Ba7202 financial management (unit3) notes

Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: sn.selvaraj@yahoo.com Page 1
UNIT – III: FINANCING AND DIVIDEND DECISIONS
Financial and Operating Leverage – Capital Structure – Cost of Capital and
Valuation – Designing Capital Structure – Dividend Policy – Aspects of Dividend
Policy – Practical Consideration – Forms of Dividend Policy – Forms of Dividends –
Share Splits
FINANCIAL AND OPERATING LEVERAGE
Leveragemeans use of assets and sources of funds having fixed costs in order to
increase the potential returns to shareholders. The term leverage, in general, refers to
the relationship between two interrelated variables. In financial matters, one financial
variable influences another variable. Those financial variables may be cost, sales
revenue, earnings before interest and tax (EBIT), output, earnings per share (EPS),
etc.
In the leverage analysis, the emphasis is on the measurement of the relationship of two
variables, rather than on measuring the variables.
Leverage = %change in dependent variable
%change in independent variable
According to James C. Van Horne,“Leverage may be defined as the employment of an
asset of funds for which the firm pays cost or fixed return. The fixed cost or return
may be thought of as the fulcrum of lever”.
According to J.E. Walter,“Leverage may be defined as percentage return on equity to
percentage return on capitalization”.
Types of Leverage
There are three types of leverage. They are:
1) Operating Leverage: The leverage associated with investment (asset acquisition)
activities is referred to as operating leverage.
2) Financial Leverage: The leverage associated with financing activities is referred
to as operating leverage.
3) Composite Leverage: The combination of both operating leverage and financial
leverage is known as composite leverage.
OPERATING LEVERAGE
Operating leveragerefers to the use of fixed costs. The degree of operating leverageis
defined as the change in a company‟s earnings before interest and tax, due to change
in sales.
Since variable costs change indirect proportion of sales and fixed costs remain
constant, the variability in Earnings before Interest and Taxes, or (EBIT), when sales

change is caused by fixed costs. Higher the fixed cost, higher the variability in EBIT
for a given change in sales. Other things remaining the same, companies with higher
operating leverage (because of higher fixed costs) are more risky. Operating leverage
intensifies the effect of cyclicality on a company‟s earnings. As a consequence,
companies with higher degrees of operating leverage have high betas.
Combining Financial and Operating Leverages
Operating leverage affects a firm‟s operating profit (EBIT), while financial leverage
affects after tax or the earnings per share. The combined effect of two leverages can
be quite significant for the earnings available to ordinary shareholders.
Degree of Operating Leverage
The degree of operating leverage (DOL) is defined as the percentage change in the
earnings before interest and taxes relative to a given percentage change in sales.
DOL = % Change in EBIT
% Change in Sales
DOL = ∆EBIT / EBIT
∆Sales / Sales
DOL = Contribution where, Contribution = EBIT + Fixed cost
EBIT
DOL = Q (s–v) where, Q is the units of output, s is the unit
Q (s– v) – F selling price, v is the unit variable cost and
F is the fixed cost.
DOL = EBIT +Fixed Cost = 1 + F
EBIT EBIT
Problem:A firm developed the following income statement based on an expected sales
volume of 100,000 units. From the particulars given below calculate the degree of
operating leverage.
Rs.
Sales (100,000 units at Rs.8) 800,000
Less: Variable costs (100,000 at Rs.4) 400,000
Contribution 400,000
Less: Fixed costs 280,000
EBIT 120,000
Solution: The following formula is used for computation.
DOL = Q (s–v) where, Q is the units of output, s is the unit
Q (s– v) – F selling price, v is the unit variable cost and
F is the fixed cost.

DOL = 100,000 (Rs.8 – Rs.4)
100,000 (Rs.8 – Rs.4) – Rs.280,000
= Rs.400,000 = 3.33
120,000
DOL of 3.33 implies that for a given change in the company‟s sales, EBIT will change
by 3.33 times.
Problem:
A company which manufactures its product for sale considers automation in its
production. The technical expert appointed by the management tells them that they
can choose a more automated production processes which will reduce unit variable
cost to Rs.2, but will increase fixed costs to Rs.480,000. If the management accepts
the expert‟s advice, then the income statement will look as follows.
Rs.
Sales (100,000 units at Rs.8) 800,000
Less: Variable costs (100,000 at Rs.2) 200,000
Contribution 600,000
Less: Fixed costs 480,000
EBIT 120,000
What will be the DOL with high fixed costs and low variable costs?
Solution:
DOL = Contribution where, Contribution = EBIT + Fixed cost
EBIT
DOL = Rs.600,000 = 5.0
Rs.120,000
If the company chooses the high-automated technology and if its actual sales happen
to be more than expected, its EBIT will increase greatly; an increase of 100 percent in
sales will lead to 5 percent increase in EBIT.
Problem:The installed capacity of a factory is 600 units. Actual capacity used is 400
units. Selling price per unit is Rs.10. Variable cost is Rs.6 per unit. Calculate the
operating leverage in each of the following three situations:
i) When fixed costs are Rs.400.
ii) When fixed costs are Rs.1000.
iii) When fixed costs are Rs.1200.

Solution:
Statement showing Operating Leverage (in Rs)
Particulars Situation 1 Situation 2 Situation 3
Sales
Variable cost (VC)
Less: Contribution (C) [Sales−VC]
Fixed cost (FC)
Operating profit (OP) [C−FC]
Operating leverage (C÷OP)
4,000
2,400
1,600
400
1,200
1600/1200
= 1.33
4,000
2,400
1,600
1,000
600
1600/600
= 2.67
4,000
2,400
1,600
1,200
400
1600/400
= 4.00
From the above it shows that the degree of operating leverage increases with every
increase in share of fixed cost in the total cost structure of the firm.
Operating Risk: Operating risk can be defined as the variability of EBIT (or return on
assets). The environment – internal and external – in which a firm operates,
determines the variability of EBIT. So long as the environment is given to the firm,
operating risk is an unavoidable risk. A firm is better placed to face such risk if it can
predict it with a fair degree of accuracy.
The variability of EBIT has two components.
 Variability of sales
 Variability of expenses
Significance of Operating Leverage
Operating leverage tells the impact of sales on income. Depending on the operating
leverage, a given percentage of increase in sales results in a higher percentage of
increase in operating income and net profit. Equally, a decline in sales may wipe out
the operating profit or turn into loss, even.
FINANCIAL LEVERAGE
Financial Leveragerefers to debt in a firm‟s capital structure. Firms with debt in the
capital structure are called levered firms. The interest payments on debt are fixed
irrespective of the firm‟s earnings. Hence interest charges are fixed costs of debt
financing. The fixed costs of operations result in operating leverage and cause EBIT
to vary changes in sales.
Financial leverage is also known as trading on equity. It is defined as the ability of a
firm to use fixed financial charges to magnify the effects of changes in EBIT on the
earnings per share, i.e. preference share capital and debt capital including debentures
with fixed rate of interest.

Characteristics of Financial Leverage
o Concerned with Liabilities side of the Balance Sheet: It is concerned with the
liabilities side of the balance sheet where different type of sources of capital is
shown.
o Related to Fixed Cost of Capital: if there is no fixed cost capital, then there will
be no financial leverage.
o Financial Risk: The financial risk of the firm increases with the presence of
financial leverage.
Combining Financial and Operating Leverages
Operating leverage affects a firm‟s operating profit (EBIT), while financial leverage
affects after tax or the earnings per share. The combined effect of two leverages can
be quite significant for the earnings available to ordinary shareholders.
A company can finance its investments by debt and equity. The company may also
use preference capital. The rate of interest on debt is fixed irrespective of the
company‟s rate of return on assets. The company has a legal binding to pay interest
on debt. The rate of preference dividend is also fixed; but preference dividends are
paid when the company earns profits.
The use of fixed-charges sources of funds, such as debt and preference capital along
with the owner‟s equity in the capital structure, is described as financial leverage or
gearing or trading on equity. The use of term trading on equity is derived from the fact
that it is the owner‟s equity that is used as a basis to raise debt; that is, the equity that
is traded upon. The supplier of debt has limited participation in the company‟s profits
and therefore he will insist on protection in earnings and protection in values
represented by ownership equity.
Measures of Financial Leverage
The most commonly used measures of financial leverage are:
1. Debt ratioThe ratio of debt to total capital
L1 = D / D+E = D/V
Where, D is value of debt, E is value of shareholders‟ equity and V is value of
total capital (i.e. D+E). D and E may be measured in term of book value. The
book value of equity is called net worth. L Shareholder‟s equity may be
measured in terms of market value.
2. Debt-equity ratioThe ratio of debt to equity
L2= D/E
3. Interest coverage The ratio of net operating income (or EBIT) to interest charges
L3 = EBIT /Interest

Degree of Financial Leverage
Degree of financial leverage may be defined as the percentage change in taxable
profits as a result of percentage change in operating profit. This may be put in the
form of following equation:
DFL = Percentage change in taxable income
Percentage change in operating income
The financial leverage affects the earnings per share. When the economic conditions
are good and the firm‟s EBIT is increasing, its EPS increases faster with more debt in
the capital structure. The degree of financial leverage (DFL) is defined as the
percentage change in EPS due to a given percentage change in EBIT.
DFL = % Change in EPS
% Change in EBIT
or
DFL = ∆EPS / EPS
∆EBIT/ EBIT
For Example, when EBIT increases from Rs.120,000 to Rs.160,000, EPS increases
from Rs.1.65 to Rs.2.45 when it employs 50 percent debt and pa interest charges of
Rs.37500 (in the earlier problem). Applying equation, DFL at EBIT of Rs.120,000 is
as follows:
DFL = ∆EPS / EPS
∆EBIT/ EBIT
= (2.45 – 1.65) / 1.65 = 0.485 = 1.456
(160,000 – 120,000)/ 120,000 0.333
This implies that for a given change in EBIT, EPS will change by 1.456 times
Significance of Financial Leverage
Financial leverage is employed to plan the ratio between debt and equity so that
earnings per share are magnified. The significance of financial leverage is as under:
1) Planning of Capital Structure:Financial leverage helps in planning the capital
structure. The capital structure is concerned with the raising of long term funds,
both from shareholders and long-term creditors. The structure has the
implication of cost and risk that are to be borne in mind, while finalizing the
capital structure.
2) Profit Planning: The earning per share is affected by the degree of financial
leverage. If the profitability of the concern is increasing, the fixed costs will
help in increasing the availability of profits for equity shareholders. When
profits decline and do not cover the interest on debt, the sufferers will be equity
shareholders. Therefore, financial leverage is important for profit planning.

COMPOSITE LEVERAGE
Operating leverage measure percentage change in operating profit due to percentage
changes in sales. It explains the degree of operating risk. Financial leverage measures
percentage change in taxable profit (or EPS) on account of percentage change in
operating profit (or EBIT). Thus, it explains the degree of financial risk. Both these
leverages are closely concerned with the firm‟s capacity to meet its fixed costs (both
operating and financial). In case both the leverages are combined, the results obtained
will disclose the effect of change in sales over change in taxable profit (or EPS).
Composite leverage, thus, expresses the relationship between revenue on account of
sales (i.e. contribution or sales less variable cost) and the taxable income. It helps in
finding out the resulting percentage change in taxable income on account of
percentage change in sales.
This can be computed as follows:
Composite Leverage = Operating leverage × Financial leverage
= C ×OP = C
OP PBT PBT
Where, C = Contribution (i.e. sales – variable cost)
OP = Operating Profit (or) EBIT
PBT = Profit before Tax but After Interest
Problem: Following are the figures related to PQR Co:
Sales Rs.10,00,000,
Variable Costs 40% of sales,
Fixed Cost Rs.2,00,000, Interest Rs.15,000
You are required to calculate (i) Operating leverage (ii) Financial leverage and (iii)
Combined leverage. Also state change in the above leverages if selling price is
increased by 15%.
Solution:
Particulars Amount (Rs)
Sales
Less: Variable cost (40% of 10,00,000)
Contribution
Less: Fixed cost
Operating profit / EBIT
Less: Interest
Profit Before Tax / EBT
10,00,000
4,00,000
6,00,000
2,00,000
4,00,000
15,000
3,85,000
1) Operating Leverage = Contribution / EBIT = 6,00,000/4,00,000 = 1.5 times
2) Financial Leverage = EBIT / Profit before tax = 4,00,000/3,85,000 = 1.038
times
3) Combined Leverage = Operating leverage × Financial leverage
= 1.5 × 1.038 = 1.557 times

If the selling price is increased by 15%
Sales (10,00,000× 1.15)
Less: Variable cost (40% of 11,50,000)
Contribution
Less: Fixed cost
Less: Interest
Profit Before Tax / EBT
11,50,000
4,60,000
6,90,000
2,00,000
4,90,000
15,000
4,75,000
1) Operating Leverage = Contribution / EBIT = 6,90,000/4,90,000 = 1.408
times
2) Financial Leverage = EBIT / EBT = 4,90,000/4,75,000 = 1.0315
times
3) Combined Leverage = Operating leverage × Financial leverage
= 1.408 × 1.0315 = 1.452 times
Problem:
A company has sales of Rs.1,00,000. The variable costs are 40% of the sales while the
fixed operating costs amount to Rs.30,000. The amount of interest on long-term debt
is Rs.10,000. You are required to calculate the composite leverage and illustrate its
impact if sales increase by 5%.
Solution:
Statement Showing Computation of Composite Leverage
Sales
Less: Variable cost (40% of sales)
Contribution (C)
Less: Fixed Operating cost
Less: Interest
Taxable Income (PBT)
1,00,000
40,000
60,000
30,000
30,000
10,000
20,000
Combined Leverage = C / PBT
=60,000 / 20,000 = 3
The composite leverage of „3‟ indicates that with every increase of Re.1 in sales, the
taxable income will increase by Rs.3 (i.e. 1× 3)

This can be verified by the following computations when the sales increase by 5%
Sales
Less: Variable cost
Contribution (C)
Less: Fixed Operating cost
Less: Interest
Taxable Income (PBT)
1,05,000
42,000
63,000
30,000
33,000
10,000
23,000
It is clear from the above computation that on account of increase in sales by 5% the
profit before tax has increase by 15%. This can be verified as follows:
Increase in percentage profits = Increase in profit × 100
Base profit
= (3,000 / 20,000) × 100 = 15%
Differences between Operating and Financial Leverage
Basis of Difference Operating Leverage Financial Leverage
1) Objective The objective is to magnify
the effect of changes in sales
on operating profit.
The objective is to magnify
the effect of changes in
operating profit on earnings
per share.
2) Relationship It establishes relationship
between operating profit and
sales
It establishes relationship
between operating profit and
return on equity
3) Measurement It measures a firm‟s ability
to use fixed cost asset to
magnify the operating
profits
It measures a firm‟s ability to
use fixed cost funds to
magnify the return to equity
shareholders.
4) Relationship It relates to the assets side of
the balance sheet
It relates to the liability side
of the balance sheet
5) Effect on
Income
It effects profit before
interest and tax
It effects profit after interest
and tax
6) Risk It involves operating risk of
being unable to cover fixed
operating cost.
It involves financial risk of
being unable to cover fixed
financial cost.
7) Decision It is concerned with
investment decision.
It is concerned with
financing decision.
8) Stage It is described as first stage
leverage
It is described as second
stage leverage

CAPITAL STRUCTURE
In order to achieve the goal of indentify an optimum debt-equity mix, it is necessary
for the finance manager to be conversant with the basic theories underlying the
relationship between capital structure, cost of capital and value of firm.
Meaning and Scope of Capital Structure
Capital structure represents the relationship among different kinds of long term
capital. Normally, a firm raises long term capital through the issue of shares,
sometimes accompanied by preference shares. The share capital is often supplemented
by debenture capital and others long-term borrowed capital.
According to Prasanna Chandra, “The composition of a firm‟s financing consists of
equity, preference and debt”.
According to James C Van Horne,“The mix of a firm‟s permanent long-term
financing represented by debt, preferred stock and common stock equity”.
Capital structure is referred to as the ratio of different kinds of securities raised by a
firm as long-term finance. The capital structure involves two decisions:
(1) Types of securities to be issued are equity shares, preference shares and long-
term borrowings (debentures).
(2) Relative ratio of securities can be determined by process of capital gearing. On
this basis the companies are divided into two categories: (a) Highly Geared
Companies whose promotion of equity capitalization is small and (b) Low
Geared Companies who equity capital dominates total capitalization.
Components of Capital Structure
The long-term funds of capital structure can broadly divided into two categories, viz.,
owners‟ capital and borrowed capital as follows:
1) Owners‟ Capital – (i) Equity capital, (ii) Preference capital and (iii) Retained
Earnings.
2) Borrowed Capital – (i) Debentures and (ii) Term Loans
Optimal Capital Structure
Optimal Capital Structure is that capital structure or combination of debt and equity
that leads to the maximum value of firm. At this point, average composite cost or
weighted average cost is the minimum. If the borrowing leads the company to increase
the market value of its shares, it is said that the company has drifted away from
optimum capital structure. A company should plan in such as way that the market
value of its shares is maximized.
Types of Capital Structure
The capital structure of any concern may be simple, compound and complex.
(a) Simple Capital Structure: A single capital structure consists of single security
base as a source of fund to finance the activities of a concern, e.g. equity share

capital issued by a concern. It is safe to use such type of capital structure when
the prospects of earnings are unpredictable and uncertain.
(b) Compound Capital Structure: In compound capital structure a combination of
two security bases in the form of equity and preference capital or equity share
capital and debentures are used as a source of funds. It is advisable to use such
type of capital structure when annual earnings of a concern are uncertain but
average earnings are rather good.
(c) Complex Capital Structure: A complex capital structure is made up of multi-
security base, consisting of equity share capital, preference share capital,
debentures and loans from financial institutions. This type of capital structure is
advisable where there is certainly of stable and adequate income to pay-off
fixed financial charges.
DESIGNING CAPITAL STRUCTURE
Designing capital structure refers to the designing of an appropriate capital structure in
the context of facts and circumstances of each firm. Designing the capital structure
means selecting a desired debt-equity combination in advance. The initial capital
structure is determined at the time the firm is promoted. So this structure should be
designed very carefully.
Capital structure designing is very important to survive the business in long-run.
Liability side of balance sheet is made under perfect capital structure designing.
Liability side is the mixture of finance of company which has collected from internal
and external sources. Hence, perfect capital structure makes strong balance sheet.
The following are the common approaches to determine the firm‟s capital structure:
 EBIT-EPS Analysis: It involves the comparison of alternatives of financing
under various assumptions of EBIT.
 Cost of Capital: Cost is an important consideration in capital structure decision.
It helps in designing the optimal capital structure of the firm.
 Cash Flow Analysis: The focus of this analysis is on the risk of cash insolvency
i.e. the probability of running out the cash – given a particular amount of debt
in the capital structure. The expected cash flows can be categorized into three
groups – (i) Operating Activities, (ii) Investing Activities, and (iii) Financing
Activities
 Leverage Analysis: This analysis emphasis on the measurement of the
relationship of the two variables, rather than on measuring the variables.
Leverage = % change in dependent variable
% change in independent variable
EBIT- EPS ANALYSIS
The EBIT-EPS analysis is one of the important tools in the hands of financial manger
to get an insight into the firm‟s capital structure. The Earnings Before Interest and Tax
(EBIT) and Earnings Per Share (EPS) analysis is useful in examining the effect of
financial leverage to analyze the behavior or EPS with varying levels of EBIT under

alternative financial plans. A capital structure may consist of debt and equity in
different proportions.
It should be noted that the 65 percent EPS is the "trailing" number, using the previous
4 quarters of earnings. Some analysts like to use "projected" EPS to analyze a stock's
current value in respect to these estimates.
EPS and ROE Calculations
EPS is calculated by dividing profit after taxes, PAT also called net income, NI, by the
number of shares outstanding. PAT is found out in two steps. First, the interest on
debt, INT, is deducted from the earnings before interest and taxes, EBIT, to obtain the
profit before taxes, PBT. Then taxes are computed on and subtracted from PBT to
arrive at the figure of PAT.
The formula for calculating EPS is as follows:
Earnings per share = Profit after tax
Number of shares
EPS = PAT = (EBIT – INT) (1 – T)
N N
Where T is the corporate tax rate and N is the number of ordinary shares outstanding.
If the firm does not employ any debt, then the formula is:
EPS = EBIT (1 – T)
N
ROE is obtained by dividing PAT by equity (E). Thus the formula for calculating
ROE is as follows:
Profit after tax
Return on Equity = --------------------------
Value of equity
ROE = (EBIT – INT) (1 – T)
E
For calculating ROE either the book value or the market value equity may be used.
Earnings per Share (EPS):For computation of earnings per share deduct from earnings
before interest and tax both interest and tax. Divide earnings after interest and tax by
number of equity shares.
EPS (for equity shares) = (EBIT – 1) (1 – t)
N
EPS (for preference shares) = (EBIT – 1) (1 – t) – P
N

Analyzing Alternative Financial Plans: Constant EBIT
Problem:Suppose a new firm, Brightways Ltd, is being formed. The management of
the firm is expecting a before-tax rate of return of 24 percent on the estimated total
investment of Rs.500,000. This implies EBIT = 500,000*0.24 = Rs.120,000. The
firm is considering two alternative financial plans: (i) either to raise the entire funds
by issuing 50,000 ordinary shares at Rs.10 per share, or (ii) to raise Rs.250,000 by
issuing 25,000 ordinary shares at Rs.10 per share and borrow Rs.250,000 at 15 percent
rate of interest. The tax rate is 50 percent.
What are the effects of the alternative plans for the shareholders‟ earnings?
Solution:The effects of the alternative plans for the shareholders‟ earnings are
calculated as follows:
Effect of Financial Plans on EPS and ROE: Constant EBIT
Financial Plan
All-equity Debt-equity
(Rs) (Rs)
1. Earnings before interest and taxes, EBIT 120,000 120,000
2. Less: Interest, INT 0 37,500
3. Profit before interest, PBT 120,000 82,500
PBT = EBIT – INT
4. Less: Taxes, T@50% 60,000 41,250
PBT×T
5. Profit after taxes, PAT 60,000 41,250
PAT = (EBIT – INT) (1 – T)
6. Total earnings of investors, 60,000 78,750
PAT + INT
--------------------------------------------
7. Number of ordinary shares, N 50,000 25,000
8. EPS = (EBIT – INT) (1 – T) / N 1.20 1.65
9. ROE = (EBIT – INT) (1 – T) / E 0.12 or 12% 0.165 or 16.5%
The above calculations show the impact of the financial leverage is quite significant
when 50 percent debt (debt of Rs.250,000 to total capital of Rs.500,000) is used to
finance the investment. The firm earns Rs.1.65 per share, which is 37.5 percent more
than Rs.1.20 per share earned with no leverage. ROE is greater by the same
percentage.
_____________________
Gain from Financial Leverage
1. EBIT on assets financed by debt, Rs.250,000*0.24 Rs.60,000
2. Less: Interest, Rs.250,000*0.15 Rs.37,500
3. Surplus earnings to the shareholders, Rs.250,000*(0.24–0.15) Rs.22,500
4. Less: Taxes at 50 percent Rs.22,500*0.50 Rs.11,250
5. After tax surplus earnings accruing
to the share holders(leverage gain) Rs.11,250

Calculation of Indifference Point: The break-even or indifference point between two
alternative methods of financing can be determined by a formula. In the earlier
problem, suppose the firm is considering only two financial plans – an all-equity plan
and 50% debt-equity plan. The firm wants to know the level of EBIT at which EPS
would be the same under both the plans.
The EPS formula under all-equity plan is:
EPS = (1 – T) EBIT where N1is number of ordinary share under first
N1 plan and since the firm has no debt, no interest
charges exists.
The EPS formula under debt-equity plan is:
EPS = (1 – T) (EBIT – INT) where N2is number of ordinary share 2nd
plan
N2 and INT is the interest charges on debt.
Setting the two formulae equal, we have the following:
EPS = (1 – T) EBIT = (1 – T) (EBIT – INT)
N1 N2
Problem: Calculation of Indifference Points
Calculate the level of EBIT at which the indifference point between the following
financing alternatives will occur:
(i) Ordinary share capital Rs.10 lakh or 15% debenture of Rs.5 lakh and
ordinary share capital of Rs.5 lakh
(ii) Ordinary share capital of Rs.10 lakh or 13% preference share capital of
Rs.5 lakh and ordinary share capital of Rs.5 lakh
Assume that the corporate tax rate is 50 percent and the price of the ordinary share is
Rs.10 in each case.
Solution: The indifference points for the various combinations of the methods of
finance are calculated as follows:
(i) Ordinary shares Vs Ordinary shares and debentures.
EBIT = N1 / N1 − N2 * INT
= 100,000 / 100,000 – 50,000 *75000 = Rs.150,000
(ii) Ordinary shares Vs Ordinary and Preference shares
EBIT = N1 / (N1 − N2)* PDIV
= 100,000 / 100,000 – 50,000 * 65000
= 2 * 65,000 = Rs.130,000

COST OF CAPITAL AND VALUATION
The cost of capital is affected by number of factors. Some are beyond a firm‟s control,
but others are influenced by its financing and investment decisions.
Factors the firm cannot control:
(i) Level of Interest Rates: Higher interest rate also increases the cost of
common and preferred equity capital.
(ii) Tax Rates: Lowering the capital gains tax rates relativeto the rate on
ordinary income makes stocks more attractive, and that reduces the cost of
equity.
Factors the firm can control:
(i) Capital Structure Policy:If a firm change its capital structure, such as change
can affect its cost of capital. The after-tax cost of debt is lower than the cost
of equity.
(ii) Dividend Policy:Since the retained earnings are income that has not been
paid out as dividend, it can affect the cost of capital because it affects the
level of retained earnings.
(iii) Investment Policy: When the cost of capital is estimated, the required rate of
return is used as the starting point on the firm‟s outstanding stock and
bonds.
Cost of Debt/Debenture
Cost of debt is the contractual rate of interest or coupon rate payable on debt. Debt
may be issued at par, at premium or discount. It may be perpetual or redeemable. The
technique of computation of cost in each case has valued as follows:
Debt Issued at Par: Generally cost of the debt (i.e. debentures and long term debt) is
defined in terms of the rate of return that the debt investment must yield to protect the
shareholder interest. Thus, the before tax cost of debt capital is simply the amount of
interest payable on principal amount.
Cost of Debt before tax (Kd) = I / P
Where, I = Interest; P = Principal
However, it requires to be adjusted by tax rate. The interest payable is an admissible
deduction for computing the taxable income. It will considerable reduce the cost of
debt capital. This can be expressed as follows:
Kd = I(1 – t)
Where, I = Interest rate payable
t = Marginal tax rate of the firm
Kd = Cost of debt after tax
Problem
SV & Company raises Rs.200,00 by the issue of 2000, 10% debentures of Rs.100 each
payable at par after 10 years. If the rate of company‟s tax is, say, 50%. What is the
cost of debt to the firm?

Solution
Costof debt Kd = I(1 – t)
= 0.10 (1 – 0.50)
= 0.05 or 5%
Debt Issued at Discount:The cost of debt issued at a discount can be computed as:
Cost of debt (Kd) = [I/P](1 – t)
Where, I = Interest rate
P= Net proceeds (Face value – Discount)
t = tax rate
Problem
Ashok Company issue 80,000, 9% debentures at a discount of 5%. The rate of tax is
50%. Compute the cost of debt capital.
Solution
= [7200/76000] × (1 – 0.50)
=0.0947 × 0.50 = 0.474 or 4.7%
Debt Issued at Premium:The cost of debt issued at premium can be computed as:
Where, I = Interest rate
P= Net proceeds (Face value + Discount)
t = tax rate
Problem
B Ltd. issuers.100,000, 9% debentures at a premium at 10%. The costs of flotation are
2%. The tax rate applicable is 60%. Compute cost of debt-capital.
Solution
= [9000/107800] × (1 – 0.60)
=0.0834 × 0.40
= 0.334 or 3.34%
I = 100,000 × 9% = Rs.9000
P = Rs.100,000 + 10,000 – (0.02×110,000)
= Rs.1,10,000 – 2200 = Rs.1,07,800
t = 60% or 0.60
Cost of Preference Share
On preference share a fixed rate of dividend is paid. Though as far as dividend is
concerned there is no legal binding on the board of directors to pay dividend but if any
dividend is paid then it is to be paid to the preference shareholders first. The cost of
preference capital is the function of dividend expected by its investor. In case

dividends are not paid to preference shareholders, it will affect the fund raising
capacity of the firm.
Normally, the dividend payable to the preference shareholders is to be treated as cost
of preference share capital. It is computed as follows:
Cost of Preference Capital (Kp) = D /NP
Where, Kp = Cost of Preference share capital
D = Annual Dividend
NP = Net Proceeds from issue
The dividend to preference shareholders is also given after tax and hence no
adjustment is required to be regarding on account of taxes.
Problem
XYZ & Company issues 20,000, 12% preference shares of Rs.100 each at par.
Calculate the cost of preference share capital.
Solution
Cost of Preference capital (Kp) = D /NP
= (240,000 /20,00,000)×100
= 0.12 or 12%
Cost of Equity Share
The cost of equity is the maximum rate of return that the company must earn on equity
financed portion of its investments in order to leave unchanged the market price of its
stock. The cost of equity share capital can be computed in the following ways:
Dividend Yield Method (or) Dividend/Price Ratio Method:According to this method, the
cost of equity capital is the „discount rate that equates the present value of expected
future dividends per share with the net proceeds (or current market price) of a share.
Ke = D /NP (or) D /MP
Where, Ke = cost of equity capital; D = expected dividend per share;
NP = net proceeds per share; MP = market price per share.
The basic assumptions underline this method is that the investors give prime
importance to the dividends and risk in the firm remains unchanged.
Problem
ABC Ltd. has disbursed dividend of Rs.25 on each equity share of Rs.10. The current
market price of equity share is Rs.60. Calculate the cost of equity as per dividend
yield method.

Solution
Ke = (Dividend per share /Market price per share) × 100
= (25 / 60) × 100
= 41.67%
Problem
A company issues 1000 equity shares of Rs.100 each at a premium of 10%. The
company has been paying 20% dividend to equity shares holders for the post five
yields and expects to maintain the same in future also. Compute the cost of equity
capital will it make any difference if the market price of equity share is Rs.160?
Solution
Ke = D /NP = (20 /110) × 100 = 18.18%
If the market price of equity share is Rs.160.
Ke = D /MP = (20 /160) × 100 = 12.50%
Dividend Yield plus Growth in Dividend Method:This method of calculating cost of
equity capital is to substitute earning for dividends. When the dividends of the firm
are expected to grow at a constant rate and the dividend-pay-out ratio is constant. This
method may be used to compute the cost of equity capital.
According to this method the cost of equity capital is based on the dividends and the
growth rate.
Cost of Equity Capital, Ke = D /NP + G
Where, Ke = cost of equity capital; D = expected dividend per share;
NP = net proceeds per share; G = rate of growth in dividends.
Ke = D /MP + G where, M = Market price per share
Further, in case cost of existing equity share capital is to be calculated, the NP should
be changed with MP in the above equation.
Problem
XYZ Ltd‟s shares are quoted in stock exchange trading at Rs.120 each. Next year‟s
dividend is expected to be Rs.30 per share and the subsequent dividends are expected
to grow at an annual rate of 5% of the previous year‟s dividend. What is the cost of
equity shares?
Solution
Ke = (Dividend /Market Price) × 100 + G
= (30 /120) × 100 + 5%
= 30%

Problem
The current market price of an equity share of a company is Rs.90. The current
dividend per share is Rs.4.50. In case the dividends are expected to grow at the rate of
7%, calculate the cost of equity capital.
Solution
Ke = D /MP + G
= (4.5 /90) + 0.07
= 0.05 + 0.07 = 0.12 or 12%
Earning Yield Method:According to this method, the cost of equity capital is the
discount rate that equates the present values of expected future earnings per share with
the net proceeds (or current market price) of a share.
Ke = Earnings per share (Or) EPS
Market Price per share MP
Problem
RS Ltd‟s shares are currently trading at price of Rs.70 with outstanding shares of
Rs.500,000. Their expected profit after tax for the coming year is Rs.84 lakh.
Calculate the cost of capital based on price earning method.
Solution
Ke = EPS = 16.8 / 70 = 0.24 or 24%
MP
EPS = 84,00,000 /500,000= 16.8
Earnings Growth Method:Under this method, earnings replace dividend and the cost is
measured by the equation.
Ke = (E /P) + g
Where, E = Earnings per share; P = Current market price;
g = Growth rate in earnings.
Problem
Te current price of an equity share of Rs.10 is Rs.20. The earnings per share is Rs.3.
Growth rate in earnings is given to be 10% p.a. Calculate the cost o equity on earnings
growth model.
Solution
Ke = (E /P) + g
= (3/20) + 0.10
= 0.15 + 0.10 = 0.25 or 25%

Capital Asset Pricing Model:It describes the relationship between the required rate of
return and the cost of equity capital and non-diversified or relevant risk, of the firm as
reflected in its index of non-diversified risk beta.
Ke = Rf + b(Km – Rf)
Where, Ke = Cost of equity capital
Rf = Rate of return required on risk free/security
Km = The required rate of return on the market portfolio of assets
b = The beta coefficient
CAPM approach formally describes the risk-return trade-off for securities. It is based
on certain assumptions:
i) All investors have common expectations regarding the expected return.
ii) All investors have same information about securities.
iii) There are no restrictions on investments.
iv) There are no taxes.
v) There are no transactions cost.
vi) No single investor an affect market price significantly.
Problem
Calculate the return on investment from the following information:
Risk-free return 10.0%
Market return 12.5%
β 1.5
Solution
Return on investment
= Risk free return + β(Market return – Risk free return )
= 10 + 1.5(12.5 – 10)
= 13.75%
Problem
The market is giving an average return of 18%. The risk-free return is 11%. You are
required to calculate:
a) What return would be expected from an investment having a β-factor of 0.9?
b) What β-factor would be necessary for an investment to yield a return of 21.6%?
Solution
a) Return = 11% + 0.9(18% − 11%) = 17.3%
b) Return = Risk free return + β(Market return – Risk free return )
21.6% = 11% + β(18% − 11%)
10.6% = β(7%)
β = 10.6/7 = 1.51

Cost of Retained Earnings
It is a misconception that the retained earnings do not involve any cost because a firm
is not required to pay dividends on retained earnings. The shareholders expect a return
on retained profits. The cost of retained earnings may be considered as the rate of
return which the existing shareholders can obtain by investing the after-tax dividends
in alternative opportunity of equal qualities. It is thus, the opportunity cost of
dividends forgone by the shareholders.
Cost of retained earnings can be computed with the help of following formula:
Kr= D/NP + G
Where, Kr = Cost of retained earnings
D = Expected dividend
NP = Net proceeds of share issue
G = Rate of growth
To make adjustments in the cost in retained earnings for tax and cost of purchasing
new securities, the formula may be adopted:
Kr= [D/NP + G] × (1 – t)(1 – b) (or) Kr = Ke (1 – t)(1 – b)
Where, Kr = Cost of retained earnings ;D = Expected dividend;
NP = Net proceeds of share issue; G = Rate of growth;
t = Tax rate; b = cost of purchasing new securities;
Ke = Rate of return available to shareholders.
Problem
A firm‟s return available to shareholders is 15%, the average tax rate of shareholders
is 40% and it is expected that 2% is brokerage cost that shareholders will have to pay
while investing their dividends in alternative securities. What is the cost of retained
earnings?
Solution: Cost of retained earnings
Kr = Ke (1 – t)(1 – b)
= 15%(1 – 0.4)(1 – 0.02)
= 0.15% × 0.6 × 0.98 = 8.82%
DIVIDEND POLICY
The term dividend policy refers to the policy concerning quantum of profit to be
distributed as dividend. The concept of dividend policies implies that companies
through their Board of Directors evolve a pattern of dividend payment which has a
bearing on future action.
According to Weston and Brigham, “Dividend policy determines the division of
earnings between payments to shareholders and retained earnings”.

Dividend is that portion of profits of a company which is distributed among its
shareholder according to the decision taken and resolution passed in the meeting of
Board of Directors. This may be paid as a fixed percentage on the share capital
contributed by them or at a fixed amount per share. It means only profits after meeting
all the expenses and providing for taxation and for depreciation and transferring a
reasonable amount to reserve funds should be distributed to shareholders as dividend.
Retained earnings are the sources of internal finance for the financing of corporate
future projects but payment of dividend constitute an outflow of cash to shareholders.
Although both-expansion and payment of dividend-are desirable, these two are in
conflicts. It is, therefore, one of the important functions of the financial management
to constitute a dividend policy which can balance these two contradictory view paints
and allocate the reasonable amount of profits after tax between retained earnings and
dividend.
Factors Determining Dividend Policy
A number of considerations determine the dividend policy of company.
 Stability of Earnings
 Age of corporation
 Liquidity of Funds
 Needs for Additional Capital
 Trade Cycles
 Government Policies
 Taxation Policy
 Legal Requirements
 Past dividend Rates
 Ability to Borrow
 Policy of Control
 Repayments of Loan
 Time for Payment of Dividend
 Regularity in Dividend Payment
Nature of Dividend Policy
The dividend policy has the following natures of its own:
o Tied-up with Retained Earnings:A dividend policy is tied-up with the retained
earnings policy. It has the effect of dividing net earnings into two parts –
retained earnings and dividends.
o Constitutes Important Areas of Decision-Making:Distribution of dividends
reduces the cash funds of the business and to that extent it has to depend upon
external sources of finance.
o Impact on Shares: The payment of dividends influences the market price of
shares. Higher the rate of dividend, greater the price of shares and vice versa.
o Optimal Dividend Policy: A policy marked with few or no dividends payment
fluctuations, over a long period of time, having a favorable impact on the
wealthof shareholders.
Importance of Dividend Policy
1) The firm has to balance between the growth of the company and the
distribution to the shareholders.
2) It plays an important role in determining the value of a firm.
3) Stockholders visualize dividends as signals of the firm‟s ability to generate
income.

4) The decision to pay dividend is independent of investment decisions dividends
can indirectly influence the external financing plans. For example, a decision
to pay high dividends will leave less internal funds for reinvestment in the firm.
This could force the firm to generate funds from new stocks or bond issues.
5) It has to also to strike a balance between the long term financing decision and
the wealth maximization.
6) The market price gets affects if dividends paid are less.
7) Retained earnings help the firm to concentrate on the growth, expansion and
modernization of the firm.
ASPECTS OF DIVIDEND POLICY
The payment of dividend of a company involves the legal and procedural aspects.
Legal Aspects
The amount of dividend that can be legally distributed is governed by company law,
judicial pronouncements in leading cases, and contractual restrictions. The important
provisions of company law pertaining to dividends are:
i) Companies can pay only cash dividends (with the exception of bonus
shares). No dividend shall be declared or paid by a company for any
financial year except out of the profits earned.
ii) Dividends can only paid out of the profits earned during the financial year
after providing depreciation and after transferring to reserve some
percentage.
iii) Due to inadequacy or absence of profits in any year, dividends may be paid
out of the accumulated profits of previous years.
iv) Dividends cannot be declared for past years for which accounts have been
closed.
v) Dividend including interim dividend once declared becomes a debt. This
can be revoked with the consent of the shareholders.
Procedural Aspects
The important events and dates in the dividend payment procedure are:
a) Board Resolution: The dividend decision is the prerogative of the board of
directors. The resolution has to be passed in this regard.
b) Shareholder Approval: The resolution of the board of directors to pay the
dividend has to be approved by the shareholders in the annual general meeting.
c) Record Date: The dividend is payable to shareholders whose names appear in
the Register of Members as on the record date.
d) Dividend Payment: Once a dividend declaration has been, dividend warrants
must be posted within 30 days.
e) Unpaid Dividend: Within a period of 7 days, after the expiry of 30 days, unpaid
dividends must be transferred to a special account opened with a scheduled
bank.

PRACTICAL CONSIDERATION
There are two important dimensions of a firm‟s dividend policy:
1) What should be the average pay-out ratio?
2) How stable should the dividends be over time?
Pay-out Ratio
A major aspect of the dividend policy of a firm is its dividend payout D/P ratio, that
is, the percentage share of the net earning distributed to the shareholders as dividend.
The considerations relevant for determining the dividend pay-out ratio are as follows:
 Funds Requirement
 Liquidity
 Access to External Sources of Financing
 Shareholder Preference
 Difference in the Cost of External Equity and Retained Earnings
 Control
 Taxes
Stability of Dividends
Irrespective of the long-term pay-out ratio followed, the fluctuation in the year-to-year
dividends may be determined mainly by one of the following guidelines:
 Stable Dividend Pay-out Ratio
 Constant Dividend Per share
 Stable Dividends or Steadily Changing Dividends
FORMS /TYPES OF DIVIDEND POLICY
Regular Dividend Policy
Payment of dividend at the usual rate is termed as regular dividend. The investors
such as retired persons, widows and other economically weaker person prefer to get
regular dividends.
Advantages of Regular Dividend Policy
A regular dividend policy offers the following advantages:
 It establishes a profitable record of the company.
 It creates confidence among the shareholders.
Types of Dividend Policy
Regular Dividend Policy Stable Dividend Policy
Irregular Dividend Policy No Dividend Policy

 It aids in long-term financing and renders financing easier.
 It stabilizes the market value of shares.
 The ordinary shareholders view dividends as a source of funds to meet their
day-today living expenses.
 If profits are not distributed regularly and are retained, the shareholders may
have to pay a higher rate of tax in the year when accumulated profits are
distributed.
However, it must be remembered that regular dividends can be maintained only by
companies of long standing and stable earnings. A company should establish the
regular dividend at a lower rate as compared to the average earnings of the company.
Stable Dividend Policy
The term „stability of dividend‟ means consistency or lack of variability in the stream
of dividend payments. In more precise terms, it means payment of certain minimum
amount of dividend regularly. A stable dividend policy may be established in any of
the following forms:
(i) Constant Dividend per Share: Some companies follow a policy of paying
fixed dividend per share irrespective of the level of earnings year after year.
A policy of constant dividend per share is most suitable to concerns whose
earnings are expected to remain stable over a number of years.
(ii) Constant Payout Ratio: Constant payout ratio means payment of a fixed
percentage of net earnings as dividends every year. The amount of dividend
of such a policy fluctuates in direct proportion to the earnings of the
company. The policy of constant payout is preferred by the firms because it
is related to their ability to pay dividends.
(iii) Stable Rupee Dividend plus Extra Dividend: Some companies follow a
policy of paying constant low dividend per share plus an extra dividend in
the years of high profits. Such a policy is most suitable to the firm having
fluctuating earnings from year to year.
Advantages of Regular Dividend Policy
A stable dividend policy is advantageous to both the investors and the company on
account of the following:
 It is sign of continued normal operations of the company
 It stabilizes the market value of shares
 It creates confidence among the investors
 It improves the credit standing and makes financing easier
 It provides a source of livelihood to those investors who view dividends as a
source of funds to meet day-to-day expenses.
Irregular Dividend Policy
Some companies follow irregular dividend payment on account the following:
(i) Uncertainty of earnings
(ii) Unsuccessful business operations
(iii) Lack of liquid resources

(iv) Fear of adverse effects of regular dividends on the financial standing of the
company
No Dividend Policy
A company may follow a policy of paying no dividend presently because of its
unfavorable working capital position or on account of requirements of funds for
further expansion and growth.
FORMS OF DIVIDENDS
Dividends can be classified in various forms. Dividends paid in the ordinary course of
business are known as Profit dividends, while dividends paid out of capital are known
as Liquidation dividends. Dividends may also be classified on the basis of medium in
which they are paid.
Equity Preference InterimRegular Special
Dividend Dividend DividendDividendDividend
Cash Stock Bond Property Composite
Dividend Dividend Dividend Dividend Dividend
On the Basis of Types of Shares
1) Equity Dividend: Dividend paid on equity shares called as equity dividend.
2) Preference Dividend:Preferencedividend is the dividend paid to preference
shareholders.
On the Basis of Modes of Payment
1) Cash Dividend:A cash dividend is a usual method of paying dividends.
2) Bonus Share/Stock Dividend: Stock dividend means the issue of bonus shares to
the existing shareholders.
3) Scrip or Bond Dividend: A scrip dividend promise to pay the shareholders at a
future specific date.
4) Property Dividend:Property dividends are paid in the form of some assets other
than cash. They are distributed under exceptional circumstances and are not
popular in India.
Dividend
On the Basis of
Types of Shares
On the Basis of
Mode of Payment
On the Basis of
Time of Payment

5) Composite Dividend:When dividend is paid partly in the form of cash and partly
in other form, it is called as composite dividend.
On the Basis of Time of Payment
1) Interim Dividend:It is the dividend paid between two annual general meetings.
2) Regular Dividend:Dividend declared in every Annual General Meeting.
3) Special Dividend:When the company earns abnormal profit it will declare
special dividend.
SHARE SPLITS
Share Split or Stock Split is the process of splitting shares with high face value into
shares of lower face value. It‟s like getting an Rs.20 note changed for two Rs.10 notes.
A share split simply involves a company altering the number of its shares outstanding
and proportionally adjusting the share price to compensate.
The most common stock split is two-for-one in which each share becomes two shares.
The price per share immediately adjusts to reflect the stock split, since buyers and
sellers of the stock all know about the stock split. For example, if you owned 25
shares of ABC at Rs.15 per share, and there was a 2-1 stock split, you would then own
50 shares of Rs.7.5 each.
For example,
Assume that ABC Corporation has 10000 shares of Rs.100 per common stock
outstanding with a current market price of Rs.150 per share. The Board of Directors
declares the following stock split:
1) Each common shareholder will receive 5 shares for each share held. This is
called 5-for-1 stock split. As a result, 50000 shares (10000×5) will be
outstanding.
2) The par of each share of common stock will be reduced to Rs.20 (Rs.100/5).
The par value of the common stock outstanding is Rs.10,00,000 both before and after
the stock split as shown below:
Before Split After Split
Number of shares
Par value per share
10,000
× Rs.100
50,000
× Rs.20
Total Rs.10,00,000 Rs.10,00,000
A stock split does not require journal entry in the books of accounts,
but is disclosed in the notes of the financial statements.
Since there are more shares outstanding after the stock split, the market price of the
stock should decrease. Thus, the market price of the stock would be expected to fall
after stock split.

Reasons for Share Splits
(a) Companies usually split their stock when they think the price of their stock
exceeds the amount smaller investors would be willing to pay.
(b) It is aimed at making the stock more affordable and liquid from retail investor‟s
point of view.
(c) Generally, there are more buyers and sellers of shares trading at Rs.100 than
say, Rs.400, as retail shareholders may find low price stocks to be better
bargains.
(d) Stock splits are usually initiated after a huge run-up in the share. This run-up
may link to the performance of the stock.
Difference between Bonus Shares and Share Split
Point of
Difference
Bonus Share Share Split
Meaning Bonus shares mean additional
free shares allotted to the existing
shareholders.
It is a process of dividing the
face value of shares.
Face Value In bonus issue, face value of the
share is not changing.
In stock split, face value is
changing.
Share Capital In bonus issue, the share capital
and number of shares are
increased.
In stock split, share capital is
not changed, but the number
of shares is changed.
Dividend Company has to give more
dividends after bonus issue,
because by the increase of the
share capital.
In stock split, the share
capital is not increasing. So
there is no need for more
dividends in future.
Reserves Only a certain amount of the
reserves is used.
The reserves are not
capitalized.
Text Books
1. M.Y.Khan and P.K.Jain, “Financial Management” Tata McGraw Hill, 6th
Edition, 2011.
2. I.M.Pandey, “Financial Management” Vikas Publishing House Pvt. Ltd., 10th
Education 2012.
References
1. AswatDamodaran, Corporate Finance Theory and Practice, John Wiley &
Sons, 2011.
2. James C Vanhorne, Fundamentals of Financial Management, PHI Learning,
11th
Edition, 2012.
3. Brigham Ehrhardt, Financial Management Theory and Practice, Cengage
Learning, 12th
Edition, 2010.
4. Prasanna Chandra, Financial Management, Tata McGraw Hill, 9th
Edition,
2012.
5. Srivatsava, Mishra, Financial Management, Oxford University Press, 2011.

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