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UNIT NO. 1

FOUNDATIONS OF FINANCE

Financial management An overview

Financial management is that management activity which is concerned with the planning and controlling of the firms

financial resources. It is concerned mainly with procuring funds in the most economical and prudent manner, deploying

these funds in most profitable way in a given risk situation, planning future operations ad controlling current and future

performances and developments through different tools. It an approach by which depending on importance, resources can

be allocated to various projects.

For efficient operations of a business, there is necessity for obtaining and effectively utilizing funds. These jobs are done by

Financial Management. Basically, therefore, finance management centres around fund raising for business in the most

economical way and investing these funds in optimum way so that maximum return can be obtained for the shareholders.

Since all business decisions have financial implications, financial management is interlined with all other functions of the

business.

FUNCTIONS OF FINANCE

1. Investment Decision : Investment decisions or capital budgeting involves the decision of allocation of capital

or commitment of duns to long term assets which would yield benefits in future. One significant aspect of this is

the task of measuring prospective profitability of new investment.

Future benefits are difficult to measure and cannot be predicted with certainty. Because of the uncertain future,

capital budgeting decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both

expected return and risk. Besides the decision to commit funds in new investment proposals, capital budgetingalso involves decision of recommitting funds when an asset become less productive or non-profitable.

Another major aspect of investment decision is the measurement of a standard or hurdle rat against which the

expected return of new investment can be compared There is a broad agreement that the correct standard to use

for this purpose is the required rate of return or the opportunity cost of capital. However, one confronts many

problems in computing the cost of capital in practice.

2. Financing Decision : The finance manger must decide when, where and how to acquire funds to meet the

firms investment needs. The central issue before him is to determine the proportion of equity and debt. The mix

of debt and equity is known as the firms capital structure.

The financial manager must strive to obtain the best financing mix or the optimum capital structure for his firm,

the firms capital structure is considered to be optimum when the market value of shares is maximized. The use of

debt affects the return and risk of shareholders; it may increase the return on equity funds but it always increases

risk.

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A proper balance will have to be struck between return and risk. When the shareholders return is maximized

with minimum risk, the market value per share will be maximized and the firms capital structure would be

considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he

must raise the appropriate amount through best available sources. In practice, a firms considers many other

factors such as control, flexibility, loan covenants, legal aspects, etc. in deciding its capital structure.

3. Dividend Decision : This is the third major financial decision. The financial manager must decide whether the

firm should distribute all profits, or retain them, or distribute a portion and retain the balance. Like the debt

policy, the dividend policy should be determined in terms of its impact on shareholders value.

The optimum dividend policy is one which maximizes the market value of the firms shares. Thus, if the

shareholders are interested in the firms dividend policy, the financial manager must determine the optimum

dividend payout ratio.

The dividend payout ratio is equal to the percentage of dividends distributed to earnings available to shareholders.

The financial manager should also consider the question of dividend stability, bonus shares and cash dividend in

practice. Most profitable companies pay cash dividends regularly. Periodically additional shares, called bonus

shares are also issued to the existing shareholders in addition to the cash dividend.

4. Liquidity Decision : Current assets management which affects a firms liquidity is yet another important

finance function, in addition to the management of long-term assets. Current assets should be managed

efficiently for safeguarding the firms against the dangers of illiquidity and insolvency. Investment in current

assets affects firms profitability, liquidity and risk.

A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest

sufficient funds in current assets, it may become illiquid. But it would lose profitability as idle current assetswould not earn anything. Thus a proper trade-off must be achieved between profitability and liquidity.

In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial

manager should develop sound techniques of managing current assts and make sure that funds would be made

available when needed.

JOB OF FINANCIAL MANAGER

Financial Manager is a person who is responsible in a significant way to carry out the finance functions. He is one of the

dynamic members of a top management team, and his role day-to-day is becoming more pervasive, intensive andsignificant in solving the complex management problems. His main functions include :

a. Raising of funds

b. Allocation of funds

c. Profit planning

d. Understanding Capital Markets

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CHANGING ROLE OF FINANCE MANAGER

The critical problem being faced by the companies today is obtaining finance for expansion. Initially the capital markets

were primitive. The transfer of funds from individual savers to businesses were quite difficult few years ago. With changes

in regulation of Stock Exchanges, the environment in the capital is better now than earlier and is progressing towards a

near perfection stage slowly.

In earlier years, Finance managers in India used to practice in an environment where sellers market prevailed. Near

monopoly was the state of affairs in the Indian business. Sources of finance used to come mostly from Bank/Financial

Institutions. The emphasis on Debt/Equity took a back sear. The satisfaction of shareholders were not the concern of the

promoters wince most companies were closely help (family businesses).

Because of the opening up of the economy, competition increased and sellers market has been converted into a buyers

market. The emphasis on decision making by the Finance manager has changed in recent years.

Firstly, there has been increasing belief that sound investment decision require accurate measurements of cost of

capital. Accordingly, ways of quantifying the cost of capital now play a key role in finance.

Secondly, capital has been in short supply, making one reconsider ways of raising funds.

Thirdly there has been continued merger activity leading to renewed interest in takeovers.

Financial Manager The financial manager raises capital from the capital markets. He or she should therefore know-how

the capital markets function to allocate capital to the competing firms and how security prices are determined in the capital

markets.

Chief Financial Officer A number of companies in India either have a finance director or a vice-president of finance

as the Chief Financial Officer (CFO). Most companies have only one CFO. But a large company may have both a

treasurer and a controller, who may or may not operate under the CFO.

Treasurer and Controller The treasurers function is to raise and manage company funds while the controller

oversees whether funds are correctly applied.

Functions of Treasurer:

1. Provision of finance

2. Investor relations

3. Short-term financing

4. Banking and custody

5. Credit and collections

Functions of Controller.

1. Planning and control.

2. Reporting and interpreting

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3. Tax administration

4. Government reporting

5. Protection of assets.

6. Economic appraisal

Agency Problem and Agency Costs :

Shareholders and managers have the principal- agent relationship. In practice, there may arise a conflict between the

interests of shareholders and managers. This is referred to the agency problem and the associated costs are called

agency costs. Offering ownership rights (in the form of stock options) to managers can mitigate agency costs.

FINANCIAL GOAL PROFIT VERSUS WEALTH

The firms investment and financing decisions are unavoidable and continuous. In order to make them rationally, the firm

must have a goal. It is generally agreed in theory that the financial goal of the firm should be the maximization of owners

equity economic welfare. Owners economic welfare could be maximized by maximizing the shareholders wealth as

reflected in the market value of share.

PROFIT MAXIMISATION

Profit maximization means maximizing the rupee income of firms. The profit maximization objective has, however, been

criticized in recent years. It is argued that profit maximization assumes perfect competition and in the face of imperfect

modern markets, it cannot be a legitimate objective of the firm.

It is also argued that profit maximization, as a business obejc6ive developed in the 19th century when characteristic feature

of business structure were self financing, private property and single entrepreneurship. The only aim of the single owner

then was to enhance his individual wealth and personal power which could easily be satisfied by the profit maximization

objective.

The modern business environment is characterized by limited liability and a divorce between ownership and management.

The business firm today is financed by shareholders and lenders but it is controlled and directed by professional

management. The other interested parties are customers, employees, government and society.

In practice, the objectives of the different stakeholders of a firm differ and may conflict with each other. The manager of a

firm has the difficult task of reconciling and balancing these conflicting objectives. In the new business environment, profit

maximization is regards as unrealistic, difficult, inappropriate and immoral.

It is also feared that profit maximization attitude may tend to produce goods and service that are wasteful and unnecessary

from the societys point of view. Also it might lead to inequality of income and wealth. It is for this reason that

governments tend to intervene in business.

Apart form the above objections, profit maximization fails to serve as an operational criterion for maximization the owners

economic welfare. It fails to prove an operational feasibility for ranking alternative courses of action in terms of their

economic efficiency. It suffers from the following limitations :

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a. It is vague

b. It ignores timing of returns

c. It ignores risk

Definition of Profit: The precise meaning of profit maximization objective is unclear. The definition of the term profit

is ambiguous. Does it mean short or-long term profit? Does it refer to profit before or after tax? Total profits or profit per

share? Does it mean total operating profit or profit accruing to shareholders?

Time Value of Money : The profit maximization objective does not made a distinction between returns received in

different time periods. It give no consideration to the time value of money and it values benefits received today and

benefits received after a period to be the same.

Uncertainty of returns : The stream of benefits may possess different degree of uncertainty. Two firms may have same

total expected earning, but if the earnings of one firm fluctuate considerably as compared to the other, it will be more risky.

Possibly, owners of the firm would prefer smaller but surer profits to a potentially larger but less certain stream of benefits.

In trying to maximize the profits the following should be remembered :

a. Profit after Taxes :

Maximizing profits after tax will not maximization the economic welfare of the owners. It is not possible for a firm

to increase profits after taxes by selling additional equity shares and investing the proceeds in low-yielding assets

such as government bonds. Profits after tax will go up but earnings per share would go down.

b. Earnings per share :

If we adopt maximizing EPS as the financial objective of a firm, this will also not ensure maximization of owners

economic welfare. It also suffers from flaws mentioned above i.e., it ignores timing and risk of the expected benefits.

Wealth Maximization :

The use of the objective of wealth maximization has been advocated as an appropriate and operationally feasible criterion

to choose among the alternative financial actions. It provides an unambiguous measure of what financial management

should seek to maximize in investment and financing decisions.

Wealth maximization means maximizing the net present value (or wealth) of a course of action. The net present value of a

course of actions is the difference between the present value of tits benefits and the initial outlay. A financial decision

which has a positive net present value creates wealth and therefore is desirable. A financial action resulting in negative net

present value should be rejected. Between a number of desirable mutually projects we have to choose those combinations

of projects which give the highest positive NPV.

SCOPE OF FINANCIAL MANAGEMENT

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Traditional Approach

(i) Arrangement of funds from financial institutions.

(ii) Arrangement of funds through financial instruments, viz, shares, bonds, etc.

(iii) Looking after the legal and accounting relationship between a corporation and its sources of funds.

Criticism on Traditional Approach:

(i) Outsider-looking in approach

(ii) Ignored routine problems.

(iii) Ignored non-corporate enterprises

(iv) Ignored working capital financing

(v) No emphasis on allocation of funds.

Modern Approach

According to modern concept, financial management is concerned with both acquisition of funds as well as their allocation.

The modern approach is an analytical way of looking at the financial problems of a firm. The main contents of the new

approach are as follows:

(i) What is the total volume of funds an enterprise should commit?

(ii) What specific assets should an enterprise acquire?

(iii) How should the funds required be financed?

The above questions relate to four broad decision areas of financial management, viz., funds requirement decisions,

financing decision, investment decision and dividend decision.

Subsidiary functions of Finance Manager:

(i) To ensure supply of funds to all parts of the organization.

(ii) Evaluation of financial performance.

(iii) To negotiate with bankers. Financial institutions and other suppliers of credit.

(iv) To keep track of stock exchange quotations and behavior of stock market prices.

(v) Financial Control

(vi) Keeping the records of all assets:

Liquidity Profitability:

The finance manager is always faced with the dilemma of liquidity vs profitability. He has to strike a balance between the

two.

a) The firm has adequate cash to pay for its bills.

b) The firm has sufficient cash to make unexpected large purchases and above all.

c) The firm has cash reserve to meet emergencies, at all times.

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Profitability goal, on the other hand, requires that the funds of the firm are so used so as to yield the highest return.

Liquidity and profitability are very closely related. When one increases the other decreases.

There is also direct relationship between higher risk and higher return. Higher risk on the one hand endangers the

liquidity of the firm. Higher return on the other hand increases its profitability.

Forecasting of cash flows and managing the flow of internal funds are the functions which lead to liquidity. Cost control

and forecasting future profits are the functions of finance manager which lead to profitability. An efficient finance manager

fixes that level of operations where both return and risk are optimized. Such a level is termed as risk-return trade-off and

every financial decision involves this trade-off. At this level the market value of the company's shares would be the

maximum.

Methods of Financial Management:

The term 'financial method' or 'financial tool' refers to any logical method or technique to be employed for the purpose of

accomplishing the following two goals.

1. Measuring the effectiveness of firm's actions and decisions.

2. Measuring the validity of the decisions regarding accepting of rejecting future projects.

Financial tools or methods:

1. Cost of Capital helps the financial manager in deciding about the sources from which the funds are to be

raised.

2. Financial Leverage or Trading on Equity is another tool which helps the financial manager in increasing the

return to equity shareholders.

3. Capital Budgeting Appraisal Methods such as, pay-back period average rate of return, internal rate of return,

net present value, profitability index, etc., help the financial manager in selecting the best among alternative

capital investment proposals.

4. ABC analysis, Cash Management Models, Aging Schedule of Inventories, Debtors' Turn-over Ratio, etc., help

the financial manager in effective management of current assets.

5. Ratio analysis is another method for evaluating different aspects of the firm. Different ratios serve different

purposes.

6. Funds flow analysis and Cash flow analysis techniques help the financial manager is determining whether the

funds have been procured from the best available source and they have been utilized in the best possible way.

TIME VALUE OF MONEY :

Individual investors generally prefer possession of a given amount of cash now, rather than the same amount at some

future time. This time preference for money may arise because of :

(a) uncertainty of cash flows,

(b) subjective preference for consumption, and

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(c) availability of investment opportunities. The last reason is the most sensible justification for the time valueof

money.

Risk PremiumInterest rate demanded, over and above the risk-free rate as compensation for time, to account for the

uncertainty of cash flows.

Interest Rate or Time Preference Rate Rate which gives money its value, and facilitates the comparison of cash

flows occurring at different time periods.

Required Interest RateA risk-premium rate is added to the risk- free time preference rate to derive required interest

rate from risky investments.

RISK AND RETURN

Return on a Securityconsists of two parts, the dividend and capital gain.

Expected Rate of Return on a Securityis the sum of the products of possible rates of return and their probabilities.

The expected rate of return is an average rate of return. This average rate may deviate from the possible outcomes (rates of

return).

DispersionWhen the expected rate of return (also called average rate of return) deviate from the possible outcomes

(rates of return), this is referred to as dispersion.

Variance and Standard Deviation Dispersion can be measured byvariance and standard deviation of returns

of a security. Variance ( s2) or standard deviation ( ) is a measure of the risk of returns on a security.

Historically investors have earned different rates of returns. The average return on shares has been more than the average

returns on government bonds and treasury bills. Also, the variance or standard deviation of returns on shares has been

more. Shares are more risky than the government bonds.

Treasury Bills Government issued bonds with guarantees which offers risk free rate, as they do not have risk of default.

Risk Premium The difference between the (long-term) average share return and (long-term) return on government

bonds or treasury bills is the risk premium.

Risk Preferences of Investors : Investors have different risk preferences. Investors may be risk averse, risk seeker

or risk neutral. Most of them are, however, risk averse.

Normal Distribution is a smoothed, symmetric curve. It best describes the mean-variance (or standard deviation). We

generally assume that returns on shares are normally distributed.

Portfolios Generally, investors in practice hold multiple securities. Combinations of multiple securities are called

portfolios.

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Expected Return on a Portfolio is the sum of the returns on individual securities multiplied by their respective

weights (proportionate investment). That is, it is a weighted average rate of return.

VALUATION OF BONDS AND SHARES

Discount Ratebeing the rate of return that investors expect from securities of comparable risk.

Bonds or Debentures are debt instruments or securities. In case of a bond/debenture the stream of cash flows

consists of annual interest payments and repayment of principal. These flows are fixed and known.

The Value of the Bond can be found by capitalising cash flows at a rate of return, which reflects their risk. The market

interest rate or yield is used as the discount rate in case of bonds (or debentures).

Yield to MaturityA bonds yield to maturity or internal rate of return can be found by equating the present value of the

bonds cash outflows with its price

Zero-Interest Bonds (called zero-coupon bonds in USA) do not have explicit rate of interest. They are issued for a

discounted price; their issue price is much less than the face value. Therefore, they are also called deep-discount bonds.

The basic discounting principles apply in determining the value or yield of these bonds.

Preference shares have a preference over ordinary shareholders with regard to dividends. The preference dividend is

specified and known. Similarly, in the case of redeemable preference share the redemption or maturity value is also known.

Preference share value can be determined in the same way as the bond value. Here the discount rate will be the rate

expected by the preference shareholders given their risk. This risk is more than the risk of bondholders and less than the

equity shareholders.

Value of the Share (General) Cash flows of an ordinary (or equity) share consist of the stream of dividends and

terminal price of the share. Unlike the case of a bond, cash flows of a share are not known. Thus, the risk of holding a share

is higher than the risk of a bond. Consequently, equity capitalisation rate will be higher than that of a bond.

OPTIONS

Option is a contract that gives the holder a right, without any obligation, to buy or sell an underlying asset at a given

exercise (or strike) price on or before a specified expiration period. The underlying asset (i.e., asset on which right is

written) could be a share or any other asset.

Call Option is a right to buy an asset. A buyer of a call option on a share will exercise his right when the actual share price

at expiration (St) is higher than the exercise price (E), otherwise, he will forgo his right.

Put Option is a right to sell an asset. The buyer of a put option will exercise his right if the exercise price is higher than the

share price; he will not exercise his option if the share price is equal to or greater than the exercise price.

American Option can be exercised at expiration or any time before expiration while European options can be

exercised only at expiration.

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In/Out/At the Money

Call option Put option

Exercise ifSt>E in-the-money Exercise ifE>St

Do not exercise ifSt

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UNIT 2

INVESTMENT DECISIONS

Capital Budgeting: Principles and techniques, Nature of capital budgeting, Identifying relevant cash flows, Evaluation

Techniques, Payback, Accounting rate of return, Net Present Value, Internal Rate of Return, Profitability Index,

Comparison of DCF techniques, Project selection under capital rationing, Inflation and capital budgeting.

CAPITAL BUDGETING DECISIONS

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. A capital

budgeting decision may be defined as the firms decision to invest its current funds most efficiently in long term assets in

anticipation of an expected flow of benefits over a series of years.

The following are the features of investment decisions:

a. the exchange of current funds for futue benefits

b. The funds are invested in long-term assets

c. The future benefits will occur to the firm over a series of years.

Importance of Investment Decisions :

a. They influence the firms growth in the long run

b. They affect the risk of the firm

c. They involve commitment of large amount of funds

d. They are irreversible, or reversible at substantial loss

e. Hey are among the most difficult to decisions to make

Types of investment decisions :

There are many ways to classify investments. One classification is as follows :

a. Expansion of existing business

b. Expansion of new business

c. Replacement and modernization

The firms investment decisions would generally include expansion, acquisition, modernisation and replacement

of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.

Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and

development programme have long-term implications for the firms expenditures and benefits, and therefore, they

should also be evaluated as investment decisions.

Yet another useful way to classify investments is as follows:

a. Mutually exclusive investments

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b. Independent investments

c. Contingent investments

Mutually exclusive investments:

Mutually exclusive investments serve the same purpose and compete with each other. If one investment is undertaken,

others will have to be excluded. A company, may, for example, either use a more labour-intensive, semi-automatic

machinery or employ amore capital intensive, highly automatic machine for production. Choosing the semi-automatic

machine precludes the acceptance of the highly automatic machine.

Independent investments:

Independent investments serve different purposes and do not compete with each other. For example, a heavy engineering

company may consider expansion of its plant capacity to manufacture additional excavators and addition of new

production facilities to manufacture a new product light commercial vehicles. Depending on the profitability and

available of funds, the company can undertake both investments.

Important Aspects of Capital Budgeting Process are :

Identification of investment ideas is the most critical aspect of the investment process, and should be guided by the

overall strategic considerations of a firm. It needs appropriate managerial focus. Each potential idea should be developed

into a project.

Development A company should have systems for estimating cash flows of projects. A multi-disciplinary team of

managers should be assigned the task of developing cash flow estimates.

Evaluation Once cash flows have been estimated, projects should be evaluated to determine their profitability.

Evaluation criteria chosen should correctly rank the projects.

Authorisation Once the projects have been selected they should be monitored and controlled to ensure that they are

properly implemented and estimates are realised. Proper authority should exist for capital spending. The top management

may supervise critical projects involving large sums of money. The capital spending authority may be delegated subject to

adequate control and accountability.

ControlA company should have a sound capital budgeting and reporting system for this purpose. Based on the

comparison of actual and expected performance, projects should be reappraised and remedial action should be taken.

Companies are increasingly using DCF techniques, but payback remains universally popular for its simplicity and focus on

recovery of funds and liquidity. In practice, judgement and qualitative factors also play an important role in investment

analysis. A number of companies pay more

attention to strategy in the overall selection of projects.

Strategic Investments Decisions are large-scale expansion or diversification projects, and they involve either by their

nature or by managerial actions valuable options. Such options include right to expand, right to abandon, right to delay,

right to build new businesses, or right to disinvest or harvest.

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Real Options create managerial flexibility and commitment. In principle, they can be valued in the same way as financial

options are valued. But in practice, it is difficult to get all input parameters for valuing real options. Since large numbers of

real assets are not traded in the market, it is quite difficult therefore to get information on the value of the underlying assets

and the volatility.

Since real options are valuable, managers must identify them, value them, monitor them and exercise them when it is

optimal to do so. Managers generally strive to create flexibility and commitment by building real options into investment

projects.

INVESMENT EVLAUATION CRITERIA

Three steps are involved in the evaluation of an investment :

a. Estimation of cash flows

b. Estimation of required rate of return (the opportunity cost of capital)

c. Application of a decision rule for making the choice.

Investment Decision Rule

It should maximise the shareholders wealth.

It should consider all cash flows to determine the true profitability of the project.

It should provide for an objective and unambiguous way of separating good projects from bad projects.

It should help ranking of projects according to their true profitability.

It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are

preferable to later ones. It should help to choose among mutually exclusive projects that project which maximises the shareholders

wealth.

It should be a criterion which is applicable to any conceivable investment project independent of others.

Evaluation Criteria:

A number of investment criteria (or capital budgeting techniques) are in use in practice. They may be grouped in the

following two categories :

a. Non-discounted Cash Flow Techniques / Traditional Methodsi. Payback period (PB)

ii. Discounted Payback period

iii. Accounting Rate of return (ARR)

b. Discounted Cash Flow Technique

i. Net Prsent value (NPV)

ii. Internal Rate of return (IRR)

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iii. Profitability index (PI)

NET PRESENT VALUE METHOD

The net present value method is the classic economic method of evaluating the investment proposals. It is a DCF technique

that explicitly recognizes the time value of money. It correctly postulates that cash flows arising at different time periods

differ and are comparable only when their equivalents present values are found out.

NPV is the difference between PV of cash flows and the PV of cash outflows is equal to NPV; the firms opportunity cost of

capital being the discount rate.

Important points to be noted with respect to NPV

Cash flows of the investment project should be forecasted based on realistic assumptions.

Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount

rate is the projects opportunity cost of capital.

Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.

The project should be accepted if NPV is positive (i.e., NPV > 0).

Net present value should be found out by subtracting present value of cash outflows from present value of cash

inflows. The formula for the net present value can be written as follows:

Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The

formula for the net present value can be written as follows :

( ) ( ) ( ) ( )

( )

31 2 x

2 3 n

n

2

t 1

CC C CNPV ..... co

1 k 1 k 1 k 1 k

etNPV co

1 k=

= + + + + + + + +

= +

Internal Rate of Return (IRR) is that discount rate at which the projects net present value is zero. Under the IRR rule,

the project will be accepted when its internal rate of return is higher than the opportunity cost of capital (IRR > k).

IRR methods account for the time value of money and are generally consistent with the wealth maximization objective.

NPV and IRR NPV and IRR give same accept-reject results in case of conventional independent projects. Under a

number of situations, the IRR rule can give a misleading signal for mutually exclusive projects. The IRR rule also yields

multiple rates of return for non-conventional projects and fails to work under varying cost of capital conditions. Since the

IRR violates the value additivity principle; since it may fail to maximise wealth under certain conditions; and since it is

cumbersome, the use of the NPV rule is recommended.

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Profitability index (PI) is the ratio of the present value of cash inflows to initial cash outlay. It is a variation of the NPV

rule. PI specifies that the project should be accepted when it has a profitability index greater than one (PI > 1.0) since this

implies a positive NPV.

NPV and PI A conflict of ranking can arise between the NPV and PI rules in case of mutually exclusive projects. Under

such a situation, the NPV rule should be preferred since it is consistent with the wealth maximisation principle.

Paybackis the number of years required to recoup the initial cash outlay of an investment project. The project would be

accepted if its payback is less than the standard payback. The greatest limitations of this method are that it does not

consider the time value of money, and does not consider cash flows after the payback period.

Discounted Paybackconsiders the time value of money, but like the simple payback it also ignores cash flows after the

payback period. Under the conditions of constant cash flows and a long life of the project, the reciprocal of payback can be

a good approximation of the projects rate of return.

Accounting Rate of Return is found out by dividing the average profit after-tax by the average amount of investment. A

project is accepted if its ARR is greater than a cut off rate (arbitrarily selected). This method is based on accounting flows

rather than cash flows; therefore, it does not account for the time value of money. Like PB, it is also not consistent with the

objective of the shareholders wealth maximisation.

Following provides a summary of the features of various investment criteria.

I. Discounted Cash Flow Methods

1. Net present value (NPV): The difference between PV of cash flows and PV of cash outflows is equal to NPV; the

firms opportunity cost of capital being the discount rate.

( ) ( ) ( ) ( )

( )

31 2 x

2 3 n

n

2

t 1

CC C CNPV ..... co

1 k 1 k 1 k 1 k

etNPV co

1 k=

= + + + +

+ + + +

= +

Acceptance rule :

Accept if NPV > 0 (i.e., NPV is positive)

Reject if NPV < 0 (i.e., NPV is negative)

Project may be accepted if NPV = 0

Merits :

Considers all cash flows. .

True measure of profitability.

Based on the concept of the time .

Satisfies the value-additivity principle (i.e., NPVs of two or more projects can be added).

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Consistent with the share-holders wealth maximization (SWM) principle.

Demerits :

Requires estimates of cash flows which is a tedious task

Requires computation of the opportunity cost of capital which poses practical difficulties.

Sensitive to discount rates. value of money

2. Internal rate of return (IRR):The discount rate which equates the present value of an investments cash inflows

and outflows is its internal rate of return.

( ) ( ) ( ) ( )

( )

31 2 n

2 3 n

n

t

t 1

CC C C............ co

1 r 1 r 1 r 1 r

CtNPV co

1 r=

+ + + + =

+ + + +

= +

Acceptance rule :

Accept if IRR > k

Reject if IRR < k

Project may be accepted if IRR = k

Merits

Considers all cash flows..

True measure of profitability.

Based on the concept of the time

Generally, consistent with wealth

Demerits

Requires estimates of cash flows which is a tedious task

Does not hold the value-additivity principle (i.e., IRRs of two or more projects do not add)

At times fails to indicate correct choice between value of money. mutually exclusive projects.

At times yields multiple rates.maximisation principle.

Relatively difficult to compute.

3. Profitability index (PI): The ratio of the present value of the cash flows to the initial outlay is profitability index or

benefit-cost ratio:

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( )t

n

t 1

PV of Annual cash flowsPI

Initial Investment

ct

1 hPI

co=

=

+=

Acceptance rule :

Accept if PI > 1.0

Reject if PI < 1.0

Project may be accepted if PI = 1.0

Merits

Considers all cash flows.

Recognises the time value of

Relative measure of profitability.

Generally consistent with the wealth maximisation principle.

Demerits

Requires estimates of the cash flows which is a tedious task.

At times fails to indicate correct choice between money. Mutually exclusive projects.

II. Non-Discounted Cash Flow Criteria

4.Payback (PB): The number of years required to recover the initial outlay of the investment is called payback.

Initial Investment CoPB

Annual cash flow C

= =

Acceptance rule

Accept if PB < standard payback

Reject if PB > standard payback

Merits

Easy to understand and compute

Emphasises liquidity.

Easy and crude way to cope with risk. .

Uses cash flows information.

Demerits

Ignores the time value of money. and inexpensive to use

Ignores cash flows occurring after the payback period.

Not a measure of profitability

No objective way to determine the standard payback.

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No relation with the wealth maximization principle

5. Discount payback: The number of years required in recovering the cash outlay on the present value basis is the

discounted payable period. Except using discounted cash flows in calculating payback, this method has all the demerits of

payback method.

6.Accounting rate of return (ARR): An average rate of return found by dividing the average net operating profit [EBIT (1

T)] by the average investment

Acceptance rule :

Accept if ARR > minimum rate

Reject if ARR < minimum rate

Merits

Uses accounting data with which

Easy to understand and calculate.

Gives more weightage to future

Demerits

Ignores the time value of money executives are familiar

Does not use cash flows.

No objective way to determine the receipts. minimum acceptable rate of return.

Net present value (NPV) method is the most superior investment criterion as it is always consistent with

the wealth maximisation principle.

CONCEPTS RELATED TO CAPITAL BUDGETING

Profits vs. Cash Flows

Cash flows are different from profits. Profit is not necessarily a cash flow; it is the difference between revenue earned and

expenses incurred rather than cash received and cash paid. Also, in the calculation of profits, an arbitrary distinction

between revenue expenditure and capital expenditure is made.

Incremental Cash Flows

Cash flows should be estimated on incremental basis. Incremental cash flows are found out by comparing alternative

investment projects. The comparison may simply be between cash flows with and without the investment proposal under

consideration when real alternatives do not exist.

The term incremental cash flows should be interpreted carefully. The concept should be extended to include the

opportunity cost of the existing facilities used by the proposal. Sunk costs and allocated overheads are irrelevant in

computing cash flows. Similarly, a new project may cannibalise sales of the existing products. The projects cash flows

should be adjusted for the reduction in cash flows on account of the cannibalisation.

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Components of Cash Flows

Three components of cash flows can be identified:

(1) initial investment,

(2) annual cash flows, and

(3) terminal cash flows.

Initial Investment Initial investment will comprise the original cost (including freight and installation charges) of the

project, plus any increase in working capital. In the case of replacement decision, the after-tax salvage value of the old asset

should also be adjusted to compute the initial investment.

Net Cash Flow Annual net cash flow is the difference between cash inflows and cash outflows including taxes. Tax

computations are based on accounting profits. Care should be taken in properly adjusting depreciation while computing

net cash flows.

Change in Net Cash Flow from Operations Depreciation is a non-cash item, but it affects cash flows through tax shield.

Free Cash Flows In practice, changes in working capital itemsdebtors (receivable), creditors (payable) and stock

(inventory)affect cash flows. Also, the firm may be required to incur capital expenditure during the operation of the

investment project. Therefore, the following formula should be used to compute the investments net cash flows or free

cash flows:

Terminal Cash Flows are those, which occur in the projects last year in addition to annual cash flows. They would consist

of the after-tax salvage value of the project and working capital released (if any). In case of replacement decision, the

foregone salvage value of old asset should also be taken into account.

Terminal Value of a New Product may depend on the cash flows, which could be generated much beyond the assumed

analysis or horizon period. The firm may make a reasonable assumption regarding the cash flow growth rate after the

horizon period.

Inflation and NPV

The NPV rule gives correct answer to choose an investment under inflation if it is treated consistently in cash flows and

discount rate. The discount rate is a market-determined rate and therefore, includes the expected inflation rate. It is thus

generally stated in nominal terms. The cash flows should also be stated in nominal terms to obtain an unbiased NPV.

Alternatively, the real cash flows can be discounted at the real discount rate to calculate unbiased NPV. The following

equation gives the relationship between nominal and real cost of capital:

Nominal discount rate = (1+real discount rate)

(1+inflation rate) -1

1+Nominall discount rateReal Discount rate= 1

1+inflow rate

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CAPITAL RATIONING :

Capital Rationing occurs because of either the external or internal constrain on the supply of funds. In capital rationing

situations, the firm cannot accept all profitable projects. Therefore, the firm will aim at maximising NPV subject to the

funds constraint.

In simple one-period capital rationing situations, the profitability index (PI) rule can be used. PI rule breaks in the case of

multi-period funds constraints and project indivisibility.

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CONCEPT AND MEASUREMENT OF COST OF CAPITAL, SPECIFIC COSTS AND OVERALL

COST OF CAPITAL

Cost of Capital to a firm is the minimum return, which the suppliers of capital require. In other words, it is a price of

obtaining capital; it is a compensation for time and risk. The cost of capital concept is of vital significance in the financial

decision-making. It is used:

(a) as a discount, or cut-off, rate for evaluating investment projects,

(b) for designing the firms debt-equity mix and

(c) for appraising the top managements financial performance.

Firms obtain capital for financing investments in the form of equity or debt or both. Also, in practice, they maintain a

target debt-equity mix. Therefore, the firms cost of capital means the weighted average cost of debt and equity. Cost of

Capital to a firm is the minimum return, which the suppliers of capital require. In other words, it is a price of obtaining

capital; it is a compensation for time and risk.

Definition

Cost of capital is defined as the minimum rate of return which a company has to earn on the total capital employed in order

to increase or maintain the market price of its shares.

Cost of Debt includes all interest-bearing borrowings. Its cost is the yield (return), which lenders expect from their

investment. In most cases, return is equal to annual contractual rate of interest (also called coupon rate). Interest charges

are tax deductible. Therefore, cost of debt to the firm should be calculated after adjusting for interest tax exemption.:

kd (after tax) = I ( 1- t)

where kdI s before-tax cost of debt and tis the corporate tax rate.

Definitions :

Cost of debt is defined as the rate at which the company pays interest to its long term creditors with a further adjustment

for the tax liability of the company. Cost of debt is defined as that discount rate which equates the present value of the

future promised interest and principal repayment with the net proceeds of the issue.

Formulae : In case of long term loans :

kd (after tax) = I I 1-t)

In case of irredeemable debentures / bonds : a. when issued at par :

kd (afer tax) = I (1 - t)

when issued at premium or discount :

kd (afer tax) = I (1 - t)

NP

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In case of redeemable debentures / bonds :

I ( 1-t ) + F - NP

n

kd (after tax) = F + NP

2

In case the floatation costs (the difference between face value and net proceeds is to be amortized evenly

over the life of debentures / bonds :

I ( 1-t ) + F - NP (1 t)

n

kd (after tax) =

F + NP

2

Cost of Preference : It is the rate at which the company declares preference dividend for its shareholders.

Definition : It is defined as that discount rate which equates the present value of the future promised dividend and

principal repayment with the net proceeds of the issue.

Formulae : In case of irredeemable preference shares :

a. when issued at par :

kp (afer tax) = Dp

F

b. when issued at premium or discount :

kd (afer tax) = Dp

NP

In case of redeemable preference shares :

Dp + F - NP

kd (after tax) = n

F + NP

2

Cost of Equity

Equity has no explicit cost, as payment of dividends is not obligatory. However, it involves an opportunity cost. The

opportunity cost of equity is the rate of return required by shareholders on securities of comparable risk. Thus, it is a price,

which the company must pay to attract capital from shareholders. In practice, shareholders expect to receive dividends

and capital gains. Therefore, the cost of equity can be thought to include expecteddividend yield and percentage capital

gain:

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Definition : Cost of equity capital is defined as the minimum rate of return which a company has to earn on the equity

capital employed in order to increase or maintain the market price of its shares. The company can expect to increase the

MPS for its shares or at least maintain a constant MPS only when the expectations of the equity shareholders are satisfied.

Hence cost of equity is always equated with the expectations of the equity shareholders.

Approaches for calculation of cost of equity capital :

Different approaches have been given for the calculation of cost of equity. They are as follows :

a. Dividend Capitalization Approach :

ke = D1

Po

where D1 is the expected dividend per share andP0 is the market price today.

b. Dividend Capitalization plus growth Approach :

ke = D1 + g

Po

where D1 is the expected dividend per share,P0 is the market price today and g is the expected dividend growth (capital

gain).

c. Capital Asset Pricing Model CAPM :

ke = rf + b j ( rm - rf )

where rf is the risk-free rate equal to current yield on the Treasury bills or government bonds; (rm rf) is the market

risk premium measured as average of historical returns of a long series; and bjis the beta of the firmj.

Cost of Retained Earnings : When a company issues new share capital, it has to offer shares at a price, which is

much less than the prevailing market price. Therefore, the cost of retained earnings will be less than the cost of new issue

of equity.

In case of retained earnings the company will not have to incur floatation costs and underwriting costs.

kr = D1 + g

Po

Weighted Average Cost of Capital

Three steps are involved in calculating the firms weighted average cost of capital (WACC). First, the component costs of

debt and equity are calculated. Second, weights to the each component of capital are assigned according to the target

capital structure. Third, the product of component costs and weights is summed up to determine WACC. The weighted

average cost ofnew capital is the weighted marginal cost of capital (WMCC).

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Divisional or Projects Cost of Capital

A firm may have several divisions or product lines with different risks. Therefore, the firms WACC cannot be used to

evaluate divisions or projects. The following procedure can be used to estimate the divisional or the projects cost of capital:

Identify comparable or pure-play firms and determine their equity beta based on the market data

Find the average equity beta, and unlever it as follows:

Determine the divisions target capital structure, and relever the beta

This is division or projects levered or equity beta. Use CAPM to calculate the cost of equity.

Calculate the after-tax cost of debt for the division or project.

Use the target capital structure to calculate the division or projects WACC.

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UNIT 3

FINANCING AND DIVIDEND DECISION:

FINANCIAL AND OPERATING LEVERAGE

Capital Structure

The debt-equity mix of a firm is called its capital structure. The capital structure decision is a significant financial decision

since it affects the shareholders return and risk, and consequently, the market value of shares.

Financial Structure The term financial structure, on the other hand, is used in a broader sense, and it includes equity

and all liabilities of the firm.

Financial Leverage or Trading on Equity The use of the fixed-charges capital like debt with equity capital in the

capital structure is described as financial leverage or trading on equity.

The main reason for using financial leverage is to increase the shareholders return. Consider an example. Suppose you

have an opportunity of earning 20 per cent on an investment of Rs 100 for one year. If you invest your own money, your

return will be 20 per cent. On the other hand, you can borrow, say, Rs 50 at 10 per cent rate of interest from your friend

and put your own money worth Rs 50. You shall get total earnings of Rs 20, out of which you will have to pay Rs 5 as

interest to your friend. You shall be left with Rs 15 on your investment of Rs 50,which gives you a return of 30 per cent. You

have earned more at the cost of your friend.

Financial leverage, on the one hand, increases shareholders return and on the other, it also increases their risk. For a given

level of EBIT, EPS varies more with more debt. Consider a simple example. Let us assume that a firms expected EBIT is Rs

120 with a standard deviation of Rs 63. This implies that earnings could vary between Rs 57 to Rs 183 on an average.

Suppose that the firm has some debt on which it pays Rs 40 as interest. Now the shareholders expected

earnings will be: Rs 120 Rs 40 = Rs 80 (ignoring taxes) and standard deviation will remain unchanged. Shareholders

earnings will, on an average, fluctuate within a range of Rs 17 and Rs 143. If EBIT is less than Rs 40, the earnings of

shareholders will be negative. In the extreme situation if the firm is unable to pay interest and principal, its solvency is

threatened.

In the insolvency, shareholders are the worst sufferers. Thus, we find that financial leverage is a double-edged sword. It

increases return as well as risk. A trade-off of between return and risk will have to be struck to determine the appropriate

amount of debt.

Earnings Per Share (EPS)A firm determines the advantage of financial leverage by calculating its impact on earnings

per share (EPS) or return on equity (ROE). For a 100 per cent equity-financed company, EPS is calculated as follows:

EPS =EBIT(1 T)

N

and for a company which employs both debt and equity EPS is given by the following formula:

EPS=( ) ( )EBIT Int 1 T

N

where EBIT is earnings before interest and taxes, INT is interest charge which is given by the product of interest rate (i)

and the amount of debt (D), Tis corporate tax rate andNis number of shares. If the firms overall profitability is more than

interest rate, EPS increases with debt. With increasing EBIT, EPSincreases faster with more debt.

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Degree of Financial Leverage (DFL) The percentage change in EPS occurring due to a given percentage change in

EBIT is referred to as the degree of financial leverage

Degree of Operating Leverage (DOL)

EBIT depends on sales. A change in sales will affect EBIT. The variability in EBIT due to a change in sales is affected by the

composition of fixed and variable costs. You may recall that the percentage change in EBIT occurring due to a given

percentage change in sales is referred to as the degree of operating leverage (DOL):

DOL=% change in EBIT EBIT / EBIT

% change in sales Sales / Sales

=

Degree of Combined Leverage (DCL) DOL and DFL can be combined to see the effect of total leverage on EPS.

For alter due formula world be:

Contribution Fixed costDOL 1

EBIT EBIT= = +

CAPITAL STRUCTURE

Meaning of Capital structure

Capital structure refers to the 'the make up of a firm's capitalization. In other words, it represents the mix of different

sources of long term funds (such as equity shares, preference shares, long term loans, retained earning etc.) in the

total capitalisation of the company.

Capital structure and financial structure

The term capital structure differs from financial structure. Financial structure refers to the way the firm's assets are

financed. In other words it includes both, long term as well as short term sources of funds Capital structure is the

permanents financing of the company represented primarily by long term debt and share holders funds but

excluding all short term credit. Thus a company's capital structure is only a part of its financial structure.

Patterns of capital structure

In case of new company the capital structure may be of any of the following four patterns :

(i) Capital structure with equity shares only.

(ii) Capital structure with both equity and preference shares.(iii) Capital structure with equity shares and debentures.

(iv) Capital structure with equity shares, preference shares and debentures.

The choice of an appropriate capital structure depends on a number of factors such as the nature of the company's

business, regularity of earnings, conditions of the money market attitude of the investor, etc. We will like to emphasize only

one point here. It is regarding the basic difference between debt and equity. Debt is a liability on which interest has to be

paid irrespective of the company's profits. While equality consists of shareholders or owners funds on which payment of

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dividend depends upon the company's profits. A high proportion of the debt content in the capital structure increases the

risk and may lead to financial insolvency of the company in adverse time. However, raising funds through debt is cheaper

as compared to raising funds through shares.

Factors affecting capital structure :

Forms of assets held by a company i.e., investment in current assets and fixed assets.

Available growth opportunities

Debt and non-debt tax shields

Financial flexibility and operating strategy

Loan covenants i.e. restrictions included in long term loan agreements, which curtail firms freedom in deciding on

the capital structure.

Financial slack which includes unused debt capacity, excess liquid assets, unutilized lines of credit and access to

various untapped sources of funds.

Early repayments - i.e. flexibility will be introduced if the company has the discretion of early repayment of its

debts.

Limits of financial flexibility

Degree of control required in managing the affairs of the business.

POINT OF INDIFFERENCE (FINANCIAL BREAK EVEN POINT)

It refers to that EBIT level at which EPS remains the same irrespective of the debt equity mix. In other words, at this

point rate of return on capital employed is equal to the rate of interest on debt. This is also known as break even level of

EBIT for alternative financial plans.

(X-I1) (1-T) PD (X-12) ( 1 T) PD

---------------------- = ----------------------------

S1 S2

Where

X = Point of Indifference or Break even EBIT level.

I1 = Interest under alternative 1.

I2 = interest under alternative 2.

T = Tax Rate

PD= Preference Dividend.

S1 = Number of equity shares (or amount of equity share

capital) under alternative 1.S2 = Number of equity shares (or amount of equity share

capital) under alternative 2.

The level of operating profit (EBIT) beyond which the debt alternative is beneficaial because of its favourable effect on

earning per share (EPS) or uncommitted earnings per share (UEPS). In other words, it is profitable to raise debt for

strengthening EPS or UEPS if there is likelihood that future operating profits are going to be higher than level of EBIT

as determined.

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Optimum capital Structure.

A firm should try to maintain an optimum capital structure with a view to maintain financial stability. The optimum

capital structure is obtained when the market value per equity share is the maximum. In case a company borrows and

this borrowing helps in increasing the value of the company's shares in the stock exchange, it can be said that the

borrowing has helped the company in moving towards its optimum capital structure. In case, the borrowing results in

fall in market value of the company's equity shares, it can be said that the fall in market value of the company's equityshares, it can be said that the borrowing has moved the company away from its optimum capital structure.

The objective of the term should therefore be to select a financing or debt equity mix which will lead to maximum value

of the firm.

Optimum leverage can be defined as that mix of bed and equity which will maximise the market value of a company.

CAPITAL STRUCTURE, COST OF CAPITAL AND VALUATION

Capital Structure Decision of the firm can be characterised as a choice of that combination of debt and equity, which

maximises the market value of the firm.

Capital Structure Theories :

General Assumptions :

a. There are only two sources of funds used by a firm :

i. Perpetual riskless debt ,

ii. Ordinary shares

b. The are no corporate taxes. This assumption is removed later.

c. The firms total financing remains constant. The firm can change its degree of leverage (capital structure )either

by selling share and use the proceeds to retire debentures or by raising more debt ad reduce the equity capital.

NET INCOME APPROACH

According to the Net Income Approach suggested by Durand, the capital structure decision is relevant to the valuation of

the firm. In other words a change in the capita structure / financial leverage will lead to a corresponding change in the

overall cost of capital as well as the total value of the firm. If, therefore, the degree of financial leverage as measured by the

ratio of debt to equity is increased, the weighted average cost of capital will decline, while the value of the firm as well the

market price of ordinary shares will increase. Conversely, a decrease in the leverage will cause an increase in the overall

cost of capital and a decline both in the value of the firm as well as the market price of equity shares.

The NI approach to valuation is based on three assumptions :

a. There are no taxes

b. Cost of debt is less than cost of equity

c. Use of debt does not change risk-perception of investors.

The implications of the three assumptions underlying the NI approach is that as the degree of leverage increases, the

proportion of an inexpensive source of funds, i.e., debt in the capital structure increases.

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As a result the weighted average cost of capital tends to decline, leading to an increase in the total value of the firm. Thus

with the cost of debt and cost of equity being constant, the increased se of debt (increase in leverage) will magnify the

shareholders earnings and thereby, the market value of the ordinary shares.

The financial leverage is, according to NI approach, an important variable in the capital structure decision of a firm. With

a judicious mixture of debt ad equity, a firm can evolve an optimum capital structure which will be the one at which value

of firm is the highest and the overall cost of capital the lowest. At that structure the market price per share will be

maximum.

If the firm uses no debt or if the financial leverage is zero, the overall cost of capital will be equal to the cost of equity. The

weighted average cost of capital will decline an will approach the cost of debt as he degree of leverage reaches one.

ke

ko

kd

Degree of financial leverage ( B/ V)

NET OPERATING INCOME (NOI) APPRAOCH :

Another theory of capital structure, suggested by Durand, is the net operating income (NOI) approach. This approach is

opposite to the net income approach. The essence of this appraoh is that the leverage / capital structure decision of the

firm is irrelevant. Any change in leverage will not lead to any change in the total value of the firm and the market price of

shares, as the overall cost of capital is independent of the degree of financial leverage.

The NOI approach is based on the following assumptions :

Overall cost of capital / Capitalisation Rate (ko) is constant :

NOI approach to valuation argues that the overall capitalization rate of the firm remains constant for all degrees of

leverage. The value of the firm, given the level of EBIT, is determined as follows :

V = EBIT

ko

In other words, the market evaluates the firm as a whole. The split of the capitalization between debt and equity is,

therefore, not significant.

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Residual Value of Equity :

The value of equity is a residual value which is determined by deducting the total value of debt (B) from the total value of

the firm (V). Symbolically,

The total market value of equity capital (S) = V - B

Changes in cost of Equity Capital :

The cost of equity (ke) increases with the degree of leverage. The increase in the proportion of debt in the capital structure

relatively to equity shares would lead to an increase in he financial risk to the ordinary shareholders. To compensate for

the increased ris, the shareholders would expect a higher rate of return on their investments. The increase in the equity

capitalization rate would match the debt-equity ratio. The ke would be

ko + (ko - kd) B / S

Cost of Debt :

The cost of debt (kd) has two parts :

a. Explicit part, represented by the rate of interest. Irrespective of the degree of leverage, the firm is assumed

to be able to borrow at a given rate of interest. This implies that the increasing proportion of debt in the

financial structure does not affect the risk perception of the lenders and they do not penalize the company by

charging higher rates of interest.

b. Implicit part, or hidden cost. Increase in the degree of financial risk or the proportion of debt to equty in

the capital structure increases the cost of equity capital. This increase in ke, being attributed to he increase

in debt, is the implicit part of kd.

Thus, the advantage associated with the use of debt, supposed to be a cheaper source of funds in terms of the explicit cost,

is exactly neutralized by the implicit cost represented by increase in ke. As a result the real cost of debt and the real cost of

equity, according to the NOI approach, are the same and equal ko.

Optimum Capital Structure :

The total value of the firm is unaffected by its capital structure. No matter what the degree of financial leverage is, the total

value of the firm will remain constant. The market price of shares will also not change with the change in the debt-equity

ratio. There is nothing such as an optimum capital structure. Any capital structure is optimum, according to the NOI

approach.

ke

Cost of capital

ko

kd

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Degree of financial leverage ( B/ V)

MODIGLIANI-MILLER (MM) APPROACH :

The Modigliani-Miller thesis relating to the relationship between the capital structure, cost of capital and valuation is

similar to the net operating income (NOI) approach. The NOI approach, as explained above lacks operational justification.

The NOI approach, in other words does not provide operational justification for the irrelevance of the capital structure.

Basic propositions :

Thee are three basic propositions of the MM approach, namely,

a. ko and value of the firm are independent of the capital structure. ko and value of the firm are constant for all

degrees of leverage.

b. ke increases in a manner to offset exactly the use of a less expensive source of funds represented by debt i.e., as

DFL increases, ke increases and vice versa.

c. The cut off rate for investment purposes is completely independent of the way in which an investment is financed.

Degree of financial leverage ( B/ V)

Assumptions :

The assumption that the weighted average cost of capital is constant irrespective of the type of capital structure is based on

te following :

1. Perfect capital markets : The implications of a perfect capital market is that :

Securities are infinitely divisible

Investors are free to buy / sell securities

Investors can borrow without restrictions on the same terms and conditions as firms can

There are no transactions costs

Information is perfect i.e., each investor has the same information which is readily available to him without cost

Investors are rational and behave accordingly

2. All investors expect the company to make the same level of EBIT.

3. Dividend payout ratio is 100%

4. There are not taxes

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MM on the other hand provides operational justification for the irrelevance of the capital structure decision with respect to

the value of the firm which is called the arbitrage process. The term arbitrage refers to an act of buying an asset /

security in one market (at lower prices) and selling it in another (at a higher price). As a result, equilibrium is restored in

the market price of a security in different markets.

MM illustrate the arbitrage process with reference to valuation in terms of two firms which are exactly similar in all

respects except leverage such that one has debt in its capital structure while the other does not.

TOTAL VALUE OF THE FIRM L AND UFirmsL U

EBIT Rs. 1,00,000 Rs. 1,00,000LESS : Interest 50,000 -Earnings available for equity holders 50,000 1,00,000Equity capitalization ate (ke) 0.16 0.125Total market value of equity (S) 3,12,500 8,00,000Total market value of debt (B) 5,00,000 -Total market value of firm (V) 8,12,500 8,00,000

The total market value of a firm which employs debt in its capital structure (L) is more than that of the unlevered firm (U).

According to the MM hypothesis, this situation cannot continue as the arbitrage process, based on the substitutability of

personal leverage for corporate leverage, will operate and the values of the two firms will be brought to an identifiable level.

ARBITRAGE PROCESS :

The application of the arbitrage process is explained as follows :

Suppose an investor, Mr. X holds 10% of the outstanding shares of the levered firm (L). His holdings amount to Rs. 31,250

(i.e. 10% of Rs. 3,12,500) and his share in the earnings that belong to the equity shareholders would be Rs. 5,000 or 10% of

Rs. 50,000.

He will sell his holdings in firm L and invest in the unlevered firm (U). Since the firm U has n debt in its capital structure,

the financial risk to Mr. X would be less than in firm L. To reach the level of financial risk of firm L, he will borrow

additional funds equal to his proportionate share in the levered firms debt on his personal account. That is, he will

substitute personal leverage (or home made leverage) for corporate leverage. Another way of saying it is that instead of

the firm using debt, Mr. X will borrow money. The effect, in essence, of this is that he is able to introduce leverage in the

capital structure e of the unlevered firm by borrowing on his personal account.

Mr. X in our example will borrow Rs. 50,000 at 10% rate of interest. His proportionate holding (10%) in the unlevered

firm will amount to Rs. 80,-000 on which he will receive dividend income of Rs. 10,000. Out of the income of R)s. 10,000

from the unlevered firm (U0 Mr. X will pay Rs. 5,000 as interest on his personal borrowings. He will be left with Rs. 5,000i.e., same amount nt as he was getting from the levered firm (L). But, his investment outlay in U firm is less (Rs. 30,000)

as compared with that in the L firm (Rs. 31,250). At the same time his risk is identifiable in both the situations.

Thus it is clear, that Mr. x will be better off by selling his securities in the levered firm and buying the shares of the

unlevered firm. With identical risk characteristic of the two firms he gets the same income with lower investment outlay in

the unlevered firm. He would obviously prefer switching from the levered to the unlevered firm.

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Traditional Appraoch :

The crux of the traditional view relating to leverage and valuation is that though judicious use of debt-equity propositions, a

firm can increase its total value and thereby reduce its overall cost of capital. The rationale behind this view is that debt is

a relatively cheaper source of funds as compared to ordinary shares. Wit a change in the leverage, i.e, using more debt in

the place of equity, a relatively cheaper source of funds replaces a source of funds which involves a relatively higher cost.

This obviously causes a decline in the overall cost of capital. If the debt-equity is raised further, the firm would become

financially more risky o the investor who would penalize the firm by demanding a higher rate of dividend. But the increase

in ke may not be so high as to neutralize the benefit of suing cheaper debt. In order worlds, the advantages arising out of

the use of debt is so large, that even after allowing for a higher ke, the benefits of the use of cheaper source of funds are still

available. If, however, the amount of debt is increased further, two things are likely to happen :

Owing to increased financial risk, ke will record a substantial rise and

b. The firm would become very risky to the creditors who would like to be compensated by higher return such

that kd will rise. Thus the use of debt beyond a point will there fore, has the effect of raising the ko and

reducing the value of the firm. Thus up to a point use of debt will favourably affect the value of a firm.

Beyond that point, use of debt will adversely affect it. At that level of debt-equity ratio, the capital structure

is an optimal capital structure.

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DIVIDEND POLICY, ASPECTS OF DIVIDEND POLICY, PRACTICAL CONSIDERATION, FORMS OF

DIVIDEND POLICY, PRACTICAL CONSIDERATIONS, FORMS OF DIVIDENDS, SHARE SPLITS

Dividends refer to the portion of a firms net earnings which are paid out to the share holders dividends are distributed out

of the profits the alternative to the payment of dividends is the retention of the earnings

DIVIDEND POLICY

There are conflicting opinions regarding the impact of dividends on the valuation of the firm. According to one school of

thought, dividends are irrelevant so that the amount od dividends paid has no effect on the valuation of a firm. On the

other hand, certain theories consider the dividend decision as relevant to the value of the firm measured in terms in the

market price of the shares.

Relevance of Dividends : Some Theories :

There are some theories that consider dividend decision to be an active variable in determining the value of a firm. The

dividend decision is, therefore, relevant. The two theories representing this notion are :

a. Walters Model and

b. Gordons Model

Walters Model :

Walters model supports the doctrine that dividends are relevant. The investment policy of a firm cannot be separated

from its dividend policy and both are, according to Walter, interlinked. The choice of an appropriate dividend policy

affects the value of an enterprise.

The key argument in support of the relevance proposition of Walters model is the relationship between the return on a

firms investment or its internal rate of return (r ) and the cost of capital or the required rate of return (k). The firm would

have an optimum divided policy which will be determined by the relationship of r and k. in other words, if the return on

investments exceeds the cost of capital, the firm should retain the earnings, whereas it should distribute the earnings to the

shareholders in case the required rate of return exceeds the expected return on the firms investments. The rationale is that

if r > k, the firm is able to earn more than what the shareholders could be re-investing, if the earnings are paid out to them.

The implication ofr < k that the shareholders can earn a higher return by investing elsewhere.

Walters model, thus, relates the distribution of dividends (retention of earnings) to available investment opportunities. If

a firm has adequate profitable investment opportunities, it will be able to earn more than what the investors expect so that

r > k. such firms may be called growth firms. For growth firms, the optimum dividend policy would be given by a D/P

ratio of zero. That is to say, the firm should plough back the entire earnings within the firm. The market value of the

shares will be maximized as a result.

In contrast, if a firm does not have profitable investment opportunities (when r < k), the shareholders will be better off if

earnings are paid out to them so as to enable them to earn a higher return by using the funds elsewhere. In such a case, the

market price of shares will be maximized by the distribution of the entire earnings as dividends. A D/P ratio of 100 would

give an optimum dividend policy.

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Finally when r = ke, (normal firms), it is a matter of indifference whether earnings are retained or distributed. This so

because for all D/P ratios (ranging between zero and 100) the market price of shares will remain constant. For such firms,

there is no optimum dividend policy (D/P ratio).

Assumptions

The critical assumptions of Walters Model are :

a. All financing is done through retained earnings; external sources of funds like debt or new equity capital are not

used.

b. With additional investments undertaken, the firms business risk does not change. It implies that r and k are

constant.

c. There is no change in the key variables namely, beginning earnings per share E and dividend per share D.

The values of D and E may be changed in the model to determine results, but, any given value of E and E are

assumed to remain constant in the determining a given value.

d. The firm has perpetual (or very long) life.

Walter has evolved a mathematical formula to arrive at the appropriate dividend decision. His formula is based on a sharevaluation model which states :

P = D

ke g

where P = Price of equity shares

D = Initial dividend

ke = Cost of equity capital

g = expected growth rate of earnings

Limitations

The Walters model, one of the earliest theoretical models, explains the relationship between dividend policy and the value

of the firm under certain simplified assumptions. Some of the assumptions do not stand critical evaluation. In the first

place, the Walters model assumes that the firms cost of investments are financed exclusively by retained earnings; no

external financing is used. The model would be only applicable to all equity firms. Secondly, the model assumes that r is

constant. This is not a realistic assumptions because when increased investments are made by the firm, r also changes.

Finally, as regards the assumption of constant ke, the risk complexion of he firm has a direct bearing on it. By assuming ke,

to be constant, Walters model ignores the effect of risk on the value of the firm.

Gordons Model :

Another theory which contends that dividends are relevant is the Gordons model. This model, which says that dividend

policy of a firm affects its value is based on the following assumptions :

1. The firm is an all equity firm. No external financing is used and the investment programmes are financed

exclusively by retained earnings.

2. rand ke are constant.

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3. The firm has a perpetual life.

4. The retention ratio, once decided upon, is constant. Thus the growth rate (g = br) is also constant.

5. ke > br

It can be seen from the assumptions of Gordon Model that they are similar to those of Walters mode. As a result, Gordons

model like Walters model contends that dividend policy of a firm is relevant and that investors put a positive premium on

current dividends /income. But Gordon goes one step further and argues that dividend policy affects the value of shares

even in a situation in which the return on investment of a firm is equal to the required / capitalization rate (i.e., r = ke)

while Walters model is of the view that the view that investors are indifferent between dividends and retention. The crux

of Gordons argument is a two-fold assumption :

a. Investors are risk averse and

b. They put a premium on a certain return and discount/penalize uncertain returns.

The investors are rational. Accordingly, they want to avoid risk. The term risk refers t the possibility of not getting a return

on investment. The payment of current dividends ipso factorcompletely removes any chance of risk. If however, the firm

retains the earnings (i.e. current dividends are withheld), the investors can expect to get a dividend in future. The future

dividend is uncertain, both with respect to the amount as well as the timing. The rational investors can reasonably be

expected to prefer current dividend. In other words, they would discount future dividends, i.e.,

Bird-in-the-hands Argument Investors are risk averters. They consider distant dividends as less certain than near

dividends. Rate at which an investor discounts his dividend stream from a given firm increases with the futurity of dividend

stream and hence lowering share prices.

MM ModelAccording toMM, under a perfect market situation, the dividend policy of a firm is irrelevant as it does not

affect the value of the firm. They argue that the value of the firm depends on firm earnings which results from its

investment policy. Thus when investment decision of the firm is given, dividend decision is of no significance.

Information Content In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend

action does provide a clear cut means of making a statement that speaks louder than a thousand words.

Market Imperfections Tax DifferentialLow Payout Clientele, Flotation Cost, Transaction and Agency Cost,

Information Asymmetry, Diversification, UncertaintyHigh Payout Clientele, Desire for Steady Income, and No or Low

Tax on Dividends:

Stable Dividend Policy

Companies like to follow a stable dividend policy since investors generally prefer such a policy for the reason of certainty. A

stable dividend policy does not mean constant dividend per share. It means reasonably predictable dividend policy.

Companies determine dividend per share or dividend rate keeping in mind their long-term payout ratio.

Firms Ability to Pay Dividend depends on its funds requirements for growth, shareholders desire and liquidity. A

growth firm should set its dividend rate at a low level (because of its high needs for funds) and move towards its target

slowly.

Practical consideration

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Financial Need of company,

Shareholders Expectations,

Closely/Widely Held Company,

Constraints on Paying Dividends,

Legal Restrictions,

Liquidity, Borrowing Capacity,

Access to the Capital Market,

Restrictions in Loan Agreements.

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UNIT 4

WORKING CAPITAL MANAGEMENT

Principles of working capital: Concepts need; Determinants, issues and estimation of working capital,

The management of current assets is similar to that of fixed asses in the sense that in both cases a firm analyses their effects

o its return and risk. However it is to be remembered that a greater degree of flexibility is enjoyed in managing current

assets.

CONCEPTS OF WORKING CAPITAL

There are two concepts of working capital gross and net.

Gross working capital refers to the firms investment in current assets. Current assets are the assets which can be

converted into cash within an accounting year and include cash, short term securities, debtors (accounts

receivables), Bills receivables and stock (investment).

Net working capital refers to the excess of current assets over current liabilities or in other words is the difference

between current assets and current liabilities. Current liabilities are those claims of outsiders which are expectedto mature for payment with an accounting year and include creditors (accounts payable), bills payable and

outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise

when current assets exceed current liabilities. A negative net working occurs when current liabilities are in excess

of current assets.

OPERATING AND CASH CONVERSION CYCLE

Operating cycle

The need for working capital