Financial management for net

Anuj Bhatia
BBA (Gold Medalist), M.Com (Gold Medalist), CA(Inter.),
CMA(Inter.), GSET, UGC NET-JRF, Ph.D (Pur.)]
Research Scholar,
Department of Business Studies,
Sardar Patel University

Introduction and Relevance
Finance is the life blood of the business.
 Without finance no business or enterprise can be commenced.
 From the beginning till its end, finance is constantly required.
For implementation of various plans and for achieving goals of
business, finance is essential.
 Any profitable and ambitious plan becomes a dream in the
absence of finance.
 Shortage of finance will disturb the production planning.
Similarly excess finance will become burden for business
enterprises for keeping it idle (unutilized).
 In business enterprises necessities of more and more finance
are increasing for purchase of raw materials, payment of wages
and for payment of selling and other administrative expenses.
Besides, finance is required for modernization and
development of business.
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A Brief History…..
 Financial management is that managerial area which
is concerned with the planning and controlling of the
firm's financial resources.
 Though it was a branch of economics till 1890, as a
separate managerial area or discipline it is of recent
origin. Still, it has no unique body of knowledge of its
own, and draws heavily on economics for its
theoretical concepts even today.
 In the early years of its evaluation it was treated
synonymously with the raising of funds. In the current
literature pertaining to financial management, in
addition to procurement of funds, efficient use of
resources is universally recognized.
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What is Financial Management?
 Financial management is the ways and means of
managing money i.e., the determination, acquisition,
allocation and utilization of financial resources usually
with the aim of achieving some particular goals or
objectives.
 In the words of Howard and Upton, “Financial
management is the application of planning and control
function to the finance function.”
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 According to Ezra Solomon, “Financial management
is concerned with the efficient use of an important
economic resource, namely, capital funds.”
In a nutshell, Financial Management is the planning,
organizing, directing and controlling of the
procurement and utilization of funds and safe disposal
of profit to end that individual, organizational and social
objectives are accomplished.
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Scope of Financial Management
 Traditional Approach of Finance Function
In common definition the concept of finance function is very
narrow and traditional i.e., Acquisition of finance according to
the objectives of business.
In traditional approach of finance, the following activities
are included:
 Estimates for requirement of finance are made by considering
the business activities
 After estimating financial requirements sources for
procurement of finance are thought of by comparative study
of ordinary shares, preference shares, Debentures, loans, bank
overdrafts, cash credits, public deposits etc.
 Function of procurement of finance should be completed at
less expense and in short period.
 Management should see that sources of finance should not be
such that may be burdensome in future.
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Modern Approach of Finance Function
According to modern concept finance function includes both the aspects i.e. acquisition and
utilization of finance.
From the above definition it can be clearly said that modern concept of finance is much
wider than traditional approach. For making effective use of finance, administration finance
is treated as more important. It includes following matters.
 Procurement of finance: After obtaining the estimate for present and future financial
requirement of the unit, management will try to obtain it at minimum cost, and
convenient conditions, from proper place. At the time of procurement of finance ratio of
fixed and working capital is considered. This function is adopted both by traditional
approach & modern approach.
 Financial Planning: Decision regarding, how much percentage in which plan and when
the use of procured finance is to be made etc. is called finance planning and it is accepted
by modern approach of finance. Because of this idea maximum use of procured finance is
made possible.
 Distribution of Income: The question of distribution of income obtained from
business activities is also accepted by modern approach. Question regarding distribution
of income such as how much amount is to be distributed as dividend, how much
amount is to be carried over as reserve fund, how much amount will be paid as taxes has
much and is to be re invested are very important.
 Financial control: The control can be effectively exercised only by comparing the actual
performance with the standards set in the plans.
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Goals/Objectives of Financial
Management
 Profit Maximization:
According to this approach, actions that increase profits
should be undertaken and those that decrease profits are
to be avoided.
In specific operational terms, as applicable to financial
management, the profit maximization criterion implies
that the investment, financing and dividend policy
decisions of a firm should be oriented to the
maximization of profits.
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Arguments for Profit Maximization
Profit maximization as an objective of financial management
can be justified on following grounds:
 It is Rational: Profit is a device that transforms the
selfishness of mankind into channels of useful service.
 Test of Business Performance: The profit earned by any
business enterprise is the result of its managerial efficiency.
It is the ultimate test of business performance.
 Maximum Social Welfare: It ensures maximum social
welfare by providing maximum dividend to shareholders,
timely payment to creditors, more wages and incentives to
workers, more employment to society and maximum
return to owners.
 Basis of Decision Making: All business decisions are
taken keeping the profit element in mind.
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Objections Against Profit Maximization
Profits maximization suffers from certain limitations:
 It is vague (out of reality / unclear)
 It ignores timing of returns
 It ignores risk
 Definition of Profit / It is Vague
The precise meaning of profit max is unclear. The definition of profit is ambiguous
(confusing). Does it mean short term or long term profits? Does it refer profit before or
after tax? Total profit or profit per share? Does it mean total operating profit or profit
occurring to shareholders? Thus profit maximization is vague (not related)
terminology.
 Time Value of Money /It Ignores Timing of Returns:
The profit maximization objective does not make a distinction between returns in
different time periods. It values benefits received today and benefits received after a
period as the same.
 Uncertainty of Returns/Ignores Risk
The benefits are always depending on future and as we know that future is uncertain
due to that risk arises and that risk is not considered in profit maximization.
Thus from above discussion it is clear that the profit maximization
objective is not having reliable parameters.
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Shareholders' Wealth Maximization
 It is also termed as value maximization or net present
worth maximization. In current academic literature
value maximization is almost universally accepted as
an appropriate operational decision criterion for
financial management decisions.
 What is meant by Shareholders' Wealth Maximization
(SWM)?
SWM means maximizing the pet present value (or wealth)
of a course of action to shareholders. The net present
value (NPV) of a course of action is the difference between
the present value of its benefits and the present value of
its costs.
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Superiority of Wealth Maximization
After having discussed the objectives of financial management, now the
question arises of the choice i.e., which should be the goal of financial
management? Profit maximization or wealth maximization? In present
day changed circumstances, wealth maximization is better objective
because it has following points in its favour:
 It is Clear
Wealth Maximization measures income in terms of cash flows, and
avoids the ambiguity associated with accounting profits because income
from investment is measured on the basis of cash flows rather than
accounting profits.
 It Recognizes the Time Value of Money
It recognizes the time value of money by discounting the expected
income of different years at a certain discount rate (cost of capital).
 It Considers Risk and Uncertainty
The objective of shareholders' wealth maximization takes care of the
questions of the timing and risk of the expected benefits. These problems
are handled by selecting an appropriate rate (the shareholders'
opportunity cost of capital) for discounting the expected flow of future
benefits.
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Financial Management Decisions
Executive Finance Functions:
1. Investment Decision
2. Financing Decision
3. Dividend Decision
4. Liquidity Decision
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Incidental/Routine Finance
Functions:
1. Supervision over Cash Receipts
2. Cash Disbursements
3. To keep records of Cash
4. To tally cash and Bank Balance
5. Supervision of Bills
6. Safeguarding Valuable papers
7. Insurance policies
8. Filling (Record Keeping)
9. To prepare reports
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 Answer (A) procurement of funds and their
effective utilization
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 Answer (c) I correct, II incorrect
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Cost of Capital
 The primary function of every financial manager is to
arrange for adequate capital for the firm. A business firm
can raise capital from various sources such as equity and or
preference shares, debentures, retained earnings etc. This
capital is invested in different projects of the firm for
generating revenue. On the other hand, it is necessary for
the firm to pay minimum rate of return on each source of
capital. Therefore, each project must earn so much of the
income that a minimum return can be paid to these sources
or suppliers of capital. The concept used to determine this
minimum capital is called “Cost of Capital”. The
management evaluates various alternative sources of
finance on this basis and selects the best one.
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 Which are the two basic concepts in FM??
A. Cost and Expenses
B. Risk and Return
C. Debit and Credit
D. Receipt and Payments
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 Ans: (B) Risk and Return
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 Market Value of the firm is a result of
A. Investment Decision
B. Financing Decision
C. Working Capital Mgt
D. Risk-Return Trade-off
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 Ans: (D) Risk Return Trade-off
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 Which of the following represent financing decision?
A. Designing Capital Structure
B. Declaring Dividend
C. Paying Interest on loan
D. Investment in New Asset
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 CONCEPT OF COST OF CAPITAL
The term cost of capital refers to the minimum rate of
return a firm must earn on its investments. This is in
consonance with the firm’s overall object of wealth
maximization. Cost of capital is a complex,
controversial but significant concept in financial
management.
“The cost of capital is a cut off rate for the allocation of
capital to investments of projects. It is the rate of return
on a project that will leave unchanged the market price of
the stock”.
-James C. Van Horn
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 FEATURES OF COST OF CAPITAL
i) Not a cost as such:
In fast the cost of capital is not a cost as such, it is the rate of return that firm
requires to earn from its projects. That is why, it is also known as “hurdle rate”.
ii) It is the minimum rate of return:
A firm’s cost of capital is that minimum rate of return which will atleast
maintain the market value of the share.
 iii) It comprises three components:
K = ro+ b + f
Where,
k = Cost of Capital;
ro= Return at zero risk level (Risk Free Rate of Return);
b = Premium for business risk, which refers to the variability in operating profit
(EBIT) due to change in sales.
f = Premium for financial risk which is related to the pattern of capital structure.
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 SIGNIFICANCE OF COST OF CAPITAL
I) CAPITAL BUDGETING DECISIONS
II) CAPITAL STRUCTURE DECISIONS
III) EVALUATION OF FINANCIAL PERFORMANCE
IV) COMPARATIVE STUDY OF SOURCES OF
FINANCING
V) EXPECTED RETURN AND RISK
VI) FINANCING AND DIVIDEND DECISIONS
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 CLASSIFICATION OF COST OF CAPITAL
Cost of capital can be classified as follows:
i) Historical Cost and future Cost:
Historical costs are book costs relating to the past, while
future costs are estimated costs act as guide for estimation
of future costs.
ii) Specific Costs and Composite Costs:
Specific accost is the cost if a specific source of capital,
while composite cost is combined cost of various sources
of capital. Composite cost, also known as the weighted
average cost of capital, should be considered in capital and
capital budgeting decisions.
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iii) Explicit and Implicit Cost:
Explicit cost of any source of finance is the discount rate
which equates the present value of cash inflows with the
present value of cash outflows. It is the internal rate of
return.
Implicit cost also known as the opportunity cost is of the next
best opportunity foregone in order to take up a particular
project. For example, the implicit cost of retained earnings is
the rate of return available to shareholders by investing the
funds elsewhere.
iv) Average Cost and Marginal Cost:
An average cost is the combined cost or weighted average cost
of various sources of capital. Marginal cost of refers to the
average cost of capital of new or additional funds required by
a firm. It is the marginal cost which should be taken into
consideration in investment decisions.
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COST OF DEBT (Kd)
Cost of debt is the contractual interest rate adjusted for
further tax liability of the firm. To ascertain the actual
Kd, the relation of interest rate is adjusted with the actual
amount realized or the net proceeds from the issue of
debentures. Net Proceeds is equal to the issue price less
all flotation cost.
Flotation cost is the cost of issuing debentures or
obtaining loans such as printing and selling of
prospectus, advertisement, stamp duty, underwriting
commission and brokerage, postage etc.
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PERPETUAL / IRREDEEMABLE DEBT
(a) Debt Issued At Par
Kd = Int. (1 – t)
Where, Kd is the cost of debt
Int. = Debenture interest rate
t = tax rate
(b) Debt Issued At Premium or Discount
Kd = Int. (1 – t)
NP
NP = Net Proceeds
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Kd = Int. (1-t) + [F – P / n]
[F + P / 2 ]
F = Maturity/Redemption Value
P = Net Proceeds
Net Proceeds:
(A) At Par = Face Value – Flotation Cost (f)
(B) At Premium = Face Value + Premium – Flotation Cost (f)
(C) At Discount = Face Value – Discount – Flotation Cost (f)
COST OF REDEEMABLE DEBT
If the debentures are redeemable after the expiry of a fixed period the
effective cost of debt is calculated by using the following formula:
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COST OF PREFERENCE CAPITAL (Kp)
In case of preference share dividend are payable at a fixed
rate. However, the dividends are not allowed to be deducted
for computation of tax. So no adjustment for tax is required
just like debentures, preference share may be perpetual or
redeemable. Future, they may be issued at par, premium or
discount.
PERPETUAL PREFERENCE CAPITAL
 If Preference Share is issued at Par
Kp = Rate of Dividend on Preference Share
 If Preference Share is not issued at par
Kp = Div / NP
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 REDEEMABLE PREFERENCE SHARES
In the case of redeemable preference shares, the cost of
capital is the discount rate that equals the net proceeds of
sale of preference shares with the present value of future
dividends and principal repayments. It can be calculated
using the following formula:
Kp = Div + [ F – P / n ]
[ F + P / 2]
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COST OF EQUITY CAPITAL (Ke)
Cost of Equity is the expected rate of return by the
equity shareholders. Some argue that, as there is no
legal for payment, equity capital does not involve any
cost. But it is not correct. Equity shareholders normally
expect some dividend from the company while making
investment in shares. Thus, the rate of return expected
by them becomes the cost of equity. Conceptually, cost
of equity share capital may be defined as the minimum
rate of return that a firm must earn on the equity part of
total investment in a project in order to leave unchanged
the market price of such shares.
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Dividend Yield / Dividend Price Approach-
According to this approach, the cost of equity will be that rate
of expected dividends which will maintain the present
market price of equity shares. It is calculated with the
following formula:
Ke = D1/NP (for new equity shares)
Or
Ke = D1/MP (for existing shares)
Where,
Ke = Cost of equity
D1 = Expected dividend per share
NP = Net proceeds per share
MP = Market price per share
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 Dividend Yield Plus Growth In Dividend
Methods
According to this method, the cost of equity is determined on the basis if
the expected dividend rate plus the rate of growth in dividend. This
method is used when dividends are expected to grow at a constant rate.
Cost of equity is calculated as:
 Ke = D1 + g (for new equity issue)
NP
Where,
D1 = Expected dividend per share at the end of the year. [D1 = Do (1 + g)]
NP = Net proceeds per share
g = Growth in dividend
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Earnings Yield Method
According to this approach, the cost of equity is the
discount rate that capitalizes a stream of future earnings
to evaluate the shareholdings. It is called by taking
earnings per share (EPS) into consideration. It is
calculated as:
i) Ke = Earnings per share / Net proceeds = EPS / NP
[For new share]
ii) Ke = EPS / MP [ For existing equity]
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Capital Asset Pricing Model (CAPM)
According to this model, cost of equity is the risk free
rate of return plus a premium for risk. It is calculated as
under:
Ke = Rf + β (Rm – Rf)
Where,
Rf = Risk Free Rate of Return
β = Beta of securities (Sensitivity of returns with market
return)
Rm = Return on Market Portfolio
(Rm – Rf) = Risk Premium
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COST OF RETAINED EARNINGS (Kr)
Retained earnings refer to undistributed profits of a firm. Out of the total
earnings, firms generally distribute only past of them in the form of
dividends and the rest will be retained within the firms. Since no
dividend is required to paid on retained earnings, it is stated that
‘retained earnings carry no cost’. But this approach is not appropriate.
Retained earnings has the opportunity cost of dividends in alternative
investment becomes cost if retained earnings.
Kr = Ke (If there is no personal tax or brokerage)
Ke = Ke ( 1 – tp) (1 – B)
Where, Kr = Cost of Retained Earnings
Ke = Cost of Equity
tp = Rate of Personal Tax
B = Cost of Purchasing New Securities or Brokerage Cost.
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WEIGHTED AVERAGE COST OF
CAPITAL (Ko)
It is the average of the costs of various sources of financing. It
is also known as composite or overall or average cost of
capital.
After computing the cost of individual sources of finance i.e
the specific cost, the weighted average cost of capital is
calculated by putting weights in the proportion of the various
sources of funds to the total funds.
Weighted average cost of capital is computed by using either
of the following two types of weights:
 Market value
 Book Value
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What do you understand by Weighted Average Cost of
Capital?
The composite or overall cost of capital of a firm is the weighted average
of the costs of various sources of funds. Weights are taken in proportion
of each source of funds in capital structure while making financial
decisions. The weighted average cost of capital is calculated by calculating
the cost of specific source of fund and multiplying the cost of each source
by its proportion in capital structure. Thus, weighted average cost of
capital is the weighted average after tax costs of the individual
components of firm’s capital structure. That is, the after tax cost of each
debt and equity is calculated separately and added together to a single
overall cost of capital.
Ko = Ke. We + Kd.Wd + Kp.We + Kr.Wr
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 Cost of Capital Refers to-
A. Dividend
B. Interest expense
C. Floatation Cost
D. Required Rate of Return
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 Ans : (D) Required ROR
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 Which Source has an implicit COC?
A. Equity Shares
B. Preference Shares
C. Debentures
D. Retained Earning
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 Ans: Retained Earning
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 COC on Govt. Securities is also known as-
A. Risk Free Rate of Interest
B. Maximum ROR
C. Rate of Int. of FD
D. All of the above
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 Ans: Risk Free Rate of Interest
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 Which Cost requires tax adjustment?
A. Cost of Equity
B. Cost of Debt
C. Cost of Pref.
D. Cost of Reserves
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 Marginal COC is the cost of:
A. Additional Sales
B. Additional Funds
C. Additional Interest
D. None of the Above
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 Additional Funds
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 Answer (B) Explicit Cost of Capital
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 Answer (D) Money paid to SEBI for permission to
acquire Capital
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Capital Structure
INTRODUCTION
 Capital Structure refers to the composition of long-
term funds such as equity shares, preference shares,
debentures, loans in the capitalization of a company.
The essence of capital structure is to determine the
relative proportion of debt and equity. Equity means
Owner’s Funds and Debt means Long Term Borrowings.
The Capital Structure Decision is significant financial
decision because it affects the shareholders return and
risk and consequently affects the market value of
shares.
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MEANING AND DEFINITIONS
 Capital Structure refers to the combination or
mix of debt and equity which a company uses to
finance its long term operations.
 In capital structure, it is decided that what portion of
total required capital be raised in the form of shares
and what portion in debt.
 In words of Weston and Brigham, “Capital Structure
is the permanent financing of the firm,
represented by long-term debt, preferred stock
and net-worth.”
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Factors Affecting Capital Structure
 Tax benefit on debt
 Flexibility
 Control
 Industry Life Cycle
 Industry Leverage Ratio
 Company Characteristics
 Legal Requirements
 Regularity and Certainty of Income
 Capital Market Conditions
 Cost of Financing
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 CONCEPT OF OPTIMUM CAPITAL STRUCTURE
The optimum or balanced capital structure implies the most economical
and safe proportion between various sources of funds. Optimum Capital
Structure may be defined as that mix of debt and equity which
maximized the value of company and minimizes the cost of capital
Profitability It should minimize the cost of financing and maximize the EPS.
Flexible A good capital structure is flexible, i.e. can be modified as and when required to
grab the profitable opportunities.
Conservatism The debt content in capital structure should not exceed the maximum limit the
firm can bear.
Solvency The optimum capital structure should be such that the company does not run the
risk of becoming insolvent.
Control There should be minimum risk of loss or dilution of the control of company.
Minimum Risk A good capital structure offers lowest risk to the investors by safeguarding their
interest by a judicious proportion between debt and equity.
Minimum Cost
of Capital
A properly designed capital structure has a minimum cost of capital which offers
highest value of firm’s share.
The following are the features of an optimum capital structure:
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CAPITAL STRUCTURE: THEORIES
Two Kinds of Funds There are only two sources of funds i.e., debt and equity. (No
preference share capital).
Constant Total Assets The total assets of the firm are given and remain constant.
Homogeneous
Investors Expectations
The investors have the same subjective probability distribution of
expected earnings.
100% Dividends All earnings are distributed as dividends to shareholders. There is no
retained earnings.
Constant Business
Risk
Business Risk is constant and is not affected by financing mix decisions.
No Taxation There are no corporate and personal taxes.
Low Cost of Debt Cost of debt is lower than cost of equity.
Perpetual Life The Firm has a perpetual life.
GENERAL ASSUMPTIONS OF CAPITAL STRUCTURE THEORIES
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NOI Net Operating Income/Operating Profit/ EBIT
NI Net Income, Earnings for Equity Shareholders,
NOI – Interest on debt
Ke
Cost of Equity Capital
Kd
Cost of Debt
KO
Overall Cost of Capital / WACC
KO = NOI / V
KO = Ke . We + Kd . Wd
S Value of Equity Share Capital (Shareholders Funds)
S = NI / Ke
B Value of Debt (Borrowings)
B = Interest / Kd
V Value of Firm
V = S + B
V = NOI / KO
SYMBOLS AND DEFINITIONS:
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NET INCOME (NI) APPROACH
[CAPITAL STRUCTURE IS RELEVANT, IT MATTERS]
 Developed by David Durand
 It is relevance theory, i.e. Capital Structure decision is
relevant to the market value of the firm.
 A change in Debt proportion in capital structure will
lead to a corresponding change in the cost of capital as
well as total value of the firm.
 In other words, A change in proportion of capital
structure will lead to a corresponding change in Cost
of Capital and Value of the Firm.
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Assumptions of NI Approach:
1. There are no taxes.
2. Cost of debt is less than the cost of equity.
3. Use of Debt in the capital structure does not change the risk
perception of the investors.
4. Cost of Debt and Cost of Equity Remains Constant.
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The essence of NI approach is that the firm can increase its
value by lowering its overall cost of capital by increasing
proportion of debt in the capital structure. According to
assumptions, increase of debt in capital structure will not
change the Cost of Equity, i.e. Ke remains constant. As a
result, the use of cheaper debt will lower down the overall
cost of capital (Ko). Thus, use of more and more debt will
increase the value of the Firm.
Thus, as per NI Approach, Capital structure does matter.
The value of firm in NI Approach is ascertained as follows:
 V = S + B
V = Value of Firm
S = Market Value of Equity = NI / Ke
B = Market Value of Debt
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NET OPERATING INCOME (NOI) APPROACH
[CAPITAL STRUCTURE IS IRRELEVANT, IT DOES
NOT MATTER]
 Suggested by David Durand.
 Irrelevance of Capital Structure, i.e. there is no
relation between the Capital Structure, Firms Value
and Cost of Capital.
 Any change in Debt will not lead to a change in the
Value of the Firm.
 They are independent of financial leverage.
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 Assumptions of NOI Approach:
1.Cost of Capital remains constant
2. Split between Debt and Equity is not important.
3. The market value of equity is residue
4. The use of Debt increase the risk of equity investors , thereby the
cost of equity increases with the use of Debt.
5. The Debt advantage is Set-off exactly by an increase in cost of
equity.
6. The cost of Debt remains Constant.
7. There are no Corporate Taxes.
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 According to NOI Approach, the market value of the
firm is not affected by the capital structure changes.
The use of less costly debt increases the risk of share-
holders. This causes the cost of equity (Ke) to increase.
Thus, advantage of debt is exactly off-set by the
increase in cost of equity. In this way a change in
leverage will not lead to any change in the value of the
firm as well as overall cost of capital (Ko).
 As the total value of the firm is unaffected by its
capital structure, there does not exist any optimum
capital structure.
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Figure shows that the cost of debt and the overall cost of capital are constant
for all levels of leverage. As the debt proportion or the financial leverage
increases, the risk of the shareholders also increases and thus the cost of
equity capital also increases. However, the increase in Ke, is such that the
overall value of the firm remains same.
Thus, as per NOI Approach, Capital Structure does not matter.
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MODIGLIANI-MILLER (MM) APPROACH
[CAPITAL STRUCTURE IS IRRELEVANT, IT DOES
NOT MATTER]
 The MM Approach relating to the relationship
between the capital structure, cost of capital and
valuation is akin to the NOI Approach. The NOI
approach is conceptual and does not provide
operational justification for the irrelevance of the
capital structure. The MM Approach supports the NOI
Approach relating to the independence of the cost of
capital and degree of leverage at any level of debt-
equity ratio.
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Assumptions of MM:
 Perfect Capital Markets: The implications of perfect capital
market are that:
 Securities are infinitely divisible
 Investors are free to buy/sell securities
 Investors can borrow without any restrictions on same terms and
conditions as firm can
 There are no transaction cost
 Information is perfect, that is, each investor has the same
information which is readily available to him without cost
 Investors behave rationally
 The WACC (Ko) is constant
 All investors have same expectation of firm’s operating income,
i.e., EBIT
 Business Risk is equal among all firms operating in same
environment
 Dividend payout ratio is 100%
 There are no taxes. However, this assumption is removed later.
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 Basic Propositions
There are three basic propositions of MM Approach
 Proposition-I
The overall cost of capital (Ko) and the Value of firm (V)
are independent of its capital structure. The Ko and V are
constant for all degrees of leverages. The total value is
given by capitalizing the expected stream of operating
earnings at a discount rate appropriate for its risk class.
 Proposition-II
Ke increases in a manner to offset exactly the use of less
expensive source of funds represented by debt.
 Proposition-III
The cut-off rate for investment purpose is completely
independent of the way in which an investment is
financed.
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Arbitrage Process
 The operational justification for MM Approach is the
arbitrage process. The term “arbitrage” refers to an act
of buying an asset/security in one market, at lower
price and selling it in another, at higher price. As a
result, equilibrium is restored in the market price of
security in different markets.
 The essence of arbitrage process is the purchase of
undervalued securities and sale of overvalued
securities in market, which are temporally out of
equilibrium. The arbitrage process is essentially a
balancing operation. It implies that a security cannot
sell at different prices.
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 The behavior of investor will have effect of (i) increasing the
share prices (value) of firm whose shares are being purchased;
and (ii) lowering the share prices (value) of the firm whose shares
are being sold. This will continue till the market prices of the two
firms become identical.
 The arbitrage process ensures to the investors the same return at
lower outlay as he was getting by investing in firm whose total
value was higher and yet, his risk has not increased. This is so
because the investors would borrow in a proportion to the degree
of leverage of the present firm. The use of debt by investor for
arbitrage is called ‘home made’ or ‘personal leverage’. The
essence of arbitrage argument of MM is that the investors are
able to substitute personal leverage for corporate leverage that is
use of debt by the firm itself.
 Thus, MM shows that the value of levered firm can neither be
greater nor smaller than that of an unlevered firm. There is
neither an advantage nor disadvantage in using debt.
 Thus according to MM, Capital Structure does not matter.
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TRADITIONAL APPROACH
[INTERMEDIATE APPROACH]
 The traditional capital structure theory has been popularized by Ezra
Solomon. This view is also known as Intermediate Approach, because it
is a compromise between NI and NOI Approach.
 According to this Approach, the value of the firm can be increased or
Cost of capital can be reduced by a judicious mix of debt and equity.
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 Stage I : Increasing Value
In this stage, the cost of equity remains constant. The cost of
capital (Ko) declines with the leverage, because debt capital is
cheaper than equity capital within reasonable limits.
 Stage II: Optimum Value
The cost of capital becomes constant, because the benefit of
cheaper debt is exactly balanced with the increase in cost of
equity. Within that range, WACC (Ko) will be minimum, and
the maximum value of the firm will be obtained.
 Stage III: Declining Value
Finally, in this stage, the overall cost increases with the leverage
as both cost of equity and cost of debt increases. Beyond the
acceptable limit of leverage, the value of firm decreases as
WACC (Ko) increases with leverage. This happens because the
investors perceive a high degree of financial risk and demand a
higher equity-capitalization rate (Ke), which exceeds the
advantage of low-cost debt.
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Leverage Analysis
 The term leverage refers to an increased means of
accomplishing some purpose. Leverage is used to
lifting heavy objects, which may not be otherwise
possible. In physics, Leverage means, “the mechanical
advantage gained by the use of levers, i.e. raise a given
thing with less effort.”
 James Horne has defined leverage as, “the
employment of an asset or fund for which the firm
pays a fixed cost or fixed return.”
 However in area of finance, the term leverage means
“the firms ability to use fixed cost assets or funds
to increase the return to the shareholders.”
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Risk exists because of lack of certainty. Risk is to a firm
can be divided into 2 categories: Business Risk and
Financial Risk.
 Business Risk: It is the variability of EBIT. It results
because of changes in business environment. It is
measured by calculating Operating Leverage. It is not
affected by the form of financing.
 Financial Risk: It refers to the variability of EBT. It is
affected by the use of funds bearing fixed interest. It
can be avoided by not using debt in capital structure.
It is measured by using Financial Leverage. It is
affected by form of financing.
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 There are 3 types of leverages:
 Operating Leverage
 Financial Leverage
 Combined Leverage
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Financial Leverage
 Financial Leverage is related to financing activities of a
firm. From the point of view capital structure, a firm can
raise funds from the sources which carry fixed financial
cost and which do not carry fixed financial costs.
 Financial leverage represents the relationship between the
company’s earnings before interest and taxes (EBIT) or
operating profit and the earning available to equity
shareholders.
 Financial leverage 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”. It involves
the use of funds obtained at a fixed cost in the hope of
increasing the return to the shareholders.
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Trading on Equity
Meaning of Trading on Equity
When a company uses fixed interest bearing capital along with
owned capital in raising finance, is said “Trading on Equity”.
(Owned Capital =Equity Share Capital + Free Reserves )
Trading on equity represents an arrangement under which a
company uses funds carrying fixed interest or dividend in such a
way as to increase the rate of return on equity shares.
Definitions:
In words of Gerstenberg, “When a person or a corporation
uses borrowed capital as well as owned capital in the
regular conduct of its business, he or she is said to be
trading on equity”
While Guthmann and Dougall have said, “the use of borrowed
funds or preferred stock for financing is known as trading
on equity.”
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 Answer (B) Net Operating Income Approach
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 Answer (D) Transferability
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 Answer (A) Ratio between different forms of
capital
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 Answer (D) All the Above
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 Answer (A) Debt Capital
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 Answer (B) Magnify the fluctuation in EBT
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 Answer (B) Increase Net Equity Return
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 Answer (b) Trading on Borrowed Funds
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Capital BudgetingCB is the Firms decision to invest its current
funds most efficiently in the long term asset in
anticipation of an expected flow of benefits over
a series of years.
They are undertaken for:
1. New Projects
2. Expansion Projects
3. Diversification projects
4. Replacement/ Modernization Projects
5. R & D Projects
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Process of CB1. Idea Generation
2. Evaluation or Analysis
3. Selection
4. Financing the Selected Project
5. Execution or Implementation
6. Review of the project
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Significance of Capital Budgeting Decisions
 Investment decisions require special attention because
of following reasons:
 They influence the firm’s growth in long run.
 They affect the risk of firm.
 They involve commitment of large amount of funds.
 They are irreversible.
 They are most difficult to make.
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Types of Capital Budgeting Decisions
A firm may face several investment proposals for
consideration. It may adopt one of them, some of them
or all of them depending upon whether they are
independent or dependent or mutually exclusive. The
firm may face basically with three types of major
decisions:
 Accept/Reject Decisions
 Mutually exclusive Project Decisions
 Capital Rationing Decision
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 Capital Rationing Decision
In the real world, there is a constraint to the supply of
capital particularly from external sources. In view of the
availability of limited amount of capital, a company sets
an absolute limit on the extent of capital budget for a
year. Such a state or situation is called as capital
rationing. Under capital rationing the company has a
fixed capital budget that it may not exceed. So, when the
company has more acceptable projects than it can afford
to invest, it will rank the available projects in descending
order of profitability index or the rate of expected
returns and then will decide on the best ones.
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Techniques of CB1. Traditional Techniques
1. PBP
2. ARR
2. Modern Techniques
1. NPV
2. PI
3. IRR
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 Answer (c) Pay Back Period
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 Answer (B) Present Value
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 Answer (B) iii, iv, i, ii
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 Answer (A) I, ii, iii, iv, v, vi
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 Answer (B) Capital Budget
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Working Capital Management
 MEANING OF WORKING CAPITAL
Management of working capital refers to the management of
current assets as well as current liabilities. The major thrust,
of course, is on the management of current assets. This is
understandable because current liabilities arise in the context
of current assets.
Thus, working capital management is an attempt to manage
and control the current assets and the current liabilities in
order to maximize profitability and proper liquidity in
business.
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 Concepts of Working Capital
There are two concepts of working capital – gross and
net.
 Gross Working Capital
It refers to the firm’s investment in current assets.
Current assets are the assets which can be converted into
cash within an accounting year and include cash, short –
term securities, debtors (accounts receivable or book
debts), bills receivable and stock (inventory).
 Net Working Capital
Working Capital = Current Assets – Current Liabilities
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 Objectives of Working Capital Management
There are two-fold objectives of the management of
working capital.
 Maintenance of working capital at appropriate level,
and
 Availability of ample funds as and when they are
needed.
In the accomplishment of these two objectives, the
management has to consider the composition of current
assets pool. The working capital position sets the various
policies in the business with respect to general
operations like purchasing, financing, expansion and
dividend etc.
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 Types of Working Capital
Working Capital can be divided into two categories on
the basis of time:
1. Permanent Working Capital
2. Temporary or Variable Working Capital
1) Permanent, Fixed or Regular Working capital
This refers to that minimum amount of investment in all
current assets which is required at all times to carry out
minimum level of business activities. In other words, it
represents the current assets required on a continuing
basis over the entire year. Tandon Committee has
referred to this type of working capital as “core current
assets”.
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2) Fluctuating, Temporary, Variable or Seasonal
Working Capital.
The amount of such working capital keeps on
fluctuating from time to time on the basis of business
activities. In other works, it represents additional
current assets required at different times during the
operating year. For example, extra inventory has to be
maintained to support sales during peak sales period.
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Factors Affecting WC1. Nature of Business
2. Size of Business
3. Production Cycle
4. Production Policy
5. Terms of Purchase and Sales
6. Dividend Policy
7. Efficiency
8. Business cycle
9. Availability of credit
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Approaches for Financing
Current Assets Matching Approach
 Life of Source of finance is matched with the life of
Current Asset.
 Conservative Approach
 Current Assets are financed through long term
Finance.
 Aggressive Approach
 Current Assets are Financed by short terms
sources of Finance.
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Operating/Manufacturing Cycle1. Cash into RM
2. RM into WIP
3. WIP into FG
4. FG into Sales
5. Sales into Debtors/Cash
6. Debtors into Cash
(than again step 1 and so on………….. )
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 Answer (c) Conservative Approach
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 Answer (D) Expenditure to acquire Capital
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 Answer (B) ii, i, iv, iii
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 Answer (C) i, v, ii, iii, iv
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Dividend Policy Dividend- The portion of company's net earnings
that is paid out of the ordinary shareholders.
 Dividend Policy- It is the a Policy of firm in
distributing net earnings to equity shareholders.
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Types of Dividend Policy Stable Dividend Policy
 Constant DPS
 Constant D/P ratio
 Constant Dividend + Extra Dividend
 Irregular Dividend Policy
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Forms of Dividend Cash Dividend
 Scrip Dividend
 Bond Dividend
 Property Dividend
 Stock Dividend (Bonus)
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Dividend Theories Walters Model
 Gordon Model
 MM Model
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Walters ModelAssumptions:
1. Finance through retained earnings
2. r and k are constant
3. 100% D/P or 100% retention
4. EPS and DPS are constant
5. The firm has perpetual life
P = [D + (r/k)(E-D)]/ K
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 Growth Firm
r>k, 100% retention
 Normal Firms
r=k, no optimum dividend policy
 Declining firms
r<k, 100% D/P ratio
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Gordon Model The share price is dependent on dividend.
 Assumptions
 All equity firms
 Financed by retained earnings
 r and Ke are constant
 Ke >g
 Life of firm is perpetual
 There are no taxes
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 P = E(1-b)/ k –b.r
 Growth Firm
r>k, 100% retention
 Normal Firms
r=k, no optimum dividend policy
 Declining firms
r<k, 100% D/P ratio
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MM Hypothesis The value of the firm is determined by basic
earning power and business risk.
 Assumptions
 Perfect Capital Markets
 No Taxes
 Fixed Investment Policy
 Risk and Uncertainty does not exist
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How to find value?
1. Find MP at the end of the period
2. Find new shares to be issued to finance new
investment
3. Value of the Firm.
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 Answer (B) James E Walter
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 Answer (D) Industry Practice
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 Answer (B) has no impact on the value of the
firm
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 Answer (D) I correct, II incorrect
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Financial management for net

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