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8/14/2019 Fiinancial Management Contd
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Theories of capital structure Theories of capital structure
Net Income ApproachNet Income Approach
Net Operating Income ApproachNet Operating Income Approach
The Traditional Approach The Traditional Approach Modiglianni and Miller ApprachModiglianni and Miller Apprach
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Net Income ApproachNet Income Approach
A firm canA firm can
minimize theminimize the
weighted averageweighted average
cost of capital andcost of capital andincrease the valueincrease the value
of the firm as wellof the firm as well
as market price of as market price of
equity shares byequity shares byusing debtusing debt
financingfinancing to theto the
maximum possiblemaximum possible
extent.extent.
ASSUMPTIONSASSUMPTIONS
The cost of debt is The cost of debt is
less than the costless than the cost
of equityof equity There are no taxes There are no taxes
The risk perception The risk perception
of investors in notof investors in notchanged by thechanged by the
use of debt.use of debt.
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Value of Firm (N I Approach)Value of Firm (N I Approach)
Total Value of firm (V)= S + D Total Value of firm (V)= S + D S= Market Value of equity sharesS= Market Value of equity shares
= Earning available to equity shareholders= Earning available to equity shareholders
Equity Capitalisation rateEquity Capitalisation rate
D= Market Value of debtD= Market Value of debt
And overall weighted avg cost of capital will be calculated as:And overall weighted avg cost of capital will be calculated as:
K K 00== EBIT / VEBIT / V
For example:For example:
(k)(k) A company expects a net income of Rs 80,000. It has RsA company expects a net income of Rs 80,000. It has Rs2,00,000, 8% debentures. The equity capitalisation rate of the2,00,000, 8% debentures. The equity capitalisation rate of thecompany is 10%. Calculate the value of the firm and overallcompany is 10%. Calculate the value of the firm and overallcapitalisation rate according to the Net Income Approachcapitalisation rate according to the Net Income Approach(ignoring income tax)(ignoring income tax)
(l)(l) If the company debt is increased to Rs 3,00,000, what will beIf the company debt is increased to Rs 3,00,000, what will be
the value of the firm and the overall capitalisation rate.the value of the firm and the overall capitalisation rate.
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80,000
24,000
56,000
10%
5,60,000
3,00,000
8,60,000
(b) Net income
Less: interest on 8% debentures of Rs 3,00,000
Earning available to equity shareholders
Equity capitalisation rate
Market value of equity (S)= 56,000 x (100/10)
Market value of debentures (D)
Value of firm (S+D)
Overall cost of capital (EBIT/ V) = 80,000/8,60,000) x 100
= 9.30%
80,000
16,000
64,000
10%
6,40,000
2,00,000
8,40,00
0
(a) Net income
Less: interest on 8% debentures of Rs 2,00,000
Earning available to equity shareholders
Equity capitalisation rate
Market value of equity (S)= 64,000 x (100/10)
Market value of debentures (D)
Value of firm (S+D)
Overall cost of capital (EBIT/ V) = 80,000/8,40,000) x 100= 9.52%
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Net Operating Income ApproachNet Operating Income Approach
Change in capital structure of a companyChange in capital structure of a companydoes not effect the market value of thedoes not effect the market value of thefirm and the overall cost of capital remainsfirm and the overall cost of capital remainsconstant irrespective of the method of constant irrespective of the method of financing.financing.
Increased use of debt increases theIncreased use of debt increases thefinancial risk of the equity shareholdersfinancial risk of the equity shareholdersand hence the cost of equity increases.and hence the cost of equity increases.
On the other hand, the cost of debtOn the other hand, the cost of debtremains constant with the increasingremains constant with the increasingproportion of debt as the financial risk of proportion of debt as the financial risk of lenders is not affected.lenders is not affected.
Thus, the advantage of using the cheaper Thus, the advantage of using the cheapersource of funds i.e. debt is exactl offsetsource of funds, i.e. debt is exactl offset
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Value of Firm (N O- I Approach)Value of Firm (N O- I Approach)
V=EBIT/K V=EBIT/K 00 where, V=Value of firm & K where, V=Value of firm & K 00 is cost of capitalis cost of capital
The market value of equity, according to this approach is The market value of equity, according to this approach is
the residual value which is determined by deducting thethe residual value which is determined by deducting the
market value of debentures from the total market value of market value of debentures from the total market value of the firm.the firm.
S = V - D where, S is Market value of equity, V is Market valueS = V - D where, S is Market value of equity, V is Market value
of firm and D is Market value of debt.of firm and D is Market value of debt.
For example; A company expects a net operating income of RsFor example; A company expects a net operating income of Rs1,00,000. It has Rs 5,00,000, 6% Debentures. The overall1,00,000. It has Rs 5,00,000, 6% Debentures. The overall
capitalization rate is 10%. Calculate the value of the firmcapitalization rate is 10%. Calculate the value of the firm
and the equity capitalization rate (cost of equity).and the equity capitalization rate (cost of equity).
If debenture debt is increased to Rs 7,50,000, what will be theIf debenture debt is increased to Rs 7,50,000, what will be the
effect on the value of the firm and the equity capitalizationeffect on the value of the firm and the equity capitalization
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1,00,000
10%10,00,0
00
5,00,000
5,00,000
Net Operating income
Overall cost of capital
Market value of firm (V) = 1,00,000x(100/10)Less: Market value of debentures (D)
Total Market value of Equity
Equity capitalisation rate or Cost of equity (Ke) is:
(EBIT - I / V - D) = (1,00,000 – 30,000/5,00,000)x100= 14%
If the debt is increased to Rs 7,50,000, the value of the firm shall remain unchanged at Rs10,00,000, the equity capitalization rate willincrease as follows:
Equity capitalization rate (Ke) is as follows:
(EBIT - I / V - D) = (1,00,000 – 45,000/2,50,000)x100
= 22%
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The Traditional Approach The Traditional Approach
This is an intermediate approach This is an intermediate approach
According to this theory, overall costAccording to this theory, overall cost
of capital decreases up to a certainof capital decreases up to a certain
point, remains more or lesspoint, remains more or less
unchanged for moderate increase inunchanged for moderate increase in
debt thereafter, and increases ordebt thereafter, and increases or
rises beyond a certain point.rises beyond a certain point. Thus, the optimum capital structure Thus, the optimum capital structure
can be reached by a proper debt-can be reached by a proper debt-
equity mix.equity mix.
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Value of firm (Traditional Approach)Value of firm (Traditional Approach)
Net operating incomeNet operating income Rs 2,00,000Rs 2,00,000 Total investmentTotal investment Rs 10,00,000Rs 10,00,000
Equity capitalisation rate, if;Equity capitalisation rate, if;(d)(d) The firm uses no debtThe firm uses no debt 10%10%
(e)(e) The firm uses Rs 4,00,000 debenturesThe firm uses Rs 4,00,000 debentures 11%11%
(f)(f) The firm uses Rs 6,00,000 debenturesThe firm uses Rs 6,00,000 debentures 13%13%
Assume that Rs 4 lacs debentures can be raised at 5% rate of Assume that Rs 4 lacs debentures can be raised at 5% rate of interest whereas Rs 6 lacs debentures can be raised at 6% rateinterest whereas Rs 6 lacs debentures can be raised at 6% rateof inerest.of inerest.
2,00,000
36,000
1,64,000
13%
12,61,538
6,00,000
18,61,538
10.7%
2,00,000
20,000
1,80,000
11%
16,36,000
4,00,000
20,36,363
9.8%
2,00,000
2,00,000
10%
20,00,000
20,00,000
10%
Net operating income
Less: Interest
Earning available to equity shareholders(a)
Equity capitalisation rate
Market Value of share (a x 100/captrate)
Market value of debt
Market value of firm
Average cost of capital (EBIT/V)
(c)(b)(a) nodebt
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Modigliani and Miller ApproachModigliani and Miller Approach
If taxes are ignored, it is identicalIf taxes are ignored, it is identical
with Net Operating approach.with Net Operating approach.
If taxes are assumed to exist, it isIf taxes are assumed to exist, it is
similar to the Net Income Approach.similar to the Net Income Approach.
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Point of IndifferencePoint of Indifference
A project under consideration by your company requires a capitalA project under consideration by your company requires a capital
investment of Rs 60 Lakhs. Interest on term loan is 10% p.a. andinvestment of Rs 60 Lakhs. Interest on term loan is 10% p.a. andtax rate is 50%. Calculate the point of indifference for the project,tax rate is 50%. Calculate the point of indifference for the project,
if the debt-equity ratio is insisted by financing agencies 2:1.if the debt-equity ratio is insisted by financing agencies 2:1.
Company has two options, 1) to raise entire amount throughCompany has two options, 1) to raise entire amount through
equity, 2) raising Rs 40 lakhs by way of debt and Rs 20 lakhs byequity, 2) raising Rs 40 lakhs by way of debt and Rs 20 lakhs by
way of equity. The point of indifference would be:way of equity. The point of indifference would be:
{(X-I{(X-I11) (1-t) – PD}/S) (1-t) – PD}/S11 = {(X-I= {(X-I22) (1-t) – PD}/S) (1-t) – PD}/S22 , where; X is point of , where; X is point of
indifferenceindifference
II1,1, II22 is interest under both alternatives, t is tax rate assume to beis interest under both alternatives, t is tax rate assume to be
50%50%
PD is preference dividend and SPD is preference dividend and S1,1, SS22 is amount of equity underis amount of equity under
different alternativesdifferent alternatives
{(X- 0) (1-.5) – 0}/60 = {(X-4) (1-.5) – 0}/20{(X- 0) (1-.5) – 0}/60 = {(X-4) (1-.5) – 0}/20
.5X/60 = .5X – 2/20.5X/60 = .5X – 2/20
10X = 30X-12010X = 30X-120
X = 6X = 6
In case, the firm has EBIT level below Rs 6 lakhs then equityIn case, the firm has EBIT level below Rs 6 lakhs then equityfinancing is preferable to debt financing; but if the EBIT is higherfinancing is preferable to debt financing; but if the EBIT is higher
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Factors Determining the Capital StructureFactors Determining the Capital Structure
1.1. Financial LeverageFinancial Leverage
2.2. Growth and stabilityGrowth and stabilityof salesof sales
3.3. Cost of CapitalCost of Capital
4.4. Cash Flow ability toCash Flow ability toservice debtservice debt
5.5. Nature and size of Nature and size of firmfirm
6.6. ControlControl7.7. FlexibilityFlexibility
8.8. Requirements of Requirements of investorsinvestors
1.1. Capital MarketCapital MarketConditionsConditions
2.2. Assets StructureAssets Structure
3.3. Purpose of financingPurpose of financing
4.4. Period of financePeriod of finance
5.5. Costs of floatationCosts of floatation
6.6. Legal requirementsLegal requirements
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Cost of debtCost of debt
Cost of preference capitalCost of preference capital Cost of equity capitalCost of equity capital
Cost of retained earningCost of retained earning
And weighted average cost of capitalAnd weighted average cost of capitalis the average cost of the costs of is the average cost of the costs of above sources. It is also known asabove sources. It is also known as‘overall cost of capital’.‘overall cost of capital’.
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EVALUATION OFEVALUATION OF
INVESTMENT DECISIONSINVESTMENT DECISIONS
Estimation of Cash FlowsEstimation of Cash Flows
Determining the Rate of Discount orDetermining the Rate of Discount or
Cost of CapitalCost of Capital
Applying the technique of CapitalApplying the technique of Capital
Budgeting to determine the viabilityBudgeting to determine the viability
of Investment Proposalof Investment Proposal
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Types Of Cash FlowsTypes Of Cash Flows
Initial Investment or Cash OutlayInitial Investment or Cash Outlay
Operating Cash Flows or Net AnnualOperating Cash Flows or Net Annual
Cash FlowsCash Flows
Terminal Cash Flows Terminal Cash Flows
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Capital BudgetingCapital Budgeting
TechniquesTechniques Capital budgeting is concerned withCapital budgeting is concerned with
the allocation of the firm’s scarcethe allocation of the firm’s scarce
financial resources among thefinancial resources among the
available market opportunities. Theavailable market opportunities. Theconsideration of investmentconsideration of investment
opportunities involve the comparisonopportunities involve the comparison
of the expected future streams of of the expected future streams of earnings from a project, with theearnings from a project, with the
immediate and subsequent streamsimmediate and subsequent streams
of expenditures for it.of expenditures for it.
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Capital BudgetingCapital Budgeting
TechniquesTechniques Non Discounted MethodNon Discounted Method
(2)(2) Pay Back MethodPay Back Method
(3)(3) Rate of return or Accounting methodRate of return or Accounting method
(4)(4) Urgency MethodUrgency Method Discounted MethodDiscounted Method
(6)(6) Discounted pay back methodDiscounted pay back method
(7)(7)
Net Present Value MethodNet Present Value Method(8)(8) Internal Rate of Return MethodInternal Rate of Return Method
(9)(9) Profitability IndexProfitability Index
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Risk Analysis in Capital BudgetingRisk Analysis in Capital Budgeting
Risk Adjusted Discount RateRisk Adjusted Discount Rate
Certainity Equivalent MethodCertainity Equivalent Method
Sensitivity AnalysisSensitivity Analysis Probability AnalysisProbability Analysis
Standard Deviation methodStandard Deviation method
Decision Tree AnalysisDecision Tree Analysis
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Working Capital ManagementWorking Capital Management
Working Capital is the amount of Working Capital is the amount of
funds necessary to cover the cost of funds necessary to cover the cost of
operating the enterprise.operating the enterprise.
Gross Vs Net Working CapitalGross Vs Net Working Capital
Gross is total of Current AssetsGross is total of Current Assets
Net Working Capital = C.A. – C.L.Net Working Capital = C.A. – C.L. Permanent Vs Temporary WorkingPermanent Vs Temporary Working
CapitalCapital
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Factors affecting WorkingFactors affecting Working
Capital RequirementCapital Requirement Nature of BusinessNature of Business Size of BusinessSize of Business Production PolicyProduction Policy Manufacturing ProcessManufacturing Process
Seasonal VariationsSeasonal Variations Operating cycleOperating cycle Rate of Stock TurnoverRate of Stock Turnover Credit policyCredit policy
Business CyclesBusiness Cycles Rate of growth of BusinessRate of growth of Business Earning capacity and Dividend PolicyEarning capacity and Dividend Policy Price never changesPrice never changes
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Financing of WorkingFinancing of Working
CapitalCapital Permanent Vs Temporary WorkingPermanent Vs Temporary Working
Capital RequirementCapital Requirement
Long Term Vs Short Term SourcesLong Term Vs Short Term Sources
Approaches for determining W.C.Approaches for determining W.C.
financing mixfinancing mix
(d)(d)
Conservative approachConservative approach(e)(e) Aggressive approachAggressive approach
(f)(f) Hedging or Matching approachHedging or Matching approach
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Motives for Holding CashMotives for Holding Cash
Transaction motive Transaction motive
Precautionary motivePrecautionary motive
Speculative motiveSpeculative motive Compensatory motiveCompensatory motive
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Managing Cash flowsManaging Cash flows
Accelerating Cash InflowsAccelerating Cash Inflows
(2)(2) Prompt payment by customersPrompt payment by customers
(3)(3) Quick conversion of payment intoQuick conversion of payment intocashcash
(4)(4) Decentralized collectionsDecentralized collections
(5)(5) Lock box systemsLock box systems Delaying Cash OutflowsDelaying Cash Outflows
(7)(7) Paying on last datePaying on last date
(8)(8) Centralization of paymentsCentralization of payments
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Investment of SurplusInvestment of Surplus
FundsFunds Treasury bills Treasury bills
Certificate of depositsCertificate of deposits
Inter-corporate depositsInter-corporate deposits Commercial papersCommercial papers
Money market mutual fundsMoney market mutual funds
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ReceivablesReceivables
ManagementManagement Receivables represent amountsReceivables represent amounts
owed to the firm as a result of saleowed to the firm as a result of sale
of goods or service on credit in theof goods or service on credit in the
ordinary course of business.ordinary course of business. Cost of maintaining receivablesCost of maintaining receivables
(iii)(iii) Cost of financing receivablesCost of financing receivables
(iv)(iv) Cost of collectionCost of collection
(v)(v) Bad debtsBad debts
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Factor Affecting the Size of Factor Affecting the Size of
ReceivablesReceivables
Size of credit salesSize of credit sales
Credit policyCredit policy
Terms of trade Terms of trade Expansion plansExpansion plans
Relation with profitsRelation with profits
Credit collection effortsCredit collection efforts Habits of cutomersHabits of cutomers
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Dimension of ReceivablesDimension of Receivables
ManagementManagement
Forming a Credit PolicyForming a Credit Policy
Executing a Credit PolicyExecuting a Credit Policy
Formulating and Executing CollectionFormulating and Executing Collectionpolicypolicy