Financial management


Published on

It covers the theory part of Finance Management for MBA Students!!

Published in: Economy & Finance, Business
1 Comment
No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Financial management

  1. 1. Module - 1 -------------------------------------------------------------------------------Unit 1: Nature and Scope of Financial Management--------------------------------------------------------Objectives• to give an insight into the Financial Management• To identify major areas of decision making in financial management• To give a overall view of the scope of financial management.Unit Outline1.1 Introduction1.2 Meaning of Business Finance.1.3 Definitions of Financial Management1.4 Which are the major areas of decision making in financial management?1.5 Scope of financial management-------------------------------------------------------------------------------1.1INTRODUCTION---------------------------------------------------------------- Finance is the lifeblood of business organisations, without finance the formation, establishment, production, functioning or operating of big, medium or small business enterprise is not possible. Finance may be defined as the art and science of managing money. The major areas of finance are 1) financial services and 2) financial management. Financial Services is concerned with the design and delivery of products to individuals, business and government within the areas 1
  2. 2. of financial institutions, personal financial planning, investments, real estate, andso on. Financial management is concerned with the duties of the financialmangers in the business firm. The subject of finance is traditionally classified intotwo classes1) Public Finance and 2) Private Finance. Public finance deals with the requirements, receipts, and disbursementof funds in the government institutions like states, local self-governments andcentral governments. Whereas the private finance deals with the requirements,receipts and disbursement of funds by the individual, a business organisation andnon-business organisation. The private finance from the above we can once againclassified into personal finance and business finance and finance of non-businessorganisation.-------------------------------------------------------------------------------1.2 MEANING OF BUSINESS FINANCE--------------------------------------------------------------------------- To understand the meaning of business finance there is a need tounderstand the concepts business and finance. Business may be understood as theorganised efforts of enterprises to supply consumers with goods and services forsatisfying these needs and wants and in the process. All businesses share thesame purpose that is to earn profits. Broadly speaking, the term business includesindustry, trade and commerce. Finance refers to provisioning of money at the time when it is required. Herefinance refers to management of flows of money through an organisation. HenceBusiness Finance concerned with acquisition of funds, use of funds anddistribution of profits by a business firm. The business finance can be further classified in to sole proprietary finance,partnership finance and company or corporate finance. The principle of businessfinance can be applied to any of the forms of business organisations. But since the 2
  3. 3. business in an economy in terms of value in companies is more hence theemphasis to the financial practices and problems of the incorporated enterprisesare studied much in business finance. So most of the authors use corporatefinance interchangeably with business finance.-------------------------------------------------------------------------------1.3 DEFINITIONS OF FINANCIAL MANAGEMENT--------------------------------------------------------------------------- Financial management refers to that part of the management activity whichis concerned with the planning and controlling of firms financial resources. It dealswith finding out various sources for raising funds for the firm.Accoding to Soloman, Financial Management is concerned with the efficient useof important economic resource, manely, Capital Funds.According to Prather & Wert, "Business finance deals primarily with raisingadministering and disbursing funds by privately owned business units operating innon-financial fields of industry."Wheeler defines Business Finance as "that business activity which is concernedwith the acquisition and conservation of capital funds in meeting the financialneeds and administering the funds used in the business."According to Guthmann and Dougall, business finance can be broadly defined asthe activity concerned the planning, raising, controlling and administering thefunds used in the business.According to James C. Van Horne Financial Management is concerned with theacquisition, financing, and management of assets with some overall goal in mind.------------------------------------------------------------------------------- MAJORAREAS OF DECISION MAKING IN FINANCIAL MANAGEMENT 3
  4. 4. ------------------------------------------------------------------------------- Therefore the decision function of financial management can be broken downinto three major areas: the investment, financing, and asset managementdecisions.Investment Decision The investment decision is the most important of the firms three majordecisions when it comes to the value creation. Investment decision relates to thedetermination of total amount of assets to be held in the firm, the composition ofthese assets like the amount of fixed assets, current assets and the extent ofbusiness risk involved by the investors. The investment decisions can be classified in to two groups: (1) Long-terminvestment decision or capital budgeting and (2) Short-term decision or Workingcapital decision.Financing Decision Financing decision follows the Investment decision. The Finance managernow has to decided how much of finance is required to meet the long-term andshort-term investment decisions, what are the sources of financing theseinvestment decisions, what is the composition of these finance and what should bethe financial mix and so on.Asset Management Decision The third important decision of the firm is the asset management decision.Once assets have been acquired and appropriate financing provided, these assetsmust still be managed efficiently. The finance manager has more responsibility inmanaging the current assets than fixed assets. A large share of the responsibilityof managing the fixed assets would reside in the hands of operating managers ofthe company.---------------------------------------------------------------------------1.5 SCOPE OF FINANCIAL MANAGEMENT---------------------------------------------------------------- 4
  5. 5. Financial management is concerned with acquisition, proper utilisation orallocation of these funds. It is an activity concerned with the planning, raising,controlling and administering the funds used in the business. Hence the financemanager have to concentrate on the following areas of finance function. 1. Estimating Financial Requirements. The finance manager has to estimate what would be the short term and long-term financial requirement of his business. For this he has to prepare financial plan for present as well as for future. He should make correct estimate of finance for purchasing of fixed assets and current assets. The estimate should be accurate other wise it leads to either excess of funds or inadequacy both these situations will have adverse impact on the profitability of an organisation. 2. Deciding Capital Structure. The capital structure refers the composition and proportion of different securities for raising funds. After deciding the estimate of financial requirements for fixed and current assets of his business the finance manager must decide what should be composition of long-term funds like capital and debt ratio. Then he has to plan what should be its proportion by taking in to consideration the cost of funds. Similarly for short-term funds. 3. Selecting a Source of Finance. After selecting the capital structure the finance manager must select the sources of finance by considering the cost of capital and availability of funds in the market. 4. Selecting a pattern of investment. After procurement of funds, he has to decide the pattern of investment. He should decide about which assets should be purchased among fixed assets and which is the method of selecting the fixed assets or capital budgeting techniques to be used and cost analysis etc., 5. Proper Cash Management. Proper cash management is another important function of finance manager. He has to asses the cash needs of the organisation like for purchasing of raw materials, making payment to the 5
  6. 6. creditors, wages, rent and other day-today expenses. He must identify the sources of raising cash like from cash sales, collection of debts, short-term loans from banks and so on. The cash in an organisation neither excess nor shortage. Excess cash will increase the idle funds in the organisation, whereas shortage of funds or cash will affect the creditworthiness of the company, hence it should be adequate. 6. Implementing Financial Controls. Efficient financial management requires implementation of some financial controls like ratio analysis, return on capital employed, return on assets, budgetary control, break-even analysis, return of investment, internal audit etc., to evaluate the performance of various financial policies of the organisation. 7. Proper use of surpluses. Proper use of profits or surpluses is also essential for the expansion and diversification plans and also protecting the interests of shareholders. Issue of bonus shares or ploughing back of capital etc., will increase the value of the shares of the company hence judicious utilisation of these surpluses is very important.----------------------------------------------------------------UNIT 2 OBJECTIVES OR GOALS OF FINANCIAL MANAGEMENT-------------------------------------------------------------------------------Objectives• To study the objectives of financial management• To analyse the relevance of each objective with the present scenario• To know other objectives of financial managementUnit outline 6
  7. 7. 2.1 Objectives of financial management2.2 Profit maximisation2.3 Arguments in favour of Profit maximisation2.4 Criticisms on Profit maximisation objective2.5 Wealth maximisation2.6 Criticisms on wealth maximisation objective2.7 Other objectives---------------------------------------------------------------------------2.1 OBJECTIVES OR GOALS OF FINANCIAL MANAGEMENT---------------------------------------------------------------- Financial management is concerned with procurement and use of funds. Itsmain aim is to use business funds is such a way that value or earnings of thefirms are maximised. There are various alternative ways of using business funds.The organisation should go through the pros and cons of each alternative way ofusing these business funds before final selection. The financial managementprovides a framework for selecting a proper course of action and deciding a viablecommercial strategy. The following are the objectives of financial management.1. Profit Maximisation2. Wealth Maximisation, and3. Other objectives.---------------------------------------------------------------------------PROFITMAXIMISATION---------------------------------------------------------------------------The main objective of a business firm is profit maximisation because the businessfirm is a profit-seeking organisation. Hence the objective of the financialmanagement of business organisation is profit maximisation. There are somearguments in favour of this objective of business. They are. 7
  8. 8. a) When profit earning is the aim of business then profit maximisation should be the obvious objective.b) Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise, therefore, profit maximisation is justified on the grounds of rationality.c) The economic and business conditions do not remain same at all the times like recession, depression, cut throat competition and so on. Hence the business organisations should earn more and more profits when the situations are favourable.d) Since profit is the main source finance for growth and development of a business organisation hence, keeping profit maximisation of profit, as an objective of the business is justifiable.e) Through maximisation of profitability of a business it is possible to contribute more and more funds for social activities to meet social goals. However, the concept of profit maximisation has been criticised and rejected asthe objective of financial management of a business organissation on account ofthe following reasons:a) It is vague. The term profit is vague and it cannot be precisely defined. It means the term profits if different to different people. Which profits are to be maximised, short term or long term profit, profits before tax or after tax, or total profits or profit per share and the like.b) It ignores timings. Profit maximisation objective ignores the time value of money and does not consider the magnitude and timing of earnings.1. It overlooks quality aspects of future activities. The business is not solely run with the objective of earning maximum profits. Some organisations give more emphasis to sales growth, by increasing its volume of sales by decreasing the profits or gain margin. Some organisations make more profits and contribute more amounts to the development of the society. 8
  9. 9. -------------------------------------------------------------------------------WEALTHMAXIMISATION--------------------------------------------------------------------------- Wealth or net worth is the difference between gross present worth and theamount of capital investment required to achieve the benefits. Any financial actionwhich creates wealth or which has a net present worth above zero is a desirableone and should be undertaken. The operating objective for financial managementis to maximise wealth or net present worth. Wealth maximisation is, therefore,considered to be the main objective of financial management. The objective ofwealth maximisation is to maximise the economic welfare of the shareholders of acompany. The value of a companys shares depends largely on its new worthwhich itself depends on earning per share (EPS). A stockholders current wealth inthe firm is the product of the number of shares owned, multiplied with the currentstock price per share.Stockholders current wealth in the firm = (Number of shares owned) x (currentstock price per share)It is symbolically represented W o = NP oThus the business organisation should strive for the increase in the current stockprice per share or EPS, so that the current wealth of a firm will increases. This inturn depends upon the proper financial management.---------------------------------------------------------------------------CRITICISM OF WEALTH MAXIMISATION--------------------------------------------------------------------------- The wealth maximisation objective has been criticised by certain financialtheorists mainly on the following grounds. 9
  10. 10. a) It is a prescriptive rather than descriptive. The objective should tell what the firm should actually do.b) The objective of wealth maximisation is not necessarily socially desirable.c) There is controversy as to whether the objective of a firm is maximise the stockholders wealth or wealth of the firm, since the firm includes stockholders, debenture-holders, preference shareholders etc.d) Since the management and ownership are separated in large corporate form of organisations, the managers will act in such a manner, which maximises the managerial utility rather than the wealth maximisation of stockholders of the firm. This is a controversial argument. In spite of all the criticism, we are of the opinion that wealth maximisation isthe most appropriate objective of a firm.-------------------------------------------------------------------------------OTHEROBJECTIVES--------------------------------------------------------------------------- Besides the above basic objectives, the following are the other objectives offinancial management.(a) Ensuring fair return to shareholders.(b) Building up reserves for growth and expansion.(c)Ensuring maximum operational efficiency by efficient and effective utilisation of finances.(d) Ensuring financial discipline in the organisation.-------------------------------------------------------------------------------Unit 3 FINANCIAL ENVIRONMENT--------------------------------------------------------Objectives• To study the environment under which the financial management is studied 10
  11. 11. • To give a brief outline of functions of financial manager and organisation of finance function.Unit outlineFINANCIAL ENVIRONMENT3.1 Functional areas of Financial Management3.2 Organisation of Finance function3.3 Functions of Controller3.4 Functions of Treasurer-------------------------------------------------------------------------------3.1 FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT------------------------------------------------------------------------------- Financial management is an applied field of business administration.Principles developed by the financial mangers from accounting, economics andother fields are applied to the problems of managing finances. Moreover, everybusiness activity requires money and hence financial management is closelyrelated with all other areas of management. The relationship between financialmanagement and other areas of management has been explained briefly.Financial Management and Cost Accounting Most of the large companies have a separate cost accounting department tomonitor expenditures in their operational areas. The cost information is regularlysupplied to the management to control the costs. The finance manager isconcerned with proper utilization of funds and therefore he is concerned with theoperational costs of the firm. 11
  12. 12. Financial Management and Marketing The success or failure of a firm is greatly depends upon the marketing. Oneof the important elements of marketing mix is price. The fixation of price for aproduct plays very important role. There are various policies of pricing. Themarketing department must observe the best pricing policy when compared to thecompetitors in the industry. Hence he collects the financial information from thefinance department, here the role of finance manager is very important.Financial Management and Assets Management The current assets and the fixed assets of the firm constitute the total assetsof a firm. The firms assets should be properly managed. Proper management ofassets refers to systematic acquisition and maintenance or better utilization ofassets. The finance manager plays very important role in the proper maintenanceof composition of these assets.Financial Management and Personnel Management Personnel management is concerned with selection, recruitment, trainingand placement of personnel department. The proper functioning and the abovesaid functions of personnel departments depend upon the decisions taken infinance department. Hence the functioning of finance department in anorganisation plays a vital role.Financial Management and Financial Accounting Financial management and financial accounting are quite distinct from eachother. Financial accounting is concerned with the systematic recording, analysing,reporting and measuring the business transactions. The objective of financialaccounting is measurement of funds and the objective of financial management isto management of funds. The management of funds depends on the measurementof financial accounting through profit and loss account and balance sheet. 12
  13. 13. ---------------------------------------------------------------------------3.2 ORGANISATION OF THE FINANCE FUNCTION-------------------------------------------------------- A firm must give proper attention to the structure and organisation of itsfinance department. If financial data are missing or inaccurate, the firm may notbe in a position to identify the serious problems confronting the firm at any timefor correcting. The roles of different finance executives should be clearly defined inorder to avoid conflict and overlapping of functions. Organisation of the finance function differs from company to companydepending on their respective needs and the financial philosophy. The titles usedto designate the key finance official are also different viz., vice-president(Finance), Chief Executive (Finance), General Manager (Finance), etc. however, inmost companies, the vice-president (Finance) has under him two officers carryingout the two important functions - the accounting and the finance functions. Theformer is designated as Controller and the latter as the Treasurer. The controller is concerned with the management and control of the firmsassets. His duties include providing information for formulating the accounting andfinancial policies, preparation of financial reports, direction of internal auditing,budgeting, inventory control, taxes, etc. while the treasurer is mainly concernedwith managing the firms funds, his duties include the following: Forecasting the financial needs; administering the flow of cash; managingcredit; floating securities; maintaining relations with financial institutions andprotecting funds and securities.-------------------------------------------------------------------------------3.3 FUNCTIONS OF CONTROLLER---------------------------------------------------------------------------Planning and control. To establish, coordinate and administer, as part ofmanagement, a plan for the control of operations. 13
  14. 14. 1. Reporting and interpreting. To compare performance with operating plans and standards and to report and interpret the results of operations to all levels of management and to the owners of the business.2. Tax administration. To establish and administer tax policies and procedures.3. Government reporting. To supervise or co-ordinate the preparation of report to the government.4. Protection of assets. To ensure protection of assets for the business through internal control, internal audit and proper insurance coverage.5. Economic appraisal. To appraise continuously economic and social forces and Government influences, and to interpret their effect upon the business. --------------------------------------------------------------------------3.4 FUNCTIONS OF TREASURER---------------------------------------------------------------------------Provision offinance. To establish and execute programmes for the provision of capital requiredby the business. 1. Investor relations. To establish and maintain an adequate market for the companys securities and to maintain adequate contact with the investment community.2. Short-term financing. To maintain adequate sources for the companys current borrowings from the money market.3. Banking and custody. To maintain banking arrangement, to receive, have custody of and disburse the companys monies and securities.4. Credit and collections. To direct the granting of credit and the collection of accounts receivables of the company.5. Investments. To achieve the companys funds as required and to establish and co-ordinate policies for investment in pension and other similar trusts.6. Insurance. To provide insurance coverage as may be required. 14
  15. 15. -------------------------------------------------------------------------------UNIT 4 FINANCING DECISIONS--------------------------------------------------------Objectives• To study the financing of investment decisions• To have the exposure of various leverages• To identify how to arrive at optimum leverage for successful investment decisions.Unit Outline4.1 What is financing decision?4.2 Meaning of leverage4.3 Types of leverageFinancial leverageOperating leverageComposite leverage---------------------------------------------------------------------------4.1 FINANCING DECISIONS--------------------------------------------------------------------------- After the Investment decision is taken the firm has to decide upon the bestmeans of financing these investment policies. The investment decisions arecontinuous in nature because the companies make the new investments in itsregular course of business since the business is ever expanding. Hence the firmswill make plan continuous its financial needs. The financial decision is not only 15
  16. 16. concerned with how best to finance new assets, but also concerned with the bestoverall mix of financing for the firm.---------------------------------------------------------------------------4.2 MEANING OF LEVERAGE--------------------------------------------------------------------------- The term Leverage refers to the ability of a firm in employing long termfunds having a fixed cost, to enhance returns to the owners; i.e. equityshareholders. . In other words leverage is the employment of fixed assets orfunds for which a firm has to meet fixed costs or fixed rate of interest obligationirrespective of the level of activities attained or the level of operating profitearned.James Horne has defined leverage as " the employment of an asset or sources offunds for which the firm has to pay a fixed cost or fixed return.,"The higher the leverage higher is the risk as well as return to the owners. A higherleverage obviously implies higher outside borrowings and hence riskier if thebusiness activity of the firm suddenly slows down. The leverage can have negativeor reversible effect also. It may be favorable or unfavorable.-------------------------------------------------------------------------------4.3 TYPES OF LEVERAGES---------------------------------------------------------------------------There are basically two types of leverages, 1) operating leverage, and 2) financialleverage. In addition to these two types of leverages there are composite leverageand working capital leverage. The leverage associated with the employment offixed cost assets is referred to as operating leverage. While the leverage resultingfrom the use of fixed cost/return source of funds is known as financial leverage.FINANCIAL LEVERAGE OR TRADING ON EQUITY 16
  17. 17. The company can finance its investments by debt and/or equity. The companymay also use preference capital. The rate of interest on debt is fixed irrespectiveof the companys rate of return on assets. The rate preference dividend is alsofixed; but preference dividends are paid when the company earns profits. Theordinary shareholders are entitled to the residual income. That is, earnings afterinterest and taxes (less preference dividends) belongs to them, this dividends alsodepends on the dividend policy of the company. The use of the fixed charge sources of funds, such as debt and preferencecapital with the owners equity in the capital structure, is described as financialleverage or trading on equity. The use of long term fixed interest bearing debt and preference share capitalalong with equity share capital is called financial leverage or trading on equity. Thelong term fixed interest bearing is employed by a firm to earn more from the useof these resources than their cost so as to increase the return on owners equity, itis called trading on equity. A firms earnings are more than what debt wouldcost is known as favourable leverage and if the firms earnings are lessthan the debt cost then its is known as unfavourable leverage. The impact of financial leverage is to magnify the shareholders earnings. Itis based on the assumption that the fixed charges can be obtained at a cost lowerthan the firms rate of return on its assets.DEGREE OF FINANCIAL LEVERAGE The degree of financial leverage measures the impact of a change inoperating income (EBIT) on change in earning on equity capital or share.The formula to calculate the degree of financial leverage Earnings before Interest and Taxes EBITFinancial Leverage = ----------------------------------------- OR ------ Earnings before Taxes EBT 17
  18. 18. 1. Operating Leverage The operating leverage occurs when a firm has fixed costs which must berecovered irrespective of sales volume. The fixed costs remaining same, thepercentage change in operating revenue (EBIT) will be more than the percentagechange in sales. This is known as operating leverage. The degree of operatingleverage depends upon the amount of fixed elements in the cost structure. Thedegree of operating leverage will be calculated as: Contribution Operating Leverage = ------------------- Operating profit If a firm does not have fixed costs then there will be no operating leverage.The percentage change in sales will be equal to the percentage change in profit.When fixed costs are there, the percentage change in profits will be more than thepercentage in sales volume. The degree of operating leverage is calculated as: Percentage Change in Profits Degree of operating leverage = ------------------------------- Percentage Change in SalesRisk Factor In a high leveraged situation will magnify the operating profits but it bringsin the risk element too. The percentage change in profits will be more in asituation with higher fixed costs as compared to that where fixed costs are lower.The higher degree of leverage brings in more decrease in operating profits.2. Composite Leverage The operating leverage measures the degree of operating risk and it ismeasured by percentage change in operating profit due to percentage change insales. The financial leverage measures the financial risk by measuring thepercentage change in taxable profit or EPS with the percentage change inoperating profit or EBIT. Both these leverages are closely concerned with the firmscapacity to meet the fixed costs. 18
  19. 19. Composite leverage expressed the relationship between revenue on accountof sales (Contribution) and the taxable income (PBT) on account of change insales. The composite ratio is calculated as follows: Composite Leverage = Operating leverage X Financial leverage Or Contribution EBIT Contribution = --------------- X -------- = ------------- EBIT PBT PBT----------------------------------------------------------------UNIT 5 PROBLEMS FINANCIAL LEVERAGES--------------------------------------------------------Objective• To understand the practical application of various leverages in the firm for better financial decisionsUnit outline5.1 Problems on:• Operating leverage• Financial leverage• Composite leverage----------------------------------------------------------------5.1 PROBLEMS OF LEVERAGES---------------------------------------------------------------- 19
  20. 20. 1. From the following data calculate the operating leverage, financial leverage and combined leverage: Sales: 10,000 units at Rs 25 per unit as selling price. Variable cost = Rs 5 per unit Fixed cost = Rs 30,000. Interest = Rs 15,000. Solution: Table to calculate OL, FL and CL Sales 2,50,000 Less Variable 50,000 cost Contribution 2,00,000 Less Fixed cost 30,000 EBIT 1,70,000 Less Interest 15,000 EBT 1,55,000 Contribution Operating Leverage = ------------------- Operating profit (EBIT) 2, 00,000 = ------------ 1, 70,000 = 1.17 times Earnings before Interest and Taxes EBITFinancial Leverage = --------------------------------------- OR ------ Earnings before Taxes EBT 1, 70,000 = ------------ 20
  21. 21. 1, 55,000 = 1.10 times Composite Leverage = Operating leverage X Financial leverage = 1.17 X 1.10 = 1.29 times 2. Evaluate two companies firm A and firm B in terms of the financial and operating leverage. Firm A Firm B Sales Rs 20,00,000 Rs 30,00,000 Variable cost 40% of Sales 30% of Sales Fixed cost Rs 5,00,000 Rs 7,00,000 Interest Rs 1,00,000 Rs 1,25,000Solution:Table to calculate OL, FL and CL Firm A Firm B Sales 20,00,000 30,00,000 Less Variable cost 8,00,000 9,00,000 Contribution 12,00,000 21,00,000 Less Fixed cost 5,00,000 7,00,000 EBIT 7,00,000 14,00,000 Less Interest 1,00,000 1,25,000 EBT 6,00,000 12,75,000 Contribution Operating Leverage = ------------------- Operating profit (EBIT) Firm A Firm B 12, 00,000 21, 00,000 = --------------- = ---------------- 21
  22. 22. 7, 00,000 14, 00,000 = 1.71 times = 1.50 times Earnings before Interest and Taxes EBITFinancial Leverage = ------------------------------- OR --------- Earnings before Taxes EBT Firm A Firm B 7, 00,000 14, 00,000 = ---------- ------------ 6, 00,000 12, 75,000 = 1.16 times = 1.10 times Composite Leverage = Operating leverage X Financial leverage Firm A Firm B =1.17 X 1.16 = 1.50 X1.1 = 2 times = 1.63 times Firm A has more business and financial risk when compared to FirmB.3. The following data are available for X Ltd.,: Selling price per unit Rs 120 Variable cost Rs 70 Fixed cost Rs 2, 00,000 a) What is the operating leverage when X Limited sells 6,000 units. b) What is the % change that will occur in the EBIT of X limited if output increases by 5%. 22
  23. 23. Solution:a) Table to calculate OL, if sales is 6,000 units Sales 7,20,000 Less variable cost 4,20,000 Contribution 3,00,000 Less Fixed cost 2,00,000 EBIT 1,00,000 Contribution Operating Leverage = ------------------- Operating profit (EBIT) 3, 00,000 = ------------ 1, 00,000 = 3 timesb) When the output increases by 5%. Now the total output increases to 6,300 unitsTherefore the change in EBIT is Sales 7,56,000 Less variable cost 4,41,000 Contribution 3,15,000 Less Fixed cost 2,00,000 EBIT 1,15,000The change in EBIT = 1, 15,000 - 1, 00,000 = 15,000Therefore the % change in EBIT = 15,000/1, 00,000 x 100 = 15% 23
  24. 24. 4. Calculate the Financial leverage and Operating leverage under situation A and situation B, under financial plans II and I from the following information relating to operations and capital structure of ABC Limited. Installed capacity = 1000 units. Actual production and Sales = 800 units.Selling price per unit = Rs 20. Variable cost = Rs 15. Fixed cost: Situation A Rs 800 Situation B Rs 1,500. Capital Structure: Particulars Plan I Plan II Equity share 5,000 7,000 capital Debt 5,000 2,000 Cost of debt 10% 10%Solution: Situation A Plan I Plan II Sales 16,000 16,000 Less Variable 12,000 12,000 cost Contribution 4,000 4,000 Less F. C 800 800 EBIT 3,200 3,200 Less interest 500 200 EBT 2,700 3,000 Plan I Plan II ContributionO. L = ------------------- =4,000/3,200 4,000/3,200 Operating profit (EBIT) 24
  25. 25. = 1.25 times = 1.25 times EBITF.L = --------- = 3200/2700 = 3200/3000 EBT = 1.19 times = 1.07 times Situation B Plan I Plan II Sales 16,000 16,000 Less Variable 12,000 12,000 cost Contribution 4,000 4,000 Less F. C 1,500 1,500 EBIT 2,500 2,500 Less interest 500 200 EBT 2,000 2,300 Plan I Plan II ContributionO. L = ------------------- =4,000/2,500 =4,000/2,500 Operating profit (EBIT) = 1.60 times = 1.60 timesF.L = EBIT ------- = 2,500/2,000 = 2500/2300 EBT = 1.25 times = 1.09 timesConclusion: It is advisable to the management that the OL should be less and FLshould be more in order to maximise the returns. Therefore OL under situation A is1.25 times and FL under situation B (Plan I) is 1.25 times, which is considered asan ideal situation. 25
  26. 26. 5. From the following data of A,B and C companies prepare their income statement: Particulars A B C VC as a % of 66 2/3 75 50 sales Interest Rs 200 Rs 300 Rs 1,000 OL 5:1 6:1 2:1 FL 3:1 4:1 2:1 Income Tax rate 50 % 50 % 50 %Solution: We knew, EBIT EBIT F.L = --------- = --------- EBT EBIT - InterestIn Company A 3 EBIT --- = ----------- 1 EBIT-200 3 EBIT - 600 = EBIT 2 EBIT = 600 EBIT =Rs 300 In Company B 4 EBIT ---- = ----------- 1 EBIT-300 4 EBIT - 1200 = EBIT 3 EBIT = 1200 EBIT = Rs 400 In Company C 2 EBIT --- = ----------- 1 EBIT-1000 26
  27. 27. 2 EBIT - 2000 = EBIT EBIT = Rs 1000 Operating Leverage Contribution OL = ---------------- EBIT In Company A In company B Contribution OL = ---------------- EBIT 5 Contribution 6 Contribution --- =---------------- --- =--------------- 1 300 1 400 Contribution = Rs 1500 Contribution = Rs 2400 In company C 2 Contribution -- = ---------------- 1 1000 Contribution = Rs 2000Computation of Sales: Contribution = Sales - VCCompany A Let Sales = 100 VC = 66 2/3Therefore Contribution = 100 -200/3 = 100/3 27
  28. 28. = Rs 1,500Therefore Sales = 1500 x 100 x 3 / 100 = Rs. 4,500Variable Cost = Rs 3,000Computation of Sales: Contribution = Sales - VCCompany B Let Sales = 100 VC = 75%Therefore Contribution = 100 -75 =25Therefore Sales = 2400 x 100/25 = Rs. 9,600Variable Cost = Rs 7,200Computation of Sales: Contribution = Sales - VCCompany C Let Sales = 100 VC = 50Therefore Contribution = 100 -50 = 50Therefore Sales = 2,000 x 100/ 50 = Rs. 4,000Variable Cost = Rs 2,0006. PQR and Co’s latest Balance Sheet is as follows;Balance Sheet of PQR & Co. Liabilities Amount Assets Amount (In Rs.) (In Rs.) 28
  29. 29. Equity Capital 60,000 Fixed Assets 150,00 (Rs 10/- each) 0 Current 10% Long term 80,000 Assets 50,00 debt 0 20,00 Retained 0 earnings 40,00 Current 0 Liabilities Total 200,000 Total 200,00 0 The Company’s total assets turnover ratio=3, Fixed cost=Rs1, 00,000/-and Variable Cost=40% of Sales, Tax=50%. Find OL, FL and CL.SolutionTotal Assets Turnover Ratio = Sales/Total Assets 3 = Sales/2,00,000 Therefore Sales = Rs.6, 00,000/-Therefore V.C=40% of Sales = 40/100 x 600000 =Rs. 240000Interest = 10%Long term debt=10/100 x 80000 =Rs.48000/-Income Statement Sales 600000 (-)V.C 240000 Contribution 360000 (-)FC 100000 EBIT 260000 (-)Interest 800 (10%on80,000) 0 29
  30. 30. EBT (-)Tax50% 252000 126000 EAT 126000Operating Leverage = Contribution/EBIT = 360000/260000=1.38 timesFinancial Leverage = EBIT/EBT =260000/252000=1.03 timesCombined Leverage = OL X FL= 1.38X1.03=1.42 times7. X Limited has estimated that for a new product, its BEP is 2000 units of theitem is sold for Rs 14per unit., the cost accounting department has currentlyidentified VC of Rs. 9/- per unit. Calculate OL for sales volume of 2500 units and3000 units. [BEP = Break Even Point]. Fixed cost not given.SolutionSelling Price=Rs14/-per unitVariable cost =Rs9/- per unitCalculation of Fixed cost.Sales 28000(-)VC 18000Contribution 10000(-)FC - 10000EBIT = 0Therefore Contribution will be considered as Fixed cost i.e. Rs. 10,000/- Income Statement 30
  31. 31. Particulars 2500Uni 3000Uni ts ts Sales 35000 42000 (-)VC 22500 27000 Contributi 12500 15000 on 10000 10000 (-)FC 2500 5000 EBITTherefore OL (2500Units) = Contribution/EBIT= 12500/2500=5 timesOL (3000Units) = Contribution/EBIT=15000/5000=3 times If sales volume is increased by 25 %(from 2000 to 2500Units) the EBITincreases unto Rs2500/- from BEP. If sales volume increases up to Rs 5000/-(doubled: 2500 to 5000)8. Following information is obtained from a hypothetical company which has thethree different situations X,Y and Z and Financial plans I, II and III. You arerequired to calculate OL, FL and CL. The total capacity of the project=10000Units,Explored capacity of sales=7500 UnitsS.P Per Unit=Rs.20/-V.C Per Unit=Rs15/-Fixed Cost; X=Rs10000 Y=Rs20000 Z=Rs25000Financial Plans;1) Rs50000/-Equity and Rs40000/-debt at 10% interest2) Rs60000/- Equity and Rs30000/-debt at 10% interest3) Rs30000/- Equity and Rs60000/- debt at 10% interest 31
  32. 32. SolutionSituation Plan-I Plan-II Plan-IIISales 1,50,000 1,50,000 1,50,000(-)VC 1,12,500 1,12,500 1,12,500Contribution 37,500 37,500 37,500(-)FC 10,000 10,000 10,000EBIT 27,500 27,500 27,500(-)Interest 4000 3000 6000EBT 23500 24500 21500Operating Leverages(I) OL=37500/27500=1.36 times(II) OL=37500/27500=1.36 times(III) OL=37500/27500=1.36 timesFinancial Leverages(I) FL=27500/23500= 1.17 times(II) FL=27500/24500= 1.12 times(III) FL=27500/21500= 1.28 timesCombined Leverages(I) CL=1.36 x 1.17 = 1.59 times(II) CL=1.36 x1.12 = 1.52 times(III) CL=1.36 x 1.28 = 1.74 times Situation-Y Plan-I Plan-II Plan-III Sales 1,50,000 1,50,000 1,50,000 (-)VC 1,12,500 1,12,500 1,12,500 Contribution 37,500 37,500 37,500 (-)FC 20,000 20,000 20,000 EBIT 17,500 17,500 17,500 (-)Interest 4000 3000 6000 32
  33. 33. EBT 13500 14500 11500Operating Leverages(I) OL=37500/17500=2.14 times(II) OL=37500/17500=2.14 times(III) OL=37500/17500=2.14 timesFinancial Leverages(I) FL=17500/13500=1.30 times(II) FL=17500/14500=1.21 times(III) FL=17500/11500=1.52 timesCombined Leverages(I) CL=2.14X1.30=2.78 times(II) CL=2.14X1.21=2.59 times(III) CL=2.14X1.52=3.25 timesSituation-Z Plan-I Plan-II Plan-IIISales 1,50,000 1,50,000 1,50,000(-)VC 1,12,500 1,12,500 1,12,500Contribution 37,500 37,500 37,500(-)FC 25,000 25,000 25000EBIT 12,500 12,500 12,500(-)Interest 4000 3000 6000EBT 8500 9500 6500Operating Leverages;(I) OL=37500/12500=3 times(II) OL=37500/12500=3 times(III) OL=37500/12500=3 timesFinancial Leverages;(I)FL=12500/8500=1.47 times(II)FL=12500/9500=1.32 times(III)FL=12500/6500=1.92 times 33
  34. 34. Combined Leverages;(I)CL=3X1.47=4.41 times(II)CL=3X1.32=3.96 times(III)CL=3X1.92=5.76 times The OL is least in situation X (all plans) and the FL is highest in situation ZPlan III.------------------------------------------------------------------------------- Unit 6 CAPITAL STRUCTURE-------------------------------------------------------Objectives• To bring clarity in concepts of capital structure, differentiating with financial structure and decide about the optimum capital structure.• To bring out the essential features for appropriate capital structure• To identify the factors which determines the capital structure.Unit Outline5.1 Introduction6.2 Meaning of capital structure6.3 Difference between capital and financial structure6.4 Optimum Capital structure6.5 Features of Appropriate Capital Structure6.6 Factors determining Capital Structure--------------------------------------------------6.1 INTRODUCTION------------------------------------------------- 34
  35. 35. The funds required by the business organisation are raised through theownership securities i.e., by equity shares, preference shares and creditorshipsecurities i.e., debentures and bonds. But the business organisation must raisethese funds by a proper mix of both these securities in such a way that the costand the risk of both these securities should be minimum. The mix of differentsecurities is disclosed by the firms capital structure.------------------------------------------------------------------------------ 5.2 MEANING OF CAPITAL STRUCTURE-------------------------------------------------------------------------- In ordinary language it implies the proportion of debt and equity in the totalcapital of a company.According to Gerstenberg Capital Structure refers to the the make up of a firmscapitalisation. In other words, it represents the mix of different sources of longterm funds in the capitalisation of the company.------------------------------------------------------------------------------- 5.3 DIFFERENCE BETWEEN CAPITAL STRUCTURE AND FINANCIAL STRUCTURE-------------------------------------------------------------------------- Financial Structure is the entire left hand side of the company balance sheeti.e., ownership securities, creditorship securities and current liabilities. Whereascapital structure refers to sources of all long-term funds like ownership securitieslike equity capital and preference capital and creditorship securities likedebentures, bonds and long term loans.--------------------------------------------------------------------------6.4 OPTIMUM CAPITAL STRUCTURE-------------------------------------------------------------------------- The optimum capital structure is obtained when the market value per equityshare is the maximum. It may be defined as that relationship of debt and equitysecurities which maximizes the value of a companys share in the stock exchange.Or at optimum capital structure, the value of an equity shares is the maximumwhile the average cost of capital is the minimum. 35
  36. 36. ---------------------------------------------------------------------------6.5 FEATURES OF APPROPRIATE CAPITAL STRUCTURE-------------------------------------------------------------------------An appropriate capital structure will posses the following features.1. Profitability. The most profitable capital structure of a company is one that tends to minimize cost of financing and maximise earning per equity share. Hence these companies naturally are profitable.2. Solvency. The pattern of capital structure should be devised in such a way that the company does not run into the risk of becoming insolvent. Excess use of debt threatens the solvency of the company.3. Flexibility. The capital structure should be in such a way that it should have a provision of easily switching over to requirements of changing conditions by easy swap and also there should be availability of funds for profitable activities.4. Conservatism. The capital structure should be conservative so that the debt content in the total capital structure does not exceed the limit which the company can bear.5. Control. The capital structure should be so devised that it involves minimum risk of loss of control of the company.--------------------------------------------------------------------------6.5 FACTORS DETERMINING CAPITAL STRUCTURE-------------------------------------------------------------------------- Great caution is required at the time of determining the initial capitalstructure of a company since it will have long-term implications. Hence the financemanager should be careful but it can be changes subsequently as per therequirements. This capital structure decision is a continuous one and has to betaken whenever a firm needs additional finances. 36
  37. 37. The following are the factors which determines the capital structure of acompany. 1. Trading on equity or Financial Leverage. The use of long-term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. Making profit to shareholders by using the other funds like debentures, preference capital is called trading on equity. In other words if the rate of return on the total capital employed is more than the rate of interest on debentures or rate of dividend on preference shares. 2. Retaining control. The capital structure of a company is also affected by the extent to which the promoters or existing management of the company desire to maintain control over the affairs of the company. if the existing management want maintain the same control over the company for further funds they will issue only debentures and preference capital instead of issuing equity shares. 3. Nature of enterprise. The nature of enterprise will determine the capital structure of the organisation. If the company is a public utility organisation or a monopoly organisation in that product then it can earn stable profit. Hence it goes for debentures or bonds since they will have adequate profits to meet recurring costs. 4. Legal requirements. The promoters of a company must comply with the legal requirements of the organisation. For example the banking companies has to raise funds only through equity share capital as per the Banking Regulations Act. 5. Purpose of financing. The purpose of financing is another factor which determines the capital structure of the organisation. The purpose of financing is for productive purposes like purchase of machinery , payment of old debts borrowed at high interest are financed through debentures 37
  38. 38. and bonds. If the purpose of financing is for non productive purposes like welfare activities etc then it is raised through equity capital. 6. Period of finance. The capital structure of a company depends on the period of finance. For example the funds required for the business is 5 to 10 years it is raised through debentures, redeemable preference shares and bonds. Whereas if funds are raised for permanently then it is raised through equity shares or preference shares. 7. Government policy. Government policy is an important factor in planning the companys capital structure. The controller of capital Issues and Government of India can interfere and dictate the capital structure of the organisation. 8. Market sentiments of investors. The market sentiments of the investors will determine the capital structure of the organisation. If companys investors expect absolute safety attitude in their investment pattern then the companies will go for raising the finance required through debentures. If the investors want to make high profits through speculation then the companies raise its capital by issuing equity shares.----------------------------------------------------------------UNIT 7 CAPITAL STRUCTURE THEORIES---------------------------------------------------------------Objectives• To give an idea of basic capital structure theories and to select optimum capital structure.• To highlight the essential features for a sound capital mixUnit outline 38
  39. 39. 7.1 Capital Structure Theories: • Net Incomes (NI) Approach, • Net Operating Income (NOI) Approach, • Modigilani - Miller (MM) Approach, and • Traditional Approach.7.2 Capital Structure Management or Planning the Capital Structure7.3 Essential features of a sound capital mix------------------------------------------------------------------------------7.1 CAPITAL STRUCTURE THEORIES--------------------------------------------------------------------------------------------- To achieve the basic goal of optimum capital structure in the organisationthe finance manager must have the basic knowledge of capital structure theories.There are extreme opinions on the optimum capital structure, hence it calls forvarious theories in this. They are: • Net Incomes (NI) Approach, • Net Operating Income (NOI) Approach, • Modigilani - Miller (MM) Approach, and • Traditional Approach.These theories are based on the following general assumption. They are:(a) The firm employs only two types of capital-debt and equity.(b) The firm pays 100% of its earnings as dividend. Thus there are no retained earnings.(c)The firms total assets given are assumed to be constant in investment decisions.(d) The operating earnings are not expected to grow.(e) The business risk remains constant and is independent of capital structure and financial risks. 39
  40. 40. (f) The firm has a continuous life.1. Net Incomes (NI) Approach Durand has suggested this approach. According to this approach, capital structure decision is relevant to the valuation of the firm because the change in capital structure decision causes a corresponding change in the overall cost of capital as well as the total value of the firm. According to this approach a higher debt content in the capital structure (high financial leverage) will result in decline in the overall or weighted average cost of the capital and increase in the value of equity shares of the company. This approach is based on the following three assumptions. (i) There are no corporate taxes. (ii) The cost of debt is less than cost of equity or equity capitalisation rate. (iii) The debt content does not change the risk perception of the investors. On the basis of Net Income approach the value of the firm is calculated as: V=S+BWhere,V= Value of Firm.S= Market value of Equity.B= market value of Debt. Market value of equity = NI/ke, where, NI = Earnigs availabe for equityshareholders; ke = cost of equity or equity capitalisation rateOverall cost of capital (Ko) = EBIT/V2. Net Operating Income (NOI) Approach This approach has also been suggested by Durand. According to this approachthe market value of the firm is not affected by the change in capital structure. 40
  41. 41. Because the market value of the firm is ascertained by capitalising the netoperating income at the overall cost of capital (k), which is considered to beconstant. Assumptions of this approach are: a) The overall cost of capital remains constant for all degrees of debt-equity mix. b) The market capitalises the value of the firm as a whole hence, the split between debt and equity is not relevant. c) The use of debt having low cost increases the risk of equity shareholders, this results in increase in equity capitalisation rate. d) There are no corporate taxes. According to this approach, the Value of the firm is calculated with the helpof the following formula. EBIT (1-Tax rate) Value of Firm (V) = -------- Ko Ko = Overall cost of capitalValue of equity = V - BAccording to NOI Approach, the total value of the firm remains constantirrespective of the debt-equity mix or the degree of leverage.Overall cost of capital (Ko) = Ke (S/V) + Kd (B/V)Whereas Kd= Cost of debt or {Interest rate (1-Tax rate)} eg. 10%(1-0.35) B = Market value of Debt V = Value of firm S=V-B EBIT-1Ke = ------- X 100 V-B 41
  42. 42. 3. Modigiliani - Miller Approach This approach is similar to the NOI approach. It also states that the value ofthe firm is independent of its capital structure. Nevertheless, there is a basicdifference the two is that the NOI approach is purely definitional or conceptual. Itdoes not provide operational justification for irrelevance of the capital structure inthe valuation of the firm. Assumptions of MM Theory The MM theory is based on the following assumptions: 1) Perfect capital markets exist where individuals and companies can borrow unlimited amounts at the same rate of interest. 2) There are no taxes or transaction costs. 3) The firms investment schedule and cash flows are assumed constant and perpetual. 4) Firms exist with the same business or systematic risk at different levels of gearing. 5) The stock markets are perfectly competitive. 6) Investors are rational and expect other investors to behave rationally.a) MM Theory: No taxation.b) MM Theory with Corporate Tax4. Traditional Approach or weighted average cost of capital (WACC)The traditional approach or intermediate approach is a mid-way between the twoapproaches. It partly contains features of both the approaches as given below:a) The traditional approach is similar to NI Approach to the extent that it accepts that the capital structure or leverage of the firm affects the cost of capital and 42
  43. 43. its valuation. However, it does not subscribe to the NI approach that the value of the firm will necessarily increase with all degree of leverages.b) It subscribes to the NOI approach that beyond a certain degree of leverage, the overall cost of capital increases resulting in decrease in the total value of the firm. However, it differs from NOI approach in the sense that the overall cost of capital will not remain constant for all degree of leverage. According to Traditional approach the firm through judicious use of debt-equity mix can increase its total value and thereby reduce its overall cost ofcapital. This is because debt is relatively cheaper source of funds as compared toraising money through shares because of tax advantage. However, beyond a pointraising of funds through debt may become a financial risk and would result in ahigher equity capitalisation rate. Traditionally, optimal capital structure is assumed at a point where weightedaverage cost of capital (WACC) is minimum. For a project evaluation, this WACC isconsidered as the minimum rate of return required from project to pay-off theexpected return of the investors and as such WACC or Composite cost of capital isgenerally referred to as the required rate of return. It is calculated as follows: WACC = (Cost of Equity X % Equity) + (Cost of debt X % debt)---------------------------------------------------------------7.2 PLANNING THE CAPITAL STRUCTURE------------------------------------------------------------- Determining the capital mix and also the estimation of capital requirementsfor current and future need of a firm are very important for a firm. Equity capitaland debt are the two principle sources of finance of a business. But it should be inwhat proportion? How much of financial leverage a firm should employ? Are thetwo important questions comes before finance manager. The relationship betweenfinancial leverage and cost of capital will answer this question. 43
  44. 44. The capital structure planning, which aims at the maximisation of profits andthe wealth of the shareholders, ensures the maximum value of a firm or theminimum cost of capital. It is very difficult for a finance manager to determine theproper mix of debt and equity for his firm. The financial manager must try to reachas near as possible of the optimum point of debt and equity mix.----------------------------------------------------------------7.3 ESSENTIAL FEATURES OF A SOUND CAPITAL MIX---------------------------------------------------------------- The following are the essential features of a sound capital mix.1. Maximum possible use of leverage.2. The capital structure should be flexible.3. The use of debt should be within the capacity of a firm.4. It should involve minimum possible risk of loss of control.5. It must avoid undue restrictions in agreement of debt.---------------------------------------------------------------UNIT 8 PROBLEMS ON COST STRUCTURE THEORIES--------------------------------------------------------Objective• To familiarise about various cost structure theories for practical applicationsUnit outline8.1 Problems on Cost Structure Theories 44
  45. 45. ---------------------------------------------------------------------------8.1 PROBLEMS ON COST STRUCTURE THEORIES-----------------------------------------------------------------------------------------------1. Companies P and Q are identical in all respects including risk factors except for debt / equity, P having issued 10% debentures of Rs, 9 lakhs while Q has issued only equity. Bothe the companies earn 20% before interest and taxes on their total assets of Rs. 15 lakhs. Assuming tax rate of 50% and capitalisation rate of 15% for an all-equitycompany, compute the value of companies P and Q using (a) net income approachand (b) net operating income approach.Particulars P QEBIT (@ 20% on Rs. 15 lakhs) 3,00,000 3,00,000Less : Interest 90,000 - ------------ -------------EBT 2,10,000 3,00,000Less : Tax @ 50% 1.05,000 1,50,000 ------------ ------------Earnings after Tax (EAT) 1,05,000 1,50,000(a) Valuation of company under Net Income ApproachCalculation of value of EquityValue of Equity (capitalised @ 15%)P = (1,05,000 x 100 / 15) = 7,00,000 Q = (1,50,000 x 100 / 15) =10,00,000Value of Debt P = 9,00,000, Q = 0Value of Company = S + DP = 7,00,000 + 9,00,000 = 16,00,000Q = 10,00,000 + 0 = 10,00,000(b) Valuation of companies under Net Operating Income Approach EBIT (1 - T) V= -------- K 45
  46. 46. Value of equity (S) = V - BCompany P EBIT (1 - T) V (value of equity) = -------- K 3,00,000 (1 - 0.50) V= ---------------------- = 10,00,000 0.15 Value of Debt = (9,00,000 x 1 - 0.5) = 4,50,000 Value of Equity (S) = V - B = 10,00,000 - 4,50,000 = 5,50,000 Add value of Debt = 9,00,000 ------------------ Value of company 14,50,000 -----------------Company Q EBIT (1 - T) V= -------- K 3,00,000 (1 - 0.50) V = ---------------------- = 10,00,000 0.15 Value of Equity (S) = V - B = 10,00,000 Value of Debt = - ---------------- Value of company 10,00,000 ---------------2. The following information is available regarding the two firms A and B which are identical in all respects except the degree of leverage. Firm A has 6% debt of Rs 6 lakhs while firm B has no debt. Both the firms are earning an EBT of Rs 2,40,000 each. The equity capitalization rte is 10% and the corporate tax is 60%. Compute the value of the two firms on MM Model.SolutionValue of unlevered firm B 46
  47. 47. Vu = EBT (1 - T) / ke = 2,40,000 (1-0.6) / 10% = 96,000 / 0.10 = 9,60,000Value of levered firm AVi = Vu + Bt = 9,60,000 + 6,00,000 (0.6) = 9,60,000 + 3,60,000 = Rs. 13,20,0003. The values for two firms X and Y in accordance with the traditional theory are given below: X YExpected operating income Rs. 50,000 Rs. 50,000Total cost of debt 0 10,000Net Income 50,000 40,000Cost of equity (ke) 0.10 0.11Market value of shares (s) 5,00,000 3,60,000Market value of debt 0 2,00,000Total value of the firm 5,00,000 5,60,000Average cost of capital (ke) 0.10 (0.09)Debt equity ratio 0 0.556 Compute the values for firms X and Y as per the MM theses. Assume that (i) Corporate income taxes do not exist, and 47
  48. 48. (ii) The equilibrium value of ke is 12.5% Solution: COMPUTATION OF THE VALUES OF FIRMS Company X Company Y Rs. Rs.Expected net operating income ¯x 50,000 50,000Less: cost of debt (D) 0 10,000 ------------ ----------Net income for equity 50,000 40,000 ---------- ---------Equilibrium cost of capital (ko) 0.125 0.125Total value of company (V)= ¯x / ko 4,00,000 4,00,000Market value of debt (B) - 2,00,000Market value of equity (V - B) 4,00,000 2,00,000Cost of equity (ke) = ¯x - D/ s 12.5% 20% 4. In considering the most desirable capital structure of a company, the following estimates of the cost of Debt and Equity capital (after Tax) have been made at various levels of Debt-Equity Mix: Debt as % of total Cost of Debt Cost of Equity capital employed (%) (%) 0 5.0 12.0 10 5.0 12.0 20 5.0 12.5 30 5.5 13.0 40 6.0 14.0 50 6.5 16.0 60 7.0 20.0 48
  49. 49. Calculate the optimal Debt-Equity Mix for the company by calculating compositecost of capital.Solution:Calculation of Optimal Debt-Equity MixDebt as % of Cost of Cost of WACCtotal capital Debt Equityemployed (%) (%)0 5.0 12.0 (5 x 0 ) + (12 x 1.00) = 12.0010 5.0 12.0 (5 x 0.10) + (12 x 0.90) = 11.3020 5.0 12.5 (5 x 0.20 ) + (12 x 0.80) = 11.0030 5.5 13.0 (5.5 x 0.30 ) + (13 x 0.70) = 10.7540 6.0 14.0 (6 x 0.40 ) + (14 x 0.60) = 10.8050 6.5 16.0 (6.5 x 0.50 ) + (16 x 0.50) = 11.2560 7.0 20.0 (7 x 0.60 ) + (20 x 0.40) = 12.20At optimum debt-equity mix 30: 70, the WACC is at minimum level of 10.75%.-------------------------------------------------------UNIT 9 COST OF CAPITAL-----------------------------------------------------Objectives• To familiarise about the cost of capital• To incorporate the importance of cost of capital in business financial decisions.Unit outline9.1 Meaning9.2 Significance or Importance of Cost of Capital9.3 COMPUTATION OF COST OF CAPITAL 49
  50. 50. A. Computation of specific cost of capital---------------------------------------------------------------9.1 MEANING OF COST OF CAPITAL-------------------------------------------------------------- The main goal of business firm is to maximise the wealth of shareholders inthe long-run, the management should only invest in projects which give a return inexcess of cost of funds invested in the projects of the business. The term cost ofcapital refers to the minimum rate of return a firm must earn on its investments sothat the market value of the company equity shares does not fall. This is intendedto achieve the objective of wealth maximisation. This is possible when the firmearns a return on the projects financed by equity shareholders funds at a ratewhich is at least equal to the rate of return expected by them. The cost of capital is the rate of return the company has to pay to varioussuppliers of funds in the company. According to Solomon Ezra, "Cost of capital is the minimum required rate ofearnings or the cut-off rate of capital expenditures." Hampton, John J. defines cost of capital as the rate of return the firmrequires from investment in order to increase the value of the firm in the marketplace". Thus, we can say that cost of capital is that minimum rate of return which afirm, must and, is expected to earn on its investments so as to maintain themarket value of its shares.-------------------------------------------------------------------------------9.2 SIGNIFICANCE OR IMPORTANCE OF COST OF CAPITAL--------------------------------------------------------------------------- The determination of cost of capital of a firm is important to themanagement to take some financial decisions like: 50
  51. 51. a) Capital Budgeting decisions. In capital budgeting decisions, the cost of capital is often used as a discount rate on the basis of which the firms future cash flows are discounted to find out their present values.b) Capital structure decisions. The cost of capital is an important consideration in capital structure decisions. The finance manager must raise capital from different sources in a way that it optimises the risk and cost factors.c) Basis for evaluating the financial performance. The actual profitability of the project is compared to the projected overall cost of capital and the actual cost of capital of funds raised to finance the project. if the actual profitability of the project is more than the projected and the actual cost of capital, the performance may be said to be satisfactory.d) Basis for taking other financial decisions. The cost of capital is also used in making other financial decisions such as dividend policy, capitalisation of profits, making the right issue and working capital.------------------------------------------------------------------------9.3 COMPUTATION OF COST OF CAPITAL--------------------------------------------------------------------------B. Computation of specific cost of capitalComputation of specific cost of various sources of finance viz., debt, preferenceshare capital, equity share capital and retained earnings is discussed as below:1. Cost of Debt (Kd). The cost of debt is the rate of interest payable on debt. The interest paid on debts will have tax benefits i.e., tax is paid on the profits after allowing debenture interest.a) Cost of Irredeemable Debentures: I (1 - t) Kd = ---------- NP Where, I = Annual interest T = Companies tax rate 51
  52. 52. NP = Net proceeds of loans or debenturesIn case of debt is raised at premium or discount, we should consider P as theamount of net proceeds received from the issue and not the face value ofsecurities. The formula is I Kd = ---------- NPIn case of underwriting commission (UC) paid if any is deducted from NP (UC isalways calculated at par value. Maximum permissible limit is 2.5%).2. Cost of Preference shares a) Irredeemable Preference shares Kp = PD / NP b) Redeemable Preference shares PD + RV-NP --------- n Kp = ------------------------- RV + NP ----------- 2Where PD is preference dividendDividend paid on preference shares is an appropriation of profit and hence is doesnot get tax benefit.Any premium or discount on issue of shares is to be adjusted with net proceeds.Underwriting paid if any is also deducted from the net proceeds (Max. permissiblelimit 5% calculated on par value)Note: there is no difference in calculation of Kp whether to be calculated beforetax or after tax because it doesnt get tax benefit.3. Cost of Equity 52
  53. 53. Cost of equity is assumed to be nil because of the following reasons: a) There is no fixed rate of dividend paid to equity shareholders. b) There is no legal binding for declaring dividends to equity shareholders. The following are the approaches to cost of equity: a) Dividend price approach (DP approach) The rate of dividend expected by the equity shareholders is considered as cost of equity. b) Earning price approach Ke = Dividend / Market Price x 100 c) DP + Growth approach Ke = Dividend / Market Price x 100 + Growth Rate d) Realised Yield approach (past) Ke = Dividend / Market Price x 100 + Growth Rate Note: Dividend MP = --------- Ke - GR There is no tax effect and always it is irredeemable.4. Weighted Average Cost of Capital (WACC) It refers to overall cost of capital after taking into consideration the weights of each source of capital. Weights can be of two types: a) Weights assumed on face value (book price) b) Weights assumed on market price.----------------------------------------------------------------UNIT 10 PROBLEMS ON COST OF CAPITAL 53
  54. 54. ----------------------------------------------------------------Objective• To study the costs of various sources of capital for better selection of source on the basis of cost of capital.Chapter outline10.1 Problems on cost of capital---------------------------------------------------------------10.1 PROBLEMS ON COST OF CAPITAL-------------------------------------------------------------I Cost of DebtProblems1. A company issues Rs. 10,00,000 16% debentures of Rs. 100 each. The company is in 35% tax rate. You are required to calculate the cost of debt after tax if debentures are issued at (i) Par (ii) 10% Discount (iii) 10% Premium (iv) If brokerage is paid at 2% what will be the cost of debenture if issued at par. (v) Calculate Kd before tax for (iv) above.Solution I (1 - t) 1,60,000 (1 -0.35) 54
  55. 55. (i) Kd (at Par) = ---------- = --------------------- = 10.4% NP 10,00,000 1,60,000 (1 - 0.35) (ii)Kd (at Discount) = ---------------------- = 11.56% 9,00,0000 1,60,0000 (1 - 0.35) (iii) Kd (at Premium) = ----------------------- = 9.45% 11,00,000 1,60,0000 (1 - 0.35) (iv) Kd (Brokerage at 2%) = -------------------------= 10.61% 10,00,000 - 20,000 I 1,60,000 (v) Kd (before tax) = ------ = ---------------------= 16.33% NP 10,00,000 - 20,000b) Cost of Redeemable debentures Formula I (1 - t) + (RV - NP) ------------ n Kd = ----------------------------------- X 100 (RV + NP) ------------ 2 Where, RV = Redemption value n = number of years2. A 7 year Rs 100 debenture is available at a net cost of Rs 95. The coupon rate is 15% and the bond will be redeemed at a premium of 6% on maturity. The firms tax rate is 40%. Calculate the cost of debenture.Solution I (1 - t) + (RV - NP) ------------ n Kd = ----------------------------------- X 100 55
  56. 56. (RV + NP) ------------ 2 15 (1 - 0.4) + (106 - 95) ------------ 7 Kd = ------------------------------- X 100 = 10.52% (106 + 95) ------------- 23. A 10% Rs. 1,000 par bond of 10 years sold at Rs. 950 and underwriting commission 5%. Calculate cost of debt. a) Before tax , and b) After tax Solution Calculation of Net proceeds: Par value Rs 1,000 (-) Discount 50 ----------- 950 (-) Underwriting commission on 1,000 at 5% 50 ---------- Net proceeds 900 a) Before tax I + (RV - NP) ------------ n Kd = ----------------------------------- X 100 (RV + NP) ------------ 2 100 + (1000 - 900) ------------ 10 Kd = ------------------------- X 100 = 11.58% (1000 + 900) 56
  57. 57. ------------- 2b) After tax I (1 - t) + (RV - NP) ------------ n Kd = ----------------------- X 100 (RV + NP) ------------ 2 100 (1 - 0.35) + (1000 - 900) ------------ 10 Kd = ------------------------------- X 100 = 7.9% (1000+ 900) ------------- 24. ABC Ltd., issues 2 sets of debentures. One at discount at 10% and the other at a premium of 15% respectively. Series 1: 12%, 1,000 debentures of Rs 100 each. Series 2 : 7 ½ % 1000 debentures of Rs 10 each. Series 2 was redeemed after a period of 8 years at a premium of 15%.Underwriting commission is paid on both the series as per the maximum limitsspecified under companys act. Calculate Kd after tax and before tax for both theseries.SolutionSeries 1: I (1 -t) 12,000 (1 -0.35)a) Kd = --------- = --------------------- x 100 = 8.91% NP 87,500 57
  58. 58. Calculation of N P:Par value 1,00,000(-) Discount 10,000 ---------- 90,000(-) UnderwritingCommission @ 2.5% 2,500(1,00,000 x 2.5%) ----------- Rs. 87,500 -----------------b) Kd = I/Np = 12,000 / 87,500 x 100 = 13.71%Series 2:Calculation of NP:Par value 1,000(+) Premium 150 ------ 1,150(-) UnderwritingCommission 25 ------ 1,125 I (1 - t) + (RV - NP) ------------ n a) Kd = ----------------------------------- X 100 (RV + NP) ------------ 2 75 (1 - 0.35) + (1,150 - 1,125) ------------ 8 Kd = ----------------------------------- X 100 (1,150 - 1,125) ------------ 2 = 4.56 % 58
  59. 59. I + (RV - NP) ------------ n b) Kd = ----------------------------------- X 100 (RV + NP) ------------ 2 75 + (1,150 - 1,125) ------------ 8 Kd = ----------------------------------- X 100 = 6.87 % (1,150 - 1,125) ------------ 2-------------------------------------------------------------------------------UNIT 11 PROBLEMS OF COST OF PREFERENCE SHARES----------------------------------------------------------------Unit Outline Problems of Cost of Preference shares a) Irredeemable Preference shares Kp = PD / NP b) Redeemable Preference shares PD + RV-NP --------- n Kp = ------------------------- RV + NP ----------- 2 c) Problems on Cost of Equity Approaches to the cost of equity: 59
  60. 60. Dividend price approach (DP approach) Earning price approach Ke = Dividend / Market Price x 100 e) DP + Growth approach Ke = Dividend / Market Price x 100 + Growth Rate f) Realised Yield approach (past) Ke = Dividend / Market Price x 100 + Growth Rate Note: Dividend MP = --------- Ke - GR There is no tax effect and always it is irredeemable.1. Assuming that the firms tax rate is 50% compute after tax cost and before tax Cost of preference shares in the following cases:a) 9 % Preference shares sold at par.b) A Company issues 14% irredeemable preference shares, the face value of share is Rs. 100 but the issue price is Rs 95. What is the cost of Preference shares? What is the cost if the issue price is Rs 105?c) A Company Preference shares sold at Rs 100 with a 10% dividend and redemption Rs 112 if the company redeems within 5 years.Solution:a) Kp = PD / NP = 9 / 100 = 9%b) i) Kp = PD / NP = 14 / 95 = 14.74% ii) Kp = PD / NP = 14 / 105 = 13.33% PD + RV-NP --------- n 60
  61. 61. c) Kp = ------------------------- x 100 RV + NP ----------- 2 10 + 112- 100 --------------- 5 Kp = ------------------------- x 100 = 11.7 % 112 + 100 ----------- 2Cost of equity shares (Ke) A companies share is quoted in market at Rs 40 currently. A company pays adividend of Rs 2 per share and investors expects a growth rate of 10% computea) The Companies cost of equity capital.b) If anticipated growth rate is 11% p.a. Calculate the indicated growth market price per share.c) If companies cost of capital is 16% and anticipated growth rate is 10% p.a. Calculate the market price if dividend of Ts 2 per share is to be maintained.Solution:a) Ke = D/MP x 100 + GR = 2 / 40 x 100 + 10% = 15 %b) MP = D /Ke% - GR% = 2 / 15% - 11% = 2 / 4% = Rs. 50.c) MP = 2 / 16 - 10 = 2 / 6% = Rs. 33.33%---------------------------------------------------------------- 61
  62. 62. Unit 12 Problems on Weighted Average cost of Capital (WACC)---------------------------------------------------------------- Unit outline • Problems on Weighted Average cost of Capital (WACC) 1. Calculate WACC of A Ltd. From the following information: Sources Capital Cost of capital Debt 4,00,000 14% Equity share 6,00,000 20% Assume corporate tax rate as 35%. Solution: Method 1: Sources Capital Weights Cost of capital WACC Debt 4,00,000 0.4 0.091 0.0364 Equity 6,00,000 0.6 0.2 0.12 ------------- ---------- 10,00,000 0.1564 ------------- ---------- WACC = 0.1564 x 100 = 15.64% Method 2: Sources Capital Cost of capital Total cost of capital Debt 4,00,000 9.1% 36,400 62
  63. 63. Equity 6,00,000 20% 1,20,000 ----------- ---------- 10,00,000 1,56,000 ------------- ------------- WACC = 1,56,400 / 10,00,000 x 100 = 15.64% Working Notes: Cost of capital: Debt = 14 x 0.65 (after tax) = 0.091 because it gets taxbenefit.2. Z Ltd, Y Ltd, and X Ltd., are in the same type of business and hence havesimilar operating risks. However the capital str5ucture of each of them is differentand the following are the details.Particulars X Ltd. Y Ltd. Z Ltd.Equity share capital:(Face value Rs. 10 / share 5,00,000 2,50,000 4,00,000Market Value per share Rs. 12 20 15Dividend per share 2.88 4 2.7Debentures(Face value Rs.100) 2,50,000 1,00,000Market valueper debenture Rs 80 125Interest rate 8% 10% Assume that the current level of dividends are generally expected tocontinue indefinitely and the income tax rate is at 50%. You are required tocompute the WACC of each of the company.Solution:Cost of equity: Formula Ke = D / M x 100 63
  64. 64. X ltd, Y ltd, Z ltd, 2.88 /12 x 100 4 / 20 x 100 2.7 / 15 x 100 = 24% = 20% = 18%Cost of Debt:FormulaKd = I (1 - T) / MPX ltd, Y ltd, Z ltd,8 (1 - 0.5) /80 10 (1 - 0.5) / 125 0% = 5% = 4% Sources Capital Cost of capital Total COC WACCX: Debt 2,50,000 5% 12,500 1,32,500 ---------- x 100 Equity 5,00,000 24% 1,20,000 7,50,000 ----------- ------------- 7,50,000 1,32,500 = 17.67% ----------- -------------Y: Debt 1,00,000 4% 4,000 54,000 --------- x 100 Equity 2,50,000 20% 50,000 3,50,000 ------------ ---------- 3,50,000 54,000 = 15.43% ----------- ---------Z: Debt --- 0% --- 72,000 -------- x 100 Equity 4,00,000 18% 72,000 4,00,000 ---------- --------- 4,00,000 72,000 = 18% ---------- --------On Face value:X Ltd., Ke = 2.88 /10 x100 = 28.8 %Y Ltd., Ke = 4 /10 x100 = 40%Z ltd., Ke = 2.7/10 x100 =27% 64