Financial management

FINANCIAL MANAGEMENT
For: II Semester MBA, Pondicherry University
Mohammed Umair| M.Com, PGDBA,
NET
Department of
CommerceKristu Jayanti
College
Department of
ManagementSt. Joseph‘s
Evening College
&
FINANCE:
AN INTRODUCTION
UNIT 1

SYLLABUS
UNIT I
Financial Management – Financial goals - Profit vs. Wealth Maximization;
Finance Functions – Investment, Financing and Dividend Decisions – Cost of
Capital – Significance of Cost of Capital – Calculation of Cost of Debt – Cost of
Preference Capital – Cost of Equity Capital (CAPM Model and Gordon‘s Model)
and Cost of Retained Earnings – Combined Cost of Capital (weighted/Overall).

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FINANCE IS THE SCIENCE AND ART OF MANAGING
MONEY AND OTHER ASSETS.
 Public Finance: Public finance deals with role of the government in
managing financial requirements of the economy.
 Personal Finance: Personal finance deals with monetary decisions and
activities of an individual or a family unit that includes routine income and
expenses planning.
 Corporate Finance: Corporate finance also called as financial
management or Business finance focuses is concerned with
planning, raising, investing and monitoring of finance in order to achieve
the financial objectives of the company.
What is finance?
Thus the study of finance can be classified into following
ways:-

Finance function refers to action performed by a finance
department that involves acquiring and utilizing funds of a
business.
 Increasing Profitability: Profitability is necessary for every organization.
The planning and control functions of finance aim at increasing profitability
of the firm.
What is finance Function?
 Acquiring Sufficient and Suitable Funds: The primary aim of finance
function is to assess the needs of the enterprise, properly, and procure
funds, in time.
 Proper Utilization of Funds: Raising funds is important, more than that
is its proper utilization. If proper utilization of funds were not made, there
would be no revenue generation.
 Maximizing Firm’s Value: The ultimate aim of finance function is
maximising the value of the firm, which is reflected in wealth maximisation
of shareholders.
AIMS OF FINANCE FUNCTION
The following are the aims of finance
function:

SCOPE OF FINANCIAL MANAGEMENT
The scope of financial decisions revolves around four important decisions.
In all the following financial areas of decision-making, the role of finance
manager is vital.
All organizations irrespective of type of business must raise funds to buy the assets
necessary to support operations. Thus financing decisions involves addressing two
questions:
 How much capital should be raised to fund the firm's operations (both existing &
proposed)
 What is the best mix of financing these investment proposals?
1. Financing Decision:
This decision in financial management is concerned with allocation of funds raised
from various sources into acquisition assets or investment in a project.
Further, Investment decision not only involves allocating capital to long term
assets but also involves decisions of utilizing surplus funds in the business, any
idle cash earns no further interest and therefore not productive.
2. Investment Decision:

SCOPE OF FINANCIAL MANAGEMENT
The scope of financial decisions revolves around four important decisions.
In all the following financial areas of decision-making, the role of finance
manager is vital.
Share holders are the owners and require returns, and how much money to be
paid to them is a crucial decision. Thus payment of dividend is decision involves
deciding whether profits earned by the business should be retained rather than
distributed to shareholders in the form of dividends.
3. Dividend Decision:
Working capital primarily deals with currents assets and current liabilities, in fact it
is calculated as the current assets minus the current liabilities. One of the key
objectives of working capital management is to ensure liquidity position of a firm to
avoid insolvency.
4. Working Capital Decisions:

ORGANIZATION OF THE FINANCE FUNCTION
In the context of financial management organisation structure of
finance indicates established pattern of relationships among individuals
and positions in a finance department of a business enterprise.

ORGANIZATION OF THE FINANCE FUNCTION
 Forecasting and Planning:
 Executing financing and investment decisions:
 Coordination and control:
 Management of financial resources:
 Maximize profits & Minimise cost:
 Dealing with financial markets:
The board of directors is the top governing body, and the chairperson of the board is
generally the highest-ranking individual. The CEO comes next, but note that the
chairperson of the board often serves as the CEO as well. The CFO, who is generally
a senior vice president and the third ranking officer, is in charge all the financial
activities of the organisation.
a The Finance Manager−Role, Functions and Duties

FINANCIAL PLANNING
Types of Financial Plans
 After the company starts, the finance manager does the financial planning.
The types of financial plans are depicted and briefly explained below.
 Short-term financial plan is prepared for maximum one year. This plan
looks after the working capital needs of the company.
 Medium-term financial plan is prepared for a period of one to five years.
This plan looks after replacement and maintenance of assets, research and
development, etc.
 Long-term financial plan is prepared for a period of more than five years. It
looks after the long-term financial objectives of the company, its capital
structure, expansion activities, etc.
Financial Planning is the process of ascertaining an organisation’s
financial needs for the future and identifying how to achieve them.

STEPS IN FINANCIAL PLANNING OR FINANCIAL PLANNING PROCESS
1. Assessing
business
environment
2. Developing
financial
goals
3. Framing
financial
policies &
procedures
4. Esuring
adaptibility &
flexibility
5. Review of
financial plan
Need, Benefits, Significance and Objectives of financial planning
What is the need of financial planning? Increase financial efficiency
Reduce finance-related risks
Coordination with other departments
Gives right direction
Helps to achieve objectives of financial management
Keeps good control of financial activities
What are the benefits of financial planning?
What is significance of financial planning?
What are the objectives of financial planning?
Principles and Characteristics of Sound Financial Planning
Principles Description
Simplicity financial plan should be easily understandable to all the stake holders
Objectivity provide clarity and direction for strategic planning
Flexibility easily changed or modified, adjusted when there is a change
Liquidity an asset can be converted to cash, financial plan should ensure availability
Economy cost of borrowing funds should always be kept in mind
Provision for
contingencies
Provision of funds should be made for meeting the contingencies
Optimum use efficiently, effective use of funds

NEED AND IMPORTANCE OF
1. ESTIMATING THE CAPITAL REQUIREMENTS OF THE CONCERN
2. DETERMINING THE CAPITAL STRUCTURE OF THE ENTERPRISE
3. FINALIZING THE CHOICE AS TO THE SOURCES OF FINANCE
4. DECIDING THE PATTERN OF INVESTMENT OF FUNDS
5. DISTRIBUTION OF SURPLUS JUDICIOUSLY
6. EFFICIENT MANAGEMENT OF CASH

OBJECTIVES OF FINANCIAL MANAGEMENT
 Profit maximization is the process of identifying the most efficient
manner of obtaining the highest rate of return from its production model.
 The following arguments are advanced in favor of profit maximization as the
objective of business:
A. PROFIT MAXIMIZATION
B. WEALTH MAXIMIZATION
 Barometer of Performance: Profitability is a barometer for measuring efficiency and
economic prosperity of a business enterprise.
 Survival in different business conditions: Economic and business conditions do not
remain same at all times. There may be adverse business conditions like recession,
depression, severe competition etc. A business will be able to survive under unfavorable
situation, only if it has some past earnings to rely upon.
 Expansion and Diversification: Profits are the main sources of finance for the growth
and expansion of a business. So, a business should aim at maximization of profits for
enabling its growth and development.
 Attract Investors: Profits are the main sources returned to investors or shareholders as
a percentage of their capital contribution.
 Maximize stakeholders return: Growth and development of a business has a number
of requirements and not only the money.
 To fulfill social desire: Profitability is essential for fulfilling social goals also. A firm by
pursuing the objective of profit maximization also maximizes socio-economic welfare by
means undertaking various social welfare initiatives.

 However, profit maximization objective has been criticized on many
grounds. They are:
 Not a clear term: The term ‗profit‘ is vague and it cannot be precisely defined. It means different
things for different people. Should we consider short-term profits or long-term profits? Does it mean
total profits or earnings per share?
 Does not Considers Risk: It does not take into consideration the risk of the prospective earnings
stream. Some projects are more risky than other.
 Leads to corrupt practices: A firm pursuing the objective of profit maximization starts exploiting
workers and the consumers. Hence, it is immoral and leads to a number of corrupt practices.
 Attracts competition: Supernormal profit attracts entry of new firms because knowledge is
everywhere and also the main aim of any producers is to make profit.
 Induces Government intervention: Firms may fear that the existence of supernormal profits
would attract government intervention into the market and thereby restrict the firm‘s activities.
 Leads to employee unrest: The concept of larger profit making would result in employers and
business owners not only focusing their attention on making a financial profit at all cost which
inevitably leads to workforce exploitation

 Wealth maximization emphasis on stockholder’s wealth, the individual
stockholder can use this wealth to maximize his individual utility.
 The following arguments are advanced in favor of Wealth maximization as the
objective of business:
 There is a rationale in applying wealth maximizing policy as an operating
financial management policy. It serves the interests of suppliers of loaned
capital, employees, management and society. Besides
shareholders, there are short-term and long-term suppliers of funds who
have financial interests in the concern. Short-term lenders are primarily
interested in liquidity position so that they get their payments in time. The
long-term lenders get a fixed rate of interest from the earnings and also
have a priority over shareholders in return of their funds.
 Wealth maximization objective not only serves shareholder‘s interests by
increasing the value of holdings but ensures security to lenders also. The
economic interest of society is served if various resources are put to
economical and efficient use.

 Cons or Demerits: The wealth maximization objective has also been
criticized by certain financial theorists mainly on following accounts;
 It is a prescriptive idea. The objective is not descriptive of what the firms actually
do.
 The objective of wealth maximization is not necessarily socially desirable.
 There is some controversy as to whether the objective is to maximize the
stockholders wealth or the wealth of the firm which includes other financial
claimholders such as debenture holders, preferred stockholders, etc.,
 The objective of wealth maximization may also face difficulties when ownership
and management are separated as is the case in most of the large corporate
form of organizations.

CONCEPT OF FINANCING DECISIONS
 Enterprises often need to raise capital for
commencing new business, expanding
business and sustaining business. Business
in most of the cases is an outcome of ideas
of people and the moment idea is
conceived the need of funds arises.
 As the business grows there is inevitably
the requirement of funds to finance the
expansion, further day to day running of the
business also needs funds.
 A solid financial base is essential for
starting up a new business. The right
financing package will carry the business
enterprise through any temporary difficulties
yet still allow business to make the most of
growth opportunities when they arise. The
financial needs of a business will vary
according to the type and size of the
business.
The financing decisions are concerned with deciding capital structure and
procuring funds.
Estimating fund requirements
Identifying Sources of Funds
Evaluating various sources
Deciding capital structure
Procuring funds
Scope or process of Financing Decisions

SOURCES OF FUNDS
SourcesofFunds
Internal Sources
Retained Earnings
Sales of assets
External Sources
Long-term:
Share Capital
Loan Capital
Short term:
Overdraft
Trade Credit
*Short term loans are discussed in Last unit-Working capital

-INTERNAL SOURCES OF FUNDS
 The after-tax profit earned and retained by a
business which is an important and inexpensive
source of finance, for example, the retained
earnings of the business. A large part of finance
is funded from profit.
Retained Earnings
© PhotoDisc
 When a business can not raise finance from
banks or other sources, it may be forced to sell
some assets, such as company cars, land
property; or even subsidiary or associated
company to solve its urgent financial problems
(this activity is called divestment).
Sales of Assets

-EXTERNAL LONG-TERM SOURCES OF FUNDS
 Types of shares are:
1. Ordinary shares: The most common types of shares, and the
most riskiest shares since no guaranteed dividend. Dividend
depends on how much profit is made by the firm. But all
ordinary shareholders have voting rights.
2. Preference shares: The share owners receive a fixed rate of
return. They carry less risk because shareholders are entitled
to the dividend before the ordinary shares. But they are not
strictly owners of the company.
 Share capital:
The most important source of funds for a limited company. It is
often considered as permanent capital as it is not repaid by the
business, but the shareholder can have a share in the profit, called
dividend.

EXTERNAL LONG-TERM SOURCES OF FUNDS
 There are four major types of loan capital: Debentures, Mortgage, Loan specialists’
funds, Government assistance.
Any money which is borrowed for a long
period of time by a business is called loan
capital
 Loan capital
 Types of loan capital:
1. Debentures: The holder of a debenture is a creditor of the company, not an
owner. Holders are paid with an agreed fixed rate of return, but having no voting
rights. The amount of money borrowed must be repaid by the expiry date.
2. Mortgage: These are long-term bank loans (usually over one year period) from
banks or other financial institutions. The borrower‘s land or property must be
used as a security on such as a loan.
3. Loan specialists’ funds: These are venture capitalists or specialists who
provide funds for small businesses, especially for high tech investment projects
in their start-up stage. There are also individuals who invest in such
businesses, which are often called ‗business angels‘.
4. Government assistance: To encourage small businesses and high
employment, governments may be involved in providing finance for businesses.
In the USA, there is an organization which is called the Small Business
Administration (SBA). SBA provides guarantees for small businesses‘ loans and
they even offer some loans themselves.

 Debt and Equity Capital: Two Basic Sources of Funds

 Comparison of Debt and Equity Capital

CONCEPT OF CAPITALIZATION, CAPITAL
STRUCTURE AND FINANCIAL STRUCTURE
Point of
Difference
Capitalization Capital Structure Financial Structure
Meaning
It is the sum of a
corporation's long term
financing included in
the capital.
Capital structure of a
company refers to types
of long term financing
included in the capital.
Financial structure refers to the
balance between all of the
company's liabilities and its
equities. Financial structure thus
concerns the entire "Liability‖ side
of the balance sheet.
Components
Debt, common stock,
preferred stock
Debt, common stock,
preferred stock, retained
earnings and reserves.
Financial structure on the other
hands also includes short term
debt and accounts payable.
Perspective
Quantitative aspect:
as it represents
quantum of funds
used
Qualitative aspects: as it
represents source of
funding
It represents financial obligations a
company owes to outside parties
Equation
CS=FS-CL
Capital Structure =
Financial Structure -
FS=Total of Liabilities

The capital structure of a company is a particular combination of
debt, equity and other sources of finance that it uses to fund its long-
term asset.
Determinants of Capital Structure or Factors influencing capital requirements
Factors affecting capital structure
Internal Factors External Factors
 Nature of Business  Corporate taxes
 Size of a Firm  Degree of competition
 Stability in Earnings  Economic condition
 Growth stage  Cost of capital
 Asset structure  Government policies
 Control factor  Floatation cost
 Risk apatite of management  Cost of capital

Planning of capital structure involves deciding the way in which assets of the company are to be
financed. The common sources of capital structure constitutes mix of long-term sources of funds,
such as debentures, long-term debt, preference share capital and equity share capital including
reserves and surpluses. Due considerations in capital structure planning should be given to formulate
appropriate capital structure, the following are key approaches for selecting appropriate capital
structure
 1. Cost and Risk Approach: In this approach
of capital structure planning a firm primarily
considers cost and risk as a basis of planning
capital structure. For business cost is the
amount payable for the capital it obtains from
various sources.
 2. EBIT—EPS Approach:
In simple words, EBIT—EPS Approach emphasis
on maximizing the earning of equity share
holders. In order to maximize earning of equity
share holders a firm must use debt capital in
such as way that that it results increased
earnings per share.
Capital Structure Planning or Approaches to select capital Structure
Establishing
Capital
structure
Cost & Risk
approach
EBIT-EPS
approach

Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of
return.
When the firms are using different sources of finance, the finance manager must take
careful decision with regard to the cost of capital; because it is closely associated with
the
value of the firm and the earning capacity of the firm.
Capital Structure Planning Cost and Risk Approach
 Meaning of Cost of Capital
Cost of capital is the required rate of return on its investments which belongs to
equity, debt and retained earnings. If a firm fails to earn return at the expected rate,
the market value of the shares will fall and it will result in the reduction of overall
wealth of the shareholders.
According to the definition of John J. Hampton ―Cost of capital
is the rate of return the firm required from investment in order to
increase the value of the firm in the market place‖.
According to the definition of Solomon Ezra, ―Cost of capital is the
minimum required rate of earnings or the cut-off rate of capital
expenditure‖.

COMPUTATION OF COST OF CAPITAL
Measurement of Cost of Capital
It refers to the cost of each specific sources of finance like:
• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings
Capital Structure Planning Cost and Risk Approach
Computation of cost of capital is a very important part of the financial
management to
decide the capital structure of the business concern.

The cost of equity is the
return a firm theoretically
pays to its equity
investors.
 Cost of equity can be calculated from the following approach (Dividend Growth
Model)
In other words:
Cost of equity refers to a shareholder's required rate of
return on an equity investment. It is the rate of return
that could have been earned by putting the same money
into a different investment with equal risk.
Measurement of Cost of Capital Cost of equity
Where,
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np = Net proceeds of an equity share
According to this method, the return
required by the investor is equal to the
current dividend yield on the common
stock plus an expected growth rate for
dividend payments. It is also known as
Gordon model.

Illustration 1: calculation of cost of equity
Given:
 D = Dividend per equity share Rs. 15
 g = 7%
 Np = Net proceeds of an equity share Market Price Rs. 125 a share
 Ke = Cost of equity capital ?
A Ltd intends to issue new equity shares. It‘s present equity shares are being sold
in the market at Rs. 125 a share. The company‘s past record show its dividend
growing at 7%. The company pays a dividend of Rs, 15 per share. You are
required to calculate Cost of funds raised by issue of equity shares.
Solution
:

Given:
 g = 4%
 Np = Net proceeds of an equity share (Issue
price of Share Flotation Cost = (100-4= Rs.
96)
A company plans to issue 10000 new shares of Rs. 100 each at a par. The floatation
costs are expected to be 4% of the share price. The company pays a dividend of Rs. 12
per share initially and growth in dividends is expected to be 5%.
(a) Compute the cost of new issue of equity shares. (b) If the current market price of an
equity share is Rs. 120. Calculate the cost of existing equity share capital
Solution
:
mpute the cost of new issue of equity shares.
Given:
 g = 4%
 Np = Net proceeds of an equity share Market Price
Rs. 120 a share
(B) If the current market price of an
equity share is Rs. 120. Calculate the
cost of existing equity share capital
Solution
:
*Flotation cost is the cost of issuing new shares in the market.

Given:
 D = Dividend per equity share Rs. 4.50
 g = 7%
 Np = Net proceeds of an equity share Market Price Rs. 95 a share
The current market price of the shares of Apple Ltd. is Rs. 95. The floatation costs
are
Rs. 5 per share, dividend paid amounts to Rs. 4.50 and is expected to grow at a
rate of 7%. You are required to calculate the cost of equity share capital.
Solution
:
*Flotation cost applicable only when new shares
are issued to the public. Here floatation cost to be
neglected as the company is not issuing new
shares.

The capital asset pricing
model (CAPM) is used to
calculate the required rate of
return for any risky asset.
 Cost of equity can be calculated from the following equation using CAPM
approach
1. This approach is based on the principle that risk and return of
an investment are positively correlated—more risky the
investment, higher is the desired returns.
2. This model emphasizes not only the risk differential between
equity share and government bond but also risk differential
among various common stocks.
Measurement of Cost of Capital Cost of equity (CAPM approach)
Ke = Rf + b (Rm—Rf)
Where,
Ke = Cost of equity capital
Rf = the rate of return for a risk-free security
b = beta of the stock
Rm = the Stock market's expected rate of return

The Hypothetical Limited wishes to calculate its cost capital using the
CAPM approach. The following information is supplied to you. The risk-free
rate of return is 10%. The firms beta is 1.50 and the return on market is
equals to 12.5%. Compute Cost of equity capital.
 Solution
Measurement of Cost of Capital Cost of equity (CAPM approach)
Ke = Rf + b (Rm—Rf)
Given,
Ke = Cost of equity capital - ?
Rf = the rate of return for a risk-free security -10%
b = beta of the stock – 1.50
Rm = the Stock market's expected rate of return –
12.5%
The CAPM says that the expected return of a share is equals the rate on a risk-free
security plus a risk premium. If this expected return does not meet or beat the
required return, then the investment should not be undertaken.
Ke = 10 + 1.5 (12.5—10) Ke = 10 + 3.75 Ke = 13.75%

Cost of debt generally
refers to the effective paid
by a company on its
debts.
 Cost of debt can be calculated from the following equation
The cost of debt can be calculated in either before or
after tax returns. However, the interest expense being
deductible, the after tax cost is considered very often.
Moreover, the cost of debt is one part of capital structure
of the company and also includes the cost of equity.
Measurement of Cost of Capital Cost of Debt
Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate

Illustration 1: calculation of cost of Debt
Given:
 Kd = ?
 I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a
 Np = Net proceeds of debenture (a) Par Rs.
1,00,000
 t = 35%
Kingfisher Limited has debt capital of Rs. 1,00,000 on which 15%
interest is payable. Tax applicable is 35%. Your are required to
calculate cost of capital assuming debt is issued at (a) Par value (b)
10% discount and (c) At a premium of 10%.
Solution
:
Given:
 Kd = ?
 I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a
 Np = Net proceeds of debenture (b) Rs. 1,00,000-
10% Discount =Rs. 90,000.
 t = 35%
Solution
:
Given:
 Kd = ?
 I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a
 Np = Net proceeds of debenture (b) Rs. 1,00,000+10% Discount =Rs. 1,10,000.
 t = 35%
(a) Par value (b) Discount
(C) Premium

1. A Ltd. issues Rs. 10,00,000, 8% debentures at par. The tax rate applicable to the
company is 50%. Compute the cost of debt capital.
2. B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The tax rate
applicable to the company is 60%. Compute the cost of debt capital.
3. C Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The tax rate is
60%, compute the cost of debt capital.
4. D Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%. The costs of
floatation are 2%. The tax rate applicable is 50%. Compute the cost of debt-
capital.
From flowing information four different companies calculate cost of debt of
each company.

A Ltd. issues Rs. 1,00,000, 8% debentures at par. The tax rate applicable to
the company is 50%. Compute the cost of debt capital.
Given:
 Kd = ?
 I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a
 Np = Net proceeds of debenture (a) Par Rs. 1,00,000
 t = 50%
Solution
:
Company (a) Par value

B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The tax rate
applicable to the company is 60%. Compute the cost of debt capital.
Given:
 Kd = ?
 I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a
 Np = Np = Face Value + Premium = 1,00,000+10,000=1,10,000
 t = 60%
Solution
:
Company (b) premium

C Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The tax rate is
60%, compute the cost of debt capital.
Given:
 Kd = ?
 I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a
 Np = Np = Face Value - Discount= 1,00,000 - 5,000= Rs. 95,000
 t = 60%
Solution
:
Company (C) Discount

D Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%. The costs
of floatation are 2%. The tax rate applicable is 50%. Compute the cost of debt-
capital.
Given:
 Kd = ?
 I= 9% on Rs. 10,00,000 = 90,000
 Np = On Rs. Rs. (10,00,000 + 1,00,000) 2% = 11,00,000 – 22,000 = Rs.
10,78,000
 t = 50%
Solution
:
Company (D) premium

The weighted average cost of capital (WACC) is the rate
that a company is expected to pay on average to all its
security holders to finance its assets.
 A company has different sources of finance, namely common
stock, retained earnings, preferred stock and debt. Weighted average cost
of capital (WACC) is the average after tax cost of all the sources.
'WEIGHTED AVERAGE COST OF CAPITAL - WACC'
The computation of the overall cost of capital (Kw) involves the following steps.
 (a) Assigning weights to specific costs.
 (b) Multiplying the cost of each of the sources by the appropriate weights.
 (c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the help of the following formula;
Kw= Kd Wd + Kp Wp + Ke We + Kr Wr
Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total
capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings
Weighted average cost of capital is calculated in the following
formula also:
Where,
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = Weight, proportion of specific sources of finance.

Illustration 1: calculation of WACC
A firm has the following capital structure and after-tax costs for the different
sources
of funds used :Source of Funds Amount Proportion (%) After-tax cost (%)
Debt 12,000 20 4
Preference Shares 15,000 25 8
Equity Shares 18,000 30 15
Retained Earnings 15,000 25 11
Total 60,000 100
Computation of Weighted Average Cost of Capital
Source of
Funds
Proportio
n % (w)
After-tax cost
% (x)
(WX)
A C D E = (c) x (d)
Debt 20 4 80
Preference
Shares
25 8 200
Equity Shares 30 15 450
Retained
Earnings
25 11 275
Solution
:

Illustration 11: calculation of WACC
ABC Ltd. has the following
capital structure.
Particulars Amount
Equity (expected dividend 12%) 10,00,000
10% Preference Shares 5,00,000
4% loan 15,00,000
Total 30,00,000
Computation of Weighted Average Cost of Capital
Source of Funds
Proportion %
(w)
After-tax
cost % (x)
(WX)
A C D E = (c) x (d)
Equity 33.33 12 399.96
Preference Shares 16.67 10 166.7
loan 50.00 4 200
Total
You are required to calculate the
weighted average cost of capital.
Solution
:

Retained earnings is one of the sources of finance for investment proposal; it is
different from other sources like debt, equity and preference shares. Cost of
retained earnings is the same as the cost of an equivalent fully subscripted issue
of additional shares, which is measured by the cost of equity capital.
 Cost of Retained Earnings
Cost of preference share capital is the annual preference share dividend by the
net proceeds from the sale of preference share.
 Cost of Preference Share
Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share

EBIT-EPS: APPROACH
 In simple words, EBIT—EPS
Approach emphasis on
maximizing the earning of equity
share holders. In order to
maximize earning of equity share
holders a firm must use debt
capital in such as way that that it
results increased earnings per
share.
Capital Structure Planning or Approaches to select capital Structure
Establishing
Capital
structure
Cost & Risk
approach
EBIT-EPS
approach

FORMAT FOR COMPUTING EBIT & EPS
Particulars Amount
Sales revenue --------
Less : Variable Cost --------
Contribution [C] --------
Less: Fixed Cost --------
Operating Profit or EBIT --------
Less: Interest of Debt capital --------
Earnings Before Tax [EBT] --------
Less: Tax --------
Earnings After Tax [EAT] --------
Less: Dividend on preference shares --------
Earnings Available to Equity Share Holders [EAESH] --------
Earnings Per Share= EAESH ÷ No. of Equity Shares ---

HDFD bank has an existing capital of Rs. 10,00,000 comprising of
1,00,000 equity shares of Rs. 10 each. The management is planning
to raise another Rs. 10,00,000 to finance its growth programme.
There are four possible financing plans which are given below:
 All 10,00,000 through issue of 1,00,000 equity shares of Rs. 10 each
 Rs. 5,00,000 in equity and the balance in debentures carrying 10%
interest
 Entire 10,00,000 through debentures carrying 8% interest
 Rs. 5,00,000 in equity and Rs. 5,00,000 through preference shares
carrying 10% dividend
The anticipated operating profits after expansion programmes amounts to
Rs. 2,40,000, the company is subject to 50% tax bracket. You are required to
advice the management in choosing appropriate capital structure plan on the
basis on EPS.
Illustration 1: Calculation of EPS
I II III IV
Entire 10 Lakhs
Equity
5 Lakhs in Equity
&
5 Lakhs
Debentures @
10% Interest
Entire 10 Lakhs
through
debentures @ 8%
Interest
5 Lakhs in Equity
&
5 Lakhs
preference @ 10%
dividend

I II III IV
Entire 10 Lakhs
Equity
5 Lakhs in Equity
&
5 Lakhs
Debentures @
10% Interest
Entire 10 Lakhs
through
debentures @ 8%
Interest
5 Lakhs in Equity
&
5 Lakhs
preference @ 10%
dividend
Illustration 1: Calculation of EPS
Particulars
Existing capital: Rs. 10 Lakhs Financial Plans
Fresh capital required: 10 Lakhs I II III IV
Expected operating Profit [EBIT] 2,40,000 2,40,000 2,40,000 2,40,000
Less: Interest on Debt capital
Plan II: 10% interest on debentures of Rs. 5
Lakhs
Plan III: 8% interest on debentures of 10 Lakhs
No Debt 50,000 80,000 No debt
Earnings Before Tax [EBT] 2,40,000 1,90,000 1,60,000 2,40,000
Less: Tax at 50% on EBT 1,20,000 95,000 80,000 1,20,000
Earnings After Tax [EAT] 1,20,000 95,000 80,000 1,20,000
Less: Preference dividend
Plan IV: 10% dividend on Rs. 5 Lakhs
No Pref. shares No Pref. shares
No Pref.
shares
50,000
Earnings Available to Equity Share Holders 1,20,000 95,000 80,000 70,000
No. of equity Shares
 Existing (Rs. 10,00,000 ÷ Rs. 10 each)
 New (Plan- I, II and III)
Total equity shares (Existing + New)
1,00,000
1,00,000
2,00,000
1,00,000
50,000
1,50,000
1,00,000
No new shares
1,00,000
1,00,000
50,000
1,50,000
EPS = EAESH ÷ Total equity shares Rs. 0.60 Rs. 0.633 Rs. 0.80 Rs. 0.47
Comments: Since the EPS in plan III is highest, therefore plan III should be

Illustration 1I: Calculation of EPS
Brave Limited is capitalised with 50,000 equity shares of Rs. 10 each. Company
wants another Rs. 5,00,000 for expansion programme. The following are the
different Plans
1. All equity shares
2. Rs. 2,50,000 in equity and the balance in preference shares carrying 10
dividend
3. Rs. 2,50,000 in debentures and the balance in debentures at 10 interest
4. All debentures at 8% interest
Tax rate is 50% and the existing EBIT is Rs. 60,000 p.a, Calculate EPS for four
plans
Particulars
Existing capital: Rs. 5 Lakhs Financial Plans
Fresh capital required: 5 Lakhs I II III IV
Expected operating Profit [EBIT] 60,000 60,000 60,000 60,000
Less: Interest on Debt capital
Plan III: 10% interest on Loan of Rs. 2.5 Lakhs
Plan IV: 8% interest on debentures of 5 Lakhs
No Debt No Debt 25,000 40,000
Earnings Before Tax [EBT] 60,000 60,000 35,000 20,000
Less: Tax at 50% on EBT 30,000 30,000 17,500 10,000
Earnings After Tax [EAT] 30,000 30,000 17,500 10,000
Less: Preference dividend
Plan II: 10% dividend on Rs. 2.5 Lakhs
No Pref. shares 25,000
No Pref.
shares
No Pref. shares
Earnings Available to Equity Share Holders 30,000 5,000 17,500 10,000
No. of equity Shares
 Existing (Rs. 5,00,000 ÷ Rs. 10 each)
 New (In all plans except IV)
Total equity shares (Existing + New)
50,000
50,000
1,00,000
50,000
25,000
75,000
50,000
25,000
75,000
50,000
No new
shares
50,000

Assessment of Capital Structure
Capital structure should be constituted in such a way that it minimises cost of
capital and maximize the value of organization. In order to assess the quality of
capital structure financial management provides two important tools, they are as
follows:
Capital
Gearing
Leverages
1. Capital gearing focuses on the capital structure by
establishing relationship between equity shares to
other fixed income bearing securities.
Interpretation:
 Highly geared—Less equity capital and more fixed cost bearing capital
 Low geared—More equity capital and less fixed cost bearing capital

High Gear or Low Gear
Sources of Funds Mar '12 Mar '11 Mar '10 Mar '09 Mar '08
Equity Share Capital 577.65 497.78 265.91 265.91 135.8
Share Application Money 0 2.95 7.48 8.11 10.09
Preference Share Capital 553.1 553.1 97 97 0
Reserves -6,213.15 -4,005.02 -4,268.84 -2,496.36 52.99
Revaluation Reserves 0 0 0 0 0
Net worth -5,082.40 -2,951.19 -3,898.45 -2,125.34 198.88
Secured Loans 5,368.76 5,184.53 4,842.43 2,622.52 592.38
Unsecured Loans 2,661.24 1,872.55 3,080.17 3,043.04 342
Data extracted from Balance Sheet of Kingfisher Airlines
Sources of Funds Mar '13 Mar '12 Mar '11 Mar '10 Mar '09
Total Share Capital 287 287 287 287 286
Equity Share Capital 287 287 287 287 286
Share Application Money 0 0 0 0 0
Preference Share Capital 0 0 0 0 0
Reserves 35,772.00 29,470.00 24,214.00 21,749.00 17,523.00
Revaluation Reserves 0 0 0 0 0
Networth 36,059.00 29,757.00 24,501.00 22,036.00 17,809.00
Secured Loans 0 0 0 0 0
Unsecured Loans 0 0 0 0 0
Total Debt 0 0 0 0 0
Total Liabilities 36,059.00 29,757.00 24,501.00 22,036.00 17,809.00
Data extracted from Balance Sheet of Infosys

CAPITAL STRUCTURE
THEORIES
UNIT II1
Operating and Financial Leverage – Measurement of Leverages – Effects of
Operating and Financial Leverage on Profit – Analyzing Alternate Financial
Plans - Combined Financial and Operating Leverage – Capital Structure
Theories - Traditional approach - M.M. Hypotheses – without Taxes and with
Taxes – Net Income Approach (NI) – Net
Operating Income Approach (NOI) - Determining capital structure in practice.
SYLLABUS
UNIT III

LEVERAGES
The concept of leverages revolves around two aspects,
 First—the effects that fixed interest cost capital (Debentures and bonds
or long term loans) have on the returns that shareholders earn.
 Second, impact of fixed cost on the earnings of company and
shareholder
 finance manager determine degree of leverage by assessing three
types of leverages
Financial
Leverage
Operating
Leverage
Combined
Leverage

[A] OPERATING LEVERAGE:
 Operating leverage is a measure to establish relation
between a firm's fixed cost and variable cost and its
impact of profits.
 EBIT: Earnings Before Interest and Tax
 Contribution = Sales — Variable cost
Interpretation:
Criteria Outcome Impact on Profitability (EBIT)
When, C>FC Favourable Positive EBIT
When, C<FC Unfavourable Negative EBIT

[B] FINANCIAL LEVERAGE
 It determines the impact of using debt financing (debentures
and bonds or long term loans) on the earnings of
shareholders.
 EBIT: Earnings Before Interest and Tax
 EBT: Earnings Before Tax [EBIT – Interest(i)]
 EPS: Earnings Per Share
Interpretation:
Criteria Outcome Impact on Profitability (EBT)
When, EBIT > Interest payable Favourable Positive EBT
When, EBIT < Interest payable Unfavourable Negative EBT

[C] COMBINED LEVERAGE
 As the name suggests, Combined leverage represents the total effect of
the operating and financial leverages on the earning per share[EPS]. In
other words, combined leverage shows the total risks associated with the
firm. It is the product of both the leverages.
Interpretation:
The combined leverage can work in either direction. It would be favourable if
sales increase and unfavourable in the reverse scenario.

STEPS IN CALCULATION OF LEVERAGES AND
EPS: GENERAL INCOME STATEMENT FORMAT
Particulars Amount
Sales revenue --------
Less : Variable Cost --------
Contribution [C] --------
Less: Fixed Cost --------
Operating Profit or EBIT --------
Less: Interest of Debt capital --------
Earnings Before Tax [EBT] --------

A company has sales of Rs. 60,00,000, variable cost of Rs.
40,00,000, fixed cost of Rs. 5,00,000 and debt of Rs. 30,00,000 at
10% rate of interest. Calculate operating, financial, operating and
combined leverages.
Particulars Amount
Sales 60,00,00
0
Less: Variable cost 40,00,00
0
Contribution [C] 20,00,00
0
Less: Fixed Cost 5,00,000
Operating Profit or EBIT 15,00,00
0
Less: Interest on Debt Capital (10% on Rs. 30,00,000 ) 3,00,000
Earnings Before Tax [EBT] 12,00,00
0
1.25
1.33
1.6625
Illustration 1: Calculation of Leverages
Comments:
 Since, EBIT is > Interest payable, this means firm has sufficient operating profits to pay interest on debt
capital and therefore it has favourable financial.
 Since, Contribution is > Fixed cost, this means firm has sufficient sales revenue to meet its fixed cost and
therefore it has favourable operating leverage and positive operating profit.
 Combined leverage is also favourable.

Capital Structure Theories
Different kinds of theories have been propounded by different authors to
explain the relationship:
Capital Structure—Cost of Capital—Value of the firm
The important theories are as follows:
1. Net Income approach
2. Net Operating Income approach
3. The traditional approach
4. Modigliani and Miller approach

NET INCOME APPROACH
This approach is based upon the following assumptions:
 The cost of debt (Kd)is less than the cost of equity (Ke)
 There are no taxes
 The risk perception of investors is not changes by the use of debt.
According to this approach, a firm can minimize the weighted
average cost of capital (WACC) and increase the value of the firm as
well as the market price of the equity shares by using debt financing
to maximum possible extent.
Net Income Approach was presented by Durand.

TEST OF NET INCOME APPROACH THEORY
 Consider a fictitious company with below figures. All figures in Rs.
According to this approach, a firm can minimize the weighted average cost of capital
(WACC) and increase the value of the firm as well as the market price of the equity
shares by using debt financing to maximum possible extent.
Earnings before Interest Tax (EBIT) = 1,00,000
Debentures(Debt part) = 3,00,000
Cost of Debentures (Debt) = 10%
Cost of Equity = 14%
EBIT = 1,00,000
Less: Interest cost (10% of 300,000) = 30,000
Earnings after Interest Tax
(since tax is assumed to be absent)
= 70,000
Earning available to equity share holders = 70,000
Market value of Equity Shares (70,000 14%) = 5,00,000
Market value of Debt = 3,00,000
Total Market value = (S + D) = 8,00,000
Overall cost of capital = EBIT (Total value of firm)
= 100,000 800,000
= 12.5%
Calculating the value of a company = Total Market Value of Shares (S) + Debentures (D)
1. Value of a company (V) = Total Market Value of Shares (S) + Debentures (D)
2. Market value of Equity shares (S) = Earning available to equity share holders Cost of Equity
3. Over all cost of capital or WACC = EBIT V)

TEST OF NET INCOME APPROACH THEORY
 Consider a fictitious company with below figures. All figures in Rs.
According to this approach, a firm can minimize the weighted average cost of capital
(WACC) and increase the value of the firm as well as the market price of the equity
shares by using debt financing to maximum possible extent.
Earnings before Interest Tax (EBIT) = 1,00,000
Debentures(Debt part) = 3,00,000
Cost of Debentures (Debt) = 10%
Cost of Equity = 14%
Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else remains s
1. Value of a company (V) = Total Market Value of Shares (S) + Debentures (D)
2. Market value of Equity shares (S) = Earning available to equity share holders Cost of
Equity
(EBIT) = 100,000
Less: Interest cost (10% of 300,000) = 40,000
Earnings after Interest Tax
(since tax is assumed to be absent)
= 60,000
Shareholders' Earnings = 60,000
Market value of Equity (60,000/14%) = 428,570 (approx)
Market value of Debt = 400,000
Total Market value = 828,570
Overall cost of capital
= EBIT/(Total value of firm)
= 100,000/828,570
= 12% (approx.)

CONCLUSIVE SUMMARY (NI APPROACH)
 According to this approach, the capital structure decision is relevant to the
valuation of the firm.
 This means that a change in the financial leverage (use of more debt capital)
will automatically lead to a corresponding change in the overall cost of capital
as well as the total value of the firm.
 According to NI approach, if the financial leverage increases, the weighted
average cost of capital decreases and the value of the firm and the market
price of the equity shares increases.
 Similarly, if the financial leverage decreases, the weighted average cost of
capital increases and the value of the firm and the market price of the equity
shares decreases.
As observed, in case of Net Income Approach, with increase in debt proportion, the
total market value of the company increases and cost of capital decreases.

NET OPERATING INCOME APPROACH
This approach is based upon the following assumptions or features:
 The overall capitalization rate remains constant irrespective of the degree
of leverage.
(This means WACC (Weightage Average Cost of Capital) remains constant with the increase
in debt, the cost of equity increases.)
 The business risk remains constant at entry level of debt equity mix.
(Increase in debt in the capital structure results in increased risk for shareholders. As a
compensation of investing in highly leveraged company, the shareholders expect higher return
resulting in higher cost of equity capital.)
 There are no corporate taxes
According to this approach, change in capital structure of a company
does not affect the market value of the firm and overall cost of capital
remains constant irrespective of the method of financing.
This approach was put forth by Durand and totally differs from the Net Income
Approach.

According to this approach, change in capital structure of a company does not affect
the market value of the firm and overall cost of capital remains constant irrespective of
the method of financing.
Consider a fictitious company with below figures. All figures in Rs.
Earnings before Interest Tax (EBIT) = 100,000
Bonds (Debt part) = 300,000
Cost of Bonds issued (Debt) = 10%
WACC = 12.5%
Calculating the value of the company:
(EBIT) = 100,000
WACC = 12.5%
Market value of the company = EBIT/WACC
= 100,000/12.5%
= 800,000
Total Debt = 300,000
Total Equity = Total market value-total debt
= 800,000-300,000
= 500,000
Shareholders' earnings = EBIT-interest on debt
= 100,000-10% of 300,000
= 70,000
Cost of equity = 70,000/500,000
= 14%
Market value of the company = EBIT WACC

According to this approach, change in capital structure of a company does not affect
the market value of the firm and overall cost of capital remains constant irrespective of
the method of financing.
Consider a fictitious company with below figures. All figures in Rs.
Earnings before Interest Tax (EBIT) = 100,000
Bonds (Debt part) = 300,000
Cost of Bonds issued (Debt) = 10%
WACC = 12.5%
Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else
remains same.
EBIT) = 100,000
WACC = 12.5%
Market value of the company = EBIT/WACC
= 100,000/12.5%
= 800,000
Total Debt = 400,000
Total Equity = Total market value-total debt
= 800,000-400,000
= 400,000
Shareholders' earnings = EBIT-interest on debt
= 100,000-10% of 400,000
= 60,000
Cost of equity = 60,000/400,000
= 15%
As observed, in case of Net Operating Income approach, with the increase in debt proportion, the
total market value of the company remains unchanged, but the cost of equity increases.

TRADITIONAL APPROACH
Traditional approach to capital structure suggests that there exist an optimal
debt to equity ratio where the overall cost of capital is the minimum and
market value of the firm is the maximum.
Traditional approach, advocated by Ezta Solomon and Fred Weston is a
midway approach also known as ―intermediate approach‖.
Assumptions/Features of Modigliani and Miller Approach
1. As per this approach, debt should exist in the capital structure only up to a specific
point, beyond which, any increase in leverage would result in reduction in value of
the firm.
2. The rate of interest on debt remains constant for a certain period and thereafter
with increase in leverage, it increases.
3. The expected rate by equity shareholders remains constant or increase gradually.
After that the equity shareholders starts perceiving a financial risk and then from
the optimal point and the expected rate increases speedily.
4. As a result of activity of rate of interest and expected rate of return, the WACC first
decreases and then increases. The lowest point on the curve is optimal capital
structure.

MODIGLIANI AND MILLER (MM) APPROACH
This suggests that the valuation of a firm is irrelevant to the capital structure of a
company. Whether a firm is highly leveraged or has lower debt component, it has no
bearing on its market value. Rather, the market value of a firm is dependent on the
operating profits of the company.
Modigliani and Miller approach to capital theory, devised in 1950s advocates
capital structure irrelevancy theory.
Assumptions/Features of Modigliani and Miller Approach
1. There are no taxes.
2. Transaction cost for buying and selling securities as well as bankruptcy cost is Nil.
3. There is symmetry of information. This means that an investor will have access to
same information that a corporate would and investors would behave rationally.
4. The cost of borrowing is the same for investors as well as companies.
5. Debt financing does not affect companies EBIT

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