Marginal cost is the cost of producing an additional unit of a product. The reasoning behind the ‘marginal cost basis of pricing policy, is that, if a consumer is willing to pay for an extra unit of a product, welfare of the community gets maximised when that extra or additional unit of product is made available to him.
It is argued that if a consumer is not willing to pay the cost of the additional unit (i.e., marginal cost), that additional unit should not be produced in the interest of maximising welfare of the community. It is also argued that if marginal cost basis is followed in pricing policy of PEs, resources of the community will automatically be allocated to the production of different goods that will lead to maximisation of the welfare of the community.
While considering ‘marginal cost’ in the short run, capital cost is fixed and only variable cost is taken into consideration therefore, called ‘short-term marginal cost’. In the case of long-term marginal cost, even fixed capital becomes variable capital and marginal cost has in that case to take note of both fixed capital cost and variable cost.
Criticism:
One criticism against the marginal cost principle of pricing of products of PEs is that, if strictly applied, it would result in deficit in the case of industries experiencing increasing returns or decreasing costs. Such deficits may have to be met by imposing taxes on other consumers who are not purchasing that commodity and this could reduce their welfare.
Surplus Revenue:
The principle of marginal cost would mean, in the case of industries which are functioning under conditions of decreasing costs, an increase in the price of commodity with every increase in production of that commodity. This would result in large surplus revenue. This surplus revenue, apart from inviting public protests, might also result in a demand for a rise in wages and bonus by workers in that unit of the PE.
Practical Difficulties:
The marginal cost principle may also be found unworkable because of the practical difficulties of calculating, with any degree of accuracy, the marginal cost in public utilities such as electricity, State transport services, post and telegraph and so on.
2.Pricing on the Basis of Average Cost:
‘Average cost pricing principle’ refers to fixing the price of a commodity on the basis of the average cost of population of the commodity. In the case of average cost pricing, total revenue obtained by selling a certain amount of commodity will be equal to its total cost of production. Thus, average cost pricing principle ensures that the entire cost of production is absorbed in to the price of the commodity.
It may be noticed that while calculating total cost of production, along with various other costs, normal profits is also included. On account of this, the price of a commodity is a little higher than the price based on the principle of ‘No profit, No losses.
3.‘No Profit, No Loss’ or ‘Break-Even’ Principle:
‘No profit. No losses or ‘Break-even’ principle of pricing of products or services of PEs maintains that the price should be fixed in such a way that there will be neither any profit, nor any loss for the concerned PE. In simple terms, price should just-cover all costs of production.
It is noted that in the case of marginal cost pricing, in the case of decreasing cost condition, the concerned-PE will suffer a loss which will have to be subsidized by taxing people to the extent of the deficit suffered by the PE. There is thus cross subsidization.
In the case of No profit, no loss’ principle of pricing of products of PEs there is no question of any loss and, therefore, no subsidizing the PE out of the government treasury or by taxing the people.
This means that when ‘No profit, no loss’ principle of pricing is adopted by a PE non-consumer of the commodity in question are not forced directly or indirectly to bear a ‘burden for the benefit of those who consume the product.
Arthur Lewis has advocated this principle of ‘No Profit No losses on the ground that the principle will prevent either over- expansion or under-expansion of a PE and will thus help avoid either inflationary or deflationary tendencies.
In India, the Damodar Valley Corporation (DVC) follows the principle of ‘No profit No loss’ in pricing. Other PEs which follow this principle of pricing are Hindustan Antibiotics, Hindustan Insecticides, Export Guarantee Corporation, etc.
4.Profit-Making Principle of Pricing:
Profit-making principle of pricing of the products or services of PEs maintains that the price charged should be such as to get for the concerned PE some surplus after absorbing all the cost elements, including normal profit. It is maintained that in developing countries like India, PEs are expected to generate as much surplus as possible so that these surplus funds can be further invested in developmental projects.
As we intend to measure the effectiveness of capital market regulation on the use of public debt and equity, we have first considered two measures of capital structure- first, the ratio of long-term debt to total asset where long term debt includes long-term borrowing from banks and financial institutions and public borrowing in form of debenture (secured and non-secured) and second, the ratio of equity to total asset where equity consists of paid-up equity capital plus share-premium reserves. We have not considered internal capital as equivalent to equity capital as this would not reflect firms’ public activities. The other reason for the choice of these two variables is as follows: The trade-off theory predicts that larger the firms’ tangible assets, lessen the chance of bankruptcy and higher value in liquidation; so tangible assets should be positively correlated with debt. On the other hand, information asymmetry theory says that higher tangible assets lead to reduction in asymmetry of information between ‘insiders’ and ‘outsiders’, and hence use of equity should increase. Considering these two dependent variables, we can distinguish between theories and the regression co-efficient on equity will particularly tell us the level of information a particular variable conveys in the market. One may argue that in a sense, debt and equity are substitutes and hence it is sufficient to consider only one of them as dependent variable. However, empirical estimation presented in Table 6 clearly shows that increase and decrease in these variables are not proportionate over time. One reason may be that retained profits are not considered. Nonetheless, given the observation that they do not increase or decrease in fixed proportion, one may get additional insights from running two separate regressions. Most importantly it helps us to derive clear indications regarding validity of the above-mentioned theories. However, the choice of explanatory variables is based on trade-off, pecking order, agency theory, control considerations as well as institutional factors. The predictions can be summarized as follows:
1. Age Trade-off Theory-It predicts that with passage of time, firms establish a historical record of honouring the financial obligations and this reputation increases the debt capacity of firms. Thus, mature firms can borrow under better terms, and the probable impact of age on debt is positive. In contrast, it may be argued that the greater availability of information on older firms tends to reduce information asymmetries associated with equity. Hence, in line with pecking order hypothesis, one can say that mature firms tend to use the capital market for equity relatively more compared to younger firms. Moreover, since mature firms are likely to have accumulated higher levels of past earnings, these firms need less of debt finance. We have calculated age as the difference between year of incorporation and the year in which firm exists in the sample.
2. Size Trade-off theory – It predicts that larger firms tend to be more diversified, and hence less risky and less prone to bankruptcy. Further, if maintaining control is important, then it is likely that firms achieve larger size through debt rather than equity financing. Thus, control considerations also support positive correlation between size and debt. However, it can also be argued that size serves as proxy for availability of information that outsiders have about the firm. From pecking order point of view, less information asymmetry makes equity issuance more appealing to the firm. Thus, a negative link between size and leverage is expected. This study uses natural logarithm of real sales as a proxy for size while some studies are found to have used natural logarithm of total assets as the proxy for size, though both yield the same result.
3. Asset Structure - The ratio of fixed assets to total assets represents the degree of asset tangibility. The trade-off theory postulates tangibility to be positively related to debt levels for two main reasons, namely, security and the cost of financial distress. First, tangible assets normally provide high collateral value relative to intangible assets, which implies that these assets can support more debt. Second, tangible assets often reduce the cost of financial distress because they tend to have high liquidation value. Information asymmetry theory predicts that larger firms disclose more information to outsiders than smaller firms. Larger firm with less information asymmetry problem should tend to have more equity than debt, and hence less leverage. Here we have introduced the ratio of gross fixed assets to total assets as the tangibility of firm’s assets.
4. Growth Opportunities- The term ‘growth opportunities’ means possible growth alternatives or future investment opportunities. This can be considered as intangible asset of the firms. The nature of intangibility creates the problem of information asymmetry between firm’s insiders and outsiders. Due to this information asymmetry, the firms with higher growth opportunities issue securities which have less problem of information asymmetry, e.g., short-term debt. However, it can also be argued that a system dominated by private lenders ought to have superior firm specific information that could reduce the problem of information asymmetry between private lenders and borrowers, even in the long-term. In a country like India, where the debt market is mostly dominated by private lenders, namely, banks and financial institutions, one can expect a positive relationship between growth and leverage. Myers (1977) has suggested using ratio of market value to the book value of assets as a proxy for growth opportunities. Moreover, Titman and Wessels (1988) have used the percentage change in total assets as a proxy for growth opportunities. In the absence of data for market value to book value of assets, this study uses the percentage growth of total assets as the proxy for growth opportunities.
5. Non-debt Tax shields - DeAngelo and Masulis (1980) argue that non-debt tax shields are substitutes for tax benefits of debt financing. Thus, a firm with high non-debt tax shields is likely to be less leveraged. This leads to prediction of negative correlation between non debt tax shields and debt. Therefore, this study uses the depreciation to gross fixed assets ratio as a proxy for non-debt tax shields.
6. Profitability- In the context of pecking order theory, profitable firms are likely to have sufficient internal finance that obviates the need to rely on external finance. Moreover, as per agency theory framework, if the contest for corporate control is inefficient, managers of profitable firms will use the higher level of retained earnings in order to avoid the disciplinary role of external finance. These two rationales point to a negative correlation between profitability and leverage. In addition, in an agency theory framework, if the market/contest for corporate control is efficient, managers of profitable firms will seek debt as a disciplinary device because debt is regarded as a commitment to pay out cash in the future. Agency theory also supports the positive correlation between profitability and leverage. On the other hand, trade-off theory postulates that firms with larger profits need to pay more taxes than firms with smaller profits. Therefore, firms with high profit should use more debt in their capital structure in order to get much more tax shields from interest payment. Hence, it can be said that trade-off theory postulates a positive relation between profitability and leverage. This study uses earnings before interest tax and depreciation to total assets as a measure of profitability.
7. Liquidity ratios may have a mixed impact on the capital structure decision. On one hand, firms with higher liquidity ratios might support a relatively higher debt ratio due to greater ability to meet short-term obligations when they fall due. This would imply a positive relationship between a firm’s liquidity position and debt ratio. On the other hand, firms with greater liquid assets may use these assets to finance their investments. Therefore, firm’s liquidity position should exert a negative impact on its leverage ratio. Moreover, as Prowse (1990) argues, liquidity of the company assets can be used to show the extent to which these assets can be manipulated by shareholders at the expense of bondholders. For the purpose of this study, the ratio of current assets to current liabilities is used as a proxy for liquidity.
8. Interest Cover Harris and Raviv (1990) have suggested that interest coverage ratio has negative correlation with leverage. They conclude that an increase in debt will increase default probability. Therefore, interest coverage ratio will act as a proxy of default probability, which means that a lower interest coverage ratio indicates a higher debt ratio. This study takes earnings before interest and tax to interest payment ratio as a measure of interest cover.
9. Exports - In developing countries, like India, firms which are net exporters are given credit benefits like export import credit facility, and forward letter of credit. This implies that firms which are net exporters may have lesser need of debt in their capital structure. Therefore, we can expect a negative relationship between exports and leverage. This study uses exports to total sales ratio as a measure of exports.
10. Labour Intensity- According to Modigliani-Miller’s (1958) capital structure irrelevance theorem, capital structure decision is independent of output, investment and employment decision, as real variables do not affect the financial variables and vice versa. Funke et al. (1999) have estimated the labour demand function for Germany and found that leverage is negatively related to the labour demand. The reason is that as debt increases, the cost of borrowing increases. On the other hand, as employment increases, productivity of capital decreases. Therefore, when marginal product of capital falls below marginal cost of borrowing, investment becomes unprofitable. So, the firm reduces its labour demand. Hence, financial decision and employment decision are interdependent. This study has used compensation to employees to fixed assets ratio as a measure of labour intensity in the production process.
11. Capital Market Regulation- Capital market regulation is aimed at reducing the information asymmetry between insiders and outside investors, and thereby reducing the cost of equity capital of the firms. This reduction in cost of equity capital leads to the development of equity market which will form a viable source of finance for the corporate sector. In this study, we are using a ‘regulation index’, which serves as an inverse proxy for information asymmetry, constructed through factor analytic approach as proxy for regulatory changes. Thus, we have explained the important independent variables to be considered in our analysis, and how they may impact our dependent variable. Also, the dependent variables may impact some of the independent variables in a later period, as is the case in most regressions. The impacts however are clearly not simultaneous.
Working capital management refers to the activities of a business’s current assets and current liabilities for the company’s effective operation.
Types of working capital-
According to the needs of business, the working capital may be classified into following two bases:
1) On the basis of periodicity
2) On the basis of concept
On the basis of periodicity: The requirements of working capital are continuous. More working capital is required in a particular season or the peck period of business activity. On the basis of periodicity working capital can be divided under two categories as under:
i. Permanent working capital
Ii. Variable working capital
(i) Permanent working capital: This type of working capital is known as Fixed Working Capital. Permanent working capital means the part of working capital which is permanently locked up in the current assets to carry out the business smoothly. The minimum amount of current assets which is required to conduct the business smoothly during the year is called permanent working capital.
For example, investments required to maintain the minimum stock of raw materials or to cash balance. The amount of permanent working capital depends upon the size and growth of company. Fixed working capital can further be divided into two categories as under:
a. Regular Working capital: Minimum amount of working capital required to keep the primary circulation. Some amount of cash is necessary for the payment of wages, salaries etc.
b. Reserve Margin Working capital: Additional working capital may also be required for contingencies that may arise any time. The reserve working capital is the excess of capital over the needs of the regular working capital is kept aside as reserve for contingencies, such as strike, business depression etc.
(ii) Variable or Temporary Working Capital: The term variable working capital refers that the level of working capital is temporary and fluctuating. Variable working capital may change from one asset to another and changes with the increase or decrease in the volume of business. The variable working capital may also be subdivided into following two sub-groups.
a. Seasonal Variable Working capital: Seasonal working capital is the additional amount which is required during the active business seasons of the year. Raw materials like raw-cotton or jute or sugarcane are purchased in particular season. The industry has to borrow funds for short period. It is particularly suited to a business of a seasonal nature. In short, seasonal working capital is required to meet the seasonal liquidity of the business.
b. Special variable working capital: Additional working capital may also be needed to provide additional current assets to meet the unexpected events or special operations such as extensive marketing campaigns or carrying of special job etc.
Factors determining working capital
The following factor determine the amount of working capital
1. Nature of Companies: The composition of an asset is a function of the size of a business and the companies to which it belongs. Small companies have smaller proportions of cash, receivables and inventory than large corporation. This difference becomes more marked in large corporations. A public utility, for example, mostly employs fixed assets in its operations, while a merchandising department depends generally on inventory and receivable. Needs for working capital are thus determined by the nature of an enterprise.
2. Demand of Creditors: Creditors are interested in the security of loans. They want their obligations to be sufficiently covered. They want the amount of security in assets which are greater than the liability.
3. Cash Requirements: Cash is one of the current assets which are essential for the successful operations of the production cycle. A minimum level of cash is always required to keep the operations going. Adequate cash is also required to maintain good credit relation.
4. Nature and Size of Business: The working capital requirements of a firm are basically influenced by the nature of its business. Trading and financial firms have a very less investment in fixed assets, but require a large sum of money to be invested in working capital. Retail stores, for example, must carry large stocks of a variety of goods to satisfy the varied and continues demand of their customers. Some manufacturing business, such as tobacco manufacturing and construction firms also have to invest substantially in working capital and a nominal amount in the fixed assets.
5.Time: The level of working capital depends upon the time required to manufacturing goods. If the time is longer, the size of working capital is great. Moreover, the amount of working capital depends upon inventory turnover and the unit cost of the goods that are sold. The greater this cost, the bigger is the amount of working capital.
6. Volume of Sales: This is the most important factor affecting the size and components of working capital. A firm maintains current assets because they are needed to support the operational activities which result in sales. They volume of sales and the size of the working capital are directly related to each other. As the volume of sales increase, there is an increase in the investment of working capital-in the cost of operations, in inventories and receivables.
7. Terms of Purchases and Sales: If the credit terms of purchases are more favourable and those of sales liberal, less cash will be invested in inventory. With more favourable credit terms, working capital requirements can be reduced. A firm gets more time for payment to creditors or suppliers. A firm which enjoys greater credit with banks needs less working capital.
8. Business Cycle: Business expands during periods of prosperity and declines during the period of depression. Consequently, more working capital required during periods of prosperity and less during the periods of depression.
9.Production Cycle: The time taken to convert raw materials into finished products is referred to as the production cycle or operating cycle. The longer the production cycle, the greater is the requirements of the working capital. An utmost care should be taken to shorten the period of the production cycle in order to minimize working capital requirements.
10. Liquidity and Profitability: If a firm desires to take a greater risk for bigger gains or losses, it reduces the size of its working capital in relation to its sales. If it is interested in improving its liquidity, it increases the level of its working capital. However, this policy is likely to result in a reduction of the sales volume, and therefore, of profitability. A firm, therefore, should choose between liquidity and profitability and decide about its working capital requirements accordingly. 11. Seasonal Fluctuations: Seasonal fluctuations in sales affect the level of variable working capital. Often, the demand for products may be of a seasonal nature. Yet inventories have got to be purchased during certain seasons only. The size of the working capital in one period may, therefore, be bigger than that in another.
Even though, the government has slashed the corporate income tax rate as follows:
1. All domestic companies to be allowed to pay corporation tax at the rate of 22% (effective rate 25.17% including cess and surcharge). This would be subject to the condition that these companies do not avail of any tax incentives or exemptions. Moreover, no Minimum Alternative Tax (MAT) would be imposed on these companies.
2. Any new domestic manufacturing company, incorporated on or after October 1, 2019, will be allowed to pay corporation tax at the rate of 15% (effective rate 17.01%). No MAT will be imposed on these companies either. This will be subject to the condition that the company does not avail of any tax incentives or exemptions and commences production by 31 March, 2023.
3. For companies who continue to avail exemptions/incentives, the rate of minimum alternate tax (MAT) has been reduced from 18.5 percent to 15 percent.
These changes in income tax rates are brought through an Ordinance which require legislative amendments as of now. They require Parliamentary ratification. When the Parliament is not in session, the government can bring these changes through an Ordinance and later bring a Bill when Parliament convenes. Under normal circumstances, income tax rate changes take place in the Union Budget during the passage of the Finance Bill. The government’s decision to bring about an ordinance mirrors the urgency attached to the economic situation. The next Parliament session—the Winter Session—is starting next month. The government did not want wait until Parliament convened for the Winter Session for bringing in these changes, given the economy’s wobbly state and the need to soothe frayed nerves of the corporate community. Though there is no stopping to get ratification from parliament to these changes.)
Tax planning for corporates comprises of means for reducing companies tax liabilities. The simplest way to achieve this is by taking into account expenses made on health insurance of employees, office expenses, business transport, employee child care expenses, charitable contributions retirement planning, etc.
By taking full benefit of various tax deductions and exemptions available under the Income Tax Act, 1961 corporates can considerably bring down their tax burden. Higher the growth of the corporate firm means growing profits of the corporate house resulting in higher taxes for the corporate firm. Under such a scenario a proper corporate tax planning activity it becomes of extreme importance. Corporate firms account team must take into account all the available sections of the income tax act, 1961 to bring down their tax burden. Proper and efficient tax planning activity by a corporate house leads to a reduction in payment of their direct and indirect taxes.
References:
- Sahai, Baldeo. (1989). Public Sector in India – Historical Perspective in SCOPE: Dynamics of Management of Public Enterprises (ed) Waris R.Kidwai and Baldeo Sahai.
- Laha, Chandra, Prakash. (1989). Public Sector: The Socio – Economic and Political Environment in SCOPE: Dynamics of Management of Public Enterprises (ed) Waris R.Kidwai and Baldeo Sahai.
- Nigam, K. Raj: Indian Public Sector at the Cross Roads.
- Dynamics of Management of Public Enterprises (ed) Waris R.Kidwai and Baldeo Sahai. New Standing conference on Public Enterprises, New Delhi.
- Rao, S.L. Ownership, Control and Management of Public Enterprises.
