Financial Management M.B.A. 2" Semester By Dr. Mohammad Anees Department of Business Administration, University of Lucknow, Lucknow © scanned with OKEN ScannerCC 202; FINANCIAL MANAGEMENT Unit I: Nature of Financial Management: Scope and objectives of finance, role and functions of finance manager, risk-retum trade off, shareholders’ wealth maximization, agency problem, General awareness of financial environment-financial instruments, regulation and markets, Unit IL Investment Decisions: Analysis of Capital budgeting decisions, application of discounted and non-discounted techniques in capital budgeting, time value of money, capital rationing, risk analysis in capital budgeting. Unit I: Financing Decisions: Cost of Capital and & Dividend Decision: Optimum capital structure, financial and operating leverages, sources of long-Term Finance, cost of capital-components’ costs and Combined Cost (WACO), capital structure theories Unit IV: Dividend theories, Inrelevance of dividend, MM Hypothesis, relevance of dividend and Walter's model, dividend policy determinants, share repurchase or buyback, Issue of bonus share and its implications, Unit V: Working Capital Management: Principles of working capital management, Accounts Receivable management, Inventory management and Cash management, factors influencing working capital requirement, computation of working capital required in business firm. References: - Principles of Managerial Finance by Lawrence J. Gitman, Pearson Financial Management and Policy by Van Home, Dhami, Pearson Fundamentals of Financial Management by Dr R.P. Rastogi, Taxman's Financial Management by Ravi M Kishore, Taxman’ Financial Management-Text Problems and Cases by Khan and Jain, Me Graw Hill © scanned with OKEN ScannerWhat is Financial Management ? Meaning and Concept Financial management means optimization of financial resources and activities of a business concern in a way to realize the financial objectives. Important points: 1. Optimization 2. Financial resources 3. Financial activities- operating and strategic 4. Financial objectives © scanned with OKEN ScannerNature of financial Management Scope and objectives of Financial Management 1. Financial management is one the functional areas of management. 2. Financial management is multidisciplinary. 3. Financial activities are operative and strategic. 4. Financial management has its implications on entire firm. 5. Knowledge of financial system is required 6. Objective of financial management- profit vs. wealth maximization Corporate finance vs. Financial Services 8. Financial management vs. Accounting n © scanned with OKEN ScannerFinancial management is one of the functional areas of management Finance Human Resource Accounting Production/ Functional Operations Business Areas Marketing © scanned with OKEN ScannerFinancial management is multidisciplinary. eerie el Eo Ce cele CCCs een Tae to Production ei ey 6 © Scanned with OKEN ScannerFinancial management has its implications on entire firm. 1. Financial management involves in budgeting for entire organization 2. Financial management involves cash flows of entire organization 3. Financial planning and investment is for entire organization 4. Financial management activities are coordinating, supervisory, advisory and facilitating. © scanned with OKEN ScannerKnowledge of financial system for managers Seer ER (cheque, FDR Coe Financial markets(money err change LSE Verna ocd Pee sett So tm Sy Act) Cooter hts 2 © scanned with OKEN ScannerObjective of financial management a2... =... Profit Maximisation Vs. Wealth Maximization © Profit maximization is basically a single period or a short-term goal. It is usually interpreted to mean the maximization of profits within a given period of time. A firm may maximize its short-term profits at the expense of its long-term profitability and still realize this goal. Incontrast, shareholder wealth maximization is a long-term goal. shareholders are interested in future as well as present profits. Wealth maximization is generally preferred because it considers (1) wealth for the long term, (2) risk or uncertainty. (3) the timing of returns, and (4) the shareholders’ return. © scanned with OKEN ScannerCorporate finance vs. Financial Services Corporate Finance Involves: — Financing — Investing — Dividend Distribution — Working capital management Financial services are intermediary services available for corporate such as: — Banking services — Insurance services — Merchant banking services — Portfolio management — Financial consultancy — Venture capital — Leasing and hire purchase — Credit rating © scanned with OKEN ScannerFinancial Management vs. Accounting 1. Recall from accounting Let’s recall that financial accounting is technical job whereas management accounting is a managerial job 2. Financial management vs. accounting The activities of financial management and management accounting are overlapping. 3. Financial management focuses on cash flow management, procurement and investment of funds. 4. On the other hand accounting focuses on preparation of accounts and use of accounting information for the betterment (enhancing profit and efficiency) of business. 5. To conclude accounting focuses on accounting information whereas financial management focuses on short term and long term funds and its proper utilization the betterment of business. Management accounting may be viewed as a subset of financial management. © scanned with OKEN ScannerObjectives of Financial Management: Profit vs. Wealth Maximization Rationale: There is a general discussion regarding the objective of financial management whether its objective is to maximize profit or there should be some other alternative and broader objective wherein the profit should be included. © scanned with OKEN ScannerAnalysis of profit maximization as an objective of financial management Arguments in favor of profit maximization as an objective: 1. Profit is an easily understandable term 2. Profit maximization is a specific objective of almost all businesses 3. Profit increases reserves and gives better return to owners 4. Easily calculated term. 5. Can be related to sales to find out margin to sales and can be related to investment to find out Return on Investment (ROI). © scanned with OKEN ScannerArguments against profit as an objective of Financial Management 1. Profit maximization is based on exploitative tendencies. 2. There are different types of profits in accounting and finance such as EBIDT, EBDT, EBT, PAT, DPS, EPS, P/E, Profit Margin, ROI, EVA etc. 3. Profit maximization is a narrow and short term approach. 4. Profit ignores the likely business risks. 5. Profit maximization does not ensure overall growth of business. 6. Profit maximization approach ignores time value money in financial decisions. © scanned with OKEN ScannerWhat is Wealth Maximization? “Wealth maximization” is a term related with shareholders or owners of corporate business. Alternatively wealth maximization is also known as “shareholders’ interest’ or “shareholders’ welfare” maximization. Experts of financial management have proved that shareholders wealth maximization is the most suitable objective of financial management. It is therefore considered that wealth maximization is an objective superior to profit maximization objective. © scanned with OKEN ScannerWealth Maximization a Superior objective to profit maximization. Why? Wealth maximization has all those virtues which have been discussed as limitations of profit maximization approach. These are as follow 1. Wealth maximization fulfills time value of money requirement into financial decisions. 2. All the financial decision are preferred on the basis of net present values. It is in long term context. 4. Wealth maximization manages all types of business risks as it is based on holistic approach of stakeholders theory. 5. Stakeholders’ theory identifies all stakeholders of business and satisfies each of them. - 6. With the help of stakeholders’ theory overall business growth is ensured. 7. Wealth maximization is not exploitative rather it is welfare oriented. 8. Wealth maximization ensures long run survival, growth and leadership of a business concern. © scanned with OKEN ScannerWealth maximization is a broader and a superior objective to profit maximization: A Pictorial Presentation Pree evn See em ciaal reenter ceemel ren iatearas remot nena. Soren Sime soles Coreen OP scanned with oxEN ScannerGuidelines to fulfill Wealth Maximization Objective 1. oe a . Value-addition approach. Financial decision on the basis of time value of money consideration. Risk- Return Trade off approach Consideration for all stakeholders Resolving agency problems Use of most modern and scientific approach in business management. Focus on research and development © scanned with OKEN ScannerHow to know that wealth maximization is taking place? 2 © Scanned with OKEN ScannerRole & Functions of Finance Manager Role of a finance manager Finance manager plays a very crucial role in any organization. The role of a finance manager can be discussed with the help of following points: 1. Finance manager looks for financial requirements of business. 2. Plans for arrangement of funds from various short term and long term sources. Controls cash flows during business operations. Co-ordinates various departments through budgeting. Optimizes the collection and application of funds Saves the organization from idle funds and idle assets. Focuses on risk return trade off. Realizes the financial objectives of business. PN Se © scanned with OKEN ScannerFunctions of Finance Manager Core functions of finance manager 1. Financing 2. Investing 3. Dividend distribution 4. Working capital management General functions of finance manager Profit planning Budgeting Risk management Productivity enhancement Business expansion Financial liaisoning Cash flow management ea ee oe ea © scanned with OKEN ScannerFinancing Financing means procuring long term funds from different sources as given below: 1. PYny 5. Objective of financing: Formulation of an optimum capital structure. Equity share capital Preference share capital Issue of debentures Term loans from long term financial institutions Internal financing through retention of profits © scanned with OKEN ScannerWhat is an optimum capital structure? an optimum capital structure is one which is most appropriate for a given business and has the following features: af MH te fo Optimum cost of capital Solvency Flexibility Conservatism Control © scanned with OKEN ScannerAbout Capital structure Capital structure consists of various types of long term funds broadly categorized into debt and equity as follows: Equity nny Tac) © scanned with OKEN ScannerRisk Return Trade off in Financing An optimum capital structure is the most appropriate when there is a trade off between risk and return in each source of long term source of fund considering the pros and cons of each source or there is an optimum ratio between debt and equity. Capital Structure with debt equity mix debt m equity © scanned with OKEN ScannerInvesting Investing means investment of long term funds collected under financing into fixed assets after a proper analysis of investment activity on the basis of available information about such investment. These information are: 1. Quantum of funds required in investment Annual estimated return from investment Cost of capital used in investment Duration of investment . Use of an appropriate technique for analysis Objective of Investing: Selection of optimum assets for investment ARLYN © scanned with OKEN ScannerRisk Return Trade off in Investing Activity Finance manager has to justify the investment from risk and return point of view. It has to use a suitable method for investment analysis. The suitable method is one which considers time value of money. It has to evaluate the project from the following angles to accept it: 1. Profitability 2. Risk 3. Monetary constraint of investible fund 4. Weighted Average Cost of Capital (WACC) © scanned with OKEN ScannerDividend Distribution Under dividend distribution function the finance manager has to take decision regarding how much dividend should be distributed to equity shareholders out the annual profits available with the company. It has to take decision with the consideration of following factors: 1. Past record of dividend payment 2. Expectation of shareholders 3. Financial requirement of business 4. Legal bindings 5. Availability of profitable investment options 6. Availability of long term funds in the capital market 7. Availability of cash resources with the firm 8. Level of inflation and taxes payable the recipient 9. Stability in dividend payment 10. Bonus shares or stock dividends © scanned with OKEN ScannerObjective and Risk Return Trade Off Objective: The objective of dividend distribution is to formulate an optimum policy which is the most appropriate for the firm. Risk return trade off: When all the concerning factors are properly considered and weightage of each factor is incorporate in the dividend policy it is called risk return trade relating to dividend policy. © scanned with OKEN ScannerWorking Capital Management Working capital management consists of the following aspects: a) Cash management b) Inventory management c) Receivables management d) Working capital financing Each of the above mentioned activities need a risk return trade-off in order to optimize the overall working capital management. © scanned with OKEN ScannerCash management and Risk Return trade-off A risk return trade-off would be achieved if the finance manager is successful in achieving a proper and adequate level of synchronization between cash inflows and outflows during business operations. For a proper cash flows synchronization the sources of cash inflows such as recovery from debtors and smooth sales level has to be ensured. On the other hand cash payments have to be controlled up-to a possible and permissible limits. © scanned with OKEN ScannerRisk return trade-off in inventory management Objectives of inventory management are: a) Ensuring smooth production and sales b) Ensuring a proper flow of inventory during production and sales c) Control of inventory related costs, such as ordering and carrying costs. Use of following inventor management techniques would ensure a trade level in inventory management: A. Economic Order Quantity B. ABC Analysis C. LIFO FIFO Methods D. Zero Base Inventory © scanned with OKEN ScannerReceivable Management and trade-off For the purpose of effective receivable management an optimum credit sales policy needs to be formulated consisting of the following: a) Decision regarding the selection of good track record customers for credit sales b) Decision regarding credit duration c) Decision regarding the prompt recovery from debtors d) Decision regarding trade discounts © scanned with OKEN ScannerFinancing of working capital For an effective working capital management its proper financing is equally important. Following sources of finance are generally available: Short term sources: cash sales, recovery from debtors, credit purchase from suppliers, bank finances etc. Long sources: Issue of share Capital, borrowings from LT financial institutions, Issue of debentures, retention of earnings. A good policy of working capital financing is to utilize the short term sources for financing the working capital requirements and avoid the use of long term sources to use in working capital needs. The reason being the short term sources are more convenient and cost effective for fulfilling working capital requirements. © scanned with OKEN ScannerGeneral Awareness of Financial Environment in India Financial environment can also be termed as financial system which is made of the following: 1. oe ae Financial markets financial intermediaries Financial instruments Financial services Financial regulation © scanned with OKEN Scannerhs Requirement/significance of financial system . Financial system assists finance manager in all its functions. Financial system is an integral part of industries in any country. Financial system in a broader framework integrated with economic growth of a country. Means of capital formation and utilization Financial system is formally developed. Formal financial system serves and protects the interest of all participants. © scanned with OKEN ScannerParticipants of financial system Participants of financial system are: . Investors- individual and institutional . Speculators . Service providers . Bankers . Regulators/Government . Researchers ON Oe eh . Clients/ customers @ scanned with OKEN sFinancial Markets Financial markets are: 1. Short tem financial markets Such financial markets are also known as money markets. Money market comprises of banks, general public and corporate. 1. Long term financial markets Such financial markets are known as capital markets. Which are further divided into primary and secondary capital markets. Primary financial market is for new securities issue and subscription. Secondary capital market is for the trading of old securities which are previously issued in primary capital market. There are other financial markets such as Insurance markets and international currency market. © scanned with OKEN ScannerFinancial Intermediaries Financial intermediaries are those institutions which intermediate between two _ parties such as client/customer and investors. Following financial intermediaries work in the financial system: 1. brokers 2. Issue managers 3. Underwriters 4. Credit rating agencies These financial intermediaries work for some fee to be charged by them as their return. © scanned with OKEN ScannerFinancial Instruments Financial instruments are those documents which are the proof of some investment or ownership of some claim. Important financial instruments are as follows: 1. Money market related instruments such as cheque, treasury bill, draft, bill of exchange, fixed deposit receipts, money market mutual fund receipts, currency notes etc. 2. Capital market related instruments such as equity and preference shares, debentures, bonds, mutual fund receipts etc. © scanned with OKEN ScannerFinancial Services Various types of services rendered by financial markets and financial intermediaries come under this category. Important financial services are: 1. pe) oe Oy Banking services Merchant banking services Fee based and fund based services Insurance services Financial consultancy services Foreign currency/exchange related services Financial Broking services Rating services Portfolio and investment related services etc. © scanned with OKEN ScannerFinancial Regulation In order to make the entire financial system disciplined and work in systematic and coordinated manner there is a requirement to regulate and control the activities of all the participants of financial system. This particular role is played by financial regulation. Some important financial regulators of financial system: i 2. 3. 4. 5. SEBI- Securities Exchange Board of India IRDA- Insurance Regulatory and Development Authority RBI- Reserve Bank of India Ministry of Finance Finance commission © scanned with OKEN ScannerObjectives of Financial Regulation Financial regulation has its defined and specific objectives to realize. Some of these objectives are being categorized as below: 1. Protection of interest of investors 2. Third party risk or default risk management 3. Streamline the growth and development of financial system. 4. Industrial growth Ensure discipline in the markets. 6. Coordinate national financial system with international financial system. w © scanned with OKEN ScannerImportance of financial system for a finance manager It is necessary for a finance manager to be aware and properly involve in the financial system in order to: Successfully arrange funds from market Successfully invest the idle funds in the market Eo 1S) ie Avail financial services available Be compensated for any loss caused by the system Understand financial trends Default risk management Financial engineering and diversified financial services rs Liquidity management © scanned with OKEN ScannerInvestment Decisions Meaning: Investment decisions are also known as capital budgeting decisions. These decisions are related to long term investment into fixed assets. Important Features: 1. Substantial amount Long term investment Irreversible decision Future implications Analysis of investment to take decision Such decisions create operating risk and operating leverage 7. With the help of capital budgeting technique profitable projects are selected. oO eo tS © scanned with OKEN ScannerAnalysis of Capital Budgeting Decisions Each capital budgeting decision is a project. Capital budgeting decisions are taken on the basis of following variables or information: 1. wR WN Investment amount or cash outflow Duration of project in years Annual cash inflows Discount rate or cost of capital Use of some specific method to analyze investment © scanned with OKEN ScannerTechniques of Capital Budgeting Overall techniques of capital budgeting have been divided into two categories: . Non-Discounted (Traditional) Techniques . Pay-Back (PB) Method . Average Rate of Return (ARR) Method . Discounted (Modern) Techniques . Net Present Value (NPV) Method . Internal Rate of Return (IRR) Method . Profitability Index (PI) On| WN > © scanned with OKEN ScannerDiscounted vs. Non-Discounted Techniques 1. Name of NPY, IRR and PI PB and ARR Techniques 2. Superiority Superior, Modem Inferior, Traditional 3. Time Value of Considered Not considered Money 4. Shareholders Fulfill the objective of | Do not fulfill the objective of Wealth | Shareholders’ Wealth objective of Maximization Maximization (SWM) | Shareholders’ Wealth (SWM) Maximization (SWM) 5. Applicability Large organizations Small organizations 6. Level of Rationality | More rational and Less rational, illogical acceptable a © scanned with OKEN ScannerTime Value of Money 1. A bird in hand is worth more than two in the bush. 2. Cash inflows accruing at different time intervals are not same in their value. Hence, are not comparable with cash outflows. 3. In order to consider the time value of money, the cash flows at different time intervals need to be discounted at a discount rate. 4. Discount rate is the opportunity cost of capital. It may be different for different companies. 5. Time value of money considered in all the discounted techniques. 6. Discounting is a process of converting the future value into the present value. © scanned with OKEN ScannerSignificance, merits and demerits of Methods of Capital Budgeting Non-discounted/Traditional Techniques of Capital Budgeting: 1. Pay Back: It is a time period within which the entire investment in the project is recovered out of the cash inflows (profits) ofthe project. Si Every investor is interested to know the payback because to recover the present investment within the stipulated time is the main concem of business. Acceptability Rule: Accept if PB < Maximum affordable period Merits: 1. Pay back focus on liquidity aspect of business. 2. This is a popular, easy to understand and use. 3. This method can be easily used along with other methods 4. This method prefers the project of earlier and heavier profits. Demerits: 1. This method is not a perfect method as the decision criterion is liquidity and not profitability. 2. This method does not consider time value of money. 3. PB does not consider the entire project’s profitability © scanned with OKEN ScannerSignificance, merits and demerits of methods of capital budgeting (Cont..) 2. Average Rate of Return (ARR) This is another non-discounting or traditional technique of capital budgeting. ARR is also known as accounting rate of return because the real accounting data are used for this method. Significance: Because of its simplicity, the ARR is popularly used to know the percentage return on the investment into the project. Acceptability Rule: Accept if ARR > Minimum desirable rate of return Merits: 1. Use of accounting data makes this method more practical and reliable. 2. ARR method is easy to understand and use. 3. This method gives an average idea about the entire profitability of business. Demerits: 1. ARR does not consider the time value of money factor. 2. As ARR take data from accounting, the limitation of historical data comes in the computation. © scanned with OKEN ScannerSignificance, merits and demerits of methods of capital budgeting (Cont..) Discounting Techniques of Capital Budgeting Net Present Value (NPV) Method Under NPV method all the cash inflows of the project are discounted with given discount rate and cash inflows are converted into present values (PVs). If total of these PVs is higher than the present investment, the given project is profitable. Acceptability Rule: Accept if NPV is positive Significance: This is the most popularly used discounting technique of capital budgeting for being consistent with the WM objective of shareholders. Merits: 1. NPV incorporates the time value of money consideration. 2. Since NPV method decides the acceptability of the project on the basis of a cut off point of discount rate, the method is more practical. 3. NPV method is useful to take decision regarding a group of projects by adding the NPV of all of these projects. 4. NPV method is superior on reinvestment Limitations: 1. Estimated figures of opportunity cost, cash flows and duration of project. 2. Requirement for risk adjustment in the estimates sumption. © scanned with OKEN ScannerSignificance, merits and demerits of methods of capital budgeting (Cont..) Discounting Techniques of Capital Budgeting Internal Rate of Return (IRR) IRR is the rate at which the NPV of a given project is equal to its present investment. Acceptability Rule: Accept if IRR > Opportunity cost of capital Significance: With the help of IRR the entire profitability of given project is known. IRR gives a complete idea of project performance in terms of profitability. Merits: 1. IRR consider the time value of money and is consistent with SWM. 2. IRR is suitable for small projects with moderate return. 3. For IRR calculation the actual discount rate is not required. 4, The entire profitable worth of a given project can be evaluated with the help ol Demerits: 1. Reinvestment assumption does not favor high IRR yielding projects. 2. IRR involves too tedious calculation. 3. Only mutually exclusive projects are evaluated with the help of IRR. © scanned with OKEN ScannerSignificance, merits and demerits of methods of capital budgeting (Cont..) Discounting Techniques of Capital Budgeting 3. Profitability Index (PI This method is also known as Benefit-Cost Ratio Method. It is based on Net Present Value method and calculates the benefit on per rupee investment. Ph _ PV of Cash Inflow Profitability Index = PV of Cash Outflow Decision Criteria 1. If there is only one project + IEPLis more than 1 Accept + TEPLis less than 1 Reject + IEPLisO Indifferent 2. If there are more than one project, the project with higher NPV should be selected. © scanned with OKEN ScannerSignificance, merits and demerits of methods of capital budgeting (Cont..) Profitability Index Advantages ¢ Simple And Widely Used Method ¢ Considers Time Value Of Money ° Easy To Make Decisions - Accurate Rate Of Return Disadvantages ° Difficult To Estimate Discount Rate - Possibility Of Incorrect Decision ° Difficult To Make Comparison © scanned with OKEN ScannerFM, Unit 2 Numericals on capital budgeting : Non-Discounted Techniques Pay Back Method 1. A project needs present investment of Rs 40 lakh. It has duration of 10 years and cash inflow in each year is Rs 10 lakh till the last year. You are required to compute payback period of this project. Suggest whether the project would be acceptable if the minimum desirable payback period by the management is 5 years? Solution: Payback period (if cash inflow is an even amount) = Present investment/Amount of Cash inflow = 40/10 =4 years (Answer) Acceptability Rule= Accept if Actual PB< Desirable PB If the minimum desirable payback by the management is 5 years then the present project would be acceptable. (Answer) © scanned with OKEN Scanner2. Present investment into a project is required Rs 50,00,000 with the duration of 10 years. Annual Cash inflows from 1s to 10" year from the project have been estimated as follows: Cee OA SRL LSU) E eo] 0} a] a] 9] A] pe] e] = Ss Required: Compute the payback period and suggest the acceptability of the given project if the minimum desirable payback period by the management is 4 years. © scanned with OKEN ScannerPresent Investment = Rs 50 lakh 2 10 15, 3 15 30 4 10 40 5 15, 55 6 10 65 7 15 30. 8 5 85 9 8 93 10 5 98 As we see in the cumulative figures of cash inflows till 4% year the total recovered amount is 40 lakh which is below the present investment but in 5" year, the total recovered amount exceeds the present investment. Therefore, we have an idea by these cumulative figures that Payback period should be somewhere in between 4 to 5 years. It is sure that 4 years are the complete years and a part of 5! year would make the exact payback period. Now we compute Payback with the help of following formula: Payback Period (if eash inflows are uneven) = Complete years + amount to be recovered/next cash inflow =4+10 lakh/15 lakh 4 +0.67 = 4.67 years (Answer) Acceptability Rule: Accept if Actual PB< Desirable PB. Hence, the actual payback period of 4.67 happens to be more than the minimum period desired by the ‘management, the project would be Rejected. (Answer) 2 © scanned with OKEN Scanner3. A project has Present investment of Rs 12,00,000 with the duration of 6 years. Annual Cash inflows from 1° to 6% year from the project have been estimated as follows: a) ep ape) eto He] ] uf al of Required: Compute the payback period and suggest the acceptability of the given project if the minimum desirable payback period by the management is 4 years. 4 © scanned with OKEN ScannerSolutio: Present Investment = Rs 12 lakh Terns 1 2 a Z a a 3 3s 10 4 5 15 5 2 17 6 1 18 ‘As we see in the cumulative figures of cash inflows till 3rd year the total recovered amount is 10 lakh which is below the present investment but in 4" year, the total recovered amount exceeds the present investment. Therefore, we have an idea by these cumulative figures that Payback period should be somewhere in between 3 to 4 years. It is sure that 3 years are the complete years and a part of 4 year would make the exact payback period. Now we compute Payback with the help of following formula: Payback Period (if cash inflows are uneven) = Complete years + amount to be recovered/next cash inflow = 3+2 lakh/S lakh 40.4 .4 years (Answer) Acceptability Rule: Accept if Actual PB< Desirable PB Hence, the actual payback period of 3.4 years happens to be less than the minimum period of 4 years as desired by the management, the project would be Accepted. (Answer) (© scanned with OKEN ScannerAverage Rate of Return (ARR) Numericals 1. Company X analyzed a project which needs present investment of Rs 18,50,000. Duration of the project is 6 years. It salvage value after 6 years remains Rs 50,000. Tax rate is charged on the company’s net profit (PBT) @ 30% and depreciation is charged on straight line basis each year. Profit before depreciation and tax (PBDT) of company X are given below: b sy de 3,50,000. a. 4,00,000 me 5,00,000 4, 7,00,000. 5. 10,00,000 6. 12,00,000 ‘You are required to compute average rate of return (ARR) for the given project. Would this project be acceptable if the minimum required rate of return of management is 20%? © scanned with OKEN ScannerSolution: ‘Computation of Average Rate of Return (ARR) 350,000. (3,00,000) 50,000 (15,000) L 35,000 = 4,00,000. (3,00,000) 1,00,000 (30,000) 70,000 x 5,00,000 (300,000) 2,00,000 (60,000) 7,40,000 4. 7,00,000 (3,00,000) 4,00,000. (120,000) 2,380,000 5. 10,00,000 (3,00,000) 7,00.000 (2,10,000) 4,90,000_ 6. 12,00,000 (3,00,000) 9,00.000 {(2,70,000) 6,30,000_ Total 16.45.00 ARR= Average Profit after tax/Average investment Where, Average profit =Total PAT/no. of years =16,45,000/6 = 2,74,167 Average investment =Initial investment+ Scrap Value/2 =18,50,000+50,000/2 =19,00,000/2 =9,50,000 Putting the values in the formula, ARR=2,74,167/9,50,000= 0.2886 or 28.86% (Answer) Acceptability Rule =Accept if Actual ARR>Minimum Rate Desired Since actual ARR of 28.86>20 The project would be accepted. (Answer) Note: Depreciation = present investment-scrap value/no. of years of project © scanned with OKEN ScannerConcluding Remarks about Traditional or Non-Discounted Methods of CB Pay-Back (PB) & Average Rate of Return (ARR) The non discounting methods = All techniques of investment appraisal are designed to answer the question: is it worth while going ahead with the proposed investment. = Pay back — the time it takes to recover the cost of an investment. = Accounting rate of return average annual rate of return as a % of the cost of the investment. © scanned with OKEN ScannerNet Present Value (NPV) Method Under NPV method all the cash inflows in the project are discounted with the help of minimum required rate of return. After discounting, the cash inflows are converted into the present values. Then the total of these present values are compared with the present investment. The decision is decision as per the following rule: Accept if TPVs>PI Reject if TPVs Reject (x) Conclusion: Projects E, A and D are fully accepted to invest Rs 12,00, 000 © scanned with OKEN ScannerRisk Aspects in Capital Budgeting Capital budgeting is an activity of investment based financial estimates and projections. Projected figures used in capital budgeting may not be the same at the time of application. This variability in real and projection may be termed as risk aspect in capital budgeting. These risk aspects may be identified as follows: 1, Estimated annual cash inflows Estimated present investment or cash outflow Opportunity cost, minimum rate of return or discount rate Time duration of the project Risk Adjustment tools used in Capital Budgeting: Use of discounted techniques Conservative estimates oe ee Use of probability analysis and decision tree etc. © scanned with OKEN ScannerRisk Adjustments 1. Estimated Annual Cash Inflows Conservative forecasts: Forecasts of less value than what actually should be in order to incorporate risks of fluctuation. 2. Present investment/Cash outflow Liberal forecast: forecast of slightly higher value of investment in order to adjust the risk of over investment. © scanned with OKEN Scanner3. Opportunity cost or discount rate Forecasting a slightly higher value for the purpose of risk adjustment. 4. Time Duration of the project Taking a conservative time period for risk adjustment. 5. Risk adjustment tools: Decision tree, probability analysis, sales forecasting techniques and other operation research techniques should be used in order to properly deal with the risks aspects of capital budgeting. © scanned with OKEN Scanner6. Use of discounted techniques Discounted techniques of capital budgeting such as NPV, IRR and Profitability Index are the best in order to adjust the risk of capital budgeting. 7. Conservative estimates These are the estimates of low values whenever revenues are concerned and taking higher values whenever the investment is concerned. 8. Use of decision tree and probability analysis. These are the tools of risk adjustment which should be used in order to combat the risk of capital budgeting with their proper incorporation. © scanned with OKEN ScannerUnit 3: Capital Structure Decision What is Capital Structure? It is a mix of various long term sources of funds used into a business a long term capital. Capital Structure Other Sources x i Preterred ot “XN Equity capital © scanned with OKEN ScannerOptimum Capital Structure Meaning: The capital structure which is “the most suitable structure of capital mix for a given business organization” is known as the optimum capital structure. To be an optimum capital structure there are certain considerations to be taken in account by the finance manager. Optimum capital structure differs from business to business and from time to time it needs changes. © scanned with OKEN ScannerOptimum Capital Structure How is the capital the most suitable for an organization? emitted oo 00 2 Business Risk: Business risk comes out of sales and business operations. Coverage of operating costs and earning profits. Financial Risk: Financial risk comes out of non-payment of interest on loans used in the capital structure. 3 © scanned with OKEN ScannerImportant Factors/Considerations for an Optimum Capital Structure Following factors contribute to make the capital structure optimum for a given concern: 1. Profitability 2. Solvency 3. Flexibility 4. Conservatism 5. Control © scanned with OKEN ScannerProfitability: Profitability consideration is achieved when the components’ and overall cost of capital (WACC) is optimally lowest in the capital structure. It leads to enhancement of profitability in the organization. For this purpose, the cost of each source of capital is analyzed and overall cost of capital is optimized. © scanned with OKEN ScannerSolvency: Solvency means that the company should be able to pay its long term debts easily out of its available assets. In order to ensure solvency, the company should ensure that excess of debt capital should be avoided to use in its capital structure so that it does not become difficult to pay the interest on them and it becomes easy to repay the principal whenever the company desires. © scanned with OKEN ScannerFlexibility: Flexibility means that the finance manager should always be in a position to alter or change the debt equity ratio in its capital structure at any point of time it feel necessary. The flexibility feature in capital structure is maintained in order to avoid risk and optimize the profitability. Flexibility in the capital structure _can_be ensured by employing redeemable capital in the capital structure. © scanned with OKEN ScannerConservatism: Conservatism here means to “under-utilize the fund raising capacity of the organization. This adds to optimacy in the capital structure by way of maintaining a positive image of the company in capital market and at the same time for ensures that some fund raising capacity is still available for the business at the time of financial emergency. © scanned with OKEN ScannerControl: Control means the decision making or voting right of shareholders in the company. This control of owners/shareholders should not be unnecessary diluted by way of adding more and more equity capital in the capital structure.Concluding Remarks Optimum Capital structure means a proper mix of various types of long term capital used in an organization. Optimum capital structure is also known as a proper mix of debt equity ratio. Optimum capital structure makes a trade-off in risk and return. To have an Optimum Capital Structure, there is requirement to the following: a) Profitability b) Solvency c) Flexibility d) Conservatism e) Control The objective of financing function of a finance manager is to have an optimum capital structure 10 © scanned with OKEN ScannerOptimum Dividend Policy Meaning: Optimum dividend policy means that the company should formulate a _ dividend distribution and profit retention policy which fulfills the underlying objectives of the company as well as the objectives of shareholders of the company. Optimum dividend policy also differs from organization to organization. © scanned with OKEN sTypes of Dividend Policies Regular Dividend Policy Dividend Policy Types Policy idend Irregular Dividend No Dividend Policy (© scanned with OKEN ScannerOptimum Dividend Policy Considerations Following consideration contribute in the optimum dividend policy of the organization: 1 2. 3, 4 D: 6. id. 8. 9. 1 Fulfilling Internal capital requirement of business Meeting the dividend expectations of shareholders Liquidity position of business Fulfilling legal rules/covenants Availing profitable projects Capital market conditions for raising fresh capital Dividend policy of other competitors Prevailing Inflation Past dividend distribution behavior of the company 0. Control of shareholders © scanned with OKEN ScannerOptimum Dividend Policy Considerations 1. Internal Capital Requirement of Business Reasons for capital requirement: a) Growing business b) Expanding sales c) More investment requirement into fixed assets What to do? Take the help of dividend policy to distribute less of dividends to shareholders and retain more in order to fulfill the above requirements. © scanned with OKEN ScannerOptimum Dividend Policy Considerations (cont..) 2. Shareholders Expectations Generally shareholders expect a fairly good return in the form of cash dividend from the company. Company is required to study and analyze the profile of shareholders so that it can know their expectations with respect to dividend from the company. What company should do? Finance manager of the company is required to distribute cash dividends fulfilling the requirement of shareholders. This will the company to build its external market image of share pricing. © scanned with OKEN ScannerOptimum Dividend Policy Considerations (cont..) 3. Liquidity position of business Internal requirement of capital on the one hand is needed for building the fixed assets and on the other hand the working capital requirements also increase giving rise to the problem of liquidity. This liquidity problem may be related to maintaining more raw materials, more finished goods and more investment into work in process. There may be more credit sales and more funds locked in debtors or more cash is required to be maintained. What should company do? The finance manager is required to retain more profits and compress the cash distribution of dividends in order to fulfill the liquidity requirements of business. © scanned with OKEN ScannerOptimum Dividend Policy Considerations (cont..) 4, Fulfilling legal rules or covenants: Sometimes there is a legal requirement to maintain a given level of liquidity in order to protect the interest of employees to pay their salaries easily or to protect the interest of financial institutions to pay their interest and loans repayment easily. In order to fulfill these legal bindings the company managers are required to fulfill these requirements and pay attention to distribute less dividends and retain more. 5. Availing profitable projects When company is more progressive it looks for profitable projects to increase profits. There may be profitable projects available and the manager may be interested to investment into such projects. At this time also a compressed dividend distribution and more retention of profit is required. © scanned with OKEN ScannerOptimum Dividend Policy Considerations (cont..) 6. Capital market conditions for raising fresh capital If company is in requirement of fresh of capital and capital market conditions are not favorable to raise fresh capital then under this situation more dependence of company comes to dividend policy. It has to ensure that sufficient profits are retained so that the fresh capital requirement can be fulfilled out of dividend policy. 7. Dividend policy of other competitors The practice of dividend distribution in the industry is also an important consideration to decide dividend distribution. If it is a general practice to distribute at least 10% dividend to shareholders then such minimum level has to be followed otherwise, a negative image is conveyed in the market. © scanned with OKEN ScannerOptimum Dividend Policy Considerations (cont..) 8. Prevailing level of inflation Prevailing level of inflation also gives an idea to the finance manager about dividend distribution. Prevailing level of inflation if constant or rising then it is advisable not to compress dividend distribution to shareholders. 9. Past dividend distribution behavior of the company This is an important consideration. As per this consideration, company should meet its past payment of dividend. It is advised not to lower the past payment at least if not to increase dividend payment. Because shareholders expect at least the previous level of dividend payment from the company. © scanned with OKEN ScannerOptimum Dividend Policy Considerations (cont..) 10. Dilution of Control of shareholders Dilution of control of ownership of shareholders means that voting power of equity shareholders comes into more shareholders. It happens when number of shareholders increase without the consent of existing shareholders. Whenever there is too much of pressure for not distributing dividend to shareholders and retaining most of the profits then the alternative left for the company is to distribute stock dividends or bonus shares. This leads to dilution of control of shareholders. this is a negative impact and should be avoided as far possible. © scanned with OKEN Scanner‘Stock Dividends or Bonus shares Stock dividend or bonus shares are distributed in place of cash dividend to the existing shareholders. Whenever, shareholders receive the stock dividend they may sell it in the market or may retain it with them. If they sell it in the market new shareholders are created. Benefits of stock dividends or bonus shares: 1. 100% retention of profits possible 2. No cash outflow 3. Helpful in extreme financial crisis Limitations of Bonus shares: 1. Dilution of ownership 2. Drop in EPS and DPS in future 3. Increased challenge to improve profitability 4. Practice of bonus share cannot be repeated often. © scanned with OKEN Scanner1, Dividend policy vs. financing decision: Dividend policy and financing both are helpful in financing. Dividend policy makes internal financing whereas financing policy provides external financing of capital. 2. Optimum dividend pol Various considerations discussed for dividend policy need to be evaluated properly and be incorporated properly while formulating an optimum dividend policy. 3. Avoidance of bonus share: As far as possible, the distribution of bonus shares be avoided as it increases challenges for business and is also disliked by the shareholders. Only in case of extreme financial crisis the issue of bonus shares is recommended. 4, Preference for cash dividend: Itis always recommended to make a distribution of cash dividend as it is an industry practice and it is expected by shareholders. This practice also gives a positive impact on the market value of shares. 5. Regular and stable dividend policy: it is also recommended that the company should distribute dividend regularly and should ensure that a stability in dividend payment should be maintained. Regularity and stability are the most desirable aspects of a dividend policy in order to have the best results. © scanned with OKEN ScannerSources of Long Term Finance Unit 3"4 of Financial Management © scanned with OKEN ScannerSources of Long Term Finance Broadly Long Term Finance has been divided into the following: A. Debt: 1. Borrowings from Financial Institutions or Term Loans 2. Issue of Debentures/Bonds B. Equity: 1. Equity Share Capital 2. Preference share Capital 3. Retained Earnings C. Other sources: 1. Leasing 2. Government Grants 3. Public Deposits 4. Inter company borrowings © scanned with OKEN ScannerAdvantages and Limitations LT Finance Debt Finance Meaning: Debt financing takes place through borrowed capital Advantages: 1. oy Tax benefit Limited cost of capital Positive Financial leverage Easy redeemability Transparency © scanned with OKEN ScannerLimitations of Loans Generally the employment of loans is apprehended because of the following reasons: 1. Financial risk or risk of insolvency 2. Negative financial leverage 3. Strict covenants 4. Interference into business 5. Image sensitiveness © scanned with OKEN ScannerBorrowing from Financial Institutions vs. Issue of Debentures: Meaning: Borrowing from financial institutions is also known as term loans. Loans are availed from financial institutions such as IDBI, IFCI, UTI, LIC, ICICI etc. These institutions are especially established to provide long term loans for industrial development. © scanned with OKEN ScannerThese term loans are of following types: 1. Short term loans ( for 2 to 5 years) 2. Mid term loans ( for 5 to 9 years) 3. Long term loans ( for 10 years and above) Term Loans Covenants : The terms and conditions of term loans are negotiable. Such covenants are related to the following: a) Mortgage or security of term loans b) Maintaining cash or working capital c) Rate of interest and loan redemption d) Default related matters etc. © scanned with OKEN ScannerIssue of Debentures Debentures are securities which are issued in capital market and are tradable. Debentures change their values as per capital market trading and demand conditions. Types of Debentures: There are different types of debentures issued in capital market as mentioned below: 1 Convertible and non- convertible 2. Redeemable and non-redeemable 3. 4. Bearer and registered Secured and unsecured © scanned with OKEN ScannerEquity Capital Meaning: Equity capital is owners’ capital. The term equity signifies that the market value is equated with the book value of equity and if the company is dissolved then the equity share holders are entitled to get the compensation equal to the market value of their shares. It is just an assumption. In reality things may not go as per the assumption. @ scanned with OKEN sAdvantages of Equity Capital Following advantages are generally attributed to the equity capital: 1. Essential for establishing a company 2. No burden for payment of dividend to shareholders 3. Freedom to retain profits 4. Last claim on dividend and compensation when company closes 5. Trading on equity or financial leverage Popularity in capital market 7. Permanent capital a © scanned with OKEN ScannerLimitations of Equity Capital Following limitations are generally experienced with equity capital: 1. Too much of speculation into capital market 2. Market price fluctuation due to malpractices of capital market 3. Safeguarding the voting right of equity shareholders 4. Practice of stability in dividend payment 5. Clash between owners and mangers © scanned with OKEN ScannerPreferences share capital Meaning: Preference share capital is included in owners capital. It is called as preference capital because a preference is given to this capital over equity capital regarding the following matters: 1. Preference for payment of dividend 2. Preference for compensation when winding up of company © scanned with OKEN ScannerAdvantages and limitations Preference Shares Ais preted Preferential payment of Rate of dividend is fixed dividend No dilution of control No voting rights Income is steady and safe Restricts the investor from enjoying higher profits No charge on assets No security of repayment of investment Lower cost of capital No tax benefits Preferred for cautious Not attractive for investors investors willing to take risk Preferential rights on Dilute the claims of equity repayment of investment shareholders 2 © Scanned with OKEN ScannerComparative Chart Liquidity Low High Voting Rights No Yes Fixed Dividend Yes (Unless ARP) No Tax Burden Low (Qualified) Low to Medium (Usually Qualified) Initial Yield High Low to Medium Cumulative Dividend Sometimes No Dividend Growth No (Rarely) Yes Price Volatility Low to Medium — Medium to High Perpetual Shares GenerallyNot_ Yes rey © scanned with OKEN ScannerComparison between Debt and Equity Debt vs. Equity Debt Equity Fixed Claim » Residual Claimant ~ Tax Deductible ~ No Tax Deduction - High Priority in Financial ~ Lowest Priority in Trouble Financial Trouble . Fixed Maturity - No Maturity » No Management Control . Management Control “ (© scanned with OKEN ScannerOther Sources of LT Finance Meaning: Though there are primarily two broad categories of long term finance i.e. debt and equity. But there are some other sources which also serve the same purpose as debt or equity do. Following are some examples of these sources: 1. Leasing 2. Government grants 3. Public deposits 4. Inter company borrowings © scanned with OKEN ScannerUnit I Leverages: Financial Leverage, Operating Leverage, & Combined LeverageMeaning of Leverage 1. Simple and dictionary meaning of Leverage is: “Use (of something) to maximize the benefit.” 2. In the context of Business Leverage means: “Use of fixed costs to maximize the profits” © scanned with OKEN ScannerTypes of Leverages Financial Leverage: “Presence of Fixed Cost Capital or Debt Capital in the Capital Structure of the Company” Operating Leverage: “Presence of Fixed Cost in the Total Cost of Business Operation” Combined Leverage: Presence of both the Leverages, financial leverage as well as operating leverage in business is known as combined Leverage © scanned with OKEN ScannerObjectives of Leverages Objective of Financial Leverage: To enhance the profitability (EPS) of shareholders by way of using debt capital along with equity capital and through positive financial leverage Objective of Operating Leverage To enhance the Profitability (EBIT) by way of investing into fixed assets and through enhancing sales and optimizing the fixed cost Objective of Combined Leverage To optimize the use of both the leverages together. First by investing into fixed assets and creating fixed cost in business operation and secondly by having debt capital (fixed cost Capital) along with equity capital (variable cost capital). © scanned with OKEN ScannerFormulas of Leverages 1. Operating Leverage =Contribution/EBIT (Where, Contribution= Sales — VC and EBIT= Sales - VC - FC) 2. Financial Leverage = EBIT/EBT (where, EBT = EBIT — Interest) 3. Combined Leverage = OL x FL = Contribution/EBIT x EBIT/EBT = Contribution/EBT © scanned with OKEN ScannerNumericals on Leverages: 1. Co X Ltd. has Total Capital of 60 Lakh. Out of which = 20 Lakh is Equity Capital and @ 40 lakh is debt. Rate of interest payable on debt is 12%. The Sales Revenue of X Ltd is = 100 lakh. Variable cost is 20% of Sales revenue and % 30 lakh is the fixed cost of operation. Required: Calculate Operating, Financial and Combined Leverages Solution: OL = Contribution/EBIT =Sales-VC/EBIT = 100-20/100-20-30 =80/50 =1.6 (Answer) FL = EBIT/EBT = 50/50-4.8 =50/45.2 =1.11 (Answer) CL = OL x FL=1.6x 1.11 = 1.776 (Answer) © scanned with OKEN ScannerSignificance/Benefits of Leverages Significance of Financial leverage Financial leverage guides the finance manager to optimize debt equity mix in the capital structure with a view to optimize the capital structure and fulfill the objective of owners’ wealth maximization. Significance of Operating Leverage Operating leverage guides the finance manager for fixed investment decision and creating a proper mix between fixed and variable cost in the total cost of business operation. It leads sales and profits optimization. Significance of combines leverage Combined leverage views the leverage in totality of financial and operating leverages so that the overall business profits and ultimate wealth maximization objective can be fulfilled. © scanned with OKEN ScannerLimitations of Leverages Limitations of financial Leverage: 1. Financial leverage can be both negative and positive. 2. Increased financial leverage creates financial risk. 3. Excessive financial leverage leads to insolvency. 4. Financial leverage needs a constant revision. Limitations of Operating Leverage: 1. Use of operating leverage creates operating risk or business risk 2. Break even point may not realize through sales. 3. Sales variability poses risk to high operating leverage firms. Limitations of combined leverage: 1. Both the leverages need to be monitored constantly 2. High combined leverage may be harmful at a time © scanned with OKEN ScannerDistinctions between Operating and Financial leverages 1, Objective Helps to boost up the Helps to boost up the EPS with operating profit (EBIT) _| the change in EBIT with the change in sales 2. Relationship | Relates Sales with EBIT Relates EBIT with EPS 3. Measurement Measures the use of fixed cost of operation such as depreciation, fixed salary and other fixed expenses Measures the use of fixed cost of debts known as interest payable. 3. Decision area Concerned with investment decision Concerned with financing decision 4. Type of Risk Itinvolves operating risk It involves the financial risk 5. Balance Sheet side OL belongs to assets side of balance sheet FL belongs to the liability side of balance sheet (© scanned with OKEN ScannerQuestion no. 2 Following are the four business situations. Interpret the impact of each situation on the business and suggest which one is the most suitable for a given business concern? aI CO} owe titres a OTe eel Situation Leverage Leverage 1. High High 2 Low Low Bo High Low 4. Low High 10 © scanned with OKEN ScannerAnswer of question no 2: Situation 1, (both the leverages being high) means that the concem is vulnerable to a very high risky situation of both the risk very high. This is not an optimum situation. Both the risk being high is not a good option. Situation 2, (both the leverages very low): This option is also not preferable as the concern is not taking benefit of any of the given leverages. Generally, it is not a good option. Situation 3 and Situation 4: (one leverage being low and another being high) : one of these options is acceptable. Out of these two Situations 3 and 4, situations 4 (low OL and high FL) is better because high OL is not reversible low once it is achieved to high on the other hand high FL is reversible if not desirable. High FL can be reduced by paying off the redeemable debt. But in case of high OL it can not be reversed because fixed assets can not be disinvested. Situation 4 is the Best One: Hence, Option 4 with low OL and high FL is the most appropriate situation. © scanned with OKEN ScannerImportant Conclusions 1. Leverages are important for profit planning and for the achievement of financial objective of shareholders wealth maximization. 2. Financial leverage is related with capital structure or with financing function 3. Operating leverage is related with investment into fixed assets or investment function 4. Combined leverage monitors both of these leverages 5. Both of these leverages may be negative and harmful for the business. So these leverages have to be used carefully. 6. No business should ignore any of these leverages as these leverage offer good advantages for a given business. 7. High operating leverage is irreversible, hence has to be increased with great care. 8. Financial leverage is flexible. It can be increase or decrease with the help of redeemable debt. 9. The most preferable option of the combined leverage is low OL and high FL © scanned with OKEN ScannerCost of Capital- Component and Weighted Average Cost of Capital (WACO), Unit 3 of Financial Management © scanned with OKEN ScannerMeaning of Cost of Capital Meaning: The cost of capital is an opportunity cost of making a specific long term investment. It is the rate of return required to be paid to investor for making investment. Whenever, the finance manager collects capital from different sources it is required to pay a cost or return to the owner of each source of fund, this payment from the part of business to the investors/suppliers of fund is termed cost of capital for the business. © scanned with OKEN ScannerComponent Cost (CC) & Weighted Average Cost of Capital (WACC) Component Cost of Capital Accompany collects long term capital from different sources. For each source it pays a return to its investor. This cost payable to each of the sources is known as component cost of capital. Following are the possible components of capital: 1. 2. Preference capital 3. 4. Retained earnings Equity Capital Debt © scanned with OKEN ScannerWeighted Average Cost of Capital (WACC) The component amount (w) and cost of capital (cc) in the capital structure of the company are in different proportion constituting the total capital of the company. On the basis of the proportional amount (w) of each component and its respective cost (cc), the average cost of capital is computed. The average cost comes after multiplying “w” and “c”. This average cost of capital is known as Weighted Average Cost of Capital (WACC). It is this weighted average cost of capital which is the opportunity cost or the minimum required rate of return or the discount rate attributable to the overall capital of the company. © scanned with OKEN ScannerSignificance of Weighted Average Cost of Capital 1. Average Cost of Entire Capital WACC gives an idea about the average cost of overall capital in the capital structure. 2. Facilitates investment decision With the help of the WACC the decision regarding the acceptability of a given project is taken. If WACC is entirely recoverable then only the project is acceptable. 3. Optimum Capital Structure It is helpful in optimizing the capital structure of the company. We can develop an optimum mix of different types of funds with varying cost. 4. Overcome risk in capital budgeting WACC is also helpful in overcoming the risk factors involved in capital budgeting as WACC is the most important consideration in it. 5. Profit planning WACC guides the company in profit planning and maximizing the shareholders’ welfare. © scanned with OKEN ScannerComputation of Component Cost (CC) Cost of Debt (K,) Debt is a fixed cost fund. The rate of interest on debt is mentioned. For the business employing debt into its capital structure, the benefit of tax is available. This benefit is adjusted in the rate of interest payable on debt fund. Since the tax adjustment is beneficial for the company, the effective cost of capital after tax tends to fall. Another thing we need to incorporate in the cost of debt is its duration. It means we should know whether the debt is perpetual or redeemable after a period of time. We therefore, need to compute after tax cost of debt both in case of redeemable and irredeemable debt. Cost of Irredeemable or perpetual debt K,=1x (1-1)/P or NP Where, Ky =after tax cost of debt T= the rate of interest payable on debt t= the tax rate P= Price, NP= Net Proceed © scanned with OKEN ScannerQuestion 1 X Lid issues 15 percent irredeemable debentures of & 100 each. Tax rate is 35 percent. Determine after tax cost of debt assuming it is issued at (a) face/par value, (b) 10 percent premium and (c) 10 percent discount. Solution (a) When issued at face/par value: Ky= 1x (1-/P = 15 x (1-0.35)/100 =15x(1-0.35)/100 =15x0.65/100 = 9.75/10 = 9.75% (Answer) (b) When issued at 10 percent premium: Kg= Ix (1-t)/NP= 15 x (1-0.35Y/100+10, = 15x0.65/110 = 9.75/10 = 8.86% (Answer) (c) When issued at 10 percent discount: Ky= Ix (1-)/NP= 15 x(1-0.35)/100-10 =15 x0.65/90 =9.75/90. = 10.83% (Answer) © scanned with OKEN ScannerCost of Redeemable Debt K,= [I x (1-t) + (RV- NP)/n]/(RV+NP)/2 Where, K, =after tax cost of debt I= the rate of interest payable on debt t= the tax rate RV = Redeemable Value NP = Net Proceed (net amount collected) n=No. of years after which the debt is payable © scanned with OKEN ScannerQuestion 2 A Ltd issues 15% debentures with par value of 2 100. The debentures are payable after 7 years at face value. The expenses involved in the issue of debentures are 3% of face value. Tax rates are 35%. You are required to calculate after tax cost of debentures. Solution: K,= [I x (1-t) + (RV- NP)/n]J/(RV+NP)/2 = [15 x (1-0.35) + (100-97)/7]/(100+97)/2 = [(15x0.65)+0.43]/197/2 = 10.18/98.5 =10.33% (Answer) © scanned with OKEN ScannerCost of Preference Share Capital Preference share capital is owners’ capital with the difference from equity capital that in preference share rate of dividend is fixed. Preference share capital may be redeemable or irredeemable. The computation of preference share capital is done as follows: Computation of Irredeemable or Perpetual Preference Share Capital : K,= D/NP Where, K,=cost of preference share D=Dividend payable on preference share NP= Net proceed © scanned with OKEN ScannerQuestion 1 X Ltd issues 12 percent perpetual preference shares with the par value of = 150 each. Compute the cost of preference shares. Solution: K,= DINP= 18/150 = Question 2 A Ltd issues 14 percent irredeemable preference shares with the face value of ¥ 200. The flotation cost is 5 percent. Compute the cost of preference shares. Solution: K,= DINP =28/190=0.1474 or 14.74% (Answer) Question 3 SR Ltd is planning to issue 14 percent perpetual preference shares with the face value of & 100 each. Flotation cost is estimated to be 4 percent. Compute the cost of preference shares if they are issued: 1, at face value; 2. at premium of 10 percent; 3. at discount of 5 percent; Solution: If preference shares are issued at face value: K,= D/NP =14/96=0.1458 or 14.58% (Answer) If preference shares are issued at 10 percent premium: K,= DINP = 14/100-4+10 =14/106=0.1321 or 13.21% (Answer) If preference shares are issued at 5 percent discount: K,= DINP = 14/100-4-5 =14/91=0.1538 or 15.38% (Answer) 12 or 12% (Answer) © scanned with OKEN ScannerExplanatory Notes: 1. Flotation cost is the issue expense which is incurred when shares or debentures are issued to the shareholders. 2. Dividend or interest payable, issue expenses, discount or premium are always computed on the face value or par value of securities. 3. If nothing is mentioned about redeemable value (RV) then it is assumed that the securities are redeemable at par only. 4. Net Proceed (NP) is the net amount of capital collected by the company after deducting issue expenses (flotation cost) and discount if it is given. © scanned with OKEN ScannerComputation of Redeemable Preference Share Capital K,= [D+(RV-NP)/n]/((RV+NP)/2 Where, K,= Cost of redeemable preference shares D=Dividend payable on preference share RV= Redeemable Value NP= Net Proceeds n=No. of years Question 1 A Company issues 1,00,000, 10 percent preference shares of = 100 each redeemable after 10 years. The cost of issue is 10 percent. Find out the cost preference shares if they are: 1. Issued at par and redeemable at par; 2. Issued at par and redeemable at 10 percent premium 3. Issued at 8 percent discount and redeemable at 10 percent premium © scanned with OKEN ScannerSolution: 1. If the preference shares are issued at par and redeemable at par: K,= [D+(RV-NP)/nJ/(RV+NP)/2 =[10+(100-90)/10]/(100+90)/2 =[10+1]/100+90/2 =11/95 =0.1158 or 11.58% (Answer) 2. If the preference shares are issued at par and redeemable at 10 percent premium: K,= [D+(RV-NP)/n]/(RV+NP)/2 = [10+(110-90)/10]/(110+90)/2 = [10+2]/100 =12/100=0.12 or 12% (Answer) 3. If the preference shares are issued at 8 percent discount and redeemable at 10 percent premium: K,= [D+(RV-NP)/n]/(RV+NP)/2 = [10+(110-82)/10]/(1 10+82)/2 =(10+2.8)/96 =0.1333 or 13.33% (Answer) © scanned with OKEN ScannerCost of Equity Capital and Cost of Retained Earnings Equity capital is owners’ capital. The entire profit after tax (PAT) earned by the business at the end of the year is considered to belong to equity shareholders. Since, companies take a decision to distribute a part of this profit to shareholders as dividend and rest of the profits are retained internally in the business. Retained earnings belong to shareholders. Company can issue fresh capital or use internal retained earnings to finance its projects. Under both the methods cost of capital is same. Approaches to calculate cost of equity Following approaches are used to calculate the cost of equity capital: A. Dividend capitalization approach: Under this method, dividend distributable to shareholders becomes the basis for calculating the cost of equity capital. K,= D/NP or MP Where, K,= Cost of equity D= Dividend per share distributable to shareholders NP= Net proceed MP= Market price of the share © scanned with OKEN ScannerQuestion 1 ABC Ltd issues 12,000 equity shares at a discount of 10 percent. The par value of the share is = 100. Flotation cost in the issue of equity shares is 10 percent. The company is expected to pay a dividend of = 8 per share. Calculate the cost of equity share. Solution K,= D/NP or MP = 8/100-10-10 = 8/80 = .01 or 10% (Answer) © scanned with OKEN ScannerB. Earnings capitalization approach According to this approach the cost of equity capital is calculated on the basis of earning per share (EPS) and current market price or the net proceed. K,= EPS/NP or MP Where, Ke = Cost of Equity EPS= Earnings per share NP= Net proceed MP= Current market price of share Question 2 Y Co. Ltd is currently earning 15 percent operating profit on its share capital of % 20 lakh. Face value of each share is 200. The company is interested to go for an expansion programme for which it needs an additional share capital of 10 lakh. Company issues these additional shares with 10 percent premium and incurs 5 percent flotation cost. You are required to calculate the cost of additional equity capital assuming that rate of earning of the co. is unaffected. © scanned with OKEN ScannerSolution: Computation of Cost of Capital after the additional issue: K,=EPS/NP or MP =30/210 = 0.1429 or 14.29% (Answer) Working Notes: 1. Calculation of EPS: Operating Profits= (20+10 )x0.15=4.5 lakh No. of equity shares=30,00,000/200=15,000 EPS=Operating profits/No. of Equity shares=4,50,000/15,000= %30 2. Calculation of Net Proceeds (NP): Face Value+ Premium- Flotation Cost =200+20-10=%210 Question 3 A firm is currently earning % 50 lakh and its share selling at a market price of 2140. The firm has 1,00,000 shares outstanding. Compute the cost of equity. Solution: K,= EPS/NP or MP = 50/140=0.3571 or 35.71% (Answer) © scanned with OKEN ScannerC. Dividend Capitalization and Growth Rate Computation of cost of capital on the basis of fixed dividend may not appropriate as the dividend over the years tend to grow. The growth in dividend may be at constant rate or may grow over the years. Whatever is the case, with the given growth rate the cost of capital would be calculated as follows: K,= D/NP or MP +G Where, K,=Cost of equity D=dividend payable NP = Net Proceed G= Growth Rate © scanned with OKEN ScannerQuestion 4 Equity share of a company is currently selling for = 100. It wants to finance its capital expenditure of & 20 lakh either by retaining earnings or by selling new shares. If Hen wants to sell the shares, the issue price would be % 95. The expected dividend next year is 24.75 per share and it is expected to grow at 6 percent perpetually. Calculate the cost of equity capital internally and externally. Solution: Cost of equity internall: It means that the project is being financed internally through the retention of earnings. In that case, the dividend would be divided by market price and growth rate would be added to find out the cost of equity capital. K,.=D/NP or MP+G = (4.75/100)+0.06 = 0.0475+0.06 = 0.1075 .75% (Answer) Cost of equity externally It means that the project is being financed through the issue of share capital and not through the retention of earnings. In that case, the dividend would be divided by net proceed and then growth rate would be added to find out the cost of capital. K.= D/NP or MP+G = (4.75/95)+0.06 = 0.05+0.06 = 0.11 or 11% (Answer) © scanned with OKEN ScannerCost of Retained Earnings Retained earnings are available within the company in the form reserves after distributing dividends to the shareholders. Retained earnings represent cumulative earnings of a business firm since its’ inception. The same retained earnings are ploughed back into the firm’s growth by making it a part of capital structure. Retained earnings are also known as capitalized profits. The cost of retained earnings is the opportunity cost of shareholders and is calculated same as we calculate the cost of equity Capital. K,,.= D/MP+G Where, G= growth rate in the dividend Question 1 Company X has 2 10 lakh of retained earnings. It has a projected dividend of 2 6.75 per share next year and the growth rate in dividend is 7 percent. The market price of share is = 150. What would be the cost of retained earnings? Solution: K,.= D/MP+G =6.75/150+.07 =.045+.07 = 0.115 or 11.5% (Answer) © scanned with OKEN ScannerCalculation of Weighted Average Cost of Capital (WACC) Weighted Average Cost of Capital (WACC) is aggregated average cost of the entire capital structure of a given concern. WACC is calculated by multiplying the specific cost of a component with its respective weight then all these amounts are added up, the resulting figure is WACC. WACC = W!C!+WC?+W3C3+.....W" C” Where, WACC2= Weighted Average Cost of Capital W!,W2,W3...W"=Weights of different Component’s of Capital C!, C2, C3...C" = Costs of different Component’s of Capital © scanned with OKEN ScannerCost of Capital: Component & WACC Question 1: Hindustan Chemicals Limited has its capital structure consisting of Equity, preference and debt capital detailed as below: 1. Equity share Capital: 6,00,000 equity shares of Rs. 10 each. The current market price of share is Rs. ae During the current year, the company has declared a dividend of Rs. 6 per share. 2. Preference share capital: 14% preference shares of Rs, 10 each aggregating Rs. 30,00,000. The company has received only 95% of the face value of preference shares after deducting issue expenses. 3. Debenture Capital 13% 50,000 debentures of Rs 100 each amounting to = 50,00,000 The company’s corporate tax rate is at 40%. The growth in dividends on equity shares is expected at 5%. You are required to calculate: a) Cost of capital if each component b) WACC of the company. 23 © scanned with OKEN ScannerSolution: Computation of Components’ Costs and Weighted Average Cost of Capital (WACC) Cost of Equity: D Ke = —~— + Growth Rate MP Where: Ke = cost of equity capital D = dividend paid by the company MP= market price of equity share Growth rate = % growth in profit and dividend Therefore, cost of equity is calculated as: Ke= 6/24+0.05=.25+.05=.3 or 30% (Answer) © scanned with OKEN ScannerCost of preference share capital Kp= D/NPx100 Where, Kp= Cost of preference share D=Dividend payable on preference share NP= Net Proceed Therefore, Cost of Preference share is: Kp= D/NP x 100 =1.4/9.5 x100 =14.74% (Answer) Cost of Debenture Kd=I (1-t) Where, Kd= Cost of debt after tax Rate of Interest on debt t=Rate of tax Therefore, cost of debt is: Kd =13x(1-0.4)= 13x0.6 =7.8% (Answer) © scanned with OKEN ScannerWeighted Average Cost of Capital (WACC) (Ory e | Amount (%) Weight % Cost of ALN Or (W) Capital (WxCC) (CC) Equity 60,00,000 | 42.86 0.30 12.86 Capital 14% 30,00,000 21.43 0.15 3.16 Preference Share Capital 15% 50,00,000 35.71 .078 2.78 Debentures Total 1,40,00,000 | 100 - 18.8% (Answer) 26 © scanned with OKEN ScannerCapital Structure Theories Unit 3 of Financial Management MBA 2" Semester, Department of Business Administration, University of Lucknow scanned with OKEN SCapital Structure Theories The capital structure theories explore the relationship between the use of debt and equity financing and the value of the firm. If the use of debt is profitable then it increases the value of the firm and vice versa. Capital structure theories belong to two categories: a) Theories of Relevance and: b) Theories of Irrelevance The capital structure theories use the following assumptions for simplicity: 1) The firm uses only two sources of funds: debt and equity. 2) The effects of taxes are ignored. 3) There is no change in investment decisions or in the firm's total assets. 4) No income is retained. 5) Business risk is unaffected by the financing mix. © scanned with OKEN ScannerFour Capital Structure Theories 1. Net Income (NI) Approach 2. Net Operating Income (NOI) Approach 3. Traditional Approach 4. M-M Hypothesis NI Approach and Traditional Approach suggest that capital structure are relevant and affect the value of the firm. On the other hand, NOI Approach and MM Hypothesis support the view of the irrelevance of capital structure. © scanned with OKEN ScannerNet Income Approach: Relevance of Capital Structure ‘According to this approach, a firm can minimize the weighted average cost of capital and increase the value of the firm as well as market price of equity shares by using debt financing to the maximum possible extent. The theory propounds that a company can increase its value and decrease the overall cost of capital by increasing the proportion of debt in its capital structure. This approach is based upon the following assumptions: 1. The cost of debt is less than the cost of equity. 2. There are no taxes. 3. The risk perception of investors is not changed by the use of debt. (Cost or equITY) (Net Income Approach: Effect of Leverageon CostofCapital) © scanned with OKEN ScannerNet Operating Income Approach: Irrelevance of CS This theory as suggested by Durand is another extreme of the effect of leverage on the value of the firm. It is diametrically opposite to the net income approach. According to this approach, change in the capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. This theory presumes that: 1. The market capitalizes the value of the firm as a whole; 2. The business risk remains constant at every level of debt equity mix; 3. There are no corporate taxes. © scanned with OKEN ScannerTraditional Approach: The Three Stages The traditional approach, also known as Intermediate approach, has three stages. According to this theory, in the first stage, the value of the firm can be increased initially by using more debt as the debt is a cheaper source of funds than equity. In the stage two, optimum capital structure is attained by a proper debt-equity mix. At stage two overall cast is the lowest. Beyond stage two, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low-cost debt, According to traditional theory, stage two is the best and preferable whereas, stages one and three are not preferable. All the three stages have been depicted in the graph below: 08 COSPOFCAerraLy ee i (Traditional Approach: Effectof Leverageon Costof Capital) canals —e © scanned with OKEN ScannerModigliani and Miller (MM) Approach: Irrelevance of CS M&M hypothesis is identical with the Net Operating Income approach if taxes are ignored. However, when corporate taxes are assumed to exist, their hypothesis is similar to the Net Income Approach. The M&M approach is based upon the following assumptions: There are no corporate taxes. There is a perfect market. Investors act rationally. The expected earnings of all the firms have identical risk characteristics. 5. The cut-off point of investment in a firm is capitalization rate. Risk to investors does not change. 7. All earnings are distributed to the shareholders. aoa s © scanned with OKEN ScannerMM Approach with No Taxes MM approach in the absence of corporate taxes, i.e., the theory of irrelevance of financing mix has been presented in the following figure: I g é 5 I 0 ——— beck oF LeveRAce ———> (MM Theory of rrelevance: Effect of Leverageon costof debt, equity and overallcost of capital) eS enreeue Pe K4(COST OF DEBT) Kg (OVERALL. ‘COST OF CAPITAL) x © scanned with OKEN ScannerMM Approach with Taxes (Theory of Relevance) Modigliani and Miller, in their article of 1963 have recognized that the value of the firm will increase or the cost of capital will decrease with the use of debt on account of deductibility of interest charges for tax purpose. Thus, the optimum capital structure can be achieved by maximizing the debt mix in the equity of a firm. VL (VALUE OF LEVERED FIRM) ‘VALUE OF INTEREST TAX SHIELD Vy (VALUE OF LUNLEVERED FIRM) ——— pect oF Leverace ———> (MM Approach: Value of Levered and Unlevered Firm) © scanned with OKEN ScannerArbitrage Process in MM Hypothesis According to MM Hypothesis, the firm using higher debt may show a higher value temporarily. M & M theory suggests this situation cannot remain for a long period because of the arbitrage process. As the investors in high-debt-company earn a higher rate of return on their investment with high financial risk, they will sell their holding of shares and invest the same in low- debt-company. Further, as low debt company does not use significant debt in its capital structure, the financial risk to the investors will be less, thus, they buy the share in high-debt-company in order to earn more. The investors can even use borrowed funds to earn more. This arbitrage process will continue till the prices of shares of both the companies are equalized. © scanned with OKEN ScannerConcluding Remarks 1. Theories of Capital Structure argue about the use of debt in the capital mix and its resulting impact on the value of firm 2. These theories have been divided into two categories, theories of relevance and theories of irrelevance. 3. All the theories are bound by certain assumptions which are subject to criticism. 4. Application of these theories would be possible if all the assumptions are realized. 5. The study of these theories develops academic and technical insights. 6. Practically, in the industry, at the time of formulation of investment and financing policies some guidance is available from these capital structure. 7. The study of these theories opens up more possibilities of further research on these topics. © scanned with OKEN ScannerDividend Decision Theories Unit 4 Financial Management MBA 2"¢ Semester, © scanned with OKEN ScannerDividend Theories Types of Dividend Theories Dividend Decision Theories Relevant Theories Irrelevant Theories — | ATi) Gordon's Miller Modigliani Model Model Theory © scanned with OKEN Scanner 2Dividend Theories Dividend theories are based on the relationship between dividend and the value of the firm. Some theories advocate that payment of dividend affect the value of firm and hence dividend policy is relevant in order to have the benefits out of the dividend payout. Other theories on the other hand say that dividend payment decision does not affect the value of the firm hence, it payment of any dividend is relevant in a given organization. Important theories advanced in this regard as under: 1. Walter’s Model 2. Gordon’s Model 3. Modigliani and Miller’s Hypothesis © scanned with OKEN ScannerWalter’s Model: Dividend Relevance Professor James E. Walter argues that the choice of dividend policies almost always affects the value of the enterprise. Important Assumptions of Walter’s Model: 1. Only Retained Earnings as a Source of Financing The firm finances all investment through retained earnings; that is debt or new equity is not issued; 2. Constant rand k The firm’s internal rate of return (r), and its cost of capital (k) are constant; 3. Either Distribute or Retain the Earnings All earnings are either distributed as dividend or reinvested internally immediately. 4. E (EPS) and D (DPS) remain constant Beginning earnings and dividends never change. The values of the earnings per share (E), and the divided per share (D) may be changed in the model to determine results, but any given values of E and D are assumed to remain constant forever in determining a given value. 5. Infinite Life of the Firm The firm has a very long or infinite life. 4 © scanned with OKEN ScannerWalter's Model Formula D+(E-D)r/k K P= Price per equity share D= Dividend per share E= Earnings per share (E-D)= Retained earnings per shares r= Internal rate of return on investment k= Cost of equity © scanned with OKEN Scanner3 Type of Firms-Growth, Normal & Declining “Growth Fm, > k Normal Fim, =k Decining Firm, r

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