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Nature And Scope of Financial Management
 Financial management is such a managerial process which is
concerned with the p...
Meaning of Financial Management
“Financial Management is the operational
activity of a business that is responsible for
ob...
Approaches to Financial Management
1. Traditional Approach :
Under this approach, financial management was
used to procure...
Limitations of Traditional Concept
1. One sided Approach
2. More Emphasis on the Financial Problems of
Corporations
3. Mor...
Modern Approach to Finance Function
According to this approach, financial management considers the
broader and analytical ...
6Dr Ajay K Patel
Characteristics of Modern Approach
1. More Emphasis on Financial Decision
2. Financial Management as an Important
Componen...
Objectives of Financial Management
(i) Profit Maximisation Approach
(ii) Wealth Maximisation Approach
(i) Profit Maximisat...
Wealth Maximisation Approach :- According to this approach,
financial management should take such decisions which
increase...
Importance of Financial Management
(1) Significant part of Business Management
(2) Liquidity and Profitability
(3) Value o...
Time Value of Money
11Dr Ajay K Patel
Time Value of Money
• An individual preference for possession of a given
amount of cash now, rather than the same amount a...
Time Value of Money
• How does interest rate help an individual or form
in making investment decision?
• Mr. Sharma is off...
Future value Or Compound Value
• The interest that is paid on the principal amount as well
as any interest earned, but not...
Future value Or Compound Value
• Suppose that Rs.1000 are placed in the saving account of a
bank at 5% interest rate. It w...
Future value Or Compound Value
• Exercise: If you deposit Rs.55,650 in a bank which is paying 10% as interest
on a ten yea...
Present Value or Discounting
 The process of determining the current value of
future cash flow/s is called Present value ...
Annuity
 Annuity is the fixed amount of cash flow after a fixed
interval of time periods.
 Example: The equal installmen...
FV of Annuity
Year 1 2 3 4
Amount
deposited
5000 5000 5000 5000
FV at the end
of 4th year
5000
(1.06)^3
=5955.08
5000
(1.0...
PV of Annuity
Year 1 2 3 4
Amount
deposited
5000 5000 5000 5000
PV 5000/
(1.06)^=
4716.98
5000/
(1.06)^2
=
4449.98
5000/
(...
FV of Annuity
• So the FV of annuity can be calculated as FVa
= An(1+i)^t + An(1+i)^t-1 + ….+ An
Where,
– FVa = Future val...
PV of Annuity
 So the PV of Annuity can be calculated as PVa =
An/(1+i) + An/(1+i)^2 + ….
…..+ An/ (1+i)^n
Where,
 PVa =...
Perpetuity
• When an annuity occurs for indefinite time
periods than it is called perpetuity.
• Perpetuity nature in an an...
Multi-Period compounding
• In practice cash flows occur more than once a
year.
• The interest rate specified on loan or de...
Multi-Period compounding
• FVa = An[{(1+i/m)^n*m – 1}/(i/m)]
• PVa = An[{1- (1+i)^(-n*m)}/(i/m)]
Illustration: The Future/...
Continuous compounding
• Some bank deposits or loan can have
continuous compounding or called daily
compounding.
• (V)Fn =...
Loan Amortization
End of year Payment Interest Principal repayment Outstanding balance
0 10,000
1 3951 900 3051 6,949
2 39...
Summary
Time value of money its three reasons
Uncertainty, Preference of consumption and
Investment.
– Future value of sin...
Why cost of capital is important?
• The return earned on assets depends on the risk of
those assets. The return to an inve...
Cost of equity
• The cost of equity is the return required by
equity investors given the risk of the cash
flows from the f...
Dividend growth model
• The dividend growth model formula and
rearrange to solve for RE
gR
D
P
E 
 1
0
g
P
D
RE 
0
1
3...
Dividend growth model—Example
• Your company is expected to pay a dividend of Rs.4.40 per
share next year. (D1)
• Dividend...
Estimating the dividend growth rate—
Example
• One method for estimating the growth rate is to use the
historical average....
Advantages and disadvantages of dividend
growth model method
• Advantage—easy to understand and use
• Disadvantages
– Only...
The SML method
• Compute cost of equity using the SML
– Risk-free rate, Rf
– Market risk premium, E(RM) – Rf
– Systematic ...
SML approach—Example
• Company’s equity beta = 1.2
• Current risk-free rate = 7%
• Expected market risk premium = 6%
• Wha...
Advantages and disadvantages of SML
method
• Advantages
– Explicitly adjusts for systematic risk
– Applicable to all compa...
Cost of equity
• Data:
– Beta = 1.2
– Market risk premium = 8%
– Current risk-free rate = 6%
– Analysts’ estimates of grow...
Cost of debt
• The cost of debt = the required return on a
company’s debt.
• We usually focus on the cost of long-term deb...
Cost of debt
• Suppose we have a bond issue currently
outstanding that has 25 years left to maturity.
The coupon rate is 9...
Cost of preference shares
• Reminders
– Preference shares generally pay a constant
dividend every period.
– Dividends are ...
Cost of preference shares— Example
• Your company has preference shares that have
an annual dividend of Rs.3. If the curre...
Weighted average cost of capital
• Use the individual costs of capital to compute
a weighted ‘average’ cost of capital for...
Capital structure weights
• Notation
– E = market value of equity = number of
outstanding shares times price per share
– D...
Capital structure weights—Example
• Suppose you have a market value of equity
equal to Rs.500 million and a market value o...
Taxes and the WACC—
Classical tax system
• We are concerned with after-tax cash flows,
so we need to consider the effect o...
WACC
WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)
Where:
(E/V) = % of common equity in capital structure
(P/V) = ...
WACC I—
Extended example
• Equity information
– 50 million shares
– Rs.80 per share
– Beta = 1.15
– Market risk
premium = ...
WACC II—Extended example
• What is the cost of equity?
– RE = 5 + 1.15(9) = 15.35%
• What is the cost of debt?
– N = 30; P...
WACC III—Extended example
• What are the capital structure weights?
– E = 50 million (80) = 4 billion
– D = 1 billion (1.1...
Investment Decision
51Dr Ajay K Patel
Definition
Investment is the employment of funds on assets to earn
income or capital appreciation.
In economic terms, in...
Investment decision
To answer for a perfect investment, it
is very much required to answer that:
Where to invest?
When to ...
Types of Investment Decision
• Purpose based
– Expansion and Diversification
– Replacement and Modernization
• Dependence ...
Investment Evaluation
• Process
1. Estimation of Cash Flows
2. Estimation of required rate of return
3. Application of dec...
Investment Evaluation
Decision Rules are referred as Capital
budgeting techniques, or investment criteria;
◦ It should co...
Capital Budgeting
“Capital budgeting is long-term planning for
making and financing proposed capital
outlays.” --- Charles...
58Dr Ajay K Patel
Capital budgeting techniques
Capital
Budgeting
techniques
Traditional
Urgency
method
Pay-Back
method
ARR
Discounted
CFs
NP...
The payback period (PbP)
• The CIMA defines payback as 'the time it takes the cash inflows from a
capital investment proje...
The payback period (PbP)
Example 2:
Years 0 1 2 3 4
Project B - 10,000 5,000 2,500 4,000 1,000
Payback period lies between...
The payback period (PbP)
• Disadvantages of the payback method:
– It ignores the timing of cash flows within the payback p...
The accounting rate of return - (ARR)
• ARR is also known as ROI .
• It is the ratio of average Net operating
after-tax pr...
NPV
• It the economic method of evaluating the investment proposals.
• It is a DCF technique that recognizes the time valu...
NPV?
10 8060
0 1 2 3
10%
Project L:
-100.00
9.09
49.59
60.11
118.79 = TPVL NPVS = 18.79.
65Dr Ajay K Patel
Rationale for the NPV Method
NPV= PV inflows - Cost
= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutual...
IRR
• It is another DCF method, which takes account of magnitude and timing
of CFs.
• It is the rate that equates the inve...
IRR
 t
n
t
t
CF
IRR



0 1
0.
IRR: Enter NPV = 0, solve for IRR.
 
.
10
NPV
r
CF
t
t
n
t



NPV: Enter r, solv...
Rationale for the IRR Method
If IRR > WACC, then the project’s rate of
return is greater than its cost-- some return is
le...
Profitability Index
• It the ratio of the present value of cash inflows, to the
initial cash outflow/ present value of inv...
• The initial cash outflow of project is Rs. 100,000
and it can generate cash inflow of 40,000, 30,000,
50,000 and 20,000 ...
Capital Rationing
• Capital rationing technique is used when
company has limited fund for investing in
profitable investme...
An Example:(Firm’s Cost of Capital = 12%)
Independent projects ranked according to their IRRs:
Project Project Size→ IRR
E...
Comparing techniques
• There are questions we need to ask when evaluating an
investment and the answer will determine whic...
Capital budgeting in practice
• There is an increased use of more sophisticated capital
budgeting techniques;
– Most FM us...
Comparing techniques
• Consider tow projects, Project Big and Project Small, each
have a cost of capital of 5% with CFs;
•...
PROJECT RISK ANALYSIS
77Dr Ajay K Patel
Techniques for Risk
Analysis
Analysis of Stand-
Alone Risk
Analysis of
Contextual Risk
Sensitivity
Analysis
Break-even
Ana...
Sources and Perspective of Risk
Sources of Risk
• Project-specific risk
• Competitive risk
• Industry-specific risk
• Mark...
Measures of Risk
Risk refers to variability. It is a complex and multi-faceted phenomenon.
A variety of measures have been...
Sensitivity Analysis
Cash Flow forecast
(‘000)
YEAR 0 YEARS 1 - 10
1. INVESTMENT (20,000)
2. SALES 18,000
3. VARIABLE COST...
RANGE NPV
KEY VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC PESSIMISTIC EXPECTED OPTIMISTIC
INVESTMENT 25000 20000 15000
(RS. I...
Evaluation
Advantages:
• It shows how robust or vulnerable a project is to changes in
values of the underlying variables.
...
Break-Even Analysis
• Accounting Break –Even Analysis
Fixed Costs + Depreciation 1 + 2
= = Rs. 9 million
Contribution marg...
Financial Break-even Analysis
At what level of sales will the project have a zero NPV?
The annual cash flow of the project...
Contd…
Since the cash flow lasts for 10 years, its present value at a discount rate of 12 percent
is:
PV (cash flows) = 0....
Decision Tree Analysis
 Decision tree analysis is a tool for analysing situations where sequential
decision making in fac...
Specification of Probabilities and Monetary Value
of Outcomes
Once the decision tree is outlined, the following data have ...
Evaluation of Alternatives
Once the decision tree is delineated and data about probabilities and monetary values
gathered,...
Spectrum case
The scientists at Spectrum have come up with an electric moped. The
firm is ready for pilot production and t...
D1
c1
D2
c2
D3
D11: Carry out pilot
production and
market test
-Rs 150
million
D12:Do nothing
C12 : Failure
Probability : ...
Spectrum Case
The alternatives in the decision tree shown are evaluated as follows:
1. Start at the right-hand end of the ...
5. Evaluate the EMV of the decision alternatives at D1 the first
stage decision point :
Alternative EMV
D11 (Carry out pil...
FINANCING DECISION
94Dr Ajay K Patel
Leverage Analysis
95Dr Ajay K Patel
‘Leverage’ is the action of a lever or the
mechanical advantage gained by an instrument;
it also means ‘effectiveness’ or ...
• It is used to describe the firm’s ability to use fixed costs or
funds to magnify the return to its shareholders.
• When ...
Types of Fixed Costs
There are two main types of fixed costs in the study
of leverages:
Operating cost – These costs are a...
Types of Risk
There are two main types of risk that a company faces:
Business risk – It is the variability in a firm’s EBI...
Types of Leverage
• Operating Leverage
• Financial Leverage
• Combined Leverage
100Dr Ajay K Patel
Degree of Operating Leverage (DOL)
• The degree of operating leverage is directly
proportional to a firm’s level of busine...
Calculating DOL
The degree of operating leverage can be
calculated as:
DOL
EBIT
Sales

%
%


• This approach is intuiti...
Sales
2000
Less: Variable costs 800
------
Contribution
1200
Less: Fixed costs 500
------
Profits 700
If the sales of this...
Degree of Financial Leverage (DFL)
The degree of financial leverage is a measure of
the % changes in EBT that result from ...
Degree of Combined Leverage (DCL)
The degree of combined leverage is a measure of
the total leverage (both operating and
f...
Trading on Equity
Trading on equity is that state of business when the
firm uses debt capital along with equity share capi...
CAPITAL STRUCTURE
 Capitalisation
 Total amount of capital
 Capital structure
 Composition of long term finance viz.
...
CAPITAL STRUCTURE
 Capital Structure is the proportion of debt, preference and
equity capitals in the total financing of ...
FACTORS DETERMINING THE
CAPITAL STRUCTURE
 Financial leverage/Trading on equity
 Growth and stability of sales
 Cost of...
 Capital market conditions
 Assets structure
 Purpose of financing
 Terms of finance
 Costs of floatation
 Corporate...
CAPITAL STRUCTURE THEORIES
There are 4 basic Capital Structure theories.
Relevance of capital structure
1. Net Income Appr...
COMMON ASSUMPTIONS
 Replacement of one form of capital to another.
 Firm value is consistent with shareholders wealth.
...
NET INCOME (NI) APPROACH
 According to, Net Income theory was introduced by David
Durand., capital structure decision has...
ASSUMPTIONS OF NI APPROACH:
 There are no taxes
 The cost of debt is less than the cost of equity.
 The use of debt doe...
AS PER NI APPROACH
 V = E + D
 E = (EBIT-Interest) / Ke
 Ko = Ke *E/(E+D) + Kd* D/(E+D)
115Dr Ajay K Patel
TRADITIONALAPPROACH
 This Traditional theory was advocated by financial experts
Ezta Solomon and Fred Weston.
 According...
ko/ke/Kd(%)
Leverage
ke
ko
Kd
Optimum capital structure
Stage I
Stage 3
Stage 2
Stage I: Kd remain constant, Ke increases ...
NET OPERATING INCOME APPROACH
 Net Operating Income Approach was also suggested by David
Durand.
 This approach suggests...
FEATURES OF NOI APPROACH:
 At all degrees of leverage (debt), the overall capitalization rate
would remain constant.
 Fo...
 Cost of equity increases with every increase in debt and the
weighted average cost of capital (WACC) remains constant.
...
Kd
ko/ke/Kd(%)
ko
ke
Leverage
121Dr Ajay K Patel
AS PER NOI APPROACH
 V = EBIT / Ko
 E = V – D
 Ke = (EBIT – Interest) / E
122Dr Ajay K Patel
MODIGLIANI MILLAR APPROACH
 Modigliani Millar approach, popularly known as the MM
approach is extension to NOI approach.
...
ASSUMPTIONS OF MM APPROACH
 Capital markets are perfect.
 All investors have the same expectation of the company's net
o...
BASIC PROPOSITIONS OF MM
APPROACH (WITHOUT TAXES):
 Proposition I: At any degree of leverage, the firm's cost of capital ...
BASIC PROPOSITIONS OF MM
APPROACH (WITHOUT TAXES):
 Proposition I:
Levered Co. Un-Levered Co.
EBIT 10,00,000 10,00,000
- ...
BASIC PROPOSITIONS OF MM
APPROACH (WITHOUT TAXES):
Proposition I: As Lev firm value is higher than Un-lev . Hence there wi...
BASIC PROPOSITIONS OF MM
APPROACH (WITH TAXES):
 The value of the levered firm would be greater than
unlevered firm by th...
Kd after-tax
Kd before-tax
Ko after tax
Ko before-tax
Ke before tax
129Dr Ajay K Patel
ARBITRAGE PROCESS
 Arbitrage is the process of purchasing a security in a market
where the price is low and selling it in...
CONCLUSION OF MM
 The value of the firm will be higher than unlevered firm by
present value of amount of taxes saved.
 T...
LIMITATIONS OF MM HYPOTHESIS:
 Arbitrage process cannot be smooth due the institutional
restrictions.
 Arbitrage process...
133Dr Ajay K Patel
Dividend policy
 The objective of firm’s dividend policy should be to
maximize a shareholder’s return so that the value o...
Dividend policy
 On relationship between dividend policy and value of
the firm, different theories can be grouped under :...
School of Thoughts
 Dividend Relevance
 Walter’s model
 Gordon’s model, Bird-in Hand Argument.
 Dividend irrelevance
...
Walter’s Model
 Professor James E Walter argues that “choice of dividend
policies almost always affect the value of the f...
Walter’s Model
 Walter’s formula of determine market rice per share is given as;
P = DIV + (EPS-DIV)r/k
Where;
P is price...
Dividend Policy and Value of share
Payout
Ratio
Growth firm( r > k) Normal firm( r =k) Decline firm( r < k)
r= 0.15, k=0.1...
Thus , dividend policy of the firm
depends on the availability of the
opportunity and relationship between
internal rate o...
Gordon’s Model
 Myron Gordon develops on model explicitly relating the market value
of the firm to dividend policy.
 Acc...
Gordon’s Model
D/P ratio r=15% r=10% r=8%
0% 0 0 0
40% 400 100 77
80% 114.3 100 95
100% 100 100 100
For growth firm
r>ke, ...
Bird in hand argument
 It suggest that dividend policy is relevant as the investor
prefer current dividend against the fu...
Irrelevance approach
 Underlying intuition for dividend irrelevance
 Firms that pay more dividend offer less price appre...
Residual Theory
 Residual Theory argues that the amount of profits to be
distributed is a balancing figure and thus depen...
Residual Theory
 Under residual Theory, firm would treat the dividend
decision in three steps;
 Find the retained earnin...
Residual theory of dividend
Capital budget: Rs.800,000,
Target capital structure: 40% debt, 60% equity.
Forecasted net inc...
M-M approach
 Under perfect market situation, dividend policy of a is irrelevant
to the value of the firm.
 He argues ne...
M-M approach
 In order to test, MM started with following valuation model.
 Po = (D1 + P1)/(1 + Ke)
 If the firm, has n...
M-M approach
 A firm having 1,00,000 shares outstanding and is planning to declare a
dividend of Rs.5 at the end of curre...
Working Capital
151Dr Ajay K Patel
Working capital: Concept
• Working capital typically means the firm’s holding of current
or short-term assets such as cash...
Concept of working capital
 There are two possible interpretations of
working capital concept:
1. Balance sheet concept
2...
Operating cycle concept
• A company’s operating cycle typically consists of three
primary activities:
– Purchasing resourc...
Operating cycle concept
• The firm has to maintain cash balance to pay the
bills as they come due.
• In addition, the comp...
Operating cycle of a typical company
Payable
Deferral period
Inventory conversion
period
Cash conversion
cycle
Operating
c...
THE WORKING CAPITAL
CYCLE
(OPERATING CYCLE)
Accounts Payable
Cash
Raw
Materials
W I P
Finished
Goods
Value Addition
Accoun...
If you Then ......
Collect receivables (debtors)
faster
You release cash from the
cycle
Collect receivables (debtors)
slow...
• Raw material storage peiod: = Average stock of raw material
Cost of raw material consumed/365
• WIP holding period: Aver...
TYPES OF WORKING CAPITAL
WORKING CAPITAL
BASIS OF
CONCEPT
BASIS OF
TIME
Gross
Working
Capital
Net
Working
Capital
Permanen...
Working capital investment
• The size and nature of investment in current assets is a
function of different factors such a...
Difference between permanent & temporary
working capital
Amount Variable Working Capital
of
Working
Capital
Permanent Work...
Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital
Time
163Dr Ajay K Patel
Concepts of Working capital
Financing
• Matching Approach
• Aggressive Approach
• Conservative Approach
164Dr Ajay K Patel
Matching approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
Rs...
Conservative approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Tim...
Aggressive approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
...
FACTORS DETERMINING WORKING CAPITAL
1. Nature of the Industry
2. Demand of Industry
3. Cash requirements
4. Nature of the ...
Working capital estimation
169Dr Ajay K Patel
Satyam Ltd profit and loss A/c and balance sheet for the year
ended 31.12.15 are given below. You required to calculate th...
Liabilities
Equities (16,000@Rs.10) 160,000
Net Profit 30,000
Creditors 10,000
2,00,000
Assets
Fixed Assets 1,00,000
Debto...
Calculation of operating cycle
Raw material
Average raw material /Raw material consumed
per day
=10,500/34,000/365 =
Work ...
Calculation of operating cycle
Finished goods
Average stock/ Total cost of goods sold per day
=6750/45,000/365 =
Debtors
A...
Calculation of operating cycle
Creditor
Average creditor/credit purchases per day
=7500/35,000/365
Net Operating Cycle is
...
Estimation of Net Working capital requirement for Exl
Ltd from the data given below
Cost of production (per unit) Amount(p...
Statement of Working Capital Requirement
Particulars Amount
Raw materials 2,000 x 4 x 100 8,00,000
WIP
•Raw materials 2,00...
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  1. 1. Nature And Scope of Financial Management  Financial management is such a managerial process which is concerned with the planning and control of financial resources.  In the initial years of its development, financial management was concerned only with collection of funds for business.  According to modern viewpoint, not only collection of funds but also their proper utilization are the basic functions of financial management.  As all the business activities like marketing, purchase, production etc include the creation and utilization of funds, financial manger must be clear about his duties and responsibilities in relation to these activities. 1Dr Ajay K Patel
  2. 2. Meaning of Financial Management “Financial Management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient business operations.”, J.L. Massie. 2Dr Ajay K Patel
  3. 3. Approaches to Financial Management 1. Traditional Approach : Under this approach, financial management was used to procure and administer funds for the corporation. Procurement of finance needs knowledge of followings: i. Institutional sources of finance. ii. Issue of financial instruments to collect necessary funds from the capital market. iii. Legal and accounting relationship between the business and source of finance. 3Dr Ajay K Patel
  4. 4. Limitations of Traditional Concept 1. One sided Approach 2. More Emphasis on the Financial Problems of Corporations 3. More importance to periodic (Long Term effect) Event 4. More Emphasis on Long term funds 4Dr Ajay K Patel
  5. 5. Modern Approach to Finance Function According to this approach, financial management considers the broader and analytical viewpoint. financial management is concerned with both acquisition of funds and their effective and optimum utilisation. This viewpoint not only considers the sporadic events but also the long term and short-term financial problems. Three core decisions are taken under financial management :- i. Investment Decision ii. Financing Decision iii. Dividend Decision 5Dr Ajay K Patel
  6. 6. 6Dr Ajay K Patel
  7. 7. Characteristics of Modern Approach 1. More Emphasis on Financial Decision 2. Financial Management as an Important Component of Business Management 3. Continuous Function 4. Broader View 5. Measure of Performance 7Dr Ajay K Patel
  8. 8. Objectives of Financial Management (i) Profit Maximisation Approach (ii) Wealth Maximisation Approach (i) Profit Maximisation Approach :- According to this approach, a firm should undertake all those activities which add to its profits and eliminates all others which reduce its profits. Criticism (i) Ambiguity (ii) Time Value of Money (iii) Risk Factor 8Dr Ajay K Patel
  9. 9. Wealth Maximisation Approach :- According to this approach, financial management should take such decisions which increase net present value of the firm. W = A1 + A2 + …………. + An - IO (1+k) (1+k) 2 (1+k) n W = Net Present Value A1 + A2 + …………. + An = Stream of expected cash benefits from a course of action over a period of time. K = Appropriate discount rate to measure risk and timing IO = Initial outlay to acquire that asset or pursue the course of action. If W is positive, the decision should be taken. On the other hand if W is negative, the decision should not be taken. 9Dr Ajay K Patel
  10. 10. Importance of Financial Management (1) Significant part of Business Management (2) Liquidity and Profitability (3) Value of firm (4) Centralised Nature (5) Benefits to shareholders Benefits to Investors (6) Other Benefits 10Dr Ajay K Patel
  11. 11. Time Value of Money 11Dr Ajay K Patel
  12. 12. Time Value of Money • An individual preference for possession of a given amount of cash now, rather than the same amount at some future time, is called time value of money. • There are three reasons for time preference for money. – Uncertainty – Preference of consumption – Investment The Time value of money is generally expressed by Interest rate. This interest rate is something which an investor require on its investment. Hence, it is also known as Required rate of return OR Opportunity cost 12Dr Ajay K Patel
  13. 13. Time Value of Money • How does interest rate help an individual or form in making investment decision? • Mr. Sharma is offered Rs.1,150 by Mr. Mehta one year from now in exchange of Rs.1000 which he should give it today, should he accept it, if the local bank is offering 10% p.a. interest rate on deposits? – Exersice: Compare the interest amount with excess amount offered by Mr. Mehta. 13Dr Ajay K Patel
  14. 14. Future value Or Compound Value • The interest that is paid on the principal amount as well as any interest earned, but not withdrawn, during the earlier years is called compound interest. • A compound value is the Future value of a cash flow/s when applying the concept of compound interest. • Future/ Compound value = Principal (1+ i)^n. – Where, i = interest, n = No. of years of compounding. 14Dr Ajay K Patel
  15. 15. Future value Or Compound Value • Suppose that Rs.1000 are placed in the saving account of a bank at 5% interest rate. It will grow to Rs.1050 at the end of one year, Since FV = 1000(1+0.05)= 1050. • At the end of two year, the amount will grow to Rs. 1,102.05, since FV = 1000(1+0.05)^2= 1102.05. Similarly, at the end of three year the amount will grow to 1157.60,.i.e 1000(1+0.05)^3. • So, Interest Earned 1st year is Rs.50, whereas Interest Earned 2nd year is Rs.52.05, and 3rd year Rs.55.55. • It is clear that due to compounding effect every year the interest earned is more than earlier year. 15Dr Ajay K Patel
  16. 16. Future value Or Compound Value • Exercise: If you deposit Rs.55,650 in a bank which is paying 10% as interest on a ten year deposit, how much would the deposit grow at the end of ten years? • Solution; To calculate the Future value of the deposited amount at the end of ten year, we can use the following formula: FV = P (1+ i)^n where, P = Rs.55,650 I = 10%= 0.10 n = 10 Therefore, FV = 55650 (1+0.1)^10 = 55650 (2.594) = 1,44,356.1 Hence, the deposit of Rs.55,650 in a bank which is paying 10% as interest on ten year deposit, will grow to Rs.1,44,356.10. 16Dr Ajay K Patel
  17. 17. Present Value or Discounting  The process of determining the current value of future cash flow/s is called Present value or Discounting.  The interest rate used for determining present value is called discount rate.  Present value gives us the answer of how much amount would investor give up now to get an amount in future year.  How to calculate Present value? ◦ Ans- By reversing the formula used to calculate Future value. ◦ We get, PV = FV/(1+i)^n 17Dr Ajay K Patel
  18. 18. Annuity  Annuity is the fixed amount of cash flow after a fixed interval of time periods.  Example: The equal installments paid on House Loan, Car Loan, receivable of pension amount, etc..  Calculation of Future value and Present value of Annuity can be illustrated with an example below.  Suppose a firm deposits Rs.5000 at the end of each year for 4 years at 6% p.a. How much would this annuity accumulate at the end of 4th year. 18Dr Ajay K Patel
  19. 19. FV of Annuity Year 1 2 3 4 Amount deposited 5000 5000 5000 5000 FV at the end of 4th year 5000 (1.06)^3 =5955.08 5000 (1.06)^2 = 5,618 5000 (1.06)^1 = 5,300 5,000 Total FV of Annuity 21873.08 19Dr Ajay K Patel
  20. 20. PV of Annuity Year 1 2 3 4 Amount deposited 5000 5000 5000 5000 PV 5000/ (1.06)^= 4716.98 5000/ (1.06)^2 = 4449.98 5000/ (1.06)^3 = 4198.09 5,000/ (1.06)^4= 3960.47 Total PV of Annuity 17,325.52 20Dr Ajay K Patel
  21. 21. FV of Annuity • So the FV of annuity can be calculated as FVa = An(1+i)^t + An(1+i)^t-1 + ….+ An Where, – FVa = Future value of Annuity – An= Annuity – i=interest – t=n-1, n=future year. • Also, the formula above can be expressed as, FVa = An[{(1+i)^n – 1}/i] 21Dr Ajay K Patel
  22. 22. PV of Annuity  So the PV of Annuity can be calculated as PVa = An/(1+i) + An/(1+i)^2 + …. …..+ An/ (1+i)^n Where,  PVa = Present value of Annuity  An= Annuity  i=interest  n=future year.  Also, the formula above can be expressed as, PVa = An[{1- (1+i)^(-n)}/i] 22Dr Ajay K Patel
  23. 23. Perpetuity • When an annuity occurs for indefinite time periods than it is called perpetuity. • Perpetuity nature in an annuity is generally seen in certain welfare funds created by Private or Government firms as a part of their CSR. • The formula to calculate the value of perpetuity is, Pr = An/i. 23Dr Ajay K Patel
  24. 24. Multi-Period compounding • In practice cash flows occur more than once a year. • The interest rate specified on loan or deposit is on annual basis, i.e., the nominal interest rate. But if compounding is done more than once in a year, the actualized interest is higher than Nominal interest rate and it is called Effective Interest Rate. • EIR = [1 + i/m]^n*m - 1 24Dr Ajay K Patel
  25. 25. Multi-Period compounding • FVa = An[{(1+i/m)^n*m – 1}/(i/m)] • PVa = An[{1- (1+i)^(-n*m)}/(i/m)] Illustration: The Future/compound value of Rs.1000, interest rate being 12% p.a. if compounded; (i) annually, (ii)semi-annually, (iii)quarterly, (iv)monthly and (v)continuously for 2 years? • (i) FV = 1000 (1+ 0.12)^2 =…? • (ii) FV = 1000(1+ …)^.. = ? 25Dr Ajay K Patel
  26. 26. Continuous compounding • Some bank deposits or loan can have continuous compounding or called daily compounding. • (V)Fn = PV * e^(i*n) • Where e= 2.7183 • FV = 1000 e^ 0.12*2 = 1000* 1.2713 = 12,713. 26Dr Ajay K Patel
  27. 27. Loan Amortization End of year Payment Interest Principal repayment Outstanding balance 0 10,000 1 3951 900 3051 6,949 2 3951 625 3,326 3623 3 3951 326 3,625* 0 Total 11,853 1,851 10,002 Suppose you have borrowed a 3-year loan of Rs.10,000 at 9% from Your employer requires three equal-of-year repayments, then the annual Installment will be: 10,000 = A x PVFA (3yrs,0.09%) A = 10,000/2.531 = 3,951. Loan Amortization Schedule We have to pay Rs.3,951 end of each year. The interest is calculated on the outstanding balance of preceding year at 9% p.a. The loan is completely paid off at the end of the 3rd year. From the schedule, the total interest paid for 3 yrs on Rs.10,000 loan is Rs.1851 27Dr Ajay K Patel
  28. 28. Summary Time value of money its three reasons Uncertainty, Preference of consumption and Investment. – Future value of single and multiple cash flows – Present value of single and multiple cash flows. – Annuity – Perpetuity 28Dr Ajay K Patel
  29. 29. Why cost of capital is important? • The return earned on assets depends on the risk of those assets. The return to an investor is the same as the cost to the company. • Our cost of capital provides us with an indication of how the market views the risk of our assets. • Knowing cost of capital can also help us determine our required return for capital budgeting projects. • The required return is the same as the appropriate discount rate and is based on the risk of the cash flows. 29Dr Ajay K Patel
  30. 30. Cost of equity • The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. • There are two main methods for determining the cost of equity: 1. Dividend growth model 2. SML or CAPM 30Dr Ajay K Patel
  31. 31. Dividend growth model • The dividend growth model formula and rearrange to solve for RE gR D P E   1 0 g P D RE  0 1 31Dr Ajay K Patel
  32. 32. Dividend growth model—Example • Your company is expected to pay a dividend of Rs.4.40 per share next year. (D1) • Dividends have grown at a steady rate of 5.1% per year and the market expects that to continue. (g) • The current stock price is Rs.50. (P0) • What is the cost of equity? 139.051. 50 40.4 RE  32Dr Ajay K Patel
  33. 33. Estimating the dividend growth rate— Example • One method for estimating the growth rate is to use the historical average. Year Dividend % change 2003 1.23 2004 1.30 2005 1.36 2006 1.43 2007 1.50 (1.30 – 1.23) / 1.23 = 5.7% (1.36 – 1.30) / 1.30 = 4.6% (1.43 – 1.36) / 1.36 = 5.1% (1.50 – 1.43) / 1.43 = 4.9% Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1% 33Dr Ajay K Patel
  34. 34. Advantages and disadvantages of dividend growth model method • Advantage—easy to understand and use • Disadvantages – Only applicable to companies currently paying dividends – Not applicable if dividends aren’t growing at a reasonably constant rate – Extremely sensitive to the estimated growth rate – Does not explicitly consider risk 34Dr Ajay K Patel
  35. 35. The SML method • Compute cost of equity using the SML – Risk-free rate, Rf – Market risk premium, E(RM) – Rf – Systematic risk of asset,  ))(( fMEfE RRERR   35Dr Ajay K Patel
  36. 36. SML approach—Example • Company’s equity beta = 1.2 • Current risk-free rate = 7% • Expected market risk premium = 6% • What is the cost of equity capital? %2.14)6(2.17RE  36Dr Ajay K Patel
  37. 37. Advantages and disadvantages of SML method • Advantages – Explicitly adjusts for systematic risk – Applicable to all companies, as long as beta is available • Disadvantages – Must estimate the expected market risk premium, which does vary over time – Must estimate beta, which also varies over time – Relies on the past to predict the future, which is not always reliable 37Dr Ajay K Patel
  38. 38. Cost of equity • Data: – Beta = 1.2 – Market risk premium = 8% – Current risk-free rate = 6% – Analysts’ estimates of growth = 8% per year – Last dividend = Rs.2 – Current stock price = Rs.30 – Using SML: RE = 6% + 1.2(8%) = 15.6% – Using DGM: RE = [2(1.08) / 30] + .08 = 15.2% 38Dr Ajay K Patel
  39. 39. Cost of debt • The cost of debt = the required return on a company’s debt. • We usually focus on the cost of long-term debt or bonds. • Method 1 = Compute the yield to maturity on existing debt. • Method 2 = Use estimates of current rates based on the bond rating expected on new debt. • Note: The cost of debt is NOT the coupon rate. 39Dr Ajay K Patel
  40. 40. Cost of debt • Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1000 bond. What is the cost of debt? – 50 [N]; PMT = 45 [PMT]; 1000 [FV]; 908.75[+/- ][PV] ; [CPT] [I/Y] = 5%; YTM = 5(2) = 10% 40Dr Ajay K Patel
  41. 41. Cost of preference shares • Reminders – Preference shares generally pay a constant dividend every period. – Dividends are expected to be paid every period forever. • Preference share valuation is an annuity, so we take the annuity formula, rearrange and solve for RP. • RP = D/P0 41Dr Ajay K Patel
  42. 42. Cost of preference shares— Example • Your company has preference shares that have an annual dividend of Rs.3. If the current price is Rs.25, what is the cost of a preference share? • RP = 3 / 25 = 0.12 = 12% 42Dr Ajay K Patel
  43. 43. Weighted average cost of capital • Use the individual costs of capital to compute a weighted ‘average’ cost of capital for the firm. • This ‘average’ = the required return on the firm’s assets, based on the market’s perception of the risk of those assets. • The weights are determined by how much of each type of financing is used. • Weights = percentages of the firm that will be financed by each component. 43Dr Ajay K Patel
  44. 44. Capital structure weights • Notation – E = market value of equity = number of outstanding shares times price per share – D = market value of debt = number outstanding bonds times bond price – V = market value of the firm = D + E • Weights – wE = E/V = percentage financed with equity – wD = D/V = percentage financed with debt 12-44Dr Ajay K Patel
  45. 45. Capital structure weights—Example • Suppose you have a market value of equity equal to Rs.500 million and a market value of debt equal to Rs.475 million. – What are the capital structure weights? • V = 500 million + 475 million = 975 million • wE = E/D = 500 / 975 = 0.5128 = 51.28% • wD = D/V = 475 / 975 = 0.4872 = 48.72% 12-45Dr Ajay K Patel
  46. 46. Taxes and the WACC— Classical tax system • We are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital. • Interest expense reduces our tax liability. – This reduction in taxes reduces our cost of debt. – After-tax cost of debt = RD(1-TC). • Dividends are not tax deductible, so there is no tax impact on the cost of equity. 46Dr Ajay K Patel
  47. 47. WACC WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC) Where: (E/V) = % of common equity in capital structure (P/V) = % of preferred stock in capital structure (D/V) = % of debt in capital structure RE = firm’s cost of equity RP = firm’s cost of preferred stock RD = firm’s cost of debt TC = firm’s corporate tax rate 47Dr Ajay K Patel
  48. 48. WACC I— Extended example • Equity information – 50 million shares – Rs.80 per share – Beta = 1.15 – Market risk premium = 9% – Risk-free rate = 5% • Debt information – Rs.1 billion in outstanding debt (face value) – Current quote = 110 – Coupon rate = 9%, semiannual coupons – 15 years to maturity • Tax rate = 40% 48Dr Ajay K Patel
  49. 49. WACC II—Extended example • What is the cost of equity? – RE = 5 + 1.15(9) = 15.35% • What is the cost of debt? – N = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y = 3.9268 – RD = 3.927(2) = 7.854% • What is the after-tax cost of debt? – RD(1-TC) = 7.854(1-.4) = 4.712% 49Dr Ajay K Patel
  50. 50. WACC III—Extended example • What are the capital structure weights? – E = 50 million (80) = 4 billion – D = 1 billion (1.10) = 1.1 billion – V = 4 + 1.1 = 5.1 billion – wE = E/V = 4 / 5.1 = .7843 – wD = D/V = 1.1 / 5.1 = .2157 • What is the WACC? – WACC = .7843(15.35%) + .2157(4.712%) = 13.06% 50Dr Ajay K Patel
  51. 51. Investment Decision 51Dr Ajay K Patel
  52. 52. Definition Investment is the employment of funds on assets to earn income or capital appreciation. In economic terms, investment is defined as the net addition made to the capital stock of the country. In financial terms, investment is defined as allocating money to assets with a view to gain profit over a period of time. Investments in economic and financial terms are inter- related, where an individual's savings flow into the capital market as financial investment, which are further used as economic investment. 52Dr Ajay K Patel
  53. 53. Investment decision To answer for a perfect investment, it is very much required to answer that: Where to invest? When to invest? How much to invest? How to invest? What is the purpose of investment? 53Dr Ajay K Patel
  54. 54. Types of Investment Decision • Purpose based – Expansion and Diversification – Replacement and Modernization • Dependence based – Mutually exclusive investments – Independent investments – Contingent/Dependent investments 54Dr Ajay K Patel
  55. 55. Investment Evaluation • Process 1. Estimation of Cash Flows 2. Estimation of required rate of return 3. Application of decision rule for making the choice. 55Dr Ajay K Patel
  56. 56. Investment Evaluation Decision Rules are referred as Capital budgeting techniques, or investment criteria; ◦ It should consider all cash flows to determine true profit. ◦ It should provide objective ways to identify Good and Bad projects. ◦ It should help to priorities projects. ◦ It should help to select among mutually exclusive projects. 56Dr Ajay K Patel
  57. 57. Capital Budgeting “Capital budgeting is long-term planning for making and financing proposed capital outlays.” --- Charles T. Horngren “Capital budgeting involves planning of expenditures for assets returns which will be realized in future periods.” --- Milton h. Spencer 57Dr Ajay K Patel
  58. 58. 58Dr Ajay K Patel
  59. 59. Capital budgeting techniques Capital Budgeting techniques Traditional Urgency method Pay-Back method ARR Discounted CFs NPV IRR PI MIRR 59Dr Ajay K Patel
  60. 60. The payback period (PbP) • The CIMA defines payback as 'the time it takes the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years'. • When deciding between two or more competing projects, the usual decision is to accept the one with the shortest payback. • Example 1: Years : 0 1 2 3 4 5 Project A: 1,000,000 250,000 250,000 250,000 250,000 250,000 For a project with equal annual receipts: = 4 years 60Dr Ajay K Patel
  61. 61. The payback period (PbP) Example 2: Years 0 1 2 3 4 Project B - 10,000 5,000 2,500 4,000 1,000 Payback period lies between year 2 and year 3. Sum of money recovered by the end of the second year = 7,500, i.e. (5,000 + 2,500) Sum of money to be recovered by end of 3rd year = 10,000 - 7,500 = 2,500 = 2.625 years 61Dr Ajay K Patel
  62. 62. The payback period (PbP) • Disadvantages of the payback method: – It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return. – It is unable to distinguish between projects with the same payback period. – It may lead to excessive investment in short-term projects. • Advantages of the payback method: – Payback can be important: long payback means capital tied up and high investment risk. The method also has the advantage that it involves a quick, simple calculation and an easily understood concept. 62Dr Ajay K Patel
  63. 63. The accounting rate of return - (ARR) • ARR is also known as ROI . • It is the ratio of average Net operating after-tax profit divided by average investment. • Average investment is half of the original investment ARR = - - - - - - - - - Average EAT Average Investment 63Dr Ajay K Patel
  64. 64. NPV • It the economic method of evaluating the investment proposals. • It is a DCF technique that recognizes the time value of money. • It postulates that CFs arising at different time periods differ in value and are comparable only when their equivalents-present values-are found out.   . 10 t t n t r CF NPV    - Investment 64Dr Ajay K Patel
  65. 65. NPV? 10 8060 0 1 2 3 10% Project L: -100.00 9.09 49.59 60.11 118.79 = TPVL NPVS = 18.79. 65Dr Ajay K Patel
  66. 66. Rationale for the NPV Method NPV= PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value. 66Dr Ajay K Patel
  67. 67. IRR • It is another DCF method, which takes account of magnitude and timing of CFs. • It is the rate that equates the investment outlay with the present value of CFs. 0 1 2 3 CF0 CF1 CF2 CF3 Cost Inflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0. 67Dr Ajay K Patel
  68. 68. IRR  t n t t CF IRR    0 1 0. IRR: Enter NPV = 0, solve for IRR.   . 10 NPV r CF t t n t    NPV: Enter r, solve for NPV. 68Dr Ajay K Patel
  69. 69. Rationale for the IRR Method If IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns. Example: WACC = 10%, IRR = 15%. Profitable. 69Dr Ajay K Patel
  70. 70. Profitability Index • It the ratio of the present value of cash inflows, to the initial cash outflow/ present value of investment. This formula is also called Benefit-cost ratio. PI = PV of cash Inflows Initial cash outflow Decision criterion Accept project if PI >1, Investment will increase shareholder wealth. Reject project if PI <1, Investment will decrease shareholder wealth. Indifferent if PI = 1. 70Dr Ajay K Patel
  71. 71. • The initial cash outflow of project is Rs. 100,000 and it can generate cash inflow of 40,000, 30,000, 50,000 and 20,000 in year 1 through 4. assume a 10 percent rate of discount. • The PV of cash inflow at 10 percent discount rate is: PV = 40000 (PVIF,1, 0.10) + 30000 (PVIF,2,0.10) + 50000(PVIF,3,0.10) + 20000(PVIF,4,0.10) = 40000(0.909) + 30000 (0.826) + 50000(0.751) + 20000(0.68) = 112,350 PI = 112,350/100000 = 1.1235 71Dr Ajay K Patel
  72. 72. Capital Rationing • Capital rationing technique is used when company has limited fund for investing in profitable investment proposals. • Capital rationing exists when investor is interested to invest his limited fund in most profitable investment proposal. 72Dr Ajay K Patel
  73. 73. An Example:(Firm’s Cost of Capital = 12%) Independent projects ranked according to their IRRs: Project Project Size→ IRR E $20,000 → 21.0% B 25,000 → 19.0 G 25,000 → 18.0 H 10,000 → 17.5 D 25,000 → 16.5 A 15,000 → 14.0 F 15,000 → 11.0 C 30,000 → 10.0 No Capital Rationing - Only projects F and C would be rejected. The firm’s capital budget would be 120,000. Existence of Capital Rationing - Suppose the capital budget is constrained to be 80,000. Using the IRR criterion, only projects E, B, G, and H, would be accepted, even though projects D and A's IRR is higher than our cost of capital but we can not include because of our capital budget is limited up to 80000. 73Dr Ajay K Patel
  74. 74. Comparing techniques • There are questions we need to ask when evaluating an investment and the answer will determine which technique is one to use for that investment: 1. Are the projects mutually exclusive or independent? 2. Are the projects subjected to capital rationing? 3. Are the projects of same risk? 4. Are the projects of the same scale of investment? • Decision rules; 1. If the projects are independent and not subject to capital rationing, we can use any one of the discounted cash flow method. 2. Of the projects are mutually exclusive, have same investment outlay, same risk, we must use only NPV or MIRR as to determine the wealth to maximize. 3. If projects are mutually exclusive and are of different risks or are of different scales, NPV preferred over MIRR. 74Dr Ajay K Patel
  75. 75. Capital budgeting in practice • There is an increased use of more sophisticated capital budgeting techniques; – Most FM use more than one technique to evaluate the same projects, with a discounted CF technique (NPV, IRR, PI) used as a primary method and pay pack period used as a secondary method; and – The most commonly used is the IRR. – IRR is popular bcoz it is measure of return and therefore easy to understand. – The popularity of IRR method is troublesome since it may lead to decisions about projects that are not in best interest of owners in certain circumstances. However, NPV method is becoming more widely accepted and, replace IRR as popular method. 75Dr Ajay K Patel
  76. 76. Comparing techniques • Consider tow projects, Project Big and Project Small, each have a cost of capital of 5% with CFs; • Applying DCF methods to each projects, If Big and Small are mutually exclusive projects which project should firm prefer. Years 0 1 2 3 Big -1,000,000 400,000 400,000 400,000 Small -10 4 4 5 Methods NPV PI IRR MIRR Big 89299 1.089 9.701 8.037 Small 1.757 1.176 13.78 10.82 76Dr Ajay K Patel
  77. 77. PROJECT RISK ANALYSIS 77Dr Ajay K Patel
  78. 78. Techniques for Risk Analysis Analysis of Stand- Alone Risk Analysis of Contextual Risk Sensitivity Analysis Break-even Analysis Simulation Analysis Scenario Analysis Corporate Risk Analysis Market Risk Analysis Hillier Model Decision tree Analysis 78Dr Ajay K Patel
  79. 79. Sources and Perspective of Risk Sources of Risk • Project-specific risk • Competitive risk • Industry-specific risk • Market risk • International risk Perspectives on Risk • Standalone risk • Firm risk • Market risk 79Dr Ajay K Patel
  80. 80. Measures of Risk Risk refers to variability. It is a complex and multi-faceted phenomenon. A variety of measures have been used to capture different facets of risk. The more important ones are: • Range • Standard deviation • Coefficient of variation • Semi - variance 80Dr Ajay K Patel
  81. 81. Sensitivity Analysis Cash Flow forecast (‘000) YEAR 0 YEARS 1 - 10 1. INVESTMENT (20,000) 2. SALES 18,000 3. VARIABLE COSTS (66* 2/3 % OF SALES) 12,000 4. FIXED COSTS 1,000 5. DEPRECIATION 2,000 6. PRE-TAX PROFIT 3,000 7. TAXES 1,000 8. PROFIT AFTER TAXES 2,000 9. CASH FLOW FROM OPERATION 4,000 10. NET CASH FLOW (20,000) 4,000 NPV = financial modelling.xls = 2,600,000 81Dr Ajay K Patel
  82. 82. RANGE NPV KEY VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC PESSIMISTIC EXPECTED OPTIMISTIC INVESTMENT 25000 20000 15000 (RS. IN MILLION) SALES 13500 18000 22500 (RS. IN MILLION) VARIABLE COSTS 70 66.67 64 (as a % of sales) FIXED COSTS 1250 1000 750 (RS. IN MILLION) Sensitivity of NPV to Variations in the Value of Key Variables 82Dr Ajay K Patel
  83. 83. Evaluation Advantages: • It shows how robust or vulnerable a project is to changes in values of the underlying variables. • It indicates where further work may be done. • It communicative the concerns that project evaluators normally have. Limitations: • It does not provide information about the chances of change. • In real life, many variable change at same time. • It is subjective interpretation. 83Dr Ajay K Patel
  84. 84. Break-Even Analysis • Accounting Break –Even Analysis Fixed Costs + Depreciation 1 + 2 = = Rs. 9 million Contribution margin ratio 0.333 Cash flow forecast for Naveen’s flour mill project (‘000) Year 0 Year 1 - 10 1. Investment (20,000) 2. Sales 18,000 3. Variable costs (66 2/3% of sales) 12,000 4. Fixed costs 1,000 5. Depreciation 2,000 6. Pre-tax profit 3,000 7. Taxes 1,000 8. Profit after taxes 2,000 9. Cash flow from operation 4,000 10. Net cash flow (20,000) 4,000 84Dr Ajay K Patel
  85. 85. Financial Break-even Analysis At what level of sales will the project have a zero NPV? The annual cash flow of the project depends on sales as follows: 1. Variable costs : 66.67 percent of sales 2. Contribution : 33.33 percent of sales 3. Fixed costs : Rs. 1 million 4. Depreciation : Rs. 2 million 5. Pre-tax profit : (.333 x Sales) – Rs. 3 million 6. Tax (at 33.3%) : .333 (.333 Sales – Rs. 3 million) 7. Profit after tax : .667 (.333 x Sales – Rs. 3 million) 8. Cash flow (4+7) : Rs. 2 million + .667 (.333 x Sales – Rs. 3 million) = 0.222 Sales 85Dr Ajay K Patel
  86. 86. Contd… Since the cash flow lasts for 10 years, its present value at a discount rate of 12 percent is: PV (cash flows) = 0.222 Sales x PVIFA (10 years, 12%) = 0.222 Sales x 5.650 = 1.254 Sales The project breaks even when the present value of cash flows equals initial investment. Hence, the financial break-even occurs when PV (cash flows) = Investment 1.254 Sales = Rs. 20 million Sales = Rs. 15.95 million Thus, the sales for the flour mill must be Rs. 15.94 million per year for the investment to have a zero NPV. Note: It is significantly highly than Rs. 9 million which represents the accounting break-even sales. 86Dr Ajay K Patel
  87. 87. Decision Tree Analysis  Decision tree analysis is a tool for analysing situations where sequential decision making in face of risk is involved.  The key steps in decision tree analysis are: 1. Identifying the problem and alternatives 2. Delineating the decision tree 3. Specifying probabilities and monetary outcomes 4. Evaluating various decision alternatives 87Dr Ajay K Patel
  88. 88. Specification of Probabilities and Monetary Value of Outcomes Once the decision tree is outlined, the following data have to be gathered :  Probabilities associated with each of the possible outcomes at various chance forks, and  Monetary value of each combination of decision alternative and chance outcome. The probabilities of various outcomes may sometimes be defined objectively. For example, the probability of a good monsoon may be based on objective, historical data. However, the possible outcomes encountered in real life are such that objective probabilities for them cannot be obtained. How can you, for example, define objectively the probability that a new product like an electric moped will be successful in the market? In such cases, probabilities have to be necessarily defined subjectively. 88Dr Ajay K Patel
  89. 89. Evaluation of Alternatives Once the decision tree is delineated and data about probabilities and monetary values gathered, decision alternatives may be evaluated as follows : 1. Start at the right-hand end of the tree and calculate the expected monetary value at various chance points that come first as we proceed leftward. 2. Given the expected monetary values of chance points in step 1, evaluate the alternatives at the final stage decision points in terms of their expected monetary values. 3. At each of the final stage decision points, select the alternative which has the highest expected monetary value and truncate the other alternatives. Each decision point is assigned a value equal to the expected monetary value of the alternative selected at that decision point. 4. Proceed backward (leftward) in the same manner, calculating the expected monetary value at chance points, selecting the decision alternative which has the highest expected monetary value at various decision points, truncating inferior decision alternatives, and assigning values to decision points, till the first decision point is reached. 89Dr Ajay K Patel
  90. 90. Spectrum case The scientists at Spectrum have come up with an electric moped. The firm is ready for pilot production and test marketing. This will cost Rs.20 mn and take 6 months. Management believes that there is a 70 % chance that the pilot production and test marketing will be successful. In case of success, Spectrum can build a plant costing Rs.150 mn. The plant will generate an annual cash inflow of Rs.30 mn for 20 years if the demand is high or an annual cash inflow of Rs.20 m if the demand is moderate. High demand has a probability of 0.6; Moderate demand has a probability of 0.4. To analyze such situations where sequential decision making is involved decision tree analysis is helpful. 90Dr Ajay K Patel
  91. 91. D1 c1 D2 c2 D3 D11: Carry out pilot production and market test -Rs 150 million D12:Do nothing C12 : Failure Probability : 0.3 Probability : 0.7 C11 : Success D21:Invest -Rs 20 million Probability : 0.6 C21 : High demand Annual cash flow 30 mn Annual cash flow 20 mn C22 : Moderate demand Probability : 0.4 D22: Stop D31: Stop Spectrum Case 91Dr Ajay K Patel
  92. 92. Spectrum Case The alternatives in the decision tree shown are evaluated as follows: 1. Start at the right-hand end of the tree and calculate the EMV at chance point C2 that comes first as we proceed leftward. EMV(C2) = 0.6 [30xPVIFA (20, 12%)] + 0.4 [20 x PVIFA (20, 12%)] = Rs.194.2 million 2. Evaluate the EMV of the decision alternatives at D2 the last stage decision point. Alternative EMV D21 (Invest Rs.150 million) (194-150) = Rs.44.2 million D22 (Stop) 0 3. Select D21 and trim D22 as EMV(D21) > EMV(D22). 4. Calculate the EMV at chance point C1 that comes next as we roll backwards. EMV (C1) = 0.7 [44.2] + 0.3 [0] = Rs.30.9 million 92Dr Ajay K Patel
  93. 93. 5. Evaluate the EMV of the decision alternatives at D1 the first stage decision point : Alternative EMV D11 (Carry out pilot production and market test at a cost of Rs.20 million) Rs.10.9 million D12 (Do nothing) 0 Based on the above evaluation, the optimal decision strategy is as follows : Choose D11 (carry out pilot production and market test) at the decision point D1 and wait for the outcome at the chance point C1. If the outcome at C1 is C11 (success), invest Rs.150 million; if the outcome at C1 is C12 (failure) stop. 93Dr Ajay K Patel
  94. 94. FINANCING DECISION 94Dr Ajay K Patel
  95. 95. Leverage Analysis 95Dr Ajay K Patel
  96. 96. ‘Leverage’ is the action of a lever or the mechanical advantage gained by an instrument; it also means ‘effectiveness’ or ‘power’. The dictionary meaning of the term ‘leverage’ refers to an increased means of accomplishing some purpose. In finance, the term leverage refers to amplify or increase profit. Meaning 96Dr Ajay K Patel
  97. 97. • It is used to describe the firm’s ability to use fixed costs or funds to magnify the return to its shareholders. • When the volume of sales changes, leverage helps in magnifying such influence. It may, therefore, be defined as relative change in profit due to change in sales. • A high degree of leverage implies that there will be a large change in profit due to relative small change in sales or vice versa. Meaning 97Dr Ajay K Patel
  98. 98. Types of Fixed Costs There are two main types of fixed costs in the study of leverages: Operating cost – These costs are associated with the operations of business, such as rent for the building, salaries of staff, etc. This is responsible for operating leverage and represent business/investment risk. Financial cost– These are associated with the fixed financial charges due to availing of finance (i.e. in form of interest on debt capital). This is responsible for financial leverage and represents business’ financial risk. 98Dr Ajay K Patel
  99. 99. Types of Risk There are two main types of risk that a company faces: Business risk – It is the variability in a firm’s EBIT. This type of risk is a function of the firm’s regulatory environment, labor relations, competitive position, etc. Note that business risk is, to a large degree, outside of the control of managers. Financial risk – It is the variability of the firm’s EBT(or earnings per share). This type of risk is a direct result of management decisions regarding the relative amounts of debt and equity in the capital structure 99Dr Ajay K Patel
  100. 100. Types of Leverage • Operating Leverage • Financial Leverage • Combined Leverage 100Dr Ajay K Patel
  101. 101. Degree of Operating Leverage (DOL) • The degree of operating leverage is directly proportional to a firm’s level of business risk. • Operating leverage refers to a changes in sales into changes in EBIT. • Operating leverage results from the presence of fixed costs in the firm’s cost structure 101Dr Ajay K Patel
  102. 102. Calculating DOL The degree of operating leverage can be calculated as: DOL EBIT Sales  % %   • This approach is intuitive, but it requires two income statements to calculate. • When we have to calculate DOL for single income statement: EBIT VCSales DOL   EBIT VCSales DOL   102Dr Ajay K Patel
  103. 103. Sales 2000 Less: Variable costs 800 ------ Contribution 1200 Less: Fixed costs 500 ------ Profits 700 If the sales of this firm is increased by 25%, the income statement will stand revised as follows: Sales 2500 (increase of 25%) Less: Variable costs 1000 (increase of 25%) ------ Contribution 1500 (increase of 25%) Less: Fixed costs 500 (No change) -------- Profits 1000 --------- A hypothetical income statement for a firm is as follows: 103Dr Ajay K Patel
  104. 104. Degree of Financial Leverage (DFL) The degree of financial leverage is a measure of the % changes in EBT that result from changes in EBIT, it is calculated as: DFL EBT EBIT  % %   • This approach is intuitive, but it requires two income statements to calculate. • When we have to calculate DOL with one income statement: DFL EBIT EBT  104Dr Ajay K Patel
  105. 105. Degree of Combined Leverage (DCL) The degree of combined leverage is a measure of the total leverage (both operating and financial leverage) that a company is using: DCL EBT Sales EBIT Sales EBT EBIT DOL DFL     % % % % % %       • It is important to note that DCL is the product (not the sum) of both DOL and DFL 105Dr Ajay K Patel
  106. 106. Trading on Equity Trading on equity is that state of business when the firm uses debt capital along with equity share capital in its capital structure. Generally in practical terms the term is technically used when the firm uses more of debt than equity. Therefore, it is also used to indicate the state of financial leverage. 106Dr Ajay K Patel
  107. 107. CAPITAL STRUCTURE  Capitalisation  Total amount of capital  Capital structure  Composition of long term finance viz.  Financial structure  Composition of long and short both kinds of finance 107Dr Ajay K Patel
  108. 108. CAPITAL STRUCTURE  Capital Structure is the proportion of debt, preference and equity capitals in the total financing of the firm’s assets.  The firm has to decide proper financing mix/capital structure that results in maximizing the wealth of the equity shareholders. Such a capital structure is called as the optimum capital structure.  At the optimum capital structure, the weighted average cost of capital would be the minimum. 108Dr Ajay K Patel
  109. 109. FACTORS DETERMINING THE CAPITAL STRUCTURE  Financial leverage/Trading on equity  Growth and stability of sales  Cost of capital  Risk  Cash flow ability to service debts  Nature and size of firms  Requirements of investors 109Dr Ajay K Patel
  110. 110.  Capital market conditions  Assets structure  Purpose of financing  Terms of finance  Costs of floatation  Corporate tax rate  Legal requirements 110Dr Ajay K Patel
  111. 111. CAPITAL STRUCTURE THEORIES There are 4 basic Capital Structure theories. Relevance of capital structure 1. Net Income Approach 2. Traditional Approach Irrelevance of capital structure 1. Net Operating Income Approach 2. Modigliani-Miller (MM) Approach and 111Dr Ajay K Patel
  112. 112. COMMON ASSUMPTIONS  Replacement of one form of capital to another.  Firm value is consistent with shareholders wealth.  Capital structure is optimum when total cost of capital is minimum.  Earning of the firm remains constant. 112Dr Ajay K Patel
  113. 113. NET INCOME (NI) APPROACH  According to, Net Income theory was introduced by David Durand., capital structure decision has an impact on valuation of the firm.  A change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm.  According to NI approach, if the financial leverage increases, the cost of capital declines and the value of the firm and market price of the equity shares increases.  Similarly, if the financial leverage decreases, the cost of capital increases and value of the firm and market price of the equity shares decreases. 113Dr Ajay K Patel
  114. 114. ASSUMPTIONS OF NI APPROACH:  There are no taxes  The cost of debt is less than the cost of equity.  The use of debt does not change the risk perception of the investors Leverage ko/ke/K d Kd ke ko 114Dr Ajay K Patel
  115. 115. AS PER NI APPROACH  V = E + D  E = (EBIT-Interest) / Ke  Ko = Ke *E/(E+D) + Kd* D/(E+D) 115Dr Ajay K Patel
  116. 116. TRADITIONALAPPROACH  This Traditional theory was advocated by financial experts Ezta Solomon and Fred Weston.  According to this theory a right combination of debt and equity will always lead to market value enhancement of the firm.  This approach accepts that equity shareholders perceive financial risk and expect premiums for the risks undertaken.  It also states that after a level of debt in the capital structure, the cost of equity capital increases. 116Dr Ajay K Patel
  117. 117. ko/ke/Kd(%) Leverage ke ko Kd Optimum capital structure Stage I Stage 3 Stage 2 Stage I: Kd remain constant, Ke increases at no or slow rate, and Ko decreases. Stage II: Beyond a certain level of increase in debt, leverage will have negative impact on Ko. At this point, Ko is minimum for maximum value of firm. Stage III: Ke, Kd increases leading to increase Ko. 117Dr Ajay K Patel
  118. 118. NET OPERATING INCOME APPROACH  Net Operating Income Approach was also suggested by David Durand.  This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares.  This approach also says that the overall cost of capital is independent of the degree of leverage. 118Dr Ajay K Patel
  119. 119. FEATURES OF NOI APPROACH:  At all degrees of leverage (debt), the overall capitalization rate would remain constant.  For a given level of Earnings before Interest and Taxes (EBIT), Value of a firm =EBIT/Overall capitalization rate  The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm.  This can be denoted as follows: Value of Equity = Value of firm - Value of debt 119Dr Ajay K Patel
  120. 120.  Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant.  When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders.  Hence, to compensate for higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital. 120Dr Ajay K Patel
  121. 121. Kd ko/ke/Kd(%) ko ke Leverage 121Dr Ajay K Patel
  122. 122. AS PER NOI APPROACH  V = EBIT / Ko  E = V – D  Ke = (EBIT – Interest) / E 122Dr Ajay K Patel
  123. 123. MODIGLIANI MILLAR APPROACH  Modigliani Millar approach, popularly known as the MM approach is extension to NOI approach.  The MM approach favors NOI approach and agrees with the fact that cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions, the value of firm remains same.  The value of firm is dependent on earnings and risk of its assets.  It provides operational or behavioral justification for constant cost of capital at any degree of leverage. 123Dr Ajay K Patel
  124. 124. ASSUMPTIONS OF MM APPROACH  Capital markets are perfect.  All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm.  Within similar operating environments, the business risk is equal among all firms.  100% dividend payout ratio.  An assumption of "no taxes" was there earlier, which has been removed. 124Dr Ajay K Patel
  125. 125. BASIC PROPOSITIONS OF MM APPROACH (WITHOUT TAXES):  Proposition I: At any degree of leverage, the firm's cost of capital (Ko) and value of the firm (V) remains constant. Although levered firm can have higher value than unlevered firm in short run, but in long run due to presence of arbitrage process, both the firms will be at equal market value.  Proposition II: With the increase in leverage, cost of equity rises exactly to offset the advantage of reduced cost by debt, keeping the value of the firm constant.  Ke = Ko – (Ko -Kd) D/E  The minimum cut-off rate for the purpose of capital investments in all the cases will be WACC and will be completely unaffected by the type of security issued to finance the investment. 125Dr Ajay K Patel
  126. 126. BASIC PROPOSITIONS OF MM APPROACH (WITHOUT TAXES):  Proposition I: Levered Co. Un-Levered Co. EBIT 10,00,000 10,00,000 - Interest 3,00,000 0 Net Profit 7,00,000 10,00,000 Ke 20% 20% Value of Equity 35,00,000 50,00,000 Value of Debt 30,00,000 Total Value 65,00,000 50,00,000 WACC 15.38% 20% 126Dr Ajay K Patel
  127. 127. BASIC PROPOSITIONS OF MM APPROACH (WITHOUT TAXES): Proposition I: As Lev firm value is higher than Un-lev . Hence there will be arbitrage by investors.  An investor owner of 10% equity in Levered firm will have ownership right of Rs.350,000. Further he will get Rs.70,000 as annual return. But, in Unlevered firm 10% equity will get 100,000 as annual return. So to avail profit he sells shares for Rs.350,000 and decides to buy 10% of Un-levered firm for Rs.500,000.  He decides to borrows additional Rs.300,000 at 10% as loan. So, the total profit that he will get from all-equity firm will be 10% of profit i.e.100,000.  The remaining amount 150,000 is left over with the investor. So the net income the investor will earn = 100,000 – 30,000= 70,000.  Although the amount of earning remains same but the investor has converted the corporate leverage to home made leverage. This opportunity will attract more investors to all-equity firm. Hence share price of all equity firm will increase and create equilibrium in long run. 127Dr Ajay K Patel
  128. 128. BASIC PROPOSITIONS OF MM APPROACH (WITH TAXES):  The value of the levered firm would be greater than unlevered firm by the value of tax shield of debt.  Increase in debt, the cost of equity will rise though at lower rate than what it would in the absence of taxes .  The WACC declines for the levered firm despite increase in cost of equity.  V of unlevered firm = EBIT (1-t)/Ko  V of levered firm = EBIT (1-t)/Ko + PV of Interest Tax Shield 128Dr Ajay K Patel
  129. 129. Kd after-tax Kd before-tax Ko after tax Ko before-tax Ke before tax 129Dr Ajay K Patel
  130. 130. ARBITRAGE PROCESS  Arbitrage is the process of purchasing a security in a market where the price is low and selling it in a market where the price is higher.  This results in restoration of equilibrium in the market price of a security asset.  This process is a balancing operation which implies that a security offering same return cannot sell at different prices. 130Dr Ajay K Patel
  131. 131. CONCLUSION OF MM  The value of the firm will be higher than unlevered firm by present value of amount of taxes saved.  The Ke will increase at lower rate with the increase in debt in presence of taxes.  Due to the continuous reduction in cost of capital with increase in leverage, it will be beneficial for the firm to keep borrowing. And value of firm will be maximum at 100% debt. 131Dr Ajay K Patel
  132. 132. LIMITATIONS OF MM HYPOTHESIS:  Arbitrage process cannot be smooth due the institutional restrictions.  Arbitrage process would also be affected by the transaction costs.  The corporate leverage and personal leverage are not perfect substitutes.  The risk perception of corporate and personal leverage may be different.  Corporate taxes do exist. However, the assumption of "no taxes" has been removed later. 132Dr Ajay K Patel
  133. 133. 133Dr Ajay K Patel
  134. 134. Dividend policy  The objective of firm’s dividend policy should be to maximize a shareholder’s return so that the value of firm is maximized.  The importance aspect of dividend policy is to determine the amount of earning to be distributed (Payout Ratio) to shareholders and amount to be retained (Retention Ratio) in the firm.  Shareholders return consists of two components .i.e., Dividends and Capital Gains.  A dividend policy has influence on both the components. 134Dr Ajay K Patel
  135. 135. Dividend policy  On relationship between dividend policy and value of the firm, different theories can be grouped under : (a) theories that consider dividend decision to irrelevant, (b) theories that consider dividend decision are relevant to the value of the firm. 135Dr Ajay K Patel
  136. 136. School of Thoughts  Dividend Relevance  Walter’s model  Gordon’s model, Bird-in Hand Argument.  Dividend irrelevance  Residual theory of dividend.  Miller-Modigliani hypothesis 136Dr Ajay K Patel
  137. 137. Walter’s Model  Professor James E Walter argues that “choice of dividend policies almost always affect the value of the firm”.  Assumptions; 1. Internal financing 2. Constant return and cost of capital 3. 100 percent payout or retention 4. Constant EPS and DIV 5. Infinite time 137Dr Ajay K Patel
  138. 138. Walter’s Model  Walter’s formula of determine market rice per share is given as; P = DIV + (EPS-DIV)r/k Where; P is price of share, EPS is earning per share, DIV is dividend, r is rate of return, k is firm’s cost of capital. Situations; Growth firm: Internal rate more than opportunity cost of capital. ( r > k) Normal firm: Internal rate equal to opportunity cost of capital. ( r = k) Declining firm: Internal rate less than to opportunity cost of capital. ( r < k) K 138Dr Ajay K Patel
  139. 139. Dividend Policy and Value of share Payout Ratio Growth firm( r > k) Normal firm( r =k) Decline firm( r < k) r= 0.15, k=0.10, EPS=10 r= 0.10, k=0.10, EPS=10 r= 0.08, k=0.10, EPS=10 0% 150 100 80 40% 130 100 88 80% 110 100 96 100% 100 100 100 Optimum payout ratio for growth firm is O NO unique Optimum payout ratio for normal firm Optimum payout ratio for decline firm is 100 139Dr Ajay K Patel
  140. 140. Thus , dividend policy of the firm depends on the availability of the opportunity and relationship between internal rate of return and cost of capital. Thus; •Retain all earning when r>k •Distribute all earning when r<k •Dividend policy has no impact when r=k Thus Walter’s model is a financing decision and payment of dividend is a Passive residual. 140Dr Ajay K Patel
  141. 141. Gordon’s Model  Myron Gordon develops on model explicitly relating the market value of the firm to dividend policy.  According to Gordon model, the market value of a share is equal to the present value of an infinite streams of dividend s received by shareholders. Thus, Po = ∑DIV (1+g)t/( 1+ ke)t = E(1-b)/Ke-g Assumptions: All equity firm Perpetual earnings No external financing g=br Constant return Constant retention Constant cost of capital Cost of capital greater than growth rate. 141Dr Ajay K Patel
  142. 142. Gordon’s Model D/P ratio r=15% r=10% r=8% 0% 0 0 0 40% 400 100 77 80% 114.3 100 95 100% 100 100 100 For growth firm r>ke, the market price decreases when the payout ratio is increased. For growth firm r=ke, the market price doesn’t change. For a firm having r<Ke, the market price increases when the payout is increased. Market price for Combination of r and D/P ratio, If XYZ has EPS = 10, Ke = 10%. Thus Gordon conclusion about the relationship between the dividend policy and value of firm are similar to that of Walter’s model. 142Dr Ajay K Patel
  143. 143. Bird in hand argument  It suggest that dividend policy is relevant as the investor prefer current dividend against the future uncertain capital gains.  When investor are certain about their returns, they discount their earning with lower rate and therefore placing higher value for share of firm.  So investor require a higher rate of return as retention rate increases and this would adversely affect the share price. 143Dr Ajay K Patel
  144. 144. Irrelevance approach  Underlying intuition for dividend irrelevance  Firms that pay more dividend offer less price appreciation but provide the same total return to shareholders.  The investors are indifferent of receiving their returns in the form current dividend or price increase in market.  Assumptions:  Investment and financing have already been made and that these decisions will not be changed by dividend payments.  The perfect capital market without any transaction cost and floatation cost. 144Dr Ajay K Patel
  145. 145. Residual Theory  Residual Theory argues that the amount of profits to be distributed is a balancing figure and thus depends upon investment of firm.  Residual dividend policy is used by those companies, which finance new projects through equity that is internally generated.  The dividend payments are made from profit that remains after all project capital needs are met. This equity is also known as residual equity. 145Dr Ajay K Patel
  146. 146. Residual Theory  Under residual Theory, firm would treat the dividend decision in three steps;  Find the retained earnings needed for the capital expenditure.  Pay out any leftover earnings (the residual) as dividends.  This policy minimizes flotation and equity costs, hence minimizes the WACC. Dividends = Net Income – We X Total capital budget. 146Dr Ajay K Patel
  147. 147. Residual theory of dividend Capital budget: Rs.800,000, Target capital structure: 40% debt, 60% equity. Forecasted net income: Rs.600,000. How much out of Rs.600,000 should we pay out as dividends?  Of the Rs.800,000 capital budget,  0.6(800,000) = Rs.480,000 will be equity to keep at target capital structure and  0.4(800,000) = Rs.320,000 will be debt.  With Rs.600,000 of net income, Residual = Rs.600,000 – Rs.480,000 = Rs.120,000 will be paid as dividends.  Payout ratio = Rs.120,000/Rs.600,000 = 0.20 = 20%. 147Dr Ajay K Patel
  148. 148. M-M approach  Under perfect market situation, dividend policy of a is irrelevant to the value of the firm.  He argues neither the firm paying dividend nor the shareholders receiving the dividends will be adversely affected by firms paying either too little or too much dividend.  MM have used arbitrage process to show that the division of profits between dividends and retained earnings is irrelevant from the point of view of shareholders .  Given the investment opportunities, a firm will finance these by earnings, but firm pays dividend, then will raise an equal amount of share capital externally. 148Dr Ajay K Patel
  149. 149. M-M approach  In order to test, MM started with following valuation model.  Po = (D1 + P1)/(1 + Ke)  If the firm, has n number of outstanding shares, then the value of company will be; nPo = n(D1 + P1)/(1 + Ke)  If firm finance its investment by new shares 'm' at price 'P1'. Then the value of firm will be; nPo = (nD1 + nP1 +mP1 -mP1)/(1 + Ke)  The new fund raised by firm 'mP1' is equal to total investment less retained earning.; mP1 = I – (E – nD1). Hence put it in earlier equation we get;  nPo = [nD1 + (n +m)P1 - {I – (E – nD1)}]/(1 + Ke) = [(n+m)P1 -I + E]/(1 + Ke)  In above equation 'D' is not present, hence MM concluded that the value of firm does not depend on dividend decision. 149Dr Ajay K Patel
  150. 150. M-M approach  A firm having 1,00,000 shares outstanding and is planning to declare a dividend of Rs.5 at the end of current year. The CMP of share is Rs.100. Ke = 10%,. Analyse what will be the value of the share/firm if (a) payment of dividend is made; (b)Payment of dividend is discarded.  Use.. Po = (D1 + P1)/(1 + Ke)  Extended case; Say the firm has total earning of Rs.10,00,000 during year 1, and is planning investment of Rs.20,000,000. Analyse what will be the value of the share/firm if (a) payment of dividend is made; (b)Payment of dividend is discarded.  Use... nPo = [(n+m)P1 -I + E]/(1 + Ke) 150Dr Ajay K Patel
  151. 151. Working Capital 151Dr Ajay K Patel
  152. 152. Working capital: Concept • Working capital typically means the firm’s holding of current or short-term assets such as cash, receivables, inventory and marketable securities. • Working Capital refers to that part of the firm’s capital, which is required for financing short-term or current assets. • These items are also referred to as circulating capital. 152Dr Ajay K Patel
  153. 153. Concept of working capital  There are two possible interpretations of working capital concept: 1. Balance sheet concept 2. Operating cycle concept Balance sheet concept: There are two interpretations of working capital under the balance sheet concept. a. Excess of current assets over current liabilities b. Gross or total current assets. Excess of current assets over current liabilities are called the net working capital or net current assets. 153Dr Ajay K Patel
  154. 154. Operating cycle concept • A company’s operating cycle typically consists of three primary activities: – Purchasing resources, – Producing the product and – Distributing (selling) the product. These activities create funds flows that are both unsynchronized and uncertain. Unsynchronized because cash disbursements usually take place before cash receipts. Uncertain because future sales and costs cannot be forecasted with complete accuracy. 154Dr Ajay K Patel
  155. 155. Operating cycle concept • The firm has to maintain cash balance to pay the bills as they come due. • In addition, the company must invest in inventories to fill customer orders promptly. • And finally, the company invests in accounts receivable to extend credit to customers. • Operating cycle is equal to the length of inventory and receivable conversion periods. 155Dr Ajay K Patel
  156. 156. Operating cycle of a typical company Payable Deferral period Inventory conversion period Cash conversion cycle Operating cycle Pay for Resources purchases Receive CashPurchase resources Sell Product On credit Receivable Conversion period 156Dr Ajay K Patel
  157. 157. THE WORKING CAPITAL CYCLE (OPERATING CYCLE) Accounts Payable Cash Raw Materials W I P Finished Goods Value Addition Accounts Receivable SALES 157Dr Ajay K Patel
  158. 158. If you Then ...... Collect receivables (debtors) faster You release cash from the cycle Collect receivables (debtors) slower Your receivables soak up cash Get better credit (in terms of duration or amount) from suppliers You increase your cash resources Shift inventory (stocks) faster You free up cash Move inventory (stocks) slower You consume more cash 158Dr Ajay K Patel
  159. 159. • Raw material storage peiod: = Average stock of raw material Cost of raw material consumed/365 • WIP holding period: Average WIP inventory/ Cost of production/365 • Finished goods storage period: Average stock of finished goods/Cost of goods sold/365 • Inventory conversion period: Avg. inventory/ Cost of sales/365 • Receivable conversion period:Accounts receivable/Annual credit sales/365 • Payables deferral period: Accounts payable/(Credit purchases)/365 Operating cycle: Inventory conversion period + receivable conversion period. Cash conversion cycle = operating cycle – payables deferral period. 159Dr Ajay K Patel
  160. 160. TYPES OF WORKING CAPITAL WORKING CAPITAL BASIS OF CONCEPT BASIS OF TIME Gross Working Capital Net Working Capital Permanent / Fixed WC Temporary / Variable WC Regular WC Reserve WC Special WC Seasonal WC 160Dr Ajay K Patel
  161. 161. Working capital investment • The size and nature of investment in current assets is a function of different factors such as – Type of products manufactured, – Length of operating cycle, – Sales level, – Inventory policies, – Unexpected demand and – Unanticipated delays in obtaining new inventories, – Credit policies and – Current assets. 161Dr Ajay K Patel
  162. 162. Difference between permanent & temporary working capital Amount Variable Working Capital of Working Capital Permanent Working Capital Time 162Dr Ajay K Patel
  163. 163. Variable Working Capital Amount of Working Capital Permanent Working Capital Time 163Dr Ajay K Patel
  164. 164. Concepts of Working capital Financing • Matching Approach • Aggressive Approach • Conservative Approach 164Dr Ajay K Patel
  165. 165. Matching approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time Rs Short-term Debt Long-term Debt + Equity Capital 165Dr Ajay K Patel
  166. 166. Conservative approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time Rs Short-term Debt Long-term Debt + Equity capital 166Dr Ajay K Patel
  167. 167. Aggressive approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time RS Short-term Debt Long-term Debt + Equity capital 167Dr Ajay K Patel
  168. 168. FACTORS DETERMINING WORKING CAPITAL 1. Nature of the Industry 2. Demand of Industry 3. Cash requirements 4. Nature of the Business 5. Manufacturing time 6. Volume of Sales 7. Terms of Purchase and Sales 8. Inventory Turnover 9. Business Turnover 10. Business Cycle 11. Current Assets requirements 12. Production Cycle 168Dr Ajay K Patel
  169. 169. Working capital estimation 169Dr Ajay K Patel
  170. 170. Satyam Ltd profit and loss A/c and balance sheet for the year ended 31.12.15 are given below. You required to calculate the working capital requirement under operating cycle method: Opening stock Raw material 10,000 WIP 30,000 Finished goods 5,000 Credit purchase 35,000 Manufacturing expn 15,000 Gross profit 55,000 150,000 Administration expn 15,000 Selling &distrbtn expn 10,000 Net profit 30,000 55,000 Credit sales 1,00,000 Closing stock Raw material 11,000 WIP 30,500 Finished goods 8,500 150,000 Gross profit 55,000 . 55,000 170Dr Ajay K Patel
  171. 171. Liabilities Equities (16,000@Rs.10) 160,000 Net Profit 30,000 Creditors 10,000 2,00,000 Assets Fixed Assets 1,00,000 Debtors 30,500 Cash and Bank 19,500 Closing stock Raw material 11,000 WIP 30,500 Finished goods 8,500 2,00,000 Opening debtors (excluding profit) and opening creditor were Rs.6,500 and Rs.5,000 respectively 171Dr Ajay K Patel
  172. 172. Calculation of operating cycle Raw material Average raw material /Raw material consumed per day =10,500/34,000/365 = Work in progress Average WIP /Total cost of production per day =30,250/48500/365 = 172Dr Ajay K Patel
  173. 173. Calculation of operating cycle Finished goods Average stock/ Total cost of goods sold per day =6750/45,000/365 = Debtors Average Debtors/ credit sales per day =18,500/ 100,000/365 = 173Dr Ajay K Patel
  174. 174. Calculation of operating cycle Creditor Average creditor/credit purchases per day =7500/35,000/365 Net Operating Cycle is Total days – Credit allowed by creditors = 174Dr Ajay K Patel
  175. 175. Estimation of Net Working capital requirement for Exl Ltd from the data given below Cost of production (per unit) Amount(per unit ) Raw materials 100 Direct labour 40 Overheads 80 220 The following are the additional information: Selling price per unit Rs.240 Level of activity 1,04,000 units p.a Raw material in stock Average 4 weeks Work In Progress (Assume 100% stage of completion of materials and 50 percent for labor and overheads) Average 2 weeks Finished goods in stock Average 4 weeks Credit allowed by supplier Average 4 weeks Credit allowed by debtors Average 8 weeks Lag in payment of wages Average 1.50 weeks Cash at bank is expected to Rs.25,000. Production is sustained during 52 weeks of year 175Dr Ajay K Patel
  176. 176. Statement of Working Capital Requirement Particulars Amount Raw materials 2,000 x 4 x 100 8,00,000 WIP •Raw materials 2,000 x 2 x 100 4,00,000 •Wages (2,000 x 2 x 40)50% 80,000 •Overheads (2,000 x 2 x 80) 50% 1,60,000 6,40,000 Finished stock 2,000 x 4 x 220 17,60,000 Debtors 2,000 x 8 x 220 35,20,000 Cash 25,000 Total Current Assets 67,45,000 Creditors 2,000 x 4 x 100 8,00,000 Outstanding wages 2,000 x 4 x 1.5 1,20,000 Total current liabilities 9,20,000 Net working capital (TCA - TCL) 58,25,000 176Dr Ajay K Patel

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