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Table of Contents
1. Role of Corporate Finance: ............................................................................................................................ 3
5. Dividends ......................................................................................................................................................13
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5.3 Signaling Hypothesis ...................................................................................................................................13
7.1 Overview.....................................................................................................................................................17
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1.Role of Corporate Finance:
The objective of Corporate Finance is to create shareholder value. It has 4 primary functions:
1. Planning for funds This involves deciding on the Capital structure of the firm
2. Raising funds The quantum and type of funds (debt/equity, etc.) is decided. This fund
is raised at a certain cost known as Weighted Average Cost of Capital (WACC)
4. Distribution of funds This involves planning for dividends. It is important for a firm to
decide whether to reinvest the reserves & surplus or pay dividends.
2.Capital Budgeting
2.1 Introduction
The Capital Budgeting Process is the process of identifying and evaluating capital projects, i.e.,
projects where the cash flow to the firm will be received over a period longer than a year.
Capital budgeting usually involves the calculation of each projects future accounting profit by
period, the cash flow by period, the present value of the cash flows after considering the time
value of money, the number of years it takes for a projects cash flow to pay back the initial
cash investment, an assessment of risk, and other factors.
The NPV is the sum of present values of all expected incremental cash flows if a project is
undertaken. The discount rate used is the firms cost of capital, it is calculated based on the
next best alternative use of the money. For a normal project with an initial cash outflow,
flowed by a series of cash inflows (after tax), the NPV is given by:
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For independent projects, the NPV decision rule is to accept projects with positive NPVs and to
reject projects with negative NPVs.
Simple Example
The Table shows the expected net after-tax cash flows of two projects, A and B. Discount Rate
(Required rate of Return) = 10%
NPV of A
-2000 + 1000/ (1.1) ^1 + 800/ (1.1) ^2 + 600/ (1.1) ^3 + 200/ (1.1) ^4 = INR 157.64
NPV of B
-2000 + 200/ (1.1) ^1 + 600/ (1.1) ^2 + 800/ (1.1) ^3 + 1200/ (1.1) ^4 = INR 98.36
Both projects A and B have positive NPVs, so both can be accepted. But, if only one project is to
be chosen and if other factors are kept constant, then Project A should be chosen because it
has a positive NPV.
Advantage of the NPV Method: It is a direct measure of the expected increase in the value
of the firm/project
Disadvantage of the NPV Method: The project size is not measured. For example, an NPV of
INR 100 for a project costing INR 10,000 is good, but the same NPV of INR 100 is not so good for
a project costing INR 10,000,000
The IRR is the discount rate which makes the present values of a projects estimated cash
inflows equal to the present value of the projects estimated cash outflow. It is the discount rate
at which the NPV of a project is equal to 0.
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If IRR > the required rate of return, accept the project
Using trial-and-error methods, financial calculators or Excel, the IRR for Project A = 14.49%
and the IRR for Project B = 11.79%. Both can be accepted as the IRRs for both projects > 10%.
Advantage of the IRR Method: It measures profitability as a percentage, showing the return
in each Rupee invested. One can comment on how much below the IRR the actual project
return could fall (in percentage terms) before the project becomes economically unfeasible
Disadvantages of the IRR Method: The possibility of producing rankings of projects which may
differ from the NPV rankings (either due to cash flow timing differences or due to differences
in project size) and the possibility of Multiple IRRs for the same project or no IRR
Payback Period = Full years until recovery + (Unrecovered Cost at the beginning of
last year/Cash flow during last year)
Payback Period (Project A) = 2 + (200/600) = 2.33 years
Since the Payback Method does not take into account the time value of money and cash flows
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beyond the payback period, project decisions cannot be based solely on this method.
However, this method is a good measure of project liquidity.
Net Cash Flow Discounted Cumulative Net Cash Flow Discounted Cumulative
NCF DCNF NCF DCNF
0 -2000 -2000 -2000 -2000 -2000 -2000
This method addresses the concern of discounting cash flows at the projects required rate of
return, but it still does not consider cash flows beyond the discounted payback period.
If PI > 1.0, accept the project, else, if PI < 1.0, reject the project.
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3.Cost of Capital
3.1 Introduction
A firm must decide on how to raise capital for its various projects, to funds its business and for
growth, dividing it among common equity, debt and preferred stock. The optimum mix which
produces the minimum overall cost of capital will maximize the value of the firm. Debt,
preferred stock and common equity are referred to as the capital components of the firm. The
cost of each of these components is called the component cost if capital.
kd: Cost of Debt The rate at which the firm can issue new debt. It can also be considered
as the yield to maturity on existing debt (pre-tax component)
WACC: Weighted Average Cost of Capital It is the cost of financing the firms assets. WACC is
the average of the costs of the above sources of financing, each of which is weighted by its
respective use in the given situation.
Simple Example
WACC = (0.45) (0.08) (1 0.40) + (0.05) (0.084) + (0.50) (0.12) = 0.0858 = 8.58%
The weights in the calculation of WACC should be based on the firms target capital structure
(The proportions the firm aims to achieve over time). The assumption here is that the
firm would stick to the same capital structure throughout the life of the project
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3.2 The Optimal Capital Budget
In the figure below, the intersection of the investment opportunity schedule with the marginal
cost of capital curve identifies the amount of the optimal capital budget. The firm should
undertake projects, whose IRRs are greater than the cost of funds as this will maximize the
value created.
It is useful to view graphically how WACC alters as leverage changes. The classic figure below
shows how WACC is high at low levels of leverage (debt), it reaches an optimum at the
idealized WACC before rising quickly into the territory where financial distress (risk of
bankruptcy) becomes a major factor.
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3.3 Cost of Debt
The after-tax cost of debt is the interest rate at which firms can issue new debt net of the tax
savings from the tax deductibility of interest.
The most commonly accepted method for calculating cost of equity comes from the Capital
Asset Pricing Model (CAPM): The cost of equity is expressed formulaically below:-
where, ke or re = the cost of equity or the required rate of return on equity, rf = the risk free
rate, rm = expected return on the market portfolio, (rm rf) = the equity market risk premium,
= beta coefficient = unsystematic risk of the firm
Risk Free Rate (rf): The amount obtained from investing in securities considered free from
credit risk, such as government bonds from developed countries
Beta (): This measures how much a company's share price reacts against the market as a
whole. A beta of 1 indicates that the company moves in line with the market. If the beta is in
excess of 1, the share is exaggerating the market's movements; less than 1 means the share
is more stable. Occasionally, a company may have a negative beta, which means the share
price moves in the opposite direction to the broader market.
Equity Market Risk Premium (rm rf): It represents the returns investors expect to compensate
them for taking extra risk by investing in the stock market over and above the risk-free rate.
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3.5.2 Dividend Discount Model Approach
If dividends are expected to grow at a constant rate, g, then the current value of the
companys stock is given by this model.
P0 = D1/(ke g)
where: P0 = the current value of the companys stock, D1 = next years dividend, ke = required rate of
return on equity or cost of equity, g = the firms expected constant growth rate (g = (Retention
Rate)(Return on Equity ROE)). Re-arrange the terms to solve for ke
WACC Example
Question: Monetrix Inc. (a listed firm) is considering a project in the Financial Education
business. It has a D/E ratio of 2, a marginal tax rate of 40%, and its debt currently has a yield of
14%. The equity beta is 0.966. The risk-free rate is 5% and the expected return on the market
portfolio is 12%. Calculate the appropriate WACC to evaluate the project.
Solution
Cost of Debt = 14%, Cost of Preferred Stock = 0%, Weight of preferred stock = 0
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4.Measures of Leverage
4.1 Introduction
Leverage, in general, refers to the amount of fixed costs a firm has. These fixed costs may be
fixed operating expenses (such as building or equipment leases) or fixed financing costs (such
as interest payments on debt. Greater leverage leads to greater variability of the firms after-
tax operating earnings and income. Leverage increases the risk and potential return of a firms
earnings and cash flows.
Business Risk:
Refers to the risk associated with the firms operating income and is the result of uncertainty
about a firms revenues and the expenditures necessary to produce those revenues. It is the
combination of the firms sales risk and operating risk (the additional uncertainty about
operating earnings caused by fixed operating costs).
Financial Risk: Refers to the additional risk that a firms common stockholders must bear
when a firm uses fixed cost (debt) financing. The fixed expenses, in this case, are in the form of
interest payments. The use of financial leverage increases the level of ROE and it also
increases the rate of change of ROE. The use of financial leverage increases the risk of default,
but it also increases the potential return for equity shareholders.
where: Q = quantity of units sold, P = price per unit, V = variable cost per unit, F = fixed costs
The DOL is highest at low levels of sales and declines at higher levels of sales.
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4.3 Degree of Financial Leverage (DFL)
It is interpreted as the ratio of the percentage change in Net Income (or EPS) to the
percentage change in EBIT. For a particular level of operating earnings, DFL is calculated as
The Contribution Margin, which is the difference between the price and the variable cost per
unit, is used to cover the fixed costs.
Breakeven Quantity of Sales = (Fixed Operating Costs + Fixed Financing Costs)/ (Price Variable Cost
per
unit)
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5.Dividends
A dividend is a pro rata distribution to shareholders that is declared by the companys board of
directors and may or may not require approval by shareholders.
Since managers hate to cut dividends, they wont raise dividends unless they think the raise is
sustainable.
However, a stock price increase at time of a dividend increase could reflect higher expectations
for future EPS, not a desire for dividends.
3. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt
investors who have to switch companies
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5.5 Residual Dividend Model
Find the retained earnings needed for the capital budget.
Pay out any leftover earnings (the residual) as dividends.
Simple Example:
Capital budget = $800,000
Target capital structure = 40% debt, 60% equity
Forecasted net income = $600,000
How much of the forecasted net income should be paid out as dividends?
Calculate portion of capital budget to be funded by equity
Of the $800,000 capital budget, 60% ie. $480,000 will be equity financed
Calculate the excess or need for equity capital?
There will be $600,000 - $480,000 = $120,000 left over to be paid as dividends.
Calculate the dividend payout ratio (DIV/PAT)?
$120,000 / $600,000 = 0.2 or 20%
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6.Stock Repurchases
A repurchase of stock is a distribution in the form of the company buying back its
stock from shareholders.
Stock split: Firm increases the number of shares outstanding, say 2:1. Shareholders get extra
shares in the ratio of stock split.
Both stock dividends and stock splits increase the number of shares outstanding, so the pie
is divided into smaller pieces.
Unless the stock dividend or split conveys information, or is accompanied by another event
like higher dividends, the stock price falls so as to keep each investors wealth unchanged.
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6.5 Reasons for Stock Dividends or Stock Splits
Theres a widespread belief that the optimal price range for stocks is $20 to $80.
Stock splits can be used to keep the price in this optimal range.
Stock splits generally occur when management is confident, so are interpreted as
positive signals. On average, stocks tend to outperform the market in the year
following a split.
6.6 Conclusion
1. Share repurchases have a positive effect on share prices.
2. Dividend initiations have a positive effect on share prices.
3. Dividend increases have a positive effect on share prices.
Interesting Read:
The Pizza Theory of Business Valuation
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7.Working Capital Management
7.1 Overview
Working Capital:-
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Payables Deferral Period the average length of time between the purchase
of materials and labor and the payment of cash for the materials and labor.
8.1 Bookkeeping
Bookkeeping is the process of recording the daily
transactions of a business entity in a chronological order.
8.2 Accounting
Accounting is the process of recording, classifying,
reporting, analysing, interpreting and communicating of
financial information to the stake holders. Accounting is
the combination of all the 6 fields while bookkeeping is
only a part of the accounting process.
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debit and credit aspect of the transaction. These entries are then posted to
separate accounts known as Ledger. The balances in the ledger are carried
over to the Trial Balance where the total of Debits and Credits tally with each
other. Using the Trial Balance, the Profit and Loss Account (earlier, known as
Trading, Profit and Loss Account) and Balance Sheet can be prepared. In the
next year, new transactions plus the opening Balance Sheet is used to create
the corresponding Financial Statements.
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Asset Turnover = Sales / Average Total Assets
Current Ratio: It is the relationship between the current assets and current
liabilities of a concern.
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Return on Total Capital = EBIT/Total Capital
The pecking order theory explains the inverse relationship between profitability and
debt ratios:
1. Firms prefer internal financing.
2. They adapt their target dividend payout ratios to their investment
opportunities, while trying to avoid sudden changes in dividends.
3. Sticky dividend policies, plus unpredictable fluctuations in profits and
investment opportunities, mean that internally generated cash flow is
sometimes more than capital expenditures and at other times less. If it is
more, the firm pays off the debt or invests in marketable securities. If it is less,
the firm first draws down its cash balance or sells its marketable securities,
rather than reduce dividends.
4. If external financing is required, firms issue the safest security first. That is,
they start with debt, then possibly hybrid securities such as convertible bonds,
then perhaps equity as a last resort. In addition, issue costs are least for
internal funds, low for debt and highest for equity. There is also the negative
signaling to the stock market associated with issuing equity, positive signaling
associated with debt.
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