FINANCIAL MANAGEMENT

FINANCE IS THE ART AND SCIENCE OF MANAGING MONEY

BUSINESS NEEDS MONEY TO MAKE MORE MONEY
FINANCIAL SERVICES IS CONCERNED WITH THE DESIGN AND
DELIVERY OF ADVICE AND FINANCIAL PRODUCTS TO INDIVIDUALS
,BUSINESS AND GOVT.
FINANCIAL MANAGEMENT IS CONCERNED WITH DUTIES OF FINANCIAL
MANAGERS IN THE BUSINESS FIRM.
FINANCIAL MANAGEMENT MEANS THE ENTIRE GAMUT OF
MANAGERIAL EFFORTS DEVOTED TO THE MANAGEMENT OF FINANCE
BOTH ITS SOURCES AND USES.
TRADITIONAL PHASE OF FINANCIAL MANAGEMENT
LASTED FOR FOUR DECADES AND TALKED ABOUT : FORMATION
,ISSUANCE OF CAPITAL , MAJOR EXPANSION , MERGERS ,
REORGANISATIONS AND LIQUIDATION.
APPROACH WAS DESCRIPTIVE AND INSTITUTIONAL
OUTSIDERS VIEW WAS MORE DOMINANT SPECIFICALLY INVESTMENT
BANKERS AND LENDERS.
MODERN PHASE
STARTED IN MID FIFTIES AND STRESS WAS LAID ON ECONOMIC
THEORY AND APPLICATION OF QUANTITATIVE METHODS.


CONCERNS WITH RATIONAL MATCHING OF
FUNDS TO THEIR USES SO AS TO MAXIMISE
SHAREHOLDERS WEALTH.

APPROACH HAS BECOME MORE ANALYTICAL AND
QUANTITATIVE.

MODERN PHASE EMPHASISES ON CAPITAL
BUDGETING ,CAPITAL STRUCTURE THEORIES ,
EFFICIENT MARKET THEORY , OPTION PRICING
THEORY , AGENCY THEORY , ARBITRAGE THEORY
, VALUATION MODELS , DIVIDEND POLICY ,
WORKING CAPITAL MANAGEMENT , FINANCIAL
MODELLING.
OBJECTIVES OF FINANCIAL MANAGEMENT
TRADITIONALLY IT WAS MAINTENANCE OF LIQUID ASSETS AND
MAXIMISATION OF PROFITABILITY OF THE FIRM.
OBJECTIVE IS A SENSE OF GOAL OR DECISION CRITERION FOR THREE
DECISIONS INVOLVED IN FINANCIAL MANAGEMENT VIZ. INVESTMENT
, FINANCING AND DIVIDEND POLICY.
ENSURING FAIR RETURNS TO SHAREHOLDERS, BUILDING RESERVES
FOR GROWTH AND EXPANSION , MAXIMUM OPERATIONAL EFFICIENCY
BY EFFECTIVE AND EFFICIENT UTILISATION OF FINANCES AND
ENSURING FINANCIAL DISCIPLINE.
MICROECONOMIC FACTORS : NATURE AND SIZE OF ENTERPRISE/
LEVEL OF RISK AND STABILITY IN EARNINGS / LIQUIDITY POSITION/
ASSET STRUCTURE AND PATTERN OF OWNERSHIP/ATTITUDE OF
MANAGEMENT
MACROECONOMIC FACTORS : STATE OF ECONOMY / GOVERNMENT
POLICY
TWO APPROACHES ARE PROFIT / EPS MAXIMISATION AND WEALTH
MAXIMISATION APPROACH.

ROLE OF FINANCE MANAGER

FINANCE MANAGER

MAXIMISATION OF SHARE VALUE

FINANCIAL DECISIONS

FUNDS REQUIREMENT DECISION -- -----
FINANCING DECISION --INVESTMENT DECISIONS --
DIVIDEND DECISIONS

RETURN--------RISK

TRADE OFF
IMPORTANCE OF FINANCIAL MANAGEMENT


WHEN FUNDS ARE INVOLVED ,SOUND FINANCIAL
MANAGEMENT IS NECESSARY.


COLLINS BROOKS REMARKED BAD PRODUCTION
MANAGEMENT AND BAD SALES MANAGEMENT HAVE SLAIN
IN HUNDREDS ,BUT FAULTY FINANCIAL MANAGEMENT
HAS SLAIN IN THOUSANDS .


FM HELPS IN ASCERTAINING HOW THE COMPANY WOULD
PERFORM IN FUTURE.WHETHER THE FIRM WILL GENERATE
ENOUGH FUNDS TO MEET ITS FUTURE OBLIGATIONS.
PROFIT / EPS MAXIMISATION
ACTIONS WHICH INCREASE EPS / PROFIT SHOULD BE
UNDERTAKEN AND WHICH DECREASE THEM SHOULD BE AVOIDED.
IT IS DESCRIBED AS PROFITABILITY AND SIGNIFIES ECONOMIC
EFFICIENCY AND PERFORMANCE . IMPLYING THEREBY SELECT
THOSE ASSETS , PROJECTS AND DECISIONS THAT INCREASE
PROFITABILITY.
HAS CERTAIN AMBIGUITY SHOULD PROFIT BE SHORT TERM OR
LONG TERM , IS IT TOTAL RATE OF PROFIT , IS IT BEFORE TAX
OR AFTER TAX, IS IT RETURN ON TOTAL CAPITAL EMPLOYED OR
TOTAL ASSETS OR SHAREHOLDERS EQUITY ETC.
TIME PATTERN OF BENEFITS : PROFITS IN THE EARLIER YEARS
ARE BETTER OR GROWTH IS MORE BENEFICIAL.
UNCERTAINITY OF BENEFITS : DEGREE OF CERTAINITY WITH
WHICH BENEFITS ARE EXPECTED.
IT IGNORES THE RISK FACTOR AND TIME VALUE OF MONEY.
THE CONCEPT IS ANALOGOUS TO RATIONAL BEHAVIOUR OF THE
FIRM.
ENSURES THAT ULTIMATE SURVIVOR IN THE CORPORATE WORLD
IS THE PROFIT MAXIMISER.
HELPS IN ACQUIRING OF MONOPOLY POWERS IN THE IMPERFECT
PRODUCT MARKET.
WEALTH MAXIMISATION
REFINED DECISION OVER EPS/ PROFIT MAXIMISATION
CRITERION.
FINANCIAL DECISIONS SHOULD BE THE MAXIMISATION
OF THE VALUE OF THE FIRM OR THE CORPORATE WEALTH.
ACCEPTABLE TO SHAREHOLDERS , CREDITORS ,
EMPLOYEES , MANAGEMENT , SOCIETY DIRECTLY OR
INDIRECTLY.
SHAREHOLDERS HIGHER VALUE OF SHARES , CREDITORS
PROTECTION IN RESPECT TO REPAYMENT OF INTEREST
AND PRINCIPLE, EMPLOYEES HIGHER PAY PACKAGES,
MANAGEMENT EXISTENCE OF THE MANAGEMENT
DEPENDS ON THE PROSPERITY OF THE FIRM.
VALUE OF THE ASSET IN TERMS OF BENEFITS WHICH IT
PROVIDES.
BASED ON THE CONCEPT OF CASH FLOWS GENERATED BY
THE DECISION RATHER ACCOUNTING PROFIT ON WHICH
PROFIT MAXIMISATON IS BASED.
IT CONSIDERS BOTH QUANTITATIVE AND QUALITATIVE
DIMENSIONS OF BENEFITS AND INCORPORATE THE TIME
VALUE OF MONEY.
TIME VALUE OF MONEY
MONEY HAS TIME VALUE . A RUPEE TODAY IS MORE VALUABLE
THAN A RUPEE AFTER ONE YEAR.
VALUE OF A UNIT OF MONEY IS DIFFERENT AT DIFFERENT TIME
PERIODS.FUTURE IS UNCERTAIN
PREFERENCE IS FOR REINVESTMENT OPPORTUNITIES FOR FUNDS
RECEIVED EARLIER.
GENERALLY REFERRED IN TERMS OF RATE OF RETURN OR
DISCOUNT RATE.
INDIVIDUALS PREFER CURRENT CONSUMPTION TO FUTURE
CONSUMPTION
CAPITAL CAN BE ENJOYED PRODUCTIVELY TO GENERATE
POSITIVE RETURNS.
DUE TO INFLATION A RUPEE TODAY REPRESENTS GREATER
PURCHASING POWER THAN RUPEE TOMORROW.
COMPOUNDING RATE : A=P(1+r)n
PRESENT VALUE OR DISCOUNTING TECHNIQUE : OPPOSITE OF
COMPOUNDING RATE . INTEREST IS ADDED BACK TO THE
PRINCIPLE AND THEN INTEREST IS CHARGED IN COMPOUNDING
METHOD , WHEREAS IN PV THE MONEY RECEIVED IN SOME
FUTURE DATE IS DISCOUNTED TO GET ITS PRESENT WORTH AS
THE INTEREST IS LOST P=A(1/1+i)n
LEVERAGE
LEVERAGE IS AN ADVANTAGE GAINED FROM THE OPERATIONS OF A
LEVER.
IN FINANCIAL TERM IT RELATES TO ACCELERATION OF PROFITS
THROUGH CHANGES IN CERTAIN FINANCIAL VARIABLES MEANING
THEREBY THAT LEVERAGE IS A TOOL OF PROFIT PLANNING.
RETURN ON INVESTMENT LEVERAGE / MARGINAL ANALYSIS LEVERAGE /
FINANCIAL LEVERAGE.
RETURN ON INVESTMENT LEVERAGE : POINTS OUT THE FIRMS
EFFICIENCY IN EARNING PROFITS WITH REGARDS TO OPERATING
PROFIT , SALES AND ASSET TURNOVER.
MARGINAL ANALYSIS LEVERAGE :RELATES TO PROFIT MEASURES TO
CERTAIN OTHER ASPECTS OF FIRMS OPERATIONS OR FINANCIAL
SITUATIONS-OPERATING LEVERAGE ,FIXED CHARGES LEVERAGE AND
COMBINED LEVERAGE.
OPERATING LEVERAGE :CHANGE IN SALES PRODUCE GREATER CHANGES
IN THE OPERATING PROFIT.INTEREST ON DEBT IS NOT INCLUDED SINCE
IT IS A FIXED FINANCIAL COST.ONCE BEP IS REACHED THE ENTIRE
MARGINAL CONTRIBUTION TAKES THE FORM OF OPERATING PROFIT.
DOL= % CHANGE IN EBIT / % CHANGE IN THE UNITS SOLD/OUTPUT.

LEVERAGE
OPERATING LEVERAGE IS DEFINED AS THE TENDENCY OF THE
OPERATING PROFIT TO VARY DISPROPORTIONATELY WITH SALES.
IT IS SAID TO EXIST WHEN THE FIRM HAS TO PAY FIXED COST
REGARDLESS OF VOLUME OF OUTPUT OR SALES.
FIRM IS SAID TO HAVE HIGH DEGREE OF OPERATING LEVERAGE IF IT
EMPLOYS GREATER AMOUNT OF FIXED COST AND SMALL AMOUNT OF
VARIABLE COST AND VICE VERSA.

FINANCIAL LEVERAGE IS DEFINED AS THE TENDENCY OF THE
RESIDUAL NET INCOME TO VARY DISPROPORTIONATELY WITH
OPERATING PROFIT.
CHANGES IN TAXABLE INCOME AS A RESULT OF CHANGES IN
OPERATING INCOME.
SIGNIFIES THE EXISTENCE OF FIXED INTEREST /FIXED DIVIDEND
BEARING SECURITIES IN THE TOTAL CAPITAL STRUCTURE OF THE
COMPANY.
FINANCIAL LEVERAGE


FINANCIAL LEVERAGE IS ALSO REFERRED AS FIXED CHARGE
LEVERAGE BUT COST THERE IS A SLIGHT DIFFERENCE AND
FINANCIAL LEVERAGE EXISTS WHEN THE CAPITAL STRUCTURE
COMPRISES OF DEBT OR OTHER FIXED COST CAPITAL AND ROI IS
NOT EQUAL TO THE PERCENTAGE OF INTEREST OR OTHER FIXED
CHARGES .THE ROI MUST BE GREATER THAN THE FIXED CHARGES
.
TO RAISE THE EPS AND ATTRACT INVESTORS A FIRM WILL APPLY
HIGHER DEGREE OF FINANCIAL LEVERAGE.
DFL=% CHANGE IN EPS / % CHANGE IN EBIT
DCL=DOL*DFL
CAPITAL BUDGETING
DEALS WITH THE SELECTION OF PROPOSALS / PROJECTS FOR MAKING
LONG TERM INVESTMENTS AND THEIR IMPLEMENTATION.

PURPOSE IS TO YIELD POSITIVE CASH INFLOWS THAT CAN ADD TO
CORPORATE WEALTH.

INVOLVES LONG TERM INVESTMENTS IN FIXED ASSETS AS THEY ARE
SIZEABLE PROPORTION OF TOTAL ASSETS AND THEIR LIFE IS
LONG,ALSO THESE ASSETS ARE SPECIALLY DESIGNED FOR SPECIFIC
ACTIVITY.

LONG TERM INVESTMENTS ARE REQUIRED FOR EXPANSION /
REPLACEMENT / DIVERSIFICATION / R & D.

STEPS IN CAPITAL BUDGETING PROCESS : IDENTIFICATION OF LONG
TERM GOALS / SCREENING PROPOSALS / PROJECT EVALUATION /
PROJECT IMPLEMENTATION / PROJECT AUDIT.
PROJECT EVALUATION CRITERION
1. AN APPRAISAL METHOD SHOULD PROVIDE FOR :
BASIS OF DISTINGUISHING BETWEEN ACCEPTABLE AND
NON ACCEPTABLE PROJECTS.
RANKING OF PROJECTS IN ORDER OF DESIRABILITY.
CHOOSING AMONG SEVERAL ALTERNATIVES.
RECOGNISES , BIGGER BENEFITS ARE PREFERABLE TO
SMALLER BENEFITS AND EARLIER BENEFITS ARE
PREFERABLE TO LATER ONES.

2. DISCOUNTED CASH FLOW TECHNIQUE :
NET PRESENT VALUE METHOD
INTERNAL RATE FO RETURN METHOD

3. CASH FLOW NON DISCOUNTING TECHNIQUE :
PAY BACK PERIOD METHOD
ACCOUNTING RATE OF RETURN
NET PRESENT VALUE
DIFFERENCE BETWEEN TOTAL PRESENT VALUES OF FUTURE CASH INFLOWS
AND TOTAL PRESENT VALUE OF FUTURE CASH OUTFLOWS.
NPV = PRESENT VALUE INITIAL INVESTMENT
PRESENT VALUE = CASH INFLOW * DISCOUNTING RATE.
CASH INFLOWS AND OUTFLOWS ASSOCIATED WITH EACH PROJECT ARE
WORKED OUT.
THE PRESENT VALUE OF CASH INFLOWS AND OUTFLOWS ARE CALCULATED AS
PER THE RETURN ACCEPTABLE TO MANAGEMENT.
NPV GREATER THAN ZERO ACCEPT THE PROJECT .
INTERNAL RATE OF RETURN
THE RATE OF RETURN AT WHICH SUM OF DISCOUNTED CASH INFLOWS EQUALS THE
SUM OF DISCOUNTED CASH OUTFLOWS.CASH INFLOWS AND OUTFLOWS ARE KNOWN ,
DISCOUNTED RATE HAS TO BE FOUND OUT.
CASH INFLOWS ARE UNIFORM , IRR = I/C , WHERE I IS INITIAL INVESTMENT AND C IS
CASH INFLOWS EVERY YEAR.
CASH INFLOWS ARE UNEVEN , IRR=r- ( PVCO- PVCI )/ DELTA PV * DELTA R.
PV=PRESENT VALUE OF CASH OUTLAY
PVCI=PRESENT VALUE OF CASH INFLOWS OF FIRST INTEREST RATE
r= EITHER OF TWO INTERESR RATES USED IN FORMULA
DELTA r = DIFF.BETWEEN TWO RATES
DELTA PV = DIFF. IN CALCULATED PRESENT VALUS OF TWO RATES.


PAY BACK PERIOD
REFERS TO THE EXPECTED NUMBER OF YEARS DURING WHICH THE
ORIGINAL INVESTMENT SHOULD BE RECOVERED.
MANAGEMENT SETS A TARGET PAY BACK PERIOD ON THE BASIS OF
NATURE OF PROJECT AND INDUSTRY NORM.
ACTUAL PAY BACK PERIOD LESS THAN TARGET NORM , PROJECT IS
ACCEPTED.
PB PERIOD = INITIAL INVESTMENT / ANNUAL CASH INFLOW.
ACCOUNTING RATE OF RETURN
ARR = AVERAGE NET INCOME / AVERAGE INVESTMENT *100.
AVERAGE INVESTMENT = NET WC + SALVAGE VALUE +1/2(COST
SALVAGE VALUE).
AVERAGE DEP. = INITIAL INVESTMENT SCRAP VALUE / LIFE OF
PROJECT.

RISK ANALYSIS IN CAPITAL BUDGETING
THE VARIABILITY THAT IS LIKELY TO OCCUR IN FUTURE BETWEEN
ESTIMATED AND ACTUAL RETURNS.
RISK IS LINKED TO BUSINESS DECISIONS AND VARIES FROM ONE
INVESTMENT TO ANOTHER INVESTMENT PROPOSAL.
TWO WAYS OF INCORPORATING RISK FACTOR - ONE BEING
CERTAINITY EQUIVALENT APPROACH AND OTHER BEING RISK
ADJUSTED DISCOUNT RATE.
CASH FLOW UNCERTAIN ,CERTAINITY FACTOR INTRODUCED IN CASH
FLOW MAKING IT CERTAIN , REDUCED TO PRESENT VALUE THROUGH
USE OF RISK FREE DISCOUNT RATE.
CAPITAL RATIONING
THE FIRM MAY ACCEPT ALL THOSE PROJECTS WHICH HAVE A
POSITIVE NPV OR WHICH GIVE HIGHER RATE OF RETURN THAN THE
COST OF CAPITAL.


WHEN A FIRM HAS MORE INVESTMENT PROPOSALS THAN IT CAN
FINANCE IT PLACES A CONSTRAINT WITH REGARD TO TOTAL SIZE OF
CAPITAL INVESTMENT. IN SUCH AN EVENT THE FIRM HAS TO SELECT
A COMBINATION OF INVESTMENT PROPOSALS THAT PROVIDES
HIGHEST NPV AND HIGHER RETURNS.


RANKING IS BASED ON THE PROFITABILITY INDEX OR IRR.
CAPITAL STRUCTURE
REPRESENTS THE RATIO BETWEEN DIFFERENT FORMS OF CAPITAL.
CATEGORISED AS OWNERS FUND / SHARE CAPITAL AND BORROWED
FUNDS.
COMPANIES CAPITAL STRUCTURE SHOULD HAVE ONLY EQUITY
CAPITAL OR IT SHOULD REPRESENT MIXTURE OF EQUITY AND
BORROWED FUNDS ?.
SEARCH FOR OPTIMAL STRUCTURE ENDS WHEN WEIGHTED AVERAGE
COST OF CAPITAL (WACC) IS MINIMUM AND VALUE OF FIRM IS
MAXIMUM.
IRRELEVANCE APPROACH STATES THAT CHANGE IN CAPITAL
STRUCTURE HAS NO INFLUENCE ON CORPORATE WEALTH----
FINANCIAL LEVERAGE HAS NO INFLUENCE ON TOTAL CASH FLOWS
AND FINANCIAL LEVERAGE DOES NOT CHANGE COST OF CAPITAL
HENCE VALUE OF FIRM REMAINS SAME.
ARBITRAGE PROCESS( M M HYPOTHESIS):
ASSUMES THAT FIRM PAYS NO TAXES / NO TRANSACTION COST /
INVESTORS HAVE SAME EXPECTATION AS TO FIRMS FUTURE
EARNINGS AND RISK / FUTURE FINANCING DECISIONS DO NOT AFFECT
FIRMS INVESTMENT IN ASSETS.
FEATURES OF SOUND CAPITAL STRUCTURE
PERFECT TRADE OFF BETWEEN RISK AND RETURN --- SOUND CAPITAL
STRUCTURE PERMITS LEVERAGE ONLY TO THE EXTENT OF PERFECT
TRADE OFF BETWEEN RISK AND RETURN.

MINIMUM COST OF CAPITAL.

SUFFICIENCY OF CASH FLOW TO SERVICE DEBT--- LEVERAGE SHOULD
BE USED TO THE EXTENT THAT THE CASH FLOWS ARE AVAILABLE TO
SERVICE THE DEBT.

MAINTAINANCE OF INDUSTRY NORM---DEBT EQUITY RATIO SHOULD BE
IN CONCURRENCE WITH INDUSTRY NORMS.

FLEXIBILITY--- IN RAISING FUNDS AND REDEEMING DEBTS.
GENERAL ASSUMPTIONS
FIRM EMPLOYS TWO TYPES OF CAPITAL i.e DEBT AND EQUITY.

THERE ARE NO CORPORATE TAXES.

FIRM PAYS 100% OF ITS EARNINGS AS DIVIDENDS.

INVESTMENT DECISIONS ARE ASSUMED TO BE CONSTANT.

FIRMS TOTAL FINANCING REMAINS CONSTANT.

EBIT REMAINS CONSTANT.

BUSINESS RISK REMAINS CONSTANT AND IS INDEPENDENT OF
CAPITAL STRUCTURE AND FINANCIAL RISK.

INVESTORS HAVE SAME SUBJECTIVE DISTRIBUTION OF FUTURE
EXPECTED OPERATING PROFIT.
FIRM HAS PERPETUAL LIFE.
TRADITIONAL POSITION
COST OF DEBT rD MORE OR LESS REMAINS CONSTANT UPTO A
CERTAIN DEGREE OF LEVERAGE BUT RISES THEREAFTER AT AN
INCREASING RATE.


COST OF EQUITY rE REMAINS MORE OR LESS CONSTANT OR
RISES ONLY GRADUALLY UPTO A CERTAIN DEGREE OF LEVERAGE
AND RISES SHARPLY THEREAFTER.

THE AVERAGE COST OF CAPITAL rA DECREASES UPTO A CERTAIN
POINT , REMAINS MORE OR LESS UNCHANGED FOR MODERATE
INCREASE IN LEVERAGE AND RISES BEYOND A CERTAIN POINT
DUE TO THE BEHAVIOUR OF rD AND rE.

COST OF DEBT (ki) = I/B AND VALUE OF DEBT(B) = I/ki WHERE I
IS TOTAL INTEREST PAYMENTS , B IS TOTAL MARKET VALUE OF
DEBT .
COST OF EQUITY CAPITAL (ke) = Di /Po + g , WHERE Di IS NET
DIVIDENDS , Po IS CURRENT MARKET PRICE OF SHARES AND g IS
GROWTH RATE .
NET INCOME APPROACH
PROPOSED BY DURAND
CHANGE IN CAPITAL STRUCTURE CAUSES CORRESPONDING CHANGE IN
THE OVERALL COST OF CAPITAL AS WELL AS VALUE OF THE FIRM.
HIGHER DEBT IN CAPITAL STRUCTURE RESULTS IN DECLINE IN
WACC.THIS CAUSES INCREASE IN VALUE OF THE FIRM AND DECREASE
IN THE EQUITY SHARES OF THE COMPANY AND VICE VERSA.
ASSUMPTIONS :
THERE ARE NO CORPORATE TAXES .
COST OF DEBT IS LESS THAN COST OF EQUITY.
DEBT CONTENT DOES NOT CHANGE RISK PERCEPTION OF INVESTOR.
VALUE OF FIRM : V=S+B ,WHERE V = VALUE OF FIRM , S=MARKET
VALUE OF EQUITY AND B= MARKET VALUE OF DEBT.
VALUE OF S = NI/Ke , NI= EARNING AVAILABLE TO EQUITY
SHAREHOLDERS AND Ke = EQUITY CAPITALIZATION RATE.
WACC = EBIT / V*100 WHERE V = VALUE OF FIRM.
A COMPANYS EBIT IS RS 50,000/- , DEBT OF RS 2,00,000/- AT 10%
AND ke IS 12.5 % . FIND WACC WHEN DEBT IS RS 2,00,000 ,
INCREASED BY 1,00,000 AND DECREASED BY 1,00,000 ?.
NET OPERATING INCOME APPROACH
FORMULATED BY DURAND
MARKET VALUE OF THE FIRM IS ASCERTAINED BY CAPITALIZING THE
NET OPERATING INCOME AT WHICH IS WACC IS CONSIDERED TO BE
CONSTANT.
OVERALL COST OF CAPITAL/ CAPITILISATION RATE Ko IS CONSTANT.
ASSUMPTIONS :
WACC IS CONSTANT FOR ALL DEGREES OF DEBT EQUITY MIX.
MARKET CAPITALIZES THE VALUE OF THE FIRM AS A WHOLE AND
THEREFORE THE SPLIT BETWEEN DEBT AND EQUITY IS NOT RELEVANT.
USE OF DEBT INCREASES RISK TO EQUITY SHAREHOLDERS AND
HENCE INCREASES Ke.
NO CORPORATE TAXES.
V= EBIT / Ko , S= V-B AND Ke= NI/S *100
OPERATING INCOME IS RS 50,000 , COST OF DEBT IS 10% on
outstanding debt of rs 2,00,000 . Overall capitalisation rate is 12.5% .
FIND VALUS OF FIRM AND EQUITY CAPITALISATION RATE WHEN DEBT
IS REDUCED BY 1,00,000 AND INCREASED BY 1,00,000 ?.
MODIGLIANI MILLER APPROACH
SIMILAR TO NOI APPROACH
SUPPORTS THE NOI APPROACH PROVIDING THE BEHAVIORAL
JUSTIFICATION FOR INDEPENDENCE OF THE TOTAL VALUATION AND
COST OF CAPITAL OF THE FIRM.
PROPOSITIONS :
WACC AND VALUE OF FIRM ARE INDEPENDENT OF CAPITAL
STRUCTURE.
COST OF EQUITY = CAPITALIZATION RATE OF A PURE EQUITY STREAM
+PREMIUM FOR FINANCIAL RISK . THE FINANCIAL RISK INCREASES
WITH MORE DEBT CONTAINED IN CAPITAL STRUCTURE.
CUT OF RATE FOR INVESTMENT PURPOSE IS COMPLETELY
INDEPENDENT OF THE WAY THE INVESTMENT IS FINANCED.

TWO FIRMS IDENTICAL EXCEPT FIRM L HAS 5,00,000 AT 10 % , EBIT
IS RS 1,00,000 FOR BOTH AND ke OF FIRM L IS 16% AND FIRM U IS
12.5% . FIND ko.
ASSUMPTIONS :

PERFECT CAPITAL MARKETS : INFORMATION IS FREELY AVAILABLE
,TRANSACTIONS ARE COSTLESS , NO BANKRUPTCY COSTS ,
SECURITIES ARE INFINITELY DIVISIBLE.
RATIONAL INVESTORS AND MANAGERS : INVESTORS RATIONALLY
CHOOSE COMBINATION OF RISK AND RETURN THAT IS MOST
ADVANTAGEOUS.MANAGERS ACT IN THE INTEREST OF SHAREHOLDERS.
HOMOGENEOUS EXPECTATIONS : INVESTORS HOLD IDENTICAL
EXPECTATIONS ABOUT FUTURE OPERATING EARNINGS.
EQUIVALENT RISK CLASS : FIRMS CAN BE GROUPED IN EQUIVALENT
RISK CLASSES ON THE BASIS OF THEIR BUSINESS RISK.
NO TAXES EXIST.
M M APPROACH
V=D+E OR O/R
WHERE V= VALUE OF FIRM
D= MARKET VALUE OF DEBT
E= MARKET VALUE OF EQUITY
O= EXPECTED OPERATING INCOME
R= DISCOUNT RATE APPLICABLE TO THE RICH CLASS TO WHICH THE
FIRM BELONGS .
CRITICISMS OF M M APPROACH :
FIRMS ARE LIABLE TO PAY TAXES ON THEIR INCOMES AND INVESTORS
ALSO HAVE TO PAY TAXES ON THEIR PERSONAL INCOME.
BANKRUPTCY COSTS ARE VERY HIGH.
AGENCY COSTS EXIST CONFLICT OF INTEREST BETWEEN MANAGERS
AND SHAREHOLDERS.
MANAGERS HAVE PREFERENCE FOR CERTAIN SEQUENCE OF
FINANCING.
INVESTORS ARE EQUALLY INFORMED AS MANAGERS AND ASYMMETRY
EXISTS.
CAPITAL STRUCTURE
Company X and Y are in the same risk class and are identical in every respect
except that company X uses debt while company Y does not. The levered firm
has Rs 9,00,000 debentures carrying 10% rate of interest .Both firms earn
20% operating profit on their total assets of Rs 15 lacs. Tax rate is 35% and
equity capitilisation rate is 15%:
1. Compute the value of firms X and Y using NI Approach
2. Compute the value of each firm using NOI Approach
3. Using the NOI Approach calculate overall cost of capital (k0) for firms X and
Y.

Solution : Valuation under NI Approach
__________________________________________________________
Particulars Firm X Firm Y
EBIT 300000 300000
Less Interest 90000 Nil
Taxable Income 210000 300000
Less Taxes 73500 105000
Earnings for equity holders 136500 195000
Equity Capitilisation rate (ke) .15 .15
Market value of the firm 910000 1300000
Market value of debt 900000 Nil
_____________________________________________________________
Total value of firm 1800000 1300000
CAPITAL STRUCTURE
Valuation under NOI Approach:
Vy = EBIT(1-tax rate )/ ko
300000(1-0.35)/.15
Rs 1300000
Vx = Rs 1300000 + Rs 900000(.35) = Rs 1615000

Kox = kd( B/V) + ke (S/V)
.065(900000/1615000) + .191(715000/1615000) = 12.1 %.

Working note : EBIT 300000
Less Interest 90000
Taxable Income 210000
Less tax 35% 73500
Net Income 136500
Value of firm (V) 1615000
Value of Debt (B) 900000
Value of Equity (S) 715000
Ke = NI/S 136500/715000 i.e 19.1%
Kd = 10(1-.35) i.e 6.5 %
COST OF CAPITAL
Understanding general concept of opportunity
cost of capital.
Distinguish between the project cost of capital
and the firms cost of capital.
Learn about the methods of calculating
component cost of capital and the weighted
average cost of capital.
Understand the concept and calculation of the
marginal cost of capital.
Recognise the need for calculating cost of capital
for divisions.
Illustrate the cost of capital calculation for a real
company.

Cost of capital
The projects cost of capital is the minimum
required rate of return on funds committed to
the project, which depends on the riskiness of
its cash flows.
The firms cost of capital will be the overall,
or average, required rate of return on the
aggregate of investment projects.
Significance of the Cost of Capital
Evaluating investment decisions,
Designing a firms debt policy, and
Appraising the financial performance of top
management.


COST OF CAPITAL
M.J.GORDON THE COST OF CAPITAL IS THE RATE OF RETURN A
COMPANY MUST EARN ON AN INVESTMENT TO MAINTAIN THE
VALUE OF THE COMPANY .
SOLOMAN EZRA THE COST OF CAPITAL IS THE MINIMUM
REQUIRED RATE OF EARNINGS OR THE CUT OFF RATE FOR CAPITAL
EXPENDITURE .
FEATURES :
1. ITS NOT A COST
2. ITS MINIMUM RATE OF RETURN
3. ITS A REWARD FOR RISK.
SIGNIFICANCE :
1. DESIGNING THE CAPITAL STRUCTURE
2. CAPITAL BUDGETING DECISIONS
3. COMPARATIVE STUDY OF SOURCES OF FINANCING
4. EVALUATION OF FINANCIAL PERFORMANCE OF TOP MANAGEMENT
5. KNOWLEDGE OF FIRMS EXPECTED INCOME AND INHERENT RISK
6. FINANCING AND DIVIDEND DECISIONS.
HISTORICAL VS FUTURE COST
HISTORICAL COST REPRESENTS THE COST WHICH HAS ALREADY BEEN
INCURRED FOR FINANCING A PROJECT . IT IS CALCULATED ON THE BASIS
OF PAST DATA.
FUTURE COST REFERS TO THE EXPECTED COST OF FUNDS TO BE RAISED
FOR FINANCING A PROJECT .
SPECIFIC COST REFERS TO THE COST OF A SPECIFIC SOURCE OF CAPITAL
SUCH AS EQUITY CAPITAL / PREFERENCE CAPITAL / DEBENTURE
CAPITAL / RETAINED EARNINGS.
COMPOSITE COST REFERS TO THE COMBINED COST OF VARIOUS
SOURCES OF FINANCE . IT IS THE WEIGHTED AVERAGE COST OF CAPITAL
.
AVERAGE COST OF CAPITAL REFERS TO THE WACC CALCULATED ON THE
BASIS OF COST OF EACH SOURCE OF CAPITAL AND WEIGHTS ARE
ASSIGNED IN THE RATIO OF THEIR SHARE TO THE TOTAL CAPITAL
FUNDS.
MARGINAL COST OF CAPITAL IS DEFINED AS THE COST OF OBTAINING
ANOTHER RUPEE OF NEW CAPITAL.
EXPLICIT COST REFERS TO THE DISCOUNT RATE WHICH EQUATES THE
PRESENT VALUE OF CASH INFLOWS WITH THE PRESENT VALUE OF CASH
OUTFLOWS OR VALUE OF INVESTMENT.ITS THE INTERNAL RATE OF
RETURN WHICH A FIRM PAYS FOR PROCURING FINANCES.
IMPLICIT COST REPRESENTS THE RATE OF RETURN WHICH CAN BE
EARNED BY INVESTING THE FUNDS IN ALTERNATIVE INVESTMENTS .
OPPORTUNITY COST OF FUNDS IS THE IMPLICIT COST.
ASSUMPTIONS
THE COST CAN BE EITHER EXPLICIT OR IMPLICIT.

FINANCIAL AND BUSINESS RISKS ARE NOT AFFECTED BY
INVESTING IN NEW INVESTMENT PROPOSALS.

THE FIRMS CAPITAL STRUCTURE REMAINS UNCHANGED.

COST OF EACH SOURCE OF CAPITAL IS DETERMINED AS AN AFTER
TAX BASIS.

COST OF PREVIOUSLY OBTAINED CAPITAL ARE NOT RELEVANT
FOR COMPUTING THE COST FOR CAPITAL TO BE RAISED FROM A
SPECIFIC SOURCE.
MEASUREMENT OF COST OF CAPITAL
IT INVOLVES : COST OF DEBT / COST OF PREFERENCE CAPITAL / COST
OF EQUITY CAPITAL / COST OF RETAINED EARNINGS.

COST OF DEBT : THE COST OF FUNDS RAISED THROUGH DEBT IN THE
FORM OF DEBENTURES OR LOAN FROM FINANCIAL INSTITUTIONS
.DEBT COULD BE PERPETUAL / IRREDEMABLE OR REEDEMABLE.
COST OF PERPETUAL DEBT : IT IS THE IRREDEMABLE DEBT AND IS THE
RATE OF RETURN WHICH THE LENDERS EXPECT.PRINCIPLE IS NOT
REEDEMED.
Kd = I/NP WHERE Kd = COST OF DEBT , I= ANNUAL INTEREST
PAYMENT AND NP= NET PROCEEDS OF DEBT .
AFTER TAX Kd=I/NP (1-t) WHERE t = TAX RATE.
COST OF REEDEMABLE DEBT : THE PRINCIPLE HAS TO BE REEDEMED
AFTER A SPECIFIC PERIOD FROM THE PAYMENT OF INTEREST.
Kd = I+(P-NP)/n WHERE I= INTEREST RATE , P=PAR VALUE OF DEBT ,
(P+NP)/2 NP= NET PROCEEDS OF DEBT , n= NO. OF YEARS OF
MATURITY.
AFTER TAX Kd = ( 1-t) (I+(P-NP)/n)
(P+NP)/2
SOLVED PROBLEM
ISSUE OF 1000 9% DEBENTURES OF RS.500/- EACH AT PAR
REEDEMABLE AFTER 8 YEARS . THE COST OF ISSUE OF DEBENTURE
INCLUDES 1.5% UNDERWRITING COMM. , .5% BROKERAGE AND 2%
AS PRINTING AND OTHER EXPENSES. CALCULATE AFTER TAX COST OF
DEBT WHEN TAX RATE IS 50 %.
SOLUTION
NP= 500-(500*1.5% + 500 * .5% + 500*2% ) = 480 /-
Kd = (1-.5) ( 45+500 480 )/8
( 500+480) /2
.5 * 47.5/490
4.85 %


COST OF PREFERENCE CAPITAL
PREFERENCE DIVIDEND IS NOT LEGALLY BINDING ON THE FIRM AS
COMPARED TO DEBT.
DIVIDEND IS PAID TO THE SHAREHOLDERS AFTER CHARGING FOR
TAXES AND HENCE THERE IS NO TAX DEDUCTION IN CASE OF COST
OF PREFERENCE SHARES.
COST OF PREFERENCE IS GENERALLY HIGHER THAN COST OF DEBT.
Kp = DP/P * 100 WHERE P= PAR VALUE OF PREFERENCE SHARES ON
PER SHARE BASIS AND DP=EXPECTED DIVIDEND ON PER SHARE BASIS.
SOLVED PROBLEM :
PREFERENCE SHARE CAPITAL OF RS.100000 BY ISSUE OF PREFERENCE
SHARES OF RS.10 EACH. CALCULATE COST OF PREFERENCE CAPITAL
WHEN THEY ARE ISSUED AT 10% PREMIUM AND DISCOUNT ?.
ISSUED AT PREMIUM Kp = DP/P , 10000/110000* 100 =9.09%
ISSUED AT DISCOUNT Kp=dp/p , 10000/90000*100 =11.11%.
COST OF EQUITY CAPITAL
Ke IS DEFINED AS THE MINIMUM RATE OF RETURN THAT A FIRM MUST EARN
ON THE EQUITY FINANCED PORTION OF AN INVESTMENT PROJECT IN
ORDER TO LEAVE UNCHANGED THE MARKET PRICES OF THE SHARES .
THE FOLLOWING ARE THE APPROACHES ACCORDING TO WHICH THE COST
OF EQUITY CAPITAL CAN BE WORKED OUT :
1. DIVIDEND PRICE APPROACH
2. DIVIDEND PRICE ALONGWITH GROWTH APPROACH
3. EARNING PRICE APPROACH
4. REALISED YIELD APPROACH.
DIVIDEND PRICE APPROACH : THE COST OF EQUITY WILL BE THAT RATE
OF EXPECTED DIVIDENDS WHICH WILL MAINTAIN THE PRESENT MARKET
PRICE OF EQUITY CAPITAL.
Ke= DPS/MP*100 WHERE DPS = DIVIDEND PER SHARE , MP=MARKET PRICE
OF SHARE.
SOLVED PROBLEM : ISSUE OF 300000 EQUITY SHARES AT RS 10 PER SHARE
MARKET VALUE BEING RS 15 PER SHARE . CO. PAYS 1.2 AS DIVIDEND PER
SHARE .CALCULATE COST OF EQUITY CAPITAL. SOLUTION : Ke =
DPS/MP*100 = 1.2/15*100= 8%.
DIVIDEND PRICE ALONGWITH GROWTH APPROACH
THE COST OF EQUITY CAPITAL IS DETERMINED ON THE BASIS OF THE
EXPECTED DIVIDEND RATE ALONGWITH THE RATE FOR GROWTH RATE
IN DIVIDEND.RATE OF GROWTH IN DIVIDEND IS DETERMINED ON THE
BASIS OF THE AMOUNT OF DIVIDEND PAID IN LAST YEARS.
Ke= DPS/MP+g , WHERE g= GROWTH.

EARNING PRICE APPROACH
ITS THE EARNING PER SHARE WHICH DETERMINES THE MARKET
PRICE OF THE SHARE.IT IS BASED ON THE ASSUMPTION THAT THE
SHAREHOLDERS CAPITALISE A STREAM OF FUTURE EARNINGS IN
ORDER TO EVALUATE THEIR SHAREHOLDINGS.HENCE THE COST OF
CAPITAL SHOULD BE RELATED TO THE EARNINGS % WHICH COULD
KEEP THE MARKET PRICE OF EQUITY SHAREHOLDERS CONSTANT.
Ke = EPS / NP , FOR EXISTING EQUITY SHAREHOLDERS WE USE MP
INSTEAD OF NP.
REALISED YIELD APPROACH
THE COST OF EQUITY CAPITAL SHOULD BE DETERMINED ON THE
BASIS OF RETURN ACTUALLY REALISED BY THE INVESTOR IN A
COMPANY ON THEIR EQUITY SHARES.THE PAST RECORDS IN A GIVEN
PERIOD REGARDING DIVIDENDS AND THE ACTUAL CAPITAL
APPRECIATION IN THE VALUE OF EQUITY SHARES SHOULD BE TAKEN
TO COMPUTE THE COST OF EQUITY CAPITAL.

COST OF RETAINED EARNINGS
COST OF RETAINED EARNINGS REPRESENT AN OPPORTUNITY COST IN
TERMS OF THE RETURNS ON THEIR INVESTMENT IN ANOTHER
ENETRPRISE BY THE FIRM WHOSE COST OF RETAINED EARNINGS HAS
TO BE CONSIDERED.
SUPPOSE THE EARNINGS ARE NOT RETAINED BY THE COMPANY AND
PASSED TO THE SHAREHOLDERS AND THEY ARE INVESTED BY THE
SHAREHOLDERS IN THE NEW EQUITY SHARES OF THE SAME COMPANY
, THE EXPECTATIONS OF THE SHAREHOLDERS FROM THE NEW EQUITY
SHARES WOULD BE TAKEN AS THE OPPORTUNITY COST OF THE
RETAINED EARNINGS.
ADJUSTMENTS


INCOME TAX ADJUSTMENT :THE DIVIDEND RECEIVED BY THE
SHAREHOLDERS ARE SUBJECT TO INCOME TAX IN THEIR HANDS.


BROKERAGE ADJUSTMENTS : THE SHAREHOLDERS HAVE TO INCUR
SOME BROKERAGE COST ON INVESTMENT OF DIVIDEND RECEIVED ,
THUS THE FUND AVAILABLE FOR REINVESTMENT IS REDUCED BY THIS
AMOUNT.


Kr = EPS(1-Tp) (1-B)/MP*100
Kr = COST OF RETAINED EARNINGS
Tp= INCOME TAX RATE OF INDIVIDUAL SHAREHOLDER
B= BROKERAGE.