Financial Decision Making Session 6: 23 rd November 2009

Financial Decision Making

Session 6: 23rd November 2009

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Topics to be covered

EBIT-EPS Analysis

Financial Decision Making

Capital Structure Analysis

Dividend Decision

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EBIT-EBT ANALYSIS

EBIT-EPT Analysis

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EBIT-EPS Analysis

Also called EBIT-EPS breakeven or indifference analysis

Objective: Analysis of the effect of financing alternatives on earnings per share

The break-even point is the EBIT level where EPS is the same for two (or more) alternatives

• Formula: Calculate EPS for a given level of EBIT at a given financing structure

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EBIT-EPS Analysis

Zydus Cadila currently has a following capital structure

1 million equity shares of Rs.10 each

Tax rate is 50%

Zydus plans to raise additional 10 million for expansion plan. It has two options

» Equity issue

» Debt: Issue of Debenture at 14% interest rate.

What will be the EPS under two plans if EBIT is Rs.4 million and Rs.2 million ?

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Example: Zydus Cadilla

Equity

financing

DEBT

financing

EBIT

20,00,000

EBIT

20,00,000

Interest @ 14% on 10 million 0 14,00,000

Earnings before tax 20,00,000 6,00,000

Tax @ 50% 10,00,000 3,00,000

Profit after tax 10,00,000 3,00,000

Number of Equity shares 20,00,000 10,00,000

EPS 0.5 0.3

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Equity financing DEBT financing

EBIT

20,00,000

EBIT

40,00,000

EBIT

20,00,000

EBIT

40,00,000

Interest @ 14% on 10 million 0 0 14,00,000 14,00,000

Earnings before tax 20,00,000 40,00,000 6,00,000 26,00,000

Tax @ 50% 10,00,000 20,00,000 3,00,000 13,00,000

Profit after tax 10,00,000 20,00,000 3,00,000 13,00,000

Number of Equity shares 20,00,000 20,00,000 10,00,000 10,00,000

EPS 0.5 1 0.3 1.3

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Break even EBIT level: The break even EBIT level for two financing options is the level of EBIT for which the EPS is the same for both financing plans

The formula for Indifferent EBIT is:

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Break even EBIT

(PBIT* - 0) (0.5) = (PBIT* - 1,400,000) (0.5)

2,000,000 1,000,000

0.5 (PBIT*) (1,000,000)

= 0.5 (PBIT*) (2,000,000) – 0.5 (1,400,000) (2,000,000)

500,000 PBIT* = 0.5 (1,400,000) (2,000,000)

Break even PBIT* = 2,800,000

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PBIT-EPS Chart

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FINANCIAL MANAGEMENT

Financial Management

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Financial Management

Meaning of Finance

According to some scholars, finance is an administrative field or group of administrative work related to management of cash and credit in an organization so that the organization has the means to fulfill its aims satisfactorily

Need for Finance

In modern times finance is as important in the business as blood in human body. Generally, finance is needed for the following items or purpose:

» Fixed assets: Furniture, Land, Building, Plant, Machinery etc.

» Current assets: Stock of material, credit sales etc.

» Establishment expenditure: Expenses relating to promotion of company, form of business enterprise, Preliminary expense, Promotion expense, Fees paid to specialist for setting up the business etc.

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Need for Finance

» Advertisement, commission, Brokerage, underwriting commission

for facilitating capital etc.

» Purchase of intangible assets: Goodwill, Patent etc.

» Adopting modern technology

» Expanding existing business

» Diversification of business

» Availing business opportunities

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Entrepreneur and Financial Management

Form of business organization

Entrepreneur

Sole proprietorship Sole trader as entrepreneur

Partnership Partner(s) as entrepreneur(s)

Joint stock companies Promoter(s)/ Director(s) as entrepreneur(s)

The basic function of financial manager are:i. Establishing capital requirements ii. Determining the composition of capital iii. Determining the source of funds iv. Disposal of profits v. Management of Cash vi. Financial Control

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Financial Planning

Financial planning is one of the important area of financial management for an entrepreneur

Meaning of Financial Planning

Financial planning is an intellectual process which helps in deciding in advance the capitalization and capital structure of the enterprises with the help of predetermined objectives, policies, procedures, programs and budget

Processing of Financial Planning

The steps in the process of financial planning as follows:

Estimating the amount capital to be raised

Determining the form and proportionate amount of securities to be issued

Formulating policies for the administration of capital

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Factors affecting Formulation of a Financial Plan

Objective

An ideal financial plan is one in which the objectives and standard are clearly expressed in quantitative/monetary term as far as possible

Solvency and liquidity

The funds should be invested in those projects or ventures which are likely to give sufficient return on investment. At the same time adequate cash should always be available to meet the requirements

Optimum structure

While an entrepreneur himself or with the help of finance manager is planning and determine the capital structure, he should see to it that it is balanced and optimum

Simplicity

The financial plan should be simple, appropriate, economical, flexible and based on the vision and foresightedness of the entrepreneur

Provision for Contingencies

The entrepreneur himself or with the help of finance manager should make proper provision in the financial plan for contingencies

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CAPITAL STRUCTURE

Capital Structure

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Capital Structure

The permanent long-term financing of a company, including long-term debt, common stock and preferred stock, and retained earnings

It differs from financial structure, which includes short-term debt and accounts payable

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Factors affecting Capital Structure

Cost of capital:

Cost of capital refers to the price paid to acquire that component of capital, generally Debt is costly. And equity is cheaper In the processing of trading, no more floatation costs, brokerage costs etc are incurred

Cash flow ability

The selection of capital structure is also influenced by the capacity of the business to generate cash inflows, stability, and certainty of such inflows. Regularity of cash inflows is much more important than the average cash inflows. A company with unstable and unpredictable cash inflows can no longer afford to depend on debts

Floatation cost

Floatation costs take place only when the funds are externally raised. Floatation costs consist of some or all of the following expenses; printing of prospectus, advertisement, underwriting and brokerage etc. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may lure the company to issue debt than common shares

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Growth and stability of sales

Firms that are growing rapidly generally need larger amount of external capital. The floatation costs associated with debt are generally less than those for common stock, so rapidly growing firms tend to use more debt. At the same time, however, rapidly growing firms often face greater uncertainty which tends to reduce their willingness to use debt. Firms whose sales are relatively stable can use more debt and incur higher fixed charges than a company with unstable sales

Competitive structure/ stability of profit margin

Firms with high rate of return on investment use relatively little debt. Their high rate of return enables them to do most of their financing with retained earnings. If profit margin is constant more debt is used

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Control

The consideration of retaining "Control" is also very important. The ordinary shareholder can elect the directors of the company. If company sells the common stock, it will bring new voting investors into the firm, making the control difficult. To maintain control within the hand of limited members, a firm has to use more amount of debt or preferred stock because they have no management and voting right. If the firm wants to more equity shares the management right will be diversified

Marketability or lender's attitude

The term 'Marketability' refers to the readiness of investors to purchase a security in a give n period of time. The capital markets keep changing continuously. The capital structure will have to be customized to the attitudes of investors prevailing at the time of issue of capital. Due to the changing market sentiments, the company has to decide whether to raise funds with a common shares issue or with a debt issue

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Size of the company

The availability of funds is greatly influenced by the size of the enterprises. A small company finds it difficult to raise debt capital.. Large companies are generally considered to be less risky by the investors and, thus, they can issue common shares, preference shares and debentures to the public

Other sources of tax shield

In order to take the advantage of low tax, borrowing is preferable for a firm because interest is considered as deductible expenditure according to the income tax law. But dividends are not considered deductible expenses and they are paid out of profits after tax

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Level of economic development

If the level of economic development is high then more debt is required. Level of economic development plays significant role in capital structure

Growth opportunities

The growth opportunities of business can be either tremendous or very low. Depending upon the growth opportunities the debt ratio fluctuates. Higher growth opportunities exist then higher debt is used otherwise vice versa

Control

The consideration of retaining "Control" is also very important. The ordinary shareholder can elect the directors of the company. If company sells the common stock, it will bring new voting investors into the firm, making the control difficult. To maintain control within the hand of limited members, a firm has to use more amount of debt or preferred stock because they have no management and voting right. If the firm wants to more equity shares the management right will be diversified

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DIVIDEND DECISION

Dividend Decision

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Dividend Decision

The Dividend Decision, in corporate finance, is a A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share)

The decision is an important one for the firm as it may influence its capital structure and stock price

There are three main factors that may influence a firm's dividend decision:

Free-cash flow

Dividend clienteles

Information signaling

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Measures of Dividend Policy

Dividend Payout: measures the percentage of earnings that the company pays in dividends

= Dividends / Earnings

Dividend Yield: measures the return that an investor can make from dividends alone

= Dividends / Stock Price

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Why do firms pay dividends

The Miller-Modigliani Hypothesis: Dividends do not affect value

Basis: If a firm's investment policy (and hence cash flows) don't change, the value of the firm cannot change with dividend policy. If we ignore personal taxes, investors have to be indifferent to receiving either dividends or capital gains

Underlying Assumptions:

The Tax Response: Dividends are taxed more than capital gains

Basis: Dividends are taxed more heavily than capital gains. A stockholder will therefore prefer to receive capital gains over dividends

Evidence: Examining ex-dividend dates should provide us with some evidence on whether dividends are perfect substitutes for capital gains

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Dividend Policy

Dividends are Sticky (Idea that dividends follow earnings):

Regular and growing dividends means stable and growing earnings

Dividend’s doesn’t matter (MM proposition)

Dividend policy is irrelevant because investors have the ability to create "homemade" dividends. These analysts claim that this income is achieved by individuals adjusting their personal portfolios to reflect their own preferences

Dividends are more certain than capital gains: The bird in the hand fallacy

Dividend policy is tailored to meet clientele needs

Dividends are a good use for excess cash

Dividends as a wealth transfer mechanism

Dividends as signals

Management view of dividends

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Determinants of Dividend Policy

Investment Opportunities

Stability in earnings

Alternative sources of capital constraints

Signaling Incentives

Stockholder characteristics

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Three Schools of Thought on Dividends

1. If (a) there are no tax disadvantages associated with dividends (b) companies can issue stock, at no cost, to raise equity, whenever needed

Dividends do not matter, and dividend policy does not affect value 2. If dividends have a tax disadvantage,

Dividends are bad, and increasing dividends will reduce value

3. If stockholders like dividends, or dividends operate as a signal of future prospects

Dividends are good, and increasing dividends will increase value

The balanced viewpoint If a company has excess cash, and few good projects (NPV>0), returning money to

stockholders (dividends or stock repurchases) is GOOD

If a company does not have excess cash, and/or has several good projects (NPV>0), returning money to stockholders (dividends or stock repurchases) is BAD

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Dividend Policies in Practice

The Tax Response: Dividends are taxed more than capital gains

Types of dividends

Special dividend: Normally, public companies declare their dividends on a specific schedule; however, they also have the option to declare a dividend at any time. This type of dividend is referred to as a special dividend

Cash dividend: Paid in checks, this is the most basic form of dividend. Cash dividends considered a type of investment earnings, and are taxable

Stock dividend: Given in the form of bonus shares or stocks of the issuing company or a subsidiary company. Normally, they are offered on the basis of a pro rata allotment

Property (in kind) dividend: Distributed in the form of assets by the issuing company or a subsidiary company

Other types of dividend: Warrants and financial assets having market value are also distributed in the form of dividends

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Dividend Dates

The distribution of dividends requires the approval of the board of directors, who

declare the time or date when the dividend will be distributed. The dates are

categorized into four types

Ex-dividend date: The ex-dividend date is defined as the date subsequent to

which every share that is traded does not have any right to claim the dividend,

which has been declared in the immediate past.

Declaration date: The declaration date is defined as the date on which the

board of directors declares its aim for payment of dividend. On this date, the

payment date and the record date are also announced.

Record date: The record date is defined as the date on or before which the

shareholders who have officially recorded their ownership and are entitled to get

the dividend.

Payment date: The payment date is defined as the date on which the checks of

dividend will be sent to shareholders or deposited to brokerage accounts.

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Bonus Shares

Bonus shares:

A bonus share is a free share of stock given to current shareholders in a company, based upon the number of shares that the shareholder already owns.

While the issue of bonus shares increases the total number of shares issued and owned, it does not increase the value of the company.

Effects of bonus issues:

1. Share capital gets increased according to the bonus issue ratio.

2. Liquidity in the stock increases.

3. Effective Earnings per share, Book Value and other per share values stand reduced.

4. Markets take the action usually as a favorable act.

5. Market price gets adjusted on issue of bonus shares.

6. Accumulated profits get reduced.

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Share Buyback

Share buyback

The purchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market

Companies will buy back shares either to increase the value of shares still available (reducing supply), or to eliminate any threats by shareholder who are looking for controlling stake.

Buybacks can be carried out in two ways:

1. Shareholders may be presented with a tender offer whereby they have the option to submit (or tender) a portion or all of their shares within a certain time frame and at a premium to the current market price. This premium compensates investors for tendering their shares rather than holding on to them.

2. Companies buy back shares on the open market over an extended period of time.

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Thank You !

Documents

Financial Decision Making Session 6: 23 rd November 2009