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W L OM
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Financial managementscoperole
of financial management in business
time value of money risk and
returnrisk diversification
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FINANCIAL MANAGEMENT:-
Financial Management means planning,organizing, directing and controlling the
financial activities such as procurementand utilization of funds of theenterprise. It means applying generalmanagement principles to financial
resources of the enterprise.
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Objectives of Financial Management
The financial management is generally concerned withprocurement, allocation and control of financial resources of aconcern. The objectives can be-To ensure regular and adequatesupply of funds to the concern.
To ensure adequate returns to the shareholders which will dependupon the earning capacity, market price of the share, expectations ofthe shareholders.
To ensure optimum funds utilization. Once the funds are procured,they should be utilized in maximum possible way at least cost.
To ensure safety on investment, i.e, funds should be invested in safeventures so that adequate rate of return can be achieved.
To plan a sound capital structure-There should be sound and faircomposition of capital so that a balance is maintained between debtand equity capital.
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Functions of Financial Management
Estimation of capital requirements
Choice of sources of funds
Investment of funds
Disposal of surplus
Management of cash
Financial controls
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Investment of funds:
The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
Disposal of surplus:
The net profits decision have to be made by the finance manager. This can
be done in two ways:
*Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
*Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
Management of cash:Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting
current liabilities, maintainance of enough stock, purchase of raw materials, etc.
Financial controls:The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.
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FINANCIAL PLANNING:-
Financial Planning is the process of estimating the capital required
and determining its competition. It is the process of framing financial policies
in relation to procurement, investment and administration of funds of an
enterprise.
Objectives of Financial Planning
Financial Planning has got many objectives to look forward to:
Determining capital requirements- This will depend upon factors like cost of current and
fixed assets, promotional expenses and long- range planning. Capital requirements have
to be looked with both aspects: short- term and long- term requirements.
Determining capital structure- The capital structure is the composition of capital, i.e.,the relative kind and proportion of capital required in the business. This includes
decisions of debt- equity ratio- both short-term and long- term.
Framing financial policies with regards to cash control, lending, borrowings, etc.
A finance manager ensures that the scarce financial resources are maximally utilized in
the best possible manner at least cost in order to get maximum returns on investment.
f l l
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Importance of Financial Planning
Financial Planning is process of framing objectives, policies, procedures,
programmes and budgets regarding the financial activities of a concern. This
ensures effective and adequate financial and investment policies. The importancecan be outlined as-
Adequate funds have to be ensured.Financial Planning helps in ensuring a
reasonable balance between outflow and inflow of funds so that stability is
maintained.
Financial Planning ensures that the suppliers of funds are easily investing incompanies which exercise financial planning.
Financial Planning helps in making growth and expansion programmes which
helps in long-run survival of the company.
Financial Planning reduces uncertainties with regards to changing market trends
which can be faced easily through enough funds.
Financial Planning helps in reducing the uncertainties which can be a hindrance
to growth of the company. This helps in ensuring stability an d profitability in
concern.
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FINANCE DECISIONS
Investment Decision
One of the most important finance functions is to intelligently allocate capital to
long term assets. This activity is also known as capital budgeting. It is important toallocate capital in those long term assets so as to get maximum yield in future.
Following are the two aspects of investment decision
a.Evaluation of new investment in terms of profitability
b.Comparison of cut off rate against new investment and prevailing investment.
Financial Decision
Financial decision is yet another important function which a financial manger
must perform. It is important to make wise decisions about when, where and how
should a business acquire funds. Funds can be acquired through many ways and
channels. Broadly speaking a correct ratio of an equity and debt has to be maintained.
This mix of equity capital and debt is known as afirmscapital structure. A firm tends to
benefit most when the market value of a companysshare maximizes this not only is a
sign of growth for the firm but also maximizes shareholders wealth.
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Dividend Decision
Earning profit or a positive return is a common aim of all the businesses.
But the key function a financial manger performs in case of profitability is to decide
whether to distribute all the profits to the shareholder or retain all the profits or
distribute part of the profits to the shareholder and retain the other half in the
business. Its the financial managers responsibility to decide a optimum dividend
policy which maximizes the market value of the firm. Hence an optimum dividend
payout ratio is calculated. It is a common practice to pay regular dividends in case of
profitability Another way is to issue bonus shares to existing shareholders.
Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid
insolvency. Firms profitability, liquidity and risk all are associated with the
investment in current assets. In order to maintain a tradeoff between profitabilityand liquidity it is important to invest sufficient funds in current assets. But since
current assets do not earn anything for business therefore a proper calculation must
be done before investing in current assets. Current assets should properly be valued
and disposed of from time to time once they become non profitable. Currents assets
must be used in times of liquidity problems and times of insolvency.
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FINANCIAL MANAGER
Financial activities of a firm is one of the mostimportant and complex activities of a firm. Therefore in
order to take care of these activities a financial manager
performs all the requisite financial activities.
A financial manger is a person who takes care of all
the important financial functions of an organization. The
person in charge must ensure that the funds are utilized in
the most efficient manner. His actions directly affect the
Profitability, growth and goodwill of the firm.
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main functions of a Financial Manager:
Raising of Funds
In order to meet the obligation of the business it is important to have enough cashand liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a
financial manager to decide the ratio between debt and equity. It is important to maintain a
good balance between equity and debt.
Allocation of FundsOnce the funds are raised through different channels the next important function is to
allocate the funds. The funds should be allocated in such a manner that they are optimally used.
In order to allocate funds in the best possible manner the following point must be considered
These financial decisions directly and indirectly influence other managerial activities. Hence
formation of a good asset mix and proper allocation of funds is one of the most important activity
Profit Planning
Profit earning is one of the prime functions of any business organization. Profit earning
is important for survival and sustenance of any organization. Profit planning refers to proper
usage of the profit generated by the firm. Profit arises due to many factors such as pricing,
industry competition, state of the economy, mechanism of demand and supply, cost and output.
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WEALTH MAXIMIZATION
A process that increases the current net value of business or shareholder
capital gains, with the objective of bringing in the highest possible return.
The wealth maximization strategy generally
involves making sound financial investment decisions which takeinto consideration any risk factors that would compromise or outweigh the
anticipated. benefits.
Wealthmaximization is a financial management technique that
concentrates its focus on increasing the net worth of a company or firm. This
approach says, more traditional method of management that seeks out increasedprofits above all other pursuits. Those who pursue this technique also seek out
profits, but they concern themselves with cash flow, earnings per share of
shareholders, and the social value of any financial initiatives as well
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TIME VALUE OF MONEYThe time value of money is the principle that a certain
currency amount of money today has a different buying
power value than the same currency amount of money in thefuture. The value of money at a future point of time would
take account of interestearned or inflationaccrued over a
given period of time.
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There are mainly three ways for accounting
for the time value of money:* Simple interest
* Compounding
* Discounting
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Compounding:-The ability of an asset to generate earnings, which are thenreinvested in order to generate their own earnings. In other
words, compounding refers to generating earnings from previousearnings.Also known as "compound interest".
The process of earningintereston a loanor other fixed-incomeinstrument where the interest can itself earn interest. That is,interest previously calculated is included in the calculation of
future interest.Compound interest is interest paid on an investment during thefirst period is added to the principal; then, during the secondperiod, interest is earned on the new sum
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Simple Interest
Interest is earned only on principal.
Example: Compute simple interest on $100
invested at 6% per year for 3 years.
1st year interest is $6.00
2nd year interest is $6.00
3rd year interest is $6.00
Total interest earned: $18.00
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DIS OUNTING
The process of determining the present value of
a payment or a stream of payments that is to be
received in the future. Given the time value ofmoney, a dollar is worth more today than it
would be worth tomorrow given its capacity to
earn interest. Discounting is the method used to
figure out how much these future payments are
worth today.
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RISK
Risk means the chance of loss.
The chance that an investments
actual return will be different than
expected. Risk includes the
possibility of losing some or all ofthe original investment.
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Sources of risk
The essence of risk in aninvestment is the variation in its
returns.The variation in risk is caused by anumber of factors.
These factors may be internal orexternal.
continues.
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External factors means the factors
which are beyond the control ofbusiness.
Internal factors means the factors
which can be controlled by the
organization.
The risk caused by external factors
is called systematic risk.
The risk caused by internal factors
is called unsystematic risk.
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REASONS :-
economic changes
political changestechnological changes
stock price
social changes
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TYPES OF SYSTEMATIC RISK
A. INTEREST RATE RISKS
B. MARKET RISK
C. PURCHASING POWER RISK
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INTEREST RATE RISK
This type of risk is affect to debt securities like
debentures or bonds.
Debt securities have normally a coupon rate of
interest and it is equal to the interest rate
prevailing in the market when these securities
are issued.
Some times, the interest rate prevailing in the
economy will be changed , but the coupon rate
will not be changed.
These variations in bond prices caused due to
the variations in interest rates is known as
interest rate risk.
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MARKET RISK
Market risk of shares may move upward or
downward.
General rise in price is called bullish trend and fall
in price is called bearish trend.These changes may reflect in the sensitive index of
BSE or nifty.
The stock market is seen to be volatile. This
volatility leads to variations in the returns ofinvestors in shares. These variations in return caused
by the volatility of the stock market is referred to as
the market risk.
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PURCHASING POWER RISK
Inflation results in reducing
purchasing power o f money.thus inflation causes a variation in
thee purchasing power of the returnsfrom an investment.
This is known as purchasing powerrisk.
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Inflation may be caused by two
reasons:-
Sometimes demand is increasing
but supply cannot be increased, priceof the goods increases.
Rise in cost of production leads to
increase in price of product.
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UNSYSTEMATIC RISK.
Risk caused due to some
factors which are controlled
by the organization is called
unsystematic risk.
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REASONS :-
Scarcity of raw materials
Labour stike
Inefficiency of management
Financial pattern
Operating environmentWork overloading
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TYPES OF UNSYSTEMATIC
RISK
A. BUSINESS RISKB. FINANCIAL RISK
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USINESS RISK
Every company operates within a
particular operating environment.The operating cost may be fixed cost
or variable cost. Too much fixed cost
adversely affects the working ofcompany. It leads to total decline of
revenue.
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FINANCIAL RISK
Financial risk is a function of financial leverage. It
means the use of debt in the capital structure.
The presence of debt in the capital structure
creates fixed payment to be made whether the
company makes profit or loss. This fixed interest
payment creates more variability in the EPS
available to equity shareholders. The variabilityin EPS due to the presence of debt in the capital
structure of a company is called financial risk.
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RISK AND RETURNRisk is the chance that an investment's actual return will be different than
expected. Technically, this is measured in statistics by standard deviation. Risk
means you have the possibility of losing some, or even all, of our original
investment.
Low levels of uncertainty (low risk) are associated with low potential returns. High
levels of uncertainty (high risk) are associated with high potential returns.
The risk/return tradeoffis the balance between the desire for the lowest possible
risk and the highest possible return. This is demonstrated graphically in the chart
below. A higher standard deviation means a higher risk and higher possible return.
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DIVERSIFICATION OF RISK
Diversification is a risk-management technique that mixes a wide variety ofinvestments within a portfolio in order to minimize the impact that any one security will
have on the overall performance of the portfolio.
Diversification essentially lowers the risk of your of portfolio. There are three main
practices that can help to ensure the best diversification:
Spread portfolio among multiple investment vehiclessuch as cash, stocks, bonds,mutual funds, and perhaps even some real estate
Vary the risk in your securities.If you are investing in equity funds, then consider large
cap as well as small cap funds. And if you are investing in debt, you could consider both
long term and short term debt. It would be wise to pick investments with varied risk
levels; this will ensure that large losses are offset by other areasVary your securities by industry.This will minimize the impact of specific risks of certain
industries
Diversification is the most important component in helping you reach your long-range
financial goals while minimizing your risk. At the same time, diversification is not an
ironclad guarantee against loss. No matter how much diversification you employ,
investing involves taking on some sort of risk.
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Long term investment decision capital
budgeting different techniques
traditional and modern methods of
capital budgeting capital rationing
risk analysis in capital rationing an
overview of cost of capital
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Investment Decision
The investment decision of a firm is generally
known as capital budgeting or capital
expenditure decisions.
It defines the investment of current funds
most efficiently in long-term assets as an
anticipation of expected flow of benefits over
a series of years.
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Importance of Investment Decision
Growth
Risk
Funding
Irreversibility
Complexity
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Capital Budgeting
Capital budgeting is the process of making
investment decisions in capital expenditure.
It involves planning and control of capital
expenditure.
It is the process of deciding whether or not to
commit the recourse to a particular long term
project whose benefit are to be realized over along period of time.
Characteristics / needs/
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Characteristics / needs/
importance of capital budgeting
Exchange of current funds for thebenefit to be achieved in future.
Future benefits.
Invested in long term non- flexibleactivities.
Investment of huge funds.
Difficulties in investment decisions.
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Factors Influencing Capital Budgeting
Availability of funds
Structure of capital
Taxation Policy
Government PolicyLending Policies of Financial Institutions
Immediate need of the Project
Earnings
Capital ReturnEconomic Value of the Project
Working Capital
Accounting Practice
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Capital budgeting process
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STAGES IN CAPITAL BUDGETING
1. Identification Stagedetermine which types of capitalinvestments are necessary to accomplish organizational
objectives and strategies
2. Search StageExplore alternative capital investments
that will achieve organization objectives3. Information-Acquisition Stageconsider the expected
costs and benefits of alternative capital investments
4. Selection Stagechoose projects for implementation
5. Financing Stageobtain project financing
6. Implementation and Control Stageget projects underway and monitor their performance
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Kinds of capital budgeting
1. Accept reject decision:-
It relates to independent projects which do not compete with oneanother. This decisions are mainly based on minimum return oninvestment.
2.Mutually exclusive project decision:-
It relates to the decisions about depend projects. In such a wayacceptance of one project causes rejection of another.
3.Capital rationing decision:-
Here the total capital should be allocated to several profitableprojects according to their nature. Simply limited capital shouldbe rationed to several projects.
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Cash inflow
The cash inflow of a company is simply the total
money earned by that company.
The cash inflow can include interest or money made
on investments, sales, or any other operating activitythat can result in a monetary profit.
Cash inflow minus cash outflow will yield the take-
home profit of a business.
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Payback Method
This method is based on the principal that everycapital expenditure pays itself back within acertain period out of the additional earningsgenerated from the capital assets.
It measures the period of time for the originalcost of a project to be recovered from theadditional earnings of the project.
Under this method various investment proposalsare ranked according to the length of their pay
back period in such a manner that the investmentwith a shorter payback period is preferred to theone which has longer pay back period.
It is also known as pay out period/ pay off period.
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PBP= Cash out flow
annual cash inflow
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Net Present Value Method
It s the modern method of evaluatinginvestment proposal method take intoconsideration the time value of money andattempts to calculate the return on
investment by introducing the factor of timeelement.
It recognizes the fact that a rupee earnedtoday is worth more than the same rupee
earned tomorrow.
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Limitations of NPV method
Estimating cash flowit is difficult to obtain
the estimates of cash flows due to uncertainty.
Measuring discount rateit is difficult to
precisely measure the discount rate.
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Discounted Cash Flows
Discounted Cash Flow (DCF) Methods
measure all expected future cash inflows and
outflows of a project as if they occurred at a
single point in time
The key feature of DCF methods is the time
value of money (interest), meaning that a
dollar received today is worth more than adollar received in the future
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Discounted Cash Flows (continued)
DCF methods use the Required Rate of Return (RRR),
which is the minimum acceptable annual rate of return
on an investment.
RRR is the return that an organization could expect toreceive elsewhere for an investment of comparable risk
RRR is also called the discount rate, hurdle rate, cost of
capital or opportunity cost of capital
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Three-Step NPV Method
1. Draw a sketch of the relevant cash inflows and
outflows
2. Convert the inflows and outflows into present
value figures using tables or a calculator3. Sum the present value figures to determine the
NPV. Positive or zero NPV signals acceptance,
negative NPV signals rejection
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NPV Method Illustrated
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Internal Rate of Return (IRR) Method
The IRR Method calculates the discount rate at
which the present value of expected cash
inflows from a project equals the present
value of its expected cash outflows.
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IRR Method
Analysts use a calculator or computer program to
provide the IRR
Trial and Error Approach:
Use a discount rate and calculate the projects NPV. Goal: find
the discount rate for which NPV = 0
1. If the calculated NPV is greater than zero, use a higher discount
rate
2. If the calculated NPV is less than zero, use a lower discount rate
3. Continue until NPV = 0
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Comparison NPV and IRR Methods
IRR is widely used
NPV can be used with varying RRR
NPV of projects may be combined for
evaluation purposes, IRR cannot
Both may be used with sensitivity analysis
(what-if analysis)
Relevant Cash Flows in
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Relevant Cash Flows in
DCF Analysis
Relevant cash flows are the differences in
expected future cash flows as a result of
making an investment Categories of Cash Flows:
1. Net Initial Investment
2. After-tax cash flow from operations
3. After-tax cash flow from terminal disposal of an
asset and recovery of working capital
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Net Initial Investment
Three Components:
1. Initial Machine Investment
2. Initial Working Capital Investment
3. After-tax Cash Flow from Current Disposal of
Old Machine
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Cash Flow from Operations
Two Components:
1. Inflows (after-tax) from producing and selling
additional goods or services, or from savings
in operating costs. Excludes depreciation,handled below:
2. Income tax cash savings from annual
depreciation deductions
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Types of capital rationingExternal capital rationing
Occurs usually due to the imperfection of capital market.
There are two kinds of reasons for capital rationing -
external and internal.
When a business is unable to borrow funds from outsidesources, it is an external reason for capital rationing. A firm
may be unable to borrow funds because of internal financial
shortages, substandard operating performance, unfavorable
credit conditions or when it introduces a new, untestedproduct. Banks are particularly reluctant to lend to small
businesses and individuals with a less-than-satisfactory
performance.
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Internal capital rationing Occurs due to the self-imposed restrictions by the
management.
In a privately-owned company, management may want to
limit growth of business to have a stronger hold on thebusiness. In larger companies, upper management mayspecify spending limits for each department, following acomprehensive corporate strategy. Internal reasons also
include human resource constraints, in which the companymay not have adequate middle management personnel tocover expansion.
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Computation of cost of capital
A . Computation of cost of specific source offinance
B . Computation of weighted average cost of
capital.
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Computation of cost of specific
source of finance
Computation of each specific sources
like DEBT, PREFERENCE SHARECAPITAL, EQUITY SHARE CAPITAL and
RETAINED EARNINGS.
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Meaning and importanceTheories of
capital structureNet incomeNet
operating incomeMM approach
l
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Capital structure
Capital structure of a company refers to thecomposition of its capitalization and it includesall long term capital sources i.e., loans,
reserves, shares and bonds.
the Capital structure of business can be
measured by the ratio of various kinds ofpermanent loan and equity capital to totalcapital.
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pt ma cap ta structure
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The OCM can be defined as that capital structure or combination of debt and equitythat leads to the maximum value of the firm
OCM maximises the value of the company and hence the wealth of its owners andminimise the companys cost of capital.
the following consideration should be kept in mind while maximising the value of thefirm in achieving the goal of the optimal capital structure:
1. If ROI is higher the fixed cost of funds, the company should prefer to raise thefunds having a fixed cost, such as, debentures, Loans and PSC. It will increase EPSand MV of the firm.
2. If debt is used as a source of finance, the firm saves a considerable amount inpayment of tax as interest is allowed as a deductible expense in computation oftax.
3. It should also avoid undue financial risk attached with the use of increased debt
financing4. The Capital structure should be flexible.
Point of indifference/ Range of earningsThe earnings per share equivalent point or point of indifference
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The earnings per share, equivalent point or point of indifference
refers to that EBIT, level at which EPS remains the same
irrespective of Different alternatives of Debt-Equity mix. At this
level of EBIT, the rate of return on capital employed is equal to
the cost of debt and this is also known as the break-even level
of EBIT for alternative financial plans
Capital Gearing
CG means the ratio between the various types of securities in the
capital structure of the company. A company is said to e high-
gear when it has proportionately higher/larger issue of Debtand PS for raising the LT resources. Whereas low-gear stands for
a proportionately large issue of equity shares.
Leverage
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everage
Leverage-an Increased means of accomplishing some
purpose
In financial management, it is the firms ability to use fixed
cost assets or funds to increase the returns to its owners;
Financial leverage- the use of long term fixed income
bearing debt and preference share capital along with theequity share capital is called financial leverage or trading
on equity
A Firm is known to have a favourable leverage if its earnings
are more than what debt would cost. On the contrary, ifit does not earn as much as the debt costs then it will be
known as an unfavourable leverage.
I t f fi i l l
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Impact of financial leverage
When the d/f b/w the earnings from assets financed byfixed cost funds and cost of these funds are distributed to
the equity stockholders, they will get additional earnings
without increasing their own investment. Consequently,
the EPS and the Rate of return on ESC will go up.
On the contrary, if the firm acquires fixed cost funds at a
higher cost than the earnings from those assets then the
EPS and return on equity capital will decrease.
Significance of financial leverage
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Significance of financial leverage
Planning of capital structure
Profit planning
Limitations of FL/ trading on equity
Double-edged weapon Beneficial only to companies having stability in
earnings
Increases risk and rate of interest
Restriction from financial instruments
O ti l
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Operating leverage
Operating leverage results from the presence of fixed coststhe help in magnifying net operating income fluctuations
flowing from small variations in revenue.
The changes in sales are related to changes in the revenue.
The fixed costs do not change with the changes in sales,
any increase in sales, FC remaining the same, will
magnify operating revenue
OL shows the ability of a firm to use fixed operating cost to
increase the effect of change in sales and the charges in
fixed operating income.
A measurement of the degree to which a firm or project incurs acombination of fixed and variable costs.
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1. A business that makes few sales, with each sale providing a veryhigh gross margin, is said to be highly leveraged. A business that
makes many sales, with each sale contributing a very slight margin, is
said to be less leveraged. As the volume of sales in a business
increases, each new sale contributes less to fixed costs and more to
profitability.
2. A business that has a higher proportion of fixed costs and a lower
proportion of variable costs is said to have used more operatingleverage. Those businesses with lower fixed costs and higher variable
costs are said to employ less operating leverage.
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C bi d l
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Combined leverage
The OL affects the income which is the resultof production. On the other hand, FL is theresult of financial decisions. The CL focusesattention on the entire income of the concern
This leverage shows the relationship betweena change in sales and the correspondingvariation in taxable income.
Working capital leverage
This leverage measures the sensitivity of ROI ofchanges in the level of current assets.
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ROI ROE Approach
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ROIROE Approach
This approach analyses the relationshipbetween the ROI and ROE for different levels
of financial leverage.
ROIreturn on investment
ROE- return on equity
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Assumptions of Capital Structure
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p p
Theories
Firm uses only two sources of funds: perceptual riskless debt andequity;
There are no corporate or income: or personal tax;
The dividend payout ratio is 100% [There are no retained earnings];
There is no change in the total assets.
There is no change in capitalThe firms operating profits (EBIT) are not expected to grow;
The business risk is remained constant
The firm has perpetual life
Definitions used in Capital Structure
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Definitions used in Capital Structure
E = Total Market Value of Equity.
D = Total Market Value of Debt.
V = Total Market Value of the Firm.
I = Annual Interest payment.
NI = Net Income.
NOI = Net Operating Income.
Ee = Earning Available to Equity Shareholder.
he weighted average cost of capital (WACC)is the ratethat a company is expected to pay on average to all its
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that a company is expected to pay on average to all itssecurity holders to finance its assets.
The WACC is the minimum return that a company mustearn on an existing asset base to satisfy its creditors,owners, and other providers of capital, or they willinvest elsewhere. Companies raise money from anumber of sources: common equity, preferred stock,
straight debt, convertible debt, exchangeabledebt, warrants, options, pension liabilities, executivestock options, governmental subsidies, and so on.Different securities, which represent different sources
of finance, are expected to generate different returns.The WACC is calculated taking into account the relativeweights of each component of the capital structure. Themore complex the company's capital structure, the
more laborious it is to calculate the WACC.
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Net Income (NI) Approach
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According to NI approach, if the financialleverage increases, the weighted average cost
of capital decreases and the value of the firm
and the market price of the equity sharesincreases. Similarly, if the financial leverage
decreases, the weighted average cost of
capital increases and the value of the firm andthe market price of the equity shares
decreases.
Assumptions of NI approach
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Assumptions of NI approach
There are no taxes
The cost of debt is less than the cost of equity.
The use of debt does not change the risk
perception of the investors
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Net Income Approach
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Net Income Approach
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Net Operating Income Approach
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Net Operating Income Approach
There is no relation between capital structure and Ko and V.
Assumptions:
(i) Overall Cast of Capital (Ko) remains unchanged for all degrees of
leverage.
(ii) The market capitalises the total value of the firm as a whole and noimportance is given for split of value of firm between debt and equity;
(iii) The market value of equity is residue [i.e., Total value of the firm minus market
value of debt)
(iv) The use of debt funds increases the received risk of equity investors, there by ke
increases
(v) The debt advantage is set off exactly by increase in cost of equity.(vi) Cost of debt (Ki) remains constant
(vii) There are no corporate taxes.
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Formula used for NOI Approach
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Formula used for NOI Approach
Value of the Firm [V] = EBIT / Ko
Market Value of Equity [E] = VD
Cost of Equity/ Equity Capitalization Rate [Ke]
= Ee / E or EBITI / V - D
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Assumptions
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Assumptions
a. Information is available at free of costb. The same information is available for all investors
c. Securities are infinitely divisible
d. Investors are free to buy or sell securities
e. There is no transaction costf. There are no bankruptcy costs
g. Investors can borrow without restrictions as the sameterms on which a firm can borrow
h. Dividend payout ratio is 100 percenti. EBIT is not affected by the use of debt
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