Financial Management I

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FINANCIAL MANAGEMENT I
Module I Introduction
Nature & Scope
Finance Functions
Financial Objectives
Roles and Responsibilities of the finance Manager
Introduction to Indian financial System
Sources of Finance
Introduction to Derivatives

NATURE AND SCOPE

The term financial management can be defined as the management of flow of funds in a firm and
it deals with the financial decision making of the firm. The financial Management as practiced by
corporate (business) firms can be called corporation finance or business finance. Finance function has
become so important that it has given birth to financial management as a separate subject. Financial
Management refers to that part of the management activity which is concerned with the planning and
controlling of the firms financial resources. It encompasses the procurement of the funds in the most
economic and prudent manner and employment of these funds in the most optimum way to maximize
the return for the owner. The financial management has got a place of prime relevance as a functional
area because raising of funds and their best utilization is the key to the success of any business
organisation. All business decisions have financial implications and therefore financial management is
inevitably relating to almost every aspect of business operations.

Financial Management
Maximization of Shame value
Financial Decisions
Investment
Decisions
Liquidity
Management
Financing
Decisions
Dividend
Decisions
Risk Return
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Figure an Overview of Financial Management

Evolution of Financial Management:
Finance has emerged as distinct area of study clearing second half of the twentieth
century. The evolution of finance function and changes in its scope appeared due to two
factors namely
1. The continuous growth and diversity in business
2. The Gradual appearance of new finance analytical tools.

Finance up to 1940 the traditional phase
a. Finance function was concerned with procuring of funds to finance the expansion or
diversification activities and thus the occurrence of finance function was episodic in
nature.
b. In order to finance business growth, there was an emergence of institutional
financing and institutional banking giving rise to finance industry.
c. Finance function was viewed particularly from the point of view of supplier of
funds i.e. the lenders, both individually and institutions so the emphasis was to
consider the interest of the outsiders. The internal decision making process were
lesser importance.
d. The focus of attention was on long-term resources and not concerned with working
capital and its management.
e. The treatment of different aspects of finance was more of a descriptive nature
neither than analytical.
f. Finance was concerned with procuring of funds primarily by issue of securities such
as equity shares, preference shares and debt instruments.

After 1940 Transitional Phase:
The scope of finance function gradually widened and the day to day problems of finance were
also incorporated. Funds analysis and control on a regular basis, rather than on a casual basis
started. This phase was an extension of the traditional phase and continued up to early fitter
when the scope of finance function started expanded in big way.

After 1950 An integrated view of finance functions:
The gradual increase in competition and growth of business widened finance function to be
analytical and decision oriented. The scope finance function not only includes the measures of
procuring funds at episodic events but also the optimum utilization through data based
analytical decision making. Two significant contributions to the development of modern
theory of financial management are:
Theory of portfolio management developed by Harry Markowitz in 1950.
The theory of leverage and valuation of firm developed by Modigillani and Miller in
1958.
These developments are in fact the start of the development of an integrated theory of
financial management which now includes theory of efficient capital markets, dividend policy
risk and uncertainty dimensions to the financial decision making, valuation models, working
capital management etc.

The modern phase of evolution of finance function can be summarized as follows:-
a) The scope has widened to include the optimum utilization of funds through analytical
decision making.
b) The finance function is now viewed from the point of view of the insiders i.e. those
who are taking decisions in the firm.
c) The knowledge of securities, financial markets and institutions is also necessary and
the scope of finance managers function has expanded beyond being nearly descriptive
into analytical in nature.
Importance of financial Management
The importance of corporation finance or financial management has arisen because of the
fact that present day business activities are predominantly carried on company or corporate form
of organisation. The advent of corporate enterprises has resulted in to:
i) The increase in size and influence of the business enterprises.
ii) Wide distribution of corporate ownership
iii) Separation of ownership & Management.
The knowledge of the discipline financial management is important not only to the practicing
managers, but also to others who deal with a corporate enterprise, such as investors, lenders,
bankers, creditors etc. as there is always a scope for the management to manipulate and window
dress the financial statement.
Financial management is indispensable in any organisation as it helping:
i) Financial planning and successful promotion of an enterprise.
ii) Acquisition of funds as and when required at the minimum possible cost.
iii) Proper use and allocation of funds.
iv) Taking sound financial of decisions.
v) Improving profitability through financial controls.
vi) Increasing the wealth of the investors and the nation.
vii) Promoting and mobilizing individual and corporate savings.

Functional Areas of Financial Management:
1. Determining Financial needs
2. Selecting the sources of funds
3. Financial Analysis and Interpretation
4. Cost volume profit Analysis
5. Capital Budgeting
6. Working Capital Management
7. Profit Planning and control
8. Dividend Policy.


Provides
Raw Data
Provides
raw data
Provides
Information

Financial Management and other areas of management:-
1. Financial Management and production Dept.

2. Financial Management and personnel Dept.
3. Financial Management and Marketing Dept.

4. Financial Management and Accounts Dept.

5. Financial management & Research and Development Function.

Production Management
Purchase function Production Function Material Dept.
Market Dept.
Selling Advertising Distributing
Financial
Account
Cost
Accounting
Management
Accounting
Process and
Analyses
Date
Received
Financial
Management
Decisions
Financing
Investment
Dividend


Financial Management, Finance Decisions, Risk Return & Market Value of the firm

Financial Decisions:

Capital Budgeting
Decisions
Capital Structure
Decisions
Dividend
Decisions
Working Capital
Decisions
Return
Risk
Market
Value Firm
Financial
Management
Investment
Decision
Financing
Decision Dividend
Decision

(Inter Relationship of Financial Decision)

Financial Management Process:

Financial Management
Financing
Decisions
Investment
Decisions
Dividend
Decisions
Analyses
Risk and Return
Relationship Trade off
To achieve the goal of
In concerned with
Wealth Maximization
Financial Planning
And control
Financial Decisions
Investment Decision
Financing Decision
Dividend Decision

Feed Back
Risk and
Return
characteristics
of the firm
Market
price
of share Po
Shareholde
r wealth
wo-NPo

FINANCE FUNCTIONS:
Aims of Finance function
Acquiring sufficient funds
Proper Utilization of funds
Increasing Profitability
Maximizing Firms Value

SCOPE OF FINANCE FUNCTION
Estimating Finance Requirement
Deciding Capital Structure
Selecting a source of Finance
Selecting a pattern of Investment
Proper Cash Management
Implementing Financial Controls
Proper Use of Surpluses.

(Organisation of Finance function)

Director (Finance)
Finance Manager Account Manager
Budget
Division
Cash
Management
Credit
Management
Capital
Expenditure
Management Financial
Accounting
Tax
Management
Internal
Audit

FINANCIAL OBJECTIVES:
Financial Goal: Profit Maximization Versus wealth Maximization
Financial Management is concerned with procurement and use of funds. Its main aim is to use business
funds in such a way that the firms value/earnings are maximized. Financial Management provides a
frame work for selecting a proper course of action and deciding a viable commercial strategy. The main
objective of a business is to maximize the owners economic welfare. This objective can be achieved by:
1. Profit Maximization
2. Wealth Maximization

Profit Maximization:
For any business firm, the maximization of the profits is often considered as the implied
objective and therefore it is natural to retain the maximization of profit as the goal of the financial
management also. Various types of financial decisions be taken with a view to maximize the profit of
the firm. This profit can be measured in terms of the total accounting profit available to the share
holders.
The profit is regarded as a yard stick for economic efficiency of a firm. If all the business firm of
the society are working towards profit maximization then the economic resources of the society as a
whole would have been most efficiently, economically and profitably used. The profit maximization as
objective of financial management will result in efficient allocation of resources not only from the point
of view of the firm but also for the society as such. Firms producing goods and services, may function in
a market economy, or in a government controlled economy. In market economy, prices of goods and
services are determined in competitive markets. Firms in the market economy are expected to produce
goods and services desired by society as efficiently as possible.
Price system is the most important organ of a market economy indicating what goods and
services society wants goods and services in great demand command higher prices. This results in
higher profit for firms. Higher profit opportunities attract other firms to produce such goods and services
ultimately with intensifying competition an equilibrium price is reached at which demands & supply
match. Prices are determined by the demand & supply conditions as well as the competitive forces and
they guide the allocation of resources for various productive activities.
According to Adam smiths logic it is generally held by economists that under the conditions of
free competition, businessmen pursuing their own self-interests also serve the interest of society.
In the economic theory, the behaviour of firms analyzed in terms of profit maximization. Profit
maximization implies that a firm either produces maximum out put for given amount of input or uses
minimum input for producing a given output.

Objections to profit Maximization:
It ignores risk: It does not take into account the amount of risk which the firm undertakes in
attempting to increase the profits. With profit maximization as the objective, the management

may undertake all profitable investment opportunities regardless of the associated risk, where as
that investment may not be worth the risk, despite its potential profitability.
The profit maximization concentrates on the profitability only and ignores the financing aspect
of that decision and the risk associated with that financing for example in order to finance a
profitable investment, a firm may even borrow beyond capacity.
It ignores the timings of costs and returns and thereby ignores the time value of money. All the
monetary benefits and costs are considered in the absolute value terms without adjusting for time
value.
The profit maximization as an objective is vague and ambiguous. Does it refer to maximization
of short term profit or long term profit, after tax profit or profit before tax; profit from the point
of view of total funds employed or from the point of view of shareholders only etc.?
The profit maximization may widen the gap between the perception of the management and that
of the share holders. Since the profit maximization is not directly related to any measure of
shareholders benefits, this principle seems to be self centered at the cost of loosing attention
from the interest of the shareholders which should be of utmost importance to any firm.
The profit maximization borrows the concept of profit from the field of accounting and thus
tends to concentrate on the immediate effect of a financial decision as reflected in the increase in
the profit of that year or in near future. This will not necessarily be correct because many
decision have their costs and benefits scattered over many years.
A variant of the objective of profit maximization is often suggested as the maximization of the
returns on investment. The firm would undertake all those investment opportunities which have
the percentage return in excess of percentage cost of funds. In this case, the financial decision
making will be directed more or less the same way as in the case of profit maximization.
Therefore, the maximization of return on investment also suffers from the same drawbacks as the
profit maximization.
Maximizing EPS: If we adopt maximizing EPS as the financial objectives of the firm, this will
also not ensure the maximization of owners economic welfare. It also suffers from the flows
already mentioned i.e. ignores timings risk of the expected benefits.

Shareholders wealth Maximization: (SWM)
SWM means maximizing the net present value of a course of action to shareholders. Net present
value (NPV) or wealth of a course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has positive NPV creates wealth for
shareholders, and therefore it is desirable. A financial action resulting in negative NPV should be
rejected since it would destroy shareholders wealth. Between mutually exclusive projects the one with
the highest NPV should be adopted. NPS of a firms projects are additive in nature.
That is : NPV (A) + (NPV (B) = NPV (A+B)
The net present value or wealth can be defined in the following way:
( ) ( ) ( ) ( )
0
1
0 2
2 1
C
K 1
Ct
C
K 1
Cn
.......
K 1
C
K 1
C
W NPV
+
=
+
+ +
+
+
+
= =

n
t
n
t

C1, C2.= the stream of cash flows (benefits) expected to occur if a course of action is adopted.
C
0
- Cash Outflow (Cost) of that action
K = Appropriate discount rate (opportunity cost of capital) to measure the quality of Cs K reflects both
timing risk of benefits.

W is the net present value or wealth which is the difference between the present value of the stream of
benefits and the initial cost.
The firm should adopt a course of action only when W is positive, i.e. when there is not increase
is the wealth of the firm.
The objective of SWM takes care of questions of the timing and risk of the expected benefits.
These problems are handled by selecting an appropriate rate (the share holders opportunity cost of
capital) for discounting the expected flow of future benefits. It is important to emphasis that benefits are
measured in terms of cash flows. In investment and financing decisions, it is the flow of cash that is
important, not the accounting profits.
The objective of SWM as on appropriate and operationally feasible criterion to choose among
the alternative financial actions. It provides an ambiguous measure of what financial management
should seek to maximize in making investment and financing decisions on behalf of shareholders.
Maximizing the shareholders economic welfare is equivalent to maximizing the utility of their
consumption overtime. With their, wealth maximized, shareholders can adjust their cash flows in such a
way as to optimize their consumption. From the shareholders point of view, the wealth created by a
company through its actions is reflected in the market value of the companys shares. So, the wealth
maximization principle implies that the fundamental objective of a firm is to maximize market value of
its share. The value of companys shares is represented by their market price that , in turn, is a reflection
of shareholders perception about quality if the firms financial decisions . The market price serves as the
firms performance indicator.
Stock holders current wealthy in a firm
= (Number of shares owned) X (Current price per share)
W
0
= NP
0
Maximum utility refers to Maximum stock holders wealth refers to

Maximum current stock price per share

Implication of wealth Maximization:
There is a rationale in applying wealth maximizing policy as an operating financial management
policy. It serves the interests of suppliers of loaned capital, employees, management and society.
Besides shareholders, there are short-term and long-term suppliers of funds who have financial interests
in the concern. Short term lenders are primarily interested in liquidity position so that they get their
payments In time. The long term lenders get a fixed rate of interest from the earnings and also have a
priority over shareholders in return of their funds. Wealth maximization objective not only serves
shareholders interests by increasing the value of holdings but ensures security to lenders also. The
employees may also try to acquire share of companys wealth. The survival of management for a longer
period will be served if the interests of various groups are served properly. Management is the elected
body of shareholders. The shareholders may not like to change a management if it is able to increase the
value of their holdings. The efficient allocation of productive resources will be essential for raising the
wealth of the company. The economic interest of society are served if various resources are put to
economical and efficient use.
Criticism of Wealth Maximization:
The wealth maximization objective has been criticized by certain financial theorists mainly on
following accounts:

i) It is prescriptive idea. The objective is not descriptive of what the firms actually do.
ii) The objective of wealth maximization is not necessarily socially desirable.
iii) There is some controversy as to whether the objective is to maximize the stockholders wealth
or the wealth of the firm which includes other financial claimholders such as debenture
holders, preferred stockholders etc.
iv) The objective of wealth maximization may also face difficulties when ownership and
management are separated as is the most of the large corporate form of organization. When
managers act as agents of the real owners (equity shareholders) there is a possibility for a
conflict of interest between shareholders and the managerial interests. The managers may act
in such a manner which maximizes the managerial utility but not the wealth of stockholders
or the firm.
In spite of all the criticism, we are of the opinion that wealth maximization is the most
appropriate objective of a firm and the side costs in the form of conflicts between the stockholders
and debenture holders, firm and society and stockholders and managers can be minimized.

Functions of a Finance Manager:
The changed business environment in the recent past has widened the role of a financial
manager. The increasing pace of industrialization, rise of larger-scale units, innovations in
information processing techniques, intense competition etc. have increased the need for financial
planning and control. The size and extent of business activities are dependent upon the availability
of finances. Financial reporting may be used as a technique for control. In the present business
context, a financial manager is expected to perform the following functions.
1. Financial Forecasting and Planning: A financial manager has to estimate the financial needs of a
business. How much money will be required for acquiring various assets? The amount will be
needed for purchasing fixed assets and meeting working capital needs. He has to plan the funds
needed in the future. How these funds will be acquired and applied is an important function of a
finance manager.
2. Acquisition of Funds.: After making financial planning, the next setup will be to acquire funds.
There are a number of sources available for supplying funds. These sources may be shares,
debentures, financial institutions, commercial banks etc. The selection of an appropriate source
is a delicate task. The choice of a wrong source for funds may create difficulties at a later stage.
The pros and cons of various sources should be analyzed before making a final decision.
3. Investment of Funds. The funds should be used in the best possible way. The cost of acquiring
them and the returns should be compared. The channels which generate higher returns should be
preferred. The technique of capital budgeting may be helpful selecting a project. The objective of
maximizing profits will be achieved only when funds are efficiently used and they do not remain
idle at any time. A financial manager has to keep in mind the principles of safety, liquidity and
soundness while investing funds.
4. Helping in Valuation Decisions: A number of mergers and consolidations take place in the
present competitive industrial world. A finance manager is supposed to assist management in
making valuation etc. For this purpose he should understand various methods of valuing shares
and other assets so that correct values are arrived at.
5. Maintain Proper Liquidity: Every concern is required to maintain some liquidity for meeting
day-to-day needs. Cash is the best source for maintaining liquidity. It is required to purchase raw
materials, pay workers meet other expenses etc. A finance manager is required to determine the
need for liquid assets and then arrange liquid assets in such a way that there is no scarcity of
funds.

Securities
Funds
Funds
Funds
Deposits / Shares
Funds
Loans
Funds
Securities
Funds
Securities

INTRODUCTION TO INDIAN FINANCIAL SYSTEM

Definition:
The introduction of money as a medium of exchange for goods and services, measure of
value of goods and services in the real system and a store value of these in the real system.
Financial system refers to the activity relating to the provision of the above services in terms of
money and facilitates activity in real system. Financial sector provides inputs in the form of cash,
credit and assets in financial form necessary for production in real system. The financial system
comprises of a variety of intermediaries, markets, and instruments that are related to each other.

This provides a conceptual framework for understanding how the financial system works. It is
divided into eight sections as follows:
Financial Institutions

Comercial Banks
Insurance Companies
Mutual Funds
Provident Funds
Non-Banking Financial
Companies

Private
Placement
Demanders of Funds

Individuals Business
Governments
Suppliers of funds

Individuals Business
Governments
Financial Markets

Money Market
Capital Market

Functions of the financial system.
Financial assets.
Financial market returns
Equilibrium in financial markets
Financial intermediaries
Regulatory infrastructure.
Trends in the Indian financial system

FUNCTIONS OF THE FINANCIAL SYSTEM

The financial system performs the following interrelated functions that are essential to a modern economy:
It provides a payment system for the exchange of goods and services.
It enables the pooling of funds for undertaking large-scale enterprises.
It provides a mechanism for spatial and temporal transfer of resources.
It generates information that helps in coordinating decentralized decision-making.
It helps in dealing with the incentive problem when one party has an information advantage.

What is the financial system?
A. Organized Markets
RBI Banks F is Inter
Bank Market
Money Market Stock
and capital
Bullion
Market
B. Unorganized markets

What Constitutes financial system?
A. Trading In liquidity
CASH CREDIT LEADING AND
BORROWING
CLAIMS
ON
MONEY

1. Indigenous Bankers
2. Money Lenders
3. Pawn Brokers
4. Traders, Landlords Etc.
SHORT TERM

LONG TERM

MONEY
MARKET

STOCK AND
CAPITAL
MARKET

RBI BANKS BANKS & F FINANCIAL
MARKETS

B. MOBILISATION OF SAVINGS AND PROMOTION OF INVESTMENT

NATIONAL
SAVINGS
AND FLOW
OF
INVESTMENT
SECTORS S/i MARKETS
HOUSEHOLD SECTOR S>I PRIMARY MARKETS
FOREIGN SECTOR S>I
ALL MARKETS-NEW
ISSUES AND CAPITAL
MARKET
BUSINESS SECTOR I>S
PRIMARY AND
SECONDARY
MARKETS
GOVT. SECTOR I>S
STOCK MARKETS-
GILT-EDGED
MARKETS
S: SAVINGS I: INVESTEMENT

FINANCIAL SYSTEM BUSINESS SECTOR
SECTOR NATURE OF ASSETS MARKETS
BANKS BORROWINGS EQUITY
SHARES PREFERENCE
SHARES CUMULATIVE
DEBENTURES-SECURED
STOCK MARKET
(TRADING IN OLD
SECURITIES)
GOVT.
SECTOR


FOREIGN
SECTOR

AND UNSECURED
CONCERTIBLE AND NON-
CONVERTIBLE
HOUSE
HOLD
SECTOR
PUBLIC DEPOSITS NEW
ISSUES FURTHER ISSUES
PURCHASE OF OLD
SECURITIES
CAPITAL MARKET
(BORROWING)
DEPOSITS, ISSUE
OF NEW
SECURITIES)

FINANCIAL SYSTEM GOVERNMENT SECTOR

RBI
CREATION
OF MONEY
AD HOC TBS
MONEY
MARKET
BANKS
LEANDING TBS(91 DAYS)
182 DAYS
364 DAYS
LENDINGS AND
INVESTMENT
(FOR PUBLIC
SECTOR
UNDERTAKING)
LEANDING
INVESTMENT
SHORT TERM
ADVANCES
RBI BANKS F.IS.
CORPORATE
SECTOR PFS.
ETC.
INVESTMENT IN
GOVT. AND SEMI-
GOVT.
SFCURITIES
SHORT TERM
MEDIUM TERM
LONG TERM (OLD
AND NEW
SECURITIES)
STOCK AND
CAPITAL MARKETS
T.B. = TREASURY BILLS

A. SEGEMENTS OF MONEY MARKET

RBI AS
LENDER
OF LAST
RESORT
BANKS
LIC UTI
RBI BNKS
Fis
BANKS Fis
CORPORATE
UNITS
SHORT TERM
INTERCORPORATE
INVESTMENTS MARKETS
INTER
BANK
MARKET
TB
MARKET
COMMERC
IAL BILLS
MARKET
CORPORATE
SECTOR
D & F.H. D & F.H. D & F.H.

B. SEGEMENTS OF CAPITAL MARKET
APEX
BODY
IDBI
INSTITUTIONS OPERATING MARKETS
IFCI
ICICI
BANKS
SFCS
DEVELOPMENT
AGENCIES
PFs
LIC
UTI
GIC
FINANCE
COMPANIES
INVESTMENT
COMPANIES
BROKERS
NEW ISSUE INITIAL
MARKET - ISSUES
SECURITIES FURTHER
MARKET - TRADING
DIRECT BORROWING
- FROM BANKS
- FROM PUBLIC DEPOSITS
- OTHERS

INTER CONNECTIONS SEGEMENTS OF
MONEY MARKET

RBI AS
LEADER
DISCOUNT &
FINANCE HOUSE
INTER BANK
MARKET
INTER CORPORATE
INVESTMENT MARKET
TREASURY
BILLS MARKET
COMMERCIAL
BILLS MARKET
BANKS

INTER CONNECTIONS
SEGMENTS OF CAPITAL MARKET

IDBI AS
LEADER
DIRECT
BORROWING
NEW ISSUES
MARKET
(INITIAL AND
FURTHER
ISSUES)
SECURITIES
MARKET
(TRADING IN
SECURITIES)
BANKS AS
TERM LENDING
INSTITUTIONS
FIs
IFC
ICICI
UTI.
LIC Etc.
PUBLIC
DEPOSITS
DOMESTIC FOREIGN

CONCEPT OF RISK AND RETURN

RISK :- Risk in investment means that the future returns from that investment are
unpredictable. The concept of risk may be defined as the possibilities that the actual
return may not be same as expected.
Risk may be defined as the possibility that the actual outcome of a financial
decision may not be same as estimated.

TYPES OF RISK:-
1. Capital risk
2. Income risk
3. Default risk

Retrun:- Return is the motivating force and the principal reward in the investment
process. The return may be defined in terms of
i. Realized return
ii. Expected return
Measuring the realized return allows an investor to access how the future expected
returns may be.
For an investor, the return from an investment is the expected cash inflows in
terms of dividends, interests, bonus, capital gains etc., available to the holder of an
investment.
The return may be measured as the total gain or loss to the holder over a period of
time and may be defined in terms of percentage of return on the initial amount
invested.
Financial assets are expected to generate cash flows and hence the riskiness of a
financial asset is measured in terms of the riskiness of its cash flows.

The riskiness of an asset may be measured on a stand-alone basis or in a portfolio
context.
In the context of portfolio, the risk of an asset is divided into two parts:
Diversifiable risk
Market risk

Diversifiable risk arises from company-specific factors and hence can be washed away
through diversification.
Market risk stems from general market movements and hence cannot be diversified
away.

In general, investors are risk averse. So they want to be compensated for bearing market
risk. In a well-ordered market there is a linear relationship between market risk and
expected return.
RISK AND RETURN OF A SINGLE ASSET

Rate of return: the rate of return on an asset for a given period is as follows:

Rate of return=
rice beginningp
rice biginningp price ending income annual +

0
0 1 1
P
P P D
k
+
=
where k=expected rate of return from the investment
D
1
=cash dividend for the period 1.
P
1
=market price at time 1.
P
0
=market price at time 0.

EXPECTED RATE OF RETURN:

The expected rate of return is the weighted average of all possible returns
multiplied by their respective probabilities.

Where, E(R)=expected return
R
i
=return for I
th
possible outcome
P
i
= probability associated with R
i
n = Number of possible outcomes

MEASUREMENT OF RISK:
Risk refers to the variability or dispersion of
expected returns. A simple way to measure risk is to find our the range of possible
=
=
n
i
i i
R P R E
1
) (

returns, which is simply the difference between the highest and the lowest value of
return. It is commonly measured by the varience or the standard deviation.

where
2
=variance
R
i
=Return for the i
th
possible
outcome
P
i
=probability associated with
the i
th
possible outcome
E(R)=expected return

= standard deviation
C.V.= coefficient of variation

CCS1 CI CAI1AL:

DIFINITION:
The cost of capital of a firm is the minimum rate of return expected by its
investors. It is the weighted average cost of capital(various sources of finance) used
by a firm.
Cost of capital may be defined as the cost of obtaining the funds, i.e., the
average rate of return that the investors in a firm would expect for supplying
bonds to the firm.
According to Hunt, William and Donaldson,cost of capital may be defined as
the rate of return that must be earned on the net proceeds to provide the cost
elements of the burden at the time they are due.
Names C.Van Horne defines cost of capital as ,a cut-off rate for the allocation
of capital to investments of projects. It is the rate of return on a project that will
leave unchanged the market price of the stock.
According to Solomon Ezra, cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditures.
Hamplton,John J.defines cost of capital as,the rate of return the firm requires
from investment in order to increase the value of th firm in the market place.

SICNIFICANCE UF THE CUST UF CAPITAL

1. As an acceptance criterion in capital budgeting.
2. As a determinant of capital mix in capital structure decisions.
3. As a basis for evaluating the financial performance.
CV=
) (
1
R E

=
2

2
=

2
)] ( [ R E R P
i i


4. As a basis for taking other financial decisions like dividend policy, capitalization
of profits, making the rights issue and working capital.

Computation of cost of capital:

A- Computation of cost of specific source of finance.
B- Computation of weighted average cost of capital.

A. Computation of specific source of finance:
1. cost of debt:
a) Before tax cost of debt;

Where K
db
=cost of debt
I = interest
P= prinicipal

b) When debt is raised at premium/discount;

Where NP = Net proceeds

c) After tax cost of debt;

Where K
da
= After tax cost of debt
t = tax rate

d) Cost of redeemable debt;
i) Before tax cost of debt;

P
I
K
db
=
NP
I
K
db
=
) 1 ( ) 1 ( t
NP
I
t K K
db da
= =
) (
2
1
) (
1
NP P
NP P
n
I
K
db
+
+
=

Where I=Interest
n=Number of years in which debt is to be redeemed.
P= Proceeds at par
NP= Net proceeds.
ii) After tax cost of debt;

2. Cost of preference capital:

i)

where,
K
p
= Cost of preference capital
D = Annual preference dividend
P = Preference share capital
ii) When preference share capital issued at premium/discount or when cost of
flotation are incurred to issued then cost of preference ;

Where NP= Net proceeds.

N:B: Dividends are not allowed to be deducted in computation of tax, so no adjustment
required for taxes.
iii) Cost of redeemable preference capital;

3. Cost of equity share capital:

a) Dividend yield method/dividend/Price ratio method;
K
pr
= Cost of redeemable preference shares
D = Annual preference dividend
MV = Maturity value of preference shares
= Net proceeds

) 1 (
) (
2
1
) (
1
) 1 ( t
NP P
NP P
n
I
t K K
db da

+
+
= =
P
D
K
p
=
NP
D
K
p
=
Kpr =
) (
2
1
NP MV
n
NP MV
D
+
+


Where;

K
e
= Cost of equity share capital.
D = Expected dividend per share.
NP = Net preceeds
MP = Market price per share.

b) Dividend yield plus growth in dividend method;

Where; G= Rate of growth in dividends
c) Earning yield method;

d) Realized yield method;

4. Cost of retained earnings:

MP
D
or
NP
D
K
e
=
G
NP
D
K
e
+ =
G
MP
D
K
e
+ =
NP
EPS
proceeds Net
share per earning
K
e
= =
MP
EPS
share price Market
share per Earning
K
e
= =
G
NP
D
K
r
+ =
) 1 )( 1 )( ( b t G
NP
D
K
r
+ =

Where;
K
r
= Cost of retained earnings.
D = Expected dividend.
NP = Net proceeds.
G = Growth rate.
t = Tax rate.
b = Cost of purchasing new securities or brokerage costs.
B. Computation of weighted average cost of capital:

It is the average cost of the cost of various sources of financing.

Where;

K
w
= Weighted average cost of capital.
X = Cost of specific source of finance.
W = Weight, proportion of specific source of
finance.

Problems in determination of cost of capital:
1. Conceptual controversies regarding the relationship between the cost of
capital and the capital structure.
2. Historic cost and future cost.
3. Problems in computation of cost of equity.
4. Problems in computation of cost of retained earnings.
5. Problems in assigning weights.

TIME VALUE OF MONEY

Money has time value. A rupee today is more valuable than a rupee a year hence. Why?
Individuals in general prefer current consumption to future consumption.
Capital can be employed productively to generate positive returns. An investment of one rupee
today would grow to (1+r) a year hence (r is the rate of return earned on the investment.)
In an inflationary period a rupee today represents a greater real purchasing power than a rupee a
year hence.

Many financial problems involve cash flows occurring at different points of time. For
evaluating such flows an explicit consideration of Time Value of Money (TVM) is required. There are
several methods.

=
W
XW
K
w

Sect|ons of 18M
Future value
of the single
Amount
Future
value of
An annuity
Present value
of a single
Amount
Present
Value of An
annuity

Future Value Of The Single Amount

The process of investing money as well as investing the interest earned there on is called
compounding. The future value or compounded value of an investment after n years when the
interest rate is r percent.

FVn =PV(1+r)
n

FVn = future value
PV = present value
(1+r)
n
= future value factor

Doubling Period
Investors commonly ask the question: how long would it take to double the amount at a given
rate of interest. To answer t6his question we may look at the future value interest factor table. From the
table we can find that when the interest rate 12% it takes about 6 years to double the amount.

Is there any rule of thumb to show the FVIF table? The answer is called Rule of 72 i.e. dividing
by the interest rate.

e.g. if interest rate is 8% doubling period is 72/8=9 years
if interest rate is 4% doubling period is 72/4=18 years.

Another accurate rule of thumb is the rule of 69. according to this rule, the doubling period is
equal to:
Rate Interest
69
35 . 0 +
Rate Interest
72

Finding The Growth Rate
To calculate the compound rate pf growth of some series, say the sales series or profit series over
a period of time we may employ the future value interest factor table. The process may be demonstrated
with the help of the following data for X ltd.

Year 2000 2001 2002 2003 2004 2005
Sales
(Rs. in millions)
50 57 68 79 86 99


Step I Find the ratio of sales 2005 to 2000 i.e. 99/50=1.98

Step II If we refer this value in FVIF table we get 12% growth.

SHORTER COMPOUNDING PERIOD
The general formula for the future value of a single cash amount when compounding is done
more frequently than annually.

n m
n
m
r
PV FV
|
.
|
\
|
+ = 1
Where,
FV
n
= Future Value after n years
PV = Cash today
r = Nominal annual rate of interest
m = Number of times compounding is done during a year.
n = Number of years for which compounding is done.

Future Value Of An Annuity
An annuity is a series of periodic cash flows ( payments or receipts) of equal amount. When the
cash flows occurs at the end of each period the annuity is called regular annuity or a deferred annuity.
When the cash flow occurs at the beginning of each period the annuity is called an annuity due.

The premium payments of a life insurance policy is an example of annuity.
Suppose you deposit Rs. 1000/ annually in a bank for 5 years and your deposits earn a compound
interest rate of 10%. What will be the value of this series of deposits (an annuity) at the end of 5
years?

Rs. 1000(1.10)
4
+ Rs. 1000(1.10)
3
+ Rs.1000 (1.10)
2
+ Rs.1000(1.10)+ Rs. 1000
= Rs.1000(1.4641)+ Rs.1000(1.331)+ Rs.1000(1.21)+ Rs.1000(1.1) + Rs. 1000
= Rs.6,105

The time line of this annuity

( ) ( )
( )
(
+
=
+ + + + + =

r
r
A
A r A r A FVA
n
n n
n
1 1
........ 1 1
2 1

Where,
FVA
m
= Future value of an annuity which has a duration of n periods.
A = Constant periodic flow
r = Interest rate per period,
n = Duration of the annuity
( )
(
+
r
r
n
1 1
= The future value interest factor for an annuity

Sinking Fund factor

( )
(
+
=
1 1
n
n
r
r
FVA A
( ) 1 1 +
n
r
r
, is the inverse of FVIFA
r,n
is called sinking fund factor

1
st
Yr
1000
2
nd
Yr
1000
3
rd
Yr
1000
4
th
Yr
1000
5
th
Yr
1000
+
1110
+
1210
+
1331
+
1464
Rs. 6105/-

This formula helps in answering the question How much should be deposited periodically to
accumulate a certain sum at the and of a given period? The periodic deposit is simply and it is obtained
by FVA
n
by FVIFA
r,n

Finding the interest rate
A finance company advertises that it will pay a lump sum of Rs.8000/- at the end of 6 years to
investors who deposit annually Rs.1000 for 6 years. What interest rate is implicit in this offer?

Step-I Find the FVIFA
r,6

Rs.8000 = Rs.1000* FVIFA
r,6

FVIFA
r,6
= 8000/1000=8.00

Step-II Look at the table FVIFA
r,n
and read the row corresponding to 6 years until you find the
value close to 8.00 and we find FVIFA
12%,6
is 8.115.
So interest rate is slightly below than 12%

Present value of a single amount

n
n
r
FV PV |
.
|
\
|
+
=
1
1

n
r
|
.
|
\
|
+ 1
1
is called as the discounting factor or present value interest factor PVIF
r,n.

This process of discounting used for calculating the present value is simply the inverse of
compounding. The present value formula can be readily obtained by manipulating the compounding
formula.

FV
n
= PV(1+r)
n

Dividing both the sides by (1+r)
n
,

( )
( )
( )
PV
r
r PV
r
FV
n
n
n
n
=
+
+
=
+ 1
1
1

PV =
( ) ( )
n
n n
n
r
FV
r
FV
(
+
=
+ 1
1
*
1

Present value of an uneven series
On financial analyses we often come across uneven cash flow streams for ex. The cash flow
stream associated with a capital investment project is typically uneven. Likewise, the dividend stream
associated with an equity share is usually uneven and perhaps growing. The present value of a cash flow
stream-uneven or-even may be calculated with the help of the following

( )
( ) ( ) ( )
= +
=
+
+ +
+
+
+
=
n
t
t
t
n
n
n
r A
A
r
A
r
A
r
A
PV
1
2
2 1
1
..........
1
1


Where,
PV
n
= present value of a cash flow stream
A
t
= cash flow occurring at the end of year t
r = discount rate
n = duration of the cash flow stream

Table of present value of an uneven series of cash flow using a discount rate of 12%
Year Cash flow (Rs.) PVIF
12%, n
Present value of Individual cash flow
1 1000 0.893 Rs.1000*0.893 = Rs.893/-
2 2000 0.797 Rs.2000*0.797 = Rs.1,594/-
3 2000 0.712 Rs.2000*0.712 = Rs.1,424/-
4 3000 0.636 Rs.3000*0.636 = Rs.1,908/-
5 3000 0.567 Rs.3000*0.567 = Rs.1,701/-
6 4000 0.507 Rs.4000*0.507 = Rs.2,028/-
7 4000 0.452 Rs.4000*0.452 = Rs.1,808/-
8 5000 0.404 Rs.5000*0.404 = Rs.2,020/-
resenL value aL Lhe cash flow sLream = Rs.13,376/-

Piesent value of an annuity
Suppose you expect to receive Rs.1,000/- annually for 3 years, each receipt occurring at the end
of the year. What is the present value of this stream of benefits if the discount rate is 10%?

The present value of this annuity is simply the sum of the present values of all the inflows of this
annuity

3 2
10 . 1
1
000 , 1 .
10 . 1
1
000 , 1 .
10 . 1
1
000 , 1 . |
.
|
\
|
+ |
.
|
\
|
+ |
.
|
\
|
Rs Rs Rs

=Rs.1,000*(0.909) + Rs.1,000*(0.8264) + Rs.1,000*(0.7513)=Rs.2,478.8

Time Line For This Problem

901.1

826.4

751.3

Rs. 2478.8 = Present Value
1000 1000 1000
0 1 2 3

lormula
In general terms the present value of an annuity may be expressed as follows:

( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
( )
( )
( )
( )
n
n
n
n
n
n n
n n n
r r
r A
PVA
r r
r
A
r r r r
r
A
r
A
r
A
r
A
PVA
+
+
=
(
+
+
=
(
+
+
+
+ +
+
+
+
=
+
+
+
+ +
+
+
+
=
=
1
1 1
1
1 1
1
1
1
1
........
1
1
1
1
1 1
. ..........
1 1
1 2
1 2

Where,
PVA
n
= present value of an annuity which has a duration of n periods
A = constant periodic flow
r = discount
( )
( )
n
n
r r
r
+
+
1
1 1
, is the present value interest factor for an annuity(PVIFA
r,n)

copltol kecovety loctot

( )
( )
(
+
+
=
1 1
1
n
n
n
r
r r
PVA A
( )
( )
(
+
+
1 1
1
n
n
r
r r
is the inverse of PVIFA
r,n
is called capital recovery factor.

resent Va|ue of A perpetu|ty
A Perpetuity is an annuity of infinite duration. Hence, the present value of perpetuity may be
expressed as follows :

=
, r
PVIFA A P
P = Present Value of A perpetuity

A = Constant annual payment
, r
PVIFA
= Present value interest factor for a perpetuity
What is the value of
, r
PVIFA
?
It is simply
( )
=
=
+ 1
1
1
1
t
t
r
r

r
A
P =


Present Value of a Growing Annuity
A cash how that grows at a constant rate for a specified period of time is a growing annuity.

The Present value of a growing annuity can be determined using the formula

PV at a Growing Annuity = ( )
( )
( )
(
(
(
(
(
+
+
+
g r
r
g l
g A
n
n
1
1
1

(
(
|
.
|
\
|
+
+
|
|
.
|
\
|
+
=
n
r
g
g r
g
A PV
1
1
1
1

VALUATION OF BONDS AND STOCKS

CONCEPTS OF VALUE:-

BOOK VALUE: - The book value (BV) of an asset in an accounting concept based
on historical data given in the balance sheet of the firm. The BV of an asset may
either be given in the balance sheet or can be ascertained on the basis figures
contained in the balance sheet.
The BV of a debenture is the face value itself and is stated in the balance sheet.
The BV of an equity share can be ascertained by dividing the net worth of the
firm by the no. of equity shares.

MARKET VALUE:- The market value of an asset is defined as the price for which
the asset can be sold. The MV of a financial asset refers to the price prevailing at
the stock exchange. Market value per share is expected to be higher than the
book value per share for profitable growing firms.

GOING COCERN VALUE:- The GV refers to the value of the business an operating,
performing and running business unit . This is the value which a prospective buyer of
a business may be ready to pay. The GV is not necessarily the MV/BV of all the
asset taken together. GV may be less than the MV/BV of the total business.

LIQUIDATION VALUE (LV):- The LV refers to the net difference between the
realizable value of al asset and the sum total of internal liabilities. The LV is a factor
of realizable value of asset and therefore is uncertain. The LV may be zero also and
in such a case the owner do not get anything if the firm is dissolved.

0 1 2 3 n
( ) g A + 1 ( )
2
1 g A + ( )
n
g A + 1

CAPITALIZED VALUE :-The CV of financial assets is defined as the sum of present
value of cash flow from an assets discounted at the required rate of return . in
order to find out the CV, the future expected benefit are discounted for time value
of money .in the valuation of financial assets, the CV, is the most relevant concept.

REPLACEMENT VALUE:- Replacement value is the amount that company would be
required to spend if it were to replace its existing assets in the current condition .it is
difficult to find cost of assets currently being used by the company. RV is also likely
to ignore benefits of intangibles and the utility resisting share.

VALUATION OF BONDS:
:-FACE VALUE
:-INTEREST RATE
:-MATURITY
:-REDEMPTION VALUE
:-MARKET VALUE
:-COUPON RATE
Face value is called at par or par value. A bond is generally issued at par value
of RS one hundred or rs 100and or 1000- and interest is paid on face value.
Interest rate is fixed and known to bond holders. Interest paid on a
bond/debenture is tax deductible
The coupon rate is the rate of which interest on the par value of bond is payable
as per the payment of schedule the coupon rate is usually described as %rate
and is applied to par value to find out the periodic interest amount.
A bond (debenture) is generally issued for a specified period of time. Et is repaid
on maturity.
The value that a bond holder will get on maturity is called redemption value or
maturity value. A bond/debenture may be redeemed at par or premium or at
discount.
A bond/debenture may be traded in a stock exchange. The price at which it is
currently sold or bought is called the market value of the bond. Market value may
be different form par value or redemption value.

THE MODEL:-

=CF1/(1+K)1 + CF2/(1+K)2 + CFn/(1+K)n

Where, V0= Value of the security at present.
CFi =cash flow expected at end of the year.
K=appropriate discount year
n =expected life of the assets.
n
V0 = CFi / (1+K)
i

i=1

VALUE OF BONDS:-

n Ii RV

B0 = +
i=1 (1=Kd)
i
(1+Kd)
n

Where:- B0 = Value of a bond at present.
Ii = Annual interest payment starting one year from now till the end of
Year
RV=Redemption repayment at the end of year n
Kd= Appropriate discount rate

B0 = I(PVAFi,n) + RV(PVIFi,n)

VALUATION OF A CONVERTIBLE DEBANTURES:-

Valuation of Compulsorily Certifiable Debentures (CCD):-

n Ii mPt RV
B0(CCD)= + +
i=1 (1+Kd) (1=Ke) (1+Kd)
n

Where,
B0 (CCD)= Value of CCD
I= Interst amount receivable per year.
Ke= Required rate of return on equity component.
M= No. of share received on conversion.
Pt= Share price at the conversion time.
RV= Redemption value , if any
N= Life of the debentures.
Kd= Rate of discount.

NOTE BOOK:- Incase of partially convertible debenture, the annual interest before
conversion and after conversion would be different. Incase of fully convertible
debenture, there will not be any RV.

Valuation of optionally convertible debenture

B0(OCD)=[ Straight Debenture Value or Value as CCD, which ever is higher ] +
Value of the option.

BOND VALUE INCASE OF SEMI- ANNUAL INTERST

2n I/2 RV
B
0
= +

i=1 (1=Kd/2)
i
(1=Kd/2)
2n

YIELD TO MATURITY(YTM):-

YTM is the measure of a bonds rate of return that consider both the interest
income and any capital gain or loss. YTM of a bond is the interest rate that makes the
present value of the cash flow receivable from owning the bond equal to the price of
the bond.
YTM is bonds internal rate of return.

Mathematically ,
B
0
= I / (1+YTM ) + I / (1+YTM)
2
+ I / (1+YTM
)3
+M V / (1+YTM)
n

Where B
0
=value of bond
I= Annual interest
MV=maturity value
N=no of years left to maturity
A Perpetual bonds yields to maturity.
n= I
B
0
= = I/KD
t=1 (1+k)
t

I+(RV-B
0
)/n
Approximate yield =
(RV+B
0
)/2

CURRENT YIELD:-
Current yield is annual internet divided by the bond current value. It
is dose not account for the capital gain or loss.

VALUIATION OF DEEP DISCOUNT BONDS(DDB):-

B
0
(DDB)= FV/(1+r)
n

Where , B
0
(DDB)=value of DDB
FV=face value of the DDB payable at maturity
R=The required rate of return
N=life of DDB

VALUATION OF REDEEMABLE PREFERENCE SHARE:-

D
1
D
2
Dn RV
P
0
= (1+Kp)
i
+ (1+Kp)
2
+ . + (1+Kp)
n
+ (1+Kp)
i

n
Di RV
Po= (1+Kp)i + (1+Kp)n

i=1


IREDEEMABLE PRAFARENCE SHARE:=

Po=D/Kp

VALUATION OF EQUITY SHARES :=

ASSUMPTIONS FOR VALUATION:=
- Equity shares do not have any redemption date.
- Equity shares do not have any given redemption or liquidating value. In case of
liquidation of the company their claim is residual in nature and arising in the last.
- Dividends on equity shares are neither guaranteed nor compulsory. Further,
neither the rate, nor the dividend can very in any direction.
-
DIFFERENT APPROACHES TO THE VALUARTION OF EQUTY SHARES:=
a- Accounting concept of valuation
b- Valuation based on dividends
c- Valuation based on earnings

VALUATION BASED ON ACCOUNTING INFORMATION:=
- Book value
- Liquidation value

VALUATION OF EQUITY SHARES BASED ON DIVIDENDS:=
Assumptions :=
- The dividends are payble annually
- The first dividend is received after one year from the date of acquisition.
- Sale of equity share if any ,occurs only at the end of a year and at the ex-
dividend terms .

D
1
D
2
D

Po = + +.+
(1+Ke)
i
(1+Ke) 1+Ke)

ZERO GROWTH IN DIVIDENT OR CONSTANT DIVIDENT:-

D
1
= D
2
= D
3
=..=D

P
0
= D/Ke
Po = Value of the equity share
D =Annual dividend
Ke =Required rate return

CONSTANT GROWTH IN DIVIDEND:-

Do(1+g)
1
Do(1+g)
2
Do(1+g)


P
0
= + ++
(1+Ke)
1
(1+Ke)
2
(1+Ke)

Do(1+g)
i
=> Po =
i=1 (1+Ke)
i
As Ke >g and infinity function, mathematically it can be derived (transformed)

Do(1+g)
Po=
( Ke g)

D
1

Po= -:D
1
=Do(1+g)
(Ke-g)

=> Ke =D
1
/P
0
+ g


Module-3
CAPITAL BUDGETING

Capital budgeting decisions pertain to fixed/long-term assets which by definition refer
to assets which are in operation, and yield a return, over a period of time, usually,
exceeding one year. They therefore, involve a current outlay or series of outlays of
cash resources in return for an anticipated flow of future benefits. Capital budgeting is
the process of evaluating and selecting long term investment that are consistent
with the goal of share holders (owners) wealth maximization. Capital expenditure is an
outlay of funds that is expected to produce benefits over a period of time exceeding
one year.
Following are some examples of capital expenditure.
1. Cost of acquisition of permanent assets as land and building, plant and
machinery, goodwill etc.
2. Cost of addition, expansion, improvement or alteration in the fixed assets.
3. Cost of replacement of permanent assets.
4. Research and development project cost.

Capital expenditure involves non-flexible long term commitment of funds. Capital
budgeting involves the planning and control of capital expenditure. It is the process of
deciding whether or not to commit resources to a particular long term project whose
benefits are to be realized over a period of time, longer that one year capital
budgeting is also called as investment decisions, planning capital expenditure and
analysis of capital expenditure.

CAPITAL BUDGETING
A project otherwise know as capital expenditure decision or a capital
budgeting decision, may involve setting up a plant a new process, replacement of an
existing plant, introduction of a new product, undertaking a research work etc.
By taking up a project a firm in fact ,makes commitment into future both by
committing to the future needs of funds of the project and, by committing to its future
implication.

FEATURES OF A PROJECT
1. Long Term Effects: The projects of long term implications. They affect the
long term risk return composition of the firm. This feature differentiates a
project from a short term decision.

2. Substantial Commitments: the projects generally involve large
commitments of funds and as a result, substantial portion of capital funds
are blocked in the projects. In relative terms, therefore more attention is
required otherwise the firm may suffer from the heavy capital losses in

time to come.

3. Irreversible decisions: Most of the projects are irreversible. Once taken the
firm may not be in a position to revert back unless it is ready to absorb
heavy losses which may result due to abandoning a project in a midway.
The projects should be taken only after considering and evaluating each
and every minute detail of the project, other wise, the financial
consequences may be far reaching.

4. Affect the Capacity and Strength to compete: Most of the projects affect
the capacity and strength of a firm to face the competition. A firm may
loose competitiveness, if the decision to modernise is delayed or not
rightly taken. Similarly a timely decision to take over a minor competitor
may ultimately result even in the monopolistic position of the firm.

5. Future Uncertainty: Even if every case is taken and the project is
evaluated to every minute detail, still 100% correct and certain forecast is
not possible. The firm should try to be as analytical as possible. The
uncertainty may be with reference to cost of the project, future
competition, expected demand in future, legal provisions, political
situation, etc.

6. Time Element: the implications of a project are scattered over a long
period. The cost and benefit of a decision may occur at different points of
time. The cost and benefits are generally not comparable unless adjusted
for time value of money. The cost of a project is incurred immediately;
however, it is recovered in number of years. These total returns may be
more than the cost incurred, still the net benefits cannot be ascertained
unless the future benefits are adjusted to make them comparable with
the cost. Moreover, the longer the time period involved, the greater
would be the uncertainty.

According to G.C. Philippatos, Capital Budgeting is concerned with the allocation of
the firms scare financial resources among the available market opportunities. The
consideration of investment opportunities involves the comparison of the expected
future streams of earnings from a project with the immediate and subsequent streams
of earnings from a project, with the immediate and subsequent streams of
expenditures for it .

Charles T. Horngreen says, Capital budgeting is long term planning for making and
financing proposed capital outlays.

Richard and Green Law have referred to capital budgeting as acquiring inputs with
long-term return.

Lynch speaks, Capital budgeting consists in planning development of available
capital for the purpose of maximizing the long term profitability of the concern.

FEATURES OF CAPITAL BUDGETING DECISIONS:


1. Capital budgeting decisions involve the exchange of current funds for the
benefits to be achieved in future.
2. The future benefits are expected to be realized over a series of years.
3. The funds are invested in non-flexible and long term activities.
4. They have a long term and significant effect on the profitability of the concern.
5. They involve, generally huge funds.
6. they are irreversible decisions.
7. they are strategic investment decisions involving large sums of money, major
departure from the past practices of the firm, significant change of the firms
expected earnings associated with the high degree of risk.

DETERMINATION OF CASH FLOW STREAMS

Estimation of Costs and Benefits of a Proposal:
The estimation of costs and benefits of a proposal as the starting point for a capital
budgeting decision. The input data for such estimation are provided by production,
marketing, accounting and other departments. This information is synchronized to
forecast the costs and benefits of a proposal. There are two alternatives for measuring
the costs and benefits of a proposal. There are two alternatives for measuring the costs
and benefits. They are:
Accounting Profit
Cash Flows
The accounting profit as a measure of estimating the costs and benefits of a capital
budgeting proposal as discarded because:
I. The accounting profits is affected by the discretionary accounting policies.
II. The accounting profit is affected by non cash items e.g. depreciation.
III. The accounting profit is in terms of current years purchasing power and
hence is affected by inflation. In view of these and other deficiencies, the
accounting profit is out rightly rejected.
The costs and benefits for a capital budgeting decision situation are measured in
terms of cash flows. Cash flows refers to movement of cash. Costs are denoted as
cash outflows and benefits are denoted as cash inflows. The cash flows (inflows and
out flows) of a capital budgeting proposal are classified into:

A. Initial Outflows: Which ascertained as;
Cost of the asset
+ Installation cost
- Sale price of old asset being discarded
+ Increase in working capital
+ Tax effect of profit/loss on sale of existing asset.

It may be noted that
All incremental relevant costs are considered
All sunk costs, being non incremental are ignored
Opportunity cost, being a sacrifice, is incorporated (though there is no
cash flow)


B. Subsequent Annual Inflows: These are the inflows expected over different
years. These are also known as operating cash inflows. There may be
calculated as ;

Cash inflows = Cash from sales Cash expenses Tax paid, or,
Cash inflows = PAT + Non cash Expenses Change in Working Capital

It may be noted that the allocated overheads are ignored for subsequent annual
inflows because these are not incremental.

C. Terminal Inflows: Are those inflows which are expected to occur at the end of
life of the project. These will include the salvage value + tax effect on profit or
loss on sale of asset.
The principle of incremental cash inflows in capital budgeting
analysis is critical. A finance manager while evaluating a proposal should note
whether a particular cash flow is incremental or not. Only the incremental cash
flows should be considered for capital budgeting. Any cash flow or outflow
that can be directly or indirectly traced to a project must be considered.
Obviously, the incremental cash flow analysis also implies that any reduction in
cash inflow or outflow that occurs as a consequence of a project being
evaluated should also be considered. Another important point is that all cash
flows are considered on after tax basis. The cash flows may be grouped in to
relevant and irrelevant cash flows as follows.
Relevant Cash Flows Irrelevant Cash Flows
Cost of new project Scrap value of
old/new plant Trade-in Value of
old plant cost reduction/savings
Effect on tax liability incremental
repairs tax benefit of incremental
depreciation. Working capital flows
revenue from new proposal etc.
Sunk cost,
Allocated Overheads,
Financial cash flows.

In the ultimate analysis, the calculation of different cash flows may be
summarized as follows:-
Initial cash outflows:
= Cost of new plant + Installation Expenses + Other Capital Expenditure +
Additional Working Capital Tax benefit on account of capital loss on sale of old
plant (if any ) Salvage of old plant + Tax liability on account of capital gain on
sale of old plant (if any).

Subsequent Annual Inflows:
= Profit After Tax + Depreciation + Financial charge (L T) Repairs (if any )
Capital Expenditure (if any).

Termination Cash Inflows:
= Annual Cash Inflows + working capital released + scrap value of the plant (if
any)


Example: ABC Ltd. Is considering the manufacture of a range of pocket
calculators. Expenditure on plant and machinery is Rs. 3,00,000. The other relevant
information is given below:
Year 1 Year 2 Year 3 Year4
Sales (A) 400 500 500 300
Opening Stock 30 30 40 30
Purchases 120 160 140 70
150 190 180 100
(-) Closing Stock 30 40 30 ---
Cost of Material Used. 120 150 150 100
+ Wages 80 140 140 120
+Overheads 60 80 80 80
+Interest 20 30 30 20
+ Depreciation 75 75 75 75
Total Cost 355 475 475 395
Profit 45 25 25 (95)

Other Information:
a) Depreciation is provided on a 25% straight line basis and there is no residual
value of the plant.
b) Opening Stock is purchased in the beginning and assume that all the other
annual cash flows occur at the end of each year.
c) Individual in overheads are allocated fixed expenses equal to 25% of
wages. All other overheads and wages are incremental cash flows.
d) Assume that no credit is granted or received on sales or purchases.

Find out the relevant cash flows for this investment given that ABC Ltd. Pays tax
@ 40% ?

Solution: Amount
(Rs.)
Initial Cash Flow
Cost of New Plant 3,00,000
+ Opening Stock required 30,000
RS.3,30,000

Subsequent annual cash flows: (Amount Rs. `000)

Particulars Year1 Year 2 Year 3 Year4
Sales (A)
Purchases
(Cash) (B)
Wages (C)
Overheads (Total)
Allocated (25% Of
Wages)
Net Overheads (D)
Total Cost
(B+C+D)=(E)
Profit before
400

120
80
60

20
40

240

500

160
140
80

35
45

345

500

140
140
80

35
45

325

300

70
120
80

30
50

240


depreciation (A-E)
( - ) Depreciation
Profit after deprn.
( - ) Tax @ 40%
Profit after tax
Depreciation
added back
Net Cash Inflow

Tax Liability has
been calculated as
follows:
Profit after deprn.
Change in stock
Profit before tax
Tax @ 40%
160
75
85
34
51

75
126

85
---
85
34
155
75
80
36
44

75
119

80
10
90
36
175
75
100
36
64

75
139

100
-10
90
36
60
75
-15
-18
3

75
78

-15
-30
-45
-18

The annual Cash inflows: (Amount Rs. `000)
Particulars Year 1 Year 2 Year 3 Year 4
Accounting Profit
Before Tax
- Tax @ 40%
Profit After Tax
+ Depreciation
+ Interest
+ Allocated
Overheads
+ Stock Change
- Tax Shield of
interest @ 40%
- Tax shield of
allocated
overheads
Net Cash Flows

45
18
27
75
20

20
--

8

8
126

25
10
15
75
30

35
-10

12

14
119

25
10
15
75
30

35
10

12

14
139

-95
-38
-57
75
20

30
30

8

12
78

Terminal Cash Inflows: There will not be any terminal cash inflow as there is no
salvage value of the machine. There will not be any terminal cash inflow with
respect to stock as the closing stock at the end of 4
th
year is given as nil.
The items of interest and allocated overheads are worth noting. The interest
being financial flow shall be ignored while calculating the cash flows of the
project. It may be noted that the tax shield of this interest expenses is also ignored
in identifying the relevant expenses is also ignored In identifying the relevant cash
flows of the project. However, the cash flows are ascertained from the
accounting profit, then the following rule is applied:
Cash Inflow = PAT + interest interest * Tax Rate

Similarly the allocated overheads are not considered for finding out the cash
inflows. As these overheads are already being incurred else where in the firm, the
allocated overheads are neither incremental nor relevant. However, if the cash
inflows are calculated from accounting profit, then the following rule is applied:

Cash Inflow = PAT + Allocated overheads Allocated overheads * Tax rate.

Needs & Importance of Capital Budgeting:
Capital Budgeting decisions are vital to any organization as they include the
decisions as to:
a) Whether or not funds should be invested in long term projects such as
setting of an industry of an industry, purchase of plant and machinery etc.
b) Analyze the proposal for expansion or creating additional capacities.
c) To decide the replacement of permanent assets such as building and
equipments.
d) To make financial analysis of various proposals regarding capital
investments so as to choose the best out of many alternative proposals.

Why Capital Budgeting ?
The need & significance or importance of capital budgeting arises mainly due to
the following:
1. Large Investments: Capital budgeting decisions, generally involve large
investment of funds. But the funds available with the firm are always limited
and the demand for funds far exceeds the resources. Hence, it is very
important for a firm to plan an control its capital expenditure.
2. Long - term commitment of Funds: Capital expenditure involves not only
large amount of funds but also funds long term or more or less on
permanent basis. The long term commitment of funds increases the
financial risk involved in the investment decision. Greater the risk involved,
greater is the need for careful planning of capital expenditure, i.e. Capital
budgeting.
3. Irreversible Nature: The capital expenditure decisions are of irreversible
nature. Once the decision for acquiring a permanent asset is taken, it
becomes very difficult to dispose of these assets without incurring heavy
losses.
4. Long term Effect on Profitability: Capital budgeting decisions have a long
term and significant effect on the profitability of a concern. Not only the
present earnings of the firm are affected by the investments in capital
assets but also the future growth and profitability of the firm depends upon
the investment decision taken today. An unwise decision may prove
disastrous and fatal on the very existence of the concern. Capital
budgeting is of utmost importance to avoid over investments or under
investment in the fixed assets.
5. Difficulties of Investment Decisions: The long term investments decisions are
difficult to be taken because (i) decisions extends to a series of years
beyond the current accounting period ,(ii) uncertainties of future and (iii)
higher degree of risk.
6. National Importance: Investment decision though taken by individual
concern is of national importance because it determined employment,
economic activities and economic growth.
Thus, we may say that without using capital budgeting techniques
a firm may involve itself in a losing project. Proper timing of purchase,
replacement, expansion and alteration of assets is essential.


Capital Budgeting Process
Capital budgeting is a complex process as it involves decisions to the
investment of current funds for the benefits to the achieved in future and the
future is always uncertain. However, the following procedure may be adopted in
the process of capital budgeting:
1. Identification of Investment Proposals.
2. Screenings the Proposals,
3. Evaluation of various proposals
Independent proposals
Contingent or dependent proposals and
Mutually exclusive proposals.
4. Fixing Priorities.
5. Final Approval and preparation of Capital Expenditure Budget.
6. Implementing Proposal.
7. Performance Review.

Methods of Capital Budgeting or Evaluation of Investment Proposals

At each pint of time a business firm has a number of proposals regarding various
projects in which it can invest funds. But the funds available with the firm are
always limited and it is not possible to invest funds in all the proposals at a time.
There are many considerations, economic as well as non economic, which
influence the capital budgeting decisions.
There are many methods of evaluating profitability of capital investment
proposals. The various commonly used methods are as follows.
(A) Traditional Methods:
1. Pay back period method or pay out or pay off method
2. Improvement of Traditional Approach to Pay Back Period Method.
3. Rate of Return method or Accounting Method.
(B) Time adjusted method or discounted Methods:
4. Net Present Value Method.
5. Internal Rate of return method.
6. Profitability index method.

Traditional Methods:
1. Pay Back period method: the pay back some times called as pay out or
pay off method represents the period in which the total investments in
permanent assets pays back itself back within a certain period out of the
additional earning generated from the capital assets. Under this method
various investments are ranked according to the length of their pay back
period in such a manner that the investment with a shorter pay back period
is preferred to the one which has longer pay back period.

The pay back period can be ascertained in the following manner:
(1) Calculated annual net earnings (profits) before depreciation and after
taxes; these are called annual cash inflows.
(2) Divide the initial outlay (cost) of the project by the annual cash flow,
where the project generates constant annual cash inflows.
Pay Back Period = Cash Outlay of the Project of Original Cost of the Asset
Annual Cash Inflows

2. Improvement in Traditional Approach to Pay back Period Method
(a) Post Pay Back Profitability method:
Post Pay Back Profitability index = Post Pay Back Profits * 100
Investment

(b) Pay Back Reciprocal Method:
Pay Back Reciprocal Method = Annual Cash Inflow
Total Investment
(c) Post Pay Back Period Method.
(d) Discounted Pay Back Method.

3. Rate of Return Method
(a) Average Rate of Return Method:
Average Rate of Return Method =
Total Profits (after dep. & Taxes) * 100
Net Investments in the project * No. of years of profits

Or, Average Annual Profits * 100
Net Investment in the project

(b) Return per unit of investment Method:
Return per unit of investment Method = Total profit (after depreciation & taxes ) *
100
Net Investment in the project
(c) Return on average Investment Method.
(d) Average Return on Average Investment Method.

(B) Time adjusted method or discounted Methods.

(4) Net Present Value Method:
i) First of all determine the appropriate rate of interest that should be
selected as the minimum required rate of return called cut off rate or discount
rate. The rate should be minimum rate of return below which the investor
considers that it does not pay him to invest. The discount rate should be either
the actual rate of interest in the market on long term loans or it should reflect
the opportunity cost of capital of the investor.
ii) Compute the present value of the total investment outlay i.e. cash outflow at
the determined discount rate if the total investment is made in the initial year,
the present value shall be the same as the cost of investment.
iii) Compute the present by value of the total investment process i.e. cash
inflows (
profit before depreciation and after tax) at the above determined discount
rate.
Iv) Calculate the net present value of each project by subtracting the present
value of the cash out flows for each project.
v) If the net present value is positive or zero i.e. Present value of cash inflows
either
exceeds or is equal to the present value of cash outflows, the proposal may

be
accepted. But in case the present value of inflows is less than the present
value
of cash outflows, the proposals should be rejected.
vi) To select between mutually exclusive projects, projects should be ranked in
order of net present value i.e. the first preference should be given to the
project having the maximum positive present value.

PV = 1
(1 + r)
Where, PV = Present Value
r = rate of interest / discount rate
n = number of years

(5 )Internal Rate of return method:
(a) When the annual net cash flows are equal over the life of the asset:
Present Value Factor = Initial Outlay
Annual Cash Flow

(b) When the annual cash flow are unequal over the life of the asset:
* Prepare the cash flow table using an arbitrary assume discount rate to
discount the net cash flows to the present value.
* Find out the NPV by deducting form the present value of total cash flows
calculated in (i) above the initial cost of investment.
* If the NPV is positive apply higher rate of discount.
* If the higher discount rate still gi e a positive NPV increases the discount
rate further until the NPV become negative.
* If the NPV is negative at this higher rate, the IRR must be between this
two
rate.

(6) Profitability index method.
Profitability Index = Present Value of Cash Inflows
Present Value of Cash Outflows
Or, PI = PV of Cash Inflows
Initial Cash Outlays
Or, PI (Net) = NPV (Net Present Value)
Initial Cash Outlay

Risk and Uncertainty in Capital Budgeting
The following methods are suggested accounting for Risk in Capital Budgeting:
1. Risk Adjusted Cut off rate or Method of varying discount
rate
2. Certainty equivalent method
3. Sensitivity technique
4. Probability technique
5. Standard deviation method

6. Co Efficient of Variation Method
7. Decision tree Method
INVESTMENT DECISIONS UNDER CAPITAL RATIONING

Projects Cash outlay
(Rs000)
NPV at 10%
(Rs000)
IRR Cumulative cash outlay
(Rs000)
Cumulative NPV
(Rs000)

A 200 18.2 20% 500 18.2
B 150 6.8 15% 450 25.0
C 100 0 10% 350 25.0
D 50 (2.3) 5% 200 22.7

Capital rationing refers to a situation where the firm is constrained for external, or
self-imposed, reasons to obtain necessary funds to invest in all investment projects with
positive NPV. Under capital rationing, the management has not simply to determine
the profitable investment opportunities, but it has also to decide to obtain that
combination of the profitable projects which yields highest NPV within the available
funds.

A firm should accept all investment projects with positive NPV in order to
maximize the wealth of shareholders. The NPV rule tells us to spend funds in projects
until the NPV of the last (marginal) project is zero.

A situation of capital rationing may occur when a firm is either unable or
unwilling to obtain additional funds in order to undertake financially viable capital
budgeting proposals. Thus a firm by choice or under compulsions sets absolute ceiling
on its capital spending in a period at a level that will cause it to reject or avoid some
of the profitable projects.

INTERNAL CAPITAL RATIONING:

It is a situation where the firm has imposed limitation the funds allocated for fresh
investment though
i) The funds might otherwise be available within the firm or
ii) Additional funds can be procured by the firm from the capital market.

Some firms may follow a policy of using only internally generated funds for
new investments.
Some firms avoid debt capital because of the associated financial risk
and avoid external equity because of a desire not to loose control.
This type of capital rationing implies that the firm is not willing to grow
further.
The internal capital rationing is not in the best interest of shareholders in
the long run, as it results in foregoing the profitable proposals.

EXTERNAL CAPITAL RATIONING

It is a situation when the firm willing to under takes the financially viable
proposals but is unable to do so because either it is not having sufficient funds
available at its disposal or the capital market conditions are not conducive enough to
let the firm raise the required funds from the market. The external rationing may occurs
because of several reasons;
I. The lack of credibility.
II. High flotation cost.
III. High marginal cost of capital.

SINGLE PERIOD CAPITAL RATIONING:

METHODS:
I. Aggregation of projects or feasible set approach:

Under this approach the NPV of various proposals are put in different possible
combinations and then that combination is selected which has the maximum
total NPV.
i. The total outlay of the combination is within the limits of capital
rationing and
ii. The total NPV of the combination is the highest among all the
combinations.

II. INCREMENTAL OUTLAY ANALYSIS:

In case, the firm wants to select the projects on the basis of their
profitability, then the above feasibility set approach may not be of much
relevance. In such case, the incremental outlay analysis based on the IRR
technique may be adopted.
Steps:
i. Find out the IRR of the individual proposals and arrange them in
descending order of their IRRs.
ii. Then proceed to select all proposals from the highest IRR down, until
the funds are exhausted or the IRR of the proposal is less than the
cut-off rate.

III. PROFITABILITY INDEX:

PI is a way of ranking different proposals on the basis of the return per rupee
invested in the project. Under this method, the PI of different proposals may be
calculated and placed in order. The firm may start from the top and go on
accepting the proposals subject to that
i. Funds are available.
ii. Pi is more than 1.


Module-4
Capital Structure

According to Gerestenbeg, capital structure of a company refers to the composition or make-up of its
capitalization and it includes all long-term resources viz: loans, reserves, shares and bonds
The capital structure is made up of debt and equity securities and refers to permanent financing
of a firm. It is composed of long-term debt, preference capital and shareholders funds.
The terms, capitalization, capital structure and financial structure, those seems the same,
but dont mean the same.
Capitlisation refers to the total amount of securities issued by a company while capital
structure refers to the kinds of securities and the proportionate amount that make up
capitalization.
Some authors define capital structure in broad sence so as to include even the proportion
of short-term debt. They refer to capital structure as financial structure.
Financial structure means the entire liabilities side of the balance sheet. Nemmers and
Grunewald, defined the financial structure refers to all the financial resources marshaled
by the firm, short as well as long-term, and all forms of debt as wells equity.

Forms of capital structure
I. Equity shares only
II. Equity and preference shares
III. Equity shares and debentures
IV. Equity shares, preference shares and debentures

POINT OF INDIFFERENCE/RANGE OF EARNINGS
The EPS, earnings per share, equivalency point or point of indifference refers to that EBIT,
earnings before interest and tax, level at which EPS remains the same irrespective of different

alternatives of debt-equity mix. At this level of EBIT, the rate of return on capital employed is equal to
the cost of debt and this is also known as break even level of EBIT for alternative financial plans.
The equivalency or point of indifference can be calculated algebraically as below;

2 1
1
) 1 )( 2 ( ) 1 )( (
S
PD T I X
S
PD T I X
=

where,
X : Equivalency point or point of indifference or Break Even EBIT level.
I
1
: Interest under alternative financial plan 1.
I
2
: Interest under alternative financial plan 2.
T : Tax rate
PD : Preference Dividend
S
1
: No. of equity shares or amount of equity share capital under alternative 1.
S
2
: No. of equity shares or amount of equity share capital under alternative 2.

The point of indifference can also be determined by preparing the EBIT chart or range of
earnings chart. This chart shows the expected earnings per share(EPS) at various levels of earnings
before interest and tax(EBIT) which may be plotted on a graph and straight line representing the EPS
at various levels of EBIT may be drawn. The point where this line intersects is known as point of
indifference or break-even point.

OPTIMUM CAPITAL STRUCTURE:
The optimum capital structure may be defined as that capital structure or combination of debt s equity
that leads to the maximum value of the firm.
Optimal capital structure leads to maximization of the value of the firm and hence the wealth
of its owners and minimizes the companys cost of capital. So, every firm should aim at
achieving the optimal capital structure and then to maintain it.
The following considerations should be dept in mind while maximizing the value of the
firm in achieving the goal of optimum capital structure.
I. Of the firms return on investment is higher than the fixed cost of funds, the company
should prefer to raise funds having a fixed cost, such as debentures, loans and preference
share capital. It will increase EPS and MV of the firm. So a firm should make maximum
possible use of leverage .
II. When the debt is used as a source of finance the firm saves a considerable amount in
payment of tax as interest is allowed as a deductible expense in computation of tax.
Hence, the effective cost of debt is reduced, called tax leverage.
III. The firm should avoid undue financial risk attached with the use of increased debt
financing. If share holders perceive high risk in rasing further debt-capital, it will reduce
the market price of share.
IV. The capital structuring should be flexible.

THEORIES OF CAPITAL STRUCTURE
1. Net Income approach
2. Net operating income Approach
3. The Traditional Approach
4. Modigliani & Miller Approach

Net Income Approach
1. 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 the equity shares by using debt financing
to the maximum possible extent.

2. the theory propounds that a company can increase it s value and reduce the overall cost of capital
by increasing the proportion of debt in its capital structure.
3. Assumptions to the Net Income Approach:
i) the cost of debt is less than the cost of equity.
ii) there are no taxes.
iii) The risk perception of investors is not changed by the use of debt.
Critique: As the proportion of debt financing in capital structure increases the proportion of a less
expensive sources of funds increases. This result I n the decrease in overall cost of capital leading to
an increase in the value of the firm. The reasons for assuming the cost of debt to be less than the cost
of equity are that interest rates are usually lower than the dividend rates are due to the element of
risk and the benefit of tax as the interest is a deductible expense.
The total market value of a firm on the basis of the Net Income Approach can be
ascertained as below:
V = S + D
Where,
V = Total Market value of the firm
S = Market value of equity shares
= Earnings Available to Equity Share holders
Equity Capitalization Rate
D = Market value of debt
Over all cost of capital or weighted average cost of capital can be calculated as:
Ko = EBIT
V
Net Operating Income Approach
1. Net theory as suggested by Durand is another extreme of the effect of the Leverage on the value
of the firm.
2. This approach says that, change in the capital structure of a company does not affect the market
value of the firm and the overall cost of capital remains the constant irrespective of the method
of financing.
3. this implies that the over all cost of capital remains the same whether the debt equity mix is
50:50 or 20:80 or 0:100
4. So, there is nothing as an optimal capital structure and every capital structure is the optimal
capital structure.
5. Assumptions to this approach:
The market capitalizes the value of the firm as a whole.
The business risk remains constant at every level of the debt equity mix.
There are no corporate taxes.
The reasons propounded for such assumptions are that the increased use of the debt increases the
financial risk of the equity share holders and hence the cost of the equity increases. On the other
hand the cost of debt remains constant with the increasing proportion of debt as the financial risk
of the lenders is not affected.
The value of a firm on this basis can be determined as:
V = EBIT
Ko
Where,
V = Value of the firm
EBIT = Net operating Income or Earnings before interest and tax.
Ko = Overall cost of capital.

The market value is the residual value which is determined by deducting the market value of
debentures from the total value of the firm.
S = V D
Where,

V = Total market value of a firm
D = Market value of the debt.

The Traditional Approach.

1. It is otherwise known as Intermediate approach, is a compromise between the two
extremes of net income approach and net operating income approach.
2. According to this theory the value of the firm can be increased initially or the cost of
capital can be decreased by using more debt as the debt is a cheaper source of funds than
equity.
3. Optimum capital structure can be reached by a proper debt equity mix. Beyond a
particular point the cost of equity increases because increased debt increases the financial
risk of the equity shareholders.
4. The advantage of cheaper debt at this point of capital structure is offset by the advantage
of low- cost debt. After this, there comes a stage, when the increased cost of equity can
not be offset by the advantage of low- cost debt.
5. So, overall cost of capital in this theory, decreases up to a certain point, remains more or
less unchanged for moderate increase in debt thereafter and increases or rises beyond a
certain point.

Modigliani and Miller Approach:
A. In the absence of taxes:-
i. This theory states that the cost of capital is not affected by changes in the capital
structure or say that the debt equity mix is irrelevant in the determination of the
total value of a firm.
ii. The reason behind that is though debt is cheaper to equity, with increased use of
debt as a source of finance, the cost of equity increases. This increase in the cost of
equity off sets the advantage of the low cost of debt.
iii. Thus, although the financial leverage affects the costs of equity, the overall cost of
capital remains constant. The theory emphasizes the fact that a firms operating
income is a determinant of its value.
iv. Again the theory propounds that beyond a second limit of debt, the cost of debt
increases but the cost of equity falls thereby again balancing the two costs.
v. In the opinion of Modigliani & Miller two identical firms in all respect except their
capital structure cannot have the different market value or cost of capital because of
arbitrage process.
vi. In case two identical firms except for their capital structure have different market
values or cost of capital arbitrage will take place and the investors will engage in
personal leverage (they will by equity in preference to the company having lesser
value) as against the Corporate Leverage and this will render the two firms have
the same total value.
Assumptions to MM approach:
i. There are no corporate taxes .
ii. There is a perfect market.
iii. Investors act rationally.
iv. Expected earnings of all the firms have identical risk characteristics.
v. The cut off point investment in a firm is capitalization rate.
vi. Risks to investors depends upon the random fluctuations of expected earnings and
the possibility that the actual value of the variables may turn out to be different
from their best estimates.
vii. All earnings are distributed to the shareholders.


B. When the corporate taxes are assumed to exist :
Modigliani & Miller in their article of 1963 have recognized that the value of the firm will
increase or the cost of the capital will decrease with the use of the debt on account of
deductibility of interest charges for tax purpose. Thus, the optimal capital structure can be
achieved by maximizing the debt mix in the equity of a firm.
According to the M & M approach the value of a firm un levered can be
calculated as:
Value of un levered firm (Vu): = Earnings before Interest and Tax
Overall cost of Capital
= EBIT (1 T)
Ko
Value of the levered firm:
Vl = Vu + td
Where,
Vu = Value of unleverd firm
Vl = Value of levered firm
T = Tax rate, D= the quantum of debt in capital mix,
tD is the discounted present value of tax savings resulting form the deducting of the interest
charges.

Essential of features of a sound capital Mix:
1. Maximum possible use of leverage
2. The capital structure should be flexible
3. To avoid undue financial/business risk with the increase of debt.
4. The use of debt should be within the capacity of a firm
5. The firm should be in a position to meet its obligations in paying the loan and internet
charges as and when due.
6. It should involve minimum possible risk of loss of contrast.
7. It must avoid undue restrictions in agreements of debt.

Factors Affecting the Capital Structure:
1. Financial leverage or Trading on Equity.
2. Growth and stability of sales.
3. Cost of capital.
4. Cash Flow ability to service debt.
5. Nature and size of the firm.
6. Control.
7. Flexibility.
8. Requirements of investors.
9. Capital Market conditions.
10. Assets structure.
11. Purpose of financing.
12. Period of Finance.
13. Cost of Flotation.
14. Personal Considerations.
15. Corporate Tax Rate
16. Legal Requirements.

Capital Gearing:
The term Capital Gearing refers to the relationship between equity capital (Equity shares plus
reserves) and Long Term debt.
1. Capital gearing means the ratio between the various types of securities in the capital
structure of the company.

2. A company is said to be in the higher gear, when it has a proportionately higher/ large issue
of debentures and preference shares for raising the long term resources.
3. A company is said to be in low gear, when there is a proportionately large issue of equity
shares.

Significance of Capital Gearing
1. It has a direct bearing on the divisible profits of a company and hence a proper capital
gearing is very important for the smooth running of an enterprise.
2. In case of the low geared company, the fixed cost of capital by the way of fixed dividend
on preference shares and interest on debentures is low and the equity share holders may get
a higher rate of dividend.
3. In a high general company the fixed cost of capital is higher leaving lesser divisible profits
for the equity share holders.
4. The capital gearing in the financial structure of a business has been rightly compared with
the gears of an automobile. The gears are used to maintain the desired speed and control.
Initially an, automobile starts with a low gear, but as soon as it gets momentum the low
gear is changed to high gear to get better speed. Similarly, a company may be started with
high equity state i.e. low gear but after momentum, it may be changed to high gear by
mixing more of fixed cost bearing securities such as preference shares and debentures.

LEVERAGE

Definition: Dictionary meaning; The term Leverage refers to an increased means of accomplishing some purpose.

Leverage allows us to accomplish certain things which are otherwise not possible. Ex:Lifting of heavy objects
with the help of leverage.
In financial management, the term Leverage is used to describe the firms ability to use fixed cost assets or
funds to increase the return to its owners (equity shareholders).
According to James Horne Leverage is the employment of an asset or sources of funds for which the
firm has to pay a fixed cost or cost of fixed return. The fixed cost also called as fixed operating cost and fixed
return otherwise called as financial cost, remains constant irrespective of the change in volume of output or sales.
So the employment of an asset or source of funds for which the firm has to pay a fixed cost or return has a
considerable influence on the earnings available for equity share holders.
The fixed cost of return acts as the fulcrum and the leverage magnifies the influence.
Higher is the degree of leverage, higher is the risk as well as return to the owners.
Leverage may be favorable or unfavorable. It can have negative or reversible effect.

Types of Leverage:

i) Financial Leverage
ii) Operating leverage
iii) Composite leverage

iv) Working capital leverage

Financial Leverage or Trading on Equity:
A firm raises its funds through two sources (i) Owners called owners equity (ii) Outsiders called creditors equity.
When the firm issues capital theses are owners funds. When the firm raises by long term and short term loans it is
called creditors or outsiders equity. The use of long term fixed interest bearing debt and preference share capital
along with equity share capital is called as financial leverage or trading on equity.

The long term fixed interest bearing debt is employed by a firm to earn more from the use of these resources than
their cost so as to increase the return on owners equity.
Capital structure cannot affect the total earnings of a firm but it can affect the share of earnings for equity share
holders.
The fixed cost funds are employed in such a way that the earnings available for common stock holders (equity
share holders) are increased.
A Firm is said to be in condition of favorable leverage if its earnings are more that what debt would cost. On the
contrary, if it doesnt earn as much as the debt costs then it will be known as an unfavorable leverage.
When the amount of debt is relatively large in relation to capital stock, a company it said to be trading on their
equity. On the other hand if the amount of debt is comparatively low in relation to capital stock, the company is
said to be trading on thick equity.
The financial leverage is used to magnify the share holders earnings. It is based on the assumption that the fixed
charges / costs funds can be obtained at a cost lower than the firms rate of return on its assets.
When the difference between the earnings form assets financed by fixed cost funds and the costs of theses funds
are distributed to the equity stock holders, they will get additional earnings without increasing their own
investment. Consequently, EPS and the rate of return on equity share capital will go up.
On the contrary, if the firm acquires fixed cost funds at a higher cost than the earning from those assets then the
EPS and return on equity capital will decrease.

Degree of Financial Leverage:
the degree of financial leverage measures the impact of a change in operating income (EBIT) on change in earning
on equity capital or on equity share.

DFL = Percentage change in EPS
Percentage change in EBIT

DFL = EBIT
EBT (EBIT I)

Significance of financial leverage:

i. Planning of capital structure: The capital structure is concerned with the raising of Long term funds, both from
share holders and long term creditors. A financial manager has to decide about the ratio between fixed cost funds
and equity share capital. The effects of borrowing on cost of capital and financial risk have to be discussed before
selecting a final capital structure.

ii. Profit planning: the EPS is affected by the degree of financial leverage if the profitability of the concerns
increasing then fixed cost funds will help in increasing the availability of profits for equity stock holders. Therefore
financial leverage is important for profit planning.

Limitations of Financial Leverage:


1. Double Edged Weapon: trading on equity is a double edged weapon. It can be successfully employed to
increase the earnings of the shareholders only when the rate of earnings of the company is more than the fixed
rate of internal dividend on debentures/preferences shares.
On the contary, if it does not earn as much as the cost of interest bearing securities, then
It will work adversely and hence can not be employed.
2. Beneficial only to companies having stability of earnings: interest on debentures is a recurring burden on the
company and a company having irregular income cannot pay interst on its borrowings during lean years.
3. Increases risks and rate of interest: Another limitation of trading on equity is on account of the fact that every
rupee of extra debt increases the risk and hence the rate of interest on subsequent loans also goes on
increasing. It becomes difficult for the company to obtain further debts without offering extra securities and higher
rates of interest reducing their earnings.
4. Restrictions from financial institutions: The financial institutions also impose restrictions on companies which
resort to excessive trading on equity because of the risk factor and maintain a balance in the capital structure of
the company.

Operating Leverage:

operating leverage results from the presence of fixed costs that help in magnifying not operating income
fluctuations flowing from small variations in revenue. The fixed cost is treated as fulcrum of a leverage.
The change in sales are related to changes in revenue. The Fixed cost dont change with change in sales. Any
increase in sales, fixed cost remaining the same will magnify the operating revenue.
The operating leverage occurs, when a firm has fixed costs which must be recovered ir respective of sales
volume. The fixed cost remaining same the percentage change in operating revenue will be more than the
percentage change in sales. The occurance is known as operating leverage.
Operating leverage can be determined by means of a break even or cost volume profit analysis.

Operating Leverage = Contribution
Operating Profit
Contribution = Sales Variable cost
Operating Profit = Sales Variable Cost Fixed Cost
Operating Profit = Contribution Fixed Cost

The break even point can be calculated by dividing the fixed cost by percentage of contribution to sales or P/V ratio.
B.E.P = Fixed Cost P/V Ratio = Contribution
P/V Ratio Sales

When the production and sales move above the B.E.P, the firm enters highly profitable range of activities. At
B.E.P the fixed cost are fully recovered any increase in sales beyond this level will increase profits equal to
contribution
A firm operating with high degree of leverage and above B.E.P earns good amount of profits.
If a firm does not have fixed cost`s then there will be no operating leverage the percentage change in sales
will be equal to the percentage change in profit. When fixed costs are ther e, the percentage change in
profits will be more than the percentage in sales volume.

Degree of Operating Leverage or D.O.L = % Change in Profits
% Change in Sales

Combined Leverage:
Both financial and operating leverage magnify the revenue of the firm.
Operating leverage affects the income which is the result of production. On the other hand financial
leverage is the result of financial decisions.

The composite/combined leverage focuses attention on the entire income of the concern. The risk factor
should be properly assessed by the management before using the composite leverage. The high financial
leverage may be offset against low operating leverage or vise versa.
The degree of composite leverage or (DCL) = % Change in EPS
% Change in Sales
Composite leverage = Operating Leverage * Financial Leverage

Financial Management I

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