Financial Management_JNTUA MBA Syllabus

1. Unit -3

2. The concept of capital is the minimum rate of return which enables a company to
make such amount of profit on its investment so as to ensure that the market value
of the company's equity shares Weather increases or remains at the same level. this
is the conformity bikini companies School of my wealth maximization for its
shareholders .
What's my resolution for shareholders of the company is a visible only with the
projects financial by the company generates revenue at rate equal to or more than
the rate expected by the shareholders. in case of company is unable to expected
rate of return the possibility of increase in the market value all the competition
share cannot ruled out, which ultimately may result in erosion of the shareholders
wealth.

3. According to Hampton John J the rate of return the form required
from investment in order to increase the value of the firm in the
Marketplace “
According to Salmon Ezra, cost of capital is the minimum required
rate of earnings or the cut off rate of capital expenditures
In simple words the minimum rate of return expected by the investors
of the business on the projects is called as cost of capital.

4. 1. Not necessarily a cash cost :Cost of capital which a company is required to pay may not be in the
form of cash every time. In fact it is indicator of expectation of the companies share holders with
regards to returns from its investment.
2. Minimum rate of return: cost of capital indicates the minimum rate of return, Which is needed
for maintaining the market value of the company's equity shares.
3. Consideration of risk premium: the risk factor is taken care of during computation cost of capital
Which is likely to be high, if the number Hundred degrees of risk increases. in the is the to
Proportional to the number/ degree of risk involved .The concept would be more clear from the
formula :
K = Rf + Rp
Where , K = Cost of required return
Rf = risk free rate
Rp = risk premium rate
In brief, cost of capital to a company is equal to the equilibrium rate of return Demanded by
investors in the capital markets for securities at a given degree of risk.

5. 1. Future Cost Versus Historical Cost: future cost on the basis on which
financial relations are taken. although there are only project what may or
may not happen in future, They are more important as compared to
historical cost, which are nothing but frozen figures. however historical cost
are like guiding tools for future forecasting.
2. Specific Cost Vs Composite Cost: specific cost is a cost of individual source
of capital, whereas the composite cost also known as overall cost is a cost
of capital All the sources taken together. to start with the cost of individual
sources like debentures, preference shares, equity share , Retained
earnings etc., are computed individually and thereafter calculation of May
be undertaken.

6. 1. Average Cost versus Marginal : After the calculation of the cost of
individual source of capital weights are assigned to each them in the ratio of
their share. The average of this is termed as weighted average cost or
Average cost. Marginal cost on the increment by unit.
2. Implicit Cost versus Explicit Cost : The rate of return related to the best
investment option available for a company which has forgone or lost the
opportunity to earn money by abandoning the project proposal is termed as
implicit Cost. Once the proposal is accepted, the opportunity cost is
immaterial. Example : Bank FD, Government Bonds, Stock Market.

7. Cost of Equity
Capital (Ke)
Cost of Preference
Capital (Kp)
Cost of Retained
Earnings (Kr)
Cost of
Debentures/Debt
Capital (Kd)

8. Cost Of Equity Capital (Ke)
The Cost Of Equity Share Capital May Be Explained As” The Minimum Rate Of Return
A Company Is Required To earn On The Part Of Equity In Financed To Its Investment
In Such A Manner That The Market Value Of Its Stock Remains Unaffected. This can
be Calculated By Applying The Following Method
DIVIDEND YIELD METHOD it is also known as dividend price ratio
𝐾𝑒 =
𝐷
𝑁𝑃
X 100 Or 𝐾𝑒 =
𝐷
𝑀𝑃
X 100
Where, Ke = Cost of equity capital
D = expected dividend per share
NP = NET proceeds per shares
MP = Market price per share

9. COST OF EQUITY CAPITAL
1. Dividend yield Method
2. Dividend Yield plus growth in dividend
3. Earning Yield Method
4. Earning Growth Method
5. Realised Yield Method
Example
xyz Limited has distributed dividend of rupees 25 on its equity shares of is rupees 10.The current
market price of equity shares is rupees 70. calculate the cost of equity as per dividend yield method
Solution :
𝐾𝑒 =
𝐷
𝑀𝑃
X 100 𝐾𝑒 =
25
70
X 100 = 35.714

10. Cost of preference capital (Kp)
Production orders are entitled to have a fixed rate of dividend. although there is no statutory
compulsion regarding the payment of dividend to preference shareholders. In a case company
decide to pay dividend to its shareholders, then preference holders would be given over other
shareholders. Non payment of dividend to its preference shareholders impact negatively on
company's a reputation and its capacity to mobilise funds add an appropriate rate. further
expected by preference shareholders has a direct relationship with the cost of preference capital
.There are separate methods of calculating cost of capital in respect to redeemable preference
shares and irredeemable preference Shares.
Redeemable Preference Shares
Redeemable preference share is very commonly seen preference share which has a maturity
date on which date the company will repay the capital amount to the preference shareholders
and discontinue the dividend payment there on. Irredeemable preference shares are little
different from other types of preference shares.

11. Cost of Debentures (Kd)
Rate of interest payable by a company on the issued debt instrument s is the cost
of funds raised by it. However, taxation is an important issue in ascertaining the
cost of debt funds, as interest paid by a company on its debt instruments is allowed
as ab expense under the relevant provisions of income tax Act.
Cost of Irredeemable Debentures
𝐾𝑑 =
𝐼
𝑁𝑃
X 100
Where, Kd = Cost of Debt
I = Fixed annual interest payable
NP = Net Proceeds

12. Cost of Retained Earning (K𝑟)
A company is not required to pay dividend out to the “retained earning’, because it is the amount
which is set aside before taking a decision with regard to dividend distribution. However to have a
view that there is no cost involved in retained earnings may perhaps not be right.
Some form of return is expected by the shareholders from retained earnings also. The cost of
retained earnings may be the rate of return, which the existing shareholders would have got, if the
retained earning been invested else where appropriately.
𝐾𝑟 = (
𝐷
𝑁𝑃
+ G) X (1-t) X (1-b)
Where , Kr = Cost of retained earnings,
D = Expected Dividend
G = Growth rate
NP = Net Proceeds of equity issue.
t = Tax Rate
b = Cost of Purchasing securities , or brokerage cost

13. Weighted Average Cost of Capital
Weighted average cost of capital (WACC) is the average rate of return a company expects to
compensate all its different investors. The weights are the fraction of each financing source in the
company's target capital structure.
HOW to Calculate WACC (EXAMPLE):
Here is the basic formula for weighted average cost of capital:
WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]
Where,
E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Ke = Cost of Equity
Kd = Cost of Debt
T= Tax Rate

14. Systems of Weighting

15. Historical Weight
These are the proportion of actual existing capital structure in terms of book value or market value. Historic
weights assume that the firm will finance its future projects in the existing capital structure and it is the
optimum structure.
Advantage: The advantage of historic weights over marginal weights is that it takes a longer term in view which
supports the going concern concept and conservative approach. The WACC of 14.25% (Book Value) or 15.67%
(Market Value) will remain more or less consistent.
Disadvantage: Raising the finance at a predefined ratio is very difficult in the market and not in our control.
There are a lot of economic and other factors affect availability and cost of finance.
Conclusion: The acceptance and rejection criterion in historical weights will not fluctuate like a pendulum but
that is possible in case of marginal weights. Looking at the consistency and long-term view of the approach, we
should use historical weights.
We have concluded historical weights between marginal vs. historical weights based on above discussion, the
next step is to zero down between book value and market value.

16. Market Value vs. Book Value
Book Value WACC is calculated using book value weights whereas the
Market Value WACC is calculated using the market value of the sources
of capital. Why the market value weights are preferred over book
values weights:
Explanation: The book value weights are readily available from balance
sheet for all types of firms and are very simple to calculate. On the
other hand, for Market Value weights, the market values have to be
determined and it is a real difficult task to acquire accurate data for the
same especially the value of equity when the entity is not listed. Still
Market Value WACC is considered appropriate by analysts because an
investor would demand market required rate of return on the market
value of the capital and not the book value of the capital.

17. Market Value Vs. Book Value ….exaMple
Explanation with Example: Assume a firm issued capital at $10 per equity share 5 years back.
Current market value of the share is $30 and book value is $18 and market required rate of return is
20%. The investors (existing and new) of the company will expect a return on $30 and not $18. Let
us see how a rational investor will behave.
New Investor: He can buy the share of the company at $30 from the market. If the firm returns 20%
on book value i.e. $3.6. The new investor will calculate his percentage of gain 12% (3.6/30) which is
far less than 20%. Why 30 dollar because the investment by him is 30 and not 10 or 18.
Existing Investor: Since, market required rate of return is 20% and return on investment at current
prices is only 12%, a better situation for existing investor would be to sell off the securities at $30 and
invest in other securities giving more than 12% return. The existing investor will exit from the
investment considering it an overpriced stock and invest in securities which are underpriced or
appropriately priced by the market.

18. Marginal Cost of Capital
Sometimes, we may be required to calculate the cost of additional funds to be
raised, called the marginal cost of capital. The marginal cost of capital is the
weighted average cost of new capital calculated by using the marginal weights.
The marginal weights represent the proportion of various sources of funds to be
employed in raising additional funds.
In case, a firm employs the existing proportion of capital structure and the
component costs remain the same the marginal cost of capital shall be equal to
the weighted average cost of capital. But in practice, the proportion and/or the
component costs may change for additional funds to be raised.

19. Example
A firm has the following capital structure and after-tax costs for the different sources of funds used:
(a) Calculate the weighted average cost of capital using book-value weights.
(b) The firm wishes to raise further Rs. 6,00,000 for the expansion of the project as below
Note : Assuming that specific costs do not change, compute the weighted marginal cost of capital.

20. Solution

21. Marginal Weights Vs. Historical Weights
These are the proportion of capital in which the fresh capital for the new project is raised. In the
table below, we can notice that funds are raised for the new project in the ratio of 1:7:2 (Equity:
Debt: Preference) and these proportion are used to calculate the WACC. We can observe that the
WACC is the lowest compared to other two weighting approaches and it is also visible that the
reason is the higher proportion of debt in the capital structure.
Advantages: There is a direct link between the project and the financing arrangement. The actual or
relevant money that is going to be used for implementing the project is the money marginally raised
in the ratio.
Disadvantages: It is a very short term approach. It is not considering leverage effect of financing the
current project. The WACC in marginal weights is low because of too high debt in the structure
which compromises the debt-equity ratio of the company. When the same company will raise
money next year for some other project, they will have to take more equity finance because of
already higher debt-equity ratio. That time, the WACC will be much higher compared to this
situation

22. Dividend Decision
INTRODUCTION
Once a company makes a profit, it must decide on what to do with those profits. They could continue to retain
the profits within the company, or they could pay out the profits to the owners of the firm in the form of
dividends. The dividend policy decision involves two questions:
1) What fraction of earnings should be paid out, on average, over time? And,
2) What type of dividend policy should the firm follow?
I.e. issues such as whether it should maintain steady dividend policy or a policy increasing dividend growth rate
etc. On the other hand Management has to satisfy various stakeholders from the profit. Out of the Stakeholders
priority is to be given to equity share - holders as they are being the highest risk.

23. DIVIDEND - DEFINED
According to the Institute of Chartered Accountants of India, dividend is "a
distribution to shareholders out of profits or reserves available for this
purpose.“
According to R.P. Rustagi, Financial Management, Galgotia Publishing
Company "The term dividend refers to that portion of profit (after tax) which
is distributed among the owners / shareholders of the firm."
According to Dr. S.N. Maheshwari, Elements of Financial Management, Sultan
Chand and Sons "Dividend may be defined as the return that a shareholder
gets from the company, out of its profits, on his shareholdings.“
In other words, dividend is that part of the net earnings of a corporation that
is distributed to its stockholders. It is a payment made to the equity
shareholders for their investment in the company.

24. DEFINITION: DIVIDEND POLICY
"Dividend policy determines the ultimate distribution of the firm's earnings between retention (that is
reinvestment) and cash dividend payments of shareholders.“
"Dividend policy means the practice that management follows in making dividend pay-out decisions,
or in other words, the size and pattern of cash distributions over the time to shareholders.“
In other words, dividend policy is the firm's plan of action to be followed when dividend decisions are
made. It is the decision about how much of earnings to pay out as dividends versus retaining and
reinvesting earnings in the firm.

25. TYPES OF DIVIDENDS
Cash Dividend
Bonus Shares referred to as stock dividend in USA
Special- dividend, extra dividend etc.
Property dividend interim dividend, annual dividend.
Liquidating dividend
Property dividend
Scrip dividend
Regular Cash Dividend

26. Cash dividend :
Companies mostly pay dividends in cash. A Company should have enough cash in its bank account when cash dividends are
declared. If it does not have enough bank balance, arrangement should be made to borrow funds. When the Company
follows a stable dividend policy, it should prepare a cash budget for the coming period to indicate the necessary funds,
which would be needed to meet the regular dividend payments of the company. It is relatively difficult to make cash
planning in anticipation of dividend needs when an unstable policy is followed
Bonus Shares : (OR Stock -dividend in USA)
An issue of bonus share is the distribution of shares free of cost to the existing shareholders, In India, bonus shares are
issued in addition to the cash dividend and not in lieu of cash dividend. Hence, Companies in India may supplement cash
dividend by bonus issues. Issuing bonus shares increases the number of outstanding shares of the company. The bonus
shares are distributed proportionately to the existing shareholder. Hence there is no dilution of ownership.
Special dividend :
In special circumstances Company declares Special dividends. Generally company declares special dividend in case of
abnormal profits.
Extra- dividend:
An extra dividend is an additional non-recurring dividend paid over and above the regular dividends by the company.
Companies with fluctuating earnings payout additional dividends when their earnings warrant it, rather than fighting to
keep a higher quantity of regular dividends.

27. Annual dividend:
When annually company declares and pay dividend is defined as annual dividend.
Interim dividend :
During the year any time company declares a dividend, it is defined as Interim dividend.
Regular cash dividends:
Regular cash dividends are those the company exacts to maintain every year. They may be paid quarterly,
monthly, semiannually or annually.
Scrip dividends:
These are promises to make the payment of dividend at a future date: Instead of paying the dividend now,
the firm elects to pay it at some later date. The ‘scrip’ issued to stockholders is merely a special form of
promissory note or notes payable
Liquidating dividends:
These dividends are those which reduce paid-in capital: It is a pro-rata distribution of cash or property to
stockholders as part of the dissolution of a business
Property dividends:
These dividends are payable in assets of the corporation other than cash. For example, a firm may distribute
samples of its own product or shares in another company it owns to its stockholders.

28. WHO MAKES DIVIDEND DECISION?
The company's Board of Directors makes dividend decisions. They are faced with the decision to pay out
dividends or to reinvest the cash into new projects.
The tradeoff between paying dividends and retaining profits within the company
The dividend policy decision is a trade-off between retaining earnings v/s paying out cash dividends
Dividend policies must always consider two basic objectives:
• Maximizing owners' wealth
• Providing sufficient financing
While determining a firm's dividend policy, management must find a balance between current income
for stockholders (dividends) and future growth of the company (retained earnings). In applying a
rational framework for dividend policy, a firm must consider the following two issues:

29. DIVIDEND PAYMENT PROCEDURES
he firm's board of directors normally meets quarterly to evaluate financial performance and decide
whether, and in what amount, dividends should be paid. If dividend is to be paid the declaration date,
record date etc. have to be established

30. Dividend Payment Dates
Declaration date: This is the day on which the board of directors declares a payment of dividend.
Date of Record: This is the day on which all persons whose names are recoded as stockholders will receive the
dividend.
Payment date: The dividend checks are mailed to shareholders of record.
Cum Dividend date: This is the last say on which the buyer who buys the stock is entitled to get the dividend.
Ex-Dividend date: Shares become ex dividend on the date seller is entitled to keep the dividend. This is the first
date on which the buyer who buys the stock is not entitled to dividend

31. DIVIDEND POLICY THEORIES
Miller & Modigliani, 1961
The Bird in the Hand Theory, (John Lintner 1962 and Myron Gordon, 1963
The Tax Differential Theory, (B. Graham and D.L. Dodd)
Percent Payout Theory (Rubner 1966)2
Per Cent Retention Theory (Clarkson and Eliot 1969
Agency Cost Theory (Jenson)
DIVIDEND MODELS
Modigliani Miller approach
Walter's approach
Gordon's approach