Anuj Bhatia BBA (Gold Medalist), M.Com (Gold Medalist), CA(Inter.),

CMA(Inter.), GSET, UGC NET-JRF, Ph.D (Pur.)]

Research Scholar,

Department of Business Studies,

Sardar Patel University

Introduction and Relevance Finance is the life blood of the business.

Without finance no business or enterprise can be commenced. From the beginning till its end, finance is constantly required.

For implementation of various plans and for achieving goals of business, finance is essential.

Any profitable and ambitious plan becomes a dream in the absence of finance.

Shortage of finance will disturb the production planning. Similarly excess finance will become burden for business enterprises for keeping it idle (unutilized).

In business enterprises necessities of more and more finance are increasing for purchase of raw materials, payment of wages and for payment of selling and other administrative expenses. Besides, finance is required for modernization and development of business.

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A Brief History….. Financial management is that managerial area which

is concerned with the planning and controlling of the firm's financial resources.

Though it was a branch of economics till 1890, as a separate managerial area or discipline it is of recent origin. Still, it has no unique body of knowledge of its own, and draws heavily on economics for its theoretical concepts even today.

In the early years of its evaluation it was treated synonymously with the raising of funds. In the current literature pertaining to financial management, in addition to procurement of funds, efficient use of resources is universally recognized.

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What is Financial Management? Financial management is the ways and means of

managing money i.e., the determination, acquisition, allocation and utilization of financial resources usually with the aim of achieving some particular goals or objectives.

In the words of Howard and Upton, “Financial management is the application of planning and control function to the finance function.”

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According to Ezra Solomon, “Financial management is concerned with the efficient use of an important economic resource, namely, capital funds.”

In a nutshell, Financial Management is the planning, organizing, directing and controlling of the procurement and utilization of funds and safe disposal of profit to end that individual, organizational and social objectives are accomplished.

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Scope of Financial Management Traditional Approach of Finance Function In common definition the concept of finance function is very narrow and traditional i.e., Acquisition of finance according to the objectives of business. In traditional approach of finance, the following activities are included: Estimates for requirement of finance are made by considering

the business activities After estimating financial requirements sources for

procurement of finance are thought of by comparative study of ordinary shares, preference shares, Debentures, loans, bank overdrafts, cash credits, public deposits etc.

Function of procurement of finance should be completed at less expense and in short period.

Management should see that sources of finance should not be such that may be burdensome in future.

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Modern Approach of Finance Function According to modern concept finance function includes both the aspects i.e. acquisition and utilization of finance. From the above definition it can be clearly said that modern concept of finance is much wider than traditional approach. For making effective use of finance, administration finance is treated as more important. It includes following matters. Procurement of finance: After obtaining the estimate for present and future financial

requirement of the unit, management will try to obtain it at minimum cost, and convenient conditions, from proper place. At the time of procurement of finance ratio of fixed and working capital is considered. This function is adopted both by traditional approach & modern approach.

Financial Planning: Decision regarding, how much percentage in which plan and when the use of procured finance is to be made etc. is called finance planning and it is accepted by modern approach of finance. Because of this idea maximum use of procured finance is made possible.

Distribution of Income: The question of distribution of income obtained from business activities is also accepted by modern approach. Question regarding distribution of income such as how much amount is to be distributed as dividend, how much amount is to be carried over as reserve fund, how much amount will be paid as taxes has much and is to be re invested are very important.

Financial control: The control can be effectively exercised only by comparing the actual performance with the standards set in the plans.

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Goals/Objectives of Financial Management Profit Maximization:

According to this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided.

In specific operational terms, as applicable to financial management, the profit maximization criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented to the maximization of profits.

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Arguments for Profit Maximization Profit maximization as an objective of financial management can be justified on following grounds:

It is Rational: Profit is a device that transforms the selfishness of mankind into channels of useful service.

Test of Business Performance: The profit earned by any business enterprise is the result of its managerial efficiency. It is the ultimate test of business performance.

Maximum Social Welfare: It ensures maximum social welfare by providing maximum dividend to shareholders, timely payment to creditors, more wages and incentives to workers, more employment to society and maximum return to owners.

Basis of Decision Making: All business decisions are taken keeping the profit element in mind.

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Objections Against Profit Maximization Profits maximization suffers from certain limitations:

It is vague (out of reality / unclear)

It ignores timing of returns

It ignores risk

Definition of Profit / It is Vague The precise meaning of profit max is unclear. The definition of profit is ambiguous (confusing). Does it mean short term or long term profits? Does it refer profit before or after tax? Total profit or profit per share? Does it mean total operating profit or profit occurring to shareholders? Thus profit maximization is vague (not related) terminology.

Time Value of Money /It Ignores Timing of Returns: The profit maximization objective does not make a distinction between returns in different time periods. It values benefits received today and benefits received after a period as the same.

Uncertainty of Returns/Ignores Risk The benefits are always depending on future and as we know that future is uncertain due to that risk arises and that risk is not considered in profit maximization.

Thus from above discussion it is clear that the profit maximization objective is not having reliable parameters.

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Shareholders' Wealth Maximization

It is also termed as value maximization or net present worth maximization. In current academic literature value maximization is almost universally accepted as an appropriate operational decision criterion for financial management decisions.

What is meant by Shareholders' Wealth Maximization (SWM)? SWM means maximizing the pet present value (or wealth) of a course of action to shareholders. The net present value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs.

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Superiority of Wealth Maximization After having discussed the objectives of financial management, now the question arises of the choice i.e., which should be the goal of financial management? Profit maximization or wealth maximization? In present day changed circumstances, wealth maximization is better objective because it has following points in its favour: It is Clear

Wealth Maximization measures income in terms of cash flows, and avoids the ambiguity associated with accounting profits because income from investment is measured on the basis of cash flows rather than accounting profits.

It Recognizes the Time Value of Money It recognizes the time value of money by discounting the expected income of different years at a certain discount rate (cost of capital).

It Considers Risk and Uncertainty The objective of shareholders' wealth maximization takes care of the questions of the timing and risk of the expected benefits. These problems are handled by selecting an appropriate rate (the shareholders' opportunity cost of capital) for discounting the expected flow of future benefits.

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Financial Management Decisions Executive Finance Functions:

1. Investment Decision

2. Financing Decision

3. Dividend Decision

4. Liquidity Decision

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Incidental/Routine Finance Functions:

1. Supervision over Cash Receipts

2. Cash Disbursements

3. To keep records of Cash

4. To tally cash and Bank Balance

5. Supervision of Bills

6. Safeguarding Valuable papers

7. Insurance policies

8. Filling (Record Keeping)

9. To prepare reports

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Answer (A) procurement of funds and their effective utilization

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Answer (c) I correct, II incorrect

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Cost of Capital The primary function of every financial manager is to

arrange for adequate capital for the firm. A business firm can raise capital from various sources such as equity and or preference shares, debentures, retained earnings etc. This capital is invested in different projects of the firm for generating revenue. On the other hand, it is necessary for the firm to pay minimum rate of return on each source of capital. Therefore, each project must earn so much of the income that a minimum return can be paid to these sources or suppliers of capital. The concept used to determine this minimum capital is called “Cost of Capital”. The management evaluates various alternative sources of finance on this basis and selects the best one.

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Which are the two basic concepts in FM??

A. Cost and Expenses

B. Risk and Return

C. Debit and Credit

D. Receipt and Payments

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Ans: (B) Risk and Return

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Market Value of the firm is a result of

A. Investment Decision

B. Financing Decision

C. Working Capital Mgt

D. Risk-Return Trade-off

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Ans: (D) Risk Return Trade-off

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Which of the following represent financing decision?

A. Designing Capital Structure

B. Declaring Dividend

C. Paying Interest on loan

D. Investment in New Asset

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CONCEPT OF COST OF CAPITAL

The term cost of capital refers to the minimum rate of return a firm must earn on its investments. This is in consonance with the firm’s overall object of wealth maximization. Cost of capital is a complex, controversial but significant concept in financial management.

“The cost of capital is a cut off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock”.

-James C. Van Horn

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FEATURES OF COST OF CAPITAL i) Not a cost as such:

In fast the cost of capital is not a cost as such, it is the rate of return that firm requires to earn from its projects. That is why, it is also known as “hurdle rate”.

ii) It is the minimum rate of return:

A firm’s cost of capital is that minimum rate of return which will atleast maintain the market value of the share.

iii) It comprises three components:

K = ro+ b + f

Where,

k = Cost of Capital;

ro= Return at zero risk level (Risk Free Rate of Return);

b = Premium for business risk, which refers to the variability in operating profit (EBIT) due to change in sales.

f = Premium for financial risk which is related to the pattern of capital structure.

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SIGNIFICANCE OF COST OF CAPITAL I) CAPITAL BUDGETING DECISIONS

II) CAPITAL STRUCTURE DECISIONS

III) EVALUATION OF FINANCIAL PERFORMANCE

IV) COMPARATIVE STUDY OF SOURCES OF FINANCING

V) EXPECTED RETURN AND RISK

VI) FINANCING AND DIVIDEND DECISIONS

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CLASSIFICATION OF COST OF CAPITAL

Cost of capital can be classified as follows:

i) Historical Cost and future Cost:

Historical costs are book costs relating to the past, while future costs are estimated costs act as guide for estimation of future costs.

ii) Specific Costs and Composite Costs:

Specific accost is the cost if a specific source of capital, while composite cost is combined cost of various sources of capital. Composite cost, also known as the weighted average cost of capital, should be considered in capital and capital budgeting decisions.

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iii) Explicit and Implicit Cost:

Explicit cost of any source of finance is the discount rate which equates the present value of cash inflows with the present value of cash outflows. It is the internal rate of return.

Implicit cost also known as the opportunity cost is of the next best opportunity foregone in order to take up a particular project. For example, the implicit cost of retained earnings is the rate of return available to shareholders by investing the funds elsewhere.

iv) Average Cost and Marginal Cost:

An average cost is the combined cost or weighted average cost of various sources of capital. Marginal cost of refers to the average cost of capital of new or additional funds required by a firm. It is the marginal cost which should be taken into consideration in investment decisions.

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COST OF DEBT (Kd) Cost of debt is the contractual interest rate adjusted for further tax liability of the firm. To ascertain the actual Kd, the relation of interest rate is adjusted with the actual amount realized or the net proceeds from the issue of debentures. Net Proceeds is equal to the issue price less all flotation cost.

Flotation cost is the cost of issuing debentures or obtaining loans such as printing and selling of prospectus, advertisement, stamp duty, underwriting commission and brokerage, postage etc.

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PERPETUAL / IRREDEEMABLE DEBT

(a) Debt Issued At Par

Kd = Int. (1 – t)

Where, Kd is the cost of debt

Int. = Debenture interest rate

t = tax rate

(b) Debt Issued At Premium or Discount

Kd = Int. (1 – t)

NP

NP = Net Proceeds

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Kd = Int. (1-t) + [F – P / n]

[F + P / 2 ]

F = Maturity/Redemption Value

P = Net Proceeds

Net Proceeds:

(A) At Par = Face Value – Flotation Cost (f)

(B) At Premium = Face Value + Premium – Flotation Cost (f)

(C) At Discount = Face Value – Discount – Flotation Cost (f)

COST OF REDEEMABLE DEBT If the debentures are redeemable after the expiry of a fixed period the effective cost of debt is calculated by using the following formula:

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COST OF PREFERENCE CAPITAL (Kp)

In case of preference share dividend are payable at a fixed rate. However, the dividends are not allowed to be deducted for computation of tax. So no adjustment for tax is required just like debentures, preference share may be perpetual or redeemable. Future, they may be issued at par, premium or discount.

PERPETUAL PREFERENCE CAPITAL

If Preference Share is issued at Par Kp = Rate of Dividend on Preference Share

If Preference Share is not issued at par Kp = Div / NP

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REDEEMABLE PREFERENCE SHARES

In the case of redeemable preference shares, the cost of capital is the discount rate that equals the net proceeds of sale of preference shares with the present value of future dividends and principal repayments. It can be calculated using the following formula:

Kp = Div + [ F – P / n ]

[ F + P / 2]

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COST OF EQUITY CAPITAL (Ke) Cost of Equity is the expected rate of return by the equity shareholders. Some argue that, as there is no legal for payment, equity capital does not involve any cost. But it is not correct. Equity shareholders normally expect some dividend from the company while making investment in shares. Thus, the rate of return expected by them becomes the cost of equity. Conceptually, cost of equity share capital may be defined as the minimum rate of return that a firm must earn on the equity part of total investment in a project in order to leave unchanged the market price of such shares.

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Dividend Yield / Dividend Price Approach-

According to this approach, the cost of equity will be that rate of expected dividends which will maintain the present market price of equity shares. It is calculated with the following formula:

Ke = D1/NP (for new equity shares)

Or

Ke = D1/MP (for existing shares)

Where,

Ke = Cost of equity

D1 = Expected dividend per share

NP = Net proceeds per share

MP = Market price per share

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Dividend Yield Plus Growth In Dividend Methods

According to this method, the cost of equity is determined on the basis if the expected dividend rate plus the rate of growth in dividend. This method is used when dividends are expected to grow at a constant rate.

Cost of equity is calculated as:

Ke = D1 + g (for new equity issue)

NP

Where,

D1 = Expected dividend per share at the end of the year. [D1 = Do (1 + g)]

NP = Net proceeds per share

g = Growth in dividend

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Earnings Yield Method

According to this approach, the cost of equity is the discount rate that capitalizes a stream of future earnings to evaluate the shareholdings. It is called by taking earnings per share (EPS) into consideration. It is calculated as:

i) Ke = Earnings per share / Net proceeds = EPS / NP [For new share]

ii) Ke = EPS / MP [ For existing equity]

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Capital Asset Pricing Model (CAPM)

According to this model, cost of equity is the risk free rate of return plus a premium for risk. It is calculated as under:

Ke = Rf + β (Rm – Rf)

Where,

Rf = Risk Free Rate of Return

β = Beta of securities (Sensitivity of returns with market return)

Rm = Return on Market Portfolio

(Rm – Rf) = Risk Premium

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COST OF RETAINED EARNINGS (Kr) Retained earnings refer to undistributed profits of a firm. Out of the total earnings, firms generally distribute only past of them in the form of dividends and the rest will be retained within the firms. Since no dividend is required to paid on retained earnings, it is stated that ‘retained earnings carry no cost’. But this approach is not appropriate. Retained earnings has the opportunity cost of dividends in alternative investment becomes cost if retained earnings.

Kr = Ke (If there is no personal tax or brokerage)

Ke = Ke ( 1 – tp) (1 – B) Where, Kr = Cost of Retained Earnings

Ke = Cost of Equity

tp = Rate of Personal Tax

B = Cost of Purchasing New Securities or Brokerage Cost.

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WEIGHTED AVERAGE COST OF CAPITAL (Ko) It is the average of the costs of various sources of financing. It is also known as composite or overall or average cost of capital.

After computing the cost of individual sources of finance i.e the specific cost, the weighted average cost of capital is calculated by putting weights in the proportion of the various sources of funds to the total funds.

Weighted average cost of capital is computed by using either of the following two types of weights:

Market value

Book Value

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What do you understand by Weighted Average Cost of Capital?

The composite or overall cost of capital of a firm is the weighted average of the costs of various sources of funds. Weights are taken in proportion of each source of funds in capital structure while making financial decisions. The weighted average cost of capital is calculated by calculating the cost of specific source of fund and multiplying the cost of each source by its proportion in capital structure. Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.

Ko = Ke. We + K d.W d + K p.We + K r.Wr

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Cost of Capital Refers to-

A. Dividend

B. Interest expense

C. Floatation Cost

D. Required Rate of Return

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Ans : (D) Required ROR

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Which Source has an implicit COC?

A. Equity Shares

B. Preference Shares

C. Debentures

D. Retained Earning

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Ans: Retained Earning

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COC on Govt. Securities is also known as-

A. Risk Free Rate of Interest

B. Maximum ROR

C. Rate of Int. of FD

D. All of the above

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Ans: Risk Free Rate of Interest

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Which Cost requires tax adjustment?

A. Cost of Equity

B. Cost of Debt

C. Cost of Pref.

D. Cost of Reserves

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Cost of Debt

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Marginal COC is the cost of:

A. Additional Sales

B. Additional Funds

C. Additional Interest

D. None of the Above

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Additional Funds

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Answer (B) Explicit Cost of Capital

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Answer (D) Money paid to SEBI for permission to acquire Capital

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Capital Structure INTRODUCTION

Capital Structure refers to the composition of long-term funds such as equity shares, preference shares, debentures, loans in the capitalization of a company. The essence of capital structure is to determine the relative proportion of debt and equity. Equity means Owner’s Funds and Debt means Long Term Borrowings. The Capital Structure Decision is significant financial decision because it affects the shareholders return and risk and consequently affects the market value of shares.

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MEANING AND DEFINITIONS

Capital Structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations.

In capital structure, it is decided that what portion of total required capital be raised in the form of shares and what portion in debt.

In words of Weston and Brigham, “Capital Structure is the permanent financing of the firm, represented by long-term debt, preferred stock and net-worth.”

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Factors Affecting Capital Structure

Tax benefit on debt Flexibility Control Industry Life Cycle Industry Leverage Ratio Company Characteristics Legal Requirements Regularity and Certainty of Income Capital Market Conditions Cost of Financing

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CONCEPT OF OPTIMUM CAPITAL STRUCTURE The optimum or balanced capital structure implies the most economical and safe proportion between various sources of funds. Optimum Capital Structure may be defined as that mix of debt and equity which maximized the value of company and minimizes the cost of capital

Profitability It should minimize the cost of financing and maximize the EPS.

Flexible A good capital structure is flexible, i.e. can be modified as and when required to

grab the profitable opportunities.

Conservatism The debt content in capital structure should not exceed the maximum limit the

firm can bear.

Solvency The optimum capital structure should be such that the company does not run the

risk of becoming insolvent.

Control There should be minimum risk of loss or dilution of the control of company.

Minimum Risk A good capital structure offers lowest risk to the investors by safeguarding their

interest by a judicious proportion between debt and equity.

Minimum Cost

of Capital

A properly designed capital structure has a minimum cost of capital which offers

highest value of firm’s share.

The following are the features of an optimum capital structure:

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CAPITAL STRUCTURE: THEORIES

Two Kinds of Funds There are only two sources of funds i.e., debt and equity. (No

preference share capital).

Constant Total Assets The total assets of the firm are given and remain constant.

Homogeneous

Investors Expectations

The investors have the same subjective probability distribution of

expected earnings.

100% Dividends All earnings are distributed as dividends to shareholders. There is no

retained earnings.

Constant Business

Risk

Business Risk is constant and is not affected by financing mix decisions.

No Taxation There are no corporate and personal taxes.

Low Cost of Debt Cost of debt is lower than cost of equity.

Perpetual Life The Firm has a perpetual life.

GENERAL ASSUMPTIONS OF CAPITAL STRUCTURE THEORIES

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NOI Net Operating Income/Operating Profit/ EBIT

NI Net Income, Earnings for Equity Shareholders,

NOI – Interest on debt

Ke Cost of Equity Capital

Kd Cost of Debt

KO Overall Cost of Capital / WACC

KO = NOI / V

KO = Ke . We + Kd . Wd

S Value of Equity Share Capital (Shareholders Funds)

S = NI / Ke

B Value of Debt (Borrowings)

B = Interest / Kd

V Value of Firm

V = S + B

V = NOI / KO

SYMBOLS AND DEFINITIONS:

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NET INCOME (NI) APPROACH

[CAPITAL STRUCTURE IS RELEVANT, IT MATTERS]

Developed by David Durand

It is relevance theory, i.e. Capital Structure decision is relevant to the market value of the firm.

A change in Debt proportion in capital structure will lead to a corresponding change in the cost of capital as well as total value of the firm.

In other words, A change in proportion of capital structure will lead to a corresponding change in Cost of Capital and Value of the Firm.

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Assumptions of NI Approach:

1. There are no taxes.

2. Cost of debt is less than the cost of equity.

3. Use of Debt in the capital structure does not change the risk perception of the investors.

4. Cost of Debt and Cost of Equity Remains Constant.

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The essence of NI approach is that the firm can increase its value by lowering its overall cost of capital by increasing proportion of debt in the capital structure. According to assumptions, increase of debt in capital structure will not change the Cost of Equity, i.e. Ke remains constant. As a result, the use of cheaper debt will lower down the overall cost of capital (Ko). Thus, use of more and more debt will increase the value of the Firm. Thus, as per NI Approach, Capital structure does matter. The value of firm in NI Approach is ascertained as follows: V = S + B V = Value of Firm S = Market Value of Equity = NI / Ke B = Market Value of Debt

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NET OPERATING INCOME (NOI) APPROACH

[CAPITAL STRUCTURE IS IRRELEVANT, IT DOES NOT MATTER]

Suggested by David Durand.

Irrelevance of Capital Structure, i.e. there is no relation between the Capital Structure, Firms Value and Cost of Capital.

Any change in Debt will not lead to a change in the Value of the Firm.

They are independent of financial leverage.

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Assumptions of NOI Approach: 1.Cost of Capital remains constant

2. Split between Debt and Equity is not important.

3. The market value of equity is residue

4. The use of Debt increase the risk of equity investors , thereby the cost of equity increases with the use of Debt.

5. The Debt advantage is Set-off exactly by an increase in cost of equity.

6. The cost of Debt remains Constant.

7. There are no Corporate Taxes.

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According to NOI Approach, the market value of the firm is not affected by the capital structure changes. The use of less costly debt increases the risk of share-holders. This causes the cost of equity (Ke) to increase. Thus, advantage of debt is exactly off-set by the increase in cost of equity. In this way a change in leverage will not lead to any change in the value of the firm as well as overall cost of capital (Ko).

As the total value of the firm is unaffected by its capital structure, there does not exist any optimum capital structure.

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Figure shows that the cost of debt and the overall cost of capital are constant for all levels of leverage. As the debt proportion or the financial leverage increases, the risk of the shareholders also increases and thus the cost of equity capital also increases. However, the increase in Ke, is such that the overall value of the firm remains same. Thus, as per NOI Approach, Capital Structure does not matter.

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MODIGLIANI-MILLER (MM) APPROACH

[CAPITAL STRUCTURE IS IRRELEVANT, IT DOES NOT MATTER]

The MM Approach relating to the relationship between the capital structure, cost of capital and valuation is akin to the NOI Approach. The NOI approach is conceptual and does not provide operational justification for the irrelevance of the capital structure. The MM Approach supports the NOI Approach relating to the independence of the cost of capital and degree of leverage at any level of debt-equity ratio.

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Assumptions of MM: Perfect Capital Markets: The implications of perfect capital

market are that: Securities are infinitely divisible Investors are free to buy/sell securities Investors can borrow without any restrictions on same terms and

conditions as firm can There are no transaction cost Information is perfect, that is, each investor has the same

information which is readily available to him without cost Investors behave rationally

The WACC (Ko) is constant All investors have same expectation of firm’s operating income,

i.e., EBIT Business Risk is equal among all firms operating in same

environment Dividend payout ratio is 100% There are no taxes. However, this assumption is removed later.

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Basic Propositions

There are three basic propositions of MM Approach

Proposition-I The overall cost of capital (Ko) and the Value of firm (V) are independent of its capital structure. The Ko and V are constant for all degrees of leverages. The total value is given by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class.

Proposition-II Ke increases in a manner to offset exactly the use of less expensive source of funds represented by debt.

Proposition-III The cut-off rate for investment purpose is completely independent of the way in which an investment is financed.

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Arbitrage Process

The operational justification for MM Approach is the arbitrage process. The term “arbitrage” refers to an act of buying an asset/security in one market, at lower price and selling it in another, at higher price. As a result, equilibrium is restored in the market price of security in different markets.

The essence of arbitrage process is the purchase of undervalued securities and sale of overvalued securities in market, which are temporally out of equilibrium. The arbitrage process is essentially a balancing operation. It implies that a security cannot sell at different prices.

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The behavior of investor will have effect of (i) increasing the share prices (value) of firm whose shares are being purchased; and (ii) lowering the share prices (value) of the firm whose shares are being sold. This will continue till the market prices of the two firms become identical.

The arbitrage process ensures to the investors the same return at lower outlay as he was getting by investing in firm whose total value was higher and yet, his risk has not increased. This is so because the investors would borrow in a proportion to the degree of leverage of the present firm. The use of debt by investor for arbitrage is called ‘home made’ or ‘personal leverage’. The essence of arbitrage argument of MM is that the investors are able to substitute personal leverage for corporate leverage that is use of debt by the firm itself.

Thus, MM shows that the value of levered firm can neither be greater nor smaller than that of an unlevered firm. There is neither an advantage nor disadvantage in using debt.

Thus according to MM, Capital Structure does not matter.

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TRADITIONAL APPROACH

[INTERMEDIATE APPROACH]

The traditional capital structure theory has been popularized by Ezra Solomon. This view is also known as Intermediate Approach, because it is a compromise between NI and NOI Approach.

According to this Approach, the value of the firm can be increased or Cost of capital can be reduced by a judicious mix of debt and equity.

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Stage I : Increasing Value In this stage, the cost of equity remains constant. The cost of capital (Ko) declines with the leverage, because debt capital is cheaper than equity capital within reasonable limits.

Stage II: Optimum Value The cost of capital becomes constant, because the benefit of cheaper debt is exactly balanced with the increase in cost of equity. Within that range, WACC (Ko) will be minimum, and the maximum value of the firm will be obtained.

Stage III: Declining Value Finally, in this stage, the overall cost increases with the leverage as both cost of equity and cost of debt increases. Beyond the acceptable limit of leverage, the value of firm decreases as WACC (Ko) increases with leverage. This happens because the investors perceive a high degree of financial risk and demand a higher equity-capitalization rate (Ke), which exceeds the advantage of low-cost debt.

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Leverage Analysis The term leverage refers to an increased means of

accomplishing some purpose. Leverage is used to lifting heavy objects, which may not be otherwise possible. In physics, Leverage means, “the mechanical advantage gained by the use of levers, i.e. raise a given thing with less effort.”

James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed cost or fixed return.”

However in area of finance, the term leverage means “the firms ability to use fixed cost assets or funds to increase the return to the shareholders.”

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Risk exists because of lack of certainty. Risk is to a firm can be divided into 2 categories: Business Risk and Financial Risk.

Business Risk: It is the variability of EBIT. It results because of changes in business environment. It is measured by calculating Operating Leverage. It is not affected by the form of financing.

Financial Risk: It refers to the variability of EBT. It is affected by the use of funds bearing fixed interest. It can be avoided by not using debt in capital structure. It is measured by using Financial Leverage. It is affected by form of financing.

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There are 3 types of leverages:

Operating Leverage

Financial Leverage

Combined Leverage

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Financial Leverage Financial Leverage is related to financing activities of a

firm. From the point of view capital structure, a firm can raise funds from the sources which carry fixed financial cost and which do not carry fixed financial costs.

Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders.

Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders.

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Trading on Equity Meaning of Trading on Equity

When a company uses fixed interest bearing capital along with owned capital in raising finance, is said “Trading on Equity”. (Owned Capital =Equity Share Capital + Free Reserves ) Trading on equity represents an arrangement under which a company uses funds carrying fixed interest or dividend in such a way as to increase the rate of return on equity shares.

Definitions:

In words of Gerstenberg, “When a person or a corporation uses borrowed capital as well as owned capital in the regular conduct of its business, he or she is said to be trading on equity” While Guthmann and Dougall have said, “the use of borrowed funds or preferred stock for financing is known as trading on equity.”

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Answer (B) Net Operating Income Approach

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Answer (D) Transferability

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Answer (A) Ratio between different forms of capital

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Answer (D) All the Above

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Answer (A) Debt Capital

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Answer (B) Magnify the fluctuation in EBT

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Answer (B) Increase Net Equity Return

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Answer (b) Trading on Borrowed Funds

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Capital Budgeting CB is the Firms decision to invest its current

funds most efficiently in the long term asset in anticipation of an expected flow of benefits over a series of years.

They are undertaken for:

1. New Projects

2. Expansion Projects

3. Diversification projects

4. Replacement/ Modernization Projects

5. R & D Projects

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Process of CB 1. Idea Generation

2. Evaluation or Analysis

3. Selection

4. Financing the Selected Project

5. Execution or Implementation

6. Review of the project

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Significance of Capital Budgeting Decisions

Investment decisions require special attention because of following reasons:

They influence the firm’s growth in long run.

They affect the risk of firm.

They involve commitment of large amount of funds.

They are irreversible.

They are most difficult to make.

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Types of Capital Budgeting Decisions

A firm may face several investment proposals for consideration. It may adopt one of them, some of them or all of them depending upon whether they are independent or dependent or mutually exclusive. The firm may face basically with three types of major decisions:

Accept/Reject Decisions

Mutually exclusive Project Decisions

Capital Rationing Decision

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Capital Rationing Decision

In the real world, there is a constraint to the supply of capital particularly from external sources. In view of the availability of limited amount of capital, a company sets an absolute limit on the extent of capital budget for a year. Such a state or situation is called as capital rationing. Under capital rationing the company has a fixed capital budget that it may not exceed. So, when the company has more acceptable projects than it can afford to invest, it will rank the available projects in descending order of profitability index or the rate of expected returns and then will decide on the best ones.

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Techniques of CB 1. Traditional Techniques

1. PBP

2. ARR

2. Modern Techniques 1. NPV

2. PI

3. IRR

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Answer (c) Pay Back Period

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Answer (B) Present Value

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Answer (B) iii, iv, i, ii

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Answer (A) I, ii, iii, iv, v, vi

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Answer (B) Capital Budget

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Working Capital Management MEANING OF WORKING CAPITAL

Management of working capital refers to the management of current assets as well as current liabilities. The major thrust, of course, is on the management of current assets. This is understandable because current liabilities arise in the context of current assets.

Thus, working capital management is an attempt to manage and control the current assets and the current liabilities in order to maximize profitability and proper liquidity in business.

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Concepts of Working Capital

There are two concepts of working capital – gross and net.

Gross Working Capital

It refers to the firm’s investment in current assets. Current assets are the assets which can be converted into cash within an accounting year and include cash, short – term securities, debtors (accounts receivable or book debts), bills receivable and stock (inventory).

Net Working Capital

Working Capital = Current Assets – Current Liabilities

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Objectives of Working Capital Management

There are two-fold objectives of the management of working capital.

Maintenance of working capital at appropriate level, and

Availability of ample funds as and when they are needed.

In the accomplishment of these two objectives, the management has to consider the composition of current assets pool. The working capital position sets the various policies in the business with respect to general operations like purchasing, financing, expansion and dividend etc.

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Types of Working Capital

Working Capital can be divided into two categories on the basis of time:

1. Permanent Working Capital

2. Temporary or Variable Working Capital

1) Permanent, Fixed or Regular Working capital

This refers to that minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities. In other words, it represents the current assets required on a continuing basis over the entire year. Tandon Committee has referred to this type of working capital as “core current assets”.

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2) Fluctuating, Temporary, Variable or Seasonal Working Capital.

The amount of such working capital keeps on fluctuating from time to time on the basis of business activities. In other works, it represents additional current assets required at different times during the operating year. For example, extra inventory has to be maintained to support sales during peak sales period.

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Factors Affecting WC 1. Nature of Business

2. Size of Business

3. Production Cycle

4. Production Policy

5. Terms of Purchase and Sales

6. Dividend Policy

7. Efficiency

8. Business cycle

9. Availability of credit

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Approaches for Financing Current Assets Matching Approach

Life of Source of finance is matched with the life of Current Asset.

Conservative Approach

Current Assets are financed through long term Finance.

Aggressive Approach

Current Assets are Financed by short terms sources of Finance.

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Operating/Manufacturing Cycle 1. Cash into RM

2. RM into WIP

3. WIP into FG

4. FG into Sales

5. Sales into Debtors/Cash

6. Debtors into Cash (than again step 1 and so on………….. )

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Answer (c) Conservative Approach

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Answer (D) Expenditure to acquire Capital

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Answer (B) ii, i, iv, iii

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Answer (C) i, v, ii, iii, iv

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Dividend Policy Dividend- The portion of company's net earnings

that is paid out of the ordinary shareholders.

Dividend Policy- It is the a Policy of firm in distributing net earnings to equity shareholders.

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Types of Dividend Policy Stable Dividend Policy

Constant DPS

Constant D/P ratio

Constant Dividend + Extra Dividend

Irregular Dividend Policy

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Forms of Dividend Cash Dividend

Scrip Dividend

Bond Dividend

Property Dividend

Stock Dividend (Bonus)

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Dividend Theories Walters Model

Gordon Model

MM Model

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Walters Model Assumptions:

1. Finance through retained earnings

2. r and k are constant

3. 100% D/P or 100% retention

4. EPS and DPS are constant

5. The firm has perpetual life

P = [D + (r/k)(E-D)]/ K

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Growth Firm

r>k, 100% retention

Normal Firms

r=k, no optimum dividend policy

Declining firms

r<k, 100% D/P ratio

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Gordon Model The share price is dependent on dividend.

Assumptions

All equity firms

Financed by retained earnings

r and Ke are constant

Ke >g

Life of firm is perpetual

There are no taxes

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P = E(1-b)/ k –b.r

Growth Firm

r>k, 100% retention

Normal Firms

r=k, no optimum dividend policy

Declining firms

r<k, 100% D/P ratio

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MM Hypothesis The value of the firm is determined by basic

earning power and business risk.

Assumptions Perfect Capital Markets

No Taxes

Fixed Investment Policy

Risk and Uncertainty does not exist

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How to find value?

1. Find MP at the end of the period

2. Find new shares to be issued to finance new investment

3. Value of the Firm.

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Answer (B) James E Walter

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Answer (D) Industry Practice

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Answer (B) has no impact on the value of the firm

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Answer (D) I correct, II incorrect

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Other

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Answer (D) All the Above

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