Advanced financial management notes

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DEPARTMENT OF MANAGEMENT
1
SOUNDARYA INSTITUTE OF MANAGEMENT AND SCIENCE, BANGALORE-560073.
UNIT-1
INVESTMENT DECISIONS AND RISK ANALYSIS
Risk:-
Risk involves the chance an investment's actual return will
differ from the expected return. Risk includes the possibility
of losing some or all of the original investment.
Definition of Risk:-
Emmett J Vaughan, “Risk is a condition in which there is
a possibility of an adverse deviation from a desired outcome
that is expected or hoped so far.”
Uncertainty:-
The lack of certainty, a state of limited knowledge where it
is impossible to exactly describe the existing state, a future
outcome, or more than one possible outcome.
Risk Analysis:-
Risk analysis is the systematic study
of uncertainties and risks we encounter in business,
engineering, public policy, and many other areas.
ADVANCED FINANCIAL MANAGEMENT

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 Difference between Risk and Uncertainty.
BASIS FOR
COMPARISON
RISK UNCERTAINTY
Meaning The probability of winning
or losing something
worthy is known as risk.
Uncertainty implies a
situation where the future
events are not known.
Ascertainment It can be measured It cannot be measured.
Outcome Chances of outcomes are
known.
The outcome is unknown.
Control Controllable Uncontrollable
Minimization Yes No
Probabilities Assigned Not assigned
Types of Risk:-
A. Systematic Risk
Systematic risk is due to the influence of external factors on an organization. Such
factors are normally uncontrollable from an organization's point of view.
It is a macro in nature as it affects a large number of organizations operating under a
similar stream or same domain. It cannot be planned by the organization.
The types of systematic risk are depicted and listed below.

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1. Interest rate risk,
2. Market risk and
3. Purchasing power or inflationary risk.
Now let's discuss each risk classified under this group.
1. Interest rate risk
Interest-rate risk arises due to variability in the interest rates from time to time. It
particularly affects debt securities as they carry the fixed rate of interest.
2. Market risk
Market risk is associated with consistent fluctuations seen in the trading price of any
particular shares or securities. That is, it arises due to rise or fall in the trading price of
listed shares or securities in the stock market.
3. Purchasing power or inflationary risk
Purchasing power risk is also known as inflation risk. It is so, since it emanates
(originates) from the fact that it affects a purchasing power adversely. It is not
desirable to invest in securities during an inflationary period.
B. Unsystematic Risk
Unsystematic risk is due to the influence of internal factors prevailing within an
organization. Such factors are normally controllable from an organization's point of
view.

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It is a micro in nature as it affects only a particular organization. It can be
planned, so that necessary actions can be taken by the organization to
mitigate (reduce the effect of) the risk.
The types of unsystematic risk are depicted and listed below.
1. Business or liquidity risk,
2. Financial or credit risk and
3. Operational risk.
Now let's discuss each risk classified under this group.
1. Business or liquidity risk
Business risk is also known as liquidity risk. It is so, since it emanates (originates)
from the sale and purchase of securities affected by business cycles, technological
changes, etc.
2. Financial or credit risk
Financial risk is also known as credit risk. It arises due to change in the capital
structure of the organization. The capital structure mainly comprises of three ways by
which funds are sourced for the projects. These are as follows:
1. Owned funds. For e.g. share capital.
2. Borrowed funds. For e.g. loan funds.
3. Retained earnings. For e.g. reserve and surplus.
3. Operational risk
Operational risks are the business process risks failing due to human errors. This risk
will change from industry to industry. It occurs due to breakdowns in the internal
procedures, people, policies and systems.

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Techniques of Measuring Risk:-
1. Risk-adjusted cut off rate Method.
2. Certainty Equivalent Method.
3. Sensitivity Technique.
4. Probability Technique.
5. Standard deviation Method.
6. Co-efficient of variation Method.
7. Decision Tree analysis.
1. Risk-adjusted cut off rate Method:-
Under this method, the cut off rate or minimum required
rate of return [mostly the firm’s cost of capital] is raised by
adding what is called ‘risk premium’ to it. When the risk is
greater, the premium to be added would be greater.

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2. Certainty Equivalent Method:-
The certainty equivalent is a guaranteed return that someone
would accept rather than taking a chance on a higher, but
uncertain, return. To put it another way, the certainty
equivalent is the guaranteed amount of cash that would yield
the same exact expected utility as a given risky asset with
absolute certainty, and represents the opportunity cost of risk.

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3. Sensitivity Technique:-
Sensitivity analysis is a good technique for forecasting the
attention of management on critical variable and showing
where additional analysis may be beneficial before finally
accepting a project.
Conditions:
 Optimistic.
 Most likely.
 Pessimistic.
Sensitivity analysis involves the following three
steps:
Step 1:
Identification of all those variables having influence on the
project’s NPV or IRR.
Step 2:
Definition of the underlying quantitative relationship
among the variables.
Step 3:
Analysis of the impact of the changes in each of the
variables on the NPV of the project.
Advantages and Limitations of Sensitivity Analysis:
Advantages:
a. It gives greater visibility to the weak spots in an
investment.
b. It will help management to more critically investigate such
factors to validate the assumptions.
c. It aids management in proper decision-making.

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Limitations:
i. Variables are often interdependent, which makes
examining them each individually unrealistic. For example,
change in selling price will effect change in sales volume.
ii. The analysis is based on using past data/experience which
may not hold in future.
iii. Assigning a maximum and minimum or optimistic and
pessimistic value is open to subjective interpretation and risk
preference of the decision-maker.
iv. It is neither risk-measuring nor a risk-reducing technique.
It does not produce any clearer decision rule.

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4. Probability Technique:-
A probability is the relative frequency with which an event
may occur in the future. When future estimates of cash
inflows have different probabilities the expected monetary
values may be computed by multiplying cash inflows with
the probabilities assigned.

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5. Standard deviation Method:-
Standard deviation is the most common quantitative
measure of risk of an Asset. Unlike the range, it considers
every possible events and weight equal to its probability is
assigned to each event.

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6. Co-efficient of variation Method:-
A coefficient of variation (CV) is a statistical measure of the
dispersion of data points in a data series around the mean. It is
calculated as follows: (standard deviation) / (expected value).
The coefficient of variation represents the ratio of the standard
deviation to the mean, and it is a useful statistic for comparing
the degree of variation from one data series to another, even if
the means are drastically different from one another.

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7. Decision Tree analysis:-
A decision tree is a schematic, tree-shaped diagram used to
determine a course of action or show a statistical probability.
Each branch of the decision tree represents a possible decision,
occurrence or reaction. The tree is structured to show how and
why one choice may lead to the next, with the use of the
branches indicating each option is mutually exclusive.

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CHETHAN.S
Department of Management, SIMS
1
UNIT-2
COST OF CAPITAL
 Meaning of capital:-
Capital refers to cash or goods used to generate income either by investing in
a business or a different income property. It is the net worth of a business;
that is, the amount by which its assets exceed its liabilities.
 Definition of Capital:-
According to Alfred Marshall, “Capital consists of all kinds of wealth, other than
free gifts of nature, which yield income”.
 Features of Capital:-
1. Productive factor.
2. Elastic supply.
3. Man-made factor.
4. Durable.
5. Easy mobility.
6. Derived demand.
7. Social cost.
8. Round about production.
 Meaning of cost of capital:-
Cost of Capital is the minimum required rate of earning or the cut off rate for
capital expenditure.
Cost of capital is the rate of return that a firm must earn on its project
investments to maintain its market value and attract funds.

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 Definition of Cost of Capital:-
According to John J Hampton, “Cost of capital is the rate of return the firm
required from investment in order to increase the value of the firm in the
market place”.
 Significance/ Importance of cost of capital:-
1. Capital budgeting decisions.
2. Designing the corporate financial structure.
3. Deciding about the method of financing.
4. Performance of top management.
5. Dividend decisions.
6. Working capital policy.
 Factors affecting cost of capital:-
1. Tax rates.
2. Level of interest rates.
3. Amount of financing.
4. Operating and financial decisions made by management.
5. Marketability of company securities.
6. General economic conditions.
7. Source of finance.
8. Business Risk.
9. Financial Risk.
10. Dividend Policy.
 Classification of cost of capital:-
1. Historical cost. 7. Average cost.
2. Future Cost. 8. Marginal cost.
3. Specific cost.
4. Composite cost.
5. Explicit Cost.
6. Implicit cost.

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 Computation of cost of capital:-
A) Computation of cost of specific sources of finance.
1. Cost of equity share capital.
2. Cost of Preference share capital.
3. Cost of Debt capital.
4. Cost of retained Earnings.
B) Computation of weighted average cost of capital.
A). Computation of cost of specific sources of finance.
1. Cost of equity share capital.
a) Dividend yield method.
Where,
Ke= Cost of equitycapital.
D= Expected Dividend rate per share.
MP= Net proceeds of an equityshare.
b)Dividend yield plus growth in dividend method.
Where,
G= Growth rate.
NP= Net proceeds per share.
Ke= Cost of equity.
D1= Expected dividend per share.
MP= Market price of equity per share.

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2. Cost of Preference Share capital.
a) Cost of Irredeemable preference shares.
Where,
PD= Preference dividend.
NP= Net proceeds.
Kp= Cost of preference shares.
b) Cost of Redeemable Preference share capital.
3. Cost of Debt capital.
Where,
I= Interest.
P= Principal.
a) Cost of Irredeemable Debt.
Before Tax cost of Debt.

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After Tax Cost of Debt.
b) Cost of Redeemable Debt.
Where,
P= Payable on Maturity.
NP= Net Proceeds.
N= No. of years to maturity.
T= Tax rate.
I= Interest.
4.Cost of Retained Earnings.
Kr= Ke (1-T) (T-B)
B)Computation of weighted average cost of capital.

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CAPITAL STRUCTURE
 Meaning:-
Capital structure of a company refers to the composition or make-up of
its capitalization and it includes all long-term capital resources viz:
loans, reserves, shares and bonds.”
 Meaning of Capitalization:-
Capitalization refers to the total amount of securities issued by a
company while capital structure refers to the kinds of securities and
the proportionate amounts that make up capitalization.
 Meaning of Financial structure:-
Financial structure is a composed of a specified percentage of short-
term debt, long-term debt and shareholders’ funds.
 Forms/Patterns of capital structure:-
1. Equity share.
2. Equity and Preference share.
3. Equity shares and debentures.
4. Equity shares, preference shares, debentures.

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 Causes of Risk:-
1. Wrong method of investment.
2. Wrong timing of investment.
3. Wrong quantity of investment.
4. Interest rate risk.
5. Nature of investment instruments.
6. Nature of industry in which the company is operating.
7. Creditworthiness of the issuer.
8. Maturity period or length of investment.
9. Terms of lending.
10. Natural calamities.
 Types of Risk:-
Risk
Systematic
Risk
1.Market Risk
2. Interest rate Risk
3. Purchasing power risk
Unsystematic
Risk
1. Business Risk
2. Financial Risk
3. Default credit risk

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 Principles of Capital structure decisions:-
1. Cost principle.
2. Risk principle.
3. Control principle.
4. Flexibility principle.
5. Timing principle.
 Factors affecting the capital structure:-
1. Financial leverage or trading on equity.
2. Growth and stability of sales.
3. Cost of capital.
4. Risk.
5. Nature and size of a firm.
6. Control.
7. Flexibility.
8. Requirements of investors.
9. Capital market conditions.
10.Asset structure.
11. Purpose of financing.
12.Period of finance.
13.Costs of floatation,
14.Personal considerations.
15.Corporate tax rate.
16.Legal requirements.

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 CAPITAL STRUCTURE THEORIES:-
1. Net Income (NI) Approach:
According to NI approach a firm may increase the total value of the
firm by lowering its cost of capital.
When cost of capital is lowest and the value of the firm is greatest, we
call it the optimum capital structure for the firm and, at this point, the
market price per share is maximized.
The same is possible continuously by lowering its cost of capital by the
use of debt capital. In other words, using more debt capital with a
corresponding reduction in cost of capital, the value of the firm will
increase.
The same is possible only when:
(i) Cost of Debt (Kd) is less than Cost of Equity (Ke);
(ii) There are no taxes; and
(iii) The use of debt does not change the risk perception of the
investors since the degree of leverage is increased to that extent.
Since the amount of debt in the capital structure increases, weighted
average cost of capital decreases which leads to increase the total
value of the firm. So, the increased amount of debt with constant
amount of cost of equity and cost of debt will highlight the earnings of
the shareholders.

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Formulas:-
Market value of the firm = S + D
Where, S= Market value of equity shares,
=
D= Market value of Debt.
Overall cost of capital:-
Particulars Amount
EBIT
Less:-Interest on Debentures
Earnings available to Equity Shareholders
Market capitalization rate:-
Market value of equity (S)
Market value of Debentures (D)
Value of the firm (S+D)
xxxx
xxxx
xxxx
XXXXX
XXXXX
XXXXXXX

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2. Net Operating Income (NOI) Approach:
Now we want to highlight the Net Operating Income (NOI) Approach
which was advocated by David Durand based on certain assumptions.
They are:
(i) The overall capitalization rate of the firm Kw is constant for all
degree of leverages;
(ii) Net operating income is capitalized at an overall capitalization rate
in order to have the total market value of the firm.
Thus, the value of the firm, V, is ascertained at overall cost of
capital (Kw):
V = EBIT/Kw (since both are constant and independent of leverage)
(iii) The market value of the debt is then subtracted from the total
market value in order to get the market value of equity.
S – V – T
(iv) As the Cost of Debt is constant, the cost of equity will be
Ke = EBIT – I/S
The NOI Approach can be illustrated with the help of the following
diagram:

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Under this approach, the most significant assumption is that the Kw is
constant irrespective of the degree of leverage. The segregation of
debt and equity is not important here and the market capitalizes the
value of the firm as a whole.
Thus, an increase in the use of apparently cheaper debt funds is offset
exactly by the corresponding increase in the equity- capitalization rate.
So, the weighted average Cost of Capital Kw and Kd remain unchanged
for all degrees of leverage. Needless to mention here that, as the firm
increases its degree of leverage, it becomes more risky proposition
and investors are to make some sacrifice by having a low P/E ratio.
Formulas:-
Value of the Firm:- V=
Where,
Ko=capitalization rate in this approach.
Equity Capitalization Rate or Cost of Equity:-
=
Where,
EBIT= Earnings before interest and tax.
I= Interest on Debentures.
V= Value of the firm.
D= Value of debt capital.
Net operating Income/
Net Income

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3. Traditional Theory Approach:
It is accepted by all that the judicious use of debt will increase the
value of the firm and reduce the cost of capital. So, the optimum capital
structure is the point at which the value of the firm is highest and the
cost of capital is at its lowest point. Practically, this approach
encompasses all the ground between the Net Income Approach and the
Net Operating Income Approach, i.e., it may be called Intermediate
Approach.
The traditional approach explains that up to a certain point, debt-equity
mix will cause the market value of the firm to rise and the cost of
capital to decline. But after attaining the optimum level, any additional
debt will cause to decrease the market value and to increase the cost
of capital.
In other words, after attaining the optimum level, any additional debt
taken will offset the use of cheaper debt capital since the average cost
of capital will increase along with a corresponding increase in the
average cost of debt capital.
Thus, the basic proposition of this approach is:
(a) The cost of debt capital, Kd, remains constant more or less up to a
certain level and thereafter rises.
(b) The cost of equity capital Ke, remains constant more or less or rises
gradually up to a certain level and thereafter increases rapidly.
(c) The average cost of capital, Kw, decreases up to a certain level
remains unchanged more or less and thereafter rises after attaining a
certain level.

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The traditional approach can graphically be represented under
taking the data from the previous illustration:
It is found from the above that the average cost curve is U-shaped.
That is, at this stage the cost of capital would be minimum which is
expressed by the letter ‘A’ in the graph. If we draw a perpendicular to
the X-axis, the same will indicate the optimum capital structure for the
firm.
Thus, the traditional position implies that the cost of capital is not
independent of the capital structure of the firm and that there is an
optimal capital structure.
At that optimal structure, the marginal real cost of debt (explicit and
implicit) is the same as the marginal real cost of equity in equilibrium.
For degree of leverage before that point, the marginal real cost of debt
is less than that of equity beyond that point the marginal real cost of
debt exceeds that of equity.

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Formulas:-
Average cost of Capital=
Particulars Amount
EBIT
Less:-Interest on Debentures
Earnings available to Equity Shareholders
Market capitalization rate:-
Market value of equity (S)
Market value of Debentures (D)
Value of the firm (S+D)
Average cost of capital
=
xxxx
xxxx
xxxx
XXXXX
XXXXX
XXXXXXX
XX

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4. Modigliani-Miller (M-M) Approach:
Modigliani-Miller’ (MM) advocated that the relationship between the
cost of capital, capital structure and the valuation of the firm should be
explained by NOI (Net Operating Income Approach) by making an attack
on the Traditional Approach.
The Net Operating Income Approach, supplies proper justification for
the irrelevance of the capital structure. In Income Approach, supplies
proper justification for the irrelevance of the capital structure.
In this context, MM support the NOI approach on the principle that the
cost of capital is not dependent on the degree of leverage irrespective
of the debt-equity mix. In the words, according to their thesis, the total
market value of the firm and the cost of capital are independent of the
capital structure.
They advocated that the weighted average cost of capital does not
make any change with a proportionate change in debt-equity mix in the
total capital structure of the firm.
The same can be shown with the help of the following diagram:

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Proposition:
The following propositions outline the MM argument about the
relationship between cost of capital, capital structure and the
total value of the firm:
(i) The cost of capital and the total market value of the firm are
independent of its capital structure. The cost of capital is equal to the
capitalization rate of equity stream of operating earnings for its class,
and the market is determined by capitalizing its expected return at an
appropriate rate of discount for its risk class.
(ii) The second proposition includes that the expected yield on a share
is equal to the appropriate capitalization rate of a pure equity stream
for that class, together with a premium for financial risk equal to the
difference between the pure-equity capitalization rate (Ke) and yield on
debt (Kd). In short, increased Ke is offset exactly by the use of cheaper
debt.
(iii) The cut-off point for investment is always the capitalization rate
which is completely independent and unaffected by the securities that
are invested.
Assumptions:
The MM proposition is based on the following assumptions:
(a) Existence of Perfect Capital Market It includes:
(i) There is no transaction cost;
(ii) Flotation costs are neglected;
(iii) No investor can affect the market price of shares;
(iv) Information is available to all without cost;
(v) Investors are free to purchase and sale securities.

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(b) Homogeneous Risk Class/Equivalent Risk Class:
It means that the expected yield/return have the identical risk factor
i.e., business risk is equal among all firms having equivalent operational
condition.
(c) Homogeneous Expectation:
All the investors should have identical estimate about the future rate of
earnings of each firm.
(d) The Dividend pay-out Ratio is 100%:
It means that the firm must distribute all its earnings in the form of
dividend among the shareholders/investors, and
(e) Taxes do not exist:
That is, there will be no corporate tax effect (although this was
removed at a subsequent date).
Interpretation of MM Hypothesis:
The MM Hypothesis reveals that if more debt is included in the capital
structure of a firm, the same will not increase its value as the benefits
of cheaper debt capital are exactly set-off by the corresponding
increase in the cost of equity, although debt capital is less expensive
than the equity capital. So, according to MM, the total value of a firm is
absolutely unaffected by the capital structure (debt-equity mix) when
corporate tax is ignored.
Criticisms of the MM Hypothesis:
We have seen (while discussing MM Hypothesis) that MM Hypothesis is
based on some assumptions. There are some authorities who do not
recognize such assumptions as they are quite unrealistic, viz. the
assumption of perfect capital market.

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Formulas:-
A] In the absence of taxes:
Firms total market value =
Firms market value of Equity S = V-D
Firms leverage cost of equity:-
=cost of equity+(cost of equity-cost of debt)
B] When the corporate taxes are assumed to exist:
Value of Unlevered Firm (Vu) = (1-t)
Value of levered firms (Vl) =Vu+tD

CHETHAN.S
DEPARTMENT OF MANAGEMENT, SIMS
1
UNIT-3
DIVIDEND THEORIES
Meaning of Dividend:-
The term dividend refers to that part of after-tax profit which is distributed to
the owners of the company.
Meaning of Retained Earnings:-
The undistributed part of the profit is known as retained earnings.
Meaning of Dividend Decision:-
Dividend decision refers to the policy that the management formulates in
regard to earnings for distribution as dividends among shareholders. Dividend
decision determines the division of earnings between payments to
shareholders and retained earnings.
Factors Influencing a Firm’s Dividend Decision
There are certain issues that are taken into account by the directors while
making the dividend decisions:
1. Free-cash flow
2. Dividend clienteles
3. Information signaling

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Free Cash Flow Theory
The free cash flow theory is one of the prime factors of consideration when a
dividend decision is taken. As per this theory the companies provide the
shareholders with the money that is left after investing in all the projects that
have a positive net present value.
Signaling of Information
It has been observed that the increase of the worth of stocks in the share
market is directly proportional to the dividend information that is available in
the market about the company. Whenever a company announces that it would
provide more dividends to its shareholders, the price of the shares increases.
Clients of Dividends
While taking dividend decisions the directors have to be aware of the needs of
the various types of shareholders as a particular type of distribution of
shares may not be suitable for a certain group of shareholders.
DIFFERENT FORMS OF DIVIDEND :
Scrip Dividend– An unusual type of dividend involving the distribution
of promissory notes that calls for some type of payment at a future
date.
Bond Dividend– A type of liability dividend paid in the dividend payer’s
bonds.
Property Dividend– A stockholder dividend paid in a form other than
cash, scrip, or the firm’s own stock.
Cash Dividend– A dividend paid in cash to a company’s shareholders ,
normally out of the its current earnings or accumulated profits
Debenture Dividend
Optional Dividend– Dividend which the shareholder can choose to take
as either cash or stock.

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Significance of dividend decision
1. The firm has to balance between the growth of the company and the
distribution to the shareholders
2.It has a critical influence on the value of the firm
3.It has to also to strike a balance between the long term financing decision(
company distributing dividend in the absence of any investment opportunity)
and the wealth maximization
4.The market price gets affected if dividends paid are less.
5.Retained earnings helps the firm to concentrate on the growth, expansion
and modernization of the firm
6.To sum up, it to a large extent affects the financial structure, flow of funds,
corporate liquidity, stock prices, and growth of the company and investor’s
satisfaction.
Factors influencing the dividend decision
1. Liquidity of funds
2.Stability of earnings
3.Financing policy of the firm
4.Dividend policy of competitive firms
5.Past dividend rates
6.Debt obligation
7.Ability to borrow
8.Growth needs of the company
9.Profit rates
10.Legal requirements
11.Policy of control
12.Corporate taxation policy
13.Tax position of shareholders
14.Effect of trade policy
15.Attitude of the investor group

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DIVIDEND THEORIES:-
1. Walter’s model
2. Gordon’s model
3. Modigliani and Miller’s hypothesis
1. Walter’s model:
Professor James E. Walterargues that the choice of dividend policies almost
always affects the value of the enterprise. His model shows clearly the
importance of the relationship between the firm’s internal rate of return (r)
and its cost of capital (k) in determining the dividend policy that will maximise
the wealth of shareholders.
Walter’s model is based on the following assumptions:
1. The firm finances all investment through retained earnings; that is debt or
new equity is not issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally
immediately.
4. Beginning earnings and dividends never change. The values of the earnings
pershare (E), and the divided per share (D) may be changed in the model to
determine results, but any given values of E and D are assumed to remain
constant forever in determining a given value.
5. The firm has a very long or infinite life.

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Walters Model P = +
P= Market price per share
D= Dividend per share
R= Internal rate of return
E= Earnings per share
Ke= Cost of equity capital
Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all
equity firm under different assumptions about the rate of return. However, the
simplified nature of the model can lead to conclusions which are net true in
general, though true for Walter’s model.
The criticisms on the model are as follows:
1. Walter’s model of share valuation mixes dividend policy with investment
policy of the firm. The model assumes that the investment opportunities of the
firm are financed by retained earnings only and no external financing debt or
equity is used for the purpose when such a situation exists either the firm’s
investment or its dividend policy or both will be sub-optimum. The wealth of the
owners will maximise only when this optimum investment in made.
2. Walter’s model is based on the assumption that r is constant. In fact
decreases as more investment occurs. This reflects the assumption that the

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most profitable investments are made first and then the poorer investments
are made.
The firm should step at a point where r = k. This is clearly an erroneous policy
and fall to optimise the wealth of the owners.
3. A firm’s cost of capital or discount rate, K, does not remain constant; it
changes directly with the firm’s risk. Thus, the present value of the firm’s
income moves inversely with the cost of capital. By assuming that the discount
rate, K is constant, Walter’s model abstracts from the effect of risk on the
value of the firm.
2. Gordon’s Model:
One very popular model explicitly relating the market value of the firm to
dividend policy is developed by Myron Gordon.
Assumptions:
Gordon’s model is based on the following assumptions.
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.

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Gordon’s Approach P=
P= Price of shares
E= Earnings per share
B= Retention Ratio
Br= Growth rate/ Rate of return on investment of an all-equity firm
3. Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant
as it does not affect the wealth of the shareholders. They argue that the value
of the firm depends on the firm’s earnings which result from its investment
policy.
Thus, when investment decision of the firm is given, dividend decision the split
of earnings between dividends and retained earnings is of no significance in
determining the value of the firm. M – M’s hypothesis of irrelevance is based on
the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist

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3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast
future prices and dividends with certainty and one discount rate is appropriate
for all securities and all time periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical for
all shares. As a result, the price of each share must adjust so that the rate of
return, which is composed of the rate of dividends and capital gains, on every
share will be equal to the discount rate and be identical for all shares.
Thus, the rate of return for a share held for one year may be calculated
as follows:
Where P^ is the market or purchase price per share at time 0, P, is the market
price per share at time 1 and D is dividend per share at time 1. As hypothesised
by M – M, r should be equal for all shares. If it is not so, the low-return yielding
shares will be sold by investors who will purchase the high-return yielding
shares.
This process will tend to reduce the price of the low-return shares and to
increase the prices of the high-return shares. This switching will continue until
the differentials in rates of return are eliminated. This discount rate will also
be equal for all firms under the M-M assumption since there are no risk
differences.
Criticism:

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Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks
practical relevance in the real world situation. Thus, it is being criticised on the
following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This
cannot be true if the costs of floating new issues exist.
3. According to M-M’s hypothesis the wealth of a shareholder will be same
whether the firm pays dividends or not. But, because of the transactions costs
and inconvenience associated with the sale of shares to realise capital gains,
shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the
discount rate (k) should be same whether firm uses the external or internal
financing.
If investors have desire to diversify their port folios, the discount rate for
external and internal financing will be different.
5. M-M argues that, even if the assumption of perfect certainty is dropped and
uncertainty is considered, dividend policy continues to be irrelevant. But
according to number of writers, dividends are relevant under conditions of
uncertainty.

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Modigliani and Miller Approach (MM Model)
a) Price of the share at the end of the current financial year
P1=P0(1+Ke)-D1
b) Number of shares to be issued
m=
c) Value of the firm
nP0=
m= Number of shares to be issued
I= Investment required
E= Total earnings of the firm during the
period
P1= Market price per share at the end of the
period
n= Number of shares outstanding at the
beginning of the period
D1= Dividend to be paid at the end of the
period
nP0= Value of the firm

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UNIT-4
PLANNING AND FORECASTING OF WORKING CAPITAL
Meaning of working capital:-
He capital of a business which is used in its day-to-day trading operations,
calculated as the current assets minus the current liabilities.
Concepts of working capital:-
There are two concepts of working capital:
(i) Gross concept, and
(ii) Net concept.
(i) Gross Concept of Working Capital:
The gross working capital refers to the total fund invested in current assets.
Current assets are those assets which are easily converted into cash within a
time period of one year. It includes cash in hand and at bank, short term
securities, debtors, bills receivable, prepaid expenses, accrued expenses and
inventories like raw materials, work-in-progress, stores and spare parts,
finished goods.
(ii) Net Concept of Working Capital:
The term net working capital refers to the excess of current assets over
current liabilities. In other words, the amount of current assets that would
remain in a firm after all its current liabilities are paid.

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Current liabilities are those claims of outsiders to the business enterprise
which are payable within a period of one year, and include sundry creditors,
bills payable, outstanding expenses, short-term loans, advances and deposits,
bank overdraft, proposed dividend, provision for taxation etc.
Importance of Working Capital:
The importance of sufficient working capital in any business concern can never
be overemphasized. A concern requires adequate working capital to carry on
its day-to-day operations smoothly and efficiently. Lack of adequate working
capital not only impairs firm’s profitability but also results in stoppage in
production and efficiency in payment of its current obligations.
Thus working capital is considered the life-blood of the business.
The advantages of having adequate working capital may be summarised:
1. Smooth Flow of Production:
To maintain a smooth flow of production, it is necessary that adequate working
capital is available for paying trade suppliers, hiring labour and incurring other
operating expenses.
2. Increase in Liquidity and Solvency Position:
It enhances the liquidity and solvency position of the business concern.
3. Goodwill:
A firm with sound working capital position can make timely payment of its
outstanding bills. This enhances the reputation of the firm.
4. Advantages of Cash Discount:
It enables the firm to avail itself of the facilities like cash discount by making
prompt payments.

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5. Easy Loan:
Adequate amount of working capital builds a sound credit-worthiness of the
firm. As a result it becomes easier for the firm to obtain additional loans in
favorable terms and conditions in order to meet seasonal increase in demand
or to finance the increased working capital resulting from expansion.
6. Regular Payment of Wages and Salaries:
The firm can make regular and timely payment of wages and salaries to its
employees. This increases the morale and efficiency of employees.
7. Security and Confidence:
It creates a sense of security and confidence in the mind of management or
officials of the firm.
8. Efficient Use of Fixed Assets:
Adequate amount of working capital enables the firm to use its fixed assets
more efficiently and extensively. If the fixed assets remain idle due to paucity
of working capital, depreciation of fixed assets and interest on borrowed
capital invested in fixed assets will have to be incurred unnecessarily.
9. Meeting of Contingencies:
It can meet unforeseen contingencies of the firm. Unforeseen contingencies
like business depression, financial crisis due to huge losses etc. can easily be
overcome, if adequate working capital is maintained by a firm.
10. Completing operating cycle:
A sound management of working capital helps in completing the operating cycle
quickly. This enables a firm to increase its profitability.
11. Timely Payment of Dividend:
Adequate working capital ensures regular payment of dividends to the
shareholders.

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Components or Composition of Working Capital:
There are two components of working capital viz., current assets and current
liabilities.
Current Assets:
Current assets generally mean those assets which, in the normal and ordinary
course of business, will be or are likely to be converted into cash within a year.
Examples of current assets are:
1. Inventories like raw materials, work-in-progress, stores and spare parts,
finished goods
2. Sundry Debtors (net of provision)
3. Short-term investment or marketable securities
4. Short-term loans and advances
5. Bills receivable or accounts receivable
6. Pre-paid expenses
7. Accrued Income
8. Cash in hand and bank balances.
Current Liabilities:
Current liabilities mean those liabilities repayable within the same period, i.e., a
year. In other words, current liabilities are those which are to be repaid in the
ordinary course of the business within a year.
Examples of current liabilities are:
1. Sundry creditors
2. Bills payable

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3. Outstanding expenses
4. Short-term loans, advances and deposits
5. Provision for tax
6. Proposed dividend
7. Bank overdraft.
Different Sources of Working Capital:
A firm can use two types of sources to finance its working capital,
namely:
(i) Long-term source, and
(ii) Short-term source.
(i) Long-Term Sources:
Every business organization is required to maintain a minimum balance of cash
and other current assets at all the times—irrespective of the ups and downs in
the level of activity. The portion of working capital which is continuously
maintained by the business at all times to carry on its minimum level of
activities is called permanent working capital.
This type of working capital should be arranged from long-term sources of
fund.
The following are the long-term sources of financing permanent working
capital:
(a) Issue of Equity shares
(b) Issue of Preference shares
(c) Retained earnings (ploughed-back profits)

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(d) Issue of Debentures and other long-term bonds
(e) Long-term loans taken from financial institutions etc.
(ii) Short-Term Sources:
The short-term financing of working capital is generally used to support the
temporary working capital which is usually needed to meet the seasonal
increase or sudden spurt in demand.
Various short-term sources of financing of temporary working capital
are:
(a) Bank credit (e.g., cash credit, letter of credit, bills finance, working capital
demand loan, overdraft facility etc.)
(b) Public deposits
(c) Trade credit
(d) Outstanding expenses
(e) Provision for depreciation
(f) Provision for taxation
(g) Advances from customers
(h) Loans from directors
(i) Security money received from employees
(j) Receipts from factoring.

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Determinants/Factors of Working Capital:
A firm should always maintain a requisite amount of working capital for smooth
and efficient functioning of its operations. The total working capital
requirement is determined by a wide variety of factors. These factors affect
different enterprises differently. They also vary from time to time.
In general, the following factors are to be considered in determining the
working capital requirement of a firm:
1. Nature of Business:
The working capital requirements of a firm are widely influenced by the nature
of business. Public utilities like bus service, railways, water supply etc. have
the lowest requirements for working capital—partly because of the cash
nature of their business and partly because of their rendering service rather
than manufacturing product and there is no need of maintaining any inventory
or book debt except capital assets.
On the contrary, trading concerns are required to maintain more working
capital because they have to carry stock-in-trade, receivables and liquid cash.
Manufacturing concerns also require large amount of working capital because
of the time lag involved in the conversion of raw materials into finished
products and, finally, into cash.
2. Size of the Business:
The amount of working capital requirement also depends upon the size of the
business. The size can be measured in terms of the scale of operations. A large
firm with a high scale of operation will require to maintain a large amount of
working capital than a firm with a small scale of operation.
3. Production Cycle:
Production cycle is the time involved in manufacturing or processing a product.
It starts when raw materials are put in the production process and ends with

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the completion of manufacturing of the product. Longer the production cycle,
higher is the need of working capital.
This is because funds remain blocked in work-in-progress for long periods of
time. For example, the working capital needs of a ship-building industry will be
much longer than those of a bakery.
4. Business Cycle:
The working capital requirements are also determined by the nature of the
business cycle. During the boom period, the need for working capital will
increase to meet the requirements of increased production and sales. On the
other hand, in a slack period, the reduced volume of operation will require
relatively lower amount of working capital.
5. Credit terms of Purchase and Sale:
The period of credit given by the suppliers and the period of credit granted to
the customers will affect the working capital needs of a firm. If a firm allows a
very short credit period, cash will be realised very soon from debtors. So the
need for the working capital will be less.
On the other hand, a liberal credit policy will result in higher amount of book
debts. Higher book debts will mean more working capital requirement. If the
firm has to purchase raw materials in cash or gets credit for shorter period, it
has to arrange for relatively higher amount of working capital.
6. Seasonal Variations:
There are industries like cold drinks, ice-cream and woolen where the goods
are either produced or sold seasonally. So, in such industries, working capital
requirements during production or sale seasons will be large and these will
start decreasing when the season starts coming-to end.
However, much depends on the policy of management with regard to
production or sale of goods. For example, the management of a woolen industry

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wants to carry on production evenly throughout the year rather than
concentrating on its production only in the busy season. In that case the
working capital requirements will be low.
7. Operating Efficiency:
If the operating efficiency of a firm is very high, the resources will be properly
utilized. As a result, it improves the profitability of the firm which ultimately,
helps in releasing the pressure of working capital. On other hand, inefficiency
compels the firm to maintain relatively a high level of working capital.
8. Price level changes:
If prices of input rise, the firm requires additional working capital to maintain
the same level of production.
9. Growth and Expansion of the Business:
Every concern wants to grow over a period of time and with the increase in its
size, so the working capital requirements are bound to increase. A growing
firm would require greater working capital than a static one.
10. Profitability and Retention Money:
The net profit earned by the firm goes to increase the working capital to the
extent it has been earned in cash. The cash profit can be found by adjusting
non-cash items such as depreciation, outstanding expenses and losses or
intangible assets written-off in the net profit.
But what portion of this profit will be reinvested as working capital will depend
upon the retention policy of a firm which is, again influenced by corporate tax
structure and dividend policy. So, if the amount of retained profit is not
immediately invested outside the business, it would increase the amount of
working capital.
11. Relationship of Material Cost to Total Cost:

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In manufacturing concerns, where raw material costs bear a large proportion
to the total cost of production, a greater amount of working capital will have to
be maintained. For example, in industries like textile and electronics, large
sums are required to maintain the inventory of such raw materials.
12. Turnover of Current Assets:
The speed with which the current assets revolve around also affects working
capital requirements of a firm. In few cases like vegetables or fruit shops,
stocks get sold very quickly and, for this reason, a little or no working capital is
required in carrying over the stock.
On the other hand, there are some businesses, like jewellery, having very slow
turnover of the stocks—leading to the need for a larger amount of working
capital.
Types of working capital:-
1. On the basis of Value
 Gross Working Capital: It denotes the company’s overall investment in the
current assets.

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 Net Working Capital: It implies the surplus of current assets over current
liabilities. A positive net working capital shows the company’s ability to cover
short-term liabilities, whereas a negative net working capital indicates the
company’s inability in fulfilling short-term obligations.
On the basis of Time
 Temporary working Capital: Otherwise known as variable working capital,
it is that portion of capital which is needed by the firm along with the
permanent working capital, to fulfil short-term working capital needs that
emerge out of fluctuation in the sales volume.
 Permanent Working Capital: The minimum amount of working capital that a
company holds to carry on the operations without any interruption, is called
permanent working capital.
Other types of working capital include Initial working capital and Regular
working capital. The capital required by the promoters to initiate the business
is known as initial working capital. On the other hand, regular working capital is
one that is required by the firm to carry on its operations effectively.
WorkingCapitalCycle

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Working Capital Cycle or popularly known as operating cycle, is the length of
time between the outflow and inflow of cash during the business operation. It is
the time taken by the firm, for the payment of materials, wages and other
expenses, entering into stock and realizing cash from the sale of the finished
good.
In short, the working capital cycle is the average time required to invest cash
in assets and reconverting it into cash by selling the assets produced.
The working capital cycle may vary from enterprise to enterprise depending on
various factors, such as nature and size of business, production policies,
manufacturing process, fluctuations in trade cycle, credit policy, terms and
conditions for purchase and sales, etc.
Format of working capital requirement:-

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Cash Management:-
Cash management refers to a broad area of finance involving the collection,
handling, and usage of cash. It involves assessing market liquidity, cash flow,
and investments
Goals of Cash Management:
Precisely speaking, the primary goal of cash management in a firm is to trade-
off between liquidity and profitability in order to maximize long-term profit.
This is possible only when the firm aims at optimizing the use of funds in the
working capital pool.
This overall objective can be translated into the following operational
goals:
(i) To satisfy day-to-day business requirements;
(ii) To provide for scheduled major payments;
(iii) To face unexpected cash drains;
(iv) To seize potential opportunities for profitable long-term investment;
(v) To meet requirements of bank relationships;
(vi) To build image of creditworthiness;
(vii) To earn on cash balance;
(viii) To build reservoir for net cash inflow till the availability of better use of
funds by conscious planning;
(xi) To minimize the operating cost of cash management.

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Functions of Cash Management:
So as to achieve the objectives stated above, a finance manager has to ensure
that investment in cash is efficiently utilized. For that matter, he has to manage
cash collections and disbursements efficaciously, determine the appropriate
working cash balances and invest surplus cash.
Efficient cash management function calls for cash planning, evaluation of
benefits and costs, evaluation of policies, procedures and practices and
synchronization of cash inflows and outflows.
It is significant to note that cash management functions, as depicted, are
intimately interrelated and inter-wined.
Linkage among different cash management functions has led to the
adoption of the following methods for efficient cash management:
1. Use of techniques of cash mobilization to reduce operating requirements of
cash;
2. Major efforts to increase the precision and reliability of cash forecasting;
3. Maximum efforts to define and quantify the liquidity reserve needs of the
firm;
4. Development of explicit alternate sources of liquidity;

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5. Aggressive search for relatively more productive uses for surplus money
assets.
The above approaches involve the following actions which a finance
manager has to perform:
1. To forecast cash inflows and outflows;
2. To plan cash requirement;
3. To determine the safety level for cash;
4. To monitor safety level of cash;
5. To locate the needed funds;
6. To regulate cash inflows;
7. To regulate cash outflows;
8. To determine criteria for investment of excess cash;
9. To avail banking facilities and maintain good relations with bankers.
Thus, for achieving the goals of cash management, a finance manager have to,
first of all, plan cash needs of the firm. This is followed by the management of
cash flows, determination of optimum level of cash and finally, investment of
surplus cash.
Importance of Cash Management:
Cash management is one of the critical areas of working capital management
and assumes greater significance because it is most liquid asset used to
satisfy the firm’s obligations but it is a sterile asset as it does not yield
anything. Therefore, finance manager has to so manage cash that the firm
maintains its liquidity position without jeopardizing the profitability.

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Cash management benefits:
1. Allows adequate cash for purchases and other purposes.
2. Ability to meet cash flow.
3. Allows planning for capital expenditure.
4. Allows for financing at better terms.
5. Enables you to make special purchases and take advantage of
business opportunities.
6. Facilitates invest.
Motives of Holding Cash:-
Majorly there are three motives for which the firm holds cash.
1. Transaction Motive: The transaction motive refers to the cash required by a firm to
meet the day to day needs of its business operations. In an ordinary course of business,
the firm requires cash to make the payments in the form of salaries, wages, interests,
dividends, goods purchased, etc.

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2. Precautionary Motive: The precautionary motive refers to the tendency of a firm to
hold cash, to meet the contingencies or unforeseen circumstances arising in the course
of business.
3. Speculative Motive: The firms hold cash for the speculative purposes to avail the benefit
of bargain purchases that may arise in the future. For example, if the firm feels the
prices of raw material are likely to fall in the future, it will hold cash and wait till the
prices actually fall.
Cash Management Techniques:-
Cash Budget:-
Cash budget is a written estimate of a firm’s future cash position. It predicts
for some future period the cash receipts from different sources, cash
disbursements for different purposes and the resulting cash position generally
on a monthly basis as the budget period develops. It is, thus, a formal
presentation of-expected circular flow of cash through the business.
The cash budget consists of three parts:
(1) The forecast of cash inflows,
(2) The forecast of cash outflows, and
(3) The forecast of cash balance.
1.
• cash management planning
2.
• cash management control
3.
• Determining the optimum cash balance
4.
• Investing surplus funds

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Cash Budget Format:-

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Receivables Management:-
Introduction:-
Receivables Management is another key area of working capital
management apart from cash and inventory. Receivables constitution a
substantial portion of current assets of a firm. As substantial amounts are
involved, proper management of receivables is very important.
Meaning of Receivables:-
The term ‘receivables’ refers to debt owed to the firm by the customer
resulting from sale of goods or services in the ordinary course of business.
These are the funds blocked due to credit sales. Receivables area also called
as trade receivables, accounts receivables, book debt, sundry debtor and
bills receivables etc. Management of receivables is also known as
management of trade credit.
Motives or Purpose of maintaining Receivables:-
 Sales growth motives:- the main objective of credit sales is to increase the total sale of
the business. On being given, the facilityof credit customers who have shortage of cash
mayalso purchase the goods. Therefore, the prime motive for investment in receivables
is sales growth.
 Increased Profits Motive:- Due to credit sale, the total sales of business increase. This,
in turn, results in increase in profits of the business.
 Sales Retention or meeting Competition Motive:-In business, Goods are sold on credit
to protect the current sales against emerging competition. If goods are sold on credit to
protect the current sales against emerging competition. If goods are not sold on credit,
the customer mayshift to the competitor who allow credit facility to them.
 Cost Of investment in Receivables:– When a firm sells goods or services on credit, it
has to bear several types of costs. These costs are as follow:-
 Administrative cost:- To record the credit sale and collection from the customers, a
separate credit department with additional staff, accounting records, stationery etc is

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needed. Expenses have also been incurred on acquiring information about the credit
worthiness of the customer.
 Capital cost:- There is a time lag between sales of goods and its collection from the
customers. Meanwhile, the firm has to pay for purchase, wages, salary and other
expenses. Therefore, the firm needs additional funds, which maybe arranged either from
external sources or from retain earnings. Both of these sources involve cost.
 Collection cost:- These are the expense incurred by the firm on collection from the
customer after expiry of the credit period. Such costs include blocking up of funds for an
extended period, expenses on issuing reminders to the customer etc.
 Default cost:-Despite all the effort bythe management, the firm maynot be able to
recover full amount due from the customers. Such dues are known as bad debts or
default cost.
Objectives of Receivables Management:-
Investment in receivables or credit sales involves benefits as well as costs. Benefits
include the growth in sales and profits. On the other hand, the firm also has to bear
some administrative, capital, collection and default costs. Hence, the management
should follows such a credit policythrough which the benefits are maximized and costs
are minimized.
For this purpose , the responsibilityof the receivables management is to promote
credit sales upto that point where profits from future credit sale becomes less than
additional costs of that further sales. In other words, the credit sales maybe
promoted upto the point where marginal profits equals the marginal cost of additional
credit sales.
At this point the difference between the total sales and total costs, that is the profit,
will be maximized and the investment in the receivables will be optimum.
Thus, the following are the main objectives of receivables management:-
 To obtain optimum volume of sale.( not maximum)
 To minimize costs of credit sale.
 To optimize investment in receivables.

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Factors affecting Size of Receivables Management:-
Beside sales, a number of factors also influence the size of receivables. The
following factors indirectly affect the size of receivables.
 Size of credit sales:- The volume of credit sale is the first factor which increase or
decrease the size of receivables. The higher the part of credit sales out of total sales,
figures of receivables will also be more or vice versa.
 Credit policy:- A firm with conservative credit policy will have a low size of receivables
while a firm will liberal credit policy will be increasing this figure
 Terms of Trade:- The size of receivables also depends upon the term of trade. The
period of credit allowed and rates of discount given are linked with receivables. If credit
Period allowed is more then receivables will be also more.
 Expansion Plans:- When a concern wants to expand its activities, it will have to enter
new market. To attract customers, it will give incentives in the form of credit facilities.
The period of credit can be reduced when the firm is able to get permanent customers. In
the earlystages of expansion more credit becomes essential and size of receivables will
be more.
 Relation with profits:- The credit policy is followed with a view to increase sales. When
sales increase beyond a certain level the additional costs incurred are less than the
increase in revenue. It will be beneficial to increase in the size of receivables or vice
versa.
 Credit Collection Efforts:-The collection of credit should be streamlined. The customers
should be sent periodical reminders if they fail to pay in time. On the other hand, if
adequate attention is not paid towards credit collection then the concern can land itself
in a serious financial problem.
 Habits of Customers:- The paying habits of the customers also have a bearing on the
size of receivables. The customer maybe in the habit of delaying payments even though
theyare financially sound. The concern should remain in touch with such customers and
should make them realize the urgencyof their needs.

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FORECASTING THE RECEIVABLES:-
We can forecast on the basis of past experience, present credit policies and polices
pursued byother concerns. The following factors will help to forecast receivables:-
 Credit policy allow:- The ageing or receivables is helpful in forecasting. The longer the
amount remain due, the higher will be the size of receivables and vice versa.
 Effect of cost of Goods sold:- Some time an increase in sales result in decrease in cost
of goods sold. If this is so then sales should be increased to that extent where costs are
low, the increase in sales will also increase the amount of receivables, the estimate sales
will enable the estimate of receivables too.
 Forecasting Expenses:- The receivables are associated with number of expenses like
administrative expenses on collection of amount, cost of funds tied down in receivables,
bad debts etc. At the same time the increase in receivables will bring in more profit by
increasing sales. If cost receivable are more than the increase in income, further credit
sales should not be allowed.
 Forecasting Collection period and Discount:- The credit collection policy will spell out
the time allowed for making payments and the time allowed for availing discounts. If the
average collection period is more then the size of receivables will be more.
 Average size of Receivables:- Average size of receivables also helpful in forecasting
receivables. Average size of receivables is calculated as follow.
Techniques of Receivables Management:-
1. Receivables turnover.
2. Average Collection Period.
3. Ageing Schedule.
4. Collection matrix.

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Debtors turnover ratio:-
Average collection Period:-
[Economic Order Quantity]EOQ:-

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UNIT-5
CORPORATE VALUATION
Meaning of Valuation:-
Valuation is the process of determining the present value (PV) of an asset.
Valuations can be done on assets (for example, investments in marketable
securities such as stocks, options, business enterprises, or intangible
assets such as patents and trademarks) or on liabilities (e.g., bonds issued by
a company).
Meaning of Business Valuation:-
Business valuation is the process of determining the ‘Economic Worth’ of a
company based on its business model and external environment and supported
with reasons and empirical evidence.
Business Valuation Purposes
Although the primary purpose of business valuation is preparing a company for
sale, there are many purposes. The following are a few examples:
1. Shareholder Disputes: sometimes a breakup of the company is in the
shareholder’s best interests. This could also include transfers of shares from
shareholders who are withdrawing.
2. Estate and Gift: a valuation would need to be done prior to estate planning
or a gifting of interests or after the death of an owner. This is also required by
the IRS for Charitable donations.
3. Divorce: when a divorce occurs, a division of assets and business interests
is needed.

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4. Mergers, Acquisitions, and Sales: valuation is necessary to negotiate a
merger, acquisition, or sale, so the interested parties can obtain the best fair
market price.
5. Buy-Sell Agreements: this typically involves a transfer of equity between
partners or shareholders.
6. Financing: have a business appraisal before obtaining a loan, so the banks
can validate their investment.
7. Purchase price allocation: this involves reporting the company’s assets
and liabilities to identify tangible and intangible assets.
Reasons for Business Valuation:-
1. Exit Strategy Planning:-
If you are planning to sell your business it is a great idea to set a base line
value for the business and develop a strategy to improve the profitability
to increase the value as an exit strategy.
2. Buy/Sell Agreements:-
If you are in a partnership or LLC, a buy/sell agreement between
principals can help to avoid future disputes. A mutually agreed upon value
is the starting point for an agreement that is acceptable to all parties.
3. Shareholder or Partnership Disputes:-
Then again, things don’t always work out. If an owner decides they want
out of the partnership, an independent business valuation is necessary to
arrive at a fair settlement of ownership interest.
4. Mergers and Acquisitions:-
If your growth strategy includes buying or merging with another company,
a business valuation will help you determine if the price you are being
asked to pay is a fair one.
5. To Determine the Annual Per Share Value of an Employee Stock
Ownership Plan (ESOP):-

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In order to meet ERISA and IRS requirements, shares of Employee Stock
Ownership Plans must be valued by an independent valuation expert on an
annual basis to establish a fair stock price.
6. Funding:-
When negotiating with banks, venture capitalists or other prospective
investors, an objective valuation will help in raising capital.
7. Litigation Support:-
An objective appraisal can help in negotiating a pretrial settlement or, if
the matter goes to trial or arbitration, expert testimony of a Certified
Valuation Analyst can strengthen a case where the value of a business is
an issue.
8. Gift Tax Planning:-
Avoid problems with the IRS by having an accurate, defensible and
documented value.
9. Estate Planning:-
Nobody wants to leave their heirs with the burden of paying heavy taxes
on a business that was undervalued. Knowing the value of your business is
necessary in order to adequately fund a future estate tax liability.
10. Marital Dissolution:-
A fair market value of the business interests must be established for an
equitable division of assets.
Basis of Valuation:-
1. Asset value.
2. Market value.
3. Investment value.
4. Book value.
5. Cost basis.

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Methods of Corporate Valuation:-
1. Discounted cash flow Method.
2. Comparable company markets multiple method.
3. Relative valuation method.
1. Discounted cash flow Method.
Discounted cash flow (DCF) analysis is a method of valuing a project,
company, or asset using the concepts of the time value of money. All
future cash flows are estimated and discounted by using cost of capital to
give their present values (PVs). The sum of all future cash flows, both
incoming and outgoing, is the net present value (NPV), which is taken as the
value of the cash flows in question.[1]
Using DCF analysis to compute the NPV takes as input cash flows and a
discount rate and gives as output a present value; the opposite process—
takes cash flows and a price (present value) as inputs, and provides as
output the discount rate—this is used in bond markets to obtain the yield.
Discounted cash flow analysis is widely used in investment finance, real
estate development, corporate financial management and patent valuation.
It was used in industry as early as the 1700s or 1800s, widely discussed in
financial economics in the 1960s, and became widely used in U.S. Courts in
the 1980s and 1990s.
6 steps to building a DCF
1. Forecasting unlevered free cash flows
Step 1 is to forecast the cash flows a company generates from its core
operations after accounting for all operating expenses and
investments. These cash flows are called “unlevered free cash flows.”

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2. Calculating terminal value
You can’t keep forecasting cash flows forever. At some point, you must
make some high level assumptions about cash flows beyond the final
explicit forecast year by estimating a lump-sum value of the business
past its explicit forecast period. That lump sum is called the “terminal
value.”
3. Discounting the cash flows to the present at the weighted
average cost of capital
The discount rate that reflects the riskiness of the unlevered free cash
flows is called the weighted average cost of capital. Because unlevered
free cash flows represent all operating cash flows, these cash flows
“belong” to both the company’s lenders and owners. As such, the risks
of both providers of capital need to be accounted for using appropriate
capital structure weights (hence the term “weighted average” cost of
capital). Once discounted, the present value of all unlevered free cash
flows is called the enterprise value.
4. Add the value of non-operating assets to the present value of
unlevered free cash flows
If a company has any non-operating assets such as cash or has some
investments just sitting on the balance sheet, we must add them to the
present value of unlevered free cash flows.
5. Subtract debt and other non-equity claims
The ultimate goal of the DCF is to get at what belongs to the equity
owners (equity value). Therefore if a company has any lenders (or any
other non-equity claims against the business), we need to subtract this
from the present value. What’s left over belongs to the equity owners.

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6. Divide the equity value by the shares outstanding
The equity value tells us what the total value to owners is. But what is
the value of each share? In order to calculate this, we divide the equity
value by the company’s diluted shares outstanding.
2.Relative Valuation Model:-
A relative valuation model is a business valuation method that compares a
company's value to that of its competitors or industry peers to assess the
firm's financial worth. Relative valuation models are an alternative
to absolute value models, which try to determine a company's intrinsic worth
based on its estimated future free cash flows discounted to their present
value, without any reference to another company or industry average. Like
absolute value models, investors may use relative valuation models when
determining whether a company's stock is a good buy.
Relative valuation uses multiples, averages, ratios and benchmarks to
determine a firm's value. A benchmark may be selected by finding an industry
wide average, and that average is then used to determine relative value.
3. Net Asset Method:-
Net asset method is an indirect method of business valuation. Value of a
company, which was derived in this way, not always conforms to its real value,
because of lack of information market in general, competitors or even
company’s history, but this method is broadly used for business valuation in
Russia.
As it is known, a book value of an asset is very seldom corresponds to its
market one, because of that this method is based on a balance sheet’s
adjustments and revaluation of company’s assets at their market price. Thus,
net asset method consists of the following phases:

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1. Examination of a balance sheet and other financial information. If
documents are not confirmed by an auditor, then estimator can do it on
his own or he can invite an independent auditor. After this, an adjusted
balance sheet is created.
2. Drawing up an economical balance sheet. The difference between
economical and normal balance sheets is that all elements of assets and
liabilities are recalculated at market prices.
3. Determination of assets and liabilities values.
4. The value of a company is equal to the market value of its assets less
market value of its liabilities: market value of equity capital.
Valuation of Securities:-
1. Debenture/Bond Valuation:-
If a company needs funds for extension and development purpose without
increasing its share capital, it can borrow from the general public by issuing
certificates for a fixed period of time and at a fixed rate of interest. Such a
loan certificate is called a debenture. Debentures are offered to the public for
subscription in the same way as for issue of equity shares. Debenture is issued
under the common seal of the company acknowledging the receipt of money.
Features of Debentures:
The important features of debentures are as follows:
1. Debenture holders are the creditors of the company carrying a fixed rate of
interest.
2. Debenture is redeemed after a fixed period of time.
3. Debentures may be either secured or unsecured.
4. Interest payable on a debenture is a charge against profit and hence it is a
tax deductible expenditure.

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5. Debenture holders do not enjoy any voting right.
6. Interest on debenture is payable even if there is a loss.
Advantage of Debentures:
Following are some of the advantages of debentures:
(a) Issue of debenture does not result in dilution of interest of equity
shareholders as they do not have right either to vote or take part in the
management of the company.
(b) Interest on debenture is a tax deductible expenditure and thus it saves
income tax.
(c) Cost of debenture is relatively lower than preference shares and equity
shares.
(d) Issue of debentures is advantageous during times of inflation.
(e) Interest on debenture is payable even if there is a loss, so debenture
holders bear no risk.
Disadvantages of Debentures:
Following are the disadvantages of debentures:
(a) Payment of interest on debenture is obligatory and hence it becomes
burden if the company incurs loss.
(b) Debentures are issued to trade on equity but too much dependence on
debentures increases the financial risk of the company.
(c) Redemption of debenture involves a larger amount of cash outflow.
(d) During depression, the profit of the company goes on declining and it
becomes difficult for the company to pay interest.

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Different Types of Debentures:
A company can issue different types of debentures for raising funds for long
term purposes.
Different forms of debentures are given and discussed below:
1. Ordinary Debenture:
Such debentures are issued without mortgaging any asset, i.e. this is
unsecured. It is very difficult to raise funds through ordinary debenture.
2. Mortgage Debenture:
This type of debenture is issued by mortgaging an asset and debenture holders
can recover their dues by selling that particular asset in case the company
fails to repay the claim of debenture holders.
3. Non-convertible Debentures:
A non-convertible debenture is a debenture where there is no option for its
conversion into equity shares. Thus the debenture holders remain debenture
holders till maturity.
4. Partly Convertible Debentures:
The holders of partly convertible debentures are given an option to convert
part of their debentures. After conversion they will enjoy the benefit of both
debenture holders as well as equity shareholders.
5. Fully Convertible Debenture:
Fully convertible debentures are those debentures which are fully converted
into specified number of equity shares after predetermined period at the
option of the debenture holders.
6. Redeemable Debentures:
Redeemable debenture is a debenture which is redeemed/repaid on a prede-
termined date and at predetermined price.

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7. Irredeemable Debenture:
Such debentures are generally not redeemed during the lifetime of the com-
pany. So, it is also termed as perpetual debt. Repayment of such debenture
takes place at the time of liquidation of the company.
8. Registered Debentures:
Registered debentures are those debentures where names, address, serial
number, etc., of the debenture holders are recorded in the register book of the
company. Such debentures cannot be easily transferred to another person.
9. Unregistered Debentures:
Unregistered debentures may be referred to those debentures which are not
recorded in the company’s register book. Such a type of debenture is also
known as bearer debenture and this can be easily transferred to any other
person.
2. Valuation of Equity shares:-
Equity shares were earlier known as ordinary shares. The holders of these
shares are the real owners of the company. They have a voting right in the
meetings of holders of the company. They have a control over the working of
the company. Equity shareholders are paid dividend after paying it to the
preference shareholders.
The rate of dividend on these shares depends upon the profits of the company.
They may be paid a higher rate of dividend or they may not get anything. These
shareholders take more risk as compared to preference shareholders.
Features of Equity Shares:
Equity shares have the following features:
(i) Equity share capital remains permanently with the company. It is returned
only when the company is wound up.

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(ii) Equity shareholders have voting rights and elect the management of the
company.
(iii) The rate of dividend on equity capital depends upon the availability of
surplus funds. There is no fixed rate of dividend on equity capital.
Advantages of Equity Shares:
1. Equity shares do not create any obligation to pay a fixed rate of dividend.
2. Equity shares can be issued without creating any charge over the assets of
the company.
3. It is a permanent source of capital and the company has to repay it except
under liquidation.
4. Equity shareholders are the real owners of the company who have the voting
rights.
5. In case of profits, equity shareholders are the real gainers by way of
increased dividends and appreciation in the value of shares.
Disadvantages of Equity Shares:
1. If only equity shares are issued, the company cannot take the advantage of
trading on equity.
2. As equity capital cannot be redeemed, there is a danger of over
capitalization.
3. Equity shareholders can put obstacles for management by manipulation and
organizing themselves.
4. During prosperous periods higher dividends have to be paid leading to
increase in the value of shares in the market and it leads to speculation.

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5. Investors who desire to invest in safe securities with a fixed income have no
attraction for such shares.
Deferred Shares:
These shares were earlier issued to Promoters or Founders for services
rendered to the company. These shares were known as Founders Shares
because they were normally issued to founders. These shares rank last so far
as payment of dividend and return of capital is concerned. Preference shares
and equity shares have priority as to payment of dividend.
These shares were generally of a small denomination and the management of
the company remained in their hands by virtue of their voting rights. These
shareholders tried to manage the company with efficiency and economy
because they got dividend only at last. Now, of course, they cannot be issued
and they are only of historical importance. According to Companies Act 1956,
no public limited company or which is a subsidiary of a public company can
issue deferred shares.
3.Valuation of Preference Share:-
Meaning:
Preference shares are one of the important sources of hybrid financing. It is a
hybrid security because it has some features of equity shares as well as some
features of debentures. The holders of preference shares enjoy the
preferential rights with regard to receiving of dividend and getting back of
capital in case the company winds-up.
Features of Preference Shares:
Preference share have the following features:
1. Preference shares are long-term source of finance.

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2. The dividend payable on preference shares is generally higher than
debenture interest.
3. Preference shareholders get fixed rate of dividend irrespective of the
volume of profit.
4. It is known as hybrid security because it also bears some characteristics of
debentures.
5. Preference dividend is not tax deductible expenditure.
6. Preference shareholders do not have any voting rights.
7. Preference shareholders have the preferential right for repayment of capital
in case of winding up of the company.
8. Preference shareholders also enjoy preferential right to receive dividend.
Advantages of Preference Shares:
The advantages of preference shares are:
(a) The earnings per share of existing preference shareholders are not diluted
if fresh preference shares are issued.
(b) Issue of preference shares increases the earnings of equity shareholders,
i.e. it has a leveraging benefit.
(c) Preference shareholders do not have any voting rights and hence do not
affect the decision making of the company.
(d) Preference dividend is payable only if there is profit.
Disadvantages of Preference Shares:
Preference shares suffer from following disadvantages:
(a) Preference dividend is not tax deductible and hence it is costlier than a
debenture.

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(b) In case of cumulative preference share, arrear dividend is payable when
the company earns profit, which creates a huge financial burden on the
company.
(c) Redemption of preference share again creates financial burden and erodes
the capital base of the company.
(d) Preference shareholders get dividend at a constant rate and it will not
increase even if the company earns a huge profit, which makes this form of
finance less attractive.
(e) Preference shareholders do not enjoy the voting rights and hence their fate
is decided by the equity shareholders.
Different Types of Preference Shares:
Preference share may be classified under following categories:
i. According to Redeemability:
Under this category preference shares is classified into following two
categories.
Redeemable Preference Shares:
Redeemable preference shares are those shares which are redeemed or
repaid after the expiry of a stipulated period. As per The Companies
(Amendment) Act, 1988, a company can issue redeemable preference shares
which are redeemable within 10 years from the date of issue.
Irredeemable Preference Shares:
Irredeemable preference shares are those shares which are not redeemed
before a stipulated period. It does not have a specific maturity date. Such
shares are redeemed at the time of liquidation of the company. As per The
Companies (Amendment) Act, 1988, a company at present cannot issue
irredeemable preference shares.

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ii. According to Right of Receiving Dividend:
As per this category, preference shares are classified under two heads:
a. Cumulative Preference Shares:
Preference dividend is payable if the company earns adequate profit. However,
cumulative preference shares carry additional features which allow the
preference shareholders to claim unpaid dividends of the years in which
dividend could not be paid due to insufficient profit.
b. Non-cumulative Preference Shares:
The holders of non-cumulative preference shares will get preference dividend
if the company earns sufficient profit but they do not have the right to claim
unpaid dividend which could not be paid due to insufficient profit.
iii. According to Participation:
Under this category preference shares are of two types
a. Participating Preference Shares:
Participating preference shareholders are entitled to share the surplus profit
of the company in addition to preference dividend. Surplus profit is calculated
by deducting preference dividend and equity dividend from the distributable
profit. They are also entitled to participate in the surplus assets of the
company.
b. Non-participating Preference Shares:
Non-participating preference shareholders are not entitled to share surplus
profit and surplus assets like participating preference shareholders.
iv. According to Convertibility:
According to convertibility, preference shares are of two types:
a. Convertible Preference Shares:
The holders of convertible preference shares are given an option to convert
whole or part of their holding into equity shares after a specific period of time.

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b. Non-convertible Preference Shares:
The holders of non-convertible preference shares do not have the option to
convert their holding into equity shares i.e. they remain as preference share
till their redemption.
Value Based Management:-
Value Based Management focuses on the identification of key value drivers at
various levels of the organization, and places emphasis on these value drivers
in all the areas, i.e. in setting up of targets, in the various management
processes, in performance measurement, etc.
Value based management is a model that allow managers to run a business
focusing on the creation, improvement, and delivery of value. According to
Copeland, Roller and Murrin, value-based management is
“an approach to management whereby the company’s overall aspirations,
analytical techniques, and management processes are all aligned to help the
company maximize its value by focusing management decision-making on the
key drivers of value”.
According to McKinsey Model of Value Based Management, the key steps in
maximizing the value of a firm are as follows:
1. Identification of value maximization as the supreme goal
2. Identification of the value drivers
3. Development of strategy
4. Setting of targets
5. Deciding upon the action plans
6. Setting up the performance measurement system.

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