Module -5 Capital Capital is the life blood of a business enterprise. Capital is a universal lubricant which keeps enterprise dynamic. Capital in its meaning covers all the elements (e.g. money, Land, Building, machinery, materials etc.) a businessman needs to start an enterprise. Capital is the measure of the amount of resources of enterprise. Capital develops products, keeps workers and machines at work, encourages management to make progress and create value.

The forms, classification or types of capital There are two categories mainly: Fixed capital Working Capital Fixed Capital: It refers to durable capital goods which are used in production again and again till they wear out. Machinery, tools, means of transport, factory building, etc are fixed capital. Fixed capital does not mean fixed in location. Since the money invested in such capital goods is fixed for a long period. Assets of this type are used over and over again for a number of years and are commonly termed s fixed capital.

Working capital : Once fixed assets e.g building, equipment , machinery etc. have been purchased the enterprise needs funds to meet its day to day needs and expenditure such as Purchase of raw materials Payment of employee wages and salaries Advertisements and selling expenses Equipment and plant maintenance costs To provide credit facilities to the customers. To meet the short term obligations of a business enterprise. Transportation and shipping expenses. To incur day to day expenses and overheads costs such as fuel, power etc. Working capital or variable capital is referred to the single use capital goods like raw materials. They are used directly and only once in production. They get converted into finished goods. Money spend on them is fully recovered when goods made out of them are sold in the market.

Types of working capital There are four types of working capital and they are as follows:- Gross Working Capital Net Working Capital Permanent Capital Temporary Working Capital

Gross Working Capital Total or gross working capital is that working capital which is used for all the current assets. Total value of current assets will equal to gross working capital. Net Working Capital Net working capital is the excess of current assets over current liabilities. Net working capital = Total current assets – Total Current Liabilities. Current assets typically include categories such as cash in hand, cash at bank, short-term investment, prepaid expenses, Sundry debtors and inventory. Current liabilities typically include categories such as accrued expenses, accounts payable, long term debt.

Permanent Capital Permanent working capital is that amount of capital which must be in cash or current assets for continuing the activities of business. It also shows the minimum amount of all current assets that is required at all times to ensure a minimum level of uninterrupted business operations. Temporary Working capital Sometime, it may possible that we have to pay fixed liabilities , at that time we need working capital which is more than Permanent working capital then this excess amount will be temporary working capital. In normal working of business, we don’t need such capital.

Factors affecting Working Capital The working capital requirements of a business depends upon a number of ‘factors which in brief are as under. Nature of business Length of period of manufacture Size of the business Terms of purchase and sale Price level changes Rate of turnover Size of labour force Seasonal variations in business Converting working assets into cash.

Risk Every business involves some risk and most people do not like being involved in any risky enterprise. Risk refers to a decision making situation where there are different possible outcomes and the probabilities of these outcomes can be measured in some way. Risk involves choice with multiple outcomes where the probability of each outcome is known or can be estimated. A manager investing in new product development adoption of new technology or new market entry faces various risks. There are various types of risk that relates to investment in projects.

Types of Risks Risks can be broadly classifies into two groups that is:- Systematic risk Unsystematic risk It arises due to macroeconomic factors of business such as social, political or economic factors, it includes, Market risk Inflation risk Interest rate risk

Unsystematic risk It arises due to the fluctuations in returns of a companys security due to microeconomic factors that is factors existing in the organization. The factors that cause systematic risk relates to a particular industry such as labour problems. It includes; Business risk: Internal business risk: Firms limiting environment External business risk: Business cycle, demographic factors, political and monetary policies Credit risk Liquidity risk.

Decision making Decision making is a process by which a course of action is consciously chosen from available alternatives for the purpose of achieving desired results. Usually, there are three different conditions under which decisions are made, which are explained below. Conditions under certainty Conditions under risk Conditions under uncertainty

Conditions under certainty: Conditions under certainty are in which the decision maker has full and needed information to make a decision . The manager knows exactly what the outcome will be, as he/she has enough clarity about the situation and knows the resources, time available for decision making, the nature of the problem. In most situations, the solutions are already available from the past experiences and are appropriate for the problem at hand. Conditions under risk: Conditions under risk provide probabilities regarding expected results for decision making alternatives, it is due to the nature of the future conditions that are not always know in advance and the managers face this condition more often in reality compared to conditions under certainty. Although some good information may be available it is not enough to answer all questions about the outcomes. Conditions under uncertainty: Conditions under uncertainty provide no or incomplete information, many unknown and possibilities to predict expected results for decision making alternatives. The manager could not even assign subjective probabilities to the likely outcomes of alternatives. The manager himself cannot predict with confidence what the outcomes of his action to be.

Business decisions under certainty Decision making under certainty implies that we are certain of the future state of nature. One common technique for decision making under certainty is linear programming. In this method, a desired benefit such as profit can be expressed as a mathematical functions ( the value model or objective functions) of several variables.

Business decisions under risk When making a decision under the condition of risk, the manager does not know the outcome of each alternative in advance, but can assign a probability to each outcome. Decisions under conditions of risk are perhaps most common. The role of the manager would be to either eliminate risk or reduce the size of the risk within a project and would a risk assessment to be undertaken which would identify the project variables and the level of risk to be attached to each project variables.

Methods for taking investment decisions under risk Sensitivity analysis Identifying all variables that affect the NPV or IRR of the project Establishing a mathematical relationship between the independent and dependent variable Studying and analysing the impact of the change in the variables. Decision tree analysis It is one of the most effective methods of assessing risks in a project. In this method, a decision tree is drawn for analysing the risks associated in a project. It is a schematic representation of the alternatives available to a decision maker and their possible consequences.

Business decisions under uncertainty Uncertainty refers to a decision making situation where there are different possible outcomes and the probabilities of these outcomes cannot be meaningful measured, sometimes because all possible outcomes cannot be foreseen or specified.

Sources of uncertainty There are two sources of uncertainty: Uncertainty with complete ignorance: Refers to those situations in which no assumptions can be made about the probabilities of alternative outcomes under different states of nature. Uncertainty with partial ignorance: Refers to those situations in which the decision maker is able to assign subjective probabilities to possible outcomes. These subjective probabilities may be based on personal knowledge, intuition or experience.

Different approaches of uncertainty Maxi-max solution: optimistic decision maker Maxi-min solution: pessimist decision maker Mini-max solution: between optimism & pessimism

Cost benefit analysis It is mainly used for economic evaluation of public projects which are mostly funded by government organisations. In addition this method can also used for economic evaluation of alternatives for private projects. The main objective of this method is used to find out the desirability of public projects as far as the expected benefits on the capital investment are concerned. As the name indicates, this method involves the calculation of ratio of benefits to the costs involved in a project.