Strategic Financial Management JPlOZ7LTBU

Strategic Financial
Management
S. No Reference No Particulars Slide
From-To
1 Chapter 1 Introduction to Strategic Financial 5-17

Management
2 Chapter 2 Making Capital Budgeting Decisions 18-54
3 Chapter 3 Cost of Capital Analysis 55-83
4 Chapter 4 Investment Decisions and Financial 84-112

Strategies
5 Chapter 5 Capital Structure (Theory and Policy) 113-148

and Valuation of a Firm
6 Chapter 6 Dividend Decision 149-177

From-To
7 Chapter 7 Corporate Restructuring 178-212
8 Chapter 8 Funding Options 213-226
9 Chapter 9 International Financial Management 227-241
10 Chapter 10 Tax Implications of International 242-256

Investments
Course Introduction
• Strategic financial management has emerged as a new discipline with the

increasing strategic role of financial management in firms.
• Strategic financial management is a fusion of two disciplines: strategic

management and financial management.
• Strategic financial management blends the basic frameworks and concepts of

these two disciplines, namely financial management and strategic managing in
order to ensure smooth operations as well as achievement of long-term goals of
the firm.
• Strategic financial management mainly deals with the decisions such as

investment, financing and dividend distribution.
Chapter 1: Introduction to
Strategic Financial
Management
Chapter Index

From-To
1 Learning Objectives 8
2 Topic 1 Fundamentals of Financial 9-10

Management
3 Topic 2 Strategic Financial 11-12

Management
4 Topic 3 Strategic Planning 13

Chapter Index

From-To
5 Topic 4 Corporate Strategy and 14

Financial Policy
6 Let’s Sum Up 15
• Define the fundamental concepts of financial management
• Explain the characteristics, scope, importance, success factors and constraints of

strategic financial management
• Describe the characteristics, components, process, benefits, constraints and

mistakes of strategic planning
• List the common goals of corporate strategy and financial policy
• Explain the emerging role of finance managers in India

1. Fundamentals of Financial
Management
• Raising funds for the operations of the business and efficiently utilising these
funds is called financial management.
• According to Guthmann and Dougall, financial management is an activity

concerned with the planning, raising, controlling and administering of funds used
in the business.
• Financial management encompasses functions involved in the management of
financial resources of a firm.
• These functions include fund procurement, working capital management,

investment decision making, capital budgeting, etc.
2. Fundamentals of Financial
Management
Scope of Financial Management

• Financial management is a wide field involving a number of important functions.
• The scope of financial management includes the following areas:
Financial Planning
Financial Control
Financial Decision Making

1. Strategic Financial Management
• Strategic financial management refers to managing the finance of a firm with a

long-term objective considering the strategic goals of the firm.
• Following are the main characteristics of strategic financial management:
− Deals with long-term financial decisions
− ‰
Emphasises allocation or acquisition of new resources
− ‰
Deals with complex strategic decisions
− ‰
Covers a wide range of activities of a firm
− ‰
Helps in harmonising resource capabilities of a firm with threats
− and opportunities
− ‰
Involves the top-level management of a firm
2. Strategic Financial Management
Importance of Strategic Financial Management

• Strategic financial management helps a firm in running business in an efficient
way. The importance of strategic financial management can be summed up as
follows:
Financial Acquisition of Utilisation of

Planning Funds funds
Value
Maintenance Improvement
Creation for
of Liquidity in profitability
Firm
Strategic Planning
• Strategic planning involves setting strategies for a firm after analysing the
internal and external business environments so that the long-term goals of the
firm become attainable.
• Strategic planning basically deals with the following types of questions:
− ‰
What do we do?
− ‰
What goals do we want to achieve?
− ‰
Are we able to achieve those goals?
• Strategic planning helps firms in adapting to the changes in the business

environment and establishing priorities on what is to be achieved in the future.
Corporate Strategy and Financial
Policy
• The corporate strategy of a firm is closely related to its financial policy.
• Corporate strategy refers to the overall long-term plan of action of a firm to

achieve its long-term goals. Such goals cannot be achieved without strategic
management of financial resources of the firm.
• The role of financial policy starts after the development of the overall corporate
strategy of a firm. It ensures that:
– Enough funds are raised to allocate resources to the projects crucial for
achieving the long-term objectives of the firm.
– The optimum capital structure is achieved to reduce cost and improve the
financial health of the firm.
Let’s Sum Up
• Financial management refers to the functions involved in the management of

financial resources of a firm.
• The scope of financial management includes financial planning, financial control

and financial decision making.
• Strategic financial management refers to managing the finances of a firm with a

long-term objective, considering the strategic goals of the firm.
• Strategic planning involves setting strategy for a firm after analysing the
internal and external business environments so that the long-term goals of the
firm become attainable.
• The corporate strategy of a firm is closely related to its financial policy.

Chapter 2: Making Capital
Budgeting Decisions
Chapter Index

From-To
1 Learning Objectives 23-24
2 Topic 1 Capital Budgeting Basics 25-27
3 Topic 2 Investment Decisions: Nature 28-30

and Types
4 Topic 3 Investment Evaluation 31-32

Criteria
5 Topic 4 Net Present Value (NPV) 33-34

Method
Chapter Index

From-To
6 Topic 5 Internal Rate of Return (IRR) 35-37

Method
7 Topic 6 Profitability Index (PI) 38-40
8 Topic 7 Payback Method 41-43
9 Topic 8 Discounted Payback Period 44-45

Chapter Index

From-To
10 Topic 9 Accounting Rate of Return 46-47

(ARR) Method
11 Topic 10 Modified Internal Rate of 48-49

Return (MIRR) Method
12 Topic 11 Varying Opportunity Cost of 50

Capital
Chapter Index

From-To
13 Topic 12 Concept of Economic Value 51

Added (EVA) and Market
Value Added (MVA)
14 Topic 13 Let’s Sum Up 52

• Explain the basic concepts of capital budgeting
• Discuss investment decisions and their nature and types
• Describe the various investment criteria
• Describe and illustrate the Net Present Value (NPV) technique of capital
budgeting
• Describe and illustrate the Internal Rate of Return (IRR) technique of capital
budgeting
• Describe and illustrate the Profitability Index (PI) technique of capital budgeting
• Describe and illustrate the payback technique of capital budgeting

• Describe and illustrate the Accounting Rate of Return (ARR) technique of capital
budgeting
• Describe and illustrate the Modified Internal Rate of Return (MIRR) technique of
capital budgeting
• Explain the concept of varying opportunity cost of capital
• Explain the concept of Economic Value Added (EVA)

1. Capital Budgeting Basics
• Capital budgeting is a process whereby a firm or an investor evaluates all the

long-term investment options.
• The basic features of capital budgeting decision are as follows:
− ‰
Large anticipated benefits
− ‰
Huge gap between the time the investment is made and the time the benefits
are realised
− ‰
Involves huge risk
• Areas where capital budgeting can be used for evaluating the feasibility of a
project include purchase of fixed assets, expenditure towards expansion,
expenditure towards replacing fixed assets, etc.
• Following are the principles of capital budgeting:
Incremental Principle
Post Tax Principle
Financing Costs are Ignored
Long-term Funds Principle

Data Requirement: Identifying Relevant Cash Flows

• In capital budgeting, before evaluating any investment option, the future benefits
from that option should be estimated in monetary terms.
• This can be estimated using two methods, namely, accounting profits and cash
flows.
• In accounting profit method of estimating future benefits, certain non-cash

expenses (such as depreciation) are not included from the profit and loss
statement.
• The relevant cash inflows and outflows for an investment decision are estimated
using the incremental approach. It means that only the cash flows that are
directly attributable to the investment should be considered.
1. Investment Decisions: Nature and
Types
• Capital budgeting is used when a company opts for new projects or a new
investment decisions. The nature of investment decisions is explained in the
following points:
− ‰
Increasing revenues: These investment decisions are taken when a firm
expands existing product lines or launches a new product in the market.
− ‰
Reducing costs: These investment decisions may reduce the costs of the firm.
The classic example is when the firm replaces the existing machinery with
new machinery to lower the operating costs.
Types
• There are three types of investment decisions, which are:
Accept–reject Decisions
Mutually Exclusive Project

Decisions
Capital Rationing Decisions

Types
Risk and Return

• The risk in investment is that it may prove to be futile and reap far less returns
than expected or may even lead to losses. These risks are divided into three major
categories, which are:
− Business risks
− Non-business risks
− Financial risks
• Return or the return on investment or the return that incurs as a result of taking
a particular investment decisions refers to the quantum of profit that is
generated as a result of undertaking the project.
• The return may be calculated in whole figures or in terms of percentage.

1. Investment Evaluation Criteria
• Investment evaluation criteria or investment decision rule refers to the capital

budgeting techniques.
• Capital budgeting technique measures the economic worth of an investment.

While evaluating an investment, three steps are required, which are:
Estimating cash flows
Estimating the required rate of return or the

opportunity cost of capital
Applying decision rule (investment evaluation

criteria) forselecting an investment option
2. Investment Evaluation Criteria
• There are many capital budgeting techniques or the investment evaluation

criteria.
• However, these investment evaluation criterions belong to two major categories,

which are:
Discounted Cash Flow (DCF)

Criteria
Non-discounted Cash Flow

Criteria
1. Net Present Value (NPV) Method
• NPV is the difference between the total present value of future cash inflows and
the total present value of cash outflows. The following are the advantages and
disadvantages of NPV:
S. No. Advantages Disadvantages
1. Time value of money is taken NPV is difficult to calculate

into account. and understand.
2. It contributes towards the Discount factor is difficult

‰
goal of maximising wealth of to compute. The NPV
the shareholders. method is inappropriate for
projects having different
useful lives.
2. Net Present Value (NPV) Method
• Accept–reject criteria for computation of NPV: A project is accepted if the present

value of the cash inflows is more than the cash value of cash outflows.
• The formula for calculating NPV is given as follows:
𝐶𝑡
NPV of a Project = σ𝑛𝑡=1
1+𝑟 𝑡 − Initial Investment
Where
Ct = Cash flows at end of year t,
n = Life of the project
r = Discount rate
1. Internal Rate of Return (IRR)
Method
• Internal Rate of Return (IRR) computes the rate at which the sum of discounted
cash flows becomes equivalent to zero. The following are the advantages and
disadvantages of IRR:
1. Time value of money is taken It is difficult to compute

into account. IRR.
2. Cash inflow and cash outflow Multiple rates are

‰
are considered. The concept of generated which may be
required rate of return is confusing for taking
ignored. decisions.
Method
• IRR is computed as follows:
𝐶𝑡
σ𝑛𝑡=1
1+𝑟 𝑡 = Initial Investment
Or
𝐶𝑡
σ𝑛𝑡=1
1+𝑟 𝑡 − Initial Investment − NPV = 0
• A short-cut method to calculate IRR is:
𝑁𝑃𝑉𝑎
IRR = ra + (rb − ra)
𝑁𝑃𝑉𝑎 −𝑁𝑃𝑉𝑏
Where
ra = lower discount rate chosen; rb = higher discount rate chosen
NPVa = NPV at discount rate a%; NPVb = NPV at discount rate b%

Method
Comparing NPV and IRR

• Both NPV and IRR are discounted methods of cash flow analysis and investment
decisions. However, there are differences between the two, which are:
S. No. NPV IRR

1. Determines whether a project Computes the profitability
is worth investing in or not. of the investment.
2. Measured in terms of Measured in terms of
‰
currency (`or $). expected returns (%)
3. In NPV, if different discount IRR gives the same

rates are applied, the results result every time.
can be different for the same
project.
1. Profitability Index (PI)
• Profitability Index (PI) is also called the benefit–cost ratio (B/C ratio).
• PI is the ratio of the present value of all cash inflows at the desired rate of return
to the initial cash outflow (initial investment).
• PI is computed by using the following formula:
Present value of all cash inflows

𝑃𝐼 =
Initial investments
• If PI is equal to 1, it is a break-even point, where the project may or may not be
accepted.
• If PI is less than 1, the project should be rejected else it should be accepted.

The advantages and disadvantages of PI are given as follows:

1. ‰I considers the time value of
P It is difficult to ascertain
money. the cash flows and discount
rate.
2. PI is consistent with a firm’s Two projects may have a
‰
goal of shareholder value huge difference in their
maximisation. It analyses the initial investments and
relative profitability of a returns. However, it is
project. possible that they have
same PI. In such
conditions, PI cannot be
used to accept or reject a
project.
Comparing NPV and PI

• The accept–reject criterion for both NPV and PI are almost similar.
• In the PI method, projects with a value greater than 1 are accepted while in NPV
method, projects with positive NPV are accepted.
• Similarly, projects with value less than 1 as PI are rejected while in NPV method;
projects with negative NPV are rejected.
• However, in case of mutually exclusive projects, conflict may arise between these
two methods.
1. Payback Method
• In the payback method, the payback period is calculated.
• Payback period refers to the time duration required to recover the initial
investment made.
• It is computed by using the formula given as:
Initial investment
Payback Period =
Annual cash flow
• If the payback period is less than the useful life of a project, the project should be
accepted otherwise it should be rejected.
2. Payback Method
• The advantages and disadvantages of payback period are given as follows:
1. Payback period is simple and Time value of money is

easy to understand and ignored.
compute.
2. Payback method focuses on Payback stresses only over

‰
liquidity and early recovery of liquidity.
investments.
3. Payback Method
3. The cost of payback method is It ignores profitability.

far less than the cost of other
techniques of capital
budgeting.
4. Payback period takes into Cash flows that the firm

account the risk involved in a incurs after the payback
project. A project with short period are not considered.
payback period is better than
that with longer payback
period
1. Discounted Payback Period
• Discounted payback is the amount of time that is required for recovery of

investments taking into account the time value of money.
• While making computation under the discounted payback period, the present
value of cash inflow is computed and appropriate discount rate is chosen for
determining discounted cash inflows. Discounted cash inflow is calculated as
follows:
Annual cash inflow
Discounted Cash Inflow =
(1 + i)n
Where
i is the discount rate
n is the period in which cash inflow occurs

2. Discounted Payback Period
• Accept–reject rule: If discounted payback period is less than the life of the project,
the project is accepted.
• Discounted payback period is more reliable than the simple payback period as it
considers the time value of money.
• The only disadvantage of discounted payback period is that it ignores the cash
inflows of the firm after the payback period is over.

1. Accounting Rate of Return (ARR)
Method
• ARR is the ratio of the after-tax profits of the firm and the average investment
made by it.
• This method uses the accounting information contained in the financial

statements of a company. Using the statements, the profitability of the
investment is measured.
• Decision criteria: After ARR has been calculated, it is compared with the required
rate of return. If ARR is greater than the required rate of return, the project is
accepted, else it is rejected.
2. Accounting Rate of Return (ARR)
Method
• ARR is computed by using the following formula:
Average income
ARR =
Average investment
𝐸𝐵𝐼𝑇 (1 −𝑇)
Average income = σ𝑛𝑡=1
𝑛
𝐼0+𝐼𝑛
Average investment =
2
𝐸𝐵𝐼𝑇 (1 −𝑇)
σ𝑛
𝑡=1
Thus, ARR = 𝑛
(𝐼0+𝐼𝑛)/2
1. Modified Internal Rate of Return
(MIRR) Method
• Modified IRR (MIRR) is the modified version of the IRR method of capital
budgeting.
• It is used to rank the alternative investments of equal size. MIRR is computed as
follows:
𝐹𝑉 (𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠, 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

MIRR = −1
𝑃𝑉 (𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦𝑠, 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝐶𝑜𝑠𝑡
• MIRR assumes that the positive cash flows to a firm are reinvested at the rate of
cost of capital of the firm.

2. Modified Internal Rate of Return
(MIRR) Method
• MIRR was introduced to solve the problem of IRR as follows:
– ‰
IRR is misapplied under the assumption that the cash flows earned are
invested at IRR.
– ‰
More than one IRR can be found for the projects.
Varying Opportunity Cost of
Capital
• The opportunity cost of capital refers to the expected return that a firm has to
forgo when it decides to invest in one project instead of another.
• While evaluating projects, it is assumed that the opportunity cost of capital

remains consistent over the entire time period. However, this may not always
hold true.
• If the opportunity cost of capital keeps changing, evaluation of projects using the
IRR method becomes difficult. This is because there is no unique benchmark
opportunity cost of capital against which the IRR can be compared.
• On the other hand, NPV can be used for evaluating projects even when the
opportunity cost of capital keeps changing over time.
Concept of Economic Value Added
(EVA) and Market Value Added
(MVA)
• Economic Value Added (EVA) is measured on the basis of the past performance of
a firm.
• In this method, it is ascertained whether or not a firm is earning a higher rate of

return on the invested funds than the weighted average cost of acquiring the
funds.
• EVA measures company performance on the basis of residual wealth, which is

computed by deducting the cost of capital from its operating profits. EVA is
computed by using the following formula:
EVA = [Net Operating Profits after Taxes – (Total Capital × WACC)]

Let’s Sum Up
• Capital budgeting is a process in which the firm/investor evaluates all long-term

‰
investment options.
• Before evaluating any investment option, the future benefits from that option
should be estimated in monetary terms.
• There are three types of investment decisions—accept-reject decisions, mutually

exclusive project decisions and capital rationing decisions.
• NPV is the difference between total present value of future cash inflows and the
total present value of cash outflows.
• IRR is the discount rate at which NPV becomes zero.
• PI is the ratio of the present value of all cash inflows at the desired rate of return
to the initial cash outflow (initial investment).
Chapter 3: Cost of Capital
Analysis
Chapter Index

From-To
2 Topic 1 Concept of Cost of Capital 59-62
3 Topic 2 Components of the Cost of 63-72

Capital
4 Topic 3 Capital Assets Pricing Model 73-75

(CAPM)
5 Topic 4 Weighted Average Cost of 76-77

Capital (WACC)
Chapter Index

From-To
6 Topic 5 Floatation Costs, Costs of 78-80

Capital and Investment
Analysis
7 Let’s Sum Up 81
• Define the concept of cost of capital
• Explain the components of cost of capital
• Discuss Capital Assets Pricing Model (CAPM)
• Explain Weighted Average Cost of Capital (WACC)

1. Concept of Cost of Capital
• Capital invested in business comes with the respective cost called the cost of
capital.
• In the words of John J. Hampton, the cost of capital is the rate of return the firm
required from investment in order to increase the value of firm in market place.
• In simple words, it can be concluded that an investor invests money for earning
return and that return is known as the cost of capital raised by the borrower
(firm).
• The cost of capital depends on the mode of financing. The combination of

financing mode can be used by many firms and for that they calculate weighted
average of all capital sources
• The management of a firm needs to pay due diligence while making decisions
pertaining to the calculation of the cost of capital due to the following aspects:
Investment Evaluation and Project

Appraisal
Designing Debt Policy

• Investment evaluation and project appraisal: The cost of capital is considered as

a vital tool to evaluate the performance of the project. Each method made for the
evaluation of investment decisions considers the cost of capital as the cut-off rate.
Therefore, the cost of capital acts as a rational mechanism that helps in making
the optimum investment decision.
• Designing debt policy: The cost of capital is considered as a yardstick of

determining the optimality of funds raised while designing the appropriate
capital structure of a firm.
• Opportunity cost refers to the cost of the second best alternative that is foregone
so that a certain action can be pursued.
• It is an economic concept that explains the significance of the scarcity of

resources.
• Due to the scarcity of resources, it is not possible to invest available money in all
desired resources. Therefore, an investor has to opt for some security.
• For choosing that respective security, he/she has to forego the return that might
be earned by him/her from investing in the second best alternative and this is
called the opportunity cost of capital.
1. Components of the Cost of
Capital
• A business firm can raise capital from a variety of financing modes that include
equity and bank loan.
• Each mode is associated with the respective cost that is termed as components of
the cost of capital. These components are:
Cost of Debt
Cost of Preference Shares
Cost of Equity
Cost of Retained Earnings

Capital
Cost of Debt
• The cost of debt refers to the interest rate on new borrowing. The cost of debt
computations are used when perpetual/irredeemable debentures are issued by
the company or if the company arranges funds from banks in the form of bank
loans.
• The formula used for the computation of the cost of debt is:
Kd = I(1− t)/B
Where
Kd is the cost of debt; I is the interest rate paid; t is the tax rate; B is the face
value of debenture
Capital
Cost of Debt
• Redeemable debentures refer to debentures that a company is bound to repay
after a certain time. The equation used for the computation of redeemable debt is:
1
𝐼+𝑛 𝑃−𝑁𝑝
Kd = 1 (1-t)
(𝑃+𝑁𝑝)
2
Where,
I is the annual interest payable
P is the redeemable value of the debenture
Np is net proceeds from the issue of debentures

Capital
Cost of Debt
N is the number of years to maturity
t is the tax rate
Kd is the cost of debt

Capital

• The cost of preference shares can be defined as expected return by shareholders
owing preference capital of a company.
• The company is not legally bound to pay dividend on preference shares but it does
not imply that a company raises capital through preference shares with an
intention of not paying dividends.
• Whenever a company earns sufficient profits, it declares dividends on preference

shares.
• Although the payment of dividend on preference shares is not mandatory for a

company but it is necessary to maintain market reputation, investor’s trust and
market value of preference shares.
Capital

• The cost of redeemable preference share capital is computed by using the
following formula:
𝐷
Kp =
𝑁𝑝
Where
Kp is a cost of preference shares
D is fixed rate of dividend given on preference shares
Np is the issue price of preference shares

Capital

• The cost of irredeemable preference shares are calculated by using the following
formula:
𝐷+ 𝑃−𝑁𝑝 /𝑛
Kp =
𝑃+𝑁𝑝 2
Where
Kp is the cost of preference shares
D is the fixed rate of dividend on preference shares
P is redeemable value of the preference shares
Np is net proceeds from the issue of preference shares
n is number of maturity period

Capital
Cost of Equity
• Cost of equity can be defined as the return that is expected by equity
shareholders/owners of a company.
• It is the return (often expressed as a rate of return) a firm theoretically pays to

its equity investors, i.e., shareholders, to compensate for risk they undertake by
investing their capital.
Capital
Cost of Equity
• The cost of equity can be calculated using a number of approaches as follows:
Dividend Price Approach
Earning Price Approach
Dividend Price Plus Growth

Approach
Capital
Cost of Retained Earnings

• Retained earnings refer to the portion of profit that is retained by company and
not distributed to shareholders. They are also called corporate savings.
• Retained earnings are considered one of the most important modes of financing
for a company.
• The cost of equity is considered the cost of retained earnings.
• Only one thing that differentiates is that the current market price prevailing for
existing shares is considered in place of issue price of an equity share.
1. Capital Assets Pricing Model
(CAPM)
• The CAPM model describes a relationship between risk and expected return that
is used to compute the expected price of risky securities.
• This model works on a few assumptions which are as follows:
− ‰
All investors are rational and risk-averse.
− ‰
The expectations of all investors are common with respect to expected
returns, variances and correlation of returns.
− ‰
Investors have common information about markets.
− ‰
Unlimited amounts can be lend or borrowed by an investor under the risk-
free rate of interest.
(CAPM)
• The CAPM model classifies associated risk with a security broadly into two
categories, which are:
Diversifiable Risks
Non-diversifiable Risks
(CAPM)
• According to CAPM, the cost of equity is calculated with the help of the following
formula:
Ke = Rf + β (Rm− Rf )
Where
Ke is the cost of capital
Rf is the rate of return of risk-free asset
β is the beta coefficient
Rm is the required rate of return on the market portfolio of assets

1. Weighted Average Cost of Capital
(WACC)
• A firm can arrange funds from several resources such as shares, debentures and
bank loans and it is not appropriate for a firm to use any specific formula to
compute the cost of capital.
• Therefore, the concept of Weighted Average Cost of Capital (WACC) came into
existence.
• This method helps to calculate the cost of capital for a firm that is arranging
funding from various resources.
• It can be defined as a rate that a company is expected to pay to its investors for
financing the asset base of a company.
• The WACC model is appropriate when a company borrows money from various
sources.
2. Weighted Average Cost of Capital
(WACC)
• WACC is computed by assigning weights to each of the source of funding. If a

company is financed by equity and debt, WACC is determined by using the
following formula:
𝐷 𝐸
Kd + Ke
𝐷+𝐸 𝐷+𝐸
Where
D is total debt
E is shareholders’ equity
Kd is cost of debt
Ke is cost of equity
1. Floatation Costs, Costs of Capital
and Investment Analysis
• The decision of financing assets/raising funds is considered one of the most crucial
tasks performed by a firm.
• This decision affects the overall functioning of a firm and comes with several
attributes that need fair consideration of the firm. These attributes include:
Floatation Costs
‰
Investment Analysis
• F
‰loatation costs: It refers to that additional cost that is borne by the public traded
company when it raises funds by issuing fresh securities. The floatation costs
include underwriting fee, legal fee and registration fee.
• I‰
nvestment analysis: The decision of investing and borrowing funds is associated
with two components, which are risk and return. Before taking any financial
decision, the implication of that decision is analysed on the other firm. Investment
analysis refers to a study pertaining to the expectation of future performance of
the undertaken investment. An organisation must take into consideration the
following during investment analysis:
− The cost of capital is the most prominent factor to be considered by a firm

while conducting investment analysis.
− The cheapest source to raise funds must be considered. Debentures are

considered to be the cheapest source due to the availability of tax deduction
on the quantum of interest paid.
− Additional costs that are associated with raising finance (includes floatation
cost) must be considered.
Let’s Sum Up
• The cost of capital depends on the mode of financing.
• Cost of debt refers to the interest rate on a new borrowing.
• The cost of preference shares can be defined as the expected return by

shareholders owing preference capital of a company.
• Tax deduction is not allowed over the payment made to preference shareholders
because dividend to preference shareholders is given after paying the tax by the
company.
• Retained earnings refer to that portion of the profit that is retained by the
company and not distributed to the shareholders. They are also called corporate
savings.
Chapter 4: Investment
Decisions and Financial
Strategies
Chapter Index

From-To
2 Topic 1 Advanced Investment 88-92

Decisions
3 Topic 2 Investment Decisions and 93-98

Capital Rationing
4 Topic 3 Capital Investments 99-104

Chapter Index

From-To
5 Topic 4 Qualitative Factors and 105-109

Judgments in Capital
Budgeting
6 Let’s Sum Up 110

• Define advanced investment decisions
• Explain the concept of capital rationing
• Explain the importance of capital investment
• List and discuss qualitative factors and judgments in capital budgeting

1. Advanced Investment Decisions
• Investment can be classified into two categories: long run and short run. Long-
term investment decision have a bigger impact as they are irreversible in nature
and ask for a huge quantum of funds.
• Capital budgeting techniques are used to evaluate various long-term investments

and decide the best option along with various considerations, which are:
Investment
P
‰rojects with
Timing and
Different Lives
Duration
Replacing an
Existing Asset
Projects with Different Lives

• Different prospective proposals may have different life tenures. This means that
they have different terminal periods.
• The valuation should consider the attribute pertaining to the different life spans
of projects so that ambiguities can be cleared. This can be done by using the
annual equivalent value (AEV) method.
• According to the AEV method, the project with lower annual cost is selected.
• This method handles the problem of calculating the replacement chains for a
period that is the least common multiple of the lives of the projects.
Investment Timing and Duration

• The timing of undertaking a project is also very crucial as some projects need to
be undertaken once in the entire lifetime, while some are strategically important
for the firm.
• There could be a possibility that a project may seem non-profitable in the short
term, but it can be undertaken in the long run.
• Therefore, there is an option that some projects can be postponed for a certain
period of time, while some can be undertaken at any time in the future.
Investment Timing and Duration

• The projects that can be postponed involve two alternatives—undertake the
investment either now or at a later stage.
• It is important to note that postponing a project comes with several uncertainties.
• To calculate the optimum timing of the proposal, the firm needs to compare the
NPVs of the alternative investment dates.
Replacing an Existing Asset

• Assets contribute directly to the productivity of a firm. If the firm acquires an
optimum level of assets, it attains a strong position.
• Each asset and project has its own life span, after which it needs replacement.
• A firm may possibly come across a new economical machinery during the life span
of its existing machinery. In such a case, the impact of the decision pertaining to
the change in the existing machinery gets intensified.
• A firm needs to consider an economic analysis before taking the replacement

decision.
1. Investment Decisions and Capital
Rationing
• Every business firm suffers from the scarcity of funds.
• There are several investment proposals and assets that firm can purchase to
enhance profitability.
• However, the scarcity of funds creates a constraint. Scarcity refers to the

limitation of resources.
• This limitation of resources makes it necessary for a firm to choose from the list
of alternatives to invest their funds. This situation leads to capital rationing.
• Capital rationing refers to a situation where the choice of investment proposals is

made under various financial constraints.
Rationing
• Capital rationing can be classified into two types, which are:
‰oft Capital Rationing/Internal

S
Rationing
Hard Capital Rationing/External

Rationing
Rationing
• Soft capital rationing/internal rationing: This occurs when a firm faces challenges
in raising funds because of the internal policies. Soft capital rationing takes place
due to the following reasons:
Increment in the
Decision of the
‰
Opportunity Cost
Promoter
of Capital
Future
expectations
Rationing
• Decision of the promoter: It could be the decision of promoters to restrain raising

funds from external sources in the early stages of a project to secure and exercise
control over the project in its initial years.
• Increment in the opportunity cost of capital: A firm may prefer to raise a lesser
amount of external funds so that the capital structure of the firm can include
more of secure investments.
• Future expectations: The firm may impose soft capital rationing because of the
•
opportunities available in the future. In such a case, the firm would try to retain
the holding of the company in a few hands only. This will ensure the distribution
of future profits in a few hands.
Rationing
• Hard capital rationing/external rationing: This occurs when a firm faces

challenges in raising funds from external markets. This leads to the shortage of
capital that can hamper the contribution of new projects in the firm. Hard capital
rationing takes place due to the following reasons:
Start-up Firms
‰ Poor Management
Lender’s Industry-specific
Restrictions factors
Rationing
• Start-up firms: Generally, new firms find it difficult to raise funds from equity
markets because the investor market may doubt the profitability of a new firm.
• Poor management: A firm having a bad track record of poor management finds it
•
difficult to raise funds from external sources.
• Lender’s restrictions: Several times, medium and large firms arrange funds from
institutional investors and banks. To maintain the security of their repayment,
these institutes often impose restrictions over the concerned firm, which affects
the fund-raising strategy of a firm.
• Industry-specific factors: A firm related to an industry facing downfall would find

it difficult to raise funds from external sources.
1. Capital Investments
• The term capital investment refers to the funds invested in a firm for furthering
the objectives of the firm.
• In simple words, capital investment refers to the money invested in a business

with the expectation of earning income over a long period of time.
• The investment in capital assets affects the profitability and functioning of the
firm. Therefore, it is important to take decision pertaining to the acquisition of
capital assets with proper consideration.
• Capital investment usually involves huge cost, owing to which a firm needs
proper planning and control.
Planning and Control of Capital Investments

• Planning and control of capital investment help the management of a firm to
invest money in the most profitable capital assets. The steps involved in it are:
Pre-
select
Evaluate Select
Control

1. Pre-select: At this stage, the business needs for investments are evaluated. The
management confirms if the respective capital investments would satisfy the
business needs. In simple words, the firm gathers data pertaining to all the available
capital investments that could be performed in fulfilling the mission and vision
statement of the firm.

2. Selection of the project: In the pre-select stage, the firm explores many options
that could be beneficial for the firm in achieving the underlined objective. Once those
options are identified and explored on the criteria chosen by the firm, the selection of
the optimum option takes place. Under this stage, the parameters are specified for
selecting a project and, those that satisfy the given parameters, are opted for.

3. Control: The third important stage ensures the control of the undertaken capital
investment. The control of the investment helps in retrieving the anticipated results
from the undertaken project. The capital investment delivering the anticipated
outcome proves to be an asset for the firm. On the other hand, the capital investment
not delivering the anticipated profit can become a liability for the firm. Control
ensures that all the undertaken capital assets are considered an asset for the firm by
contributing the anticipated results.

4. Evaluate: This is the last stage that evaluates the performance of the undertaken
project. This is the last stage in which the evaluation takes place. It evaluates
whether the investments deliver the desired output or not. If the desired output is
not retrieved by the capital investment, the reasons are identified for the variations.
Evaluation is basically carried out by measuring the actual results against the
planned results so that any deviation from the expected outcome can be evaluated.
1. Qualitative Factors and
Judgments in Capital Budgeting
• All factors affecting capital budgeting decisions can be classified into quantitative
and qualitative categories.
• All quantitative factors result in the outcome that are expressed in numerical
terms, such as price and return on investment.
• On the other hand, qualitative factors are measured subjectively.
• In the current scenario, there is a wide range of qualitative factors considered by

managers while making capital investment decisions.
• Qualitative factors that affect capital decisions are:
Quality of
Culture of a Firm
‰
Product/Service
Concerns related
‰
Ethical
to the
Considerations
Environment
• Culture of the firm: Capital investments affect the structural composition of a

firm. Before making a capital investment decision, the management of the firm
needs to understand the effects of that decision on the culture of the firm. The
culture includes the value of the firm and employees, the working style and the
motivational level of the workforce.
• Quality of product/service: Capital investments are always made to enhance the

productivity of a firm to produce goods or deliver services. The quality of capital
resources directly affects the quality of goods or services. The firm should strike a
balance between cost and quality while making decisions pertaining to the
maximisation of investment efficiency.
• Concerns related to the environment: In the current scenario, the society is aware
about the protection of the environment. Therefore, many companies have started
including expenditure in their budgets to serve this important cause of
community development. These factors may seem qualitative, but in the long run,
this results in quantitative terms, such as an increase in revenue or sales. A firm
must consider the impact of capital investment on the environment.
• Ethical considerations: There are many ethical considerations that need to be

taken into account by the management of a firm while taking decisions related to
capital investment. It includes safety of employees, generation of employment
and community development. All this can be done by making capital investment
in new facilities and equipment that contribute on the ethical ground irrespective
of the fact whether they are generating economic profits for the firm on not.
Let’s Sum Up
• Investment decisions are considered one of the most prominent decisions made by
a firm. It is owing to the fact that these decisions impact almost every decision
that is made by the firm.
• Assets contribute directly to the productivity of a firm. If the firm acquires an

optimum level of assets, it attains a strong position.
• The management of a firm needs to consider economic analysis before taking the
replacement decision.
• The term capital investment refers to the funds invested in a firm for furthering
the objectives of the firm.
• The process of planning and control of capital investment includes different

stages of pre-select, selection of the project, control and evaluate.
Chapter 5: Capital
Structure (Theory and
Policy) and Valuation
of a Firm
Chapter Index

From-To
2 Topic 1 Capital Structure 118-120
3 Topic 2 Relevance of Capital Structure 121-123

Approach
4 Topic 3 Irrelevance of Capital Structure 124-125

Chapter Index

From-To
5 Topic 4 Relevance of Capital 126-127

Structure: MM Hypothesis
with Taxes
6 Topic 5 Trade-Off Theory: Costs of 128-129

Financial Distress and Agency
Costs
7 Topic 6 Pecking Order Theory 130-131

Chapter Index

From-To
8 Topic 7 Capital Structure Planning 132-137

and Policy
9 Topic 8 Valuation and Financing 138-145

• Define capital structure
• Explain the effect of capital structure on the valuation of a firm
• List and discuss various approaches to capital structure
• Explain the concepts related to valuation and financing

1. Capital Structure
• The capital structure of a firm refers to a mix of various financial securities that
are used to finance its various assets.
• According to Gerestenberg, capital structure of a company refers to the

composition or make up of its capitalization and it includes all long term capital
resources viz. loans, reserves, shares and bonds.
• Keown et al. have defined capital structure as balancing the array of funds
sources in a proper manner, i.e., in relative magnitude or in proportions.
• In simple words, capital structure is a mix of both short-term and long-term debt,
equity share capital and preference share capital.
• Capital structure decisions include two important aspects, which are:
Mode of Financing
‰
Proportion of Securities in Capital

Structure
• Various factors are taken into consideration while determining the capital
structure of a firm. These factors are:
Position of Cash
‰ Interest Coverage
‰
Flow Ratio (ICR)
Return on
Control
Investment (ROI)
1. Relevance of Capital Structure
Approach
• There are two types of approaches that define the relationship between capital
structure and value of a firm.
• One approach states that the capital structure has an impact on the value of a
firm, and the other states that it has no impact.
• There are two approaches that assert that the capital structure has an impact on
the valuation of a firm. These two approaches are:
− Net Income (NI) approach
− Traditional approach
Approach
Net Income (NI) Approach

• According to the NI approach, suggested by David Durand, the decision about
capital structure plays an important role in the valuation of a firm.
• It discusses the relationship between the cost of capital, financial leverage and
valuation of the firm. The NI approach is based on the following assumptions:
– Capital requirements are given and constant.
– ‰
Cost of debt (Kd) is less than the cost of equity (Ke).
– ‰
Kd and Ke are constant.
– ‰
Increase in the financial leverage means that the proportion of debt does not
affect the risk perception of the investor.
Approach
Traditional Approach
• Unlike the NI and NOI approaches, the traditional approach takes the
intermediate path to define the impact of capital structure on the value of a firm.
• This approach advocates the need for the right combination of equity and debt to
be taken by the firm so that it can maximise its value.
• The following assumptions are made in the traditional approach:
− ‰
The rate of interest on debt remains constant only for a certain period, and
thereafter, it results in increased leverage, which increases the cost of debt
for the firm.
− ‰
The cost of equity remains constant for a certain period.
1. Irrelevance of Capital Structure
Net Operating Income (NOI) Approach

• There are some authorities that believe that capital structure does not impact the
value of a firm.
• The NOI approach supports the absence of a relationship between the capital
structure and the value of a firm.
• The NOI approach makes the following assumptions:
− To compute the valuation of a firm, an investor considers the capitalisation of

the firm.
− ‰
WACC (Ko) is constant.
− ‰
Kd remains constant.
2. Irrelevance of Capital Structure
MM Hypothesis Without Taxes

• The MM hypothesis without taxes approach suggests that the market value of a
firm is affected by its future growth prospects.
• The following assumptions are made under the MM approach:
– There are no taxes involved.
– The securities are divisible.
– Investors have information about risk and return.
– Investors are rational in nature.
– Personal and corporate leverages are the same.
– ‰
The firm does not need to pay tax.
1. Relevance of Capital Structure:
MM Hypothesis with Taxes
• The assumption of no corporate tax was considered to be unrealistic, and

therefore, it was decided to not include it in the MM approach.
• According to the MM approach, the market value of a firm can be increased by

using the maximum quantum of debt.
• It is important to find out the degree or extent to which a firm would finance its
capital structure with the help of debts. There could be two possibilities:
− ‰
The impact of personal and corporate taxes needs to be considered on the
firm’s borrowing.
− Borrowing may result in extra cost, known as cost of financial distress.

2. Relevance of Capital Structure:
MM Hypothesis with Taxes
Financial Leverage and Corporate and Personal Taxes

• Investors get the net amount that remains with a firm after it has paid corporate
tax.
• It is also important to note that personal tax is required to be paid by the

investors on the amount earned from the firm.
• Suppose the expected net operating income of the firm is `500. The firm has two
options: Either it can distribute the amount as interest over debts or it can
distribute it as return on equity.
• If the firm chooses to pay the full amount of the net operating income as interest,
it is not liable to pay corporate tax; however, in this case, the investor is required
to pay personal tax.
1. Trade-off Theory: Costs of
Costs
• According to the trade-off theory of capital structure, a firm would choose the
amount of debt finance and equity finance to use by balancing the costs and
benefits.
• The debt option comes with tax deduction and hence is counted as a cheap source
of financing.
• The trade-off theory states that a majority of firms finance their capital structure
with the debt component, which leads to financial distress them.
• The debt option carries several types of costs, such as bankruptcy cost of debt,
which means the firm’s inability to make payment to the debenture holders.
2. Trade-off Theory: Costs of
Costs
• The debt option also carries non-bankruptcy costs, which can take the following
forms:
− ‰
Low morale of employees as they are uncertain about their future and may
think of changing their jobs
− Liquidation worries of customers and concerns about the quality of the

products offered
− Discontinuation of the provision of credit by suppliers, which can further

impact the operations of the firm
− ‰
Uncertainty of shareholders over their investments, which they want to
withdraw
1. Pecking Order Theory
• The pecking order theory works on the concept of asymmetric information.
• Asymmetric information refers to a situation where one party in a transaction

has better access to information that could impact the result of the transaction.
• This theory states that managers generally have more information about a firm
than investors.
• According to this theory, managers prefer to raise capital from the debt option if
they are sure that the firm would do well in future. On the other hand, if they are
unsure, they prefer to arrange finance from the equity option.
• The theory argues that raising capital through debts means the managers are
quite sure that they would be able to maintain a steady cash outflow in the form
of fixed interest payment in the future.
2. Pecking Order Theory
• On the other hand, if a firm prefers to raise funds through equity, it implies that
the managers find the rate of shares to be overvalued.
• Therefore, the way a manager raises capital for a firm indicates his/her
perception about the future prospects of the firm.
• While financing projects, a firm first uses its internal funds; thereafter it uses
debts; and finally, when no other source is left, it uses equity to finance a project.
1. Capital Structure Planning and Policy
• The capital structure of a firm is the result of all the financial decisions
undertaken by its financial managers.
• Practically, financial managers should select an optimum capital structure so

that the value of the firm can be increased. The following are the key factors that
govern capital structure:
Determination
‰ Maturity and
‰
of capital mix priority
Terms and
conditions
• Determination of capital mix: A firm must decide on the capital mix, that is, it
must determine the composition of debt and equity in the capital structure.
• Maturity and priority: Different financial instruments come with different

‰
maturity periods. Equity is treated as permanent capital. On the other hand,
debt has different maturities.
• Terms and conditions: The issuance of equity requires a firm to fulfil fewer terms
‰
and conditions than the issuance of debt instruments, which includes payment of
interest to ensure the safety of borrowers.
• A financial structure can be analysed from different perspectives. A popular

method of analysing capital structure is the FRICT analysis, which is stated as
follows:
Flexibility Risk
Income Control
Timings
Approaches to Establishing Target Capital Structure

• Most common approaches that are taken by firms to determine their target
capital structure are:
EBIT-EPS Analysis Approach

‰
Cash Flow Analysis Approach
Valuation Approach

• EBIT-EPS analysis approach: This approach helps in analysing the effects of
debts on risks and returns to shareholders. A firm evaluates various financing
plans and considers their impact on EBIT and Earnings Per Share (EPS). If the
cost of equity is more than the cost of debt, the firm can increase EPS by raising
capital through debts.
• Cash flow analysis approach: This approach helps in evaluating the ability of a
firm in paying debts and avoiding financial distress. It ensures that the cash flow
of the firm is sufficient to meet its debt obligations.

• Valuation approach: Debts are considered a cheaper source of finance than equity,
but they come with financial leverage. The debt option may result in enhanced
financial distress for a firm and increases the cost of equity. Tax deduction on
interest payment adds to the return earned by the shareholders, but it also leads
to financial distress and agency costs. Hence, the firm should raise capital
through debts till the WACC of the firm reaches the minimum point. Once WACC
starts increasing, the firm should not raise more capital from the debt option.
1. Valuation and Financing
Relation between Beta, Cost of Capital and Capital Structure

• Financial leverage introduces variation in the returns earned by equity
shareholders.
• This variation creates financial risks and further leads to increment in the beta of
the levered firm’s equity.
• On the other hand, the unlevered beta is a measure of the business risk of a firm.
• To derive beta, equity beta and debt beta can be used.
• Beta can be calculated as follows:
Asset beta = β of Asset 1 x weight of Asset 1 + β of Asset 2 x weight of Asset 2 +

…… β of Asset n x weight of Asset n.
Relation between Beta, Cost of Capital and Capital Structure

• A firm usually finances its assets through debts and equity. In such cases, the
following formula can be used to calculate β:
Asset beta = Equity β x equity weight + Debt β x debt weight
• In CAPM, the assets and opportunity cost of capital of a pure equity can be
computed as follows:
Ka = Rf + Rpβa
Where
Ka = Opportunity cost of capital; Rf = Risk-free rate
Rp = Risk premium; βa = Beta of asset

FCFs and WACC

• Free Cash Flow (FCF) represents the cash that a firm is able to generate after
laying out the money required to maintain or expand its asset base. It can be
calculated as follows:
FCF = EBIT (1-t) + D – change in WC – CAPEX
Where
EBIT = Earnings before interest and tax; T = Tax rate; D = Depreciation
WC = Working capital; CAPEX = Capital expenditure
• WACC is used as a discount rate for calculating the value of a firm. It can be
calculated as follows:
WACC = Cost of equity × Weight of equity + Cost of debt × Weight of debt

CCFs and Opportunity Cost of Capital

• In the FCF approach, the effect of the interest tax shield is adjusted by using the
discounted rate (WACC) in place of cash flows.
• An alternative to this is the Capital Cash Flow (CCF) approach. In this approach,
WACC is not used to make adjustments in the interest tax shield.
• Instead, CCF is discounted at the opportunity cost of capital of the project.

Therefore:
CCF = Free cash flow + Interest tax shield

Adjusted Cost of Capital: Perpetual Cash Flows

• The adjusted cost of capital of a project is the rate at which the Net Present Value
(NPV) of the project is zero.
• The opportunity cost of capital is reduced by the value of the project through
addition to the debt capacity of the firm and is treated as the adjusted cost of
capital.
• A firm can use this adjusted cost to discount other projects having similar
business risks.
• In place of Adjusted Present Value (APV), a project’s free cash flow can be
discounted as the adjusted cost of capital.
Adjusted Cost of Capital: Perpetual Cash Flows

• The adjusted cost of capital is used in the MM approach for calculating the cost of
capital of a levered firm.
• Adjustments to the interest tax shield are made while calculating the opportunity
cost of the capital. Thus:
Adjusted cost of capital for a levered firm = Opportunity cost of capital (1-tax
rate × leverage)
• The following points are assumed in the adjust cost of capital approach:
− ‰
The firm has perpetual cash flows.
− ‰
The amount of debt is given and remains constant.
Choosing an Appropriate Valuation Approach

• A firm can use any valuation approach including APV, FCF and CCF. The
approach that is eventually selected depends on the convenience of calculation.
• The APV or CCF approach would be a better option where the debt amounts to be
paid in the future or the repayment schedule has been given.
• In case a firm has a fixed proportion of the debt as part of a specific project’s
capital structure, WACC is preferred. This is because in the given capital
structure, it is easier to consider the interest tax shield while using WACC.
• It is important to note that the APV approach is more dynamic and versatile in
nature as it considers several side effects of the NPV approach, including the
changing amount of the debt.
Valuation of a Firm
• One of the most appropriate theoretical approaches used to find out the value of a
firm is discounted cash flows.
• According to this approach, the expected cash flow of the firm is discounted.
• Usually, WACC is considered an appropriate discount rate to calculate the

valuation of a firm.
• The following formula is used to determine the value of a firm:
∞
𝐹𝐶𝐹𝑡
V=෍
1 + 𝐾𝑜 𝑡
𝑡=1
Let’s Sum Up
• The capital structure of a firm refers to a mix of various financial securities that
are used to finance its various assets.
• According to the NI approach, suggested by David Durand, the decision about

capital structure plays an important role in the valuation of firms.
• U
‰nlike the NI and NOI approaches, the traditional approach takes the
intermediate path to define the impact of capital structure on the value of firm.
• T
‰he pecking order theory works on the concept of asymmetric information.
• An FCF represents the cash that a firm is able to generate after laying out the
money required to maintain or expand its asset base.
• The adjusted cost of capital ACC of a project is the rate at which the NPV of the
project is zero.
Chapter 6: Dividend
Decision
Chapter Index

From-To
2 Topic 1 Forms of Dividend 153-155
3 Topic 2 Dividend Policy: Issues and 156-159

Objectives
4 Topic 3 Theories Supporting Dividend 160-164

Relevance
5 Topic 4 Theories Supporting Dividend 165-166

Irrelevance
Chapter Index

From-To
6 Topic 5 Major Considerations in 167-174

Dividend Policy

• Define dividend and dividend policy
• Describe the theories supporting dividend relevance
• Explain the theories supporting dividend irrelevance
• List and Discuss the major considerations in dividend policy

1. Forms of Dividend
• The term dividend can be defined as the distribution of a portion of earnings

made by the firm.
• All decisions pertaining to the distribution of dividends are taken by the Board of
Directors.
• A firm can distribute dividends in several forms, such as cash payments, shares
of stock or in the form of some property.
• According to the Institute of Chartered Accountants of India, dividend is defined

as a distribution to shareholders out of profits or reserves available for this
purpose.
• In simple words, dividend refers to the distribution of profits amongst the
shareholders of the firm.
Various forms of dividend are:
Scrip
dividend
Property Cash
Dividend Dividend
Forms of
Dividend
Liquidati
Buy Back
ng
of Shares
Dividend
Bonus
Shares
• Cash dividend: As the name suggests, this dividend is paid in the form of cash. It
is paid out of the Profits After Interest and Tax (PAIT).
• Liquidating dividend: This kind of dividend can be observed only at the time of
the closure of a company. In this, the original capital is returned.
• Bonus shares: A firm prefers to pay bonus shares as dividend. This is usually
done when the firm has insufficient cash for the payment of dividend.
• Buy back of shares: It refers to the purchase made by a firm of its own shares
from the marketplace.
• Property dividend: This dividend is paid in the form of asset other than cash.
This form is not very popular in India.
• Scrip dividend: This option is preferred by a firm when it encounters insufficiency
of funds to be distributed as dividends.
1. Dividend Policy: Issues and
Objectives
• A dividend policy refers to the rules and regulations made by a firm pertaining to
the distribution of profits to its owners or stockholders.
• Dividend policy is a kind of financing decision because the profits retained could
also be used as a means of financing the operational requirements of the firm.
• While designing the dividend policy of a company, some legal restrictions should
be considered, which are:
– If the liabilities of the firm exceed its assets.
– ‰
If the proposed dividend exceeds the retained earnings.
– ‰
Debt holders and preferred stockholders may impose some restrictions. They
may articulate that interest on debt and dividend on the preferred stock
should be paid before the distribution of the dividend amount.
Objectives
The three main approaches to the payment of dividends are:
Residual Dividend Policy

‰
Dividend Stability Policy
Hybrid Dividend Policy

Objectives
• Residual dividend policy: In this, the company is dependent on internally

generated equity for the financing of new projects. In other words, the dividends
are paid out of the capital left after making payments towards the project
financing.
• Dividend stability policy: In this policy, quarterly dividend is paid on a regular

basis. A fraction amount of the yearly income is distributed as dividend on
regular intervals.
• Hybrid dividend policy: This policy is a combination of the residual and stable
dividend policy approach. It is adopted to ensure that an optimum debt equity
ratio is maintained for a long term rather than short term.
Objectives
The objectives of a dividend policy are:
Objectives of a
Dividend Policy
Future Stability in
Maximisation Exercise
Expansion the Rate of
of Wealth Control
Plans Dividend
1. Theories Supporting Dividend
Relevance
• There are two theories that analyse the impact of distribution of dividend on the
valuation of the firm.
• These theories support the opinion that a firm observes a variation in the value of
the firm with respect to the distribution of the dividend. These theories are:
Walter’s Model

Gordon’s Model
Relevance
Walter’s Model
• The Walter’s model argues that the value of a firm is contingent on the choice of
the dividend model. In this model, a relationship is established between the firm’s
internal rate of return and its cost of capital.
• This model is based on the following assumptions:
− Retained earnings are used to finance all investment proposals.
− Funds are not arranged by issuing fresh equity and debentures.
− ‰
The rate of return and cost of capital of the firms remains constant.
− ‰
Either the firm will have 100% retention rate or 100% dividend payout rate.
− ‰
Initial EPS and Dividend Per Share (DPS) of the firm remain constant.
Relevance
Walter’s Model
• Walter evolved the following mathematical formula to determine the market
value of a share:
𝑟
𝐷+ 𝑘 𝐸−𝐷
𝑀=
𝑘
Where
M is the market price of a share
D is the DPS
r is the internal rate of return
E is the EPS
k is the cost of capital
Relevance
Gordon’s Model
• This model states that the dividend policy of a firm does affect the value of the
firm.
• The model has the following assumptions:
− The firm is totally financed through equity capital. This means that no
capital is raised through debt.
− ‰
There is no external source of finance used for financing the firm.
− ‰
The return and cost of capital of the firm remain constant.
− ‰
The life of the firm is perpetual.
− ‰
There are no taxes in the system.
− ‰
Cost of capital is higher than the growth rate.
Relevance
Gordon’s Model
• The mathematical formula used in Gordon’s model is given as follows:
𝐸 1−𝑏
𝑀=
𝑘 − 𝑏𝑔
Or
M = [D (1 + g)/k – g]
Where
M is the market value of a share; E is the earning per share; b is the retention
ratio of the firm; 1 – b is the portion of the earnings distributed as dividend; k is
the capitalisation rate; r is the rate of growth; g is the growth rate of the firm = b × r
Irrelevance
Modigliani-Miller (MM) Hypothesis

• According to the MM hypothesis, the dividend policy of a company is not relevant
in perfect market conditions and it does not affect the value of the firm.
• This model assumes the presence of perfect market conditions where an investor
is rational and gives equal preference to dividends and capital gains.
• The MM approach is based on the following assumptions:
− Capital market is a perfect competition market.
− ‰
Investors make rational decision.
− ‰
There are no taxes to be paid.
− ‰
There is no risk of uncertainty.
− ‰
Investment policy of a firm is fixed.
Irrelevance
Modigliani-Miller (MM) Hypothesis

• According to this hypothesis, the following is the formula to calculate the share’s
market price at the end of a period:
P1 = P0 × (1 + k) – D
Where
P1 is the share’s market price at the end of a period
P0 is the share’s market price at the beginning of a period
k is the cost of capital
D is the dividend
1. Major Considerations in Dividend
Policy
Dividends and Uncertainty: The Bird-in-Hand Argument

• This is an argument in which Modigliani-Miller assumptions are relaxed. It is
based on the fact that a bird in hand is worth two in the bush.
• Similarly, the present dividend is better than the amount that shall be received in
future.
• Gordon argues that the future is uncertain and therefore predicting the correct
amount of dividend for the future is very unlikely.
• Therefore, if the current dividend is withheld in anticipation of earning a higher

profit in the future, it is unlikely to state whether in future the shareholders
would be able to earn that dividend or not.
Policy
Dividend Policy under Market Imperfections

• MM hypothesis works on the assumption of perfect competition market.
• It considers that the financial markets function in the absence of many

imperfections, such as tax, flotation cost and transaction cost.
• In other words, MM hypothesis assumes that capital markets are perfect, which
refers to the fact that there are no taxes, flotation costs or transaction costs;
however, these conditions are just imaginary.
Policy
Informational Content of Dividends: Information Asymmetry and Conflict of Interest
• The informational content is the information that is provided by the firm to its
investors pertaining to the expected dividend and earnings of the firm.
• Information content helps owners to bid for the prices of the shares.
• Information asymmetry refers to a situation where one party possesses

comparatively more and better information than others.
• The informational content just acts as a parameter of future profitability of the

firm and helps in determining the value of the firm.
• This results in an imbalance of power in transactions and further leads to the

conflict of interest of various parties.
Policy
Practical Considerations in the Dividend Policy

• Various practical considerations while deciding on the dividend policy are:
Profitability of Future Inflow

the Firm of Cash
Legal
Growth Rate
Constraints
Tax Policy Inflation

Policy
Stability of Dividends
• The term stability of dividend refers to consistency in the payment of dividend or
lack of variability in the payment of dividend. In this kind of policy, the payment
of dividend is fixed.
• One form of stability of the dividend is to have a constant payout ratio, which
specifies that a pre-determined rate of dividend is paid on the net earnings of the
company.
• Another form of stable dividend is fixed rupee dividend and an extra dividend. In
this case, a certain amount of fixed dividend is paid.
Policy
Target Payout and Dividend Smoothening

• The target payout ratio measures the size of the dividend of a firm. It is
measured through a stable dividend policy to be followed in the long run
associated with sustainable earnings.
• This ratio can be computed using the following formula:
Target payout ratio = EPS/DPS
• The firm looks at smoothening the dividend payout because if the dividends are
more volatile, the stock is said to be riskier.
• Normally, no firms want to see the prices of their stock tumbling; hence, they
prefer adopting a constant payout ratio to achieve the objective of dividend
smoothening.
Policy
Share Split
• Share split is a corporate action in which the company divides its prevailing
shares into multiple shares.
• In case of splitting of shares, the number of outstanding shares increases, but the
total value of shares remains the same.
• Splitting of shares do not add any value to the share capital of the company.
• A stock price is affected by a stock split. After the splitting of shares, the price of
the stock is reduced as the number of outstanding shares increases.
• If a share is split in the ratio of 2:1, then the number of shares is halved.
Policy
Shares Buyback
• The share buyback is a process in which a firm buys back its own shares from the
market.
• Generally, the share buyback scheme is carried out when the management of the
company feels that its shares are undervalued.
• The objective of shares buyback are to:
− Making internal investment
− ‰
Making modifications in the capital structure
− Eliminating the minority shareholding
− ‰
Creating an impact over earnings per share
Let’s Sum Up
• T
‰he term dividend can be defined as the distribution of a portion of earnings
made by a firm.
• The forms of dividend include cash dividend, bonus share, buy back of shares,
property dividend, scrip dividend and liquidating dividend.
• A dividend policy refers to the rules and regulations made by a firm pertaining to
the distribution of profits back to its owners or stockholders.
• According to Modigliani-Miller (MM) hypothesis, the dividend policy of a

company is not relevant in perfect market conditions, and does not affect the
value of the firm.
• The term stability of dividend refers to consistency or lack of variability in the

payment of dividend.
Chapter 7: Corporate
Restructuring
Chapter Index

From-To
2 Topic 1 Corporate Restructuring — 182-187

Business and Financial
Restructuring
3 Topic 2 Modes of Restructuring 188-193
4 Topic 3 Valuation Concerns in 194-196

Restructuring
Chapter Index

From-To
5 Topic 4 Turnaround Strategies 197-200
6 Topic 5 Financial Distress 201-209

• Explain the concept and motives of corporate restructuring
• Discuss the various modes of corporate restructuring
• Describe the valuation concerns in corporate restructuring
• Explain the various turnaround strategies
• Discuss the concept of financial distress

1. Corporate Restructuring —
Restructuring
• Corporate restructuring refers to the effort to restructure the policies,

procedures, programmes, products, structure, processes or people in a firm.
• According to Justice D.Y Chandrachud, the Chief Justice of Allahabad High

Court, Corporate restructuring is the means that can be employed to meet
challenges which confront businesses.
• Corporate restructuring is carried out by merging or demerging the departments
or units of an existing firm to increase profitability and/or to achieve efficiency in
the operations of the firm.
• The objective of restructuring is to enable the restructured entity to achieve

financial synergy.
Restructuring
• Corporate restructuring is basically of four types, which are:
Financial Restructuring
‰
Technological Restructuring
Market Restructuring
Organisational Restructuring
Restructuring
• Financial restructuring: It involves reorganising the capital of a firm. This is

achieved by buy-back of shares, Corporate Debt Restructuring (CDR),
acquisitions, mergers, joint ventures, strategic alliances, etc.
• Technological restructuring: It involves entering into alliances to gain technical

expertise and know-how.
• Market restructuring: It involves restructuring efforts with respect to a product

or market.
• Organisational restructuring: It involves restructuring efforts aimed at

improving internal structures and procedures.
Restructuring
Motives of Restructuring
• A firm resorts to corporate restructuring when it wants to:
− ‰
Redirect and restructure its activities to expand or increase efficiency or
reduce costs
− Reduce risks and identify and develop core competencies
− ‰
Redirect surplus cash from one business to another business.
− Fulfil the objectives of consolidation to benefit from economies of scale
− Revive and restructure sick units by merging them with profit-making firms
− Get access to regular supply of raw materials
− ‰
Give stiff competition to competitors
Restructuring
• Implementation of corporate restructuring requires efficient pooling of resources
and utilisation of idle resources.
• Before performing corporate restructuring, a detailed study has to be carried out

to understand:
− Market demand
− Resources available
− Idle resources
− Competitor analysis
− Environmental impact
Restructuring
• Ideally, various aspects are considered while planning or implementing
restructuring, which are:
− Valuation and funding of the firms involved in the restructuring exercise
− Legal aspects and procedures that must be adhered to
− Tax and stamp duty involved in restructuring
− Accounting aspects involved in restructuring
− Human and cultural aspects involved in restructuring

1. Modes of Restructuring
• There are three basic methods through which restructuring can be performed,
which are:
Expansions
‰
Contractions
Ownership and Control

Expansions
• The literal meaning of expansion is to become larger or more extensive.
• In the context of corporate restructuring, expansion refers to an activity resulting

in the enhancement or increase in the capacity or scope (operations, product
range, etc.) of a firm.
• Some examples of expansions commonly seen in the corporate world are mergers,
consolidations, joint ventures and acquisitions.
Contractions
• A contraction refers to any form of restructuring in which the size of business
units is reduced.
• The objective of a contraction may be to ease the operations of the business unit
or to restructure certain processes.
• Contractions can be achieved through spin-offs, divestitures, carve-outs and sell-

offs.
Ownership and Control

• Ownership and control restructuring involves issues such as who will have the
ownership and control of the firm after it has undergone corporate restructuring,
and to what extent.
• In ownership and control restructuring, usually a new management takes control

under a new board of directors.
• Such a major change may entail further changes in the firm because the focus
and orientation of members of the new board may be different from those of the
people in the earlier setup.
Tax Aspects of Mergers, Acquisitions and Demergers

• The Income-tax Act, 1961 contains provisions applicable for corporate
restructuring activities such as mergers, acquisitions and demergers.
• The tax implications for mergers, acquisitions and demergers can be categorised
into three parts, which are:
− Tax concessions to the amalgamating (seller) firm
− •
Tax concessions to the amalgamated (buyer) firm
− •
Tax concessions to the shareholders of the amalgamating firm
Legal and Procedural Aspects of Mergers, Acquisitions and Demergers

• With the implementation of the Companies Act, 2013, the National Law Company
Tribunal would be constituted.
• This tribunal shall assume the jurisdiction to sanction the mergers and high
courts will no longer entertain the merger cases.
• In the existing process of a merger, the merging firms must follow:
– The scheme of arrangement or the merger needs to be prepared and shall

have details of the transferor and transferee companies; the authorised, paid
up and subscribed capital of the company; main terms of the scheme,
valuation report, transfer date, etc.
1. Valuation Concerns in
Restructuring
• Valuation means a process through which the value of a firm is derived.
• Valuation is required when an offer is made for the acquisition of shares, making
an investment in a joint venture, buy-back of shares, mergers, demergers and
other cases of restructuring.
• Some common methods used for performing the valuation of a firm are:
Assets-based Valuation
‰
Valuation based on Earnings
Market-based Valuation
Restructuring
• Assets-based valuation: In this method, the net assets of the firm are estimated.
The total assets of the firm are calculated and from that the total amounts of
liabilities are deducted.
• Valuation based on earnings: In this method, the net earnings of a firm are
‰
calculated by deducting the expenses such as tax, preference dividend, etc., from
the gross earnings.
• Market-based valuation: Here, the value of a firm is determined by comparing

‰
the firm with similar firms in the market. The financial data of comparable firms
(in the same industry) is collected from both the public and private sectors and
compared with that of the firm to be valued.
Restructuring
• There are some concerns with regard to the valuation of stocks. These concerns
can be listed as follows:
− ‰
No method of valuation can be considered the absolutely correct method;
therefore, a combination of two or more methods should be adopted.
− ‰
Merger and amalgamations may take some time to complete; therefore, the
valuations can vary substantially depending on when they are made.
− ‰
Deciding upon the time of valuation of the assets
− ‰
Evaluating a fair value of the shares of competitors
1. Turnaround Strategies
• A turnaround strategy is a strategy that is employed to effect the financial

recovery of a firm that has been performing poorly for sometime.
• The strategy involves acknowledging and identifying the problems faced by the
firm, making the necessary structural or managerial changes, developing a
strategy to solve the problems and finally implementing the strategy.
• Different types of business entities may employ different types of turnaround

strategies to improve their poor financial condition and take the road to recovery.
• With the help of a turnaround strategy, a loss-making or sick firm can be nursed
back to health and converted into a profit-making firm.
• A firm needs to implement a turnaround strategy in the following cases:
− When its market share is declining
− ‰
When its gross or net profit margins are declining
− ‰
When its costs or losses are increasing
− ‰
When its return on capital is decreasing
• Turnaround strategies are of two types, which are:
Operational Strategies
‰
Strategic Strategies
• Operational strategies: Operational strategies are turnaround strategies that

focus on improving the operations of the firm. Operational strategies are of four
types: revenue-increasing strategies, cost-cutting strategies, asset-reduction
strategies and combination strategies.
• Strategic strategies: A strategic strategy focuses on improving the products or

‰
offerings of a firm, which may require major of the firm. Firms use this type of
strategy to increase their market share in a particular product-market segment
or reposition the existing brand/product.
1. Financial Distress
• Financial distress can be defined as a condition where a firm is unable to meet or

finds it difficult to pay off its financial obligations to its creditors.
• In other words, it is a situation in which the firm cannot pay the amounts it owes
on the due date.
• If the state of financial distress continues for a long time, it may lead to
bankruptcy, restructuring, liquidation or bail-out.
• Moreover, suppliers may demand on Cash of Delivery (COD) terms for their goods
and important clients may cancel their orders because of the fear that their
deliveries would be delayed.
• The characteristics of a firm in financial distress are:
Unfavourable Financial Position

‰
Costs Exceed Revenues
‰ifficulty/Inability to Honour Financial

D
Obligations
Low Market Valuation

• There are various factors that may lead a firm to financial distress. Some of them
are as follows:
− Inefficient
‰ management
− ‰
Over/under diversification
− ‰
Improper management of costs, revenues and budgets
− ‰
Irreversible investments
− ‰
Inclusion of more debt
− ‰
Lack of liquidity
− ‰
Flaws in strategic decision making
Cost of Financial Distress

• Cost of financial distress refers to the cost that a firm has to bear when it faces
financial distress. The cost of financial distress may or may not be quantifiable.
• Generally, there are two types of costs related to financial distress:
Quantifiable Costs
‰
Qualitative Costs
Cost of Financial Distress

• Quantifiable costs: The costs that the firm incurs when it faces a situation of
financial distress and which are quantifiable or measurable in monetary terms
are called quantifiable costs. Bankruptcy costs, legal charges, etc., are examples
of quantifiable costs.
• Qualitative costs: Costs that are not measurable are called non-quantifiable or
qualitative costs. A firm incurs some qualitative costs in financial distress, for
example, loss of goodwill, damaged or strained relationship with shareholders,
creditors, suppliers and financial institutions.
Impact of Financial Distress

• Financial distress has various negative impacts on a firm. Some of the most
common impacts of financial distress are:
‰
Loss of Profits or Revenues
Loss of Reputation and Goodwill
Low Morale of Employees
Breakdown of Relationship with Stakeholders
Difficulty in Procuring New Projects


• Loss of profits and revenues: Firms in financial distress suffer consistent loss of
revenues, which ultimately impacts their profitability. As a result, these firms are
unable to repay debts, at least in the short term.
• Loss of reputation and goodwill: Financial distress leads to loss of reputation and
goodwill of a firm. This in turn negatively impacts acquisition of new clients and
makes it difficult to retain existing clients.
• Low morale of employees: The employees of a distressed firm usually have low
morale and high stress due to the increased chance of bankruptcy, which would
force them out of their jobs.

• Breakdown of relationship with stakeholders: The major stakeholders in a firm
are its creditors (shareholders and banks or financial institutions who provide
loans). When the condition of distress persists for a long time, the firm is unable
to provide benefits to the shareholders in the form of capital appreciation and
dividends.
• Difficulty in procuring new projects: A firm in distress would lack the finance
required for starting new projects. Moreover, such firms have a low reputation
and lack goodwill in the market. Consequently, other firms would be wary of
contracting any projects to them because of the risk that the project would not be
completed on time.
Bankruptcy
• Financial distress, if not handled promptly, may lead to bankruptcy. Bankruptcy
refers to a legal proceeding involving a person or business that is not able to
repay outstanding debts.
• The process to declare a firm bankrupt is initiated by a petition that is filed by

the debtor or on behalf of creditors in a court of law.
• The court may declare a firm as bankrupt in the following cases:
− ‰
The firm is unable to pay its debts
− ‰
The court feels that it is just and equitable to wind up the firm
− The firm has not filed financial statements and annual returns consecutively
for five financial years
Let’s Sum Up
• Corporate restructuring refers to the effort to restructure the policies,

procedures, programmes, products, structure, processes or people in a firm.
• Corporate restructuring is basically of four types: financial restructuring,

technological restructuring, market restructuring and organisational
restructuring.
• There are three basic methods through which restructuring can be performed.
These are expansions, contractions and ownership and control.
• Valuation means a process through which the value of a firm is derived.
• A turnaround strategy is a strategy that is employed to effect the financial

recovery of a firm that has been performing poorly for some time.
Chapter 8: Funding
Options
Chapter Index

From-To
2 Topic 1 Project Funding 216-223

• Explain the concept of project funding
• Discuss how funding is done in case of brown field and green field projects
• Describe the concept of seed funding
• Discuss the role of equity and debt in funding a project
• Explain the concept and significance of venture funding

1. Project Funding
• Project funding or project finance refers to allotting financial resources for the
execution of the project.
• The characteristics of project funding are:
− It usually refers to the financing of long-term infrastructure or industrial

projects.
− ‰
If debt is used for financing a project, then the debt amount along with the
interest needs to be paid after the project starts generating cash flows.
− ‰
Debt used for project finance is normally secured by attaching the assets of
the firm as collateral.
− ‰
Risky projects require surety and guarantees from project sponsors.
2. Project Funding
• Project funding is usually done by taking loans from banks or financial

institutions. Some important features of loans are listed as follows:
− ‰
Maturity: The loan obtained from banks or financial institutions have a
maturity of 3–10 years.
− Negotiated: The terms and conditions for granting the loan amount is
negotiated between the banks/financial institutions and borrowers.
− ‰
Security: Usually, the loans granted to a project are secured. The assets of
the firm are usually attached as collateral.
− Covenants: The loan amount granted by banks is secured by using assets of

the firm. However, the banks/financial institutions also attach various
restrictive terms and conditions known as covenants.
3. Project Funding
• Various stages involved in project financing are:
Pre-financing Stage
Financing Stage
Post-financing Stage
4. Project Funding
Funding in Brown Field and Green Field Projects

• Brown field projects are those projects in which investment is made in the
existing firm or in the project of an existing firm. On the other hand, green field
projects are those in which investment is made for an entirely new project.
• The possible sources of funds for the brown field and green field projects are:
− Equity finance
− Debt infusion
− Loans from banks
− Funding through hybrid instruments
− Subsidy from government

5. Project Funding
Seed Capital Funding

• Seed capital refers to the initial capital required for starting a business.
• Usually, this capital is arranged by the founders of the company or the project
owners from their personal assets or retained earnings of the business.
• Seed funding is usually raised in the form of equity and used to pay the
preliminary expenses incurred in incorporating a firm or setting up a new project.
• The risk involved while disbursing the seed capital is more than the risk involved
in any other mode of funding.
• All businesses require seed capital to initiate their operations.

6. Project Funding
Funding with Debt and Equity

• All businesses whether big or small, need funds for carrying out and expanding
its operations.
• The possible sources of fund for a company can be debt, equity or any
combination thereof.
• In debt financing, a promise is made to pay back the borrowed amount along with
an interest.
• On the other hand, in equity finance, the financers or equity holders are treated
as the owners of the company and they take a share in the profits of the company.
• Deciding between equity finance and debt finance and their combination remains
a challenge for the firm.
7. Project Funding
Venture Funding
• Venture funding is a kind of financing under which individual venture capitalists
or venture capitalist firms provide funds to those firms that are in their early
stage or are emerging.
• Venture capital is granted to the firms in return for a share in the equity of the
firm.
• Venture funding is usually suitable for those firms that have a limited operating
history and are too small to access capital markets or financial institutions for
raising finance for expansion.
• Venture financing extends financial support to new entrepreneurial endeavours.

8. Project Funding
Angel Financing
• Angel financing refers to funds provided by an angel investor to start-ups.
• An angel investor is an individual that provides the necessary capital to start-up

enterprises, which have little or no access to other sources of funds.
• Angel investors usually provide one time start-up capital or seed capital to
enterprises.
• Angel investments may be made by an individual (angel investor) or by angel

investment companies (angel groups/angel network).
• Angel investors are usually retired or ex-entrepreneurs themselves. They may or

may not invest for monetary benefits.
Let’s Sum Up
• Project funding or project finance refers to the activity of providing financial

resources to finance a project, i.e., for executing the project.
• Brown field projects are those projects in which the investment is made in the
existing firm or in the project of an existing firm.
• When an investment is made in an entirely new project that does not impose any
restrictions on the project, it is known as a green field project.
• Seed capital refers to the initial capital required for starting a business.
• T
‰he major factors that influence the decision of venture capitalists include nature
of business, industry, area and expectations of venture capitalists.
• The various stages in venture funding include early stage financing and later
stage financing.
Chapter 9: International
Financial Management
Chapter Index

From-To
2 Topic 1 External Commercial 231-232

Borrowings (ECBs)
3 Topic 2 Euro Issues 233-236

Chapter Index

From-To
4 Topic 3 Foreign Currency Exchangeable 237-238

Bonds (FCEBs)

• Discuss the concept and end-use of External Commercial Borrowings (ECB)
• Describe the concept and components of Euro Issues
• Explain the concept of Foreign Currency Exchangeable Bonds (FCEBs)

1. External Commercial Borrowings
(ECBS)
• ECBs refer to commercial loans that can be in the form of bank loans or
securitised instruments.
• An ECB is a financial instrument used by Indian companies to access foreign

money. The use of ECBs in India is regulated by the Ministry of Finance (MoF)
and the Reserve Bank of India (RBI).
• The guidelines and policy related to ECBs are:
− Eligibility criteria for accessing the international financial markets
− Total amount of funds that can be raised through ECBs
− Maturity period of ECB loan and the cost involved
− End use of the ECBs
− Conversion of ECB into equity

2. External Commercial Borrowings
(ECBS)
End-use of ECB
• The end-use of ECB is also established in the Master Circular on External
Commercial Borrowings and Trade Credits dated 1st July, 2015 issued by RBI.
• The end use of ECB varies in automatic and approval modes.
• The end uses of ECB in the automatic route can be broadly stated as:
– ECB can be raised for investment such as import of capital goods (as
classified by DGFT in the Foreign Trade Policy), new projects,
modernisation/expansion of existing production units in real sector—
industrial sector including small and medium enterprises (SME),
infrastructure sector and specified service sectors, viz. hotel, hospital and
software and miscellaneous services sector.
1. Euro Issues
• Euro Issues refer to the modes of raising funds by an Indian company in foreign
currency outside India.
• Indian companies primarily used two mechanisms to obtain credit from

international markets which are as follows:
• Indian companies primarily used two mechanisms to obtain credit from

international markets which are:
− Depository receipts: It is a means of indirect equity investment using ADRs

and GDRs.
− ‰
Foreign Currency Convertible Bonds (FCCBs): It is a form of debt which can
be converted to equity.
2. Euro Issues
Listing
• The prerequisite of raising finance through Euro Issues (ADR/GDR) is that the
securities of the issuing company must be listed on one or more stock exchanges
located outside India.
• An Indian company that issues ADR/GDR has to fulfil certain requirements

related to disclosure and documentation as mandated by the overseas stock
exchange for getting its shares listed on that particular exchange.
• Shares issued against ADR/GDR are to be listed at one or more stock exchanges
in India.
• For issuing equity shares outside India, companies seek help of the listing agent
who assists in listing shares outside India.
3. Euro Issues
Listing
• Steps helpful for promoting and listing of the issue are:
Distributing the Circular

Letter
Preparing Research
Papers
Conducting Pre-marketing
Performing Road Shows

4. Euro Issues
Transfer and Redemption

• A non-resident investor holding GDR can transfer GDR or may also redeem the
GDR through the overseas depository bank.
• Once the request for redemption is received through the overseas depository
bank, the bank will ask the local custodian bank to release shares to be sold
directly in the market on behalf of the overseas investor.
• Upon the request of redemption, the price of the ordinary shares prevailing on
Bombay Stock Exchange or National Stock Exchange shall be taken as the cost of
acquisition.
• If FCCB is converted, in that case, the cost of acquisition shall be determined on

the basis of the price of the share at either of the exchange.
1. Foreign Currency Exchangeable Bonds
Foreign Currency Exchangeable Bonds

• Foreign Currency Exchangeable Bonds (FCEB) can be defined as bond
denominated in foreign currency, wherein the principal and interest is also paid
in foreign currency.
• These bonds are exchangeable into the equity share of another company either
wholly or partially or on the parameters of equity related warrants which are
attached to debt instruments.
• FCEBs are regulated by Foreign Currency Exchangeable Bond Scheme, 2008

issued by Ministry of Finance, Department of Economic Affairs.
2. Foreign Currency Exchangeable Bonds
Foreign Currency Exchangeable Bonds

• There are three parties involved in the issuance of FCEB. These are:
− ‰
Issuer company: An Issuer company is a company that issues FCEB in a
foreign currency and these FCEBs are convertible into the shares of another
company, which forms the part of the same promoter group.
− ‰
Offered company: The offered company is a company whose shares are
offered.
− ‰
Investors: Investors are the persons who invest in FCEB.
Let’s Sum Up
• ECBs refer to a commercial loan which can be in the form of bank loans or
securitised instruments. It is a financial instrument used in India. An ECB is
used by Indian companies to access foreign money.
• An Indian company may access foreign funds through four methods, namely,
External Commercial Borrowings (ECBs), Foreign Currency Convertible Bonds
(FCCB), Preference Shares and Foreign Currency Exchangeable Bonds (FCEB).
• Foreign Currency Exchangeable Bonds (FCEBs) are regulated by Foreign

Currency Exchangeable Bond Scheme, 2008 issued by the Ministry of Finance
and the Department of Economic Affairs. For issuing FCEB, a prior approval of
RBI is required.
Chapter 10: Tax
Implications of
International Investments
Chapter Index

From-To
2 Topic 1 Scope of Tax Charge: Status- 246-247

Situs Nexus (Sections 5 & 6)
3 Topic 2 Tax Implications of Foreign 248

Activities of an Indian
Enterprise
4 Topic 3 Tax Incentives for Earnings in 249

Foreign Currency
Chapter Index

From-To
5 Topic 4 Tax Implications of Activities of 250

Foreign Enterprises in India
6 Topic 5 Transfer Pricing 251
7 Topic 6 Double Taxation and Double 252-253

Taxation Avoidance Agreement
(DTAA)

• Explain the scope of tax charge
• Explain the tax implications of foreign activities on an Indian enterprise
• Describe the tax incentives for earnings in foreign currency
• Define transfer pricing
• Discuss double taxation and double taxation avoidance agreements

1. Scope of Tax Charge: Status-situs
Nexus (sections 5 & 6)
• The liability of tax payment is closely related to the residential status and place
of the earnings of an individual or company.
• For determining the residential status of individuals or companies, every country

develops its own rules.
• Based on these rules, taxes are levied on individuals and companies.
• Under these rules, a linkage is established between the tax liability and place of
residence of individuals and companies.
• These rules emphasise the fact whether an individual or a company should be

treated as a ‘resident’ or not, in the previous financial year.
2. Scope of Tax Charge: Status-situs
Nexus (sections 5 & 6)
• These rules emphasise the fact whether an individual or a company should be

treated as a ‘resident’ or not, in the previous financial year.
• A resident individual of a previous year can be further classified either as an

‘ordinary’ resident or as a ‘non-ordinary’ resident.
• An Indian company is always treated as a resident and tax is levied on it

accordingly. A company is said to be resident if it satisfies any of the following
parameters:
a. It must be an Indian company.
b. In the previous year, the company’s effective management was wholly located
in India.
Tax Implications of Foreign
Activities of an Indian Enterprise
• If an Indian enterprise carries activities outside India, in that case the following
aspects need to be considered carefully:
− Taxation of exchange gains, expenditures and losses: As per the Income-tax

Act, 1961, transactions that are capital in nature are not allowed tax
deductible items.
− Exchange gain and loss on the acquisition of fixed assets: If the assessee
acquires any asset outside India incurring liability on foreign currency, in
that case any decrease or increase in the liability due to the change in the
exchange rate should be adjusted to the historical cost of the fixed assets
which is concerned with the computation of depreciation.
Tax Incentives for Earnings in
Foreign Currency
• To encourage industrialisation in specific areas and promote a particular

business, the government provides tax incentives to firms with an aim to
eliminate regional disparity in the country.
• These tax incentives are provided for:
– ‰
Establishing units in special economic zone (SEZ)
– Establishing undertakings in free trade zones (FTZ)
– Establishing units under the Export-oriented Unit (EOU) scheme
– Exporting certain articles

Tax Implications of Activities of
Foreign Enterprises in India
• In India, taxes are not levied for the flow of foreign currency but the revenue
department has identified many cases of unexplained cash credits.
• The activities of foreign enterprises are continuously tracked and monitored to

ensure that sources of their investments can be identified.
• To achieve the objective of balanced growth, various incentives are paid and taxes
are collected from foreign enterprises.
Transfer Pricing
• Transfer pricing refers to determining the price of goods and services sold
between the related legal entities within an enterprise.
• Transfer pricing rules are implemented to ensure that earnings from the high tax
jurisdiction are not shifted to the low tax jurisdiction.
• The entities where the related party transactions are involved have to follow the
arm’s length principle of transfer pricing.
• The determination of the arm’s length price could be easy when the comparable
are available but the determination of the arm’s length price would not be easy in
the case of proprietary goods or customised goods.
1. Double Taxation and Double
(DTAA)
Tax Treaties
• Double taxation refers to the levying of taxes in two different jurisdictions on the
same declared income, asset or any financial transaction.
• Tax treaties are agreements entered between two countries to reduce the impact
of DTAA. They generally deal with the following aspects:
− Covering the types of taxes and residents who can avail the facility of the
deduction allowed on the amount paid as double taxation.
− Reducing the amount of withholding tax from interests, dividends and

royalties paid by the resident of one country to the resident of the other
country.
2. Double Taxation and Double
(DTAA)
General Anti Avoidance Rules (GAAR)

• The General Anti Avoidance Rules (GAAR) was proposed in the annual budget of
2012-13.
• It is a regulation pertaining to anti-tax avoidance in India. This encountered

several controversies as it contained the provision of charging taxes from the past
overseas transaction including local assets retrospectively.
• GAAR was proposed with an aim to check tax avoidance. In other words, the
rules framed to check the potential evasion of taxes are known as GAAR.
• GAAR can be effective only if the main purpose of the transaction or a part of the
transaction is to obtain a tax benefit.
Let’s Sum Up
• The liability of the payment of tax is closely related to the residential status and
place of the earnings of an individual or company.
• I‰
n the case of an individual, the residential status depends on the period of stay
in a particular country.
• Transfer pricing refers to determining the price for goods and services sold
between the related legal entities within an enterprise.
• Double taxation refers to the levying of taxes in two different jurisdictions on the
same declared income, asset or any financial transaction.
• In India, under section 90 of the Income-tax Act, 1961 the government can enter
into double tax avoidance agreements with other countries.

Strategic Financial Management JPlOZ7LTBU

Hochgeladen von

Dokumentinformationen

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Strategic Financial Management JPlOZ7LTBU

Hochgeladen von

Copyright:

Verfügbare Formate

Strategic Financial

1 Chapter 1 Introduction to Strategic Financial 5-17

2 Chapter 2 Making Capital Budgeting Decisions 18-54

3 Chapter 3 Cost of Capital Analysis 55-83

4 Chapter 4 Investment Decisions and Financial 84-112

5 Chapter 5 Capital Structure (Theory and Policy) 113-148

6 Chapter 6 Dividend Decision 149-177

7 Chapter 7 Corporate Restructuring 178-212

8 Chapter 8 Funding Options 213-226

9 Chapter 9 International Financial Management 227-241

10 Chapter 10 Tax Implications of International 242-256

• Strategic financial management has emerged as a new discipline with the

• Strategic financial management is a fusion of two disciplines: strategic

• Strategic financial management blends the basic frameworks and concepts of

• Strategic financial management mainly deals with the decisions such as

S. No Reference No Particulars Slide

2 Topic 1 Fundamentals of Financial 9-10

3 Topic 2 Strategic Financial 11-12

4 Topic 3 Strategic Planning 13

S. No Reference No Particulars Slide

5 Topic 4 Corporate Strategy and 14

• Explain the characteristics, scope, importance, success factors and constraints of

• Describe the characteristics, components, process, benefits, constraints and

• List the common goals of corporate strategy and financial policy

• Explain the emerging role of finance managers in India

• According to Guthmann and Dougall, financial management is an activity

• These functions include fund procurement, working capital management,

Scope of Financial Management

• The scope of financial management includes the following areas:

Financial Decision Making

• Strategic financial management refers to managing the finance of a firm with a

• Following are the main characteristics of strategic financial management:

− Deals with long-term financial decisions

Importance of Strategic Financial Management

Financial Acquisition of Utilisation of

• Strategic planning basically deals with the following types of questions:

• Strategic planning helps firms in adapting to the changes in the business

• The corporate strategy of a firm is closely related to its financial policy.

• Corporate strategy refers to the overall long-term plan of action of a firm to

• Financial management refers to the functions involved in the management of

• The scope of financial management includes financial planning, financial control

• Strategic financial management refers to managing the finances of a firm with a

• The corporate strategy of a firm is closely related to its financial policy.

S. No Reference No Particulars Slide

1 Learning Objectives 23-24

2 Topic 1 Capital Budgeting Basics 25-27

3 Topic 2 Investment Decisions: Nature 28-30

4 Topic 3 Investment Evaluation 31-32

5 Topic 4 Net Present Value (NPV) 33-34

S. No Reference No Particulars Slide

6 Topic 5 Internal Rate of Return (IRR) 35-37

7 Topic 6 Profitability Index (PI) 38-40

8 Topic 7 Payback Method 41-43

9 Topic 8 Discounted Payback Period 44-45

S. No Reference No Particulars Slide

10 Topic 9 Accounting Rate of Return 46-47

11 Topic 10 Modified Internal Rate of 48-49

12 Topic 11 Varying Opportunity Cost of 50

S. No Reference No Particulars Slide

13 Topic 12 Concept of Economic Value 51

14 Topic 13 Let’s Sum Up 52

• Discuss investment decisions and their nature and types

• Describe the various investment criteria

• Describe and illustrate the payback technique of capital budgeting