SFM U.GANGADHAR - ASSOC. PROFESSOR - DEPT.

OF MANAGEMENT STUDIES

Unit-2
CORPORATE FINANCIAL STRATEGY

Corporate Financial Strategy presents a practical guide to how corporate finance can be used to add value to a
business. A company's financial strategy requires simultaneous decisions about capital structure, dividend and capital management,
cash levels, financial risk profile and target credit rating. All of these decisions must be made in the context of the company's
operating performance and growth strategies.
Corporate financial strategy is a business approach in which financial tools and instruments are used to assess and
evaluate the likely success and outcomes of proposed business strategies and projects. In the twenty-first century, corporate leaders
and decision makers use corporate financial strategy to:
 Actively enhance shareholder value
 Fundraise
 Attain venture capital
 Promote corporate growth.

 Steps for Developing Successful Corporate Financial Strategy:

Corporate financial strategy is most successful when the strategy is maintained internally and aligned with the
operations of the corporation. Fully integrated corporate financial strategies can be developed using the following steps:

 Build a Sufficient Capital Structure: Capital structure refers to the means through which a company finances itself.
Financing may come from long term-debt, common stock, and retained earnings. Corporations can determine the best
capital structure for its purposes through the use of three forms of analyses: Downside cash flow scenario modeling, peer
group analysis, and bond rating analysis. Downside cash flow scenario modeling is a process in which a capital structure is
taken from a set of downside cash flow scenarios. Peer group analysis is a process in which common capital structures and
fads of peer businesses are evaluated for insight into operating features. Bond rating analysis is a process in a review of the
debt capacity within certain debt ratings.
 Determine The Correct Market Valuation: Correct market valuation evaluates whether the corporation is undervalued or
overvalued in the marketplace. Market valuation refers to a measure of how much the business is worth in the marketplace.
Review financial measures such as investor expectations for growth, margins, and investments. Compare investors'
expectations and managements' expectations to check for disparity.
 Establish The Optimum Corporate Financial Strategy: Develop an optimum strategy for value creation that provides
sufficient funding, financial balance, and a growing cash reserve.

 Capital Structure Planning or Management:

Introduction:
Estimation of capital requirements for current and future needs is important for a firm. Equally important
is the determining of capital mix. Equity and debt are the two principle sources of finance of a business. But, what should
be the proportion between debt and equity in the capital structure of a firm how much financial leverage should a firm
employ? This is a very difficult question. To answer this question, the relationship between the financial leverage and the
value of the firm or cost of capital has to be studied. Capital structure planning, which aims at the maximization of profits
and the wealth of the shareholders, ensures the maximum value of a firm or the minimum cost of the shareholders. It is
very important for the financial manager to determine the proper mix of debt and equity for his firm. In principle every
firm aims at achieving the optimal capital structure but in practice it is very difficult to design the optimal capital structure.
The management of a firm should try to reach as near as possible of the optimum point of debt and equity mix.

Definition:
“Capital Structure refers to the composition of a firm’s financing consists of equity, preference and debt.”
----------- Prasanna Chandra.

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 Optimum Capital Structure: It means capital structure that maximizes the value of the firm and minimizes the cost of
capital. The financial manager must try to obtain the best financing mix or the optimum capital structure for his / her firm.
The firm’s capital structure is considered optimum when the market value of the share is maximized.
 Pattern of Capital Structure (Form of Capital Structure):
1. Capital Structure with equity shares only.
2. Capital Structure with both equity shares and preference shares.
3. Capital Structure with equity and debt.
4. Capital Structure with equity, preference shares and debt.

 Factors Affecting Capital Structure:

1. Cost of Capital: Cost is an important consideration in capital structure decision. The capital structure should provide the
minimum cost of capital i.e., the cost of capital should be less than the rate of return.
2. Control: The control of a company is hold in the hands of a board of directors elected by the equity shareholders. If
they wish to retain control over the company, they should not permit to issue further equity shares to the public. In such
a case, debt financing is recommended.
3. Legal Requirements: A company should also fulfill the legal requirement when its capital structure is framed. For e.g.
the banking companies are permitted to issue only equity shares as per the Banking Companies Regulation Act.
4. 4. Size of the Company: Small companies depend heavily on owners’ funds while large companies are generally
considered to be less risky by the investors and therefore, they can issue different types of securities.
5. Period of Financing: When the company requires funds for permanent investment, it should prefer equity share
capital. Otherwise, it may issue redeemable preference shares and debentures.
6. Requirement of Investors: Different types of securities are issued to different classes of investors according to their
requirement.
7. Provision for Future: While planning capital structure the provision for future requirement of capital is also to be
considered.
8. Government Policies: Govt. policies are a major factor in determining capital structure. For example, a change in the
lending policies of financial institutions may mean a complete change in the financial pattern to be followed in the
companies. Monetary and fiscal policies of the government also affect the capital structure decisions.

 Approaches of Capital Structure Planning:

Introduction:

The use of fixed cost sources of finance, such as debt and preference share capital to finance the assets of the
company, is known as financial leverage or trading on equity. If the assets financed with the use of debt yield a return greater
than the cost of debt, the EPS also increases without an increase in the owners’ investment. The EPS also increase when the
preference share capital is used to acquire assets. But the leverage impact is more pronounced in case of debt because:
 The cost of debits usually lower than the cost of preference share capital and
 The interest paid on debt is tax deductible.

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Because of its effect on the EPS, financial leverage is an important consideration in planning the capital structure
of a company. The companies with high level of the earnings before interest and taxes (EBIT) can make profitable use of the
high degree of leverage to increase return on the shareholders’ equity.
There are three most common approaches to determine a firm’s capital structure. They are:
A. EBIT-EPS Analysis
B. Cost of Capital / Valuation Approach
C. Cash Flow Analysis

A. EBIT – EPS Analysis: It is one common method of examining the impact of leverage is to analyze the relationship
between EPS and various possible levels of EBIT under alternative methods of financing. It explains the sensitivity of
EPS to the changes in EBIT under different financial plans / capital structure.
This approach is helpful to analyze the impact of debt on earning per share (EPS). The EBIT-
EPS analysis is a very potential tool in the hands of the financial manager to get an insight (knowledge) into the
company’s capital structure management.
 Limitations of EBIT-EPS Analysis: If maximization of the EPS is the only criterion for selecting the particular debt-
equity mix, then that capital structure which is expected to result in the highest EPS will always be selected by all the
firms. However, achieving the highest EPS need not be the only goal of the firm. The main shortcomings of the EBIT-
EPS analysis may be noted as follows:
(i) The EPS criterion ignore the risk dimension: The EBIT-EPS analysis ignores as to what is the effect of
leverage on the overall risk of the firm. With every increase in financial leverage, the risk of the firm and
therefore that of investors also increase. The EBIGT-EPS analysis fails to deal with the variability of EPS
and the risk return trade-off.
(ii) EPS is more of a performance measure: The EPS basically, depends upon the operating profit which in
turn, depends upon the operating efficiency of the firm. It is a resultant figure and it is more a measure of
performance rather than a measure of decision-making.
Exercise-1:

Let us suppose firm X has a capital structure consisting of equity capital only. It-has 50,000 equity shares of Rs. 10 each. Now the
firm wants to raise a fund for Rs. 1,25,000 for its various investment purposes after considering the following three alternative
methods of financing:
(i) If it issues 12,500 equity shares of Rs. 10 each;
(ii) If it borrows Rs. 1,25,000 at 8% interest; and
(iii) If it issues 1,250, 8% Preferences Shares of Rs. 100 each.

Show the effect of EPS under various methods of financing if EBIT (after additional investment) is Rs. 1,56,250 and rate of taxation
is @ 50%.

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Thus, from the above table it becomes quite clear that the EPS is maximum when the firm uses debt-financing
although the rate of preference dividend and the rate of debt financing is the same. These happened due to the most significant role
played by Income Tax as preference dividend is not a deductible item from taxation while the interest on debt is deductible item.
It has already been stated above that EPS will increase with a high degree of leverage with the corresponding
increase in EBIT. But if the firm fails to earn a rate of return in its assets higher than the rate of debt financing, or preference share
financing, it will have to experience an opposite effect on EPS.

This can be shown with the help of the following illustration: Let us suppose the EBIT is Rs. 40,000 instead of Rs. 1,56,250.
The EPS under various methods of financing is shown:

Exercise -2:
Suppose that a firm has an all equity capital structure consisting of 100,000 ordinary shares of Rs.10 per share. The firm wants to
raise Rs.250,000 to finance its investments and is considering three alternative methods of financing – (i) to issue 25,000 ordinary
shares at Rs.10 each, (ii) to borrow Rs.2,50,000 at 8 per cent rate of interest, (iii) to issue 2,500 preference shares of Rs.100 each at
an 8 per cent rate of dividend. If the firm’s earnings before interest and taxes after additional investment are Rs.3,12,500 and the tax
rate is 50 per cent, the effect on the earnings per share under the three financing alternatives will be as follows:

Table: EPS under alternative financing favourable EBIT:

Equity Debt Preference
Financing Financing Financing
Rs. Rs. Rs.
EBIT 3,12,500 3,12,550 3,12,550
Less: Interest 0 20,000 0
PBT 3,12,500 2,92,500 3,12,500
Less: Taxes 1,56,250 1,46,250 1,56,250
PAT 1,56,250 1,46,250 1,56,250
Less: Preference dividend 0 0 20,000
Earnings available to ordinary shareholders 1,56,250 1,46,250 1,36,250
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 1.25 1.46 1.36

The firm is able to maximize the earnings per share when it uses debt financing. Though the rate of preference dividend is equal to
the rate of interest, EPS is high in case of debt financing because interest charges are tax deductible while preference dividends are
not. With increasing levels of EBIT, EPS will increase at a faster rate with a high degree of leverage. However, if a company is not
able to earn a rate of return on its assets higher than the interest rate (or the preference dividend rate), debt (or preference financing)
will have an adverse impact on EPS. Suppose the firm in illustration above has an EBIT of Rs.75,000/- EPS under different methods
will be as follows:
Table: EPS under alternative financing methods: Unfavourable EBIT:
Equity Debt Preference

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Financing Financing Financing

Rs. Rs. Rs.
EBIT 75,000 75,000 75,000
Less: Interest 0 20,000 0
PBT 75,000 55,000 75,000
Less: Taxes 37,000 27,500 37,500
PAT 37,500 1,46,250 1,56,250
Less: Preference dividend 0 0 20,000
Earnings available to ordinary shareholders 27,500 17,500
1,56,250
Shares outstanding 1,00,000 1,00,000
1,25,000
EPS 0.27 0.17
0.30

It is obvious that under Unfavourable conditions, i.e. when the rate of return on the total assets is less
than the cost of debt, the earnings per share will fall with the degree of leverage.

 Return on Equity:
Return on Equity is also known as Return on Net Worth. Return on Equity shows how many rupees
of earnings result from each rupee of equity. Return on equity is calculated by taking a year’s net incomes dividing them by the
average shareholder equity for that year, and is expressed as a percentage:
Definition:
“The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate
profits from its shareholders investments in the company.”

This is an important for potential investors because they want to see how efficiently a company will use
their money to generate net income. ROE is also an indicator of how effective management is at using equity financing to fund
operations and grow the company.

 Formula: The return on equity ratio formula is calculated by dividing net income by shareholder's equity.

Most of the time, ROE is computed for common shareholders. In this case, preferred dividends are not
included in the calculation because these profits are not available to common stockholders. Preferred dividends are then taken
out of net income for the calculation. Also, average common stockholder's equity is usually used, so an average of beginning
and ending equity is calculated.
 Return on Equity Analysis: Return on equity measures how efficiently a firm can use the money from shareholders to
generate profits and grow the company. Unlike other return on investment ratios, ROE is a profitability ratio from the
investor's point of view—not the company. In other words, this ratio calculates how much money is made based on the
investors' investment in the company, not the company's investment in assets or something else.
That being said, investors want to see a high return on equity ratio because this indicates that the
company is using its investors' funds effectively. Higher ratios are almost always better than lower ratios, but have to be
compared to other companies' ratios in the industry. Since every industry has different levels of investors and income, ROE
can't be used to compare companies outside of their industries very effectively.
Many investors also choose to calculate the return on equity at the beginning of a period and the end of a
period to see the change in return. This helps track a company's progress and ability to maintain a positive earnings trend.
Example:
Tammy's Tool Company is a retail store that sells tools to construction companies across the country. Tammy reported net
income of Rs.1,00,000 and issued preferred dividends of Rs.10,000 during the year. Tammy also had 10,000, Rs.5 par
common shares outstanding during the year. Tammy would calculate her return on common equity like this:

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As you can see, after preferred dividends are removed from net income Tammy's ROE is 180%. This means that every rupee of
common shareholder's equity earned about Rs.1.80 this year. In other words, shareholders saw a 180 percent return on their
investment. Tammy's ratio is most likely considered high for her industry. This could indicate that Tammy's is a growing company.
An average of 5 to 10 years of ROE ratios will give investors a better picture of the growth of this company.

Example 1: Company A earned net income of $1,722,000 during the year ending march 31, 2011. The
shareholders' equity on April 30, 2010 and March 31, 2011 was $14,587,000 and $16,332,000 respectively.
Calculate its return on equity for the year ending March 31, 2011.

Solution
Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500
Return On Equity = $1,722,000 / $15,459,500 ≈ 0.11 or 11%

Example 2: Total assets and total liabilities of Company B on Jan 1, 2010 were $2,342,000 and $1,383,000.
During the year ended December 31, 2011 it made a net profit of $242,000 and its shareholders' equity
increased by $302,000. Calculate ROE of Company B.

Solution
Step 1: Beginning Shareholders' Equity = $2,342,000 − $1,383,000 = $959,000
Step 2: Ending Shareholders' Equity = $959,000 + $302,000 = $1,261,000
Step 3: Average Shareholders' Equity = ( $959,000 + $1,261,000 ) / 2 = $1,110,000
Step 4: Return On Equity = $242,000 / $1,110,000 ≈ 0.22 or 22%

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 Dividend Policy and Value of the Firm:

Dividend decision of the firm is a crucial area of financial management. The important aspect of
dividend policy is to determine the amount of earnings to be distributed to shareholders and the amount to be
retained in the firm. Shareholders’ return consists of two components. They are dividends and capital gains.
Dividend policy has a direct influence on these two components.

 Theories of Dividend Policy: Dividend policy determines the division of earnings between shareholders and retained
earnings. According to some authors the dividend decision affects value of the firm and to some it is not. So, dividend
theories are broadly classified into two categories. They are:

Theories of Dividend Policy

Relevance Theories Irrelevance Theories

Walter’s Gordon’s Modigliani Miller Traditional

Approach Approach Approach Approach

A. Relevance Theories: Relevance theories which consider dividend decision to be relevant as it affect the value of the firm.

I. Walter’s Approach: According to him dividend policy affects the value of the firm. Walter’s model is based on the
relationship between the firm’s a) return on investment / internal rate of return(r) and b) cost of capital / required rate of
return (k).
o Classification of Firms: In order to explain the relationship between dividend policy and the market value of the firm
Walter classified into three categories. They are:
1. Growth Firm: If r > k i.e., the firm earns higher returns than the cost of capital, it is known as growth firm. In the
growth firm optimum dividend policy would be to retaining the entire earnings. In this case:
 the dividend pay-out ratio = 0 and
 retention ratio = 100%
2. Normal Firm: In the case of firm where r = k, it is a normal firm. In this case there are no fluctuations in the market
share value with the changes in dividend rates. Therefore, there is no optimum dividend policy for such firms.
3. Declining Firm: In case of firms where r < k, it is declining firm. The optimum dividend policy for them would be
distributing the entire earnings as dividends. 100% dividend payout ratio in their cases would result in maximizing
the value of the firm.
 Assumptions:
i. The firm does the entire financing through retained earnings. It does not use external sources of funds.
ii. The firm return on investment should be constant.
iii. The firm cost of capital should be constant.
iv. The firm has a very long life.
v. All earnings are either distributed or retained immediately.
 Formula: James Walter has presented the following formula for determining the market value of a share.

Where, P = Market Value of an equity share

D = Dividend per Share

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r = Internal rate of return

E = Earnings per Share
K = Cost of Capital

 The criticisms on the model are as follows:

1. Investments are through internal finance is not true. Both internal and external funds are needed.
2. The return and cost of capital are constant is not true, as investment goes up return and cost of capital also goes up.
3. The firm has a long life. How one can predict?
Exercise - 1: The details regarding three companies A ltd, B Ltd and C Ltd are as follows:
A Ltd. B Ltd. C Ltd.
R = 15% R = 5% R = 10%
k = 10% k = 10% k = 10%
E = Rs. 8 E = Rs. 8 E = Rs. 8

Calculate the value of an equity share of each of these companies applying Walter’s Approach when
dividend payment ratio is: 1) 75%, 2) 50%, 3)25%. What conclusion do you draw?
Excercise - 2:
A company has the following facts:
Cost of capital (k) = 0.10
Earnings per share (E) = Rs.10
Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25%
Show the effect of the dividend policy on the market price of the shares.

Exercise – 3:The following information is available for Avanti Corporation . (Prasanna Chandra 535, Walters)
Earnings purchase = Rs. 4/-; Rate of return on investment = 18%; Rate of return required by share
holders = 15%; What will be the price per share as per the Walter model. If the payout ratio is 40%;
50% & 60%?
Exercise – 4:The following data is available for Parkson company (Prasanna Chandra 537, Exercise Problem;
Walters) Earnings per share = Rs. 3/-; Internal rate of return = 15%; Cost of capital = 12%. If Walter’s
valuation formula holds what will be the price per share. If dividend payout ratio is 50%; 75% & 100%?
II. Gordon’s Model: This theory was given by Myron Gordon. Gordon’s theory on dividend policy is one of the theories
believing in the ‘relevance of dividends’ concept. It is also called as ‘Bird-in-the-hand’ theory that states that the current
dividends are important in determining the value of the firm. Gordon’s model is one of the most popular mathematical
models to calculate the market value of the company using its dividend policy.
 Assumptions:
i. The firm is an all-equity firm; only the retained earnings are used to finance the investments, no external source
of financing is used.
ii. The rate of return (r) and cost of capital (k) are constant.
iii. The life of a firm is indefinite.
iv. Retention ratio once decided remains constant.

 Formula: Myron Gordon has presented the following formula for determining the market value of a share.

Where, P0 = Market value of an equity share

E1= Earnings per Share
K = Cost of Capital
B = Retention Ratio
R = Rate of Return
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(1-b) = Dividend Payout Ratio

 Criticism of Gordon’s Model:

i. It is assumed that firm’s investment opportunities are financed only through the retained earnings and no
external financing viz. Debt or equity is raised. Thus, the investment policy or the dividend policy or both can
be sub-optimal.
ii. The Gordon’s Model is only applicable to all equity firms. It is assumed that the rate of returns is constant, but,
however, it decreases with more and more investments.
iii. It is assumed that the cost of capital (K) remains constant but, however, it is not realistic in the real life
situations, as it ignores the business risk, which has a direct impact on the firm’s value.
Thus, Gordon model posits that the dividend plays an important role in determining the share price of the firm.

Exercise - 1: From the following information calculate the values of an equity share of the companies by using
Gordon’s model when dividend pay-out ratio is 40%, 60%, 90%.
A Ltd. B Ltd. C Ltd.
R =0.15 R =0.10 R =0.08
k = 0.10 k = 0.10 k = 0.10
E = Rs. 10 E = Rs. 10 E = Rs. 10
Exercise – 2:The following information is available for Kavitha Musicals. (Prasanna Chandra 536)
EPS=Rs. 5/-
Rate of return required by share holders=16%
Assuming that the Gordon valuation model holds, what rate of return should be earned on investment ensure that
the market price is Rs. 50/- When the dividend payout is 40%.

Exercise – 3: The following data are available for Rajdhani Corporation.

EPS=Rs. 8/-
Internal rate of return =16%; Cost of capital = 12%
If Gordon’s valuation formula holds what will be the price per share when the D.P.O is 25%; 50% & 100%.

B. Relevance Theories: Irrelevance theories which consider dividend decision to be irrelevant as it does not affect the value of
the firm.
I. Modigliani-Miller Model: Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’ notion.According
to this approach, the dividend policy of a firm is irrelevent; as it does not affect the value of the firm. According to this
thoery the value of the firm depends on solely on its earnings power resulting from the investment policy. This theory is
in direct contrast to the ‘Dividend Relevance’ theory which believes dividends to be important in the valuation of a
company.
 Assumptions: Modigliani – Miller theory is based on the following assumptions:

o Perfect Capital Markets: Capital markets are perfect. Investors are rational as information is freely available,
transaction costs are nil.
o No Taxes: There is no existence of taxes. Alternatively, both dividends and capital gains are taxed at the
same rate.

o Fixed Investment Policy: The company does not change its existing investment policy. This means that new
investments that are financed through retained earnings do not change the risk and the rate of required rate of
return of the firm.
 Formula: According to M-M model the market price of a share is calculated by the following formula:

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Where, P0= Market Price of a share at beginning of a period.

P1= Market price of a share at the end of the period.
D1=Dividend received at the end of period.
Ke = Cost of equity capital.

15) (MM, SKG 9.23) ABC Ltd has a capital of Rs 10 lakhs in equity shares of Rs 100 each. The shares are currently
quoted at par. The company proposes declaration f a dividend of Rs 10 per share at the end of the current financial
year. The capitalisation rate for the risk class to which the company belongs is 12%.
What will be the market price of the share at the end of the year, if:
(i) a dividend is not declared?
(ii) a dividend is declared?
Assuming that the company pays the dividend and has net profits of Rs 5,00,000 and makes new investments of Rs 10
lakhs during the period, how many new shares must be issued. Use the MM model.

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