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MB0045 : Explain each of the following: a) Operating cycle b) Shareholders wealth maximisation c) Capital rationing d) Economic order quantity

Posted on: October 18, 2011

MB0045  : Explain each of the following:

a) Operating cycle

b) Shareholders wealth maximisation

c) Capital rationing

d) Economic order quantity

Answer : Operating Cycle

The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle

Operating cycle of a firm involves the following elements.

  • Acquisition of resources from suppliers
  • Making payments to suppliers
  • Conversion of raw materials into finished products
  • Sale of finished products to customers
  • Collection of cash from customers for the goods sold

The five phases of the operating cycle occur on a continuous basis. There is no synchronisation between the activities in the operating cycle. Cash outflows occur before the occurrences of cash inflows in operating cycle.

Cash outflows are certain. However, cash inflows are uncertain because of uncertainties associated with effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods.

Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements.

Shareholders wealth maximisation

Wealth maximisation means maximising the net wealth of a company’s shareholders. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. It has been accepted by the finance managers as it overcomes the limitations of profit maximisation.

The following arguments are in support of the superiority of wealth maximisation over profit maximisation

  • Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand, profit maximisation is based on accounting profit and it also contains many subjective elements.
  • Wealth maximisation considers time value of money. Time value of money translates cash flows occurring at different periods into a comparable value at zero period. In this process, the quality of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallises into the rate of return that will motivate investors to part with their hard earned savings. Maximising the wealth of the shareholders means positive net present value of the decisions implemented.

Capital Rationing

Firms may have to make a choice from among profitable investment opportunities, because of the limited financial resources. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control.

Capital rationing may be needed due to:

  • External factors
  • Internal constraints imposed by management


External capital rationing

External capital rationing is due to the imperfections of capital market. Imperfections are caused mainly due to:

  • Deficiencies in market information
  • Rigidities that hamper the force flow of capital between firms

When capital markets are not favourable to the company, the firm cannot tap the capital market for executing new projects even though the projects have positive net present values. The following reasons attribute to the external capital rationing:-

  • The inability of the firm to procure required funds from capital market because the firm does not command the required investor’s confidence
  • National and international economic factors may make the market highly volatile and unstable
  • Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the market for funds
  • High cost of issue of securities i.e. high floatation costs. Smaller firms may have to incur high costs of issue of securities. This discourages small firms from tapping the capital market for funds

Internal capital rationing

Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing.

This decision may be the result of a conservative policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount that they can commit on new projects.Another internal restriction for capital budgeting decision may be imposed by a firm based on the need to generate a minimum rate of return. Under this criterion only projects capable of generating the management’s expectation on the rate of return will be cleared.

Generally internal capital rationing is used by a firm as a means of financial control.

Economic order quantity (EOQ)

Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage.

EOQ model answers the following key quantum of inventory management.

  • What should be the quantity ordered for each replenishment of stock?
  • How many orders are to be placed in a year to ensure effective inventory management?

EOQ is defined as the order quantity that minimises the total cost associated with inventory management.

EOQ is based on the following assumptions:

  • Constant or uniform demand: The demand or usage is even through-out the period
  • Known demand or usage: Demand or usage for a given period is known i.e. deterministic
  • Constant unit price: Per unit price of material does not change and is constant irrespective of the order size
  • Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of inventory
  • Constant ordering cost: Cost per order is constant whatever be the size of the order

Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory.

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