Financial Management - Meaning, Objectives and

Functions

Meaning of Financial Management :

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital

budgeting).Investment in current assets are also a part of investment decisions called
as working capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources
which will depend upon decision on type of source, period of financing, cost of
financing and the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will
depend upon expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs
 and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period
of financing.

4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager.
This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansion, innovation, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current
liabilities, maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

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 Organisation of Finance Function

The Role of Finance Manager

The role of finance manager in the company is an important one. The function of the finance
manager is not confined to the management and making of the accounts but it also plays a
major role in dividend decisions, capital budgeting decisions, capital structure outlay of the
firm, decision related to the merger and acquisitions, and all the investment decisions of the
firm. Thus the finance manager plays an important role in any business enterprise.

The different decisions can be classified into:

1. The routine working capital and cash management decisions.

2. Dividend decisions
3. Investment decisions
4. Financial forecasting
5. International financial decisions
6. Portfolio management
7. Risk management
8. Cash management
 • while the dividend decisions are related to deciding the amount that is to be
distributed to the shareholders, the investment decisions relate to the investment that
the company makes in different projects so as to expand the business and improve its
profitability. The finance manager here appraises the various projects and judges their
profitability.

• The manager also decides how much capital should be employed in the project and
which sources are the best for financing the project. Such decision also extends to the
investments in the foreign and the local market which requires a thorough knowledge
of the market trends thus the role becomes important.

• The top management takes the advice of the finance manager for the capital structure
outlay of the firm.

• On the monthly and yearly basis the manager looks into the inventory requirements,
daily cash requirements, and the objectives of the firm and then plans a budget
accordingly for different departments so that they receive optimum amount to carry
out the activities and achieve the business objectives.

• On the basis of the previous year budget utilization, different reviews and study
reports prepared by the research department, finance manager prepares a budget and
allocate the recourses for the coming year.

• With globalization the role of finance manager is not confined to the regional
boundaries but has spread to the activities involving taking the decisions regarding
mergers and acquisitions, establishing of the subsidiaries and investing in the foreign
markets.

• Here the finance manager looks into the profits that the business can generate from
establishing the subsidiary, what should be the capital outlay of the firm, what tax
benefits the firm can avail by establishing and expanding into the foreign market?

• A finance manager thus not only acts as a person maintaining the accounts but also
plays a major role in the management of portfolio, risk, cash and capital.

ROLE OF FINANCIAL MANAGER :

• Estimation of capital requirement.

• Choice of sources of funds.
• Investment of funds.
• Management of cash.
• Disposal of funds.
• To plan a sound capital structure
• Make proper plan and policy according to their budget
What Does Investment Analysis Mean?
1. The study of how an investment is likely to perform and how suitable it is for a given
investor. Investment analysis is key to any sound portfolio-management strategy.
Investors not comfortable doing their own investment analysis can seek professional
advice from a financial advisor.

2. An analysis of past investment decisions. An investment analysis is a look back at

previous investment decisions and the thought process of making the investment
decision. Key factors should include entry price, expected time horizon, and reasons
for making the decision at the time.

3. For example, in conducting an investment analysis of a mutual fund, the investor

would look at factors such as how the fund has performed compared to its benchmark.
The investor could also compare performed to similar funds, its expense ratio,
management stability, sector weighting, style and asset allocation. Investment goals
should always be considered when analyzing an investment; one size does not always
fit all, and highest returns regardless of risk are not always the goal.

4. For any beginner investor, investment analysis is essential. Looking back at past
decisions and analyzing the mistakes and successes will help fine-tune strategies.
Many investors don't even document why they made an investment let alone analyze
why they were wrong or right. You could make a proper decision, extraordinary
events could lose you money, and if you didn't analyze it, you would shy away from
making the same decision.

What Does Discounted Cash Flow - DCF Mean?

• A valuation method used to estimate the attractiveness of an investment opportunity.
Discounted cash flow (DCF) analysis uses future free cash flow projections and
discounts them (most often using the weighted average cost of capital) to arrive at a
present value, which is used to evaluate the potential for investment. If the value
arrived at through DCF analysis is higher than the current cost of the investment, the
opportunity may be a good one.

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Calculated as:

• Also known as the Discounted Cash Flows Model.

Explains Discounted CashFlow(DCF)

There are many variations when it comes to what you can use for your cash flows and
discount rate in a DCF analysis. Despite the complexity of the calculations
involved, the purpose of DCF analysis is just to estimate the money you'd receive
from an investment and to adjust for the time value of money.

• Discounted cash flow models are powerful, but they do have shortcomings. DCF is
merely a mechanical valuation tool, which makes it subject to the axiom "garbage in,
garbage out". Small changes in inputs can result in large changes in the value of a
company. Instead of trying to project the cash flows to infinity, terminal
value techniques are often used. A simple annuity is used to estimate the terminal
value past 10 years, for example. This is done because it is harder to come to a
realistic estimate of the cash flows as time goes on.

CASH FLOW

• Cash flow is the money coming into an organization minus money going out. It is
calculated using information from a company's balance sheet and income statement.
The direct method of calculation requires knowledge of which income and expense
items to include as cash flow items, and which to exclude because they don't involve
the transfer of cash or cash equivalents, such as Treasury bills.

INSTRUCTIONS
 Calculate cash flows related to operating activities. Add together cash receipts from
customers and cash generated from operations. Then subtract cash payments (to
employees, suppliers, vendors, etc.), interest paid and income taxes paid. The result is
the net cash flows from operating expenses.

 Calculate cash flows related to investing activities. Total the sale proceeds from
equipment and land and any cash dividends or coupon interest received from other
companies. This is the net cash flow from investing activities.

 Calculate cash flows related to financing activities. Subtract dividends paid and
financial interest (non-operating interest) paid. Add in cash received through the
issuance of stock, bonds or any paid-in capital in the form of cash. If you have used
 cash to pay down existing debt or repurchase stock, subtract it from your total. You
now have the net cash flows due to financing activities.

 Add together your three net cash flows. The result is the net cash flow for the period.
Add this flow to the amount of cash and cash equivalents available at the start of the
reporting period to find your current amount of cash and equivalents. Post all of this
information in the statement of cash flows.

Working capital
 Working capital is a financial metric which represents operating liquidity available
to a business, organization, or other entity, including governmental entity. Along with
fixed assets such as plant and equipment, working capital is considered a part of
operating capital. Net working capital is calculated as current assets minus current
liabilities. It is a derivation of working capital, that is commonly used in valuation
techniques such as DCFs (Discounted cash flows). If current assets are less than
current liabilities, an entity has a working capital deficiency, also called a working
capital deficit.
Working Capital = Current Assets
Net Working Capital = Current Assets − Current Liabilities
Net Operating Working Capital = Current Assets − Non Interest-bearing Current
Liabilities
Equity Working Capital = Current Assets − Current Liabilities − Long-term Debt
 A company can be endowed with assets and profitability but short of liquidity if its
assets cannot readily be converted into cash. Positive working capital is required to
ensure that a firm is able to continue its operations and that it has sufficient funds to
satisfy both maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing inventories, accounts receivable
and payable, and cash.
Calculation

Current assets and current liabilities include three accounts which are of special
importance. These accounts represent the areas of the business where managers have the most
direct impact:

 accounts receivable (current asset)

 inventory (current assets), and
 accounts payable (current liability)
 The current portion of debt (payable within 12 months) is critical, because it
represents a short-term claim to current assets and is often secured by long term
assets. Common types of short-term debt are bank loans and lines of credit.
  An increase in working capital indicates that the business has either increased current
assets (that is has increased its receivables, or other current assets) or has
decreased current liabilities, for example has paid off some short-term creditors.
 Implications on M&A: The common commercial definition of working capital for
the purpose of a working capital adjustment in an M&A transaction (i.e. for a working
capital adjustment mechanism in a sale and purchase agreement) is equal to:
 Current Assets – Current Liabilities excluding deferred tax assets/liabilities, excess
cash, surplus assets and/or deposit balances.
 Cash balance items often attract a one-for-one purchase price adjustment.
Working capital management

• Decisions relating to working capital and short term financing are referred to
as working capital management. These involve managing the relationship between a
firm's short-term assets and its short-term liabilities. The goal of working capital
management is to ensure that the firm is able to continue its operations and that it has
sufficient cash flow to satisfy both maturing short-term debt and upcoming
operational expenses.
Decision criteria
 By definition, working capital management entails short term decisions - generally,
relating to the next one year period - which are "reversible". These decisions are
therefore not taken on the same basis as Capital Investment Decisions (NPV or
related, as above) rather they will be based on cash flows and / or profitability.
 One measure of cash flow is provided by the cash conversion cycle - the net number
of days from the outlay of cash for raw material to receiving payment from the
customer. As a management tool, this metric makes explicit the inter-relatedness of
decisions relating to inventories, accounts receivable and payable, and cash. Because
this number effectively corresponds to the time that the firm's cash is tied up in
operations and unavailable for other activities, management generally aims at a low
net count.
 In this context, the most useful measure of profitability is Return on capital (ROC).
The result is shown as a percentage, determined by dividing relevant income for the
12 months by capital employed; Return on equity(ROE) shows this result for the
firm's shareholders. Firm value is enhanced when, and if, the return on capital, which
results from working capital management, exceeds the cost of capital, which results
from capital investment decisions as above. ROC measures are therefore useful as a
management tool, in that they link short-term policy with long-term decision making.
See Economic value added (EVA).
 Credit policy of the firm: Another factor affecting working capital management is
credit policy of the firm. It includes buying of raw material and selling of finished
goods either in cash or on credit. This affects the cash conversion cycle.
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Management of working capital
 Guided by the above criteria, management will use a combination of policies and
techniques for the management of working capital. These policies aim at managing
the current assets (generally cash and cash equivalents,inventories and debtors) and
the short term financing, such that cash flows and returns are acceptable.
 Cash management. Identify the cash balance which allows for the business to meet
day to day expenses, but reduces cash holding costs.

1. Inventory management. Identify the level of inventory which allows for

uninterrupted production but reduces the investment in raw materials - and minimizes
reordering costs - and hence increases cash flow. Besides this, the lead times in
production should be lowered to reduce Work in Progress (WIP) and similarly,
the Finished Goods should be kept on as low level as possible to avoid over
production - see Supply chain management; Just In Time (JIT); Economic order
quantity (EOQ); Economic quantity
2. Debtors management. Identify the appropriate credit policy, i.e. credit terms which
will attract customers, such that any impact on cash flows and the cash conversion
cycle will be offset by increased revenue and hence Return on Capital (or vice versa);
see Discounts and allowances.
3. Short term financing. Identify the appropriate source of financing, given the cash
conversion cycle: the inventory is ideally financed by credit granted by the supplier;
however, it may be necessary to utilize a bank loan(or overdraft), or to "convert
debtors to cash" through "factoring".

Types of Working Capital

1. Gross working capital

Total or gross working capital is that working capital which is used for all the
current assets. Total value of current assets will equal to gross working capital.

2. Net Working Capital

Net working capital is the excess of current assets over current liabilities.

Net Working Capital = Total Current Assets – Total Current Liabilities

This amount shows that if we deduct total current liabilities from total current
assets, then balance amount can be used for repayment of long term debts at
any time.

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3. Permanent Working Capital

Permanent working capital is that amount of capital which must be in cash or

current assets for continuing the activities of business.

4. Temporary Working Capital

Sometime, it may possible that we have to pay fixed liabilities, at that time we
need working capital which is more than permanent working capital, then this
excess amount will be temporary working capital. In normal working of
business, we don’t need such capital.

In working capital management, we analyze following three points

1. What is the need for working capital?

After study the nature of production, we can estimate the need for working
capital. If company produces products at large scale and continues producing
goods, then company needs high amount of working capital.

2. What is optimum level of Working capital in business?

Have you achieved the optimum level of working capital which has invested
in current assets? Because high amount of working capital will decrease
the return on investmentand low amount of working capital will increase the
risk of business. So, it is very important decision to get optimum level of
working capital where both profitability and risk will be balanced. For
achieving optimum level of working capital, finance manager should also
study the factors which affects the requirement of working capital and
different elements of current assets. If he will manage cash, debtor and
inventory, then working capital will automatically optimize.

3. What are main Working capital policies of businesses?

Policies are the guidelines which are helpful to direct business. Finance
manager can also make working capital policies.
 1. Working capital policy

Liquidity policy

Under this policy, finance manager will increase the amount of liquidity for
reducing the risk of business. If business has high volume of cash
and bank balance, then business can easily pays his dues at maturity. But
finance manger should not forget that the excess cash will not produce and
earning and return on investment will decrease. So liquidity policy should be
optimized.

2. Profitability policy

Under this policy, finance manger will keep low amount of cash in business
and try to invest maximum amount of cash and bank balance. It will sure that
profit of business will increase due to increasing of investment in proper way
but risk of business will also increase because liquidity of business will
decrease and it can create bankruptcy position of business. So, profitability
policy should make after seeing liquidity policy and after this both policies
will helpful for proper management of working capital.

OBJECTIVES OF WORKING CAPITAL MANAGEMENT

• The main objective is to ensure the maintenance of satisfactory level of working

capital in such a way that it is neither inadequate nor excessive. It should not only be
sufficient to cover the current liabilities but ensure a reasonable margin of safety also.
• To minimize the amount of capital employed in financing the current assets. This also
leads to an improvement in the “Return of Capital Employed”.
• To manage the current assets in such a way that the marginal return on investment in
these assets is not less than the cost of capital acquired to finance them. This will
ensure the maximization of the value of the business unit.
• To maintain the proper balance between the amount of current assets and the current
liabilities in such a way that the firm is always able to meet its financial obligations,
whenever due. This will ensure the smooth working of the unit without any
production held ups due to paucity of funds.
Types of Working Capital
A. Permanent Working Capital
B. Temporary Working Capital

Permanent Working Capital:

• The operating cycle is a continuous feature in almost all the going concerns and
therefore creates the need for working capital and their efficient management.
• However the magnitude of working capital required will not be constant, but will
fluctuate. At any time, there is always a minimum level of current assets which is
constantly and continuously required by a business unit to carry on its operations.
• This minimum amount of current assets, which is required on a continuous and
uninterrupted basis is after referred to as fixed or permanent working capital. This
type of working capital should be financed (along with other fixed assets) out of long
term funds of the unit. However in practice, a portion of these requirements also is
met through short term borrowings from banks and suppliers credit.

PERMANENT CURRENT ASSETS AND TEMPORARY CURRENT ASSETS

• The amount of current assets required to meet a firm’s long-term minimum needs are
called Permanent current assets.
• For e.g., In a manufacturing unit, basic raw materials required for production has to be
available at all times and this has to be financed without any disturbance.
Temporary Working Capital:
• Any amount over and above the permanent level of working capital is variable,
temporary or fluctuating working capital.
 • This type of working capital is generally financed from short term sources of finance
such as bank credit because this amount is not permanently required and is usually
paid back during off season or after the contingency.
• As the name implies, the level of fluctuating working capital keeps on fluctuating
depending on the needs of the unit unlike the permanent working capital which
remains constant over a period of time. Current assets that fluctuate due to seasonal or
cyclical demand are called temporary current assets.

DETERMINANTS OF WORKING CAPITAL:

 Working capital management is an indispensable functional area of management.

However the total working capital requirements of the firm are influenced by the
large number of factors. It may however be added that these factors affect differently
to the different units and these keep varying from time to time. In general, the
determinants of working capital which are common to all organizations can be
summarized as under:
a. Nature and Size of Business
b. Production Cycle
c. Business Cycled.
d. Production Policy
e. Credit Policy
f. Growth & Expansion
g. Proper availability of raw materials
h. Profit level
i. Inflation
j. Operating Efficiency
SOURCES OF WORKING CAPITAL:

The working capital necessary and what constitutes working capital have been analyzed in
depth. Now we look out what are the ways we can generate working capital
a. Trade Credits
b. Bank Credit
c .Current provisions and non-bank short term borrowings: and
d. Long term sources i.e., equity share capital, preference share capital and other long term
borrowings.

Factors Determining Working Capital Requirements

There are a number of factors which determine the amount of working capital requirements in
business. Therefore, it is not possible to give general principles applicable to all enterprises
equally. It is desirable to analyze the factors in the context of each particular unit. We may
point out some basic factors influencing working capital requirements.

1. Nature and Volume of Business:

 The nature and volume of business is an important factor in deciding the amount of
working capital. For example, the amount of working capital is generally more in
trading concerns and in service units as compared to the manufacturing units.

 The retail trading units have also to invest large funds in working capital. In some
manufacturing units also, the working capital holds a significant place. On the other
hand, public utilities require less working capital. Other manufacturing units need
more working capital as compared to public utilities.

 The relation between the volume of business and the requirement of working capital
is more direct and clear. The bigger the size of the units, the more will be the
requirement of working capital.

2. Length of Manufacturing Cycle:

 The time that elapses from the purchase and use of raw materials to the production of
finished goods is called manufacturing cycle. The longer the period a manufacturing
cycle takes, the larger is the amount of working capital required, because the funds get
locked up in production process for a longer period of time.

 It is in view of this that, when alternative methods of production are available, the
method with the shortest manufacturing cycle should be chosen (assuming other
 factors to be equal). Once a choice is made, care is taken to see that the manufacturing
cycle is completed within a specified period. Any delay in production is bound to
increase the requirement of working capital.

3. Business Fluctuations:

 Business fluctuations are of two types: seasonal fluctuations which arise out of
seasonal changes in demand for the product and cyclical fluctuations which occur due
to ups and downs of economic activities in the country as a whole.

 If demand for the product is seasonal, production will have to be increased during the
season, and it will have to be reduced during the off-season. Correspondingly, there
will be fluctuations in the requirement of working capital. The business unit will have
to face some other problems in addition to this one.

 It has to bear extra expenses to increase production when product demand increases. It
has to bear, costs even to maintain work force and physical facilities during slack
season. For this reason, many units prefer to continue production even during slack
season and increase the level of their inventories.

 The cyclical fluctuations are made up of periods of prosperity and depression. The
sales and prices increase during prosperity necessitating more working capital in the
form of inventories and book-debts. If new investment is made in fixed capital to
meet additional demand for the product, then also there will be an increase in working
capital requirement.

 Generally, business units adopt the policy to borrow funds on a large scale to increase
investment in working capital. As against this, the requirement of working capital gets
reduced during depression and therefore they adopt the policy of reducing their short
term debts.

4. Production Policy:

 The production policy of business is also an important determinant of working capital

requirement. If the policy of Constant Production is adopted, there are two possible
effects. If demand for the product is regular and constant, this policy helps in reducing
working capital requirement to the lowest possible level.

 But if demand for the product is seasonal, this policy raises the level of inventory
during off season and thereby increases the working capital requirement. If the cost of
maintaining inventory is considerably high, the policy of varying production
according to demand is preferred.

 If the unit produces varied products, it can reduce the requirement of working capital
by adjusting the structure of production to the changes in demand.

5. Credit Policy:
  In the present-day circumstances, almost all units have to sell goods on credit. The
nature of credit policy is an important consideration in deciding the amount of
working capital requirement. The larger the volume of credit sales, the greater will be
the requirement of working capital. Also, the longer the period the collection of
payment takes, the greater will be the requirement of working capital.

 Generally, the credit policy of an individual firm depends on the norms of the industry
to which the firm belongs. Yet it is possible to pursue different credit policies for
different customers in accordance with their creditworthiness. To ignore
creditworthiness of the individual customers can be dangerous to the firm. In addition,
it is necessary that the firm should be prompt in collection of payments. Any
slackness in this respect will increase the requirement of working capital and will
increase the chance of bad debts.

FACTORS DETERMINING THE WORKING CAPITAL

• The working capital requirement of the concern depends upon a large numbers of
factors such as nature and the size of business, the character of their
operations, the length of production cycles, the rate of stock turnover
and the state of economic situation. It is not possible to rank them because all
such factors are of different importance and influence of i n d i v i d u a l f a c t o r
changes for a firm overtime. However, the following are
i m p o r t a n t factors generally influencing the working capital requirements.

 Nature and character of business.

 Size of business\scale of operation.
 Production policy.
 Manufacturing process\length of production cycle.
 Seasonal variation.
 Working capital cycle.
 Rate of stock turnover.
 Credit policy
 Business cycle.
 Rate of growth of business.
 Earning capacity and dividend policy.
 Price level changes.
 Other factors.
ESTIMATION OF WORKING CAPITAL REQUIREMENTS

1. Cost of fixed assets including land and buildings, plant and machinery, furniture, etc. The
amount invested in these items is called fixed capital.

2. Cost of current assets including cash, stock of goods (also called inventory of merchandise),
book debts, bills, etc.

3. Cost of promotion including the expenses on preliminary investigation, accounting,

marketing and legal advice, etc.

4. Cost of setting up the organisation.

5. Cost of establishing the business, i.e., the operating losses which have generally to be
sustained in the initial periods of a company.

6. Cost of financing including brokerage on securities, commission on underwriting, etc.

7. Cost of intangible assets like goodwill, patents, etc.

Of the various items of financial requirements listed above, the first two deserve special
consideration, as the successes of any concern will depend largely on them.

INVENTORY MANAGEMENT
MAIN OBJECTIVES OF RECEIVABLES MANAGEMENT:-

(1) To optimise the amount of sales.

(2) To minimise cost of credit.

(3) To optimise investment in receivables.

THE COST OF CAPITAL

In previous classes, we discussed the important concept that the expected return on an
investment should be a function of the “market risk” embedded in that investment – the risk-
return tradeoff.

The firm must earn a minimum of rate of return to cover the cost of generating funds to
finance investments; otherwise, no one will be willing to buy the firm’s bonds, preferred
stock, and common stock.

This point of reference, the firm’s required rate of return, is called the COST OF CAPITAL.

• The cost of capital is the required rate of return that a firm must achieve in order to
cover the cost of generating funds in the marketplace. Based on their evaluations of
the riskiness of each firm, investors will supply new funds to a firm only if it pays
them the required rate of return to compensate them for taking the risk of investing in
the firm’s bonds and stocks.

• If, indeed, the cost of capital is the required rate of return that the firm must pay to
generate funds, it becomes a guideline for measuring the profitability’s of different
investments. When there are differences in the degree of risk between the firm and its
divisions, a risk-adjusted discount-rate approach should be used to determine their
profitability.

What impacts the cost of capital? INTEREST

RATE

LEVELS IN
RISKINES
S OF FINANCIAL
THE
EARNING SOUNDNE
S
THE DEBT SS OF THE US/GLOBAL
TO EQUITY
FIRM
MIX OF
THE FIRM MARKETPLA

CE

• The Cost of Capital becomes a guideline for measuring the profitabilities of different
investments.
 • Another way to think of the cost of capital is as the opportunity cost of funds, since
this represents the opportunity cost for investing in assets with the same risk as the
firm. When investors are shopping for places in which to invest their funds, they have
an opportunity cost.

• The firm, given its riskiness, must strive to earn the investor’s opportunity cost. If the
firm does not achieve the return investors expect (i.e. the investor’s opportunity cost),
investors will not invest in the firm’s debt and equity. As a result, the firm’s value
(both their debt and equity) will decline.

WEIGHTED AVERAGE COST OF CAPITAL

(WACC)

The firm’s WACC is the cost of Capital for the firm’s mixture of debt and stock in their
capital structure.

WACC = wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. stock)

So now we need to calculate these to find the WACC!

wd = weight of debt (i.e. fraction of debt in the firm’s capital structure)

ws = weight of stock
wd
wp = weight of prefered stock
ws
Think of the firm’s
THE FIRM’S
capital structure as a
CAPITAL
pie, that you can slice
STRUCTURE IS
into different shaped
THE MIX OF DEBT
pieces. The firm
AND EQUITY
strives to pick the
USED TO
weights of debt and
FINANCE THE
equity (i.e. slice the
wp pie) to minimize the
cost of capital.
COST OF DEBT (Kd)

We use the after tax cost of debt because interest payments are tax deductible for the firm.

Kd after taxes = Kd (1 – tax rate)

EXAMPLE

If the cost of debt for Cowboy Energy Services is 10% (effective rate) and its tax rate is 40%
then:

Kd after taxes = Kd (1 – tax rate)

= 10 (1 – 0.4) = 6.0 %

We use the effective annual rate of debt based on current market conditions (i.e. yield to
maturity on debt). We do not use historical rates (i.e. interest rate when issued; the stated
rate).

Cost of Preferred Stock (Kp)

Preferred Stock has a higher return than bonds, but is less costly than common stock. WHY?

In case of default, preferred stockholders get paid before common stock holders. However,
in the case of bankruptcy, the holders of preferred stock get paid only after short and long-
term debt holder claims are satisfied.

Preferred stock holders receive a fixed dividend and usually cannot vote on the firm’s affairs.

preferred stock dividend

Kp = market price of preferred stock

<OR if issuing new preferred stock>

preferred stock dividend

Kp = market price of preferred stock (1 – flotation cost)

Unlike the situation with bonds, no adjustment is made for taxes, because preferred stock
dividends are paid after a corporation pays income taxes. Consequently, a firm assumes the
full market cost of financing by issuing preferred stock. In other words, the firm cannot
deduct dividends paid as an expense, like they can for interest expenses.

Example

If Cowboy Energy Services is issuing preferred stock at $100 per share, with a stated
dividend of $12, and a flotation cost of 3%, then:

preferred stock dividend

Kp = market price of preferred stock (1 – flotation cost)

$12
= $100 (1-0.03) = 12.4 %
Cost of Equity (i.e. Common Stock & Retained Earnings)

The cost of equity is the rate of return that investors require to make an equity investment in a
firm. Common stock does not generate a tax benefit as debt does because dividends are paid
after taxes.

The cost of common stock is the highest. Why?

Retained earnings are considered to have the same cost of capital as new common stock.
Their cost is calculated in the same way, EXCEPT that no adjustment is made for flotation
costs.

3 Ways to Calculate

1. Use CAPM
2. (GORDON MODEL) The constant dividend growth model – same as DCF method
3. Bond yield – plus – risk premium

1. Ks using CAPM (capital asset pricing model)

The CAPM is one of the most commonly used ways to determine the cost of common stock.
This “cost” is the discount rate for valuing common stocks, and provides an estimate of the
cost of issuing common stocks.

Ks = Krf + β (Km - Krf)

Where: Krf is the risk free rate

β is the firm’s beta
Km is the return on the market

EXAMPLE:

Cowboy Energy Services has a B = 1.6. The risk free rate on

T-bills is currently 4% and the market return has averaged 15%.

Ks = Krf + β (Km - Krf)

= 4 + 1.6 (15 – 4) = 21.6 %

For information on estimating the cost of equity based on the dividend growth model, or the
bond-yield plus risk premium, refer to the background readings’ textbook.
WACC: PUTTING IT ALL TOGETHER
RECALL:

WACC = wd (cost of debt after tax) + ws (cost of stock/RE) + wp(cost of PS)

EXAMPLE
Cowboy Energy Services maintains a mix of 40% debt, 10% preferred stock, and 50%
common stock in its capital structure. The WACC is:

WACC = 0.4(6%) + 0.1 (12.4) + 0.5(21.6)

= 2.4 + 1.24 + 10.8
= 14.4 %

DETERMINING THE WEIGHTS TO BE USED:

 The firm’s balance sheet shows the book values of the common stock, preferred stock,
and long-term bonds. You can use the balance sheet figures to calculate book value
weights, though it is more practicable to work with market weights.

 Basically, market value weights represent current conditions and take into account the
effects of changing market conditions and the current prices of each security. Book
value weights, however, are based on accounting procedures that employ the par
values of the securities to calculate balance sheet values and represent past conditions.

 The table on the next page illustrates the difference between book value and market
value weights and demonstrates how they are calculated.

VALUE DOLLAR WEIGHTS ASSUMED

AMOUNT OR % OF COST OF
TOTAL CAPITAL (%)
VALUE
Book Value
Debt 2,000,000 40.4 10
2,000 bonds at par, or $1000
Preferred stock 450,000 9.1 12
4,500 shares at $100 par value
Common equity 2,500,000 50.5 13.5
500,000 shares outstanding at $5.00
par value

Total book value of capital 4,950,000 100 11.24 is the

WACC
Market Value
Debt 1,800,000 30.2 10
2,000 bonds at $900 current market
price
Preferred stock 405,000 6.8 12
4,500 shares at $90 current market
price
Common equity 3,750,000 63.0 13.5
500,000 shares outstanding at $75
current market price
Total market value of capital 5,955,000 100 What is the
WACC?
 Note that the book values that appear on the balance sheet are usually different from
the market values. Also, the price of common stock is normally substantially higher
than its book value. This increases the weight of this capital component over other
capital structure components (such as preferred stock and long-term debt).

 The desirable practice is to employ market weights to compute the firm’s cost of
capital. This rationale rests on the fact that the cost of capital measures the cost of
issuing securities – stocks as well as bonds – to finance projects, and that these
securities are issued at market value, not at book value.

 Target weights can also be used. These weights indicate the distribution of external
financing that the firm believes will produce optimal results. Some corporate
managers establish these weights subjectively; others will use the best companies in
their industry as guidelines; and still others will look at the financing mix of
companies with characteristics comparable to those of their own firms.

 Generally speaking, target weights will approximate market weights. If they don’t,
the firm will attempt to finance in such a way as to make the market weights move
closer to target weights.

HURDLE RATES:

• Hurdle rates are the required rate of return used in capital budgeting. Simply put,
hurdle rates are based on the firm’s WACC. To understand the concept of hurdle
rates, I like to think of it this way.

• A runner in track jumps over a hurdle. Projects in the firm is considering must “jump
the hurdle” – or in other words – exceed the firm’s borrowing costs (i.e. WACC). If
the project does not clear the hurdle, the firm will lose money on the project if they
invest in it – and decrease the value of the firm.

• The hurdle rate is used by firms in capital budgeting analysis (one of the next topics
we will be studying). Large companies, with divisions that have different levels of
risk, may choose to have divisional hurdle rates.

• Divisional hurdle rates are sometimes used because firms are not internally
homogeneous in terms of risk. Finance theory and practice tells us that investors
require higher returns as risk increases. For example, do the following investment
• projects have the same level of risks? Engineering projects such as highway
construction, market-expansion projects into foreign markets, new-product
introductions, E-commerce startups, etc.
BREAKPOINTS (BP) IN THE WACC:

 Breakpoints are defined as the total financing that can be done before the firm is
forced to sell new debt or equity capital. Once the firm reaches this breakpoint, if
they choose to raise additional capital their WACC increases.

• For example, the formula for the retained earnings breakpoint below demonstrates
how to calculate the point at which the firm’s cost of equity financing will increase
because they must sell new common stock. (Note: The formula for the BP for debt or
preferred stock is basically the same, by replacing retained earnings for debt and using
the weight of debt.)

BPRE = Retained earnings

Weight of equity

CASH MANAGEMENT

Cash is money that is easily accessible either in the bank or in the business. It is not
inventory, it is not accounts receivable, and it is not property. These might be converted to
cash at some point in time, but it takes cash on hand or in the bank to pay suppliers, to pay
the rent, and to meet the payroll. Profit growth does not always mean more cash.

Profit is the amount of money you expect to make if all customers paid on time and if your
expenses were spread out evenly over the time period being measured. However, it is not
your day-to-day reality. Cash is what you must have to keep the doors of your business open.
Over time, a company's profits are of little value if they are not accompanied by positive net
cash flow. You can't spend profit; you can only spend cash.

Cash Flow refers to the flow of cash into and out of a business over a period of time. The
outflow of cash is measured by the money you pay every month to salaries, suppliers, and
creditors. The inflows are the cash you receive from customers, lenders, and investors.

 Positive Cash Flow

If the cash coming into the business is more than the cash going out of the business,
the company has a positive cash flow. A positive cash flow is very good and the only
concern here is managing the excess cash prudently.

 Negative Cash Flow

 If the cash going out of the business is more than the cash coming into the business,
the company has a negative cash flow. A negative cash flow can be caused by a
number of problems that result in a shortage of cash, such as too much or obsolete
inventory, or poor collections on accounts receivable. If the company doesn't have
money in the bank or can't borrow additional cash at this point, it may be in serious
trouble. A Cash Flow Statement is typically divided into three components so that you
can see and understand both the internal and external sources and uses of cash.

1. Operating Cash Flow (Internal)

Operating cash flow, often referred to as working capital, is the cash flow generated
from internal operations. It is the cash generated from sales of the product or service of
your business. Because it is generated internally, it is under your control.
2. Investing Cash Flow (Internal)
Investing cash flow is generated internally from non-operating activities. This
component would include investments in plant and equipment or other fixed assets,
nonrecurring gains or losses, or other sources and uses of cash outside of normal
operations.
3. Financing Cash Flow (External)
Financing cash flow is the cash to and from external sources, such as lenders, investors
and shareholders. A new loan, the repayment of a loan, the issuance of stock and the
payment of dividend are some of the activities that would be included in this section of
the cash flow statement.

Good cash management means:

• Knowing when, where, and how your cash needs will occur,
• Knowing what the best sources are for meeting additional cash needs; and,
• Being prepared to meet these needs when they occur, by keeping good relationships
with bankers and other creditors.
FACTORS INFLUENCING DIVIDEND POLICY
• Capital Impairment Rule -- many states prohibit the payment of dividends if these
dividends impair “capital” (usually either par value of common stock or par plus
additional paid-in capital).
 Incorporation in some states (notably Delaware) allows a firm to use the “fair value,”
rather than “book value,” of its assets when judging whether a dividend impairs
“capital.”

• Insolvency Rule -- some states prohibit the payment of cash dividends if the
company is insolvent under either a “fair market valuation” or “equitable” sense.
• Undue Retention of Earnings Rule -- prohibits the undue retention of earnings in
excess of the present and future investment needs of the firm.
FACTORS INFLUENCING DIVIDEND POLICY

• Funding Needs of the Firm

• Liquidity
• Ability to Borrow
• Restrictions in Debt Contracts (protective covenants)
• Control

TYPES OF DIVIDENDU :
3.1 CASH DIVIDEND

Example: $.5 for every share you hold

Regular, regular + "extra" , special
Dates:
____ |___________|______________|_____________|
1/15 1/26 1/30 2/15
Declaration Ex-dividend Record Payment
Date Date Date Date

Only investors who hold the security prior to the ex-dividend date receive the dividend.
3.2 STOCK DIVIDEND
Example: 1 new stock for each 10 you hold
Reasons
 Alternative to "extra" or special dividend
Eg. A company just sold a division and cannot use the proceeds for favourable
investments.
 If management believes the stock is under-valued.
 As an obstacle to takeovers.
3.3 STOCK REPURCHASE
in the open market tender offer direct negotiation with major shareholders
(OR)
TYPES OF DIVIDEND POLICY
The following are various types of dividend policies
(1) Policy of No Immediate Dividend
(2) Stable Dividend Policy.
(3) Regular Dividend plus Extra Dividend Policy.
(4) Irregular Dividend Policy.
(5) Regular Stock Dividend Policy.
(6) Regular Dividend plus Stock Dividend Policy.
(7) Liberal Dividend Policy.
LEVERAGES
In finance, leverage is a general term for any technique to multiply gains and
losses. Common ways to attain leverage are borrowing money, buying fixed assets and
using derivatives. Important examples are:

 A public corporation may leverage its equity by borrowing money. The more it
borrows, the less equity capital it needs, so any profits or losses are shared among a
smaller base and are proportionately larger as a result.
 A business entity can leverage its revenue by buying fixed assets. This will increase
the proportion of fixed, as opposed to variable, costs, meaning that a change
in revenue will result in a larger change in operating income. Hedge funds often
leverage their assets by using derivatives.
 A fund might get any gains or losses on $20 million worth of crude oil by posting $1
million of cash as margin. It shows relation between various aspects – particularly risk
and reward
 Leverage is a relation of your efforts and rewards.
 Some factors like fixed cost resources etc. have impact on increase or decrease in
profit.

 It increases your speed and also your risk.

We have two types of leverages in FINANCIAL MANAGEMENT :

•A. operating leverage
•B. financial leverage

FINANCIAL LEVERAGE:

 Use of fixed charge securities like debentures in the overall capital structure is called
financial leverage.
DFL = degree of financial leverage
 It tells us about the level of financial risk that we are taking. If financial leverage
increases, the risk of the firm increases.

% change in net income / % change in EBIT

•EBIT = earnings before interest and taxes, it is also called net operating income
•Net income = income after payment of all dues including interest.
 Example : your EBIT is 1000, your interest is 500. your EBIT increases by 20%, interest
remains same, so net income increases from 500 to 700. Thus DFL = 40/20= 2 answer
(% change in net income is 40% due to increase in earning, but no change in interest).

OPERATING LEVERAGE
It measures the impact of change in volume (sales) on EBIT. It measures the riskiness due to
fixed cost resources in the organisation.
• DOL = degree of financial leverage = % change in EBIT / % change in sales
• It measures the impact of fixed cost onprofitability
 DCL = degree of combined leverage
DCL = DOL * DFL (PRODUCT OF DOL AND DFL)

COST OF CAPITAL
In the context of financial management, the term "cost of capital" refers to the remuneration
required by investors or lenders to induce them to provide funding for an ongoing business. If
the firm's goal is to remain profitable and to increase value to its shareholders, any use of
capital must return at least its cost of capital, and optimally, an amount greater than its cost of
capital.
The Weighted Average Cost of Capital (WACC) is often used as a benchmark, or "hurdle
rate" when evaluating new projects and businesses that would require use of the scarce
resource of funding.

Computing a company's cost of capital is not as simple as using, for example, the rate of
interest it is charged on bank financing. The true cost of capital must be determined
considering economic, market, and tax issues. Sometimes investor relations and market
perception play a role in determining a company's capital structure as well.

Most firms do not rely on only one type of financing, but seek to maintain an acceptable
capital structure using a mix of various elements. These sources of financing include long-
term debt, common stock, preferred stock, and retained earnings. In this discussion we will
examine the four types of capital, their relative costs, and the methods by which a Weighted
Average Cost of Capital is derived for practical use.

COST OF LONG-TERM DEBT

The cost of long-term debt is the after-tax cost of borrowing through the issuance
of bonds. The proceeds of the bonds are reduced by the costs incurred to issue and sell the
securities, called flotation costs. The following formula illustrates the computation of the
before-tax cost of debt of a $1000 bond:

where

I = Annual interest P = Net proceeds of bond issue n = Number of years to maturity

K d = Before-tax cost of debt

It is important to state the cost of financing on an after-tax basis because interest on debt is
tax-deductible. The before-tax cost of debt can be converted to the after-tax cost of debt by
applying the following equation:

where T = the firm's corporate tax rate K i = the after-tax cost of debt to the firm

COST OF COMMON STOCK EQUITY

The cost of common stock equity is estimated by determining the rate at which the investor
discounts the expected dividends to determine the share value. That is, the amount an investor
is willing to pay for a share of stock is determined by his view of the future dividends
potential of the security.
One method used to determine the cost of common stock equity is the Constant Growth
Valuation (Gordon) Model. This model is based on the assumption that a share's value is
based on the present value of all future dividends in perpetuity. The following formula
illustrates the model:

where K i = the cost of common stock equity D 1 = the expected dividend for the next period
P o = the present value of future dividends g = the expected percentage dividend growth rate
in decimal form

COST OF PREFERRED STOCK

Preferred stock is a unique type of ownership in a firm. Its dividends are senior to, or take
priority over, the payment of those on common stock. The amount of dividends that will be
paid to the holders of preferred shares may be stated as a percent of its par value, or as a flat
dollar amount. For purposes of analysis, dividends based on a percentage should be converted
to dollar amounts before computation. The cost of preferred stock is determined by dividing
the annual preferred stock dividend by the net proceeds from the issuance. The following
formula illustrates:

where D p = the annual dollar dividends N p = the net proceeds from the issuance
K p = the cost of preferred stock equity

COST OF RETAINED EARNINGS

Earnings that are retained are either kept by the company or paid out to shareholders in the
form of dividends. Therefore, retained earnings increase the shareholders equity in the
company in much the same way as a new issue of common stock. Therefore, the cost of
earnings retained as financing is the same as the company's cost of common stock equity.

If the company can deploy its profits to get the shareholder's required return on its internal
investments, stockholders are amenable to the firm's retention of earnings. However, if the
company cannot manage its assets to meet this requirement, erosion of shareholder value
occurs. This can happen if large amounts of low performance assets, such as cash, are
retained.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

After the cost of each component of the capital structure is estimated, a blended or weighted
average cost must be computed. The result of this calculation is the company's WACC, a
piece of information that is very important to the management of the firm's assets. The
WACC is used to make investment and business decisions, and is often used as a benchmark
in determining a business unit's performance.

To compute the WACC, multiply the specific cost of each form of financing by its proportion
in the firm's capital structure, then sum the weighted values.

where W i = proportion of long-term debt in capital structure W p = proportion of preferred

stock in capital structure W s = proportion of common stock equity in capital structure

The determination of the proportions may be based on the company's book or market value.
Since the market value more closely approximates the actual dollars that would be received
from the sale of the securities, this method is preferable to book, or accounting value.

In general, the WACC can be calculated with the following formula:

where N is the number of sources of capital (securities, types of liabilities); ri is the required
rate of return for security i; MVi is the market value of all outstanding securities i.

Tax effects can be incorporated into this formula. For example, the WACC for a company
financed by one type of shares with the total market value of MVe and cost of equity Re and
one type of bonds with the total market value of MVd and cost of debt Rd, in a country with
corporate tax rate t is calculated as:

FINANCIAL INFORMATION SYSTEM

A financial information system (FIS) is a business software system used to input and track
financial and accounting data. The system generates reports and alerts that assist managers in
effectively running the business.

WHAT DOES ECONOMIC VALUE ADDED - EVA MEAN?

A measure of a company's financial performance based on the residual wealth calculated

by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis).
(Also referred to as "economic profit".)
The formula for calculating EVA is as follows:

= Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)

ECONOMIC VALUE ADDITION

• The Economic Value Added (EVA) is a measure of surplus value created

on an investment.
• Define the return on capital (ROC) to be the ìtrueî cash flow return on
capital earned on an investment.
• Define the cost of capital as the weighted average of the costs of the
different financing instruments used to finance the investment.

EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project)

Things to Note about EVA

• EVA is a measure of dollar surplus value, not the percentage difference in

returns.
• It is closest in both theory and construct to the net present value of a project
in capital budgeting, as opposed to the IRR.
• The value of a firm, in DCF terms, can be written in terms of the EVA of
projects in place and the present value of the EVA of future projects.

DCF Value and NPV

Value of Firm = Value of Assets in Place + Value of Future Growth

= ( Investment in Existing Assets + NPVAssets in Place) + NPV of all future projects

= ( I + NPVAssets in Place ) +

where there are expected to be N projects yielding surplus value (or excess returns)
in the future and I is the capital invested in assets in place (which might or might
not be equal to the book value of these assets).

The Basics of NPV

NPVj = : Life of the project is n years

Initial Investment = : Alternative Investment

NPVj =

NPV to EVA (Continued)

• Define ROC = EBIT (1-t) / Initial Investment: The earnings before interest
and taxes are assumed to measure true earnings on the project and should
not be contaminated by capital charges (such as leases) or expenditures
whose benefits accrue to future projects (such as R & D).

• Assume that : The present value of

depreciation covers the present value of capital invested, i.e, it is a return of
capital.

DCF Valuation, NPV and EVA

Value of Firm = ( I + NPVAssets in Place ) +

In other words,
Firm Value = Capital Invested in Assets in Place + PV of EVA from Assets in
Place + Sum of PV of EVA from new projects

DIFFERENCE BETWEEN PERFORMANCE METRIC AND WEALTH METRIC

Performance metric Wealth metric

Return on Equity (ROE), EPS growth P/E Ratio
Return on Capital (ROC or ROIC), Ratio of: Entity value ÷ EBITDA
Operating Income Growth
Economic Profit Market Value Added (MVA)
Free Cash Flow Equity Market Capitalization (price x
common shares outstanding)
Cash Flow Return on Investment Total Shareholder Return (TSR)
(CFROI)

WHAT DOES EARNINGS BEFORE INTEREST & TAX - EBIT MEAN?

An indicator of a company's profitability, calculated as revenue minus expenses, excluding tax and
interest. EBIT is also referred to as "operating earnings", "operating profit" and "operating income", as
you can re-arrange the formula to be calculated as follows:

EBIT = Revenue - Operating Expenses

Also known as Profit Before Interest & Taxes (PBIT), and equals Net Income with interest and taxes
added back to it.

Earnings Before Interest & Tax – EBIT

 In other words, EBIT is all profits before taking into account interest payments and income
taxes. An important factor contributing to the widespread use of EBIT is the way in which it nulls
the effects of the different capital structures and tax rates used by different companies.

 By excluding both taxes and interest expenses, the figure hones in on the company's ability to
profit and thus makes for easier cross-company comparisons. EBIT was the precursor to the
EBITDA calculation, which takes the process further by removing two non-cash items from the
equation (depreciation and amortization).

CAPITAL STRUCTURE

 In finance, capital structure refers to the way a corporation finances

its assets through some combination of equity, debt, or hybrid securities. A firm's
capital structure is then the composition or 'structure' of its liabilities.For example, a
firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-
 financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in
this example, is referred to as the firm's leverage.

 In reality, capital structure may be highly complex and include dozens of sources.
Gearing Ratio is theproportion of the capital employed of the firm which come from
outside of the business finance, e.g. by taking a short term loan etc.

 The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller,

forms the basis for modern thinking on capital structure, though it is generally viewed
as a purely theoretical result since it disregards many important factors in the capital
structure decision. The theorem states that, in a perfect market, how a firm is financed
is irrelevant to its value.

 This result provides the base with which to examine real world reasons why capital
structure is relevant, that is, a company's value is affected by the capital structure it
employs. Some other reasons include bankruptcy costs, agency costs, taxes,
and information asymmetry. This analysis can then be extended to look at whether
there is in fact an optimal capital structure: the one which maximizes the value of the
firm.

There are 4 basic Capital Structure theories. They are:

i. NET INCOME APPROACH

According to net income approach: the firm can increase its value (or) lower the
overall cost of capital by increasing the proportion of debt in the capital structure

ASSUMPTIONS OF NET INCOME APPROACH

1. The use of debt does not change the risk perception of investors; as a result,
the equity capitalisation rate, ke, and the debt capitalisation rate kd, remain constant
with changes in leverage

1. The debt capitalisation rate is less than the equity capitalisation rate
2. The corporate income taxes do not exist

ii. NET OPERATING INCOME APPROACH

According to net operating approach (noi) the market value of the firm is not affected by the
change in capital structure the weighted average cost of capital is said to be constant.
ASSUMPTIONS OF NOI APPROACH

1. The market capitalises the value of the firm as a whole. Thus, the split between debt and
equity is not important.

2. The market uses an overall capitalisation rate, Ko to capitalise the net operating income.
Ko depends on the business risk. If the business risk is assumed to remain unchanged, Ko is a
constant.

3. The use of less costly debt funds increases the risk to shareholders. This causes the equity
capitalisation rate to increase.

iii. MODIGLIANI-MILLER (MM) APPROACH

iv. TRADITIONAL APPROACH

___________________________________________________________________________
________________________________________________________________________
CORPORATE GOVERNANCE

 Corporate governance is the set of processes, customs, policies, laws,

and institutions affecting the way a corporation (or company) is directed, administered
or controlled. Corporate governance also includes the relationships among the
many stakeholders involved and the goals for which the corporation is governed.
 In contemporary business corporations, the main external stakeholder groups
are shareholders, debtholders,trade creditors, suppliers, customers and communities af
fected by the corporations activities. Internal stakeholders are the board of
directors, executives, and other employees.

 Corporate governance is a multi-faceted subject.[1] An important theme of corporate

governance is the nature and extent of accountability of particular individuals in the
organization, and mechanisms that try to reduce or eliminate the principal-agent
problem. A related but separate thread of discussions focuses on the impact of a
corporate governance system on economic efficiency, with a strong emphasis on
shareholders' welfare; this aspect is particularly present in contemporary public
debates and developments in regulatory policy (see regulation and policy regulation).

 There has been renewed interest in the corporate governance practices of modern
corporations since 2001, particularly due to the high-profile collapses of a number of
large corporations, most of which involved accounting fraud.

 In the U.S., these include Enron Corporation and MCI Inc. (formerly WorldCom).
Their demise is associated with the U.S. federal government passing the Sarbanes-
 Oxley Act in 2002, intending to restore public confidence in corporate governance.
Comparable failures in Australia (HIH, One.Tel) are associated with the eventual
passage of the CLERP 9 reforms.

 Similar corporate failures in other countries associated stimulated increased

regulatory interest (e.g., Parmalat in Italy). Corporate scandals of various forms have
maintained public and political interest in the regulation of corporate governance.

 The Manner in which a Corporation is Run

– Achieving its Objectives
– Transparency of its Operations
– Accountability & Reporting
– Good Corporate Citizenship
 The Processes & Operating Relationships that Best Achieve Organisational Goals