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ASSIGNMENT
_____________________________________________________________________
Course Code : MS - 42
Course Title : Capital Investment and Financing Decisions.
Assignment Code : MS-42/SEM - I /2011
Coverage : All Blocks
_____________________________________________________________________

Note: Answer all the questions and send them to the Coordinator of the Study
Centre you are attached with.

1. Find the present value of Rs. 2,000 due in 6 years if money is worth
compounded semi-annually. (b) Ascertain the present value of an amount of Rs.
8,000 deposited now in a commercial bank for a period of 6 years at 12% rate of
interest.

Now
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2. You are required to determine the weighted average cost of capital (K) of the
K.C Ltd. Using (i) book value weights; and (ii) market value weights. The
following information is available for you perusal. The K.C. Ltd.’s present book
value capital structure is:

Debentures (Rs. 100 per debenture) 8,00,000


Preference Shares (Rs.100 per share) 2,00,000
________
Equity Shares (Rs. 10 per share) 10,00,000
20,00,000

All these securities are traded in the capital markets. Recent prices are
debentures @ Rs. 110, preference shares @ Rs. 120 and equity shares @ Rs. 22.
Anticipated external financing opportunities are:
i. Rs. 100 per debenture redeemable at par: 20-year maturity, 8% coupon
rate, 4% flotation costs, sale price Rs. 100.
ii. Rs. 100 preference share redeemable at par: 15-year maturity, 10%
dividend rate, 5% floatation costs, sale price Rs. 100.
iii. Equity shares Rs. 2 per share flotation costs, sale price Rs. 22.
In addition, the dividend expected on the equity share at the end of the year Rs. 2

per share; the anticipated growth rate in dividends in 5% and the company has
the practice of paying all its earning in the dorms of dividends. The corporate tax
rate is 50%
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Cost of Capital = 11.81%

3. Explain the various theories of capital structure and discuss the factors
influencing pattern of capital structure.
Sol

Ans. Various theories of capital structure


The important theories are discussed below
1. net income approach
2. net operating income approach
3. the traditional approach
4. miller approach
1. net income approach
One of the important questions in any long-term financing decisions is
whether the cost of capital of a firm is dependent on its capital structure. Whether the
cost of capital changes with the change in capital structure of the company. The
answer is available in the following two approaches (a) Net Income approach (NI)

(b) Net Operating approach (NOI)


NET INCOME APPROACH
The essence of the net income (NI) approach is that the firm can increase its
value or lower the overall cost of capital by increasing the proportion of debt in the
capital structure. The crucial assumptions of this approach are:
The use of debt does not change the risk perception of investors; as a result,
the equity-capitalisation rate and the debt-capitalisation rate, remain constant
with changes in leverage.
The debt-capitalisation rate is less than the equity-capitalisation rate.
The corporate income taxes do not exist.
Assumption (1) implies that, if equity capitalisation rate and debt capitalisation rate
are constant, increased use of debt, by magnifying the shareholders' earnings, will
result in higher value of the firm via higher value of equity. Consequently. the overall,
or the weighted average, cost of capital will decrease.
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It is obvious that, with constant annual net operating income (NOI), the overall cost of

capital would decrease as the value of the firm increases. As per the assumptions of
NI approach the rate of equity capitalisation and rate of debt capitalisation are
constant and debt capitalisation rate is less than equity capitalisation rate. Therefore,
overall cost of capital will decrease as the value of the firm increases.

Under NI approach, equity capitalisation rate and debt capitalisation rate are assumed
not to change with leverage. As the proportion of debt is increased in the capital
structure, being less costly, it causes weighed average cost of capital to decrease and
approach the cost of debt. The optimum capital structure would occur at the point
where the value of the firm is maximum and overall cost of capital is minimum.
Under the NI approach, the firm will have the maximum value and the lowest cost of
capital when it is all debt-financed or has as much debt as possible.

NET OPERATING INCOME APPROACH


According to the net operating income (NOI) approach the market value of the firm is
not affected by the capital structure changes. The market value of the firm is found
out by capitalising the net operating income at the overall, or the weighted average
cost of capital, which is a constant.

The overall capitalisation rate depends on the business risk of the firm. It is
independent of financial mix. If NOI and overall cost of capital are independent of
financial mix, market value of firm will be a constant and independent of capital
structure changes. The critical assumptions of the NOI approach are:
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, to capitalise the net operating
income.
Overall cost of capital depends on the business risk. If the business risk is
assumed to remain unchanged, overall cost of capital is a constant.
3. The use of less costly debt funds increases the risk to shareholders. This
causes the equity-capitalisation rate to increase. Thus, the advantage of debt is
offset exactly by the increase in the equity-capitalisation rate.
4. The debt-capitalisation rate is constant.
5. The corporate income taxes do not exist.
Thus, we find that the weighted cost of capital is constant and the cost of equity
increases as debt is substituted for equity capital.

THE TRADITIONAL VIEW


The traditional or classical theory also known as dependent or intermediate approach
of capital structure suggests that the average cost of capital does depend on the
financial pattern which includes a moderate amount of debt that generally results into
a least cost financing solution. As the average increases over moderate debt ranges the
average cost of capital falls because the debt capital has a lower cost than the equity
capital.
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It is assumed in this theory that a moderate amount of debt does not add significantly
to the risks attached to holding the equity shares and so the company does not have to
go for other higher yields to its equity share holders. The theory implies however, that
after a certain level any further increase in the proportion of debt to equality with the
additional prior claims to profits increase the risk of equity shareholders and they
consequently require a higher yield.

In simple words the traditional view is a compromise between the net income
approach and the net operating approach. According to this view; the value of the firm
can be increased or the cost of capital can be reduced by the judicious mix of debt and
equity capital. This approach very clearly implies that the cost of capital decreases
within the reasonable limit of debt and then increases with leverage. Thus, an
optimum capital structure exists and occurs when the cost of capital is minimum or
the value of the firm is maximum.

The cost of capital declines with leverage because debt capital is cheaper than equity
capital within reasonable, or acceptable, limit of debt. The statement that debt funds
are cheaper than equity funds carries the clear implication that the cost of debt, plus
the increased cost of equity, together on a weighted basis, will be less than the cost of
equity which existed on equity before debt financing. In other words, the weighted
average cost of capital will decrease with the use of debt.

Criticism of the Traditional View


(1) The validity of the traditional position has been questioned on the ground that the
market value of the firm depends upon its net operating income and risk attached to it.
The form of financing can neither change the net operating income nor the risk
attached to it. It can simply change the way in which net operating income and the
risk attached to it are distributed between equity and debt-holders. Therefore, firms
with identical net operating income and risk, but differing in their modes of financing,
should have same total value.
(2) The traditional view is criticized because it implies that totality of risk incurred by
all security-holders of a firm can be altered by changing the way in which this totality
of risk is distributed among the various classes of securities.
(3) The argument of the traditional theorists that an optimum capital structure exists
can be supported on two counts: the tax deductibility of interest charges and market
imperfections.

Modigliani and Miller also do not agree with the traditional view. They criticise the
assumption that the cost of equity remains unaffected by leverage up to some
reasonable limit. They assert that sufficient justification does not exist for such an
assumption. They do not accept the contention that moderate amounts of debt in
"sound" firms do not really add very much to the "riskiness" of the shares

Modigliani and Miller or M-M approach is an alternative theory regarding cost of


capital that has received a great deal of attention from Economists. It is also known as

independent theory of cost of capital. This independent theory of cost of capital as


propounded by Modiglani and Miller suggests that the cost of capital of the firm is an
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independent factor and it has no concern with the capital structure. This model implies
that the value of the firm is independent of the proportion of debt to total
capitalisation or the cost of capital is invariant with respect to capital structure. In
other words, the theory implies that any change in the capital structure of the concern
does not affect the cost of capital; obviously this approach has static character and
denies a basic fact that leverage influences the price of equity shares. In simple words
the cost of capital of a particular enterprise is independent of its method or level of
financing. The change in the debt equity ratio does not affect the cost of capital.

The M-M hypothesis explains that the value of firm and cost of capital is same for all
the firms irrespective of the proportion of debt included in a capital structure. In this
simplified model, they abstract away the effect of any taxes.

The crucial support for this hypothesis is the presence of arbitrage in the capital
markets which is being discussed. Arbitrage precludes perfect substitutes from selling
at different prices in the same market. In their case the perfect substitutes are two or
more firms. Later on M-M incorporated taxes in their hypothesis and contended its
impact on the value of the firm and cost of capital. The Modigliani-Miller hypothesis
is identical with the net operating income approach. Modigliani and Miller (M-M)
argue that, in the absence of taxes, a firm's market value and the cost of capital remain
invariant to the capital structure changes. They provide analytically sound and
logically consistent behavioural justification in favour of their hypothesis, and reject
any other capital structure theory as incorrect.

Assumptions
The M-M hypothesis can he best explained in terms of their Propositions I and II. It
should, however, be noticed that their propositions are based on certain assumptions.
These assumptions, as described below, particularly relate to the behaviour of
investors and capital market, the actions of the firm and the tax environment:
1. Securities (shares and debt instruments) are traded in the perfect capital market
situation. This specifically means that (1) investors are free to buy or sell securities;
(2) they can borrow without restriction at the same terms as the firms do: and (3) they
behave rationally; (4) that the transaction costs, i.e., the costs of buying and selling
securities, do not exist,
2. Firms can be grouped into homogeneous risk classes if their expected earnings have
identical risk characteristics. It is generally implied under the M-M hypothesis that
firms within same industry constitute the homogeneous class.
3. The expected NOI is a random variable, with a constant mean probability
distribution and a finite variance.
4. Firms distribute all net earnings to the shareholders, which weans a 100 per cent
payout.
5. In the original formulation of their hypothesis, M-M assume that no corporate
income taxes exist.

Criticism of M•M Hypothesis


This approach has however, been criticised in several quarters on several grounds.
The assumption that individual engages himself in costless perfect arbitrage, does not
hold good.
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The arbitrage process is the behavioural foundation for the M-M thesis. The
shortcoming of the M-M thesis lies in the assumption of perfect capital market in

which arbitrage is expected to work. Due to the existence of imperfections in the


capital market, arbitrage will fail to work and will give rise to discrepancy between
the market values of levered and unlevered firms.
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4. A company is considering which of two mutually exclusive projects it should


undertake. The Finance Director thinks that the project with the higher NPV
should be chosen whereas the Managing Director thinks that the one with the
higher IRR should be undertaken especially as both projects have the same
initial outlay and length of life. The company anticipates a cost of capital of 10%
and the net after-tax cash flows of the projects are as follows:

Year 0 1 2 3 4 5
Class flows:
Project X (200) 35 80 90 75 20
Project Y (200) 218 10 10 4 3
Required
a) Calculate the NPV and IRR of each project
b) State, with reasons, which project you would recommend.
c) Explain the inconsistency in the ranking of the two projects. The discount
factors are as follows:

Year 0 1 2 3 4 5
Discount factors (10%) 1 0.91 0.83 0.75 0.68 0.62
(20%) 1 0.83 0.69 0.58 0.48 0.41
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Q2 b
Based on NPV Method
Since NPV of project X is greater the NPV of Project X is preferred
Based on IRR method:
IRR of Project Y is greater than IRR of project X hence Project Y is Preferred.

Q2 c
The cashflow of the both the projects are uneven during the years. It is very difficult
to calculate the correct annual cash flow.

As per the NPV method, the project X is having NPV of 29.15 which is greater then
the NPV of the project Y i.e. 18.76. Hence project X can be selected.

If we take IRR for the selection criteria, the project Y is having IRR of 11.71% which
is higher than the IRR of the project X i.e. 11.2%. Hence the project Y can be
selected.

Since both the method is giving the different solution, we can consider the Pay back
period for the selection of the project. Payback period is expressed in years, the time
in which the cash outflows equal cash inflows.

Pay Period:

Total Cash inflow for Project X = 35 + 80 + 90 + 75 + 20 = 300


Annual Cash Inflow = 300 / 5 = 60
Payback period = Cost of project / Annual Cash inflow
= 200 / 60 = 3.33 years

Total Cash Inflow for Project Y = 218 + 10 + 10 + 4 + 3 = 245


Annual Cash Inflow = 245 / 5 = 49
Pay back Period = Cost of Project / Annual Cash inflow
= 200 / 49= 4.08 years

5. Discuss about economic appraisal and explain Social Cost Benefit Analysis.

Cost-benefit analysis (CBA) and related economic appraisal methodologies allow \


investors to determine the economic return to potential disaster risk reduction
interventions, to support a rational comparison of available options and to help ensure
that investment decisions are accountable. Such tools can be used to determine the net
economic benefits both of dedicated disaster risk reduction projects and of the
inclusion of disaster risk reduction features in other development projects.

Economic criteria are not the only ones by which projects are judged and only
multilateral lending agencies routinely undertake formal economic analysis as part of
their project appraisal process. However, in the face of tight budgetary constraints and
many competing demands for public resources, there is widespread pressure to
demonstrate that government funding and international aid resources are well spent.
As such, international development organizations and governments at least require
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robust secondary evidence that their investment decisions are economically sound.
Evidence on the potential net economic benefits of disaster risk reduction activities
also plays a more fundamental role in securing initial attention in and commitment to
disaster risk reduction
The cost-benefit analysis of disaster risk reduction investments involves a number of
particular challenges, including that

• The flow of benefits is probabilistic, with the actual level realized dependent
on the degree of severity of hazard events - if any - occurring over the life of a
project.
• Little related information may be available on the frequency and intensity of
the hazard event, particularly in a developing country context, implying
uncertainty about the level of risk.
• Many of the benefits of any disaster risk reduction measures, whether
undertaken in the context of a disaster risk reduction project or as part of
another type of development project, are related to the direct and indirect
losses that will not ensue should the related hazard event occur over the life of
the project, rather than streams of positive benefits that will take place, as
would be the case for other investments. This can present certain measurement
difficulties.
• Levels and forms of vulnerability may change considerably over the life of a
project, particularly in developing countries undergoing rapid socioeconomic
change and/r high demographic growth. These changes need to be considered
in exploring potential flows of net benefits resulting from related disaster risk
reduction measures.
• Predicted impacts of global warming on the frequency and intensity of
climatological hazards over the life of the project need to be taken into
account

Social Cost Benefit Analysis

So, to reflect the real value of a project to society, we must consider the impact of the
project on society.

Thus, when we evaluate a project from the view point of the society (or economy) as
a whole, it is called Social Cost

Benefit Analysis (SCBA)/Economic Analysis


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The social cost-benefit analysis of Delhi Metro has been already done by the people
of institute of economic growth. They tried to measure all the benefits provided by
Delhi Metro such as reduction in air pollution, time saving to passengers, reduction in
accidents, reduction in traffic congestion and fuel savings in terms of monetary term.
Also they made an attempt to measure the costs from Phase I and Phase II projects
covering a total distance of 108 kms in Delhi. Estimates of the social benefits and
costs of the projects were obtained using the recently estimated shadow prices of
investment, foreign exchange and unskilled labor as well as the social time preference
rate for the Indian economy for a study commissioned by the Planning Commission,
Government of India and done at the Institute of Economic growth. The findings
were:
• The financial cost-benefit ratio of the Metro was estimated at 2.30 and 1.92 at
8% and10% discount rates respectively.
• Its financial internal rate of return was estimated as 17% while the economic
rate of return is 24%.
• The estimated net present social benefit (NPSB) of the Metro at 2004-05
prices and the 8 percent social time preference rate for the Indian economy
was Rs. 419979.6 million.
• The social rate of return on investment in the Metro was calculated as 22.7
percent. This could be explained by the provision of incremental income to the
Delhi public by Delhi Metro.

Line 1 Shahdara – Rithala


• Shahdara-Tis Hazari section has been completed and commissioned on
24.12.2002.
• Tis Hazari - Inderlok section has been commissioned on 3.10.2003.
• Inderlok - Rithala section has been commissioned on 31.3.2004.

Line 2 Vishwavidyalaya - Central Secretariat


• Vishwavidyalaya - Kashmere Gate section has been commissioned on
20.12.2004.
• Kashmere Gate - Central Secretariat has been commissioned on 3.7.2005.

Line 3 Barakhamba Road - Kirti Nagar - Dwarka


• Barakhamba Road- Dwarka section has been commissioned on 31.12.2005.
• Extension of Line 3
• Extension into Dwarka sub-city commissioned on 1.4.2006.
• Barakhamba Road - Indraprastha commissioned on 11.11.2006

The Phase II of the project will consist of the following:


• Vishva Vidyalaya - Jahangir Puri
• Central Secretariat - Qutab Minar
• Shahdara - Dilshad Garden
• Indraprastha - New Ashok Nagar
• Yamuna Bank - Anand Vihar ISBT
• Kirti Nagar - Mundka (along with operational link to Inderlok)
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The second phase of Delhi metro will be essentially an extension of the 1st phase. For

example a person who had to commute the distance between Qutab Minar and
Jahangir puri earlier when only phase 1 was operational had to go to central
secretariat using a different mode of transport and then catch a metro till
Vishwavidyalaya and then again take a different mode of transport to reach
Jahangirpuri. But the same person after the completion of phase 2 will catch the metro
directly from Qutab Minar and reach Jahangirpuri. This explains the fact that the
ridership will not go up steeply when phase 2 is operational because the people who
had been using the metro earlier would still be using it but for a longer distance now
and will be paying more money for the increased distance travelled.

6. Explain in detail the various non traditional sources of long term financing.

Sol NON-TRADITIONAL SOURCES OF LONGTERM FINANCING They are


(a) Leasing and Hire-purchase
(b) Suppliers’ Credit
(c) Asset Securitization
(d) Venture capital.

Leasing and Hire-Purchase


Firms need finance to acquire assets. Instead of borrowing and acquiring assets, it is
possible for firms to acquire the assets on lease. There are two types of leasing -
operational lease and financial lease. Operational lease is used when the assets are
used for temporary period and the asset is returned at the end of the short period.
Suppose a firm gets an extra order for which it requires some additional equipment.
Such additional equipment can be taken on lease for few days, say three weeks and at
the end of the three weeks, the equipment is returned to the owner. Some of the assets
that are normally acquired under operational lease arrangement are computers,
vehicles, generators, small movable equipment, etc. While operational lease is not
considered a source of finance, financial lease is used when the assets are required
permanently or for a long period. Normally, the assets are ultimately purchased by the
firm from the lessor at a nominal value. During the period of lease, the firm which
acquired the assets on lease (called lessee) can use the assets but it is not the owner of
the asset. The ownership rests with the company which provided the assets on lease.
During the period of lease, the lessee has to pay lease rent to the lessor. Lessee is not
entitled for any depreciation whereas lessor can claim depreciation for the assets for
tax purpose. Hire-purchase is similar to financial lease. A hire-purchase transaction is
usually defined as one where the hirer (user) has, at the end of the fixed term of hire,
an option to buy the asset at a token value. In other words, financial leases with an
option to buy the asset at the end of the lease term can be called a hire-purchase
transaction.
Suppliers Credit
The concept of supplier credit is fairly simple and in existence for a long time.
Under this, the equipment suppliers provide long-term credit and accept the payment
for the supply of equipment over a longer period of time say 5 to 8 years. In that
process, the company which acquires the assets neither take bank loan nor approach
has leasing company for credit but directly takes the credit from the supplier of the
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equipment. In other words, the supplier of equipment acts as a lender or lessor. The
question is how it is superior to other forms of acquiring the assets. First of all, the
buyer need not approach any other agency for credit.

Normally, suppliers provide short period of credit, and in this special case, the
suppliers provide long-term credit. Since there is no intermediary to fund the
acquisition between the seller and buyer, it reduces the cost. In addition, it is possible
that the supplier may be a cash rich company or may get funds at a much lower rate
than the buyer. For instance, the credit rating of the supplier is far above than the
credit rating of buyer or seller may be in another country where the interest rates are
low. There are specialised government agencies to provide funds to the suppliers in
order to improve the export sales or to help a particular sector. Though suppliers
provide long-term credit to the buyers, there is no need for the suppliers to stuck with
such huge long-term receivables because they can get finance under certain specific
scheme against such receivables. They can also sell such receivables through
securitization
Asset Securitization
Securitization is fairly a simple concept. It is the process through which an asset
(fixed or current) is converted into financial claim. It other words, it brings liquidity to
an illiquid asset. The concept is very popular in housing finance. Let us explain the
concept with a simple example. Suppose a housing finance company has Rs. 100 cr.
During the first six months, it accepts the loan proposals and lent Rs. 100 cr. at an
average interest rate of 10% and the duration of the loan is 15 years. Suppose the
housing finance company gets some more loan applications say for Rs. 20 cr. in
seventh month. The company has to look for new source of finance to fund the new
loan proposals since it has already invested the entire capital and converted them into
illiquid long-term 15 years receivables. The growth of the housing finance company
is thus restricted to its ability to raise additional funds. Securitization assumes
importance in this context. Suppose a group of pension companies is willing to buy
Rs. 100 cr. 15-years receivables from the housing finance company discounting the
receivables at say 9%. With this new cash flow, the housing finance company can
finance new loans without making any fresh borrowing. In other words, the housing
finance company has sold its 15-year illiquid receivables and raised money against it.
The process of selling makes the concept slightly different from simple bill
discounting concept. Under securitization, an intermediary agency is created, which
initially buys the illiquid asset and against that it issues securities, which are tradable
in the market through listing. Thus, it is also called asset-backed securities or
mortgaged backed securities. The value of the securities is improved by taking credit
rating and often through insurance cover.
Venture Capital
While leasing/hire-finance, suppliers’ credit or securitizations are debt financing,
venture capital is a equity finance. Venture capital is investment in early-stage, high-
growth projects, which are high-risk with the potential to give extraordinarily high
returns over a period ranging from three to seven years. The risk factor being high, the

probability of failure is also high. The returns to the venture capitalist are from the
handful of the projects, which succeed. Venture capital investment is generally in
equity or quasi-equity instruments in unlisted companies, often set up to
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commercialize a novel idea. The venture capitalist will, in the normal course of
business, like to have a 20% to 50% stake in the company invested in. The returns to
the venture capitalist are at the time of disinvestment from the venture backed unit.

This could be in several ways, such as buy-back of the stake of the venture capitalist
by the promoters, disinvestment of the investment at time of an IPO, or during a
merger or acquisition transaction. Venture capital investment is “hands-on”
investment, where the investor mentors and advises the promoters of the business in
which the investment has been made. The venture capitalist is an investor who
guides the project through its different stages of growth by identifying avoidable
pitfalls and directs the business along possible avenues of growth. The venture
capitalist is, therefore, a partner who brings much more than money to the project

7. Write short notes on the following.


a) Leveraged recapitalization

Sol. Leveraged Recapitalization is a strategy where a company takes on significant


additional debt with the purpose of either paying a large dividend or repurchasing
shares. The result is a far more financially leveraged company -- usually in excess of
the "optimal" debt capacity. After the large dividend has been paid, the market value
of the shares will drop. A share is referred to as a "stub" when a financial recap results
in the decline if its price to 25% or less of its previous market value. In a successful
recap the value of the dividend plus the value of the stub exceeds the pre-recap share
price.

The simplest measure of value added comes from the tax shield gained when a firm,
which has debt capacity resulting from free cash flows in excess of ongoing needs,
increases its leverage. The classic Modigliani-Miller calculation of the present value
of the tax shield is obtained by multiplying the amount of debt by the tax rate of the
firm. Other results of leverage include the disciplinary effects of having to meet debt
service payments, and the possible negative effects of the costs of financial distress.

The technique can be used, and has been used, as a "shark repellant" to ward off a
hostile takeover, actual or potential. This is done by adding debt, eliminating idle cash
and debt capacity. Prospective bidders would face the daunting task of returning the
firm to leverage ratios closer to historical industry levels. The recap may also give
management a higher percentage of share ownership and control. Although such
recaps are designed as a takeover defense, a high percentage of firms that adopt them
are subsequently acquired. The technique can also be employed proactively, as a
means of placing free cash flows into shareholders' hands, and employing debt's
disciplinary effect to improve performance, thus increasing shareholder value. A
related motivation is giving founder-owner liquidity.

The market response to announcements of leveraged recaps depends on whether they


are defensive or proactive. For defensive recaps, the effects are so varied -- negative
as well as positive -- as to make research results inconclusive. On average the effects
seem to be positive. Long run returns in excess of expected for proactive recaps seem
to be of the order of 30%, similar to the level in tender offers
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b) Merger as a source of value addition


Sol While taking decision whether to acquire a firm, finance manager of a firm must
ensure that this step would add value to the firm.

If you are considering a merger or acquisition, you should assess your target business.
Talk to those who regularly interact with it - the customers and suppliers.

Consider asking customers about:

• the business' products or services


• the comparison with competitors in terms of payments
• who their main contacts are
• how much their relationship with the business relies on dealing with the owner
• Ask your target business for:
• Financial information. If you have to rely on un audited financial accounts, get
warranties from the seller.
• Details about their customer base.
• Trends in sales and profit margins.
• Future forecasts. Consider whether forecasts are realistic and tally with your
knowledge of the market and its prospects.
• Stock levels and debt collection trends, investments and the business' debts.
• Information about its marketing.
• Information about key employees and their plans - in particular, the extent of
the involvement of the owner.
• Information about its systems, suppliers and legal and contract issues.

For this purpose he has to follow the procedure laid down below:
(i) Determine if there is an economic gain from the merger. There is an economic gain
only if the two firms are worth more together than apart. Thus, economic gain of the
merger is the difference between the present value (PV) of the combined entity (Pvxy)
and the present value of the two entities if they remain separate (Pvx + pvy). Hence

Gain = Pvxy - (Pvx+Pvy)


(ii) Determine the cost of acquiring firm Y. If payment is made in cash, the cost of
acquiring Y is equal to the cash payment minus Y’s value as a separate entity. Thus,
Cost = Cash paid - Pvy
(iii) Determine the net present value to X of a merger with Y. It is measured by the
difference between the gain and cost. Thus, NPV = gain - cost
= W Pvxy - (Cash-Pvy)
If the difference is positive, it would be advisable to go ahead with the merger.

c) Financial Engineering

Sol Financial engineering is the design, development, and implementation of


innovative financial products and of financial processes in the major market segments
of currency, interest rates, equities, and commodities, for trading, investment,
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hedging, and risk management. Within this cross-disciplinary field, finance considers
returns, risks and transaction costs, economics brings into focus aspects of
equilibrium and preference optimization under incomplete markets, mathematics
provides analytics and equivalent martingale measures, physics considers solutions
for heat equation PDEs and path integral methods, computational science offers fast
computational methods and technology, and engineering considers Fourier
transforms, wavelets, neural nets, and visualisation.

Product Development
As products such as futures, options, swaps and securitised loans become
standardized and move from intermediaries to markets, the proliferation of new
trading markets in those instruments makes feasible the creation of new custom--
designed financial products that improve ``market completeness''; to hedge their
exposures on those products, their producers, financial intermediaries, trade in these
new markets and volume expands; increased volume reduces the marginal transaction
costs and thereby makes possible further implementation of more new products and
trading strategies by intermediaries, which in turn leads to still more volume. Success
of these trading markets and custom products encourages investment in creating
additional markets and products, and so on it goes, spiraling towards the theoretically
limiting case of zero marginal transaction costs and dynamically--complete markets

An increasing share of the business undertaken by investment banks has been in the
form of exotic options, hybrid securities and collateralized obligations. These
products are used to enhance return or to insure against legal, fiscal, regulatory or
liquidity risks— some of which are company specific and may require customized
solutions.

An example has been the development of collateralized obligations. The most


common of these are mortgage-backed securities (MBSs), which break apart a
payment stream into sub-deals or tranches, e.g., separating the principal and interest
streams, POs and IOs, respectively. In turn, derivatives of these trenches can be
created, e.g., in which the yield from a fixed rate IO is swapped with a floating rate.

Other examples include hybrid securities that overlay various fixed income or equity
investments with derivatives to enhance yield or create a more tax efficient income
stream. For example, a debtor can combine a fixed rate bond with a receiver swaption
to give an issuer the benefits of both a fixed and floating rate bond. This structure
allows the issuer to retain fixed rate payments if rates rise but switch to floating rate
payments if rates fall, albeit with an “insurance” cost.

These products involve complex provisions and are difficult to price. They often
demand the assessment of events and probabilities for which there is no or only an
illiquid “market”. This difficulty, however, is an opportunity. Financial institutions
are in a better position to model these instruments, trade them at an attractive
spread, and, as counterparties to many such deals, build internal portfolios whose
component risks offset one another.
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Risk Control
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Laws and regulations dealing with credit and capital requirements have been around
for decades, in certain forms for centuries. However, recent catastrophic, high profile
failures of hedge funds and investment banks have led to a call for a more consistent,
verifiable, quantitative, firm-wide approach to risk monitoring and control. Firms now
recognize that, with the increasing complexity of financial products and markets, the
organization's survival depends upon being able to define and enforce coherent risk
management policies.
Defining, developing, implementing, operating and maintaining the necessary
infrastructure to accomplish this is a demanding task. It requires a deep understanding
of a wide spectrum of financial instruments and how exposure to them is financed.
There are also significant technical challenges in real-time processing, high
performance databases, and visualization.
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Portfolio Management
Portfolio management deals with the identification of financial objectives and their
translation into a portfolio of assets that must be managed over time in the face of
uncertain investment performance and consumption demands. This is no simple task:
There are thousands of potential investments related to one another in complex ways,
an enormous number of parameters which must be estimated in a statistically
meaningful fashion and a system of operational, business and legal goals and
requirements which must be expressed in a consistent mathematical framework.

Once this foundation has been set down, the challenges associated with making
the choice of assets in a portfolio are formidable. Even with the guidance of existing
theory, there are many real world issues that complicate the solutions. We are dealing
with underlying parameters that are non stationary and poorly understood and with
transactions costs that are highly nonlinear and uncertain. Such complications, in turn,
mean that standard single period approaches may be only poor representations of the
actual problem.

Individuals in this area may work either as in-house portfolio managers or as outside
consultants. Large portfolios such pension funds, corporate sinking funds, and
university endowments typically employ both in-house and consulting talent.
However, all investors, even individuals managing their 401(k)s, require these
services.
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d) Modigliani - Miller Hypothesis


Sol According to Modigliani and Miller (MM) the dividend decision of a firm has no
effect on its share prices and is therefore of no consequence. They argue that the value
of the firm depends upon firm's earnings which results from its investment policy.
Given the investment decision of the firm - the split of earnings between dividends
and retained earnings is of no significance in determining the value of the firm.

Assumptions of MM Hypothesis
The MM hypothesis of dividends irrelevance is based upon the following
assumptions.
1. Perfect Capital markets where investors behave rationally. Information is freely
available and transactions are free of cost. Securities are infinitely divisible. No
investor is large enough to affect the market-price of a share.
2. Investment policy of firms is fixed. It does not depend upon dividend policy.
3. Taxes do not exist. Alternatively there are no difference in tax rates on dividend
and capital gains.
4. Every investor is certain about future investment and profits of the firm. It .means
at investors can forecast future prices and dividends with certainty.

Crux or MM Hypothesis
MM hypothesis of irrelevance of dividend is based upon arbitrage process. Arbitrage
process involves a switching or balancing operation. It involves entering
simultaneously into two transactions which completely offset each other. These two
transactions in the case of dividend policy are payment of dividends and raising an
equivalent amount by issue of new equity shares or debt. Take the case of a firm
which has a fixed investment programme. Given the investment decision the firm can
(i) retain entire earnings for reinvestment;
(ii) (ii) or pay dividends and raise the equivalent amount through the issue of new
equity shares or debt for investment The second course of action involves arbitrage
process as the payment of dividends is completely matched by the issue of new shares
or debt.
When the firm pays dividends the market price of its shares increases, but the
issue of additional share causes a decline in the terminal value of the shares. The
advantage of paying dividend is completely neutralised by the issue of new shares. As
a result the present value of per share after dividends and external financing is equal
to the present value per share before the payment of dividends. Since the market value
of the shares is not affected by the dividend payment, shareholders would be
indifferent between dividend and retention of earnings.

MM assert that dividend irrelevance hypothesis will not be affected, even if


the external funds are raised through the issue of debt instead of equity capital. This is
due to the irrelevance of leverage (capital structure decision) on the value of firm. The
firm's cost of capital remain unaffected as the real cost of debt is the same as the real
cost of equity.

The MM hypothesis also implies that the total market value plus current
dividends of two firms which are similar in all respects except payment ratio would be
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same. Also the firm's cost of capital would be independent of its dividend decision
since dividends are irrelevant.
MM dividend irrelevance hypothesis also implies that the shareholders are
indifferent between dividends and capital gains. If a shareholder is paid dividend, he
can do either of the two things; (i) spend it on consumption or (ii) invest it. On the
other hand if dividend is not paid, it increases the market value of the share i.e. he gets
capital appreciation. If he does not require income for current consumption, high
earnings are automatically invested by company An his behalf. If he requires income
to support his current consumption, he can sell the capital appreciation portion of his
investment in the equity shares of the company. The individual shareholder can retain
or invest his own earnings and do these as well as the firm would do. Thus the
payment or non payment of dividend does not affect the shareholders in any way.