Financial Management - Introduction

LEARNING OBJECTIVESExplain the nature of finance and its interaction with other management functionsReview the changing role of the finance manager and his/her position in the management hierarchyFocus on the Shareholders Wealth Maximization (SWM) principle as an operationally desirable finance decision criterionDiscuss agency problems arising from the relationship between shareholders and managers

IMPORTANT BUSINESS ACTIVITIESProduction MarketingFinance

Real And Financial AssetsReal Assets: Can be Tangible or IntangibleTangible real assets are physical assets that include plant, machinery, office, factory, furniture and building. Intangible real assets include technical know-how, technological collaborations, patents and copyrights. Financial Assets are also called securities, are financial papers or instruments such as shares and bonds or debentures.

Equity and Borrowed FundsShares represent ownership rights of their holders. Shareholders are owners of the company. Shares can of two types: Equity SharesPreference SharesLoans, Bonds or Debts: represent liability of the firm towards outsiders. Lenders are not owners of the company. These provide interest tax shield.

Equity and Preference SharesEquity Shares are also known as ordinary shares. Do not have fixed rate of dividend. There is no legal obligation to pay dividends to equity shareholders.Preference Shares have preference for dividend payment over ordinary shareholders. They get fixed rate of dividends. They also have preference of repayment at the time of liquidation.

Finance and Management FunctionsAll business activities involve acquisition and use of funds. Finance function makes money available to meet the costs of production and marketing operations.Financial policies are devised to fit production and marketing decisions of a firm in practice.

Finance FunctionsFinance functions or decisions can be divided as followsLong-term financial decisionsLong-term asset-mix or investment decision or capital budgeting decisions. Capital-mix or financing decision or capital structure and leverage decisions. Profit allocation or dividend decision Short-term financial decisionsShort-term asset-mix or liquidity decision or working capital management.

Finance Managers RoleRaising of FundsAllocation of FundsProfit PlanningUnderstanding Capital Markets

Financial GoalsProfit maximization.Wealth maximization

Profit MaximizationMaximizing the rupee income of firm Resources are efficiently utilizedAppropriate measure of firm performanceServes interest of society also

Objections to Profit MaximizationIt is VagueIt Ignores the Timing of ReturnsIt Ignores RiskAssumes Perfect CompetitionIn new business environment profit maximization is regarded as UnrealisticDifficultInappropriate Immoral

Shareholders Wealth MaximizationMaximizes the net present value of a course of action to shareholders.Accounts for the timing and risk of the expected benefits.Benefits are measured in terms of cash flows.Fundamental objectivemaximize the market value of the firms shares.The NPV of course of action is Net benefit of project to be obtained in future Net cost of the project at present.The Project with positive NPV is selected.

Need for a Valuation ApproachSWM requires a valuation model.The financial manager must know,How much should a particular share be worth? Upon what factor or factors should its value depend?

Risk-return Trade-offFinancial decisions of the firm are guided by the risk-return trade-off.The return and risk relationship: Return = Risk-free rate + Risk premiumRisk-free rate is a compensation for time and risk premium for risk. Risk and expected return move in tandem; the greater the risk, the greater the expected return.

Overview of Financial Management

Agency Problems: Managers Versus Shareholders GoalsThere is a Principal Agent relationship between managers and shareholders.

In theory, Managers should act in the best interests of shareholders.

In practice, managers may maximise their own wealth (in the form of high salaries and perks) at the cost of shareholders.

Managers may perceive their role as reconciling conflicting objectives of stakeholders. This stakeholders view of managers role may compromise with the objective of SWM.

Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholders wealth. Such satisfying behaviour of managers will frustrate the objective of SWM as a normative guide.

This conflict is known as Agency problem and it results into Agency costs

Agency CostsAgency costs include the less than optimum share value for shareholders and costs incurred by them to monitor the actions of managers and control their behaviour.

Organisation of Finance FunctionOrganization for finance functionOrganization for finance function in a multidivisional company

Time Preference for MoneyTime preference for money is an individuals preference for possession of a given amount of money now, rather than the same amount at some future time.Three reasons may be attributed to the individuals time preference for money:riskpreference for consumptioninvestment opportunities

Required Rate of ReturnThe time preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It may be therefore called the risk-free rate.An investor requires compensation for assuming risk, which is called risk premium. The investors required rate of return is: Risk-free rate + Risk premium

Required Rate of ReturnWould an investor want Rs. 100 today or after one year?Cash flows occurring in different time periods are not comparable. It is necessary to adjust cash flows for their differences in timing and risk. Example : If preference rate =10 percent An investor can invest if Rs. 100 if he is offered Rs 110 after one year. Rs 110 is the future value of Rs 100 today at 10% interest rate. Also, Rs 100 today is the present value of Rs 110 after a year at 10% interest rate.If the investor gets less than Rs. 110 then he will not invest. Anything above Rs. 110 is favorable. Required rate of return = Risk free rate + Risk Premium

Time Value AdjustmentTwo most common methods of adjusting cash flows for time value of money: Compoundingthe process of calculating future values of cash flows and Discountingthe process of calculating present values of cash flows.

Future ValueCompounding is the process of finding the future values of cash flows by applying the concept of compound interest.Compound interest is the interest that is received on the original amount (principal) as well as on any interest earned but not withdrawn during earlier periods.Simple interest is the interest that is calculated only on the original amount (principal), and thus, no compounding of interest takes place.

Future Value

Future Value: Example

Future Value of an Annuity

Future Value of an Annuity: Example

Present ValuePresent value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent value to the decision-maker. Discounting is the process of determining present value of a series of future cash flows. The interest rate used for discounting cash flows is also called the discount rate.

Present Value of a Single Cash Flow

PV of Uneven Cash Flows: Example

Nature of Investment DecisionsThe investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.

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.

Features of Investment Decisions The exchange of current funds for future benefits.

The funds are invested in long-term assets.

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

Importance of Investment DecisionsGrowth

Risk

Funding

Irreversibility

Complexity

Types of Investment DecisionsOne classification is as follows:Expansion of existing businessExpansion of new businessReplacement and modernisationYet another useful way to classify investments is as follows:Mutually exclusive investmentsIndependent investmentsContingent investments

Investment Evaluation CriteriaThree steps are involved in the evaluation of an investment:Estimation of cash flowsEstimation of the required rate of return (the opportunity cost of capital)Application of a decision rule for making the choice

Investment Decision RuleIt 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 Criteria1.Discounted Cash Flow (DCF) CriteriaNet Present Value (NPV)Internal Rate of Return (IRR)Profitability Index (PI)2.Non-discounted Cash Flow CriteriaPayback Period (PB)Discounted payback period (DPB)Accounting Rate of Return (ARR)

Net Present Value MethodCash flows of the investment project should be forecasted based on realistic assumptions.Appropriate discount rate should be identified to discount the forecasted cash flows. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if NPV is positive (i.e., NPV > 0).

Net Present Value MethodThe formula for the net present value can be written as follows:

Calculating Net Present Value Assume that Project X costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 per cent.

Why is NPV Important?Positive net present value of an investment represents the maximum amount a firm would be ready to pay for purchasing the opportunity of making investment, or the amount at which the firm would be willing to sell the right to invest without being financially worse-off.

The net present value can also be interpreted to represent the amount the firm could raise at the required rate of return, in addition to the initial cash outlay, to distribute immediately to its shareholders and by the end of the projects life, to have paid off all the capital raised and return on it.

Acceptance RuleAccept the project when NPV is positiveNPV > 0Reject the project when NPV is negativeNPV < 0May accept the project when NPV is zeroNPV = 0

The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.

Evaluation of the NPV MethodNPV is most acceptable investment rule for the following reasons:Time value Measure of true profitability Value-additivity Shareholder value Limitations:Involved cash flow estimation Discount rate difficult to determineMutually exclusive projects Ranking of projects

INTERNAL RATE OF RETURN METHODThe internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period. This also implies that the rate of return is the discount rate which makes NPV = 0.

CALCULATION OF IRR Uneven Cash Flows: Calculating IRR by Trial and ErrorThe approach is to select any discount rate to compute the present value of cash inflows. If the calculated present value of the expected cash inflow is lower than the present value of cash outflows, a lower rate should be tried. On the other hand, a higher value should be tried if the present value of inflows is higher than the present value of outflows. This process will be repeated unless the net present value becomes zero.

CALCULATION OF IRRLevel Cash Flows Let us assume that an investment would cost Rs 20,000 and provide annual cash inflow of Rs 5,430 for 6 yearsThe IRR of the investment can be found out as follows

Acceptance RuleAccept the project when r > k

Reject the project when r < k

May accept the project when r = k

In case of independent projects, IRR and NPV rules will give the same results if the firm has no shortage of funds.

Evaluation of IRR MethodIRR method has following merits:Time value Profitability measure Acceptance rule Shareholder value IRR method may suffer fromMultiple rates Mutually exclusive projects Value additivity

PROFITABILITY INDEXProfitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.The formula for calculating benefit-cost ratio or profitability index is as follows:

PROFITABILITY INDEXThe initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. Assume a 10 percent rate of discount. The PV of cash inflows at 10 percent discount rate is:

Acceptance RuleThe following are the PI acceptance rules:Accept the project when PI is greater than one. PI > 1Reject the project when PI is less than one. PI < 1May accept the project when PI is equal to one. PI = 1The project with positive NPV will have PI greater than one. PI less than means that the projects NPV is negative.

Evaluation of PI MethodTime value:It recognises the time value of money.

Value maximization: It is consistent with the shareholder value maximisation principle. A project with PI greater than one will have positive NPV and if accepted, it will increase shareholders wealth.

Relative profitability:In the PI method, since the present value of cash inflows is divided by the initial cash outflow, it is a relative measure of a projects profitability.

Like NPV method, PI criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems.

PAYBACKPayback is the number of years required to recover the original cash outlay invested in a project. If the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow. That is:

ExampleAssume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is:

PAYBACKUnequal cash flows In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay. Suppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the projects payback? 3 years + 12 (1,000/3,000) months3 years + 4 months

Acceptance RuleThe project would be accepted if its payback period is less than the maximum or standard payback period set by management. As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period.

Evaluation of Payback Certain virtues:Simplicity Cost effective Short-term effects Risk shield LiquiditySerious limitations: Cash flows after payback Cash flows ignored Cash flow patterns Administrative difficulties Inconsistent with shareholder value

INTRODUCTION TO COST OF CAPITALThe projects cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. The firms cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects

SIGNIFICANCE OF THE COST OF CAPITALEvaluating investment decisions

Designing a firms debt policy

Appraising the financial performance of top management

THE CONCEPT OF THE OPPORTUNITY COST OF CAPITALThe opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk.

Cost of CapitalViewed from all investors point of view, the firms cost of capital is the rate of return required by them for supplying capital for financing the firms investment projects by purchasing various securities. The rate of return required by all investors will be an overall rate of return a weighted rate of return.

Weighted Average Cost of Capital vs. Specific Costs of CapitalThe cost of capital of each source of capital is known as component, or specific, cost of capital. The overall cost is also called the weighted average cost of capital (WACC).Relevant cost in the investment decisions is the future cost or the marginal cost. Marginal cost is the new or the incremental cost that the firm incurs if it were to raise capital now, or in the near future. The historical cost that was incurred in the past in raising capital is not relevant in financial decision-making.

COST OF DEBTDebt Issued at Par

Debt Issued at Discount or Premium

Kd = [Int+(F-Bo)/n]/(F+Bo)/2 OR

Tax adjustment

EXAMPLE

Cost of the Existing DebtSometimes a firm may like to compute the current cost of its existing debt.

In such a case, the cost of debt should be approximated by the current market yield of the debt.

COST OF PREFERENCE CAPITAL

Irredeemable Preference Share

Redeemable Preference Share

Example

Suppose, we have to pay Rs. 10, 00,000 of Rs 100 each but at the time of issue of pref. share, discount Rs. 2 per issue of pref. share. So, net proceed is Rs. 9,80,000 but if this amount is payable after 10 years at 10% premium, this will also benefit to pref. share capital and total cost of pref. share capital will increase. Rate of dividend is 10%.

Cost of pref. share capital = D + (MV NP )/n / (MV +NP) X 100 = 100,000 + ( 11,00,000- 9,80,000 )/10/ ( 11,00,000 + 9,80,000) x 100 = (100,000 + 12,000)/ 10, 40,000 X 100 = 10.76%

Equity capitalEquity capital can be raised by retained earnings. Alternatively , the retained earnings can be used to give dividend to shareholders and raise equity capital externally. So it can be concluded that there are two type equity capital Internal and external capital.The firm may have to issue new shares at a price lower than the current market price and it also includes flotation cost. Thus external equity will cost more to firm than internal equity.The question arises, Is Equity Capital Free of Cost? No, it has an opportunity cost.The market value of the shares determined by the demand and supply forces in a well functioning capital market reflects the return required by ordinary shareholders. Thus, the shareholders' required rate of return, which equates the present value of the expected dividends with the market value of the share, is the cost of equity.Determining equity is complex as it includes:Estimation of expected dividendExpected growth rateWhich is difficult to estimate.

Return on equityThe amount of net incomereturnedas a percentageof shareholders equity.Return on equitymeasures a corporation's profitabilityby revealing how muchprofit a company generateswith the money shareholders have invested. ROE is expressed as a percentage and calculated as: Return on Equity = Net Income/Shareholder's Equity

Retention ratio - The percent of earnings credited to retained earnings. In other words, the proportion of net income that is not paid out as dividends. Calculated as:

Growth rate can be calculated as: g = ROE * b

COST OF EQUITY CAPITAL

Cost of Internal Equity: The Dividend-Growth ModelNormal growth

Zero-growth

COST OF EQUITY CAPITALCost of External Equity: The Dividend Growth Model

EarningsPrice Ratio and the Cost of Equity

Example

A firm is currently earning Rs 100,000 and its share is selling at a market price of Rs 80. The firm has 10,000 shares outstanding and has no debt. The earnings of the firm are expected to remain stable, and it has a payout ratio of 100 per cent. What is the cost of equity? We can use expected earnings-price ratio to compute the cost of equity. Thus:

Cost of Equity & CAPMCertain concepts required to be understood are following: Risk & its typesBeta

Risk Risk in finance refers to the possibility of loss due to uncertainty.It can be of two typesDiversifiable (Unsystematic risk)Non Diversifiable (Systematic Risk)

Systematic RiskSystematic risk arises on account of the economy-wide uncertainties and the tendency of individual securities to move together with changes in the market. This part of risk cannot be reduced through diversification. It is also known as market risk. Investors are exposed to market risk even when they hold well-diversified portfolios of securities.

Unsystematic RiskUnsystematic risk arises from the unique uncertainties of individual securities. It is also called unique risk. These uncertainties are diversifiable if a large numbers of securities are combined to form well-diversified portfolios.Uncertainties of individual securities in a portfolio cancel out each other. Unsystematic risk can be totally reduced through diversification.

Total Risk

Systematic and unsystematic risk andnumber of securities

Beta Estimation

Example

CAPM and the Opportunity Cost of EquityFrom the firms point of view, the expected rate of return from a security of equivalent risk is the cost of equity because when a from retains profit, there is a loss of opportunity for which shareholders needs to be compensated. So the expected rate of return from a security of equivalent risk in capital market is the cost of opportunity lost and shareholders wants firm to earn this rate on the capital invested so it is considered as cost of equity.

The expected rate of return or the cost of equity in CAPM is given by the following equation:

Now the question arises where to use this conceptIn cost of equity we have a assumption under normal growth that dividend will grow at normal rate and its growth rate will be less than cost of equity.

So this implies that dividend growth approach can not be applied to those companies that are not paying dividend or whose dividend per share growing is higher that the cost of equity or whose dividend policies are very volatile.

Suppose in the year 2002 the risk-free rate is 6 per cent, the market risk premium is 9 per cent and beta of L&Ts share is 1.54. The cost of equity for L&T is:

COST OF EQUITY: CAPM VS. DIVIDENDGROWTH MODELThe dividend-growth approach has limited application in practice It assumes that the dividend per share will grow at a constant rate, g, forever. The expected dividend growth rate, g, should be less than the cost of equity, ke, to arrive at the simple growth formula.The dividendgrowth approach also fails to deal with risk directly.

CAPM has a wider application although it is based on restrictive assumptions. The only condition for its use is that the companys share is quoted on the stock exchange. All variables in the CAPM are market determined and except the company specific share price data, they are common to all companies.The value of beta is determined in an objective manner by using sound statistical methods. One practical problem with the use of beta, however, is that it does not probably remain stable over time .

THE WEIGHTED AVERAGE COST OF CAPITAL

The following steps are involved for calculating the firms WACC:Calculate the cost of specific sources of fundsMultiply the cost of each source by its proportion in the capital structure.Add the weighted component costs to get the WACC.

WACC is in fact the weighted marginal cost of capital (WMCC); that is, the weighted average cost of new capital given the firms target capital structure.

Criticism of Walters ModelNo external financingConstant return, rConstant opportunity cost of capital, k

Capital Structure Defined

The term capital structure is used to represent the proportionate relationship between debt and equity. The various means of financing represent the financial structure of an enterprise. The left-hand side of the balance sheet (liabilities plus equity) represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing the firms capital expenditure.

The capital structure decision process

While making the Financing Decision...How should the investment project be financed?Does the way in which the investment projects are financed matter?How does financing affect the shareholders risk, return and value?Does there exist an optimum financing mix in terms of the maximum value to the firms shareholders?Can the optimum financing mix be determined in practice for a company?What factors in practice should a company consider in designing its financing policy?

Meaning of Financial Leverage The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners equity in the capital structure, is described as financial leverage or gearing or trading on equity. The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners equity. The rate of return on the owners equity is levered above or below the rate of return on total assets.

Measures of Financial Leverage Debt ratioDebtequity ratioInterest coverageThe first two measures of financial leverage can be expressed either in terms of book values or market values. These two measures are also known as measures of capital gearing.The third measure of financial leverage, commonly known as coverage ratio. The reciprocal of interest coverage is a measure of the firms income gearing.

Financial Leverage and the Shareholders ReturnThe primary motive of a company in using financial leverage is to magnify the shareholders return under favourable economic conditions. The role of financial leverage in magnifying the return of the shareholders is based on the assumptions that the fixed-charges funds (such as the loan from financial institutions and banks or debentures) can be obtained at a cost lower than the firms rate of return on net assets (RONA or ROI).

EPS, ROE and ROI are the important figures for analysing the impact of financial leverage.

EPS and ROE Calculations

Effect of Leverage on ROE and EPS

Favourable

ROI > i

Unfavourable

ROI < i

Neutral

ROI = i

Operating LeverageOperating leverage affects a firms operating profit (EBIT).The degree of operating leverage (DOL) is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales.

Degree of Financial LeverageThe degree of financial leverage (DFL) is defined as the percentage change in EPS due to a given percentage change in EBIT:

Combining Financial and Operating LeveragesOperating leverage affects a firms operating profit (EBIT), while financial leverage affects profit after tax or the earnings per share.

The degrees of operating and financial leverages is combined to see the effect of total leverage on EPS associated with a given change in sales.

Combining Financial and Operating LeveragesThe degree of combined leverage (DCL) is given by the following equation:

another way of expressing the degree of combined leverage is as follows:

Net Income (NI) Approach: Relevance ApproachAccording to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.

This approach has been suggested by Durand. According to this approach a firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. In other words, if the degree of financial leverage increases the weighted average cost of capital will decline with every increase in the debt content in total funds employed, while the value of firm will increase. Reverse will happen in a converse situation.AssumptionsThere are no corporate taxesThe cost of debt is less than cost of equity or equity capitalization rate.The use of debt content does not change at risk perception of investors as a result both the kd (debt capitalization rate) and kc (equity-capitalization rate) remains constant

The value of the firm on the basis of Net Income Approach can be ascertained as follows:V = S + D, where, V = Value of the firm, S = Market value of equity, D = Market value of debtMarket value of equity (S) = NI/Kcwhere, NI = Earnings available for equity shareholders.Kc = Equity Capitalization rate

Under, NI approach, the value of the firm will be maximum at a point where weighted average cost of capital is minimum. Thus, the theory suggests total or maximum possible debt financing for minimizing the cost of capital

Zero debt300000 @ 5%900000 @ 5% NOI100000100000100000LESS INT1500045000Net income1000008500055000 Market value of equity (EQUITY CAPITALISATION RATE IS 10%) 1000000850000550000Market value of debt0300000900000Value of firm100000011500001450000WACC = NOI/V0.1000.0870.081

Net Operating Income Approach: Irrelevance ApproachThis approach has been suggested by Durand. According to this approach, the market value of the firm is not affected by the capital structure changes. The market value of the firm is ascertained by capitalizing the net operating income at the overall cost of capital which is constant.

The Net Operating Income Approach is based on the following assumptions:The overall cost of capital remains constant for all degree of debt equity mix.The market capitalizes the value of firm as a whole. Thus the split between debt and equity is not important.The use of less costly debt funds increases the risk of shareholders. This causes the equity capitalization rate to increase. Thus, the advantage of debt is set off exactly by increase in equity capitalization rate.There are no corporate taxesThe cost of debt is constant.

Market value of the firm (V) = (Earnings before interest and tax)/(Overall cost of capital)

The value of equity can be determined by the following equation

Value of equity (S) = V (market value of firm) D (Market value of debt) and the cost of equity = (Earnings after interest and before tax)/(market value of firm (V)- Market value of debt (D))

ABC Ltd., is expecting an Earning before interest & tax of $ 4,00,000 and belongs to risk class of 10%. You are required to find out the value of firm % cost of equity capital if it employs 8% debt to the extent of 20%, 35% or 50% of the total financial requirement of $ 20,00,000.

20% debt35% debt50% debtEBIT400000400000400000Cost of capital10%10%10%Value of firm is 400000040000004000000Value of debt (interest is 8%)4000007000001000000Value of equity360000033000003000000Net Profit368000 (400000 32000)344000 (400000 56000)320000 (400000 800000)

Cost of equity (net profit/value of equity)10.22%10.42%10.66%

Traditional Approach: Relevance ApproachThe traditional approach argues that moderate degree of debt can lower the firms overall cost of capital and thereby, increase the firm value. The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity.

The traditional theory on the relationship between capital structure and the firm value has three stages:First stage: Increasing valueSecond stage: Optimum valueThird stage: Declining value

Firm has an expected earning of Rs 150 cr (entirely equity financed). The equity capitalization rate 10%. If the firm uses 300cr debt @ 6%, than its cost of capital increases to 10.56%.If the firm uses 600 cr debt @ 7%, than its cost of capital increases to 12.5 %.Calculate WACC.

No debt(RS IN CRORE)6% Debt of 300 cr(RS IN CRORE)7% Debt of 600 cr(RS IN CRORE)NOI150150150Interest01842Net Income150132108Cost of equity10%10.56%12.5%Market value of Equity (NI/ cost of equity)15001250864Value of firm150015501464WACC10%9.7%10.3%

Criticism of the Traditional ViewThe contention of the traditional theory, that moderate amount of debt in sound firms does not really add very much to the riskiness of the shares, is not defensible.

There does not exist sufficient justification for the assumption that investors perception about risk of leverage is different at different levels of leverage.

ModiglianiMiller theoremMMs Proposition I is that, for firms in the same risk class, the total market value is independent of the debt-equity mix and is given by capitalizing the expected net operating income by the capitalization rate (i.e., the opportunity cost of capital) appropriate to that risk class.

MMs Proposition I: Key AssumptionsPerfect capital marketsHomogeneous risk classesRiskNo taxesFull payout

The cost of capital under MM proposition I

MM Proposition IMMs Proposition I states that the firms value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage.

Suppose there are two firm L & U and they have same NOI of Rs 10000. The value of firm U is Rs 100000 assuming the cost of Equity is 10%. Firm U has no debt and firm L employs 6% debt of Rs 50000, suppose its cost of capital is 11.7%

Firm U (Unlevered)Firm L (Levered)NOI1000010000Into3000NI100007000Cost of Equity10%11.7%Value of Equity10000060000Value of debt050000Market value of firm100000110000

Lets assume that you 10% share of the levered firm L and you hold 10% of firm Ls corporate debt. You are entitled to receive 10% of L equity is 10%your investment = 0.10 * 60000 + 0.10 * 50000 = 6000 + 5000 = 11000Return = 0.10 (7000) = 700

You can earn the same return with the help of following strategySelling your investment in Ls share for Rs 6000.Borrowing the personal loan of 5000 at 6% interest. Buying the share 10 percent of share of Unlevered firm i.e. (0.10* 100000) 10000.Now your investment is of Rs 10000 and you have surplus money of Rs 1000.Return from Us Investment at 10% , 0.10 * 10000 =1000.Interest payable on loan of Rs 5000 @ 6% is 300.Thus your net return is 1000 300 = 700.

Arbitrage ProcessSo the strategy would result in arbitrage and investor will sell the share of L and invest in U. due to which the share price of these firm become equal. Suppose two identical firms, except for their capital structures, have different market values. In this situation, arbitrage (or switching) will take place to enable investors to engage in the personal or homemade leverage as against the corporate leverage, to restore equilibrium in the market.

On the basis of the arbitrage process, MM conclude that the market value of a firm is not affected by leverage. Thus, the financing (or capital structure) decision is irrelevant. It does not help in creating any wealth for shareholders. Hence one capital structure is as much desirable (or undesirable) as the other.

MMs Proposition IIFinancial leverage causes two opposing effects: it increases the shareholders return but it also increases their financial risk. Shareholders will increase the required rate of return (i.e., the cost of equity) on their investment to compensate for the financial risk. The higher the financial risk, the higher the shareholders required rate of return or the cost of equity.The cost of equity for a levered firm should be higher than the opportunity cost of capital, ka; that is, the levered firms ke > ka. It should be equal to constant ka, plus a financial risk premium.

To determine the levered firm's cost of equity, ke:

Dividend PolicyThe policy a company uses to decide how much it will pay out to shareholders in dividends.

Its objectives are following:Firms Need for FundsShareholders Need for Income

PRACTICAL CONSIDERATIONS IN DIVIDEND POLICYFirms Investment Opportunities and Financial NeedsShareholders ExpectationsConstraints on Paying DividendsLegal restrictionsLiquidityFinancial condition and borrowing capacityAccess to the capital marketRestrictions in loan agreementsInflationControl

STABILITY OF DIVIDENDSConstant Dividend per Share or Dividend Rate.Constant Payout.Constant Dividend per Share Plus Extra Dividend.

Constant dividend per share policy

Dividend policy of constant payout ratio

Significance of Stability of DividendsResolutions of investors uncertainty.Investors desire for current income.Institutional Investors Requirement.Raising Additional Finances.

FORMS OF DIVIDENDSCash Dividends Bonus Shares (Stock Dividend)

Advantages of Bonus SharesTo shareholders:Tax benefitIndication of higher future profitsFuture dividends may increasePsychological valueTo company:Conservation of cashOnly means to pay dividend under financial difficulty and contractual restrictionsMore attractive share price

Limitations of Bonus SharesShareholders wealth remains unaffectedCostly to administerProblem of adjusting EPS and P/E ratio

Share splitA share split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share. A share split affects only the par value and the number of outstanding shares; the shareholders total funds remain unaltered.

ExampleThe following is the capital structure of Walchand Sons & Company:

Walchand Company split their shares two-for-one. The capitalization of the company after the split is as follows:

Bonus Share vs. Share SplitThe bonus issue and the share split are similar except for the difference in their accounting treatment. In the case of bonus shares, the balance of the reserves and surpluses account decreases due to a transfer to the paid-up capital and the share premium accounts. The par value per share remains unaffected. With a share split, the balance of the equity accounts does not change, but the par value per share changes.

Reasons for Share SplitTo make trading in shares attractiveTo signal the possibility of higher profits in the futureTo give higher dividends to shareholders

DIVIDEND RELEVANCE: WALTERS MODELWalters model is based on the following assumptions:Internal financingConstant return and cost of capital100 per cent payout or retentionConstant EPS and DIVInfinite time

Walters formula to determine the market price per share:

Optimum Payout RatioGrowth Firms Retain all earningsNormal Firms No effect Declining Firms Distribute all earnings

Example: Dividend Policy: Application of Walters Model

Criticism of Walters ModelNo external financingConstant return, rConstant opportunity cost of capital, k

DIVIDEND RELEVANCE: GORDONS MODELGordons model is based on the following assumptions:All-equity firmNo external financingConstant returnConstant cost of capitalPerpetual earningsNo taxesConstant retentionCost of capital greater than growth rate

ValuationMarket value of a share is equal to the present value of an infinite stream of dividends to be received by shareholders.

Example: Application of Gordons Dividend Model*

It is revealed that under Gordons model:

DIVIDEND IRRELEVANCE: THE MILLERMODIGLIANI (MM) HYPOTHESISAccording to M-M, 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.

It is based on the following assumptions:-Perfect capital marketsNo taxesInvestment policyNo risk

Concepts of Working Capital A managerial accounting strategy focusing on maintainingefficientlevels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. Gross working capital (GWC) GWC refers to the firms total investment in current assets. Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, (accounts receivable or book debts) bills receivable and stock (inventory).Gross Working Capital = Total of all Current Assets

Concepts of Working Capital Net working capital (NWC)NWC refers to the difference between current assets and current liabilities. Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses. NWC can be positive or negative. Positive NWC = CA > CLNegative NWC = CA < CLGWC focuses onOptimisation of investment in currentFinancing of current assets NWC focuses on Liquidity position of the firmJudicious mix of short-term and long-tern financing

Working Capital ManagementDecisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Operating cycle of Working CapitalCashCreditorsRaw MaterialWork-in-progressFinished goodsDebtorsWorking Expenses

PERMANENT AND VARIABLE WORKING CAPITALPermanent or fixed working capitalA minimum level of current assets, which is continuously required by a firm to carry on its business operations, is referred to as permanent or fixed working capital.Fluctuating or variable working capital The extra working capital needed to support the changing production and sales activities of the firm is referred to as fluctuating or variable working capital.

Determinants of Working CapitalNature of businessMarket and demand Technology and manufacturing policyCredit policySupplies creditOperating efficiencyInflation

Sources of FinanceA business requires funds to purchase fixed assets like land and building, plant and machinery, furniture etc. These assets may be regarded as the foundation of a business. The capital required for these assets is called fixed capital.Purpose of long term financeTo Finance fixed asset To Finance permanent part of working capitalTo finance growth and expansion of fixed assetFactors determining long term sources of financeNature of businessNature of goods producedTechnology used.

Sources of Finance Long termSharesDebenturesPublic depositRetained earningTerm loan from bankLoan form financial institution

Sources of Finance Short TermTrade creditBank creditLoansCash creditOverdraftDiscounting of billCustomer advancesInstallment creditLoan from co-operatives

International Sources of FinanceADR/GDRLoan in foreign currency from Financial institutionInternational Bonds

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