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FINANCE:
AN INTRODUCTION
For: II Semester MBA, Pondicherry University
FINANCE IS THE SCIENCE AND ART OF MANAGING MONEY AND OTHER ASSETS.
1. Financing Decision:
All organizations irrespective of type of business must raise funds to buy the assets necessary
to support operations. Thus financing decisions involves addressing two questions:
How much capital should be raised to fund the firm's operations (both existing & proposed)
What is the best mix of financing these investment proposals?
2. Investment Decision:
This decision in financial management is concerned with allocation of funds
raised from various sources into acquisition assets or investment in a project.
Further, Investment decision not only involves allocating capital to long term
assets but also involves decisions of utilizing surplus funds in the business,
any idle cash earns no further interest and therefore not productive.
SCOPE OF FINANCIAL MANAGEMENT
3. Dividend Decision:
Share holders are the owners and require returns, and how much money
to be paid to them is a crucial decision. Thus payment of dividend is
decision involves deciding whether profits earned by the business should
be retained rather than distributed to shareholders in the form of
dividends.
A. PROFIT MAXIMIZATION
B. WEALTH MAXIMIZATION
A. PROFIT MAXIMIZATION
B. WEALTH MAXIMIZATION
Not a clear term: The term profit is vague and it cannot be precisely defined. It means different
things for different people. Should we consider short-term profits or long-term profits? Does it mean
total profits or earnings per share?
Does not Considers Risk: It does not take into consideration the risk of the prospective earnings
stream. Some projects are more risky than other.
Leads to corrupt practices: A firm pursuing the objective of profit maximization starts exploiting
workers and the consumers. Hence, it is immoral and leads to a number of corrupt practices.
Attracts competition: Supernormal profit attracts entry of new firms because knowledge is
everywhere and also the main aim of any producers is to make profit.
Induces Government intervention: Firms may fear that the existence of supernormal profits
would attract government intervention into the market and thereby restrict the firms activities.
Leads to employee unrest: The concept of larger profit making would result in employers and
business owners not only focusing their attention on making a financial profit at all cost which
inevitably leads to workforce exploitation
OBJECTIVES OF FINANCIAL MANAGEMENT
A. PROFIT MAXIMIZATION
B. WEALTH MAXIMIZATION
A. PROFIT MAXIMIZATION
B. WEALTH MAXIMIZATION
Cons or Demerits: The wealth maximization objective has also
been criticized by certain financial theorists mainly on following
accounts;
PhotoDisc
-EXTERNAL LONG-TERM SOURCES OF FUNDS
Share capital:
The most important source of funds for a limited
company. It is often considered as permanent capital as it
is not repaid by the business, but the shareholder can
have a share in the profit, called dividend.
Cost of capital is the required rate of return on its investments which belongs to
equity, debt and retained earnings. If a firm fails to earn return at the expected
rate, the market value of the shares will fall and it will result in the reduction of
overall wealth of the shareholders.
+
g
Given:
D = Dividend per equity share Rs. 15
g = 7%
Np = Net proceeds of an equity share Market Price Rs. 125 a share
Ke = Cost of equity capital ?
Solution:
+ g + Growth Rate of dividend
+ 7%
+ 0.07
0.19 or 19%
A company2:
Illustration plans to issue of
calculation 10000 new
cost of shares of Rs. 100 each at a par. The
equity
floatation costs are expected to be 4% of the share price. The company pays a
dividend of Rs. 12 per share initially and growth in dividends is expected to be
5%.
(a) Compute the cost of new issue of equity shares. (b) If the current market
price of an equity share is Rs. 120. Calculate the cost of existing equity share
capital
(B) If the current market price of an
ompute the cost of new issue of equity shares.
Given:
equity share is Rs. 120. Calculate
D = Dividend per equity share Rs. 12 the cost of existing equity share
g = 4% capital
Given:
Np = Net proceeds of an equity share (Issue
D = Dividend per equity share Rs. 12
price of Share Flotation Cost = (100-4= Rs. 96)
Ke = Cost of equity capital ? g = 4%
Solution:
+ g Np = Net proceeds of an equity share Market Price
+ 5% + g
Solution:
+ 0.05 + 5% + 0.05
Given:
D = Dividend per equity share Rs. 4.50
g = 7%
Np = Net proceeds of an equity share Market Price Rs. 95 a share
Ke = Cost of equity capital ?
Solution:
+ g + Growth Rate of dividend
+ 7%
+ 0.07
*Flotation cost applicable only when new
shares are issued to the public. Here
floatation cost to be neglected as the
0.1173 or 11.73% company is not issuing new shares.
Measurement of Cost of Capital Cost of equity (CAPM
approach)
The capital asset pricing 1. This approach is based on the principle that risk and
return of an investment are positively correlated
model (CAPM) is used to more risky the investment, higher is the desired
calculate the required rate returns.
of return for any risky 2. This model emphasizes not only the risk differential
asset. between equity share and government bond but also
risk differential among various common stocks.
Ke = Rf + b (RmRf)
Where,
Ke = Cost of equity capital
Rf = the rate of return for a risk-free security
b = beta of the stock
Rm = the Stock market's expected rate of return
Measurement of Cost of Capital Cost of equity (CAPM
The Hypothetical Limited wishes to calculate its cost capital using
approach)
the CAPM approach. The following information is supplied to you.
The risk-free rate of return is 10%. The firms beta is 1.50 and the
return on market is equals to 12.5%. Compute Cost of equity
capital.
Solution
Ke = Rf + b (RmRf)
Given,
Ke = Cost of equity capital - ?
Rf = the rate of return for a risk-free security
-10%
b = beta of the stock 1.50
Rm = the Stock market's expected rate of return
Ke = 10 + 1.5 (12.5 Ke = 10 + 3.75
12.5% Ke = 13.75%
10)
The CAPM says that the expected return of a share is equals the rate on a
risk-free security plus a risk premium. If this expected return does not meet
or beat the required return, then the investment should not be undertaken.
Measurement of Cost of Capital Cost of
Cost of debt generally
Debt The cost of debt can be calculated in either
refers to the effective before or after tax returns. However, the interest
expense being deductible, the after tax cost is
paid by a company on considered very often. Moreover, the cost of debt
its debts. is one part of capital structure of the company
and also includes the cost of equity.
(1
Tax rate)
(1-t)
Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate
Illustration 1: calculation of cost of Debt
Kingfisher Limited has debt capital of Rs. 1,00,000 on which
15% interest is payable. Tax applicable is 35%. Your are
required to calculate cost of capital assuming debt is issued
at (a) Par value (b) 10% discount and (c) At a premium of
10%.
Given:
Given: (a) Par value Kd = ?
(b) Discount
Kd = ? I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a
I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a Np = Net proceeds of debenture (b) Rs. 1,00,000-
Np = Net proceeds of debenture (a) Par Rs. 1,00,000 10% Discount =Rs. 90,000.
t = 35% t = 35%
(1 Tax rate)
(1 Tax rate)
(1-0.35)
(1-0.35)
0.15 (0.65) 0.167 (0.65)
Given:
Kd = ?
I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a
Np = Net proceeds of debenture (a) Par Rs. 1,00,000
t = 50%
(1-0.50)
0.08 (0.50)
0.04 or 4%
(1-0.60)
0.072 (0.60)
0.0432 or 4.32%
Given:
Kd = ?
I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a
Np = Np = Face Value - Discount= 1,00,000 - 5,000= Rs. 95,000
t = 60%
(1-0.60)
0.0842 (0.60)
0.05052or 5.052%
(1-0.50)
0.0834 (0.50)
0.0417 or 4.17%
The overall cost of capital can be calculated with the help of the
following formula; Where,
Ko = Overall cost of capital
K =KW+KW+KW+KW
w d d p p
Weighted average cost of capital is calculated in the
e e r rKd = Cost of debt
Kp = Cost of preference share
following formula also: Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to
Where,
Kw = Weighted average cost of capital total capital
X = Cost of specific sources of finance We = Percentage of equity to total capital
W = Weight, proportion of specific sources of finance. Wr = Percentage of retained earnings
Illustration 1: calculation of WACC
A firm has the following capital structure and after-tax costs for the
different sources
of funds
Sourceused :
of Funds Amount Proportion (%) After-tax cost
(%)
Debt 12,000 20 4
Preference Shares 15,000 25 8
Equity Shares 18,000 30 15
Retained Earnings 15,000 25 11
Total 60,000 100
Computation of Weighted Average Cost of Capital Solution:
Source of Proporti After-tax
(WX)
Funds on % (w) cost % (x)
A C D E = (c) x (d)
Debt 20 4 80
Preference 25 8 200
Shares
Equity Shares 30 15 450
Retained 25 11 275
Earnings
Illustration 11: calculation of WACC
Particulars Amount
ABC Ltd. has the following
capital structure. Equity (expected dividend 10,00,000
You are required to calculate 12%)
the
weighted average cost of 10% Preference Shares 5,00,000
capital. 4% loan 15,00,000
Total 30,00,000
(1-t)
Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share
apital Structure Planning or Approaches to select capital Structure
EBIT-EPS: APPROACH
Particulars Amount
Sales revenue --------
Less : Variable Cost --------
Contribution [C] --------
Less: Fixed Cost --------
Operating Profit or EBIT --------
Less: Interest of Debt capital --------
Earnings Before Tax [EBT] --------
Less: Tax --------
Earnings After Tax [EAT] --------
Less: Dividend on preference shares --------
Earnings Available to Equity Share Holders --------
[EAESH]
Earnings Per Share= EAESH No. of Equity ---
Shares
Illustration 1: Calculation of EPS
HDFD bank has an existing capital of Rs. 10,00,000
comprising of 1,00,000 equity shares of Rs. 10 each. The
management is planning to raise another Rs. 10,00,000 to
finance its growth programme. There are four possible
financing plansthrough
All 10,00,000 which are given
issue below: equity shares of Rs. 10
of 1,00,000
each
Rs. 5,00,000 in equity and the balance in debentures carrying
10% interest
Entire 10,00,000 through debentures carrying 8% interest
Rs. 5,00,000 in equity and Rs. 5,00,000 through preference
shares carrying 10% dividend
The anticipated operating profits after expansion programmes
amounts to Rs. 2,40,000, the company is subject to 50% tax
bracket. You are required to advice the management in choosing
appropriate
I capital structure
II plan on the basis
III on EPS. IV
Entire 10 Lakhs 5 Lakhs in Entire 10 Lakhs 5 Lakhs in
Equity Equity & through Equity &
5 Lakhs debentures @ 5 Lakhs
Debentures @ 8% Interest preference @
10% Interest 10% dividend
Illustration 1: Calculation of EPS
I II III IV
Entire 10 Lakhs 5 Lakhs in Entire 10 Lakhs 5 Lakhs in
Equity Equity & through Equity &
5 Lakhs debentures @ 5 Lakhs
Debentures @ 8% Interest preference @
10% Interest
Existing capital: Rs. 10 Lakhs 10%
Financial dividend
Plans
Particular
Fresh capital required: 10 Lakhs I II III IV
s
Expected operating Profit [EBIT] 2,40,000 2,40,000 2,40,000 2,40,000
Less: Interest on Debt capital
Plan II: 10% interest on debentures of
Rs. 5 Lakhs No Debt 50,000 80,000 No debt
Plan III: 8% interest on debentures
Earnings Before Taxof 10
[EBT] 2,40,000 1,90,000 1,60,000 2,40,000
LakhsTax at 50% on EBT
Less: 1,20,000 95,000 80,000 1,20,000
Earnings After Tax [EAT] 1,20,000 95,000 80,000 1,20,000
Less: Preference dividend No Pref. No Pref. No Pref.
50,000
Plan IV: 10% dividend on Rs. 5 Lakhs shares shares shares
Earnings Available to Equity Share Holders 1,20,000 95,000 80,000 70,000
No. of equity Shares
Existing (Rs. 10,00,000 Rs. 10 each) 1,00,000 1,00,000 1,00,000 1,00,000
New (Plan- I, II and III) 1,00,000 50,000 No new shares 50,000
Total equity shares (Existing + New) 2,00,000 1,50,000 1,00,000 1,50,000
EPS = EAESH Total equity shares Rs. 0.60 Rs. 0.633 Rs. 0.80 Rs. 0.47
Comments: Since the EPS in plan III is highest, therefore plan III
Illustration 1I: Calculation of EPS
Interpretation:
Highly gearedLess equity capital and more fixed cost bearing capital
Low gearedMore equity capital and less fixed cost bearing capital
High Gear or Low Gear
Data extracted from Balance Sheet of Kingfisher Airline
Sources of Funds Mar '12 Mar '11 Mar '10 Mar '09 Mar '08
Equity Share Capital 577.65 497.78 265.91 265.91 135.8
Share Application Money 0 2.95 7.48 8.11 10.09
Preference Share Capital 553.1 553.1 97 97 0
Reserves -6,213.15 -4,005.02 -4,268.84 -2,496.36 52.99
Revaluation Reserves 0 0 0 0 0
Net worth -5,082.40 -2,951.19 -3,898.45 -2,125.34 198.88
Secured Loans 5,368.76 5,184.53 4,842.43 2,622.52 592.38
Unsecured Loans 2,661.24 1,872.55 3,080.17 3,043.04 342
CAPITAL STRUCTURE
THEORIES
SYLLABUS
UNIT III
Financial Leverage=
Interpretation:
Criteria Outcome Impact on Profitability
(EBT)
When, EBIT > Interest Favourable Positive EBT
payable
When, EBIT < Interest Unfavourable Negative EBT
[C] COMBINED LEVERAGE
Particulars Amoun
t
Sales revenue --------
Less : Variable Cost --------
Contribution [C] --------
Less: Fixed Cost --------
Operating Profit or EBIT --------
Less: Interest of Debt capital --------
Earnings Before Tax [EBT] --------
Illustration 1: Calculation of Leverages
A company has sales of Rs. 60,00,000, variable cost of Rs.
40,00,000, fixed cost of Rs. 5,00,000 and debt of Rs.
30,00,000 at 10% rate of interest. Calculate operating,
financial, operating and combined leverages.
Particulars Amoun
t
Sales 60,00,0
00
Less: Variable cost 40,00,0
00
Contribution [C] 20,00,0
00
Less: Fixed Cost 5,00,00
0
Operating Profit or EBIT 15,00,0
00
Less: Interest on Debt Capital (10% on Rs. 30,00,000 ) 3,00,00
0
Comments: Earnings Before Tax [EBT] 12,00,0
Since, EBIT is > Interest payable, this means firm has sufficient operating profits to pay
00
interest on debt capital and therefore it has favourable financial.
Financial Leverage= = 1.25
Since, Contribution is > Fixed cost, this means firm has sufficient
Operating sales revenue
Leverage= = to meet
1.33its
fixed cost and
Combined therefore it has favourable
Leverage=Operating operating
Leverage leverage and
Financial positive operating
Leverage = profit.
1.6625
1.25
Combined
1.33leverage is also favourable.
Capital Structure Theories
Different kinds of theories have been propounded by different
authors to explain the relationship:
Capital StructureCost of CapitalValue of the firm
ating the value of a company = Total Market Value of Shares (S) + Debentures (D)
EBIT = 1,00,000
Less: Interest cost (10% of 300,000) = 30,000
Earnings after Interest Tax = 70,000
(since tax is assumed to be absent)
Earning available to equity share holders = 70,000
Market value of Equity Shares (70,000 = 5,00,000
14%)
Market value of Debt = 3,00,000
Total Market value = (S + D) = 8,00,000
Overall cost of capital = EBIT(Total value of firm)
= 100,000800,000
1. Value of a company (V) = Total Market Value of =
Shares (S) + Debentures (D) 12.5%
2. Market value of Equity shares (S) = Earning available to equity share holders Cost
of Equity
TEST OF NET INCOME APPROACH THEORY
According to this approach, a firm can minimize the weighted average cost
of capital (WACC) and increase the value of the firm as well as the market
price of the equity shares by using debt financing to maximum possible
extent.
Consider a fictitious company with below figures. All figures in Rs.
sume that the proportion of debt increases from 300,000 to 400,000 and everything else remain
(EBIT) = 100,000
Less: Interest cost (10% of 300,000) = 40,000
Earnings after Interest Tax = 60,000
(since tax is assumed to be absent)
Shareholders' Earnings = 60,000
Market value of Equity (60,000/14%) = 428,570 (approx)
Market value of Debt = 400,000
Total Market value = 828,570
= EBIT/(Total value of firm)
Overall cost of capital = 100,000/828,570
= 12% (approx.)
1. Value of a company (V) = Total Market Value of Shares (S) + Debentures (D)
2. Market value of Equity shares (S) = Earning available to equity share holders
Cost of Equity
CONCLUSIVE SUMMARY (NI APPROACH)
As observed, in case of Net Income Approach, with increase in debt
proportion, the total market value of the company increases and cost of
capital decreases.
The business risk remains constant at entry level of debt equity mix.
(Increase in debt in the capital structure results in increased risk for shareholders. As a
compensation of investing in highly leveraged company, the shareholders expect
higher return resulting in higher cost of equity capital.)
This approach was put forth by Durand and totally differs from the
Net Income Approach.
NET OPERATING INCOME APPROACH
1. As per this approach, debt should exist in the capital structure only up
to a specific point, beyond which, any increase in leverage would result
in reduction in value of the firm.
2. The rate of interest on debt remains constant for a certain period and
thereafter with increase in leverage, it increases.
3. The expected rate by equity shareholders remains constant or increase
gradually. After that the equity shareholders starts perceiving a financial
risk and then from the optimal point and the expected rate increases
speedily.
4. As a result of activity of rate of interest and expected rate of return, the
WACC first decreases and then increases. The lowest point on the curve
is optimal
Traditional capital structure.
approach, advocated by Ezta Solomon and Fred Weston is
a midway approach also known as intermediate approach.
MODIGLIANI AND MILLER (MM) APPROACH